Graham-Doddsville-Spring-2013 by mfolly


									                                    Graham & Doddsville
                             An investment newsletter from the students of Columbia Business School

                             Issue XVIII                                                                      Spring 2013
Inside this issue:
Conference           P. 3    Preston Athey                              Li Lu —
Omaha Trek           P. 4     — Holding                              Know What You
                             Winners Longer                           Don’t Know
Moon Lee Prize       P. 5
Preston Athey        P. 10                                          Li Lu ’96 is the founder of
                                                                    Himalaya Capital, an invest-
Li Lu                P. 24                                          ment partnership focused on
                                                                    both public and private op-
Pershing Square                                                     portunities in Asia and North
Finalist Pitches     P. 36                                          America. Mr. Li grew up in
                                                                    China and was a student                  Li Lu
Paul Isaac           P. 46                                          leader in the 1989 Tianan-
                                                                    men Square protests. Prior to founding Himalaya
                                                                    Capital in 1997, Mr. Li worked in investment bank-
                                                                    ing. He earned his B.A. in economics from Colum-
                                                                    bia College, a J.D. from Columbia Law School, and
Editors                            Preston Athey
                                                                    an M.B.A. from Columbia Business School.
Jay Hedstrom, CFA
MBA 2013                     Preston Athey is a vice                                                       (Continued on page 24)

                             president of T. Rowe
Jake Lubel                   Price Group and has led
MBA 2013                     the $8 billion T. Rowe                 Paul Isaac — Know Your Style and
                             Price Small-Cap Value
Sachee Trivedi               Fund since 1991. During
                                                                              Enjoy the Ride
MBA 2013                     that time, the fund has
                             returned nearly 11.9% per                                      Paul Isaac is the founder
Richard Hunt                 year after fees, making it                                     of Arbiter Partners, a
MBA 2014                     a superior performer                                           New-York based hedge
                             among its peers. Prior to                                      fund and nephew of
Stephen Lieu                 joining the firm in 1978,                                      noted value investor
MBA 2014                     he was a contract                                              Walter Schloss. Prior to
                             administrator on Admiral                                       Arbiter, he was the Chief
                             H. G. Rickover’s staff at                                      Investment Officer at
                             the U.S. Atomic Energy                                         Cadogan Management, a
Visit us at:
                             Commission. Preston                                            fund of funds. Mr. Isaac                earned a B.A. in                                               began his career at the
                             economics from Yale                                            Allied International-
                             University and an M.B.A.                                       American Eagle Trading
                             from Stanford University.                                      Corporation. He
                             He has also earned the                                         graduated from Williams
                             Chartered Financial                                            College with Highest
                             Analyst designation and is                   Paul Isaac        Honors in Political
                             a Chartered Investment                                         Economy and was a
                             Counselor.                              Thomas J. Watson Foundation Fellow.
                                           (Continued on page 10)                                            (Continued on page 46)
                 Page 2

                               Welcome to Graham & Doddsville
                               It is our pleasure to bring you      Chinese car manufacturer            Doddsville, we want to spend a
                               the 18th edition of Graham &         BYD. In reading this interview,     brief moment looking back at
                               Doddsville. This student-led         we expect you will also have a      our time leading this publica-
                               investment publication of Co-        sense of Mr. Li’s commitment        tion. The many interviews we
                               lumbia Business School is co-        to intellectual honesty, some-      conducted with successful,
                               sponsored by the Heilbrunn           thing he believes is critical to    respected and contemplative
                               Center for Graham & Dodd             being a successful investor.        value investors are some of our
                               Investing and the Columbia Stu-                                          fondest memories of our time
Pictured: Professor Bruce      dent Investment Management           We also had the opportunity         at Columbia Business School.
Greenwald. The Heilbrunn       Association (CSIMA).                 to sit down with Paul Isaac of      It has been an experience we
Center sponsors the Ap-                                             Arbiter Partners, who de-           have truly appreciated from
plied Value Investing pro-     Our first interview is with Pres-    scribed the experiences and         our first day on the “job”. We
gram, a rigorous academic      ton Athey, the long-tenured          influences of growing up in a       leave Graham & Doddsville in
curriculum for particularly    portfolio manager of the T.          family closely tied to the value    the eminently capable hands of
committed students that is     Rowe Price Small Cap Value           investing community. He also        Chris Brigham, Jackson Thies
taught by some of the in-      fund. Mr. Athey discussed how        fielded questions regarding         and Jason Yang, and we look
dustry’s best practitioners.   he thinks about selling stocks,      investing internationally - which   forward to reading the thought
                               something which so many value        included the discussion of a        provoking interviews they will
                               investors find to be one of the      promising (if illiquid) invest-     assemble in next year’s three
                               toughest parts of the profes-        ment opportunity among re-          editions. We also want to
                               sion. He also walked through         gional banks affiliated with        share our great appreciation
                               the theses on a couple of stocks     Crédit Agricole - and the risks     for the diligent efforts of Rich-
                               he currently likes and imparted      that potentially face markets       ard Hunt and Stephen Lieu.
                               other bits of wisdom gained          when the Fed eventually ceases      They did an excellent job this
                               from more than 20 successful         its extraordinary monetary          year and we were lucky to have
                               years as a money manager.            operations.                         them as part of the team.
                                                                                                        CSIMA will be in good hands
                               Li Lu, founder of Himalaya Cap-      Due to popular demand, after a      next year with those two at the
                               ital and annual guest lecturer in    two issue hiatus, student pitch-    helm as co-presidents. Lastly,
                               Professor Greenwald’s value          es are back! We are glad to be      as always, we thank our great
                               investing course, was gracious       able to share with you seven        lineup of investor interviewees
Pictured: Heilbrunn Center     enough to spend time with us         great ideas from the 2013           for sharing their time and in-
Director Louisa Serene         and detail his thoughts on in-       Moon Lee Prize Competition          sights and we thank you for
Schneider. Louisa skillfully   vesting. Mr. Li highlighted how      and the 2013 Pershing Square        reading.
leads the Heilbrunn Center,    he initially received the value      Challenge.
cultivating strong relation-   investing “inoculation” from                                                          G&Dsville Editors
ships with some of the         Warren Buffett himself as well       With this being our last issue as
world’s most experienced       as his thesis for an investment in   editors of Graham &
value investors and creating
numerous learning oppor-
tunities for students inter-
ested in value investing.
The classes sponsored by
the Heilbrunn Center are
among the most heavily
demanded and highly rated
classes at Columbia Busi-
ness School.

                                  Bill Miller of Legg Mason chats with a                  Jane Siebels of Green Cay Asset
                                  guest at the 2013 CSIMA Conference                    Management answers questions at the
                                                                                             2013 CSIMA Conference
  Volume I,
 Issue XVIIIIssue 2                                                                               Page 3

2013 CSIMA Conference—February 1, 2013 at Columbia Business School

            Bruce Greenwald and Seth Klarman                 Jeremy Grantham speaking with Tom Russo

 Louisa Schneider presents a tribute to Ben Graham             Bruce Berkowitz during Q&A

  Student conference coordinators Matt Christ, Geoff   Jean-Marie Eveillard talks with audience members in
   Abbott, and Ashley Miller deliver opening remarks                      between panels
            Page 4

         Columbia Business School Trek to Omaha — Fall 2012
                                                              An annual tradition at Columbia Business
                                                              School, a group of 19 students traveled to
                                                              Omaha in November 2012. The first event on
                                                              the agenda was a dinner with Todd Combs ’02,
                                                              an investment manager at Berkshire Hatha-
                                                              way. Combs spent time discussing his invest-
                                                              ment approach and his in-depth research pro-
                                                              cess, and took questions from students. The
                                                              following day, along with other schools, CBS
                                                              students enjoyed an hour-long Q&A session
                                                              with Warren Buffett ’51, followed by a custom-
                                                              ary lunch at Piccolo’s. The trip also included a
                                                              tour of local Berkshire retailers Borsheims and
                                                              Nebraska Furniture Mart.
    Warren Buffett speaks to students visiting Omaha

                  Meeting the Oracle of Omaha                           Shopping at Berkshire-owned Borsheims

Dining at Piccolo’s, Warren Buffett’s favorite restaurant   Participants pose with “Lulu,” their trusty Omaha bus
  Volume I,
 Issue XVIIIIssue 2                                                                         Page 5

                            2013 Moon Lee Prize Competition
On March 1, 2013, Amici Capital hosted the 4th annual Moon
Lee Prize Competition. The prize is given in memoriam of Moon
Lee, a dedicated value investor with Amici Capital from 2003 to
2008, who demonstrated a tireless ability to identify and analyze
deep-value opportunities that few could see. In his honor, his
friends at Amici Capital initiated this competition. Finalists
(selected based on pitches submitted by students taking a course
in Applied Value Investing) included Andrew Gordon (Crocs),
Arjun Bhattacherjee (Precision Castparts), David Magid (Motors
Liquidation Company GUC Trust), and Patrick Staub
(Groupon). Magid walked away with the $15,000 first-place
prize while Bhattacherjee was awarded $5,000 for his second-
place finish.
                                                                      Alexander Porter

                         The four finalists                         Professor Tano Santos

                     The judges listen intently                          Paul Orlin
                Page 6

                               Motors Liquidation Company GUC Trust Units (MTLQU) - Long
                               David Magid
                               Investment Thesis: Motors Liquidation Company General Unsecured Creditors (GUC) Trust Units
                               (MTLQU or Trust Units), publicly traded units of the liquidating trust set up to resolve remaining
                               disputed general unsecured claims of the General Motors bankruptcy, currently provide a compelling
                               risk-reward opportunity. The Trust Units, which receive a higher pay-off the more disputed claims
                               are disallowed, are currently pricing in an unrealistically high level of allowed claims. Further, the
                               Trust Units pay out in New GM Securities, which themselves are trading at a compelling valuation. At
                               $22.90/unit, the Units provide 15% - 85% upside, plus a free option on the underlying GM stock price.

      David Magid

David is a second-year MBA
student, participant in
Columbia’s Applied Value
Investing Program and the
co-president of CSIMA.         All the Pieces in Place for a Mispricing (1) Complex structure and underlying assets: The mechanics
Prior to school, he was an     of the Trust Units payout is complicated and does not easily lend itself to traditional equity or credit
investment banker at Credit    analysis. (II) Forced selling: All initial holders of Trust Units receive their stake as a result of the resolu-
Suisse and next year will be   tion of their previously disputed claims, and the vast majority of these holders are natural sellers. (III)
a research analyst at York     Obscure: The Trust Units are outside most traditional funds’ investment mandates, have a relatively
Capital, focused on credit     small market value (~$700mm), and have very limited sell-side coverage.
and distressed debt. He        Descriptions of the Trust: The Motors Liquidation Company GUC Trust is a successor to the
holds a BA from Brandeis       Motors Liquidation Company (the old General Motors Corp.). The Trust was formed on March 30,
University.                    2011, for the purpose of resolving disputed general unsecured claims against the former GM (i.e. al-
                               lowing GM to exit bankruptcy without resolving all outstanding claims). The Trust’s assets comprise
David was the winner of the    of GM common stock and warrants to purchase
2013 Moon Lee Prize for his    GM common stock. For each $1,000 of GUC
pitch on the Motors            that is allowed, the Trust pays out “New GM
Liquidation Company GUC        Securities” in the following proportion:
Trust Units.                   Since inception, the Trust has been very effective
                               in resolving outstanding claims to the benefit of Trust Unit holders. Only 9.7% of the $4.4bn in re-
                               solved claims to date have been allowed. There are ~$5.3bn disputed claims remain outstanding, and
                               current trading prices of the Units imply ~50% of remaining claims will be allowed.
                               Analysis of the Remaining Disputed General Unsecured Claims:
                               As of 12/31/12, there were $5,259mm of remaining disputed GUC’s. If these claims are allowed at
                               under 50%, there will be a positive return to the units. There are three major buckets of remaining
                               disputed claims, and for each bucket, allowed claims are highly likely to be well below 50%.
                               1) Term Loan Avoidance Claim ($1,500 million)
                               In November 2006, the old GM entered into a $1.5bn term loan agreement with a group of lenders,
                               secured by a first-priority lien in certain assets of GM. Post Chapter 11 filing, GM secured a $33 bil-
                               lion DIP loan from the U.S. Treasury Department and Export Development Canada. GM received
                               court permission to use a portion of the proceeds to repay in full the Term Loan obligation, given its
                               first-priority claim status. Subsequently, it was discovered that a lien securing the term loan was not
                               properly perfected. As a result, the Unsecured Creditors Committee is seeking to have the proceeds
                               of that repayment clawed back (proceeds would not benefit Trust Unit holders), and the $1.5bn claim
                               would become a general unsecured claim (thus the potential for $1.5bn incremental allowed GUC).
                               The matter has been awaiting a ruling from the judge from approximately two years. While there is
                               uncertainty in how Judge Gerber will rule, it is highly unlikely that most of the $1.5bn potential for
                               incremental allowed unsecured claims will be realized:
  Volume I,
 Issue XVIIIIssue 2                                                                                                                         Page 7

MTLQU (Continued from previous page)
   I.    The court will likely reject the request. The 2008 UCC-3 Termination Statement, which canceled
         the lien perfection, was filed erroneously, for a totally unrelated transaction, and by a law firm not
         representing JP Morgan (the admin agent) in term loan. Further, JPM did not authorize the filing.
   II. It is undisputed that the term loan was also properly secured by additional collateral, consisting of
         26 fixture filings filed by JPM in counties where term loan collateral was located and a UCC-1
         financing statement against Saturn as debtor. The value of this uncontested collateral alone was
         more than sufficient to cover the term loan (book value of $5.6bn 3 days prior to filing).
Therefore, a reasonable range of outcomes (i.e. new allowed claims) for the Term Loan Avoidance is
between $0 (0% allowed) and $600mm (40%).
2) Nova Scotia Litigation Claim ($2,680 million)
In 2003, GM’s wholly-owned, unlimited liability subsidiary, GM Nova Scotia Finance, issued ~$1bn of
notes, which were guaranteed by GM. In March 2009, a group of holders of these notes sued GM enti-
ties for “oppressive conduct,” as a result of transfers of funds from Nova Scotia Finance to GM. In an
effort to settle before filing and keep the Canadian unit out of bankruptcy, holders dropped the suit and
released GM from liability in exchange for (i) a $367mm consent fee; (ii) the right to assert $2.7bn in
claims against the GM estate (double dip claim plus swap claim). While this is the area with the greatest
variability in potential outcomes, there is a strong case that much of the $2.7bn claim will be disallowed:
   I.    The deal was completed post-petition (and backdated) and without court approval. Judge Gerber
         was “shocked” to learn of the transaction and berated the “lack of disclosure to the court.”
   II. The “consent fee” of $367mm was egregious and uneconomic. It represented over 35% of the
         notional amount of notes at issue, as should there-
         fore be reclassified as a principal pay down.                                  Trust Unit Valuation build-up
   III. Strong fraudulent conveyance argument: In the deal,                                           Current      High        Low
         GM did not receive the reasonably equivalent value Ad'l allowed claims ($BN):                     2,635           70      2,151
         necessary in any pre-petition transaction.                Total Allowed Claims                 $32,834       $30,269    $32,349
Therefore, a reasonable range of outcomes for the Nova             Total Units                               32.8        30.3       32.3

Scotia Litigation Claim is between $0 (0% allowed) and             GUC Trust Assets (in millions):

$1,340mm (50%). This issue is currently in trail before Judge GM Warrants Stock:
                                                                       Common                               17.24
Gerber.                                                            “B” Warrants                             15.67        24.95      17.42
3) Miscellaneous Claims ($1,079 million)                           Asset Distributions / Unit:
The composition of the remaining $1,079mm of claims                GM Common Stock:
                                                                   “A” Warrants
closely mirrors all the claims resolved to date. It is reasona- “B” Warrants                                 0.48        0.82       0.54
ble to assume these claims will follow the historical resolu- Value of Distributable Assets / Unit:
tion pattern (~10%), albeit incrementally more will be al-         GM Common Stock:
                                                                   “A” Warrants
lowed as it is later in the process. However, this is offset by “B” Warrants                               $5.13        $8.87      $5.80
fact that the $377mm of these claims are likely all duplic-        Total (pretax)                         $27.12       $46.85     $30.61

itous debt claims, and will be disallowed. Therefore, it is        Less: Trust Tax on Capital Gains / share:
                                                                   Total tax / unit                       ($4.22)      ($4.58)    ($4.28)
conservative to assume, for the remaining “other” claims,
                                                                   Total Value/unit (post tax)            $22.90       $42.27     $26.32
$70mm (10% ) – $210mm (30%) of claims will be allowed. Implied % Allowed                                   50.1%         1.3%      40.9%
Combining that analysis , the Trust Units are worth                Change vs current                        0.0%        84.6%      15.0%

between $26 and $43, or up 15 to 85% (see right).
Underlying GM Securities are Cheap as Well: While not central to my analysis, the GM securities
underlying the Trust are currently cheap, only making the Trust Units more compelling:
    Cheap absolute valuation: 4.9x EV/EBITDA – Maint-Capex (20% yield); 1.4x P/B; 9.3x P/E (LTM)
    Good business: ~15% ROIC; strong brand power, global presence (#1 in China).
    Post-bankruptcy GM has a much stronger balance sheet and improved cost structure.
    Levered to continued global economic recovery.
    Impacted by temporary bankruptcy overhang, concerns about pensions and weakness in Europe
Investors can also hedge out the price risk of these securities, and just invest in the “discount to NAV”
type situation that currently exists in the Trust Units.
Key Investment Risks
    Adverse tax implications of rising GM stock price (mitigant: gains from rising stock price more than
         offsets losses from increased tax liability).
    Timing uncertainly of ultimate claim resolution (likely resolved within year due to trust expiry).
    Underlying value of GM securities (margin of safety in both valuation and claim allowance).
    Unexpected, adverse ruling from Judge Gerber.
                Page 8

                               Precision Castparts Corp (PCP) - Long
                               Arjun Bhattacherjee

                               Business Description
                               Precision Castparts (NYSE:PCP) (“PCP”, “the Company”) manufactures highly engineered and critical,
                               alloy based components for the commercial aerospace, power generation and oil & gas industries.
                               PCP is a leading supplier to all jet engine manufacturers and as such, almost all aircraft in the
                               sky fly with parts (turbine parts, fasteners, subassemblies, nickel alloys) made by PCP. The
                               Company’s unique ability (stems from ownership of unique assets and decades of knowledge/
 Arjun Bhattacherjee           experience) to make complex parts out of nickel and titanium has resulted in very high market
                               share. This combined with the fact that PCP’s parts are not especially expensive in the context
Arjun is a second-year MBA     of overall costs (e.g. PCP represents ~ 5% of a 787) allow PCP to earn high returns.
student participating in the
Applied Value Investing        Recommendation
Program. While at school,      I recommend a long position in PCP with a price target of $275.00, which represents 50%
he has worked at three         upside from current levels. I believe PCP will beat near term numbers and that, consequently, long
long/short equity hedge        term expectations will be revised significantly higher.
funds. Prior to enrolling at
Columbia Business School,      Investment Thesis
he was in private equity and   Given its sustainable competitive advantages (unique production capabilities and vertical integration),
investment banking. Arjun      strong management and pristine balance sheet, PCP is well positioned to take advantage of the near
holds a BA from Macalester     term accelerated growth in aerospace to continue its successful strategy of vertical integration, con-
College.                       solidation of lucrative niches of the aerospace supply chain and entry into fast growing adjacent mar-
Arjun was the second place            With 787 production still on track to double by the end of 2013 and with increasing
winner of the 2013 Moon                exposure to this platform, PCP is poised to reap over a $1.0 billion in sales and $300 million
Lee Prize for his pitch on             of EBIT from the 787 alone over the next three years
Precision Castparts and was           This increased production will drive higher utilization across PCP’s platforms thereby im-
part of the second place               proving incremental margins
winning team of the 2012              This accelerated near term growth in aerospace and the related improvement in margins will
Pershing Square Challenge              result in record free cash flows—a $6.5B hoard in three years
for an activist pitch on
                                      PCP has been a successful consolidator in the past and this cash hoard represents a huge
                                       and undervalued opportunity
                                           PCP acquired five companies in the fragmented aerostructures segment in 2012 and in-
                                            tends to build out this segment
                                           Both Airbus and Boeing want the supply chain, especially aerostructures, to consolidate
                                            to ensure reliability
                                           PCP’s scale and vertical integration allow it to extract synergies that none of
                                            its competitors are able to
                                                     Vertical integration in nickel and titanium allows PCP to lower costs through
                                                       maximizing utilization of assets and maximizing scrap use across the chain
                                           PCP’s competitors are highly levered and unable to participate in this consolidation
                                      Increased titanium and nickel usage in aircraft (e.g. 787, A350Neo) represents an expansion
                                       of PCP’s TAM
                                      Specialty oil & gas pipe represents an attractive new market given the need for cor-
                                       rosion resistant alloys for deepwater and shale plays
                                      PCP’s industrial gas turbine business is at a cyclical low point—recent GE numbers suggest a
                                       nascent recovery in IGT
  Volume I,
 Issue XVIIIIssue 2                                                                                           Page 9

Precision Castparts (Continued from previous page)
The Street has historically underestimated the Company’s ability to successfully deploy free
cash flow and extract synergies from acquisitions. Having completed seven acquisitions, including its
largest ever, in the last twelve months alone and poised to generate the most cash in its history, long
term consensus expectations now are significantly below true earnings power thereby cre-
ating an attractive entry opportunity.

Situation Overview
During 2005 – 2008, PCP vertically integrated nickel alloys and used rising cash flows to consolidate
aerospace fasteners. During the last twelve months, PCP has effectively been setting itself up
to repeat the success of the 2005 – 2008 period. PCP acquired five companies in the aerostruc-
tures niche to create a platform to begin consolidating that segment and acquired its largest supplier of
titanium. But in the context of the aerospace cycle, post 2012, there will be 50% more aircraft being
delivered annually (than the 2005 – 2008 period) resulting in significantly higher cash flows.

Based on a conservative set of assumptions, PCP will likely earn > $17.00 / share by FY 2016 vs. $15.08
consensus. A 16.0x P/E multiple is at historical averages and mid-cycle levels and leads to a $275.00 price
target—and represents a 20% IRR. In summary, the record backlog in commercial aerospace
supports a near term acceleration in growth, but the natural replacement cycle, emerging
market demand and the introduction of new, more fuel efficient platforms will support
growth thereafter.

