Graham and Doddsville an Investment Newsletter from the Students of Columbia Business School

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

Volume II, Issue I Winter 2007/2008 Inside this issue:

Graham and Dodd p. 3 Staying Power: Jean-Marie Eveillard Breakfast

Jean-Marie Eveillard is a leg- Jean-Marie Eveillard’s strict D.R. Horton, Inc. p. 14 end in the world of value investment discipline and Macy’s p. 16 investing. Widely recognized outstanding investment re- as the first truly global value turns earned him a Morning- star Lifetime Achievement Netflix p. 18 investor, Jean-Marie achieved his status by adhering to the Award in 2003.

Industry p. 20 investment principles of Gra- Networking Night ham and Dodd, and ex- On March 26, 2007 First panded upon by Warren Eagle Funds and its invest- Value Investing in p. 22 Buffett. ment advisor, Arnhold and S. India Bleichroeder Advisors, offi- Jean-Marie began his career cially announced that Jean- in 1962 with Societe Gener- Marie would resume portfo- Jean-Marie Eveillard, Portfolio Editors: ale and became portfolio lio management responsibili- Manager - First Eagle Funds. manager of what is now the ties for the First Eagle David Kessler First Eagle Global Fund in Global, Overseas, Gold, you tell us your story? MBA 2008 1979. Prior to his brief re- Overseas Variable and U.S. tirement in 2004, Jean-Marie Value Funds. JME: I had been working Charles Murphy since the early 1960’s with a led the First Eagle Global MBA 2009 French bank doing securities Fund to a 15.8% average Q: It seems that every value investor has their own story analysis in Paris. The French annual return - compared to David Silverman about how they stumbled bank sent me to New York MBA 2009 13.7% for the S&P 500 upon value investing. Can presumably for a year or (according to Morningtar).

Contact us at: Welcome Back to Graham and Doddsville [email protected] As we enter our second value investor Jean-Marie and The Heilbrunn Center. Visit us at: year, we are pleased to pro- Eveillard of First Eagle Funds. Inside you will find coverage www.grahamanddodd.com vide you with the third edi- Mr. Eveillard was gracious of the 17th Annual Graham www.gsb.columbia.edu/students/ tion of Graham and enough to sit down with us and Dodd Breakfast featuring organizations/ cima/ Doddsville , Columbia Business and share the wisdom he has David Einhorn of Greenlight School’s student-led invest- gained during a distinguished Capital; lessons from the ment newsletter, co- career that has spanned over Industry Networking Night sponsored by the Heilbrunn three decades. featuring William von Muef- Center for Graham & Dodd fling (’95) of Cantillon Capital Investing and the Columbia We also hope to give you a Management and David Investment Management taste of some of the extraor- Greenspan (’00) of Blue Association. dinary events sponsored by Ridge Capital; and you will Columbia Business School, travel to India with Professor This edition features an in- the Columbia Investment Bruce Greenwald and mem- terview with legendary global Management Association, (Continued on page 2) Page 2

Welcome to Graham And Doddsville (continued from page 1)

(Continued from page 1) bers of The Heilbrunn Cen- ter to discuss value investing, globalization, corporate social responsibility, and competitive strategy.

As always, we also feature investment ideas from the students of Columbia Busi- ness School.

Please feel free to contact us if you have comments or ideas about the newsletter, as we continue to refine this Legendary investors Martin Whitman and Edwin Schloss at publication for future edi- the 17th Annual Graham & Dodd Breakfast on October tions. Enjoy! 19, 2007. The annual breakfast is organized by The Heil- brunn Center for Graham and Dodd Investing. -G&Dsville