Risks / Mitigants
 Prolonged 787 Issues / Issue appears to center around batteries and appears to have been resolved
 Cycle Peaks in 2015 / New engine platforms (737 and A320) and continued demand from EMs

Catalysts: Q4 2013 (March) and Q1 2014 earnings re: Timet synergies; 787 production updates
          Page 10

                       Preston Athey
                       (Continued from page 1)           simple. At the time, we had        take a lot of time to really
                       G&D: Could you tell us            a draft and the Vietnam            get to know the companies
                       about your background and         War was going on, so I             in the fund and learn about
                       how you became interested         made the decision that for         potential new additions. I
                       in investing?                     me, being a Naval Officer          realized you couldn't do
                                                         was probably a smarter             both jobs effectively, so I
                       Preston Athey (PA): I             thing than getting drafted         asked to be switched off the
                       was very fortunate because        and being an enlisted soldier      growth portfolios to work
                       my father was an investment       in Vietnam. I wasn’t moving        full-time on Small-Cap
                       counselor in Chicago. As a        to Canada to try to avoid          Value, which T. Rowe Price
                       boy, my dad would often           the draft, but I wanted to         allowed me to do.
                       talk about the investing          have a little more say on
                       business, about his clients,      how I served.                      The second point is that
                       and about managing                                                   there are significant
  Preston Athey        portfolios. Because we had        G&D: Before managing the           differences in running
                       a very good relationship,         Small-Cap Value Fund, you          growth and value portfolios.
                       one day I told him that I'd       managed the small-cap              Interestingly, my natural
                       like to own a stock. That is      growth portfolios. How did         proclivities in my personal
                       not particularly unusual          you make the transition            account are to buy and hold
                       except for the fact that I        from growth investing to           growth stocks that are great
“As a boy, my dad      was seven years old. I            value investing? What were         companies. They may not
 would often talk      bought one share, which           some of the challenges in          be super high growth, but
                       was all I could afford at the     doing so?                          they're really solid
about the investing    time. Then I bought                                                  companies. You buy them
                       another stock the following       PA: I came to T. Rowe              and hold them forever, and I
business, about his    year and another stock the        Price in 1978 and spent four       have a number of those in
                       year after that, which meant      years as a technology              the portfolio today. I was
 clients, and about    that as a little kid, I was       analyst covering mostly            not somebody who
                       reading annual reports. I'd       telecom companies and              naturally liked to go find the
managing portfolios    look at the pictures and I        some electrical equipment          classic Ben Graham half-
 … one day I told      didn't understand the             companies. In 1982, I began        smoked cigar butt on the
                       financials, but I could kind of   managing small-cap growth          ground and try to get a few
him that I'd like to   understand what the               portfolios, which are              more puffs out of it. I had
                       companies did. By the time        separate accounts run in the       to teach myself that. It was
own a stock. That      I was in college, I'd pretty      same style as the New              not my natural inclination to
                       much figured out what I           Horizons Fund, our small-          do it; I was not a natural
 is not particularly   wanted to do in life. I took      cap growth product. Then           value investor.
                       Economics as a major              in 1991, a spot opened up
unusual except for     because that seemed to be a       on the Small-Cap Value             On the other hand, I believe
the fact that I was    good foundation. Then in          Fund, and the firm asked me        that you should develop the
                       business school, I took all       to take that on. Within two        skills that enable you to do
 seven years old.”     the finance and investment        or three weeks, it was             almost anything in your
                       courses offered. That's           pretty clear to me that            business. That's really the
                       basically how I got into it.      managing the value fund was        definition of a professional.
                                                         a completely different job         For example, if an
                       G&D: After graduating             than managing the growth           investment professional is
                       from Yale, you decided to         fund.                              asked to run a portfolio for
                       postpone your career in                                              an order of nuns and it
                       investing and you spent five      First of all, it was a different   needs to be 75% blue chip,
                       years in the Navy. What           set of stocks. There was           high dividend-paying stocks
                       led you to that decision?         almost no overlap between          and 25% good quality bonds,
                                                         the two, and it was going to                    (Continued on page 11)
                       PA: Well, it was pretty
 Volume I,
Issue XVIIIIssue 2                                                                                        Page 11

Preston Athey
(Continued from page 10)          what value investors look        small-cap investors?
even if you’re a small-cap        for, so it was a question of
investor, you still ought to      just putting it into practice.   PA: First of all, over that
be able to put a different set                                     21 ½ year history, value has
of eyeglasses on and say, "I                                       done a little bit better than
can do this. I know what                                           growth, so I’ve had a
the client needs. I know                                           tailwind versus the Russell
basically what has to                                              2000 which is a blend of
happen. We'll take a                                               value and growth. That is
conservative approach and                                          part of our outperformance.
do it." That's really the way                                      The second thing is that
I approached it. I trained                                         when you're running a fair
myself to do what's                 “The one thing that            amount of money and you
necessary to do a good job                                         have a lot of names, you
in small-cap value and put
                                           makes me
                                                                   cannot do it by yourself. T.
aside my natural beliefs            somewhat different             Rowe Price is just a
about growth stocks. It                                            wonderful organization.
took about a year to change           than most of my              We have a lot of analysts,
my mindset, but I did it.                                          and part of our job is to
                                        value peers is             train them. We're asking
G&D: How did you train                                             them to find interesting
yourself to be a value               perhaps the good              companies, not necessarily
investor? Did any particular                                       great companies because
books or investors inspire
                                     fortune of having
                                                                   sometimes cheap companies
you?                                spent that first nine          that have a catalyst to
                                                                   change can be a great
PA: I got to know the key            years as a growth             investment. We train them
competitors in the industry.                                       to look for things that make
I studied Chuck Royce of            investor. The result           sense. So the second
Royce & Associates, who                                            reason I'd give is that we
has done a marvelous job            is that when I get a           have great research analysts,
over many years. I think of                                        as I wouldn't be able to do
Chuck as the preeminent
                                       winner, I'm less
                                                                   it by myself.
and certainly the earliest           likely to sell it too
small-cap value                                                    The one thing that makes
practitioners. The                   quickly. I'm more             me somewhat different than
organization that he's built is                                    most of my value peers is
still focused on small-cap          likely to let it run. ”        perhaps the good fortune of
value investing. I also                                            having spent that first nine
looked at John Neff, who                                           years as a growth investor.
had run the Windsor Fund                                           The result is that when I get
at Vanguard for years, and is                                      a winner, I'm less likely to
certainly a very well-known                                        sell it too quickly. I'm more
value investor. Also, I had                                        likely to let it run. I follow a
personally been a                                                  pretty good value discipline
shareholder in Berkshire          G&D: You've been running         in adding new names to the
Hathaway and I understood         the Small-Cap Value Fund         portfolio. But some people
what Warren Buffett was           since 1991, and your fund        might argue, probably
trying to do. I had read a        has outperformed the             legitimately so, that several
couple of Ben Graham's            Russell 2000 over that time      of my top 25 holdings don't
books. I understood               period. What would you           look like value stocks; they
intellectually what it meant      say is your edge over other                    (Continued on page 12)
to be a value investor and
           Page 12

                       Preston Athey
                       (Continued from page 11)         before. That tells me you           and where is the company
                       look like growth stocks.         need to rethink what a fair         relative to everything else?
                       They were value stocks           or overvalued price would           You need to constantly put
                       when I first bought them,        be. A lot of people don't do        all of that together to know
                       then the catalysts came          that.                               whether or not you're
 “You can imagine      about and they began to be                                           selling a stock too early.
that when money's      appreciated in the market.       The danger is, of course,
                       Then their PEs went up and       that some people constantly         G&D: How has the
sloshing in and out    growth rates accelerated.        raise their price targets as        landscape changed for the
                       I'm not that quick to sell       the stock goes up. They're          investing opportunities out
  of these passive     those. So even though I          always going to be 30%              there? Has it become
                       follow a value discipline, the   higher than where the               tougher to beat the market?
portfolios, some of    portfolio looks like a blend     current price is, even if
                       portfolio in its                 nothing fundamentally good          PA: Interestingly, I think
  these small-cap      characteristics because          has happened at the                 that in some respects it's
  stocks become        some of the top holdings         company and if the market           become easier in the small-
                       are big winners.                 hasn't done a whole lot. I          cap world. First of all,
collateral damage.                                      look at the valuation of the        there's relatively less Wall
                       G&D: Do you set price            company relative to the             Street research. Wall
    When that          targets for the companies in     market and its peer group. I        Street firms don't make as
                       your portfolio? How do           look at where the company           much money trading the
 happens, if you're    you know when to sell?           is in its cycle. If it's early in   stocks and there have not
 nimble and know                                        an economic cycle, then it          been as many IPOs and
                       PA: When I buy a stock, I        may have gone up awhile             secondary opportunities to
the company well,      personally don't have a price    but it still might have             make money on the banking
                       target in mind, and here's       another two or three years          side. If you look at all of the
 you can pick up a     the reason why. If you set a     left to go.                         various firms, there's
                       price target without any                                             somewhat less research
  bargain, or trim     reference behind it, it          An example today would be           being done on small-cap
                       becomes an excuse to sell        homebuilder stocks.                 companies, particularly
some at a high price   too quickly, and you may         They've had a great run off         companies below $1 billion
                       leave a lot of money on the      the bottom. On the                  in market cap. That means
 that's well outside   table. For example, let's        surface, they look ahead of         there is some opportunity
of its normal range.   assume that you buy a stock      themselves, and if one were         for mispricing in the market
                       and you've set a price target    to say you should take some         with less analysis being
That happens more      30% above your buy price.        profits in homebuilder              done. Second, a greater
                       Six months go by and it          stocks today, I'd have a hard       percentage of the trading
today than it did 20   comes close to hitting your      time arguing against that.          volume is now being done
                       price target; is it now really   However, the housing cycle,         one of two ways: either
    years ago.”        a sell? What happens if the      even six to twelve months           with high frequency traders,
                       company has actually             from now, could still be in         who are really just
                       reported two wonderful           the early to middle innings.        arbitraging pennies, or with
                       quarters where earnings          We've got a long way to go          trading that's done in
                       were up 25% each and             as some of these companies          passive portfolios such as
                       where the market itself is       have earnings potential of          ETFs and index funds. One
                       up 15% in that period? You       two to three times what             would think that trading
                       now have a company that          they generated in 2012. If          done in passive portfolios
                       might be just as undervalued     they earn three times what          shouldn't have much impact
                       – relative to the market, its    they did in 2012, today's           on the price level of
                       peer group and any other         price will look pretty cheap.       individual companies, but
                       metrics you might want to        That's how I think about it.        surprisingly it does have an
                       look at – as it was when you     Where are we in the cycle,                        (Continued on page 13)
                       first bought it six months
 Volume I,
Issue XVIIIIssue 2                                                                                                  Page 13

Preston Athey
(Continued from page 12)         effects in related companies.    initiated. Historically on
impact when fairly large         You still get that today. I'm    that 10% turnover rate,
amounts of money get             hard pressed to say that the     about 3% or 4% was related
moved in and out of passive      ETFs per se have created         to takeovers. The other 6%
portfolios. From time to         more volatility because          to 7% would be considered              “Unless [a position
time, some of these stocks       we've had plenty of high-        manager initiated. The last
will move fairly significantly   volatility periods. You          two years have had lower-               is] demonstrably
with almost no fundamental       could look at the VIX for        than-average takeover
news to account for it. You      the past 35 years and tell       opportunities, so the low
                                                                                                           overpriced, I'm
can imagine that when            me whether there is more         turnover rates have been
money's sloshing in and out
                                                                                                         reluctant to sell it.
                                 volatile today or not – I'm      partly due to that.
of these passive portfolios,     not an expert on that.                                                     First of all, a
some of these small-cap          However, more of the             Additionally, if a scenario
stocks become collateral         volatility today is unrelated    that I had painted for a               sizeable fraction of
damage. When that                to fundamental news from         particular company is still
happens, if you're nimble        the companies, which may         playing out, then unless it's           my shareholders
and know the company well,       lead to investing                demonstrably overpriced,
you can pick up a bargain,       opportunities.                   I'm reluctant to sell it. First
                                                                                                         are taxable, so if I
or trim some at a high price                                      of all, a sizeable fraction of
that's well outside of its
                                                                                                         sell something at a
                                 Volatility affects all equity    my shareholders are
normal range. That happens       investors who worry about        taxable, so if I sell something          gain and make
more today than it did 20        volatility. I don't think it     at a gain and make them pay
years ago. All of that means     makes a difference whether       the tax, I have to find                them pay the tax, I
active managers who know         they're in a passive product     something that's better than
what they’re doing can           or an active product. If they    what I sold. It has to be                  have to find
actually gain an edge.           don't like volatility, it will   substantially cheaper and
                                 make them less willing to        have a better future to
                                                                                                          something that's
G&D: ETFs have been              invest in equities. If they      make up for the capital gains
growing rapidly, and like you
                                                                                                         better than what I
                                 can shrug it off and look        lost to tax. Studies show
alluded to, they seem to         long term, then I don't think    that it's very difficult to             sold. It has to be
have some potential for          it has an impact.                create enough alpha from
volatility since many buy and                                     trading to still come out                 substantially
sell large baskets of            G&D: Over the past two           ahead after taxes. The
securities. How do your          years, you've had turnover       studies are very clear, and            cheaper and have a
shareholders absorb the          of 4.8% and 5.5%, which is       yet 98% of the trading in the
potential for additional         unusually low in the             stock market either ignores
                                                                                                           better future to
volatility from those passive    industry. Can you talk a         them or doesn't even
portfolios? Does it
                                                                                                          make up for the
                                 little bit about the rationale   believe them. I believe the
contribute to additional         behind that?                     studies. To get me to sell             capital gains lost to
volatility?                                                       something, particularly
                                 PA: The last two years           something that's up, means                    tax.”
PA: When I think about           have been extraordinarily        I've either completely lost
some of the moves that           low. The prior 10 years, I       faith in the company or I
small-caps stocks have had       averaged around 10%.             think it is highly overvalued
before ETFs existed, my gut      Historically, part of my         and I can do substantially
tells me no. The difference      turnover is not investment       better in some other stock.
is, in the past, you’d see       driven but rather forced on      If you follow that philosophy
volatility based on sector       me by takeovers. If              religiously, it leads to quite
moves such as the whole          someone takes over one of        low turnover. In a very
technology sector being          your companies, you have         volatile market where
down 10% in the month, or        to sell it. That is turnover,    stocks are up a lot one
based on fundamental news        but it's not one that you                      (Continued on page 14)
that would have spillover
             Page 14

                           Preston Athey
                           (Continued from page 13)          chart, you can see it’s         or has a catalyst for realizing
                           month and down a lot the          bounced off the bottom and      change. Third, I have a
                           next month, I'll probably do      it seems like it's gone         stock that is clearly washed
                           some trimming here and put        sideways for six months.        out. It could go down more
                           that money back to work           They just reported a            or it could be flat for a long
                           the following month. If           quarter that was better than    time, but it's unlikely that
                           takeovers pick up, turnover       anyone was expecting.           there's much euphoria
Pictured: Tom Russo        will go up.
speaks at the Omaha Din-                                     However, the stock went         surrounding the company. I
ner in May 2012.                                             up only about half a point.     don't have a lot of downside
                           G&D: How do you                   It's clear that nobody on       risk because everybody who
                           generate your investment          Wall Street cares – all of      owns it wants to own it.
                           ideas, and what do you look       the momentum investors          When it's an experienced
                           for in a good investment?         are long gone. Here's the       analyst who has followed
                                                             scenario – over the next        the company for a while and
                           PA: About 90% of new                                              we can look at it together, it
                           ideas are generated by our                                        just gets me excited.
                           analysts. We’ll discuss the
                           idea and if I agree that it                                       G&D: It sounds like you're
                           makes sense for the                                               not necessarily looking for a
                           portfolio, I'll generally buy a                                   company with a moat.
                           starter position and ask
                                                              “I generally tend to
                           them to formally follow the                                       PA: You would always like
                           company. Over time, as we            avoid companies              to see a company with a
                           get to know the company                                           moat. Several companies
                           better, we may increase the             with stressed             that I own that have small-
                           holding. We may buy it                                            to mid-sized moat in their
                           cheaper if we happen to             balance sheets. …             niche area. But I generally
                           have a dip in the market, or                                      tend to avoid companies
                           we could buy it at a higher          I've been through
                                                                                             with stressed balance
                           price, assuming the                                               sheets. The types of
                                                                 too many cycles
                           company is meeting its                                            companies that I probably
                           goals. That's how we                  where debt kills            would not be interested are
                           generate most of our ideas.                                       those with high leverage,
                                                                        you.”                where debt significantly
                           In terms of what I look for                                       exceeds book equity, or
                           in an investment, here's an                                       companies that have made a
                           example of the type of                                            string of acquisitions in the
                           company that gets me                                              past and had to write half of
                           excited. An analyst walks                                         them off. There is no
                           into my office and says,                                          capital discipline in a
                           "Preston, I've been following     three years, if results         company like that. I've been
                           this particular company for       improve as I think they will,   through too many cycles
                           two years. I've been              the stock could be a very,      where debt kills you.
                           listening to conference calls,    very big stock.”
                           looking at the earnings, and                                      G&D: Given that you focus
                           I think there's definitely        So first of all, I have a       on small-cap value stocks,
                           something here. They have         company with a decent           you have the elevated risk
                           a product or service that         product or service and a        of companies going under.
                           makes sense, but they've          decent balance sheet.           How do you factor in that
                           had some rough times and          Second of all, I have a         risk when looking at
                           the stock is down from its        management that's either        investment opportunities?
                           all-time high of five years       turned around the company                     (Continued on page 15)
                           ago. When you look at the
 Volume I,
Issue XVIIIIssue 2                                                                                                   Page 15

Preston Athey
(Continued from page 14)         stocks of the group that I        the value of the cash on
PA: There's absolutely           held, so in a scary market        their balance sheet, and
some bankruptcy risk in          where people are worried          another half dozen met Ben
investing in small-cap value     about balance sheets or           Graham's favorite net-net
companies. By definition,        businesses that maybe aren't      standard where they were
they are considered value        as solid as others, the           selling for below their net            “I would say if the
stocks because there's           stocks are going down a lot       working capital. I felt pretty
something wrong. Perhaps                                                                                  stock goes below a
                                 more. The bottom line is          comfortable holing those
their record isn't very good     they're all below $1.00. The      stocks. Fast forward a year,
or they're overburdened
                                                                                                          $1.00, the market is
                                 question was asked by the         four of those 20 actually did
with debt or they've had         reporter, “Doesn't that           go bankrupt. Let's say that I            telling you they
some bad news that's really      mean they're all going            sold them at some point
knocked the stock. In the        bankrupt?” In a normal            either right before or right             think it's going
22 years that I've run the       market, I would say if the        after they filed and realized
Small-Cap Value Fund, I’ve       stock goes below a $1.00,         something less than $1.00.               bankrupt. In a
averaged less than one           the market is telling you it      Of the remaining 16
company per year go                                                                                       market like today,
                                 think the company is going        companies, all of them
bankrupt while I own the         bankrupt. In a market like        eventually recovered well
stock. It happens
                                                                                                           that's probably a
                                 today, that's probably a          above $1.00. Some tracked
occasionally, but it doesn't     reasonable guess – 20% to         the market, while some                 reasonable guess –
happen very often. I             30% of those companies            went up two times to four
consider it an overblown         probably will go bankrupt.        times. One of them, Dollar             20% to 30% of those
concern and it's not             But, at the bottom of a bear      Thrifty, went from $0.60 to
something I spend a whole        market when people are            $45.00 in a year and half, at          companies probably
lot of time worrying about.      worried about everything,         which point I sold it.
                                 my experience was that
                                                                                                           will go bankrupt.
In March 2009, which was         they're not all going to go       If you took that portfolio of
the bottom of the bear
                                                                                                          But, at the bottom
                                 bankrupt.                         20 companies and evenly
market, I gave an interview                                        weighted them at 5% each, I             of a bear market
to Barron’s on the topic         There were 20 of my               guarantee you the two-year
‘Stocks selling for below        positions trading at below        returns on that portfolio               when people are
$1.00’. After giving the         $1.00. I believed that from       were better than the
interview, I decided to          that point on, when the           number one small-cap value                worried about
check how many stocks I          market came back, most of         fund in the country. But
actually had below $1.00.                                                                                   everything, my
                                 these stocks would recover.       who has the guts to invest a
Remember, this was at the        A small fraction would            lot of money at the bottom
bottom of the market. At
                                                                                                          experience was that
                                 probably go bankrupt, some        of the market into what the
the time, 20 stocks out of       would track the market,           market perceives as horrible           they're not all going
300 in the fund were selling     some would do substantially       companies? I didn't sell
for below $1.00. I               better, and one or two            them, but I held on and                 to go bankrupt.”
guarantee you, not one of        would be home runs. The           when the junk rallied, I
them had I bought below          question was asked "Well if       realized my fair share of
$1.00. In fact, most were        that's the case, why don't        profits.
bought at prices significantly   you sell the ones that are
above that, often above          going to go bankrupt and          G&D: Did you add to your
$5.00, so that shows you         buy the ones that are going       positions at the time?
how much they had come           to be home runs?" If we
down. So what was going          knew that, obviously we           PA: Not substantially. In a
on? First of all, we were in     wouldn't hold the ones that       few cases, I added a little
a horrible bear market, so a     were going bankrupt. Two          bit, but not in most cases. I
lot of stocks were down.         of those 20 companies were        had to think about risk. The
Secondly, these were             literally selling for less than                 (Continued on page 16)
probably the lower-quality
              Page 16

                             Preston Athey
                             (Continued from page 15)         how management really            questions. Ask about
                             bottom line is there is          thinks. Many analysts new        strategy and long-term
                             bankruptcy risk in small-cap     to the industry have their       goals. Ask about how they
                             value stocks and sometimes       questions and don't really       deal with problems and how
                             that's reflected in the stock    think about follow-ups.          they think about capital
                             price. Though even when          They're not actually thinking    allocation. Those are CEO
                             it's reflected in the stock      about what it is that they’re    questions. When you
Pictured: Jason Zweig,
                             price, only a small fraction     trying to determine.             interview other members of
Mark Cooper, Jean-Marie
Eveillard, John Spears and
                             of companies actually go out     They're just asking a lot of     the management team, ask
Jennifer Wallace speaking    of business.                                                      questions that are specific
in the Graham and Dodd                                                                         to their area.
Investing Panel at the       G&D: You're known to
2013 CSIMA Conference.       have a knack for                                                  G&D: How much weight
                             interviewing management –                                         do you put on the quality of
                             in fact, you lead the              “The longer I’ve               the management versus
                             “interviewing management”                                         other quantitative or
                             training session for T.               been in the                 qualitative factors?
                             Rowe’s new hires. Could
                             you talk about how you                business, the               PA: The longer I’ve been in
                             developed this ability over                                       the business, the more I
                             time?                                 more I think                think management really
                                                                                               makes a difference. In small
                             PA: I don't think I have an          management                   companies, I think
                             unusual knack at all. There                                       management makes a huge
                             are other people who are
                             much better at the business
                                                                 really makes a                difference. The main
                                                                                               question is, how do you
                             of interpreting management                                        determine if it's a good
                             body language – I'm not              difference. In
                                                                                               management? The
                             very good at that. I think                                        interview is not sufficient;
                             what I do well though is to,      small companies,                it's only a first step.
                             over time, learn to read                                          Interestingly though,
                             management teams on                       I think                 studying the past record of
                             whether or not they’re                                            that management more
                             telling the truth. If you see        management                   often than not is a pretty
                             a management enough times                                         good indicator of what the
                             over the years, you can              makes a huge                 future will be. Is the
                             really begin to see whether                                       manager someone who
                             they are trustworthy or not,          difference.”                grew up in that company
                             or if they're always                                              and was made CEO last
                             optimistic or always                                              year? The previous 10-year
                             pessimistic. That's the big                                       record at the company is
                             advantage. When you've                                            not that person's record, as
                             got a lot of experience, you     questions. I try to teach        he or she has only been
                             don't really have to sit there   our analysts to have a line of   CEO for a year. However,
                             and ask questions and take       questioning. Figure out          if he or she was the COO
                             notes all the time. You can      what it is that you want to      or had run one of the
                             ask a general question, hear     know and have a line of          divisions, you could study
                             the answer, and think            questioning that will help       that division’s record, or
                             through what the next            you to get to that point.        you could study the time
                             follow-on question is that       Also, when you're with a         period that the individual
                             extends that line of             CEO, don't spend time            was COO. You can also
                             reasoning. By doing that,        asking about CFO-related                      (Continued on page 17)
                             you get a good indication of
 Volume I,
Issue XVIIIIssue 2                                                                                                    Page 17

Preston Athey
(Continued from page 16)          relevant either, as there          obvious question: “If this
ask other people in the           probably isn’t a lot of cash       stock is so cheap, why is it
industry about the person’s       flow, particularly in small-       cheap?” The cheaper it is,
background and experience.        cap mining companies. On           the more the market is
What is it that the person        the other hand, if you can         telling you that there is
has done that would give          value the proven reserves          something wrong. If that's
you confidence that he or         based on takeout prices of         the case and you're still
she will be a good CEO and        other companies in the             intrigued, you better dig
take the company forward?         industry, that's the way a         really deep. Maybe what
If the person has been at
the job for a few years, then
                                  CEO of a competitive firm          you'll find is that it's a cheap       “The best way to
                                  might look at valuation.           stock because management
you can more easily judge         You can begin to build a           uses all of the cash flow that
the record.                                                                                                   avoid a value
                                  framework around what              the company generates to
                                  NAV would be and assess            make poor acquisitions. By
G&D: Do you have a                the current market                 studying the past several
                                                                                                            trap is to ask the
preferred valuation               valuation’s discount or            years of their acquisitions,
framework to assess the           premium. If it's a premium,        that may become clear. If
                                                                                                            obvious question:
attractiveness of an              it's likely not interesting at     there's no chance that
investment?                       all, but if it's a discount, how   management is changing                 ‘If this stock is so
                                  large is the discount? If it’s     because they either own
PA: Yes. My preferred             more than is usual, that           too much stock, the board               cheap, why is it
valuation framework is to         makes it attractive.               is in their hip pocket, or
use those measures of value                                          whatever the reason is, it               cheap?’ The
that are most relevant for        As an alternative example,         almost doesn't matter how
the company and the               take a service company that        cheap it is. You're going to           cheaper it is, the
industry you're looking at.       I own called G&K Services,         be throwing your money
If you think of all the various   which does uniform rentals.        away. That's really how you            more the market
metrics you might use,            Price-to-earnings is a pretty      avoid value traps.
some are very readily             good measure, price-to-cash                                               is telling you that
available through databases       flow is a pretty good              I'll give you another example
and some you may have to
calculate yourself because
                                  measure, and price-to-book         – Cliffs Natural Resources is               there is
                                  value is a reasonably good         an iron ore company that I
there's a measure of              measure. You would want            first bought in 2000. The
uncertainty. Net asset value                                                                                   something
                                  to look at these ratios            stock was down because its
is an uncertain number and        relative to the market,            sales and earnings were
it may rely on your forecast      relative to other companies        down and they were
of cash flows and what            in its industry, and relative      expected to decrease
discount rate you want to         to its own history over the        further that year. The U.S.
use. What is really relevant      past 10 years. When I find         steel industry was hurting,
is how a knowledgeable            companies that are cheap           and some were betting that
investor in that industry         on those relevant measures,        the domestic steel industry
would look at the company         that's when I start to get         would fade away and we
and what metrics that             interested.                        would import all of our
person would use. For                                                steel from Asia. Cliffs had
example, if we were talking       G&D: On that point, how            essentially all of its reserves
about a mining company            do you avoid value traps at        in Northern Minnesota, and
where the majority of the         companies that seem                if that played out the
value in the company is its       statistically cheap but are so     Chinese would not need
proven reserves, price-to-        for a reason?                      Minnesota iron as they
earnings is an irrelevant                                            could get it from Australia.
measure because there are         PA: The best way to avoid          The market was essentially
probably no earnings. Price       a value trap is to ask the                       (Continued on page 18)
to cash flow is probably not
Page 18

          Preston Athey
          (Continued from page 17)        well go through the various       Industries, which is a
          making the bet that the         stages of ownership. The          cement producer. It was
          steel industry wasn't coming    first owners are the deep         considered very risky and it
          back. On the other hand,        value investors, followed by      wasn't earning money. You
          we took the opposite view       the relative value investors.     had to bet on a recovery in
          that the U.S. steel industry    Then you have the GARP-y          the housing cycle and the
          would come back, and that's     (growth at a reasonable           road-building cycle, and
          exactly what happened.          price) investors, followed by     anything that's a big user of
                                          the fundamental growth            cement. If I thought I only
          G&D: You mentioned              investors. Pretty soon, you       had 10% or 20% upside,
          earlier that you do not         have the momentum growth          then I wouldn't have
          assign price targets. How       investors and after that, the     bothered. But I could see
          do you compare two              last stage of investors           based on where it'd been in
          opportunities? Also, given      focuses on pure                   the past and what earnings
          that you have very low          momentum. They don't              could be in the future, that
          turnover and hold things for    really care what the              there was some likelihood
          a long time, at what point      company does or what the          that I could get a double in
          do you actually get around      earnings are. All they know       three years. That for me
          to selling?                     is that the stock is going up     was a good buy trigger.
                                          and they want to ride it.
          PA: First of all, with as       That type of shareholder is       G&D: Given your 20+
          many companies as I have,       the most risky for me. At         years of experience running
          there’s almost never a          the first hint that there's a     a value fund, are there any
          situation where I have to       little perturbation in what       common mistakes that you
          sell something in order to      people are expecting,             see value investors make?
          buy something else. I've        momentum investors will           You mentioned earlier
          always got some cash and I      sell a stock that could be        about how you hold most
          always have many things on      down 25%, 30%, or 40% in a        positions longer than others
          the sell desk and many          day. When I see the               do – would you consider
          things on the buy desk.         shareholder base shifting         that a mistake that other
          There's some point at which     towards that end of the           investors make?
          a stock truly gets              spectrum, that is my sign to
          overpriced and you have to      get out because I don't need      PA: It's hard to say that's a
          figure out what that is. As     that kind of risk.                mistake if investors take a
          for selling, I have a number                                      50% profit over a
          of sell triggers. The obvious   G&D: What are your buy            reasonable period of time
          one would be if the stock       triggers?                         and re-deploy it into the
          just gets too big. I'm                                            next great underpriced
          running a small-cap fund, so    PA: If there's nothing            stock, and they have a good
          if the company gets to be       spectacular about the stock       track record of doing that.
          over $5 billion, I move it      or if I don't think I can         Who am I to say that
          out. Another trigger is if      theoretically get a double in     they're making an error?
          the stock chart goes            12-18 months, in most cases       That’s just a different style
          parabolic. The stock has        I probably won't buy it. An       of investing. All I'm
          tripled in 12 months and        exception of that rule would      suggesting is that for me,
          although earnings are good,     be something like a utility.      holding winners longer has
          it's now trading at 35 times    For example, if you have to       worked very, very well. I
          earnings.                       own some utilities, you're        haven't had that many
                                          just trying to find good          experiences where I've
          Another trigger could be        relative value among all the      ridden a stock all the way
          that the character of the       various utilities. Last year, I   up and then ridden it all the
          shareholders has changed.       bought shares in Texas                         (Continued on page 19)
          Companies that have done
 Volume I,
Issue XVIIIIssue 2                                                                                                     Page 19

Preston Athey
(Continued from page 18)         So why do I own it? Well,        reason to think this
way back down. It's just a       the stock in the last five       company couldn't earn
function of constantly re-       years has been as high as        $1.50 in 2015. If they earn a
evaluating what you have         $18, and in the depths of        $1.50 and you put a 10x
and where that stock is in       2009, it was actually below      multiple on earnings at the
relation to what you think a     $1. The stock fell from the      beginning of 2015, that's
full market cycle might          high teens in 2011 because       close to a double in the               Pictured: Mario Gabelli at
mean.                            the truck cycle turned           next two years. That would             the 2012 Graham & Dodd
                                 downwards and their auto         be a pretty attractive                 Breakfast.
G&D: Do you mind talking         business deteriorated. This      return. There is no
about an idea that you           was despite the fact that        guarantee that this will
currently like?                  management had done a            happen, but the stock
                                 good job of improving            doesn't seem to want to go
PA: I own shares in a            operations. There's nothing      below $6 because there's
company called Modine. It's      they can do when the             book value support. The
a Wisconsin-based                demand falls off. The            balance sheet is not too
manufacturer of automotive       market saw that, the stock       stressed. The risk-reward
radiators and heat exchange      came down, and at around         seems pretty good to me.
equipment. The company is        $8, we got interested. At
particularly strong in trucks    that point, it was selling for   We talked a little bit about
and off-road vehicles, but       slightly more than book          what makes me different
they also have some              value. What we saw was a         from other investors: one
business in regular              company with a good              thing we’ve discussed is that
passenger cars. They also        product set, good market         I hold winners longer. The
make industrial HVAC             position, decent balance         other thing is, I'm willing to
products. It's certainly one     sheet, and a management          time arbitrage my
of the world's leaders in its    that was doing what they         investments. You can show
market, with well over a         could to pay down debt and       a lot of investors an idea
20% market share. The            improve operational              and they'd say, "Well that is
company has a checkered          efficiency. Management also      a good price and I can see
history over the past 25         seemed to understand             how sometime in the future
years because it operates in     capital allocation.              the stock could be a lot
a very cyclical industry; it’s                                    higher given a normal
difficult for them to predict    So this was really a cyclical    recovery in their earnings
exactly what their sales and     company with nothing             and sales. But the problem
earnings will be from year       fundamentally wrong, where       is, it isn't going to happen in
to year. It's totally            if you could wait out the        the next six months. Come
dependent on what the            cycle, the stock could be        to me when it looks like it's
customers are doing and          worth substantially more.        starting to happen and I'll
their customers are in a         We started buying at             buy the stock.” So they just
very cyclical industry.          around $8, and we                refuse to buy the stock.
Additionally, before the         continued buying it down         With Modine, I asked a
current CEO took over five       into the $6s, and also during    particular Wall Street
years ago, the company's         its way back to about $9         analyst who was following
capital allocation was not       today. If we have a normal       the company when the
great. While they had a          truck cycle in the next three    stock was at $6.50, "Why
good product, they did not       years, if some new business      aren’t you recommending
manufacture it in the most       they picked up in Europe is      this stock?" He had a weak
cost effective manner, so        as profitable as we think it     hold on it at the time. He
even in good times, their        will be, and if they continue    responded, "I know what it
return on capital wasn't         to do well on the industrial     could be three years from
very high.                       HVAC side, there's no                          (Continued on page 20)
Page 20

          Preston Athey
          (Continued from page 19)        sharing another idea that          own, but typically you get
          now, but the next 12            you currently like?                paid for that risk. The
          months look bad to me.                                             second thing they do is
          There's no reason their         PA: I'll talk about another        securitize. They buy loans,
          earnings are going to turn,     stock that I've been buying        package and securitize them,
          they're barely breaking         over the past year. It's           and market them through
          even, and I just can't afford   starting to work now, but if       an investment bank.
          to get out there in front of    things go as well as I think       Investors buy the AAA
          this. I have to wait until I    they will over the next            tranche and the AA tranche
          have a lot more confidence      three years, it still has a long   and Redwood makes a fee
          in the next quarter or two.”    way to go – it's a company         on it. Often, in addition to
          When he finally has                                                the fee, Redwood will make
          confidence in the next                                             a spread on the sale.
          quarter, that stock will be                                        Therefore, a typical
          $11. A move from $6.50 to                                          securitization for Redwood
          $15 is a whole lot better                                          would be a pool of jumbo
          than a move from $11 to           “One thing you                   home loans that would be
          $15. Also, if you're only                                          generated by dozens of
          running a small amount of
          money, you might be able to
                                          can do as a value                  banks around the country.
                                                                             These banks typically will
          get a decent position at $11,                                      want to hold onto the five-
          but if you want to make this        investor is to
                                                                             year ARM for their own
          a 50 basis point position on                                       balance sheet, but if it's a 15
          $11 billion, you have to           arbitrage time                  -year fixed or a 30-year
          start buying it today. You                                         fixed, they don't want to
          can't wait until it’s at $11     and to recognize                  take that kind of duration
          because you will move it up                                        risk, so they'll sell those to
          to $13 all by yourself.          that you're going                 Redwood and Redwood will
          That's time arbitrage.                                             package them together.
                                           to be early, but if               That market completely
          I'm willing to build a                                             went away in mid-2008, and
          position and wait, not           you get the right                 the first securitization
          knowing when the turn will                                         wasn't until Redwood did it
          happen, because there will       price, it all works               in the fourth quarter of
          be other stocks in my                                              2010. They did two in 2011
          portfolio that are working       out in the end. “                 and five in 2012. They'll
          just fine that I bought two                                        probably do well north of
          or three years before.                                             half a dozen, maybe as many
          People ask me how I can                                            as 10 or 12 this year.
          run a lot of money. It's                                           They've been working on
          harder than a small amount      called Redwood Trust.              their pipeline. So the result
          of money and you have to        Redwood Trust is a                 is accelerating activity,
          do things differently. One      mortgage REIT based in             which means they're going
          thing you can do as a value     California. Its business is        to generate more fees,
          investor is to arbitrage time   twofold – first, it owns           they're going to get more
          and to recognize that you're    mortgage securities,               spread, and they're going to
          going to be early, but if you   typically the lower-rated          get more products at the
          get the right price, it all     tranches of mortgage               bottom end for them to
          works out in the end. By        securities such as BBB, BB,        hold. That's the simple
          the way, the truck cycle is     B and the equity of a              story. It's very
          just starting to turn now.      mortgage RMBS or CMBS.             conservatively managed.
                                          It's a highly risky thing to                     (Continued on page 21)
          G&D: Would you mind
 Volume I,
Issue XVIIIIssue 2                                                                                       Page 21

Preston Athey
(Continued from page 20)          business. Redwood's sitting      more bankruptcies before
They got through the              there looking very, very         we're done. Energy stocks
problems of 2008 and 2009         smart.                           are not quite hated but
when the rest of the                                               they're certainly way down
industry was dying. They          G&D: Any particular              from where they were a
had seen it coming and sold       industries that you are          couple of years ago. Also,
a lot of assets in 2007.          finding very attractive right    mining stocks are
They were very                    now?                             increasingly hated these
conservative and had no                                            days. Those are the areas
recourse debt on their            PA: Not so much                  where I would say there are
balance sheet. The only           industries. I would say that     opportunities. On the
debt they had was tied            one of the questions I'm         other hand, can I say that
specifically to securitizations   always asking broker             it's a great time to be buying
and was non-recourse to           salespeople is, “I don’t want    software as a service
the parent, so that was not       to know what your analysts       companies? Most of those
an issue. Now they're             like. Tell me what your          are trading at high
starting to lever up.             clients hate. What are the       valuations and there aren't
                                  sectors that are most hated?     too many bargains in that
I like the company because I      What are the industries that     area.
see an increasing set of fees     your clients don't want to
and assets on which they          hear about?” It doesn't          G&D: Are there any
can generate returns. The         even necessarily mean that's     companies that you would
stock has done very well          the best value, but I just       have traditionally invested in
over the past six months,         want to know what the            which now you stay away
but there's no reason to          world hates. When it's out       because of destructive
think that if we have a really    of favor and really hated,       technologies like Amazon or
good housing market and           that to me is a good sign,       e-commerce?
Redwood continues to sell         and it means it's time to do
RMBS securitizations, the         the work and move                PA: Years ago, a lot of
stock could still double over     forward.                         people would have told you
the next two or three years.                                       that newspapers are a great
It's at $23 today. That's one     I'll tell you some areas that    business. Newspapers are
where when the stock was          seem to be relatively hated      not a great business
at $12 and somebody might         today, but I can't necessarily   anymore. Some individual
say the target price is $20,      tell you that they're good       newspapers may still have a
people would laugh. Well,         values. Education stocks         good return on capital and a
it went through $20 last          today are relatively hated,      good margin, but let's face
month. So should you sell it      and that's tied to increasing    it, newspapers are a dying
because it hit its target         regulatory constraints from      industry. Most of them
price? If Redwood was             Washington and the fact          have not found a way to
selling two securitizations a     that in an improving             monetize the content if
year and had no opportunity       economy, fewer people feel       people don't actually buy a
to do more than that, then        that they have to go back to     physical paper. I don't know
the stock would be kind of        school, particularly a school    one that's really making
expensive. But it's               where they have to borrow        enough money from their
absolutely staggering to          a lot of money. Shipping         website to pay for all the
think of how they've              stocks in general and oil        journalists on the staff.
increased their pipeline of       tanker stocks in particular
loans – even the big              are really hated. Again for      In a related field, TV and
investment banks are now          good reason, almost nobody       radio are still decent
hard pressed to do this –         is making any money in that      businesses, but an awful lot
while so many of their            industry and there will be                    (Continued on page 22)
competitors went out of
            Page 22

                       Preston Athey
                       (Continued from page 21)          or foreign bonds, then U.S.      been absolutely clear and
                       of TV and radio stations          equities are still reasonably    deliberate about what he
                       were bought at very high          attractive but may or may        intends to do. Until we get
                       prices over the last 10           not be the first choice.         to a 6.5% or lower
                       years, so people who made                                          unemployment rate and
                       those investments are not         G&D: How much cash do            until we get to inflation well
                       getting a good return on          you hold currently?              north of 3%, I think he's
Pictured: 2013 CSIMA
                       their investment. I probably                                       going to keep very loose
                       would not invest in any           PA: Typically I will not go      money. Someday, it will be
                       newspaper company today,          below 3% cash. That's really     a problem, but that's not a
                       and I would only invest in a      an amount that I feel I need     problem today, and I'm not
                       radio or TV company if I          in case we have a very bad       necessarily preparing for it.
                       found that it was really          market and I get                 I just want to be alert to it.
                       cheap, and if management          redemptions. I would             One of the interesting
                       understood the need to            prefer not to have to sell       things people say is that
                       generate cash to pay a            some of my key holdings          when interest rates go up, it
                       dividend or buy back stock,       down 25% just to meet the        is bad for stocks. If you
                       and not spend cash buying         needs of shareholders who        look at all of the economic
                       other stations because the        decide to get out.               cycles since World War II in
                       return on capital would be        Fortunately though, the          the U.S., you'll find that on
                       pretty low.                       Small-Cap Value Fund has a       average, four to six
                                                         very loyal group of              tightening rounds on Fed
                       G&D: How would you rate           shareholders that do not         funds occur before it really
                       the attractiveness of the         whip us around. We don't         begins to affect the stock
                       equity markets generally          attract hot money, so it's       market. In fact, early on it's
                       today?                            also less likely to mean that    a good sign because it
                                                         they're going to get out         means the economy is doing
                       PA: They're certainly less        quickly.                         well and profits are good.
                       attractive than they were                                          While price-to-earnings
                       four years ago. In March          Typically I won't have more      multiples might stall out or
                       2009, in hindsight one could      than 10% cash at the top.        even begin to come down,
                       say that was a once in every      That’s a function of finding     corporate earnings are
                       10 years kind of a valuation      fewer stocks to buy when         doing very well. Stocks still
                       that you had available. We        the market is high. It's also    continue to go up even as
                       all know that if you had had      more likely to happen if we      the Fed starts to tighten.
                       the guts to buy at that time,     have a surge in takeovers.       It's only when we are well
                       you'd have made very, very        So my cash percentage            into the second or third
                       handsome returns on a             generally ranges between         year of the tightening cycle
                       diversified portfolio of U.S.     3% and 10%. Today, I'm           that it begins to have an
                       equities. Having said that, I     somewhere a little below         impact on the economy.
                       think the stock market is         the midpoint of that range.      We haven't even started to
                       fairly valued today on its                                         tighten yet, so I think we're
                       own right, but I think the        G&D: Are you concerned           still many months away
                       bond market is overpriced.        about the Fed eventually         before I even get the least
                       If the choice is to put           turning off the spigot and, if   bit concerned on that score.
                       money in cash, bonds, or          so, how are you preparing
                       stocks, I think stocks are        for that eventuality?            G&D: Next year, you will
                       clearly the best investment                                        be transitioning your
                       in that group. If you expand      PA: I'm not worried about        portfolio management
                       it to other things that           the Fed turning off the          duties to David Wagner.
                       particularly large institutions   spigot any time soon             What advice will you give
                       can invest in such as direct      because Mr. Bernanke has                      (Continued on page 23)
                       real estate, private equity,
 Volume I,
Issue XVIIIIssue 2                                                                                 Page 23

Preston Athey
(Continued from page 22)          to have the highest             a job that they hate. They
him?                              paycheck. Do not                ask themselves, is this
                                  automatically assume that       something I want to do the
PA: David is going to be a        some glamorous job that         rest of my life? The
worthy successor. He's a          requires 80 hours a week        answer's going to be no.
very good investor today          will be all worth it three      Two or three years later,
and very experienced. He's                                        they move onto something
been with us for 13 years.                                        else and maybe they've
My advice to him will be to                                       gotten some good
follow his instincts, know                                        experience, but it's really
what he's good at, and be                                         made them cynical. I
his own person. If he                                             encourage students to think
figures out what he's good                                        more broadly about what it
at, then I'm not worried                                          is that you really want to
about it at all.                  “As you think about             do in life and begin to point
                                                                  toward that and recognize
G&D: Are you going to              a career, think in a           that a balance between
miss managing the portfolio?                                      work and personal life is
                                    mature, long-term             really important.
PA: Yes, but there's a time
and a season for everything        fashion about what
                                                                  As far as going into the
in our lives, and it'll be time     you really want to            investments business, the
for me to step down from                                          one thing I would say is
managing institutional                 do in life, and            whether you want to be on
portfolios. I'm perfectly at                                      the sell side or the buy side,
peace with that decision.           especially for the            whether you want to work
It's time to turn it over to                                      for a long-only shop or
the next generation. I've          next 15 or 20 years.           prefer greater flexibility
had a wonderful run, I love                                       with a hedge fund, that's
the business, I love what I         Do not accept the
                                                                  really a personal choice and
do, but it's not right for me      first job that comes           some people have
to block the next                                                 personalities that are more
generation.                        along that seems to            fitted for one over the
                                                                  other. Before you sign up,
G&D: What advice would               have the highest             understand the stresses and
you give to students                                              risks involved in each job.
interested in a career in               paycheck.”                Really check out the firm
investing?                                                        you're going with. How
                                                                  have they treated the
PA: I love that question                                          employees that they've
and we could go on for                                            hired? What's the average
hours talking about it. This                                      tenure? If it's 18 months,
is something I would say to                                       what makes you think
all business students, not                                        you're going to be any
just those interested in          years later. I've seen too      different?
investing. As you think           many examples of people
about a career, think in a        who get into those jobs and     G&D: Thank you very
mature, long-term fashion         frankly regret it. They have    much for your time, Mr.
about what you really want        no life, they can't keep up     Athey.
to do in life, and especially     with their friends, and after
for the next 15 or 20 years.      a while, they're wondering
Do not accept the first job       why are they slaving away at
that comes along that seems
   Page 24

             Li Lu
             (Continued from page 1)          money.” I wasn’t sure what      through right out of the
             G&D: How did your                it was all about. I just re-    gate. And I thought this
             unique experience as a           member thinking that there      fellow was just so intelligent
             Tiananmen Square protest         was a “buffet” involved. So I   – he could put very com-
             leader lead you to where         assumed that it was some        plex ideas into such simple
             you are today, running           kind of talk with a free        terms. I was immediately
             Himalaya Capital?                lunch! I said it was a good     drawn to value investing. By
                                              combination – a free lunch      the time the lecture was
             Li Lu (LL): When I first         plus a talk about how to        over, I thought that this was
             came to Columbia Universi-       make money. So I went.          what I was looking for; I
             ty, I was dirt poor. I did not   To my dismay there was no       could do this.
             choose to come here – I
Li Lu        just ended up here because I                                     At the time, I couldn’t really
             had nowhere else to go,                                          start companies, and I didn’t
             having just escaped from                                         want to work in a big com-
             China after Tiananmen. I                                         pany because of the differ-
             was in a new country where           “There are few              ences in language and cul-
             I didn’t understand the lan-                                     ture. Investing, on the oth-
             guage, didn’t know anybody,      people that switch in
                                                                              er hand, sounded like it re-
             and didn’t have a penny to          between or get it            quired a lot of reading and
             my name. So I was desper-                                        mathematics, hard work,
             ate and afraid. In retro-            [value investing]           and good judgment – I was
             spect, that is good inspira-                                     confident that I could do
             tion for trying to figure out        gradually. They             those things well. And the
             how to make money! I just                                        fundamental principles of
             wanted to know how to               either get it right          value investing appealed to
             survive.                                                         me – buy good securities at
                                                away or they don’t
                                                                              a bargain price. If you’re
             For the first couple of years,     get it at all. I never        wrong, you won’t lose a lot,
             I really struggled with the                                      but if you’re right you’re
             language, but I eventually        really tried anything          going to make a lot. It fit
             became much more com-                                            my personality and temper-
             fortable. I always had this       else. The first time I         ament very well. Warren
             fear in the back of my mind                                      used to say, “Value investing
             of how I was going to make        heard it, it just made         is like an inoculation – ei-
             a living here. I didn’t even                                     ther it takes or it doesn’t.”
             think about success at the        sense; and I heard it
                                                                              I totally agree with him.
             time – I just wanted to pay          from the best.”             There are few people that
             my bills. I grew up in Com-                                      switch in between or get it
             munist China and never had                                       gradually. They either get it
             much money to my name,                                           right away or they don’t get
             and then all of a sudden I                                       it at all. I never really tried
             had giant student loans. So      lunch. [laughs] There was       anything else. The first time
             naturally I tried to make a      just a guy with the name        I heard it, it just made
             buck or two.                     “Buffett.”                      sense; and I heard it from
                                                                              the best. I guess it turned
             One day, about two years         Mr. Buffett really made a lot   out better than a free lunch.
             after I arrived, a friend of     of sense during that talk. It
             mine who knew my issues          was like a punch in my eyes.    G&D: How did your in-
             said, “If you really want to     It was like I had just woken    vesting process develop
             make money you have to           up and a light had switched     differently from Buffett’s?
             listen to this fellow. He        on. His honesty came                          (Continued on page 25)
             truly knows how to make
 Volume I,
Issue XVIIIIssue 2                                                                                               Page 25

Li Lu
(Continued from page 24)        against the best counterar-     LL: Oh, there are so many.
LL: Part of the game of         gument of the smartest op-      We share a fundamental
investing is to come into       ponent.” He is right about      ethos about life and about
your own. You must find         that.                           approaching investing. So I
some way that perfectly fits                                    learn more about how to
your personality because        Investing is about predicting   conduct myself personally as
there is some element of a      the future, and the future is   much, if not more, than
zero sum game in investing.     inherently unpredictable.       investing.
If you buy, somebody else       Therefore the only way you
has to sell. And when you                                                                               “There is some
                                can do it better is to assess   G&D: How would you
sell, somebody has to buy.      all the facts and truly know    define your circle of compe-           element of a zero
You can’t both be right.        what you know and know          tence?
You really want to be sure      what you don’t know.                                                     sum game in
that you are better in-         That’s your probability edge.   LL: I let my own personal
formed and better reasoned      Nothing is 100%, but if you     interests define my circle of          investing. If you
than the person on the oth-     always swing when you have      competence. Obviously I
er side of the trade. It is a   an overwhelmingly better        know something about Chi-
                                                                                                      buy, somebody else
competitive game, so you’re     edge, then over time, you       na, Asia, and America –
going to run into a lot of                                                                              has to sell. And
                                will do very well.              those are things that I am
very intelligent, hardworking                                   really familiar with. I have            when you sell,
fellows.                        G&D: How did you be-            also over the years expand-
                                come friends with Charlie       ed my horizon [in terms of             somebody has to
The only way to gain an         Munger? Do you have a           analyzing businesses].
edge is through long and        friendship with Warren Buf-                                           buy. You can’t both
hard work. Do what you          fett as well?                   I started out looking for
love to do, so you just natu-                                   cheap securities. When you
                                                                                                      be right. You really
rally do it or think about it   LL: Charlie and I have          start out, you really have no
all the time, even if you are                                                                           want to be sure
                                some very close mutual          choice. You don’t have
relaxing, and even if you’re    friends. Over time, we          enough experience, and you            that you are better
just walking in the park.       started talking about busi-     don’t want to lose money,
Over time, you can accumu-      nesses, and then it evolved     so what do you do? You                informed and better
late a huge advantage if it     into a strong bond. I view      end up buying dirt-cheap
comes naturally to you like     him as a mentor, teacher,       securities. But over time, if         reasoned than the
this. The ones who really       partner, and friend, all in     you are interested in busi-
figure out their own style      one. I am also friendly with    nesses in addition to securi-
                                                                                                      person on the other
and stick to it and let their   Warren, but not nearly as       ties, you begin to become a
natural temperament take                                                                              side of the trade.”
                                close as with Charlie be-       student of businesses.
over will have a big ad-        cause Warren is in Omaha.
vantage.                        I admire him, and I learn       Eventually, one thing leads
                                more about him from his         to another and you begin to
The game of investing is a      writings and deeds than         learn different businesses.
process of discovering: who     through interpersonal inter-    You learn the DNAs of
you are, what you’re inter-     actions. I have a lot of in-    businesses, how they pro-
ested in, what you’re good      teraction with Charlie, so I    gress, and why they are so
at, what you love to do,        know him both as person         strong. Over time, I really
then magnifying that until      and through his writing and     fell in love with strong busi-
you gain a sizable edge over    personal deeds.                 nesses. I morphed into find-
all the other people. When                                      ing strong businesses at bar-
do you know you are really      G&D: Do you have a fa-          gain prices. I still have a
better? Charlie Munger al-      vorite Charlie Munger           streak in me that favors
ways said, “I would not feel    quote?                          finding really cheap securi-
entitled to a view unless I                                                  (Continued on page 26)
could successfully argue
          Page 26