Jean-Marie Eveillard (continued from page 1)

two. I got to New York There is a story in France approach – trading the big City for the first time in about a famous French poet stocks. Neither in New “To me, value January of 1968. I didn’t named Paul Claudel who York, nor when I went back know many people, but I had not believed in God. to Paris for a few years, investing is a knew a few people in the One day, he was standing by could I convince anybody to French community, and I a pillar at a Cathedral near look at value investing. Still got to meet two French Paris and he said: “I was today to my knowledge, the big tent that students attending Columbia illuminated by faith.” In a French banks and institu- Business School whose in- sense, I was illuminated not tions do not have value in- accommodates terests were not investing – by faith, but all of a sudden, vesting. Societe Generale their interest was market- it seemed to me that Ben sold our operation to Arn- ing. During that summer, Graham simply made sense. hold and S. Bleichroeder at many different we bicycled together on The idea of margin of safety, the end of 1999, and I’ve weekends in Central Park. the idea of intrinsic value, kept in touch with some of people.” They knew that I was in the the idea of Mr. Market, the the people there. I have field of investments, and very humble idea that the tried to convince them over they had heard of Ben Gra- future is uncertain - it made the past seven years that ham. Investments were not sense to me. I stayed in they should make some their interest, but they men- New York for another few room somewhere in a little tioned Ben Graham to me. years, but I could not con- corner for value investing, So, I went to a bookstore vince Paris headquarters but they are not into it. and bought The Intelligent because their whole ap- Investor and Securities Analy- proach was completely dif- Today in Paris there are a sis . The Intelligent Investor in ferent. Their approach, in a few people practicing value particular sort of struck me. sense, was more of a trading (Continued on page 4) Volume II, Issue 1 Page 3

Fooling Some of the People All of the Time

Graham and Dodd Breakfast with David Einhorn

On the morning of October 19 th , close to 400 investors gathered at The University “The crisis Club in Manhattan for the 17 th Annual Graham & came because Dodd Breakfast. This year’s keynote speaker was David we have a lot Einhorn, President of Greenlight Capital. Under of bad the title “Fooling Some of the People All of the Time,” practices and a Mr. Einhorn addressed the current state of the capital practices and a lot of bad This includes not only the lot of bad markets and shared his ideas.” The result is that sub-prime market but also thoughts on ways to remedy lenders were “induced to all areas of residential real the current situation in the take imprudent risks and estate, commercial real es- ideas.” credit markets. make imprudent loans, tate and the corporate lend- which of course led to ing markets and has applied Mr. Einhorn, introduced by losses.” One practice ad- equally to borrowers Professor Bruce Greenwald monished by Mr. Einhorn is whether they are an average as an investor with a crea- the current system of dele- American trying to purchase tive mind, a powerful intelli- gating the assessment of a house or a private equity gence, and a sound instinct credit risk to credit rating firm pursuing an LBO. for value, is a graduate of agencies that are paid by Cornell University. He be- bond issuers rather than Why have borrowers en- gan his career in the Invest- bond buyers. joyed such low rates? Ac- ment Banking Group of cording to Mr. Einhorn, the Donaldson, Lufkin & Jen- While the media might lead answer lies in how this risk rette. After 2 years with one to believe that sub- of structured financial prod- DLJ, Mr. Einhorn left to take prime loans are at the root ucts are assessed. Rating a job as an analyst with a of the current capital mar- agencies perform their hedge fund. In January 1996 ket disarray, Mr. Einhorn analysis free from the re- he co-founded Greenlight asserts that that sub-prime strictions of “Reg FD”. Capital. Starting with less loans have become a con- Without access to the same CBS alumni reconnect at the Graham & Dodd Breakfast than $1 million in capital, venient excuse for a much information as the credit Mr. Einhorn built Greenlight larger problem. The real agencies, investors are not into one of the most suc- issue is that lenders of all able to decide whether they cessful hedge funds in the sorts lent too much money agree or disagree with the industry. Greenlight, which and did not demand enough rating. “Without enough has grown to over $4 bil- interest to compensate information in the market lion, boasts returns which their risk. “There has been other than the credit rating, are reported to be 27% a colossal undercharging for it is hard for buyers and annualized. credit across the board,” sellers to decide what to do Einhorn stated. Loans were once the credit rating In speaking about the credit issued based on the bor- comes into doubt.” Einhorn markets, Mr. Einhorn de- rower’s ability to refinance believes that one solution to clared “the crisis came be- rather than the borrowers this problem is to make all cause we have a lot of bad ability to repay the loan. (Continued on page 4) Page 4