                     Li Lu
                     (Continued from page 25)         the people who bought the         ty. We learned quickly that
                     ties – I just can’t help it!     business from us.                 we couldn’t really compete
                     But over time, I’ve become                                         with Bloomberg.
                     more attracted to looking        I like win-win situations. I
                     for great businesses that are    do not complain about sell-       G&D: You don’t short
                     inherently superior, more        ing Capital IQ too early.         stocks at Himalaya, correct?
                     competitive, easier to pre-      We made a lot of money on
                     dict, and with strong man-       that investment, and we           LL: That’s right; not any
“The only way to     agement teams. I’m just not      contributed a great deal. I       more. That change oc-
                     quite satisfied with the sec-    remain friends with the           curred nine years ago.
 gain an edge is     ondary market. As I said,        founders. That aspect gave        Shorting was one of the
                     there is an aspect of the        me enormous pleasure. But         worst mistakes I’ve made.
through long and     securities business that is      the venture side is hard to
 hard work. Do       zero-sum. And that’s the         scale; you must put in a lot      G&D: Is your lack of a
                     area in which I don’t feel       of effort. So, over time, I       short book due to your
what you love to     entirely comfortable. I’m        gradually moved into helping      desire to be a constructive
                     more interested, by my na-       in a different way. Even in       third-party for companies
  do, so you just    ture, in win-win situations.     public securities, you can        and their management
                                                      still be very helpful and con-    teams?
naturally do it or   I want to create wealth to-      structive. So, that’s who I
                     gether with the business         am. I’m still learning, and       LL: Yes. But also, you can
think about it all   operators and employees          I’m still interested. I’m still   be 100% right, and you
 the time, even if   when I invest. So that led       young, and still incredibly       could still bankrupt yourself.
                     me to venture businesses. I      curious. So, who knows?           That aspect of shorting just
     you are         try to apply the principles of   Hopefully, I will continue to     frustrated me too much!
                     intelligent investing there,     gradually expand my circle        [laughs]
 relaxing...Over     but I actually can contribute    of competence.
                     quite a bit, so it becomes a                                       Three things about shorting
  time, you can      win-win situation.               G&D: How were you able            make it a miserable busi-
accumulate a huge                                     to figure out that Capital IQ     ness. On the long side, you
                     Over my career, I’ve had         would become so success-          have 100% downside but
  advantage if it    the satisfaction of building a   ful?                              unlimited upside. On the
                     number of different venture                                        short side, you have 100%
comes naturally to   businesses. Some of them         LL: In the beginning it was       upside and unlimited down-
                     became enormously suc-           Bloomberg. We wanted to           side. I do not like that
  you like this.”    cessful, even after we sold      create something just like        math. Second, the best
                     them. You could say we           Bloomberg, and in the pro-        short has some element of
                     sold them too early! I was       cess, we grew to appreciate       fraud. However, a fraud can
                     the first investor in Capital    Bloomberg much more be-           be perpetrated for a long
                     IQ, and then look at what        cause it was so hard to           time. Of course you bor-
                     happened. If we would have       compete with them. Then           row to short, so they could
                     kept it, we would have been      we realized the investment        really just wear you down.
                     far richer! It’s not like we     banking side was not fully        That’s why I could be 100%
                     didn’t make a lot of money       penetrated.                       right and bankrupt at the
                     in that investment. We did.                                        same time. But, you know
                     [laughs] But I like it that      So we basically applied what      what, you go bankrupt first!
                     way. I like to create some-      we learned about Bloom-           Lastly, it screws up your
                     thing that everybody finds       berg and created a similar        mind. Shorts just grab your
                     useful. We created employ-       product for the investment        mind and take away from
                     ment, and we created a           banking side. Over time, we       the concentrated effort that
                     beautiful product that’s sus-    also penetrated different         is required to do proper
                     tainable, and everybody          businesses like private equi-                  (Continued on page 27)
                     made a lot of money, even
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Issue XVIIIIssue 2                                                                                                      Page 27

Li Lu
(Continued from page 26)         bunch of different problems.      feel comfortable with. They
long investing. So, those are    So you have to admit the          have that $11 billion invest-
the three reasons why I just     record is impressive. They        ment in IBM, which, I can
stay away from shorting.         also happen to be in the          argue, is a technology com-
                                 right industry and the right      pany. But I can guarantee
It was a mistake on my part.     environment, and they get         that’s not how they think
I shorted for a couple of        the right support from the        about things. It has nothing
years. I don’t discard peo-                                                                              Pictured: Christopher Davis
                                 government. Their engi-           to do with whether it’s a             of Davis Advisors at the
ple who are really doing         neering culture consistently      technology stock or not.              2013 CSIMA Conference.
well at shorting – it’s just     demonstrates its ability to
not me. If I want to add a       tackle big, difficult problems.   G&D: Buffett admitted in a
fourth reason, it is that the    It works. So it’s hard not to     2009 Fortune article that he
economy overall has been         be impressed by the record        doesn’t really understand
really growing at a com-         the guy has. At the time we       BYD.
pounding rate for 200-300        invested, we had quite a bit
years, ever since the mod-       of a margin of safety.            LL: That is true. Warren
ern science technology era.                                        and Charlie have a great
So, naturally, the economic                                        partnership and Charlie
trend favors long positions                                        knows more about BYD
rather than short.                                                 than Warren. But I would
                                                                   not bet against the collec-
But you cannot live life                                           tive track record of those
without making a mistake.          “ cannot live             two. It’s not that they don’t
Every time I make a mistake                                        make errors from time to
I learn something.                life without making
                                                                   time. Everybody is capable
                                    a mistake. Every               of doing that. They have a
G&D: How were you able                                             few, but very, very few over
to get Charlie Munger inter-          time I make a                a long investment career.
ested in a company like
BYD [a Chinese company               mistake I learn               G&D: Do you see the
which manufactures electric                                        quality of BYD cars improv-
cars, batteries, electronics           something.”                 ing?
and solar equipment] given
that Berkshire Hathaway                                            LL: This company is a
typically shies away from                                          learning machine. Think
technology-oriented compa-                                         about it – they really didn’t
nies?                                                              get into industry until 10
                                                                   years ago. They didn’t pro-
LL: I don’t think that War-      They play in a big field with     duce their first car until
ren and Charlie are ideolog-     open-ended possibilities and      eight years ago. They are in
ical. Neither am I. It’s real-   have a reasonable chance of       a market where every single
ly how much you know.            being successful. As I said,      international major brand is
The story of BYD is rela-        nothing is a sure thing, but      competing, with an all-out
tively simple. This guy, who     this strikes me as having as      effort, because it’s such a
is a really terrific engineer,   good of a chance as any.          big market. So they never
started the business from        Charlie was equally im-           had any home advantage
just a $300,000 loan with no     pressed by the company,           whatsoever because China’s
additional money until the       which then led to the in-         auto market started out
IPO. He created a company        vestment. Berkshire is not        completely open with every-
with $8 billion in revenue       ideologically against technol-    body competing. Yet
and 170,000 employees and        ogy stocks. They’re just          there’s a little car company
tens of thousands of engi-       against anything they don’t                    (Continued on page 28)
neers. He solved a whole
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          Li Lu
          (Continued from page 27)          tomers, suppliers, and man-      LL: Well, management
          with very little money, and,      agement?                         always has a big influence on
          in less than 10 years, it’s                                        your success, no matter
          selling more than half a mil-     LL: All of them. I don’t         how good or how bad the
          lion cars a year and has          talk to as many investors –      business is itself. Manage-
          carved out a position for         very few. I am more inter-       ment is always part of the
          itself. You have to say, the      ested in talking to people       equation of making the
          record is not too bad, and        who are actually running         company successful, so the
          so there’s something to it.       businesses and entrepre-         quality of management al-
          They also have an engineer-       neurs or CEOs or just good       ways matters. But to assess
          ing culture and a can-do          businessmen. I read all of       that quality is not that easy.
          spirit. They consistently         the major newspaper publi-       If you can’t assess the quali-
          demonstrate that they’re                                           ty of management, you may
          able to tackle really com-                                         have to make a decision in
          plex engineering problems                                          spite of that. That’s just
          and come up with very                                              part of the process. So you
          practical solutions faster,        “You can recognize              have to figure out other
          cheaper, and better than                                           ways such as looking at the
          most other people. That is             good ideas by               quality of the business, the
          an advantage in the manu-                                          valuation, or something else
          facturing economy.                reading a great deal             until you can justify an in-
          G&D: Can you talk about           and also by studying
          your investment process?                                           If you do have a way to as-
                                             a lot of companies
                                                                             sess the quality of the man-
          LL: Ideas come to me from             and constantly               agement team, either be-
          all sources, principally from                                      cause you’re an astute stu-
          reading and talking. I don’t           learning from               dent of human psychology,
          discriminate how they                                              or you have a special rela-
          come, as long as they are          intelligent people –            tionship with the people,
          good ideas. You can recog-                                         then you’ll take that into
          nize good ideas by reading a          hopefully more
                                                                             consideration. Why would-
          great deal and also by study-                                      n’t you? The management
          ing a lot of companies and
                                             intelligent than you
                                                                             team is part of what really
          constantly learning from             are, especially in            makes a company.
          intelligent people – hopeful-
          ly more intelligent than you            their field.”              But, it’s not that easy. It’s
          are, especially in their field.                                    not that easy to have an in-
          I try to read as much as I                                         depth, solid understanding
          can. I study all of the inter-                                     of the management team.
          esting and great companies,                                        Very few people are able to
          and I talk to a lot of intelli-   cations and annual reports       do that. I admire people
          gent people. You know             of the leading companies. I      that say, "Hey, look. What-
          what? In some of those            get a lot of ideas out of        ever the information, what-
          readings or conversations,        those too.                       ever the kind of presenta-
          ideas just click. Then you                                         tion they make, I will never
          do more research and then         G&D: How do you assess           be able to learn about man-
          you get comfortable or you        if the management is being       agement beyond that. I
          don’t get comfortable.            forthright with you? How         know it’s a show for me, so
                                            useful is it to speak with the   I might as well just discard
          G&D: Are the people that          management?                      it." I respect that.
          you talk to fellow investors                                                    (Continued on page 29)
          or are they people like cus-
 Volume I,
Issue XVIIIIssue 2                                                                                      Page 29

Li Lu
(Continued from page 28)         tunity cost.                     That’s my goal, and there-
                                                                  fore the compensation
Investing is about intellectu-   G&D: Is your fund open to        structure of the fund re-
al honesty. You want to          new investors?                   flects that. Over time, I
know what you know. You                                           switched into the best com-
want to know, mostly, what       LL: The fund has been            pensation structure I knew
you don’t know. If under-        closed to new investors for      in the industry, the original
standing the management          nine years. However, we          “Buffett partnership formu-
team is not in the cards, it’s   will open it up a bit this       la”. We don’t take any
not in the cards.                year. We have more op-           management fee. We pro-
                                 portunities than we have         vide a 6% return for free to
G&D: What is your do-            money around, but that’s         our investors and then take
mestic versus international                                       25% after that. I don’t in-
allocation?                                                       vest anything outside of the
                                  “That way we’re all             fund. I put all of my invest-
LL: I don’t have a precon-                                        ment capital into my funds.
ceived notion about alloca-                                       So it’s a true partnership.
                                   in the same game
tion. I let the opportunity                                       There are very few conflicts
dictate where I end up. I          together. … That               between the general part-
just happen to have more                                          ners and the limited part-
interest in Asia and the U.S.,   ethos is what makes              ners.
so that’s where I end up. I
do not feel that interest in      Charlie and Warren              That way we’re all in the
Europe. I do not feel that in                                     same game together. I have
Africa. But I approach it           so special. They
                                                                  zero incentive to take new
with an open mind. I want                                         money for the sake of taking
                                         believe in
to really find the best com-                                      new money because I don’t
pany at the best price, run          fundamentally                take things off the top. The
by the best people and avail-                                     minute that new money
able to me at the time I am          earned success.              arrives, it begins to com-
looking. Those don’t neces-                                       pound 6% on an annual basis
sarily always meet, and it’s      That’s why, despite             against me, so I better be
OK.                                                               able to find something that
                                     their enormous
                                                                  is worthwhile and doing
You start out by holding                                          better. When I make mon-
                                    success, nobody
cash, and that is a pretty                                        ey, I feel like I earn it, and
good opportunity cost, be-        criticizes them very            when my investors make
cause it doesn’t go down.                                         money, they earn it. It is
So any time you find an in-               much.”                  just a better way to struc-
vestment, it has to be an                                         ture a business – you feel
improvement on an overall        rare. I usually don’t want to    that everybody’s success is
risk-adjusted basis. You         increase our size. My ambi-      deserved. That ethos is
may find some very interest-     tion has never been to run       what makes Charlie and
ing things, and now you’ve       the largest fund. I never        Warren so special. They
got a basket of a few inter-     wanted to earn the most          believe in fundamentally
esting securities plus cash.     money out of a fund. I just      earned success. That’s why,
That is a pretty good oppor-     wanted to have, by the time      despite their enormous suc-
tunity cost, and the next        I finished my career, one of     cess, nobody criticizes them
time you add another secu-       the best track records on a      very much. When you cre-
rity, it better make the         risk-adjusted basis.             ate the hundreds of billions
portfolio better than the        If I achieve that, I will feel   in wealth for everybody
existing one. You just con-      very good about myself.                       (Continued on page 30)
stantly improve your oppor-
Page 30

          Li Lu
          (Continued from page 29)        10 years from now?              panies are the ones that are
          while taking a salary of                                        capable of reinventing them-
          $100,000 per year for more      LL: Most businesses are         selves and dealing with
          than 40 years, it’s hard to     subject to change if you stay   change. Take the example
          criticize them.                 with them long enough.          of Intel. The whole business
                                          There’s not a single business   changes every 18 months.
          G&D: Are there industries       that I know of that will nev-   Failure to change leads to
          that you completely stay        er change. That’s the fasci-    quite a substantial disad-
          away from?                      nating thing about business.    vantage and yet they’re able
                                          Successful businesses have      to build their culture based
          LL: I’m not ideologically       some combination of things      on that change.
          opposed to anything. I am
          against any ideology.                                           Take Samsung – their early
          [laughs]                                                        memory chip business de-
                                                                          creased in price by 1% every
          There are lots of things I      “I think you want to
                                                                          week, and yet they really
          don’t know. I’ll be the first                                   developed a culture that
          one to admit. But it doesn’t
                                                avoid wrong
                                                                          precisely deals with that
          mean that I’m not curious         decisions as much             change. So when they apply
          from time to time. Maybe I                                      the same culture to some-
          know some aspect of the           or more than you              thing like a cell phone, they
          story. That little aspect                                       get ahead very quickly.
          might even constitute the            want to get it             Now they’re outselling Ap-
          investment. I don’t know. I                                     ple. So culture really plays
          don’t want to rule it out,          approximately
                                                                          an important role in those
          but I can say that when you                                     faster-changing environ-
          present me an idea, I can
                                            right. If you avoid
                                                                          ments, enabling certain
          quickly tell you whether it’s   the wrong decisions,            companies to always surge
          a “no” within a few minutes.                                    ahead of everybody else.
                                              you’ll probably
          There are basically three                                       G&D: Do you need to
          buckets that Charlie has.        come out okay over             understand the technology
          “Yes”, “no”, or “too hard”.                                     on an engineering level to
          Most of the things fall in                time.”                have a good sense of the
          "too hard." Some get a                                          risk/reward?
          quick “yes” or “no”, but if
          it’s too hard, it’s too hard.                                   LL: It certainly is a plus,
          So you end up not doing a       that enable them to adapt       but not a must. If you were
          lot. You end up really con-     to changes better than any-     really a great engineer in the
          centrating on the ideas         one else. In each situation,    product the business is sell-
          where you truly have the        it’s slightly different.        ing, obviously it’s a plus.
          time and energy to fully                                        But it’s certainly not a must
          understand the situation        Every company in today’s        because no matter how
          better than anybody.            age is a technology company     good you are at a certain
                                          somehow, but the technolo-      area, you’re not so good in
          G&D: How to you get             gy may not be on the cut-       other areas. The pace of
          comfortable with the risk/      ting edge, and may not play     change is such that whatev-
          reward of a high tech com-      an important role in the        er you are now specialized
          pany like BYD that is under-    success or failure of the       in will become obsolete.
          going pretty rapid techno-      overall business.               But that doesn’t disqualify
          logical change? Do you                                          you from making a judgment
          think you have a good sense     Successful technology com-                   (Continued on page 31)
          of what BYD will look like
 Volume I,
Issue XVIIIIssue 2                                                                                                     Page 31

Li Lu
(Continued from page 30)          that don’t appear to be very    your sell decisions?
on how a company can de-          stable actually turn out to
velop a culture to deal with      be.                             LL: One should make sell
that. Successful companies                                        decisions on one of three
are able to deal with change      I think you want to avoid       occasions. Number one, if
consistently by hiring the        wrong decisions as much or      you make a mistake, sell as
right people, building the        more than you want to get       fast as you can, even if it’s a
right culture, and staying        it approximately right. If      correct mistake. What do I             Pictured: Mason Hawkins of
ahead of their competitors.       you avoid the wrong deci-       mean by a correct mistake?             Southeastern Asset Manage-
That’s the aspect that really     sions, you’ll probably come     Investing is a probability             ment at the 2013 CSIMA
makes them successful. And                                                                               Conference.
                                                                  game. Let’s say you go into
that’s kind of a predictable                                      a situation with 90% confi-
aspect of businesses.                                             dence that things will work
                                                                  out one way and a 10%
There is always a certain                “The most                chance they work out an-
element that is unpredicta-                                       other way, and that 10%
ble. And there is a certain
                                    important thing in
                                                                  event happens. You sell it.
element that is predictable.           our business is            Then there’s a mistake that
You want to have a little of                                      your analysis is completely
both. But overall, I think         intellectual honesty.          wrong. You thought it was
you’re right. In a business                                       99% one way but it was
that is subject to rapid           What I mean is four            actually 99% the other way.
change, it is a lot more diffi-                                   When you realize that, sell
cult to make a reliable fore-         different things:           as fast as you can. Hopeful-
cast. There is no question                                        ly at not too much of a loss,
about that. But it doesn’t
                                      know what you
                                                                  but even if it is a loss it
mean an investor cannot             know, know what               doesn’t matter – you have
make a few predictions that                                       to sell it.
could indicate that the odds         you don’t know,
are in your favor. You want                                       The second time you want
to play when you feel very            know what you               to sell is when the valuation
comfortable that the odds                                         swings way too much to the
are in your favor. Many            don’t have to know,            other end of the extreme. I
times, that’s searching                                           don’t sell a security because
among typically stable busi-
                                     and realize that
                                                                  it’s a little overvalued, but if
nesses where something has           there is always a            it is way overboard on the
changed all of a sudden.                                          other side into euphoria,
                                   possibility that ‘you          then I will sell it. If you are
Take Eastman Kodak for                                            right and hold a company
example. It used to be one        don’t know that you             for a long time, you have
of the best companies; it                                         accumulated a large amount
invented photography. But              don’t know.’”              of unrealized gains. A big
look at where they are now.                                       portion of those unrealized
Take Bell Labs and AT&T.                                          gains act like borrowings
They used to really have all                                      from the government inter-
the power. They had mo-           out okay over time. But, I      est free and legally. So
nopoly businesses. Where          agree with you, it’s not easy   when you sell that position,
are they now? Just a name.        and it’s not precise or a       you take all the leverage and
That is the nature of brutal      science at all. Hopefully one   you take a bunch of the
capitalism. It’s the nature of    improves overtime.              capital out, so your return
the business. Things that                                         on equity has just become a
appear to be predictable          G&D: How do you make                          (Continued on page 32)
and stable are not. Things
            Page 32

                          Li Lu
                          (Continued from page 31)           possibility that “you don’t       the whole country could go
                          little less.                       know that you don’t know.”        down!” Everyone was con-
                                                             Those four things are dis-        stantly in crisis mode. All of
                          The third occasion when to         tinctly different. In a crisis,   the things come out that
                          sell is when you find some-        things emerge that test you       you don’t normally care
                          thing that is better. Essen-       on all four categories.           about and normally don’t
                          tially, a portfolio as I said is                                     pay attention to. Normally
Pictured: Tom Russo of    opportunity cost. Your job
Gardner Russo & Gardner
                                                             For example, during the           you think, “Well, that has
                          as a portfolio manager is to                                         nothing to do with my in-
and Timothy Hartch of
                          constantly improve on your                                           vestment in this company.”
Brown Brothers Harriman
at the CSIMA Conference   basket. You start with a                                             Then all of the sudden, you
in February 2013.         high bar. You want to in-                  “The most                 say, “Oh Jesus, it has every-
                          crease the bar higher and                                            thing to do with my compa-
                          higher. You do that by con-          important thing in              ny.” Well, you are right or
                          stantly improving the oppor-                                         you are wrong. That crisis
                          tunity costs; you find some-            our business is
                                                                                               will put those questions to
                          thing better. Those are the               intellectual               the test.
                          three reasons that I would
                          sell.                                 honesty. What I                That’s why people freeze in
                                                                                               the midst of a crisis. People
                          G&D: In your 16 years                    mean is four                freeze because they were
                          running Himalaya, you’ve                                             not intellectually honest
                          experienced three major                different things:             before. They never quite
                          financial crises: the Asian                                          distinguished certain issues
                          financial crisis of 1997, the          know what you
                                                                                               or questions and put them
                          dot com bubble burst in              know, know what                 into the appropriate basket.
                          2000, and the financial crisis                                       If you make an overall judg-
                          of 2008. How have you                 you don’t know,                ment, for example, of how
                          navigated these crises as a                                          the U.S. is going to perform
                          fund manager, and what                 know what you                 over time through ups and
                          have you learned from                                                downs, and you go into it
                          them?                                   don’t have to                knowing that there is a pos-
                                                               know, and realize               sibility something much
                          LL: That’s an excellent                                              worse could happen. Maybe
                          question. You know every                                             it’s small, but when it hap-
                                                              that there is always
                          time that that happens, they                                         pens, it happens. At that
                          always bill it as “once in a          a possibility that             time, the question becomes
                          century,” except these ma-                                           “Is it an unknown un-
                          jor events happen every five          “you don’t know                known,” or do you know
                          years in my case. [laughs]                                           that you don’t have to
                          What is interesting about               that you don’t               know? You absolutely will
                          crisis is that it puts your                                          be asked that question.
                          intellectually honesty to the                know.”
                          test.                                                                So the financial system
                                                                                               might be in trouble. Yes, a
                          The most important thing in        Asian financial crisis, all of    business needs financing, but
                          our business is intellectual       the sudden the world was          I suppose if life goes on, my
                          honesty. What I mean is            saying, “how much debt do         business will be there, how-
                          four different things: know        these companies have?! Oh         ever it will end up. So the
                          what you know, know what           my goodness, they really          question then becomes,
                          you don’t know, know what          have that much of a depend-       “Do I have to know how
                          you don’t have to know, and        ence on debt! Oh my God,                       (Continued on page 33)
                          realize that there is always a
 Volume I,
Issue XVIIIIssue 2                                                                                        Page 33

Li Lu
(Continued from page 32)          force in our global market-       China and the U.S. together
the financial system will sort    places because of the sheer       would make the Pacific Ba-
out its problems for me to        size of it and the path that      sin somewhat of an eco-
predict my business?”             they’re on.                       nomic center the same way
That’s the question and                                             that the Atlantic Ocean was
that’s the question that you      China is on a historic path       around Europe and the U.S.
want to answer before a           of continuing to grow into a      A lot of opportunity will
financial crisis hits.            modern economy. They              emerge. That doesn’t mean
                                                                    that it’s a one-way street or
If you can answer that ques-                                        a smooth pass. All sorts of
tion honestly and correctly,                                        things could happen. It
you will do more after the                                          doesn’t mean you’re going
financial crisis. Christopher       “China is so big. It            to make money guaranteed.
Davis’s grandfather used to                                         But it does offer a tremen-
say that you make the most             has all sorts of
                                                                    dous amount of opportunity
money out of a bear market                                          to those who can navigate
financial panic – you just
                                                                    this development. The im-
don’t know it at the time.           phenomena. Yes,                portance of China cannot be
It’s always the case. Less                                          ignored.
intelligent investors will be         there are ghost
sorted out. Intelligent in-                                         G&D: Do you have any
vestors are the ones who              towns, but there              concerns on a real estate
are always intellectually                                           bubble in China? We saw a
honest. They can distinctly         are also towns that
                                                                    60 Minutes piece about the
know whether they know                                              ghost cities in China, and it
or they don’t know, and
                                    are utterly, utterly
                                                                    was very striking.
know what they don’t have           crowded … China
to know, and that there                                             China is so big. It has all
exist unknown unknowns.                  is a case of               sorts of extreme phenome-
If you can really put things                                        na. Yes, there are ghost
into those categories cor-          contradiction, as it            towns, but there are also
rectly, you will pass the test.                                     towns that are utterly, ut-
Otherwise, you will have             has always been,
                                                                    terly crowded. I mean, eve-
gotten yourself in trouble.                                         ry space is occupied, and
                                    and will always be;
                                                                    there are towns seemingly
G&D: In 2010 panel at                you’ll always find             out of nowhere that have an
Columbia Business School,                                           enormous number of high
you mentioned that Asia’s            evidence of every              rises that are all occupied. I
role in the global financial                                        remember, twenty years
system is becoming increas-         theory you want to              ago that Pudong was viewed
ingly important. Can you                                            as a semi-ghost town. To-
talk about this view for our                prove.”
                                                                    day, you cannot help but be
readers?                                                            impressed by the economic
                                                                    vibrancy there.
LL: Asia will become an
important economic force,         still have a long way to go,      We live in Manhattan, but
not necessarily just in a fi-     but they have come a long         think about it: there are
nancial sense. The financial      way from the starting point.      10,000 high rises in Shanghai
part is a derivative of Asia’s    Because of the enormity of        that are taller than thirty
overall economic perfor-          the size of China, it will have   floors, multiple times that of
mance. Asia, and particular-      a huge impact in Asia and         Manhattan – that is enor-
ly China, is shaping up to        the rest of the world. So                      (Continued on page 34)
become a bigger economic
Page 34

          Li Lu
          (Continued from page 33)         things to worry me.             energy is the next big revo-
          mous. Manhattan probably                                         lution. You’ve done a lot of
          has the highest concentra-       G&D: How do you view            work on battery technology
          tion of high rises in the        the overall attractiveness of   and BYD, so is that some-
          whole world other than           equities today?                 thing that you think about
          Shanghai. The scary part is                                      beyond batteries? What do
          that China’s not done. So, I     LL: I also put that into "too   you think the energy revolu-
          say China is a case of con-      hard" and "I know I don’t       tion will look like?
          tradiction, as it has always     have to know." I only think
          been, and will always be;                                        LL: I pay attention to those
          you’ll always find evidence                                      macro trends only in the
          of every theory you want to                                      hope that I can have com-
          prove.                                                           fort that they’re a tailwind
                                                                           as opposed to a headwind.
          But overall, the economy                                         Now, how much they can
          still has a long way to go.       “I pay attention to
                                                                           help if they’re a tailwind, or
          They still have a sense that      those macro trends             how much they can hurt if
          this is their time. It doesn’t                                   they’re in my face, I don’t
          mean that they don’t have           only in the hope             know. But I want such mac-
          problems; they have an                                           ro trends to be behind me
          enormous amount of prob-             that I can have             rather than in front of me.
          lems, but so does America,                                       So that’s the extent that I
          and so did America over the           comfort that               want to know mega trends.
          last 200 years.
                                           they’re a tailwind as
                                                                           But as a concerned citizen,
          If you go through the Amer-           opposed to a               I’m intellectually curious
          ican Civil War, the country                                      about it. But it doesn’t
          killed two percent of its           headwind. Now,               mean that I’ll be able to
          population. And yet, not                                         know for sure how a given
          only was it rebuilt, but it       how much they can              development is going to
          was rebuilt at a furious pace.                                   come about. In fact, we
          And it went through two             help if they’re a            don’t know, and that’s why
          great world wars. After                                          the free market with mil-
          World War II, if you                tailwind, or how
                                                                           lions of participants acting in
          thought Japan and Germany         much they can hurt             their own self interests will
          were doomed, boy were                                            figure out a way. To predict
          you wrong.                           if they’re in my            ahead of time is not easy,
                                                                           and the good thing is that
          G&D: Do you think real            face, I don’t know.”           you don’t have to be able to
          estate has gotten a little                                       do that.
          ahead of itself where there
          would be a need for a cor-                                       If such trends are at your
          rection, or do you think                                         back, that’s fabulous, espe-
          that demand will just catch      about it when things go to      cially if you don’t need them
          up?                              an extreme. I don’t foresee     to be at your back. If
                                           that as going to the ex-        they’re really a headwind,
          LL: I put that in the "too       treme, either way. In that      you do want to examine
          hard” basket. I also put in      case, I know I don’t have to    them a little more. So that
          the basket of "I know I don’t    know.                           is how I view this renewable
          have to know." It certainly                                      energy issue. I know that at
          is “I don’t know”, but I also    G&D: A lot of smart peo-        some point, human civiliza-
          know that I don’t have to        ple believe that renewable                    (Continued on page 35)
          know! I don’t want those
 Volume I,
Issue XVIIIIssue 2                                                                                  Page 35

Li Lu
(Continued from page 34)         gone through the discipline      finances, how management
tion will have to find some-     of understanding one busi-       makes its decisions, how it
thing other than fossil fuels.   ness as if you own 100% of       compares to the competi-
We don’t have enough fossil      that business is very valua-     tion, how it adjusts to the
fuels, and we need to pre-       ble.                             environment, how it invests
serve them for agricultural                                       extra cash, and how it fi-
and food security reasons.       To start, take an easy-to-       nances the business.
We also can’t afford to have     understand business. It
the weather deteriorating        could be a tiny business – a     You should understand eve-
the way it has been over the                                      ry aspect of one business as
last few decades. Eventually                                      if you own 100% but you
it will catch up to us.                                           don’t actually run it. This
                                 “Start learning from
                                                                  causes you to be desperate
So for multiple reasons I               the best —                to understand every aspect
understand why we need to                                         to protect your investment.
figure out alternatives to         listening, studying            That will give you a sense of
fossil fuels. But am I quali-                                     a disciplined approach.
fied to make an informed           and reading. But               That’s how you truly under-
investment decision based                                         stand business and investing.
on that now? Probably not.        the most important              Warren always says that to
But if that one happened to                                       be a good investor, you
be at my back, hey I’m all                thing in
                                                                  need to be a good business-
for it.                            understanding the              man, and to be a good busi-
                                                                  nessman, you need to be a
G&D: Do you have any              investment business             good investor in terms of
advice for students who are                                       capital allocation.
interested in getting into            is by doing it.
investment management,                                            Start by understanding one
especially for those readers            There is no               thing within your control
who can’t go and listen to                                        that you can understand
Warren Buffett speak during           substitute for
                                                                  inside and out. That is a
their lunch break?                  actually doing it.            terrific starting point. If you
                                                                  start from that basis, you
LL: If you do get a chance        The best way to do              are fundamentally in the
to meet Mr. Buffett, I’d run                                      right direction of becoming
to it if I were you. I would-       it is to study one            a great security analyst.
n’t even take an airplane; I
would just run to Omaha!          business inside and             G&D: It was a pleasure
[laughs]                                                          speaking with you, Mr. Li.
                                  out for the purpose
Start by learning from the            of making the
best – listening, studying,
and reading. But the most              investment.”
important thing in under-
standing the investment
business is by doing it.         little concession store, a
There is no substitute to        restaurant, or a small public-
actually doing it. The best      ly traded company. It
way to do it is to study one     doesn’t matter. Understand
business inside and out for      one business and what really
the purpose of making the        makes it tick: how it makes
investment – you may not         money, how it organizes its
actually invest. But having
               Page 36

                                  Hertz Global Holdings, Inc. (NYSE: HTZ) - Long
                                  Winner — 2013 Pershing Square Challenge
                                  Richard Hunt                            Stephen Lieu                                Rahul Raymoulik

                                                                                                             As of 4/19/13; in USD m except per share data
       Richard Hunt               We recommend investors buy Hertz stock with a 12-month target                    Current Capitalization
                                  share price of $36, which represents ~52% upside to the current      Stock Price                                        $23.72
Richard is a first-year MBA       share price. There are four main points to our investment thesis:    Diluted Shares Outstanding (M)                      462.0
student at Columbia Business                                                                           Market Cap                                        $10,959
                                  1)   The market significantly underestimates the impact of Hertz's
School. Richard is Co-President
                                       recent merger with Dollar Thrifty, which marks the completion Corporate Debt                                        6,545
of the Columbia Student
                                       of a ten-year industry consolidation that dramatically improves Cash                                               (1,105)
Investment Management
                                       the competitive dynamics of the industry                              Unfunded Pension Liability                      227
Association. Prior to CBS,
                                  2)   The market underestimates the levers Hertz can pull to coun-          Enterprise Value                            $16,626
Richard was a Senior Financial
Analyst at New Constructs.             ter the negative impact of falling used car prices
                                                                                                                             Trading Statistics
                                  3)   Hertz has strong growth opportunities in the U.S. and will        52-Week Range                            $10.22-$24.28
                                       realize significant revenue and cost synergies through its acqui- Dividend Yield                                   0.0%
                                       sition of Dollar Thrifty                                          Avg. Daily Volume (M)                              7.7
                                  4)   A divestiture of the non-core Equipment Rental segment would Short Interest as % of Float                         11.0%
                                       unlock substantial value by deleveraging the balance sheet
                                                                                                                Summary Valuation
                                  Business Description
                                                                                                                             2013e                           2014e
                                  Hertz operates two main segments: car rental and equipment rental. EV / Revenue              1.5x                           1.4x
                                  Car rental is the company’s core business – it operates over 10,000 EV / EBITDA              7.4x                           6.4x
      Stephen Lieu                locations worldwide and generated $7.6 billion in revenue last year. P / E                  12.5x                           9.9x
                                  The equipment rental segment rents out industrial, construction, and
Stephen is a first-year MBA       material handling equipment. It generated $1.4 billion in revenue last year.
student at Columbia Business
School. Stephen is Co-President   Investment Thesis
of the Columbia Student           1) The market underestimates the industry consolidation’s impact on car rental pricing
Investment Management
Association. Prior to CBS,        Ten years ago, there were six major rental car companies.
Stephen worked for four years     Since then, there have been a number of acquisitions: Avis
                                  acquired Budget in 2002, Enterprise acquired National Alamo         90%
in investment banking and
private equity.                   in 2007, Hertz acquired Advantage in 2009, and in the past six      80%
                                  months, Avis acquired Zipcar and Hertz acquired Dollar              70%
                                  Thrifty. This marks the completion of an industry consolida-
                                  tion with the three remaining players controlling 95% of the        60%
                                  market. We believe this oligopoly structure dramatically            50%
                                  improves the competitive dynamics and profitability of the          40%
                                  industry, as the three players can now focus on profitability
                                  instead of market share.
                                  We’re seeing signs of this already playing out – prior to the       10%
                                  closing of the Dollar Thrifty acquisition in November 2012,
    Rahul Raymoulik               Hertz had experienced nine consecutive quarters of pricing            0%
                                  declines and Avis had experienced 11 consecutive quarters of
Rahul is a first-year MBA         pricing declines. Since the acquisition closed, pricing has in-
student at Columbia Business      creased every month.                                                           Enterprise                  Hertz
School. Prior to CBS, Rahul was                                                                                  Avis                        Dollar / Thrifty
a Sector Specialist at Fidelity   We believe the market is significantly underestimating the                     National / Alamo            Budget
Investments, focusing on the      improved pricing environment that has resulted from the                        Other
technology, media, and telecom    industry’s consolidation. Management’s EPS guidance assumes         Strong Pricing Environment w/ Price Signaling
industries.                       0% pricing growth. Sell-side consensus estimates assume only        “One of the headlines I'd like to make is we don't want to
                                  a 1% increase in pricing. Pricing is the single biggest driver of   gain share by reducing price. We want to gain share by
                                  our model, as a 1% price increase results in a 6% increase in       increasing value, and that's how we're doing it.”
                                  our target share price.                                                                              – Hertz CEO in April 2013

                                  Post the Dollar Thrifty acquisition, the pricing environment        “We're seeing our competitors move for profitability, rather
                                  has been very strong, with consistent price increases and           than share, and that has a positive impact on all of us.”
                                  cooperative matching among the three players. There has                                           – Avis CFO in February 2013
                                  also been blatant price signaling by Hertz and Avis. We be-
                                  lieve this is the beginning of long-term rational behavior in the   “We've been very aggressive in initiating price increases
                                  U.S. car rental industry and management and the market’s            over the last 4 months or so and I think that's had a
                                                                                                      positive impact. And we've seen a fairly good matching of
                                  assumptions on pricing are too conservative.                        increases by both Hertz and the Enterprise.”
                                                                                                                                      – Avis CFO in March 2013

                                                                                                      “We made a strategic decision to minimize our
                                                                                                      participation with less profitable commercial accounts.”
                                                                                                                                   – Hertz CEO in February 2013
 Volume I,
Issue XVIIIIssue 2                                                                                                                   Page 37

Hertz Global Holdings (Continued from previous page)
2) The market underestimates the levers Hertz can pull to counter negative impact of falling used car prices
The market believes that Hertz’s used car residual values closely follow the Manheim Market Index, the most widely
followed index of used car prices. This is simply not true. Since January 2011, the Manheim Market Index is down 3%,
but Hertz’s residual values have actually increased by 10%. So how is this possible? It’s possible because of the dramatic
shift in how Hertz purchases and sells its fleet. In 2012 alone, the company reduced its purchase of program cars,
whose residual values are guaranteed by auto manufacturers, from 45% in 2011 to just 19%. Not only does the compa-
ny save about 1% on the purchase of these non-program cars, it can also realize substantially higher residual value selling
its cars via much more profitable channels, and can keep cars on rent for longer.
For example, in 2009, the company sold 88% of its non-program cars at auction, the least profitable remarketing chan-
nel. In 2012, only 33% of the company's cars were sold at auction. So where are these cars going? Hertz sold 47% of
its cars directly to dealers, which netted them $500 more per vehicle than a comparable sale at auction. Hertz also sold
13% of its vehicles via retail, a channel that didn't exist four years ago, but today nets them an additional $1300 per
vehicle. We expect retail to triple by 2014.
These changes are possible because consumers and dealers are now willing to purchase cars online. Thanks to the
internet, local markets have been transformed to national markets, which makes it easier and more profitable for Hertz
to dispose of its fleet. We believe that the market does not appreciate the impact that these new channels have on
Hertz’s fleet cost. The market also misses the fact that declines in residual values affect all rental car companies equally,
so pricing can simply increase to offset the impact of falling used car prices.
3) Hertz has strong growth opportunities in the U.S. and will realize significant revenue and cost synergies
through Dollar Thrifty
There are substantial growth opportunities in the U.S. rental car market, as well as significant synergies from the Dollar
Thrifty acquisition. First, we expect Hertz to increase its profitable off-airport locations. In just six years, Hertz has
increased its off-airport locations by 60%, and we expect continued double-digit growth. Second, we expect double-
digit growth in the value segment, a segment that grew by 25% in 2012. Third, Hertz is significantly expanding its busi-
ness by using 24/7 Kiosks that allow the company to increase fleet utilization and operate in more areas in a cost-
effective manner. Lastly, we expect Hertz's entire fleet to have the 24/7 car sharing ability by 2014.
Also, as a result of the Dollar Thrifty acquisition, Hertz will realize $600 million in revenue and cost synergies over the
next three years. One of the largest areas of synergies is fleet sharing, because Hertz experiences peak demand on
weekdays while Dollar Thrifty experiences peak demand on weekends, and thus sharing fleet results in lower fleet costs
and higher utilization. As part of our primary research, we visited a couple of Hertz locations in Manhattan and found
that Hertz has already begun sharing fleet.
4) A divestiture of the non-core Equipment Rental segment would unlock substantial value
A divestiture of the non-core Equipment Rental segment (HERC) would provide shareholders with 20% incremental
upside to our base case. Divesting HERC would make sense for two main reasons. First, it allows management to
focus on the core and higher-return car rental business and the integration of Dollar Thrifty. Second, it would be highly
deleveraging for the company, pushing it closer to its goal of becoming investment grade, and leading to an immediate
EPS accretion of $0.14 to $0.19.
Based on our analysis, Hertz would maximize shareholder value by levering up HERC, using proceeds to pay down
corporate debt, and spinning off HERC in a manner that qualifies for tax-free treatment under IRS Section 355(e) “Safe
Harbor” rule. The EPS accretion plus additional value in the spun-off company would lead to a 20% incremental upside
Capital Allocation
                                           ($ millions except per share)                     Base      Bear      Bull     Street
We project a steady increase in FCF
                                           FY2014 Estimates
going forward with FCF yield reaching
                                           Car Rental EBITDA                                 $2,413    $1,828    $2,727    $2,143
14% by 2014. Management plans to           Equipment Rental EBITDA                              509       432       539       453
use the free cash flow to pay down         Consolidated EBITDA                               $2,922    $2,261    $3,266    $2,596
debt and has stated that once it reach-    EPS                                                $2.87     $1.90     $3.39     $2.38
es its target leverage of 1.6x, it will
                                           Target Forward Multiples
start returning cash to shareholders.
                                           P/E                                                12.5x     11.0x     13.0x     12.5x
We believe Hertz will hit this mark
                                           EV/EBITDA                                           7.4x      6.0x      8.0x      7.4x
within the next 18 months, at which        SOTP: Car Rental                                    7.4x      6.0x      8.0x      7.4x
point shareholders will see significant    SOTP: Equipment Rental                              6.2x      5.0x      6.5x      6.2x
cash returns. Deploying one third of
                                           Price per Share
FCF towards share repurchase would
                                           P/E x EPS                                         $35.93    $20.91    $44.06    $29.80
lead to incremental EPS accretion of
                                           EV/EBITDA x EBITDA                                $36.73    $18.87    $46.90    $31.53
$0.13 or 6% EPS growth to our base
                                           SOTP                                              $35.41    $17.89    $45.16    $30.36
case estimate.
                                           Target Price                                      $36.00    $19.00    $45.00    $30.56
Valuation                                  Upside (Downside)                                   52%      (20%)      90%       29%
Using an average of three valuation
methodologies (P/E multiple, EV/           Key Assumptions
                                           RPD CAGR (FY'12-'14)                                2.5%     (1.0%)     3.5%    0%-1%
EBITDA multiple, and SOTP analysis),
                                           Manheim Index CAGR (FY'12-'14)                     (3.0%)    (5.0%)    (2.0%) (2%)-(4%)
we arrive at a target share price of $36
                                           Chg. in Residual Value due to Channel Mix Shift     $256         $0     $383 $125-$175
or ~52% upside to the current price.
                                           Cost Synergies (FY2014)                             $250      $150      $300      $300
               Page 38

                                 Advance Auto Parts (NYSE: AAP) - Long
                                 Finalist — 2013 Pershing Square Challenge
                                 Joe Fleury                                       John Gallagher, CFA                                     Seth Kirner

                                 Recommendation: BUY
                                  ($ in millions except per share values)
                                                                                                                                                   We recommend a long position
                                  CAPITAL STRUCTURE                                   TTM FINANCIAL METRICS                                        in Advance Auto Parts (“AAP”)
         Joe Fleury               Current Share Price                   $                          80.00
                                                                                      Enterprise Value/EBITDAR                                6.7x stock with a three year target
                                  Avg. Daily Vol. (mm)                                Enterprise Value/EBIT
                                                                                                       1.3                                  12.0x price of ~$165. AAP trades at a
Prior to CBS, Joe worked as an    52 Week Low- High                                            $61-$93           Price/Free Cash Flow       14.1x significant discount to its intrin-
analyst at Ionic Capital          Short Interest                                                        2% Price/Earnings                   15.3x sic value as well as its peers due
                                  Shares - diluted                                                 74.14         ROIC                         23% to an inefficient cost structure as
Management, a multi-strategy
                                  Market Cap                                                  $ 5,931            Free Cash Flow Yield        7.1% a result of historical strategic
hedge fund in New York. Joe
                                  (+) Debt                                                            605
holds a BA in Economics from                                                                                                                       decisions. Our target price
                                  (-) Cash                                                            598
Yale University.                                                                      1
                                                                                                                                                   represents a ~100% upside to
                                  (+) Capitalized Oper. Lease (6x)                                               COMPS                2011  2012
                                  Total Adj. Net Debt                                         $ 1,929            SSS Growth           2.2% -0.8%
                                                                                                                                                   the current share price of $80,
                                  = Total Enterprise Value                                    $ 7,860            Total Sales Growth   4.1% 0.6% and is based on a 7x forward
                                  (1) 6x lease capitalization is industry standard used by companies, credit agencies, and analysts                2016E EV/EBITDAR multiple
                                                                                                                                                   (13.6x forward 2016 P/E). We
                                 believe that AAP is undervalued with an attractive margin of safety and that there are multiple ways to win with
                                 Advance Auto Parts. With management’s current plan, a passive investor could achieve a three year IRR of 20%,
                                 resulting in 2015 stock price of about $140. However an activist investor advocating necessary changes in opera-
                                 tions could receive a three year IRR of 28%, resulting in a stock price of approximately $165. In addition we be-
                                 lieve there is a measure of downside protection because AAP could likely be a takeover candidate if the price
                                 dropped below $70.
      John Gallagher
                                 Key Investment Highlights
Prior to CBS, John worked with   1) Strong Barriers to Entry
the TARP funds at the U.S.               Significant scale needed to compete on a national scale
Treasury Department. Before
TARP, he worked for the                  Economies of scale on sourcing allow AAP to finance majority of inventory on attractive terms
Federal Reserve. John holds a    2)     Significant Free Cash Flow Generation
BS in Finance from George                $400+mm in annual free cash flow; 7% 2012 free cash flow yield
Mason University and is a U.S.           Inventory almost fully funded by trade
Army veteran.                    3)     Attractive Growth Opportunities in Commercial
                                         The aftermarket auto-parts industry is highly fragmented
                                         Significant room for consolidation
                                         Growth opportunities in the commercial segment for larger competitors
                                 4)     Multiple Ways to Win
                                            Activist proposal
                                            Passive investment — recent signs of a turnaround
                                            Merger or buyout
        Seth Kirner                         Continued share buybacks
Prior to CBS, Seth worked in     Business Description
Restructuring at Loughlin        Advance Auto Parts is a leading specialty retailer of automotive aftermarket parts, accessories, batteries and
Management Partners. Prior to    maintenance items primarily operating within the United States. As of December 2012, AAP operated 3,794
that he worked at Jennison       stores throughout 39 states, Puerto Rico and the Virgin Islands. AAP operates in two segments: Retail, or “Do-it-
Associates. Seth holds a BA in   yourself” (62% of 2012 sales) and Commercial, or “Do-it-for-me” (38% of 2012 sales).
Finance from Northeastern
University.                      Investment Thesis
                                 We believe AAP is a great business with meaningful competitive advantages but has been mismanaged, primarily
                                 due to underinvestment in its distribution network over the past 5 years. We believe this is the root cause of an
                                 approximately 400 basis point EBITDAR differential to O’Reilly Auto Parts, AAP’s main competitor and only direct
                                 comp (AutoZone is almost entirely a retail business). This margin gap results in AAP trading at a 6.2x forward
                                 EBITDAR versus O’Reilly’s 9.0x, a premium of 50% to AAP. We propose that AAP invest $300mm over the next
                                 three years to augment their distribution network, building 6 additional distribution centers. Investing in the dis-
                                 tribution network has two positive effects: 1) increases AAP’s ability to raise prices in the commercial segment
                                 and 2) decreases AAP’s distribution costs, as costly, rushed deliveries are reduced. We believe the combination of
                                 the two will help narrow the 400 basis point EBITDAR gap that currently persists between AAP and O’Reilly and
                                 also narrow the valuation gap.
 Volume I,
Issue XVIIIIssue 2                                                                                                                                                                                                                      Page 39

Advance Auto Parts (Continued from previous page)
Investment Thesis Continued:
Increase Prices in Commercial Segment: Commercial customers we talked to stated that delivery speed and
reliability are the top factors when deciding who to use as a supplier. Currently AAP discounts its prices to compete
in the commercial segment to compensate for not having daily replenishment. As such, by improving service and
speed, AAP should be able to increase prices inline with peers without losing volume.

Decrease Distribution Costs in SG&A: The investment we propose in distribution centers would allow AAP to
reach a critical level of 2,000 sq. ft. of distribution center per retail store, which is the level that O’Reilly, the best in
class operator in the industry, cites as the necessary level to achieve daily part replenishment. Daily replenishment is
critical for best-in-class service in the commercial segment, but more than 90% of AAP stores are unable to re-stock
on a daily basis, and, as a result incur significant additional SG&A costs to procure and deliver parts that are stocked
out. As a result, AAP spends 300bps more, as a % of sales, in SG&A than O’Reilly does. We believe that our plan to
build 6 new distribution centers would allow AAP to meaningfully reduce its SG&A expenditure and close the gap
versus O’Reilly.

Management: The natural question is why hasn’t management implemented these changes in the past? Our analy-
sis suggests that 1) management did not previously have the expertise to build out a distribution network for a com-
mercial driven business and 2) management was not properly incentivized to do so. The current management team
comes from a retail background and was put in place in 2008 when AAP was largely a retail business. Since 2008,
AAP’s percentage of sales from commercial has risen from ~25% to ~40%. Management must shift its focus towards
providing the infrastructure necessary to run a commercial business.

Recent Positive Signs of Change / Near Term Catalysts:                                                                                                                                                                 “And there are certain things I do
1) On April 4, 2013, both the COO and SVP of Commercial Sales were fired. George Sherman, an executive who                                                                                                             well, but to be honest, I didn't
    has experience at Best Buy, Home Depot and Target was hired to be President and lead the operational change                                                                                                        grow up in a field organization.
    and commercial focus                                                                                                                                                                                               And one of the changes here that
2) On March 7, 2013, AAP announced that they would implement a one-time bonus incentive to get operating                                                                                                               we're trying to affect in our senior
    margins to 12% in three years (vs. ~10% currently)                                                                                                                                                                 leadership team is to add that
3) During 2012, AAP completed its first new distribution center in five years. This distribution center is the first                                                                                                   field customer execution…”
    one to offer daily replenishment                                                                                                                                                                                   Darren Jackson — CEO
4) After halting share repurchases in 2012, Management stated that they will resume buying back shares at their
    historic levels starting in 2013
                                                                                                                                                                                                                       “It’s the first distribution center
These signs are positive and are indications that the Board is willing to make the necessary changes to make AAP                                                                                                       we’ve opened in many, many
more cost effective and increase shareholder value                                                                                                                                                                     years, the first DC that I’ve
                                                                                                                                                                                                                       opened in the five years that I’ve
                                                                                                                                                                                                                       been here.”
Valuation: Our activist target price represents a ~100% upside in three years to the current share price of $80.                                                                                                       Kevin Freeland — COO
Our price target assumes a 7x forward EBITDAR multiple (currently 6.2x) and a 13.6x forward P/E (currently 13.0x),
We believe these are conservative assumptions on both a relative and absolute basis. On a relative basis, AAP’s best
comp, O’Reilly currently trades at 9.0x forward EBITDAR and 17.4x forward P/E. On an absolute basis, we think
AAP’s business justifies such multiples. Replacement auto-parts are not discretionary, AAP has significant barriers to
entry, produces strong free cash flow, has attractive unit economics and has strong pricing power over suppliers
(more than 85% of inventory is financed by trade).