17th Annual Graham and Dodd Breakfast

(Continued from page 3) an enormous systemic risk David Einhorn concluded his information as these entities are able to remarks by reading an ex- shared with maintain access to cheap cerpt from his forthcoming rating agen- credit while over extending book due on bookshelves cies available themselves beyond pru- next spring. Among the to the entire dence.” guests at the breakfast were market. three generations of value In describing his own invest- investors including Walter Einhorn sug- ment philosophy, Mr. Ein- and Edwin Schloss, Marty gested that horn said that the idea is to Whitman, Mario Gabelli, “the rating preserve capital on an in- Jean Marie Eveillard, and agencies vestment-by-investment Tom Russo. The breakfast, Mario Gabelli (’67) and have lost their ability to basis. His goal is to put which is organized by The Walter Schloss catch up at the Graham and Dodd impose discipline on the together a portfolio of indi- Heilbrunn Center for Gra- balance sheets of the broker vidual ideas that are set up ham and Dodd Investing, Breakfast dealers, the financial guaran- to preserve capital if he is was simulcast to London tee companies, enablers of wrong, and will achieve a and webcast to an audience structured finance that bring good return if he is some- around the world. so much business to the thing other than wrong. rating agencies. This creates -G&Dsville

Jean-Marie Eveillard (continued from page 2)

(Continued from page 2) about value investing. They best book that has ever investing. Twenty years said: “Hey – we have a small been written about invest- ago, there was nobody to fund in New York - $15 ing. my knowledge, but I think million – why don’t you go today there are a few inde- back to NY and run it?” Over the past almost 30 pendent shops that tend to Because it was small and years, we (First Eagle) have do value investing. And, because I was across the sort of floated between Ben indeed, there are two young ocean, they basically let me Graham and Buffett. We Italian men three or four run it the way I wanted. began with the Graham ap- years ago who went to the Within a few months of proach which is somewhat same business school I went when I came back to New static and less potentially to in Paris. They looked up York in late 1978, I also rewarding then the Buffett my name in the alumni book came across the annual re- approach, but less time con- and called me and came to ports of Berkshire Hatha- suming. So as we staffed up, see me because they had way. To me, value investing we moved more to the Buf- just started a small value is a big tent that accommo- fett approach, although not shop in Paris. I became a dates many different people. without trepidation because minority shareholder in At one end of the tent the Buffett approach – yes, their advisory firm. there is Ben Graham, and at you can get the numbers the other end of the tent right, but there is also a So in any case, I came there is Warren Buffett, major qualitative side to the across The Intelligent Investor who worked with Graham Buffett approach. We, or at in 1968 and, then, had to and then went out on his least I, surely do not have wait a little more than 10 own and made adjustments the extraordinary skills of years until late 1978 when to the teachings of Ben Gra- Buffett, so one has to be Paris headquarters was get- ham. Still today, Buffett says very careful when one ting tired of hearing me talk The Intelligent Investor is the (Continued on page 5) Volume II, Issue 1 Page 5

Jean-Marie Eveillard (continued from page 4)