           Estimated Year End 2015 Valuation                                                                                                   EBITDAR Bridge
    ($ in millions)               2012                 2016              $ Impact                                                   Passive                                             Active
    Financials                   Current     Passive          Activist
    Sales                        $   6,205   $    7,686   $      7,908
    Gross Profit                     3,098        3,843          3,993                                     $2,000                                                                                             2016
      margin                         49.9%        50.0%          50.5%                                                                                                                               SG&A Active
    SG&A                             2,441        2,933          2,860                                                                                                                               Saving EBITDAR
      % sales                        39.3%        38.2%          36.2%                                     $1,800
                                                                                                                                                                                       Gross          $161    $1,803
      Improvement vs. 2012                       117bps         317bps                                                                                            2016                         D&A
                                                                                                                                                                               SSS/ Margin
                                                                                                                                                                Passive Store
    EBIT                        $      657   $      910   $      1,134                                                                                   SG&A
                                                                                                                                                                EBITDAR Growth
                                                                                            2016 EBITDAR

      margin                         10.6%        11.8%          14.3%                                     $1,600                                        Saving                         $40    $19
                                                                                                                                                SSS/                            $41
    + D&A                              190          235            261                                                                   Store Pricing    $90    $1,541   $1
                                                                                                                              Organic   Growth
    + Rent                             320          397            408                                                         Store
                                                                                                           $1,400                        Acq.   $102
    EBITDAR                     $    1,167   $    1,541   $      1,803                                                        Growth
      margin                         18.8%        20.1%          22.8%                                               2012

                                                                                                                    EBITDAR $118
    1-yr Fwd EV/EBITDAR Multiple      6.7x         7.0x           7.0x                                     $1,200
    1-yr Fwd P/E Multiple            13.0x        14.4x          13.6x                                               $1,167
    Enterprise Value             $   7,860   $   10,789   $     12,620
    Net Debt + Leases            $   1,929   $    2,281   $      2,339                                     $1,000
    Stock Price                  $    80.0   $    138.3   $      166.0                Implied Fwd                     6.2X                                       7.0x                                          7.0x
                                                                                    EBITDAR Multiple
    Current Stock Price         $     80.0   $     80.0   $       80.0
    Total 3 Year Return                n/a       72.9%         107.5%               2015 Stock Price                 $80                                        ~$140                                        ~$165
    3 year IRR                         n/a       20.0%          27.6%

Key Investment Risks: (1) failure to execute commercial business focus; (2) O’Reilly competing for same geo-
graphic areas as AAP; (3) consumers shift more towards buying new cars and the age of vehicles on the road declines
                Page 40

                                    Dollar Tree, Inc. (NASDAQ: DLTR) - Long
                                    Finalist — 2013 Pershing Square Challenge
                                    Jeremy Colvin                                Eric Lai                                         Akhil Subramanian

                                    Recommendation: BUY
                                    We recommend a BUY on Dollar Tree (DLTR) shares with a target price of $64.75. This target price represents
                                    ~40% upside to today’s price of $45.99, and is based on 19.3x forward P/E (consistent with last three year aver-
        Jeremy Colvin               age) as well as $4.90 from a leveraged recap.
Prior to joining CBS, Jeremy
served as an investment banking
                                                 Current Valuation                          Price Target                              DLTR Stock Price
associate and analyst in the
                                    Stock Price                      $45.99   Stock Price                    $64.75    $60
Financial Sponsors Group at
                                    Shares Out. (mm)                  227.2   Shares Out. (mm)                227.2
Goldman Sachs. He holds a BA                                                                                           $55
                                    Market Capitalization        $10,449.2    Market Capitalization        $14,712.2
from Columbia College.                                                                                                 $50
                                    Total Debt                        271.3   Total Debt                     1,500.0   $45
                                    Total Cash                        399.9   Total Cash                      399.9
                                    TEV                          $10,320.6    TEV                          $15,812.3
                                    FY2014E EPS                       $3.10   FY2014E EPS                     $3.10
                                    Implied FY2014E P/E               14.8x Implied FY2014E P/E                20.9x     Apr-12     Jul-12   Oct-12      Jan-13   Apr-13

                                    Business Description
                                    Dollar Tree is a value-oriented chain of discount varie-
            Eric Lai                ty stores that sells every item for $1 or less. The Com-          Customer             Customer
Prior to joining CBS, Eric          pany currently has 4,531 stores in 48 states in the U.S.         finds great           receives
served as a private equity          and an additional 140 stores in Canada, with a total of            deals at            paycheck
associate at American               40.5 million selling square feet. In 2012, Dollar Tree
Securities. Prior to that, he was   opened 345 new stores, expanded 87 others and
an investment banking analyst in    closed 25, which led to an additional 2.9 million square
the Industrials Group at            feet. The average store has ~8,100 selling square feet,
Deutsche Bank. He holds a BA        which management believes to be the optimal size
                                    operationally, giving customers a shopping environment    Customer
from Yale University.
                                    that invites them to shop longer but also return more      wants to                          Customer
                                                                                               maximize                           shops at
                                    often (thereby increasing customer traffic). Initiatives
                                                                                             bang for buck
                                    the company has undertaken include debit and credit
                                    card penetration and a continued roll-out of frozen and
                                    refrigerated merchandise. The Company focuses on                             Customer
                                    customers looking to spend the leftover change from                             has
                                    their purchases at Wal-Mart or Target; and ideally it                         leftover
                                    provides them with the best and biggest bargains in the                       change

     Akhil Subramanian              Investment Thesis

Prior to joining CBS, Akhil was
                                    DLTR is unlike other dollar store competitors: DLTR is the only dollar store that sells substantially all of its
a consultant at Freakonomics
                                    products at a $1 price point. This allows DLTR to be the pre-eminent treasure hunting store where customers
Consulting. Prior to that, he
                                    can maximize their bang for buck. The Company also takes advantage of not having planograms to maximize its
was an investment banking
                                    merchandising flexibility; this leads to industry-leading price markups. Despite close proximity to Wal-Mart (75%
analyst in the M&A Group at
                                    of stores within 3 miles of WMT vs. 43% and 48% for DG and FDO respectively), DLTR enjoys the highest mar-
Credit Suisse. He holds a BS
                                    gins among dollar stores. Said another way, DLTR is a fill-in store to Wal-Mart as opposed to a competitor; it
from University of Chicago.
                                    can exist in a symbiotic relationship as shown in the chart above.

                                    Market has runway of at least 10,000 more stores and DLTR has superior store opportunities: DLTR
                                    (4,600 stores) sits well behind DG (>10,000) and FDO (~7,500). The U.S. currently has 64mm households making
                                    <$50K annually (DLTR’s target customer base). There are currently 30K dollar stores, which represents ~2,100
                                    household/store nationally. Some regions such as the Southeast (1,600 households/store) are fully penetrated
                                    while other regions such as the West Coast (15,000 households/store) are under-penetrated. We estimate that at
                                    1,600 households per store (nationally) the U.S. can support a market of ~40K stores, representing another 25%
                                    of runway. DLTR enjoys first-mover advantage in the under-penetrated west coast as it has already established a
                                    distribution center in California. This gives DLTR an advantage in the push toward market saturation.
 Volume I,
Issue XVIIIIssue 2                                                                                                                                              Page 41

Dollar Tree (Continued from previous page)
Convenient locations drive consumer traffic regardless of economic environment: The average DLTR cus-
tomer drives 15-20 minutes per visit, and DLTR stores are conveniently located close to Wal-Marts (75% stores within
3 miles). Since customers think about total dollar spend as opposed to dollar per unit DLTR provides customers a con-
venient shopping experience; the average ticket is only ~$8.
Industry leading unit economics and store returns: The average DLTR store costs less than $400K to start up
and enjoys a payback period of ~2.7 years. DLTR new store productivity has been ~87% with full-ramp by year three.
First-year stores typically operate at 11% EBIT, translating to post tax ROIC of 20%. Over the past five years, DLTR has
averaged an ROIC of 28% (vs. 21% and 9% for FDO and DG respectively).
The market is undervaluing DLTR: DLTR is superior in almost every single industry operating metric, notably
enjoying significant advantage on EBITDA margin and ROIC. However, DLTR is trading in-line with the industry average
and below DG. Over the last year, DLTR’s stock price has been down 4.6% (vs. up 10.4% for DG).

                          Retail Operating Metrics                     Returns (5yr. Avg.)                                Margins (5yr. Avg.)
Name                 Sales / Sq.  Inventory     SSS (5yr.                                                                                         Levered
                                                                  ROA               ROE           ROIC                GM             EBITDA
                             Ft.      Turns        avg.)                                                                                             FCF
Dollar General               $216       5.0x        6.8%          8.0%          13.8%             9.3%             31.2%              10.9%              3.2%
Family Dollar                $181       4.8x        4.8%         11.7%          26.4%            21.0%             34.9%               8.9%              1.7%
Dollar Tree                  $182       4.9x        5.4%         17.6%          29.6%            28.3%             35.5%              13.4%              6.1%

                                                                                                            TEV / NTM
Name                  Price Shares (MM)        Mkt Cap      Net debt            TEV           Div yield                        NTM P/E           NTM EPS
Dollar General      $49.85          327.2      $16,312       $2,632        $18,944               0.0%             8.9x                15.4x          $3.28
Family Dollar       $59.80          115.8       $6,925        $604          $7,529               1.8%             7.4x                14.8x          $3.99
Average                                                                                          0.9%             8.2x                15.1x
Dollar Tree         $45.99          224.6      $10,329        ($129)       $10,200               0.0%             8.3x                14.8x          $3.10

DLTR has maintained profitability despite moving to lower margin consumables: From FY2005 to FY2013,
DLTR shifted its consumable mix from 41% to 51%, while lower variety and seasonal decreased from 50% to 44% and
8% to 4% respectively. Consumables consist of food, drinks and other high turnover + lower margin products. Howev-
er, DLTR has maintained gross margins at 36% despite this mix-shift. Indeed, DLTR’s SSS has remained robust; custom-
ers who intend on purchasing lower margin consumables end up impulse-buying seasonal and variety products.
Potential to unlock value via leveraged recapitalization: DLTR currently has $271mm of debt on its balance
sheet, representing leverage ratio of less than 0.25x. Given DLTR’s strong and consistent cash flow profile ($360-
$380mm FCF over the past 4 years), we believe that DLTR can unlock significant value by tapping the debt markets. By
adding $1.5bn senior secured bonds at 1.875% and paying the proceeds as a dividend, DLTR can unlock $4.90 of value
for shareholders or 10.9% return. The 1.875% coupon is based on what DG received less than three weeks ago. Given
DLTR’s superior financial metrics, we believe that DLTR could receive equal (or better) rates from investors.


At 2014E EPS of $3.10 and a P/E multiple of 19.3x (which is in-
line with 3 year average), DLTR should be trading at ~$64.75/                                                                $0.14               $3.10
share (including the $1.5bn leveraged recap with a share price              $3.00
impact of $4.90). In order to reach $3.10, we assume relatively             $2.80     $2.68
conservative new store growth of (340 stores), 3% same store                $2.60
sales growth (below historical average 4.4%), 20bps margin                  $2.40
uptick (below 2012 improvement) and $500mm of share buy-                    $2.20
backs.                                                                      $2.00

Near-term Catalysts
1.     On pace to opening 250+ stores in FY2014
2.     Q1 2014 earnings of flat to improving margins with continued roll-out of freezers
3.     Q1 2014 SSS of 2-3%
4.     Leveraged recap

Key Investment Risks: (1) increasing competition from market saturation and Wal-Mart; (2) increasing payroll taxes
could hurt discretionary spending in 2014; (3) long term inflation could be a detriment to single price point model; (4)
sustained period of economic growth could see core customers trade up.
               Page 42

                                  Stanley Black & Decker (NYSE: SWK) - Long
                                  Finalist — 2013 Pershing Square Challenge
                                  Arjun Bhattacherjee    Rory Ellison               Colin Kennedy

   Arjun Bhattacherjee

Prior to CBS, Arjun worked in
Private Equity at Olympus         Recommendation: BUY
Partners. Arjun holds a BA in     We recommend a long position in Stanley Black & Decker (“SWK” or the “Company”) stock with a target price
Mathematics and Economics         of $107.00. The stock has an asymmetrical risk/reward profile from current levels. The Company trades at a 15-
from Macalester College.          20% discount to its peer group and has significantly underperformed the market in 2012-2013. Our target price
                                  represents a ~43% total upside to the current share price of $76.40, and is based on a Sum-of-the-Parts analysis.
                                  Our downside case generates $68.00 (down ~11%) which equates to a base case Up/Down of 3.9x.
                                  SOTP Analysis
                                  ($ in mm)

                                  Segment                           FY14E EBITDA      Current     Base Case   Avg. Comparable Company
                                  CDIY                                     1,144        10.0x         10.0x                             10.6x
                                  Industrial                                 737         9.0x          9.0x                              9.5x
                                  Security                                   537         1.6x         10.5x                             10.8x
                                  Corporate Expenses                        (427)        7.8x          9.8x
                                    Total                                  1,991         7.8x          9.8x
                                  Enterprise Value                                     15,618       19,605
        Rory Ellison
                                  Current Share Price                                  $76.40       $107.00
Prior to CBS, Rory worked in      Dividend / Share                                                     1.96
Private Equity at Leonard         Premium / (Discount) to Current                                       43%
Green & Partners. Rory holds
a BA with Honors in Business      We believe that SWK is in a cycle of suboptimal capital allocation and has significant activist poten-
Admin. from the Richard Ivey      tial. The Company is a collection of superior market leading businesses whose intrinsic value is obscured by a
School of Business at the         conglomerate structure. SWK has strong FCF, but currently ~80% of that cash is generated overseas. This dynam-
University of Western Ontario.    ic coupled with management’s desire to build a ‘diversified industrial company’ forces the Company to undertake
                                  risky acquisitions outside of its core competency. SWK has 30% end market exposure to US construction mar-
                                  kets, yet due to a lack of managerial focus and execution the Company has struggled to grow organically and is
                                  losing share in its core power tools and hand tools segment (CDIY). We believe an activist solution that spins
                                  out the SWK Security segment will unlock significant value for current shareholders. In addition, we believe that
                                  spinning out security will allow SWK Management to better focus on core segments and drive organic growth

                                                                                                                  Key Investment Highlights
                                                                                                                                         Market Leading Businesses
                                                                                                                                              #1 and #2 Market Share

                                                                                                                                                    Macro Tailwinds
                                                                                                                     30% exposure to domestic construction end markets
      Colin Kennedy               In addition, we believe there is incremental upside available to SWK
                                  shareholders by undertaking a split off and simultaneous merger (via                                   Significant FCF Generation
                                                                                                                                                   ~9% 2014E FCF yield
Prior to CBS, Colin worked in     a Reverse Morris Trust structure) with Ingersoll-Rand’s Security
Private Equity at FdG             segment. We believe this would create an Irish-domiciled security                               Activist Potential: Hidden Value
Associates. Colin holds a BA in   powerhouse, and the RMT transaction would add an incremental                                            1) Spin off SWK Security Asset
                                                                                                                2) Reverse Morris Trust with Ingersoll-Rand Security Asset
Economics and Psychology from     ~$7.50 per share due to the combined company receiving a higher
Duke University.                  valuation than a straight spinoff scenario. The longer term earnings                                               Cheap Valuation
                                  power of such an entity significantly exceeds this initial valuation                                                Trades below peers
                                                                                                                                                       11.4x 2014E P/E

                                              Incremental Upside: RMT
                                  RMT Value Creation                          $7.57
                                  Total Value                               $116.53
                                  Premium to Current                            53%         Up/Down
                                  Business Description
                                  SWK provides power and hand tools (50% of revenue), industrial and auto repair tools and engineered fasteners
                                  (28% of revenue), and mechanical access solutions and electronic monitoring systems (22% of revenue) globally.
 Volume I,
Issue XVIIIIssue 2                                                                                                              Page 43

Stanley Black & Decker (Continued from previous page)
Market Leading Businesses: SWK has the #1 market position in hand and power tools within its CDIY segment and
has occupied this leadership position for over 100 years. SWK’s principal brands include Stanley, Dewalt and Black &
Decker and these brands are front of mind of contractors and pros in the industry. This segment will continue to bene-
fit tremendously as housing and non-residential construction recover domestically (30% exposure) from their current
depressed levels. In addition, CDIY has significant exposure to LATAM—a driver of future growth in this industry. In
its Industrial Segment, SWK holds the leadership position in industrial automotive tools and engineered fasteners. This
segment has high barriers to entry due to its highly engineered products, many SKU’s and mobile distribution network.
In addition, the Industrial Segment has a highly fragmented and significant Total Addressable Market (~$80 BN) that will
allow for accretive acquisitions over time. In Security, SWK is the dominant player in the automated and mechanical
security market and competes directly with Assa Abloy, Ingersoll-Rand and Tyco’s security division. This segment bene-
fits from high barriers to entry as network effects are developed through longstanding relationships, code driven rules
create millions of SKU’s and a high degree of customization prevent offshore competition.
Significant FCF Generation: SWK generates an approximately 9% 2014E FCF yield. The Company currently sup-
ports a strong dividend of $1.96/share on an annual basis representing a 2.6% dividend yield at current levels.
Macro Tailwind: SWK has significant exposure to US residential and non-residential construction markets—markets
that are improving but continue to operate at depressed levels. 20% of SWK revenues are tied to US residential hous-
ing, and housing starts remain ~50% below average levels. In addition, SWK has significant exposure to US commercial
construction and recent improvements in the Architectural Billings Index (a leading indicator) support a nascent recov-
ery in US commercial construction likely to occur in 12-18 months. Finally, SWK CDIY is still 20% below peak
levels (PF for SWK and Black and Decker transaction) supporting significant upside from a continued recovery in end
Significant Activist Potential: Management has been using its significant FCF to become a diversified industrial com-
pany. This strategy has not worked and has led to a vicious cycle of poor capital allocation as SWK management has
been focused on non-core acquisitions in weak geographies. In addition, these acquisitions have led to management
losing focus on their core business (selling power tools and hand tools) and losing domestic share. Organic growth has
been roughly flat in the last decade despite management’s stated goal of 4-6% annual growth. Thus, we believe an ac-
tivist shareholder can address SWK’s problems, as a push for a tax-free spin (similar to TYCO and Inger-
soll Rand) of SWK Security would unlock significant value. Assa Abloy (a pure-play Security comparable) trades
at ~12x EV/EBITDA, a significant premium to the current implied valuation for the SWK Security segment in the SWK
conglomerate structure. In addition, a separation of SWK Security would enable SWK management to better focus on
organic growth in the tool industry. Further, we believe the PF SWK entity (CDIY + Industrial) would be an attractive
pure play acquisition target due to its significant FCF, market leading brands and strong growth prospects.
We also believe there is incremental upside available to SWK shareholders by pursuing a double RMT, which is a tax-
efficient separation of the SWK Security segment and simultaneous merger with Ingersoll-Rand Security (IR announced
its intention to spin-off Security in Q4 2012). This strategy would create an Irish-domiciled Security entity, which is a
significant tax-benefit for future earnings and capital allocation, and form the second largest global security company
with ~$1BN EBITDA. The levered RMT structure could also allow for a dividend distribution of up to $1.3 billion to
SWK shareholders. The combined entity would create significant additional value for both SWK and IR shareholders
due to its strong market position and earnings power.
SOTP Valuation                                                     Incremental RMT Upside
 ($ in mm)

 Segment                       14E EBITDA    Current   Base Case
                                                                              Stanley Black and Decker, Inc.
 CDIY                               1,144      10.0x       10.0x
 Industrial                           737       9.0x        9.0x
                                                                                           Upstream To SWK Shareholders:
 Security                             537       1.6x       10.5x      Tax-free split-off
                                                                                           $1.3BN dividend from debt issuance
 Corporate Expenses                  (427)      7.8x        9.8x                           $5.5BN equity stake (55%) in NewCo
   Total                            1,991       7.8x        9.8x
                                                                      SWK Security                        Ingersoll-Rand
 Enterprise Value                            15,618      19,605        SpinCo, Inc.                       Security Corp.
                                                                                           M erger

 Current Share Price                         $76.40     $107.00 RMT Value Creation                                      $7.57
 Dividend / Share                                          1.96  Total Equity Value                                   $116.53
 Premium / (Discount) to Current                            43% Premium / (Discount) to Current                           53%

Outside Executive / Board Member
We also believe that an outside Director would be beneficial to help expedite the process to unlock hidden value for
SWK shareholders. A potential candidate for this position is Edward Breen (the former chairman of Tyco, where he
oversaw several spin-offs and breakups of divisions).
Failure of Activist Campaign: 30% exposure to US construction markets and growing emerging markets present a clear
path to near term earnings growth. A 9% FCF yield is an effective floor.
                 Page 44

                                     Yum! Brands, Inc. (NYSE: YUM) - Long
                                     Finalist — 2013 Pershing Square Challenge
                                     Omar Elangbawy                              Ranjan Ramchandani                               Andrew Woodruff
                                     Capitalization                              Trading & Liquidity                          Implied Multiples
                                     Stock Price                        $65.04   Name                          Yum! Brands                              2012       2013
                                     Shares Outsanding                   449.9   Ticker                               YUM     Revenue                 $13,633.0   $14,053.0
                                       Market Cap                      $29,261   Date                             4/19/12     EBITDA                    2,758.0     2,983.0
                                                                                 52-Week High                      $74.75     EBIT                      2,227.0     2,264.0
     Omar Elangbawy                                                              52-Week Low                       $59.68
                                     Cash                                $776
                                     Debt                               $2,942   Free Float (m)                     449.5
Omar is a second-year MBA                                                        Insider Ownership                   0.3%     EV / Sales                   2.3x        2.2x
student. Prior to Columbia, he       Minority Interest                    $158   Short Interest                      2.3%     EV / EBITDA                 11.5x       10.6x
worked in Private Equity for         Enterprise Value                  $31,585   Daily m Volume                        2.9    EV / EBIT                   14.2x       14.0x
FLAG Capital and interned as
an analyst for a small-cap, value-   Recommendation
oriented hedge fund. Omar
                                     We recommend a long position in Yum! Brands, which we believe is undervalued due to its suboptimal operating
holds a BA in Economics and a
                                     structure. Given the predictable, steady cash flows in the U.S. and Yum’s broad international footprint, we believe
BS in Computer Science from
                                     the inherent stability of the business lends itself to an asymmetric risk-reward profile. While the short-term focus
the University of Pennsylvania.
                                     on recent food safety and avian flu scares in China has depressed the stock price, our view on the long-term sus-
                                     tainability of the business makes a stake in Yum! an attractive proposition.
                                     Our thesis revolves around two drivers of value. In order to capitalize on the value creation mechanisms we’ve
                                     identified, an investor would need to take an activist stance and create his/her own catalyst. The crux of our thesis
                                     is as follows:
                                     1) Yum’s operating structure exposes US investors to a high degree of emerging markets risk. A
                                        spinoff of Yum’s domestic operations into a separate entity from the high growth international
                                        business would allow investors to more efficiently define their risk tolerance .
   Ranjan Ramchandani                        Yum U.S. - a stable, highly cash-generative business focused on returning capital to shareholders
Ranjan is a second-year MBA                  Yum International - a growth-focused entity working to expand Yum’s footprint in developed and
student focusing on healthcare                   emerging markets outside of the U.S.
management and
entrepreneurship. Before
                                             A split would allow investors to better allocate their risk between two fundamentally different risk /
                                                 growth profiles. We believe the split would reverse an estimated 25% discount on the combined entity.
school, he worked for 3 years
in the New York office of the        2) A spinoff would drive increased management discipline, improving the likelihood of capitalizing
Boston Consulting Group,                on operational improvements within each entity to drive both top-line growth and margin ex-
where he will be returning after        pansion.
graduation.                                  Yum U.S. - Continue to focus on innovative product development and franchise-level operational im-
                                                 provements while also improving G&A efficiency.
                                             Yum International - Invest in smart growth in underpenetrated cities in China. Capitalize on largely un-
                                                 tapped India and RoW opportunity. Consolidate suppliers and rationalize supply chain logistics where
                                                 possible to improve margins.
                                     Business Description
                                     Yum! Brands is the world’s largest quick service restaurant company with over 39,000 stores all over the world.
                                     Stores are both corporate owned and franchised under three main brands: KFC, Pizza Hut, and Taco Bell. In addi-
    Andrew Woodruff                  tion to these brands, Yum also owns a number of smaller, local brands primarily throughout China. Approximate-
Andrew is a second year MBA          ly 75% of revenues and operating income comes outside the U.S., with China making up about two-thirds of that
student. Before CBS, Andrew          amount. Approximately 80% of Yum’s stores are franchised or licensed, leaving 20% corporate owned.
worked three years in emerging                     Financial Summary
markets sales & trading for J.P.                                                               Year Ended December 31,                                                        Quarter Ende
                                                                                   2007         2008      2009     2010       2011          2012
Morgan. He has worked as an                        Revenue                         $10,435     $11,304 $10,836 $11,343       $12,626        $13,633
analyst for two different long/                     % Growth                             -        8.3%     (4.1%)    4.7%      11.3%           8.0%
short equity funds over the past                   Gross Profit                       2,662       2,839    2,902     3,223     3,486          3,781
year. He has also passed all                        % Margin                         25.5%       25.1%    26.8%     28.4%     27.6%          27.7%
three levels of the CFA exams.                     G&A                                1,293       1,342    1,221     1,277     1,372          1,510
                                                    % Margin                         12.4%       11.9%    11.3%     11.3%     10.9%          11.1%
                                                   EBIT                              1,369       1,497    1,681     1,946     2,114          2,271
                                                    % Margin                         13.1%       13.2%    15.5%     17.2%     16.7%          16.7%
                                                   EBITDA                            1,911       2,053    2,261     2,535     2,742          2,916
                                                    % Margin                         18.3%       18.2%    20.9%     22.3%     21.7%          21.4%
 Volume I,
Issue XVIIIIssue 2                                                                                                                Page 45