(Continued from page 4) So there are not a great there are two characteris- moves to the Buffett ap- number of value shops, al- tics to borrowing. Number proach. Today, we have though I must confess that one: borrowing works both Bruce Greenwald as direc- there are quite a few value ways. So you are compro- tor of research, and there shops on the hedge fund mising the idea of margin of are nine in-house analysts. I side. Usually they are long safety if you borrow. Num- think Bruce will take that only. They have the ability ber two: borrowing reduces number up to something to borrow, the ability to your staying power. As I Professor Bruce Greenwald and like twelve within the next short, but there are very said, if you are a value inves- Dean Glenn Hubbard few months. few value investors that get tor, you are a long term involved in shorting because investor, so you want to Columbia Business School is So this is how I came across have staying power. a leading resource for invest- Ben Graham and then 10 ment management profession- years later, just in time, the I’m not familiar with many als and the only Ivy League Buffett approach. “There are very of the value shops on the business school in New York long only hedge fund side, City. The School, where value Q: You have been managing few value investors but if you look at the mutual investing originated, is consis- the First Eagle Global fund that get involved in fund world, you don’t have tently ranked among the top since 1979, and you spoke that many value shops. You programs for finance in the about how your philosophy shorting because if have Marty Whitman’s world . has shifted over time. How Third Avenue, you have have you seen the philoso- you are a value Mason Hawkins at South- phy of Value Investing in east, you have Oakmark in general evolve over that investor, you are a Chicago, you have Tweedy Browne, and a few others, time? long term investor. but you don’t have that JME: I think today, to some If you are a long many. extent because of the extreme popularity of Warren term investor, you Q: You were probably one Buffett, there is more com- of the first recognized global petition. If you think of the don’t have to worry value investors. How has previous generation of true global investing, in general, value investors – individuals about market changed over the past 30 like Walter Schloss and the psychology.” years? like - they were truly very close to the Graham ap- JME: It has changed in the proach. And I think today sense that it has also be- when you look at the vari- if you are a value investor, come more competitive ous value shops in the U.S. - you are a long term inves- because there are more keeping in mind what the tor. If you are a long term American value investors late Bill Ruane tried to fig- investor, you don’t have to who invest on a global basis, ure out six or seven years worry about market psy- and because there is a little ago, and it is probably true chology. As Ben Graham bit more competition from today - there was really no said: “Short term - the stock the locals, there are more more than 5% of profession- market is a voting machine; people outside the U.S. ally managed money in the long term - it is a weighing looking for value investment U.S. that was invested on a machine.” But it is very ideas. Let me give you an value basis, broadly speak- hard to get involved in example: In the 80’s and up ing. And there was much shorting without taking mar- until the early 90’s, there less than that outside the ket psychology into account. were many companies in U.S. Of course, by definition, (Continued on page 6) Page 6

Jean-Marie Eveillard (continued from page 5)

that if we decide to look For instance in the early into a particular investment 1970’s, Buffett figured out idea we have to do most of that the major characteris- the work in-house, hence tics of the newspaper busi- the extreme importance of ness had to do with the fact the in house research de- that many newspapers had a partment. This is because quasi-monopoly. Buffett sell-side research is directed determined that what was towards the 95% or so of important was not the fact professional investors who that already in the 1970’s are not value investors, so circulation was not growing their time horizon is usually much, if at all, but that the more along the lines of six local department store to twelve months as op- automatically advertised in

Jean-Marie Eveillard, Xavier (Continued from page 5) posed to five or more years the local newspaper. On De Romana (‘02), Walter for us. top of that, it was not a Schloss Europe that had very con- capital intensive business. It servative accounting. The The work, of course, starts was a service business with locals did not pay attention with public information – higher margins, not that to how conservative the running numbers. Some- they could charge any price, “Every chief finan- accounting could be. This is times, we make adjustments but they were the advertising instrument of choice for cial officer in this no longer true. to the reported numbers, which is particularly impor- local businesses. Wall country, and even Q: What are the character- tant today because every Street was entirely focused istics that draw you to an chief financial officer in this on the fact that they were some outside the investment and how do you country, and even some not growth companies, pre- go about finding new ideas? outside the U.S., seems to sumably because circulation U.S., seems to be be trying to show the high- was not going up. JME: Well, in terms of est possible reported earn- trying to show his hunting grounds, in general, ings without going to jail. In This fits in with Buffett’s we don’t do screens be- order to do so, they have to idea that value investors are or her highest pos- cause we like to check the make sure that they observe not hostile to growth. Buf- sible reported accounting carefully and the letter of the regulation, fett says that value and make our own adjustments. but they don’t hesitate to growth are joined at the hip earnings without To take an extreme exam- betray the spirit of the regu- – value investors just want ple, take a look at an Ameri- lations. So, we run the profitable growth and they going to jail.” can forest products com- numbers coming from public don’t want to pay outra- pany. If they still own tim- information, and it’s not a geous prices for future

berland, as is the case of matter of having fifteen growth because, as Graham Weyerhaeuser, which they pages of numbers. I like the said, the future is uncertain. acquired about a century idea that the important And also, what is probably ago, they continue to carry numbers have more or less more important from Buf- it on the balance sheet for to fit on a single page or fett’s point of view is to about $1 an acre. Today, it two pages at the most. identify the extremely small is more like $1,000 an acre number of businesses or more in the south and Then, there is the qualitative where, after doing a lot of $2,000 an acre in the Pacific side, which is of course homework and exercising Northwest. So a screen judgmental and has a lot to judgment, you come to the would not help you in any do with trying to figure out conclusion that the odds are way in that respect. the three, four or five major good that the business has a The way we go about it is characteristics of a business. (Continued on page 7) Volume I,II, Issue Issue 2 1 Page 7

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(Continued from page 6) details, so sometimes the rassed because she didn’t ‘moat’, the business has a analyst investigates an idea know. And so that evening, competitive advantage, and for a few days or for a few when I came home, she that business will be as prof- weeks and comes back to asked “What do you do at itable five or ten years down me and says “Sorry, but this the office?” I thought, the road as it is today. This is not a very a good idea rather than trying to explain is opposed to simply ex- and here are the reasons what money management is trapolating 20% or 25% an- why.” This is fine with me. to a six year old, I said, “I nual growth observed over Third, we always make sure spend half of my time read- the past three years. There the analysts have enough ing and half of my time talk- “For value is a very limited number of time left to initiate and de- ing with my colleagues.” My businesses that can continue velop their own investment daughter said: “Reading? investors, the edge that type of growth. In any ideas. They come to me Talking? That’s not work!” case, Buffett never insisted first, but it is very rare for But in fact, that is what I do! is seldom in on 20% - 25% growth. I me to tell them that I think I spend a considerable think he even said some- they are barking up the amount of time talking with unusual thing to the effect that a wrong tree, wasting their the analysts, looking with profitable business that is time for such and such rea- them at the various angles, information which not growing is not a business sons. It very seldom hap- trying to make sure that the rest of the that has no value. A busi- pens. they have properly esti- ness can have value even if it mated the strengths and the market doesn’t is not growing. In that So the analysts go out, run weaknesses of the business sense, value investors tend the numbers according to – then they go back and have. There is a to think like private equity public information, and investigate further. investors – we are looking make the adjustments to the fine line between for stable and profitable numbers as necessary. For We invest, if in the end, we businesses - sometimes in instance, for quite a while, agree with them from an unusual what appears to be mun- we had to make the adjust- analytical point of view. In information being dane areas. ments for the issuance of other words, we think we stock options because there understand the business, we obtained by The analysts here keep were many companies that think we like the business, track of what we own but in until they were forced to do and we think investors are regular means or our case, most of the work it, just didn’t do it. mis-pricing the business. is done before we start buy- For value investors, the by ‘not so regular’ ing a stock. Afterwards, it is The analysts try to figure edge is seldom in unusual just a matter of updating the 3 – 5 major characteris- information which the rest means. It is more and we don’t spend any tics of the business. I don’t of the market doesn’t have. in the time trying to figure out the ask them to write about There is a fine line between next quarter. So our nine this, but it comes in the unusual information being interpretation of analysts keep track of the conversation that we have obtained by regular means securities we own, they after we look at the num- or by ‘not so regular’ the information.” investigate the ideas that the bers. Then there is the means. It is more in the portfolio manager may have back and forth between me interpretation of the infor- which, at least in my case, and the analyst. mation. It is more figuring usually comes from reading out the major characteris- newspapers or flipping Many years ago, when our tics of a business. Buffett through some sell-side re- younger daughter was six or didn’t know more than Wall search and saying “hmmm, seven years old, somebody Street knew about the maybe we should look at at school must have asked newspaper business. He this.” Of course, for a value her, “What does your fa- just decided that looking at investor the devil is in the ther do?” She was embar- (Continued on page 8) Page 8

Jean-Marie Eveillard (continued from page 7)