Yum! Brands (Continued from previous page)
Investment Thesis
1) Rationale for spinoff
     Current operating structure is an inefficient capital allocation vehicle. Yum’s International operation is concen-
        trated in China, a market that entails significant upside but also significant volatility. By contrast, the US business
        is largely franchise-owned and generates stable, high-margin revenues. Yum! investors are obliged to participate
        in risk inherent in the emerging markets portion of the business and cannot choose the level of exposure to this
        risk relative to the stable US business. Consequently, we believe the combined entity trades at a discount. A
        spinoff of the US operations would close this discount.
     The spinoff is feasible from an operational perspective. Yum! US is organized by brand vertical, whereas Yum’s
        International divisions (China, India, and YRI) are organized by geography. Management teams and supply chains
        are already totally distinct. Additionally, financials are reported in line with our proposed spinoff structure,
        allowing investors transparency into forecasted NewCo results.
     From a governance perspective, there are few impediments to a successful spinoff. Ownership of Yum! is con-
        centrated among institutional shareholders (>70%), insiders hold a very small percentage of the firm (less
        than .3%), and short interest is low. The Board is up for re-election every year and the proxy statement indi-
        cates no active poison pill mechanism.
2) US opportunities
     Yum’s US brands have continued to innovate, both in terms of product development and in terms of operating
        model improvements. The introduction of the Doritos Locos taco in 2012 by Taco Bell was widely regarded as
        one of the most successful product launches in QSR history, and Taco Bell is on track to sell 500 million units in
        2013. KFC will soon be making a shift to a largely boneless menu, a change it believes will align its menu closer
        to the tastes of younger consumers. Pizza Hut has shifted many of its locations to a “Delco Lite” model, cutting
        the store footprint in half and focusing on delivery/carryout operations.
     Yum US lags its peers in terms of G&A as a percentage of US sales. While this metric is highly sensitive to fran-
        chise mix and same-store sales, it is indicative of the fact that there are opportunities for increased G&A effi-
        ciency. Yum US’ brand vertical operating structure has created duplicative functions (HR/IT/Finance) across
        business units; centralization of these functions could drive synergy value. Furthermore, menu rationalization at
        the brand level could allow for more efficient use of corporate ad dollars, driving increased top line. We believe
        the combined effects could generate an additional 200bps in margin over the next two to three years.
3) International operational improvements
     China will continue to be a growth engine. Yum! is the market leader among QSR chains but is still underpene-
        trated in “lower tier” smaller cities, implying significant room for growth. Additionally, Yum!’s recent acquisition
        of Little Sheep, the world’s leading hotpot chain, suggests opportunities for growth through M&A.
     Management’s focus on China growth has come at the expense of capitalizing on rest-of-world opportunities. A
        spinoff would allow management to focus on expanding Yum’s footprint in other developing markets, particular-
        ly in India. Management guidance suggests India system sales growth will top 40% per annum over the next
        several years. India is also a candidate for a first major toehold for Taco Bell abroad, as pilot locations in Delhi
        have proved extremely successful, likely due to the relative familiarity of Indian consumers.
     The historical focus on China growth has also led to a “long tail” of international markets in which Yum! has a
        limited presence. A more concentrated approach to expansion in these markets will drive enhanced synergies at
        the franchise and corporate level as penetration in these markets approach scale.
Our model assumes the two business units, Yum! Intl. and Yum! US, will each trade at a more appropriate multiple in
line with their individual growth/risk prospects. Given the inherent stability of the US business, we have assumed the
business will trade at 11x EBITDA, which is below some of the larger QSR chains in the US that have a similar mix in
terms of franchised vs. company-owned stores (e.g. McDonald’s). For Yum! International, we believe the growth pro-
spects in China and RoW would allow the company to trade in-line with its competitors with a similar growth profile at
15x EBITDA. As a result, we believe an investment in Yum! Brands represents an attractive investment opportunity for
an activist investor with 50-70%+ upside in two years (price target of $100-$110 per share by 2015).
Key Investment Risks
Given the scope of the proposed activist maneuver and the size of Yum! ($30B), the spinoff proposal could encounter
resistance from management and the Board. A proxy contest could be a protracted and difficult endeavor, though the
concentrated institutional ownership and relatively lax anti-activist governance provisions mitigate this risk.
The investment is also exposed to operational risk for both the US and International businesses. Though we believe the
US business is largely stable—particularly given its high proportion of franchisee ownership—a secular trend toward
healthy eating could negatively affect system sales. Yum’s brands are attempting to preempt this with healthier menu
options (e.g. the Cantina Bell menu at Taco Bell). Internationally, the business is subject to the volatilities of emerging
markets—regulatory, food safety, political, and currency risks—and to competitive threats from other multinational and
international QSR chains. Nonetheless, we believe the existing infrastructure and store footprint mitigate these con-
cerns to a certain extent.
     Page 46

               Paul Isaac
               (Continued from page 1)          trading was in the distressed     Walter studied under at the
               G&D: You were brought            securities of public utility      stock exchange institute
               up in a family involved in       holding companies,                back in the 1930s.
               early value investing circles    railroads, or a lot of the real
               (for example, Isaac’s uncle is   estate companies that got         Graham-Newman was an
               Walter Schloss). Barron’s        into trouble in the 1930s.        investment company with a
               said that you have the                                             limited balance sheet in
               “value gene.” How was it         In many ways, the early           1946. They had six or
               growing up with relatives        arbitrage business was            seven people on staff, and
               like that, and how did that      essentially following the         they were running about $7
Paul Isaac     influence your career and        outcomes of those                 or $8 million. Graham-
               decision-making?                 securities, which any market      Newman was doing a range
                                                maker would do, especially        of event- and cheap-
               Paul Isaac (PI): I don’t         given the relatively limited      securities-type investing in
               know that it was that            secondary turnover in the         the 1940s. Walter got a job
               unique. When I was               securities markets of the         there as an analyst and
               working on a money               1930s. You can see                stayed with Graham-
               markets trading desk, the        references to how difficult it    Newman virtually until the
               head of the money markets        was to maintain some of           end. He later set up a
               department at DLJ said,          those positions in Phil           partnership because one of
               “People think that all these     Carret’s memoir, A Money          the Graham-Newman
               guys in New York are so          Mind at 90, and in Peter          investors said they would
               sophisticated, but they’re       Drucker’s Adventures of a         stake him with $100,000,
               really nothing but a bunch of    Bystander. Drucker                which even at the time was
               tree toppers. If they’d been     describes working on some         a modest amount of money.
               born in Astoria, Oregon,         Kreuger & Toll bonds for a
               they’d be out topping trees      poorly disguised Singer &         People can be active money
               for Weyerhaeuser, but they       Friedlander in London in the      managers in the way they
               were born in New York, so        1930s. So these were              are today partly as a
               the job at the end of the        essentially a side activity of    product of a long bull
               subway line was working in       the business of being a           market and partly as a
               a cage or working at a           market maker.                     product of developments in
               trading desk. They’re just                                         trading, analytics, the
               tree toppers.”                   My father always had the          availability of information, as
                                                idea that you basically           well as the separation of the
               There’s some truth to that.      worked in the securities          execution function from the
               This was a local business.       business. Investing on the        investing function as a result
               Active principal investing as    side meant that you could         of regulatory changes and
               a separate activity, as          be somewhat more intrepid.        compliance concerns. What
               opposed to being a portfolio     You had another source of         I remember most about
               manager at a fiduciary           income and you did well           growing up was that most of
               institution (a very different    partially because it gave you     my father’s friends were in
               thing), was really a side        an opportunity to both see        the business. Many of them
               activity of people mainly        flow and to be patient. My        came out of the arbitrage
               engaged in intermediary          uncle, Walter Schloss, who        community. A few of them,
               functions, often as market       actually worked in the cage       Max Heine, for example,
               makers in various types of       at Loeb Rhoades in the            were really in the brokerage
               securities. So my father, for    1930s before he went into         business. When they came
               example, graduated from          the service, came out and         over, I heard a lot more
               the NYU School of                got a job at Graham-              about Spingarn Heine than I
               Commerce in 1928, and            Newman. Benjamin                  did about Mutual Shares,
               wound up working at a            Graham was an instructor                        (Continued on page 47)
               trading desk. Some of the
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Issue XVIIIIssue 2                                                                                       Page 47

Paul Isaac
(Continued from page 46)         My father was much more          more complicated. You
which was really a sideline      interested in the dynamics       have to be sensitive to both.
for customers too small to       of complex situations and        When a stock is relatively
have independent brokerage       how things would ultimately      expensive, it is much harder
accounts at Spingarn Heine.      get picked apart. For            to assess whether other
                                 example, he closely              people have simply done a
Walter didn’t talk too much      followed the reversion of        better job than me at
about the people he knew –       the Waddell field to             assessing the probabilities of
he talked about stocks, and      Southland Royalty from Gulf      successful outcomes. So
that was always interesting      Oil. This was a major case       you have to start with
and very memorable. But a        in the 1970s which hinged        something that is
lot of what I remember was       on whether the lease on the      demonstrably cheap
really how prosaic it actually   field could be involuntarily     because, first, it is harder to
was. When Bob Heilbrunn          extended as a result of the      get hurt if you fall out of a
came over for dinner with        Texas Railroad                   basement window, and
Harriet, they were talking       Commission’s proration           second, it’s so difficult to
more about kids and less         policies after the lease was     assess whether other
frequently about something       put into effect in 1925. My      people have a more
like the utility industry.       father became very involved      accurate handle on
There was no great sense of      in looking at that and           favorable characteristics
the sorts of corporate           decided there was going to       than you do.
battles that people talk         be a reversion, and he was
about today. It all seemed       right. But as with so many       G&D: How do you ensure
to move at a very slow           other things in investing,       that the statistically cheap
pace.                            Southland Royalty was a          stocks aren't value traps?
                                 spectacularly successful
G&D: What are the most           investment less because          PI: They are always value
important things you             they were right on the           traps in retrospect, right? In
learned from your uncle or       reversion, but rather            other words, if it works, it's
your dad about investing?        because the case was             not a value trap. There are
                                 launched before the Arab         certain characteristics that
PI: They actually had very       oil embargo and was              lead to value traps. For
different styles. Walter was     resolved after oil had tripled   example, a company with an
always vociferously opposed      in value. So it was a            extremely conservative
to the idea of owning bonds.     serendipitous event that         financial policy and
My father, who was in many       drove a large part of the        entrenched management
ways more aggressive than        return. My father was much       that has no desire to
Walter, probably stayed          more interested in finding a     increase the dynamism of
about 30% in T-bills for         deeper edge. He was more         the company or to realize
most of the post-war             of a company analyst in          the value in the security can
period. I think Walter really    some ways than Walter            lead to a value trap – you
had the courage of his           was.                             can be sitting with
convictions in terms of                                           something for a very long
principles and ideas about       G&D: Are you more like           time with relatively little
valuation. With Walter,          Walter Schloss, in that you      uplift in the asset value or a
what you saw was what you        look for statistically cheap     corporate event which
got. If a stock was really       stocks, or more like your        captures much of the
cheap, Walter basically took     father, in that you look for     disparity between the
the view that as long as         complex situations?              secondary market price and
managements weren't                                               asset value.
crooks, the valuation would      PI: The process has moved
eventually reach fair value.     on and become somewhat                         (Continued on page 48)
              Page 48

                               Paul Isaac
                               (Continued from page 47)         money on your first             the broad equity markets,
                               But those situations have a      purchase. If the valuation      and the broad bond markets
                               way of eventually resolving      never becomes really            for institutional investors.
                               themselves. There was a          compelling, there is always a
                               company, Stern and Stern         tendency to be less             It's a frustrating business.
                               Textile, which was a textile     involved. Pain is nature’s      It's like trying to become a
                               importing business that          way of telling you that         professional three-legged
Pictured: The four finalists   accumulated a tremendous         you’re doing something          racer – you're trying to put
of the Moon Lee Prize Com-     amount of cash and always        wrong, and mindlessly           together a variety of funds
petition in March 2013.        sold at a very cheap price       buying more just because        where you want them to be
                               relative to its book value. It   something goes down is a        great runners, but not
                               disappointed an awful lot of     poor practice. But it is also   collectively run too fast, and
                               people. But then a family        equally true that just          they have to do it in the
                               member died who was              because you’ve discovered       approved form. I met some
   “The question in            active in the business and       something cheap with long-      fascinating people, and it
                               had a major holding in the       term merit does not mean        was very interesting to see
avoiding a value trap          company. So they worked a        that the rotation out of a      the different ways in which
 is twofold. First, are        deal where they sold off the     previous population of          people thought about and
                               textile business and merged      investors that is currently     structured their portfolios.
     the dominant              the company into one of the      occurring is going to stop
                               Neuberger Berman mutual          just because you’re buying      Running a hedge fund is
    shareholders or            funds. Ultimately it worked      some. This is a tension you     more to my taste partly
     management                out very well, but for years     have to look for, assess, and   because I like coming up
                               it was a value trap.             accept as a fact of life.       with an idea and seeing it
 incentivized to have                                                                           through on my own. I also
                               The question in avoiding a       G&D: There were a               have something of a Lewis
    some kind of a             value trap is twofold. First,    number of years where you       Carroll/Red Queen
  transaction that's           are the dominant                 ran both a fund of hedge        approach to investing –
                               shareholders or                  funds and a hedge fund at       you’ve got to run really fast
going to increase the          management incentivized to       the same time. Can you          to stay in the same place in
                               have some kind of a              compare and contrast these      the long run, particularly
 market value of the
                               transaction that's going to      two experiences?                when you're dealing with
company in the near            increase the market value of                                     taxes and inflation. So I’m
                               the company in the near          PI: First of all, there's the   relatively aggressive in terms
 future? And second,           future? And second, is the       question of what's a hedge      of how I run money. As
                               intrinsic value of the           fund. It's pretty much          long as the underlying value
 is the intrinsic value
                               company increasing at a          anybody who is running          of the securities I own is
   of the company              relatively attractive rate of    tradable assets and gets an     continually improving, I'm
                               return? If you've got the        incentive fee. So it's a very   somewhat indifferent to
    increasing at a            latter, then presumably the      inclusive definition. A fund    what happens on an interim
 relatively attractive         valuation is going to rise at    of funds is really somebody     market basis. That is the
                               least at that rate of return,    who's running assets            antithesis of what you're
    rate of return?”           even preserving a big sum-of     invested in a collection of     doing in the fund of funds
                               -the-parts discount under an     hedge funds. The fund of        business. A fund of funds
                               unfavorable value trap           funds business that I was       business can be thought of
                               situation. What you'd love       involved with provided a        as an annuity with a
                               to have is both, but what        zero-beta-targeted portfolio    knockout option – if you
                               you want to avoid is where       of hedge funds that aimed       have too much of an
                               you have neither.                for a moderate rate of          investor drawdown, you're
                                                                return at low volatility with   going to lose your annuity.
                               My father had a saying that      diversification away from       This has adverse feedback
                               you never make a lot of          the return characteristics of                 (Continued on page 49)
                               money unless you lose
 Volume I,
Issue XVIIIIssue 2                                                                                       Page 49

Paul Isaac
(Continued from page 48)         that would give you pause,       PI: Every security that you
effects when other investors     apart from things like the       own, with the exception of
flee and cause instability in    accountants, which we            new issues, has already been
your organization. So, it        never actually got to. One       owned by somebody else.
requires you to think very       of them was that nobody          So it’s really the standard
much in terms of controlling     ever left. It’s very hard for    stuff. We screen for
volatility.                      managers to hold all of their    businesses that are
                                 good people forever. Yet,        inexpensive relative to
There are similar                no one ever left the Madoff      straightforward criteria.
constraints running a hedge      organization to set up           We try to find businesses or
fund, but they are less acute.   “Madoff Light.” It was very      industries that are becoming
In that sense, I find it an      anomalous. The attraction        somewhat cyclically
easier process, partially        of Madoff was that he was        depressed. We also try to
because I can focus on the       purportedly doing what we        find good businesses that
intrinsic attractiveness of      were supposed to be doing;       are down considerably
the underlying securities and    but much better. In other        because they’ve
not worry so much about                                           disappointed people.
what might happen to them                                         Sometimes it’s related to a
over the short run.                 “Any investment               broad development within a
                                                                  particular field. For
G&D: At the fund of funds,         decision should be             example, we’ve decided that
you managed to completely                                         the increase of compliance
avoid all investments in           made on the basis              and regulatory burdens on
Bernie Madoff’s funds. How                                        community banks is going to
you were able to do that?
                                   of your enthusiasm
                                                                  make community banking
                                  for that investment.            relatively difficult to conduct
PI: Any investment                                                profitably, particularly in a
decision should be made on            It shouldn’t be             low-interest-rate
the basis of your enthusiasm                                      environment. So we’re
for that investment. It            made because you               interested in acquiring
shouldn’t be made because                                         shares in banks with
you can’t think of a reason          can’t think of a             reasonable footprints that
not to be in that investment.                                     are relatively clean trading
Anybody who did any
                                   reason not to be in
                                                                  at significant discounts to
serious due diligence on the        that investment.”             their tangible book value. If
Madoff funds rapidly                                              the discount is great
discovered that you couldn’t                                      enough, the lack of
figure out what they were        words, he was running with       profitability is not a
doing. Plus, from the            low volatility and reportedly    deterrent – it’s actually an
scuttlebutt, it seemed very      moderately high returns.         incentive because chances
unlikely that anybody could      There are lots of funds          are they’re more likely to
deploy the amount of             where if you’re willing to       give up the ghost.
money Madoff was widely          accept somewhat higher
reputed to be running in the     volatility, you were likely to   We also look at industries
strategies that people           earn a Madoff-like return,       that are undergoing
believed he was using. In        and you could be perfectly       consolidation. We try to
addition, there were other       comfortable with them. So,       find things that would have
people who were trying to        why invest with Madoff?          asymmetric payoffs in terms
do the same thing, and                                            of financial market fashions.
weren’t doing it nearly as       G&D: Can you talk about          I confess that I’m always
successfully as Madoff was.      your search process?             interested in following what
                                                                                (Continued on page 50)
There were other red flags
               Page 50

                               Paul Isaac
                               (Continued from page 49)         portfolio. It's not like I'm      wonderful job of building a
                               really smart people do in        going to call up Jeffrey          large number of businesses,
                               this business and the stuff      Immelt and say, "Let's chew       and NAV discounts in
                               they’re most frustrated in.      the fat over what you're          Malone vehicles don't seem
                               There’s an old Marty             going to do at GE." So in         to survive very long. So in
                               Whitman line that says,          that sense, no, we don't          that particular case, I think
                               “You should do what I do,        really talk to management in      the management matters a
Pictured: Paul Orlin of Ami-   but just do it two years         most cases. However, with         lot.
ci Capital at the Moon Lee     later.” I’m perfectly happy      smaller companies, we may
Prize Competition in March     to listen to Marty. I’ll look    talk to them, especially if the   We won't buy something at
2013.                          at what he bought a couple       leadership or strategic view      a premium just because it’s
                               of years ago that hasn’t         of the company is                 a particular manager or
                               worked that he still owns,       particularly important. We        promotional guy. There are
                               particularly if he’s adding to   want to understand how            certain people where, if
                               it, and see if we agree.         they look at the business         their stock is trading
                                                                and determine if that’s a         relatively inexpensively and
                               We also look for                 reasonable strategy for           they have a track record,
                               commodity businesses that        them to pursue. Also, if          we're more inclined to get
                               are cyclically depressed that    they come in and their eyes       involved.
                               may undergo a long-term          are rolling in alternate
                               reversion to the mean,           directions in either socket,      In certain types of
                               especially if the replacement    you might want to avoid the       businesses, the management
                               cost is a lot higher for         company. If they seem to          has a much bigger effect on
                               capacity that is currently       be really knowledgeable and       operating effectiveness, and
                               embedded in the producers.       engaged in the business, and      when we get involved we
                               We try to determine how          if they function well with the    want to talk to them about
                               long it’s likely to take and     other senior members of           strategy. A lot of
                               how cheap these things are,      the management team, then         managements really try, and
                               and what their earnings          that's a plus.                    they try hard. Most
                               power is going to be at the                                        businesses are more
                               peak. Can we see ourselves       There are people who say,         complex and more difficult
                               getting an attractive IRR        "I want to have a great           than they ever seem to
                               making some moderately           capital allocator," and within    outsiders. If senior
                               unfavorable assumptions?         limits I understand that.         management is intelligently
                                                                Occasionally we will follow       engaged with the business
                               Sometimes it’s sum-of-the-       that, too. So, for example,       and has a plausible plan for
                               parts stuff. Sometimes it’s      our largest position is in the    dealing with the issues that
                               relatively complex               Bolloré Group in France.          we see and the stock is
                               structures that occasionally     That is partially the result of   cheap, then that’s a big plus
                               fall out of favor. There are     Vincent Bolloré and his           for us.
                               fashions in this business, and   talents, although it happens
                               the things that are out of       to be very cheap statistically    But we’re not looking for
                               fashion may well be worth        and is a complex situation as     Sir Galahad. We’re not
                               looking at.                      well.                             necessarily going to find
                                                                                                  him, and we certainly don’t
                               G&D: How do you assess           Anytime John Malone comes         have the ability to identify
                               management? Many                 up with yet another fanciful      him better than others. On
                               investors spend a lot of time    creation, and it seems to be      the short side, there is a bit
                               with management while            trading at a thirty or forty      of a tension because I react
                               others tend to avoid them.       percent discount to NAV,          viscerally negatively to
                                                                we're inclined to get             highly promotional
                               PI: I started out with a         involved. He's done a                           (Continued on page 51)
                               relatively small personal
 Volume I,
Issue XVIIIIssue 2                                                                                      Page 51

Paul Isaac
(Continued from page 50)         was also the largest             G&D: You’ve said in the
managements, yet those           shareholder, had decided         past that you don't
people are extremely             that he wanted to do the         necessarily look for catalysts
talented in getting the stock    best impersonation of            and that allows you to have
up. So you have to               Corporate King Lear ever         a longer-term holding
recognize that the               seen in the Hudson Valley.       period. Could you explain
promotional guy you dislike      We thought that could            the rationale behind this
may actually be very good at     destabilize the company. So      strategy?
causing you a lot of pain in     one of our analysts, not me,
something that you think is      went on the board and            PI: Many times, what's
a natural short.                 contributed clarity to the       happening is that we're
                                 strategic process, and I think   buying into something that
G&D: Have you                    this really did a lot of good    has gone down a lot
considered taking activist       for shareholders.                recently. And it's going
positions where                                                   down for good reasons;
management is not                In another case, we invested     there are people who are
extracting full value?           in a real estate company         disenchanted, there have
                                 that was extremely               been cyclical problems,
PI: The presence of other        inexpensive and had some,        there may be a general
people who we think are          frankly, incompetent second      economic problem, or there
competent activists is a         -generation family               may be product or business
positive, especially if we       leadership. The family           transitional issues. We try
think the stock is attractive.   managed to get itself into       to figure out what the
It won’t cause us to buy the     trouble financially in the       company is worth if it's
stock, but a “make your          crisis, and we had someone       competently run under
own catalyst kit” is a           go on the board to help          normal future conditions.
positive to a lot of value       with the strategic effort.       Maybe it's not attractive
situations. I prefer to have     When management did a            today, but if it continues to
someone else do the work.        deal that we thought was         go down, you may start to
We do a pretty good job          extremely unfavorable for        see an attractive IRR on a
looking for value and            shareholders, we went to         weighted-average basis.
sometimes finding it amid        the acquirer and said, “If       There are a couple of points
complexity. But what I           you don't let us in the deal,    here that I think are a bit of
ideally want to do is just buy   we have to consider putting      an advantage for us.
T-bills at 120% a year in a      in a competing bid for the
non-inflationary                 company.” This was after         First, we don't have a stop-
environment. The problem         our guy was off the board,       loss discipline, and second,
is that the market won’t do      but we came to terms and         we don't require a catalyst.
that for me.                     participated in the buyout       Many hedge funds have a
                                 vehicle. So if we can make a     stop-loss discipline, so they
So we generally do not seek      difference, we will push for     really aren't buying a stock –
to be activists. Doing it well   change. We can't always          in some ways, they’re
is a lot of work, and we         make a difference though I       buying a knockout option,
have a limited number of         don't want to rule anything      creating an inherent,
people to spread over a          out. I think our role is         inflexible whipsaw risk in
moderately large number of       rarely activist, but when we     the financial proposition.
positions. However, we           get involved, we try to be as    These stops are often pretty
have had two activist            positive as possible and act     tight and it is easy to lose
positions in the past. First,    for the benefit of all           your acceptable loss, plus it
we invested in an insurance      shareholders as much as          becomes difficult to get
company undergoing               possible.                        involved again.
turmoil because the                                                            (Continued on page 52)
nonagenarian founder, who
Page 52

          Paul Isaac
          (Continued from page 51)         to help determine                   sheet, and investor
          We have the problem that         allocations?                        sensitivity.
          we may have to revisit our
          assumptions, but if we do        PI: It is a bottom-up               G&D: How you think
          and decide that it’s even        proposition. If you can’t           about position sizing when
          cheaper, we can buy more.        find enough bottom-up               you initiate a position?
          We have sense of certainty       ideas, it gets harder to fill
          of what’s going to happen        the portfolio. A target-rich        PI: Different funds will size
          from here. We’re                 environment probably                positions in different ways,
          competing against a lot of       means that you’re running           partially because they have a
          really smart people. If          your gross lower because            different implied volatility
          there’s an obvious catalyst,     volatility has gone up pretty       target that they’re shooting
          other people will jump on it     sharply. You may be in              for so as to not to rattle
          and the price will go up.        some particularly difficult         their investors.
          But we’re more inclined to       macroeconomic
          play out these multiple          circumstances where you             We are all running
          possible path opportunities.     may have had a draw-down            portfolios that have a sort
          In practical terms, that         and have to be sensitive to         of leverage – where we
          means that we’re not             what your investors are             have participating capital, it
          looking at shorter-duration      doing.                              can be withdrawn. There’s
          transactions or positions.                                           probably an absolute
          Many of the things that we       So, ironically, a lot of guys at    drawdown level where
          get involved with can take       really low market bottoms           money tends to flow out,
          one to several years to          are trying to be substantially      but there’s also a relative
          work out. We therefore           net long, managing their            performance level where
          generate most of our return      gross, and biting their             money tends to flow out.
          in the form of long-term         fingernails that their              That is based upon your
          capital gains. That’s            investors will give them            investors’ expectations,
          attractive for most of our       enough time for the                 surprise, and the
          investors who are taxable        recognition of value. When          temperamental population
          individuals.                     stocks are expensive, there         that you’ve targeted and
                                           is more of a tendency to try        have accumulated.
          G&D: Is it the same on the       to find shorts against them
          short side?                      to control the aggregate size       I take chunkier positions
                                           of the net, which pushes up         than most other hedge fund
          PI: No. Short investing is       your gross. That also               managers. Our history has
          not the opposite of value        means you’re probably               been relatively volatile, and
          investing. Short investing is    trying to find securities that      it’s worked out well for our
          actually the opposite of         are more liquid, so you can         investors. So my limited
          growth investing. It is much     adjust the portfolio more           partners have been more
          more dependent upon              quickly if circumstances            tolerant (so far) than many
          continued checks of the          change. Volatility also acts        others, which is very
          growth story. Shorting is a      as a constraint on gross            fortunate.
          challenge for us just as it is   because you want to limit
          for almost every other           how much your portfolio             That said, I’m very
          hedge fund manager.              bounces around.                     conscious of any binary risk
                                                                               in a security. Some things
          G&D: How do you                  You’re trying to find the           may seem tremendously
          determine your long-short        best bottom-up situations           attractive, but you’ve got to
          allocations? Is it just based    that you can and manage             be honest about them. If
          on the attractiveness of         them against the constraints        the wrong court case arises,
          your current ideas, or do        of liquidity, volatility, balance                 (Continued on page 53)
          you use the macro picture
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Issue XVIIIIssue 2                                                                                       Page 53

Paul Isaac
(Continued from page 52)         I like the business. It's a      inexpensive again,
if foreclosures continue to      perfectly reasonable             particularly the Class B
cascade down, or if there        business. We're not long         shares, in the aftermath of
are serious business             the Class A shares. We           the 2002 bear market and
transition problems, you         bought the Class B shares        started building a position.
could have a substantial loss.   because they were very
There also may be too            inexpensive. We have             There were a number of
much leverage and the            accumulated a large position     things about it that we liked.
enterprise could become          in Class B shares relative to    They had a CEO who did a
financially fragile because of   us. Now it’s a 6%-7%             wonderful job of
covenant violations, for         position.                        rationalizing the business
example. Under those                                              and making it more
circumstances, I will restrict   I first encountered the          profitable. There was an
the position size to about       company in the 1970s when        octogenarian granddaughter
half of the maximum for a        Tweedy, Browne had               of the founder who
security that has all of the     bought Greif in a vehicle        controlled a lot of Class B
attractive elements.             they took over, a small          stock. She subsequently has
                                                                  passed away. The family is
There’s no magic formula to                                       no longer involved in the
it, but securities with a fair    “I’m very conscious             business, and they seem to
amount of binary risk are                                         disagree with each other
going to have higher rates of     of any binary risk in           about enough things that it's
return when they work. It’s                                       not impossible that
important to be in a                a security. Some              something could happen to
position where you’re not                                         the business. You now see
under a lot of pressure to
                                    things may seem
                                                                  a pattern where
get out of a position just            tremendously                management in the company
because it’s not working for                                      is buying back Class B
a while.                             attractive, but              shares much more
                                                                  aggressively than they're
G&D: Can you talk about a           you’ve got to be              buying back Class A shares.
stock that you think is
attractive?                           honest about                They also have some
                                           them.”                 interesting diversification
PI: We have a sizable                                             initiatives, notably into
position in the Class B                                           flexible packaging, where
shares of Greif, Inc. The        closed-end fund called           they're manufacturing all
company is a packaging           Cambridge Fund. My uncle,        sorts of bags for bulk
manufacturer with two            Walter Schloss, had offices      transport. Where we
classes of stock, Class A and    with Tweedy. I knew a little     currently have it, it's trading
Class B. The Class A stock       bit about them and thought       at about ten times earnings
is liquid and is in several      they were talented people.       on the Class B shares and
indices. The Class B stock       So I bought some of              pays about a five and change
has all the voting rights and    Cambridge Fund because it        dividend. This is with
is entitled to 150% of the       was trading at a 25% or 30%      depressed profitability in a
per-Class-A-share dividends      discount from NAV. I             business that we think is
and earnings. Yet, it often      eventually got a little bit of   growing. Greif
trades at a discount to the      Greif A after the liquidation    Manufacturing has 240
Class A shares. The Class B      of the Cambridge Fund, and       plants that manufacture
shares currently trade at        so I gained some familiarity     containers for people
about 105% of the Class A        with it. I later saw that it     making stuff, so it's hard to
share price.                     had become quite                               (Continued on page 54)
            Page 54

                         Paul Isaac
                         (Continued from page 53)          Street.                         people tend to think of it as
                         imagine that it’s going to get                                    a top-down organization,
                         supplanted anytime soon.          What should a well-run          the real locus of power
                         It's been a nice stock for us     investment banking firm         within the organization is
                         over time. Between the            applying moderate leverage      the board of the holding
                         dividends and the                 with a lot of fee-based         company of the regional
                         appreciation, it's been a mid     businesses be able to           banks. The regional banks
Pictured: Meryl Witmer
                         -to-high teens IRR. We            generate? A ten-to-twelve       needed capital in the 1990s,
at the 2012 Graham &
Dodd Breakfast
                         have traded around the            percent ROE seemed pretty       so they issued a class of
                         position occasionally, either     reasonable. If that's the       share which is effectively a
                         by doing “buy-writes” selling     case, Goldman should trade      non-voting economic share
                         calls on Class A shares, or       at 1.2 to 1.4 times tangible    that, for dividends and
                         in some cases shorting the        book value in this              earnings purposes, ranks
                         A outright when the A             environment. Buying in at       pari passu with the 25%
                         really significantly outran the   0.8 to 0.9 times tangible       holding in each of the
                         B.                                book, with an underlying        regional banks owned by
                                                           rate of accretion in the mid-   the corporate and
                         G&D: Is six or seven              to-high single digits, given    investment bank.
                         percent generally your            the earnings that they were
                         largest position size?            generating, seemed              So there are 13 of these
                                                           reasonable.                     non-voting shares in these
                         PI: No. In fact our Bolloré                                       various regional banks,
                         -related positions are now        Our second-largest position     which are decent regional
                         in the high-teens of capital.     is more esoteric. It’s in the   banks. They have non-
                         The stock has done very           regional affiliates of Crédit   performing assets of 1% to
                         well. We still think it's very    Agricole. Crédit Agricole is    4% of assets. They usually
                         cheap, so we have not sold        a bit like the federal farm     have loan loss reserves of
                         any.                              credit system. The majority     70% to 150% of the non-
                                                           ownership is a pyramid with     performing assets. The
                         We also have a sizable            several thousand local          tangible common equity to
                         position in Goldman Sachs.        mutual societies at the         assets runs 8% to 15% on
                         There was no particular           bottom. They own, through       the outside. The ROE runs
                         insight there. I was in too       a special class of stock, the   in the mid-single digits to
                         early when it was trading at      majority of each of 40          about 10%. The efficiency
                         a substantial discount to         regional Crédit Agricole        ratios are around 45% to
                         tangible book value, and          banks. Crédit Agricole Sud      60%.
                         then it traded down to a          Rhone Alpes, Crédit
                         level where we re-upped.          Agricole d’lle de France, and   These are not bad regional
                         It's by far the most              so on.                          banks, and as they have
                         productive investment                                             assets between $8 and $60
                         banking organization in           The regional banks              billion apiece, they're also
                         terms of revenues per head.       collectively own all of a       not tiny, either. You can
                         The company still does a          holding company called Rue      get information on them if
                         really good job of recruiting     La Boétie, which owns 56%       you speak French or can use
                         and developing a culture          of the listed Crédit Agricole   Google Toolbar. Just go to
                         internally, so they have a        vehicle, which in turn          the website of each of the
                         deep bench. The                   controls their foreign          regional banks. They don’t
                         combination of a deep             holdings, the insurance         make it easy for you. You
                         bench and higher comp than        companies, the asset            have to go through the site
                         all of their competitors          management division, and        and find the required legal
                         indicated that they are going     about 25% of each of the        filings, and then they’ll show
                         to have a leg up in adjusting     regional banks. While                        (Continued on page 55)
                         to the new ways of Wall
 Volume I,
Issue XVIIIIssue 2                                                                                      Page 55

Paul Isaac
(Continued from page 54)        are not entirely rational for     concerned about it. In
you the annual and              an essentially mutual             1994, I was working in a
trimestral reports.             institution to have               brokerage house that was
                                outstanding indefinitely, and     primarily in the fixed
These things are trading at     we may get some buybacks          income business. We were
25%-40% of tangible book,       of whole issues. These            clearing for some people
with somewhat depressed         positions are not terribly        who were small mortgage
earnings this year, partially   easy to buy – they typically      securities dealers out of
because of economic             trade between twenty              town, and a couple of them
conditions in France,           thousand and a couple             vaporized in the experience.
partially because of            hundred thousand dollars a        Anybody who went through
incremental taxes, and          day each, so accumulating         the Granite Capital
partially because of the lack   them took a long time.            meltdown and its associated
of flow through of any                                            mortgage bond debacle or
earnings from the holding       G&D: What is the                  anyone who experienced
entity where they take the      composition of the assets at      the second quarter of 1994,
dividends into their income     the regionals? Is it what we      which was the worst
statement when they pay         would expect from                 quarter on record for the
them.                           traditional banks?                treasury market, went
                                                                  through a very painful
These entities are trading at   PI: Yeah, it's small              experience. At one point
five or six times earnings.     commercial, consumer, and         treasuries were down more
They're paying dividends of     municipal loans. The one          than 20%.
five to seven percent. Most     thing that really concerns
of them have buyback            me is if interest rates were      Everybody has to be
programs. There have been       to go up moderately, it           concerned. With the
buybacks of whole share         probably would help their         degree of debt that’s out
classes of these entities.      profitability. But if interest    there, the authorities are
When they've occurred           rates were to go up a lot,        likely to lean very heavily on
they've been at significant     there is an inherent              a really sharp increase in
premiums to what these are      duration mismatch because         interest rates. Otherwise,
currently trading for.          they do some term lending,        given the very short average
                                particularly to municipalities.   duration of treasury debt,
We had some misgivings          So I think that is probably       it's just inconceivable to me
about the French economic       the biggest risk if you're        that they would let Treasury
situation and the value of      looking for an outlying           bill rates go up to 6%, 8%,
the Euro, so we neutralized     structural risk.                  or 10%, almost regardless of
a large chunk of our Euro                                         how stupid the policies
exposure by shorting ten-       G&D: Seth Klarman in his          would be that would be
to fifteen-year French          2012 letter to investors          needed to suppress rates.
sovereign treasuries against    commented that the end of         At high rates, it’s much
the position when the Euro      the “free lunch” of low           more difficult to manage
was at $1.30. If these banks    interest rates and high           your government budget
are going to get into serious   government spending could         because of the increase in
trouble, it’s unlikely that     come to an end, which             the cost of debt service.
France will continue to have    would push interest rates
a bond market that's trading    up significantly and could        The United States and other
at two percent in fifteen       cause significant financial       countries have experienced
years. We're getting a nice     pain. Are you preparing for       sharply negative real returns
current income on the           that moment?                      on fixed income
position, and there is some                                       instruments. So, yes, I am
accretion to book value.        PI: You have to be                             (Continued on page 56)
My hope is that these things
          Page 56

                       Paul Isaac
                       (Continued from page 55)         If I look at Merck versus         there are international
                       concerned about what will        Sanofi, what’s the real           valuation parameters, can
                       happen when interest rates       difference of the geographic      make a difference.
                       go up. It could have a           allocation of their business
                       pronounced effect on             base? Sanofi is doing             I know a great investor in
                       financial markets, and it's      something like 60% of its         London. He buys breweries
                       not going to be any fun to       business in Europe, 30% in        partially based upon the
                       go through. We’re not            North America, and 10% in         cost per hectoliter of
                       even talking about rates         Asia. Merck is doing 15% in       capacity, and when he finds
                       going to 10% – it will be        Asia, 40% in Europe, and          a ten-to-one disparity
                       pretty ugly even if the 5-       45% in North America. Just        between his longs and
                       year goes up to 3% or 4%.        how much of a home                shorts, he figures he has a
“My father, and to     That's one of the reasons        country bias can you justify      pretty good trade. I’m not
                       why what the Fed is doing is     when you have truly               nearly that sophisticated or
  a lesser extent,     progressively less effective.    international businesses?         intrepid, but there is a price
 Walter [Schloss],     In other words, people                                             at which things become
                       aren't stupid. They are          Nevertheless, for us to go        attractive, and then you’re
 had a saying that     anticipating that at some        overseas, the opportunity         looking for some indication
                       point this is going to have to   must be very compelling.          that you’re likely to make
  he almost never      end. Therefore, I think it       That may be because we            money.
                       has a major effect on the        can’t express the idea
invested outside the   willingness of people to lock    through an American               In Sri Lanka we got involved
                       up long-term commitments.        security, or because the          because it was extremely
   United States
                                                        valuation disparity is simply     inexpensive. The Civil War
because he’d always G&D: How do you get                 enormous. Then we have            had also ended recently.
                       comfortable with the             to be reasonably                  The country has a history of
  found plenty of      regulatory and general           comfortable that the legal        British-based accounting and
                       investing environment in         system works for us. I            commercial law, which gave
 opportunities to      more esoteric countries          don’t relish the idea of being    us some comfort. Some of
                       such as Sri Lanka, where         an unsympathetic hedge            the situations that we were
 lose money in the     you have invested in the         fund investor in France, but      involved in had substantial
                       past?                            I can tolerate it, particularly   foreign shareholders from
American markets.”
                                                        if we like the management.        countries with good
                       PI: Well, greed helps! My                                          corporate governance
                       father, and to a lesser          But on the other hand, we         standards, which gave us
                       extent, Walter, had a saying     really don’t do anything in       comfort with that sort of
                       that he almost never             Russia or China because we        J/V partner. It wasn’t
                       invested outside the United      don’t have any real comfort       necessarily favorable for
                       States because he’d always       in the accounting, the legal      outside shareholders, but it
                       found plenty of                  system, or the culture. And       was unlikely there were
                       opportunities to lose money      if we make a lot of money,        going to be a tremendous
                       in the American markets.         there’s a chance that             number of self-interested
                       There have been some             someone will try to take it       deals on the part of
                       changes that make it easier      away. So that skews the           principals that were going to
                       to invest in places like Sri     risk-reward ratio in a way        take out value.
                       Lanka, most notably the          that we don’t get involved.
                       ability to control execution     But in a lot of other             If we can get comfortable
                       and risk, and the ability to     countries, there are              with the institutional risks,
                       get information. Changes in      intermediate positions. You       and there is enough of a
                       corporate governance             lose the color, the context,      valuation disparity, we will
                       standards in foreign markets     and the familiarity, but          get involved. That does
                       have also helped.                valuation, particularly if                      (Continued on page 57)
 Volume I,
Issue XVIIIIssue 2                                                                                       Page 57

Paul Isaac
(Continued from page 56)         inclined to be aggressive in      and opening up potential
carry the risk that we get       the region after Chávez’s         competition from a
involved in a perma-cheap        death, and the FARC will          multiplicity of sources. I
or in something where we         probably get less support.        look at the Kindle, and it
don’t understand the             Pacific Rubiales, which has a     strikes me that it's an
principals’ motivations. But     good record of developing         intermediate step to better-
if you’re falling out of a       reserves, is trading              quality screens on tablets
basement window with             inexpensively relative to         with other types of services
something that is very           North American analogs.           that can be linked more
inexpensive, chances are         It's a company of some size       broadly with how people
you’re not getting hurt all      and we're willing to make a       manage their media intake.
that badly, and you pick         bet.                              So, it doesn't strike me that
yourself up and hopefully                                          the Kindle is a long-term
you have some                    G&D: You’re a noted bear          moat for Amazon within
disproportionate winners         on Amazon. What is your           that sector.
that compensate for the          short thesis on the stock?
incremental uncertainties.                                         Amazon does not have an
                                 PI: I am bearish. It's not a      asset-light model. Amazon
G&D: Do you have                 primary driver of the             now has a depreciation rate
analysts that only look at       portfolio, and it's one where     that is slightly higher last
international deals?             I've been wrong in P&L            year than Aéropostale’s and
                                 terms. We actually short          somewhat lower than Gap’s.
PI: No, if an idea takes us      Amazon by essentially doing       They've got 50 million
overseas, then we’ll look at     a naked buy-write. We sell        square feet of these vast,
it. Personally, I like smaller   calls on Amazon and roll          dystopian warehouses that
markets that have natural        them and alter the exposure       have been Taylorized with
oligopolistic tendencies         somewhat based upon               monitored guys walking
simply because of the            certain valuation criteria.       around fulfilling orders. It’s
limited size of the markets.                                       very difficult for them to
So, I have personal holdings     The question of what              automate that. They are
in places like Mauritius,        Amazon’s business model           losing the sales tax
Bermuda, and Sri Lanka.          will be when it grows up is       advantage that they had
                                 still not proven. Amazon          progressively, and it will
At Arbiter, which has a          had developed a terrific          eventually go away
greater liquidity                business, and may still have      completely.
requirement, we follow           a terrific business in physical
investment themes in liquid      media – books and physical        It’s true that they can
markets in industries that       things like DVDs – because        deliver a lot of goods to a
we understand reasonably         originally about 20% of the       lot of people, but they are
well. For example, we have       U.S. population was not           competing against the
a small long position in         near a media superstore.          implied untaxed labor costs
Pacific Rubiales, which is a     Now that you don't have           of people going to the store
sizable Colombian oil            many bookstores any more,         and picking up their own
company that was started         that physical market may          stuff. Amazon has delivery
by one of the teams of           have grown, and Amazon            expenses. We are long this
Petróleos de Venezuela           clearly dominates it.             trend via UPS, because we
engineers that fled the                                            could buy it at a 6% or 7%
Chávez politicization of the     However, they've got the          free cash flow yield. UPS’s
company. Colombia is a           problem that an increasing        network would be difficult
petroliferous area, and the      amount of media is being          to replicate and is already
politics of Colombia have        digitized. This is changing       quite profitable. A lot of
been getting better.             Amazon’s business model                        (Continued on page 58)
Venezuela will be less
           Page 58

                       Paul Isaac
                       (Continued from page 57)        You can also have shopping         I'm not sure that's really the
                       the hopes of what people        bots that can intermediate         same thing.
                       want to get from of Amazon      among vendors very, very
                       are ultimately going to be      quickly. In other words,           Businesses have to make
                       indissolubly associated with    people argue that Amazon           profits to justify their
                       a guy in a brown suit and a     can aggregate things from          valuations. It’s a critical
                       brown truck.                    everywhere, and they have          mass issue for many
                                                       tremendous economies of            businesses, which should
                       Amazon has been                 scale. But when you're up          result in a higher degree of
                       spectacular at being able to    to $50 billion of sales, what      profitability going forward.
                       find new areas to go into       kind of scale do you need to       But how large does a
                       unprofitably. It will be        become profitable?                 company have to be before
                       difficult for them to develop                                      they start making money in
                       their third-party business      I'm a great admirer of             some aspects of their
                       because it’s really a           people who can find Phil           business? And the fact that
“Amazon has been       fulfillment operation.          Fisher-like growth                 Amazon isn’t profitable at
spectacular at being   Where they’ve become a          situations. I'm not good at        their current scale makes
                       merchant, they are rapidly      doing that. But the essence        me wonder whether it’s all
  able to find new     becoming competitors to         of a Phil Fisher growth            that profitable in any
                       companies that they serve,      situation is that it's a rapidly   material portion.
  areas to go into     which limits Amazon’s           growing business that does
                       ability to be a preferred       such a good job of fulfilling      It’s interesting because
unprofitably. … As     vendor of choice on that        customers' needs that it is        we’re focusing on Amazon.
                       kind of platform. E-            profitable enough to fund its      It’s a decent-sized short for
   an investment       commerce is not a unique        own more-rapid-than-               us. It’s really not going to
proposition, I don’t   skill. Amazon does it well,     normal growth. Amazon              be a major driver of the
                       but other people also do it     funds its growth through a         portfolio. But it’s also an
      get it.”         well.                           combination of anti-dilutive       indication of a failing that we
                                                       stock offerings through            all have in our business –this
                       Amazon has a negative           options and its negative           tendency to look for the big
                       working capital model.          working capital model, and I       controversial name and then
                       They have actually used a       don't think that's the same        have an opinion. Often the
                       portion of that negative        thing.                             big controversial name is
                       working capital to fund their                                      controversial for legitimate
                       very large capital plan. They   I've got one guy who told          reasons, and you don’t have
                       have to continue to grow,       me today, "Hey, look, given        to get involved. You can get
                       because if they ever stopped    the rapid growth of the            involved in names about
                       growing, they would no          number of searches on              which any sane person is
                       longer be able to keep their    Amazon for goods that get          going to basically say, yeah
                       expenses down by paying a       sold through Amazon, if I          that’s cheap, and I just want
                       substantial portion of their    value that relative to the         to know why it’s going to
                       wage bill in stock options.     valuation of Google based          get un-cheap? Or, yeah
                       When you put all that           on its search and advertising      that’s really expensive, but
                       together, there’s a good        business, I can justify a          why do you think they
                       chance Amazon is a              substantial portion of the         won’t be able to keep the
                       perpetual motion machine.       market cap for Amazon              promotion going?
                       I am a happy Amazon             based on what it would be
                       customer. If somebody is        able to do if it turned it into    It's fun to have a debate
                       willing to sell me stuff at     a local advertising business."     about something like
                       cost or below, why not?         Instead, Amazon manages to         Amazon because it’s a “how
                       They do a very competent        advertise itself for goods         do you like those Yankees”
                       job. But as an investment       that it sells at no profit. So                   (Continued on page 59)
                       proposition, I don’t get it.
 Volume I,
Issue XVIIIIssue 2                                                                                              Page 59

Paul Isaac
(Continued from page 58)         somebody looking to             Icahn when you're eighty
topic? It indicates that a lot   maximize their own capital.     because, by that time, the
of us are spending time on       I think targeting investment    world could be a very
things where it's very           products is perfectly valid     different place. It's going to
difficult to have more than a    work. Products are              be very path dependent as
moderate incremental             designed for institutional      to how you get there.
advantage. You have only a       contexts and they conform                                            “You should be
limited amount of time,          to popular preferences.         You should be personally
attention, and analytical                                                                             personally and
                                 These can be enormously         and financially conservative
resources. This whole            lucrative jobs, you can build   for a few reasons. First, it is
exercise that we've got is
                                 up tremendously attractive      a cyclical business, as people
one of 'applied                  businesses out of them, and     have now rediscovered.             conservative for a
epistemology': what do we        some people make a lot of       Second, it's a lot more fun if
know and how do we know          money doing it. I don't see     you have some of your own          few reasons. First,
it? Try to look at things on     anything wrong with that        money to invest. And third,
a scale where you can have       even if I think it is sub-      it opens up a lot of flexibility      it is a cyclical
a relative information           optimal for my investing        to you, particularly in the
advantage compared to the                                                                           business, as people
                                 preferences.                    intermediate stages of your
rest of the world. We are                                        career.                                 have now
in an intermediate stage         But it's important to
where that's getting harder      distinguish that type of        Enjoying the ride is really           rediscovered.
given our size, but I'm          investment approach from        important. Too many
always a little bit surprised    one that fully reflects your    people have a fixed star of         Second, it’s a lot
that individuals, particularly   temperament and style.          what they want to become.
for their own account, don't     Figure out who you are,         Frankly, I started in some           more fun if you
do that more.                    what you're trying to           very different areas, and I
                                                                                                    have some of your
                                 accomplish, and what your       had several sub-specialties
G&D: Do you have any             temperament is.                 shot out from under me in            own money to
advice for students looking      Otherwise, you may find         the course of various types
to get into investment           yourself as a square peg in a   of technological or                invest. And third, it
management?                      round hole. On the other        regulatory changes. Be
                                 hand, I'm a great believer      open to where this will take        opens up a lot of
PI: It's a very long race.       that there is not one right     you or what opportunities
You've got half your capital     slot. You're going to learn a   you will have. You could be         flexibility to you,
from the last doubling,          lot about investing, no         a great growth stock guy;
which is one reason why                                                                             particularly in the
                                 matter where you wind up.       but if you find yourself in
you have all these elderly                                       the middle of the TMT
guys tottering up and giving
                                                                                                    intermediate stages
                                 Most of you are going to        bubble maybe you're
you advice at Columbia.          have careers that are           supposed to shift your focus         of your career.”
Time really matters.             twenty-five to forty years      for a while, if you have the
Compounding really               long. And by the way, the       ability to do so.
matters. The investing           investing world will be very
process really matters.          different. You will have        G&D: It was a pleasure
What are you doing for           been through several            speaking with you, Mr. Isaac.
whom?                            economic cycles and there
                                 will, undoubtedly, have been
There are an awful lot of        a number of important
investment products out          agency and regulatory
there that are targeted for      changes, none of which
specific agency needs of         you'll be able to forecast
particular types of investors.   with precision. So don't
They are not necessarily         decide you want to be Carl
ideal ways of investing for
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                                    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

                                                    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

                                                    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

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