(Continued from page 7) Only after the analysts have you are a long-term inves- the advertising power of the already done a lot of work tor, you accept in advance newspaper was more im- will they go and meet man- that you are making no ef- portant that the flat circula- agement, because manage- fort whatsoever to keep up tion numbers. ment figures out very early with your benchmark or in the conversation whether your peers on a short term Q: You said that occasion- we already know a lot about basis. So you know in ad- ally you will tell an analyst their business, so they are vance that every now and they are barking up the less likely to lie. I am exag- then you will lag. We wrong tree. Are there any gerating here, but some- lagged sometimes in the “Sometimes, there recurring traps that inves- times there are instances 1980’s, in the early 1990’s tors with less experience where either they tell you we lagged as well, but then are non-value inves- might fall into? nothing, or they tell you lies, in the late 1990’s we lagged or they tell you things that terribly for several years. tors who tell me, JME: It might be the impres- they shouldn’t tell you in We were still producing sion I might have had be- the first place. We have to absolute returns, but rela- well, I would love to cause maybe I looked at the be very careful, not because tive to our benchmark and businesses six or eight years management deliberately to our peers we were lag- do what you do, but before, and I was under the tries to give us inside infor- ging terribly because I had if I did it and start impression that manage- mation, but sometimes, par- declined to participate in ment was intellectually dis- ticularly if we own 10% - technology, media and tele- lagging, either my honest. In terms of man- 15% of a business, we are com, together with many agement, of course there is the second largest holder other value investors. boss or my share- the Buffett quip that when after a family that controls rowing a boat - what mat- the business and we’ve held In less than 3 years, be- holders will fire me. ters less is how strong your the stock for 7 or 10 years, tween the fall of 1997 and arms are, what matters so management truly looks the spring of 2000, our Of course, the an- more is whether the boat is at us as long term partners. Global Fund, which I had swer is you have the leaking. This is, of course, a run since early 1979 and metaphor for the fact that had a long term record, lost wrong boss or Wall Street tends to pay a Q: You have often been seven out of ten sharehold- great deal of attention to quoted as saying you have a ers. One has to live with wrong shareholders how good the management five-year time horizon vs. that because a mutual fund is, but Buffett has also said Wall Street’s six-to-twelve is open to subscriptions and or both!” that he wants to buy into month time horizon – redemptions every day. businesses that even an idiot When do you think about You don’t get to choose could run. It is the quality, selling a stock? Especially your investors. You take or lack thereof, of a particu- given that your performance whoever is sending the lar business. is measured against other check. You try in your sales mutual funds, how do you effort to explain very clearly I could think, again because I have the staying power to what you are trying to do, came across the stock be- remain disciplined? so that you don’t get the fore, this is a business wrong type of investors. where the accounting is But there are many inves- dubious, or I could be under JME: That is a key question tors who will either not the impression that there is – to answer the second understand what we’re try- a major weakness to the question first – if you are a ing to do or will understand business that may not be value investor - you are a what we’re trying to do, but apparent immediately. long-term investor. Warren if we lag for a year or two, Buffett did not become very they will forget about it. rich trading securities. If (Continued on page 9) Volume II, Issue 1 Page 9

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(Continued from page 8) me. Of course, the answer ment had done much worse There is impatience among is you have the wrong boss than Peter Lynch’s record investors. Ideally, if you run or wrong shareholders or because they usually bought money professionally on a both! into the fund after Peter Professor Bruce long-term basis, you would Lynch had really hit the ball Greenwald want shareholders in your Q: You must have experi- and then they would leave if fund to be long-term inves- enced that, especially early for six or nine months if he Bruce C. N. Greenwald tors, but that’s not always in your career when you was doing less well or if the holds the Robert Heil- what happens. were with Societe Gener- market went down during brunn Professorship of ale? that period. I hesitate Finance and Asset Man- Incidentally, not only does whenever I meet with finan- agement at Columbia value investing make sense, cial planners or brokers, Business School and is at least to me, but it works. JME: That is why very early, who are our real constitu- the academic Director of In that respect, you are late 1997, after only a few ency, because they are the the Heilbrunn Center probably familiar with the months of net redemptions, ones who decide to choose for Graham & Dodd piece written by Buffett – they made the decision of which mutual fund to invest Investing. Described by “The Superinvestors of Gra- selling our investment advi- in for their own clients. I the New York Times as ham and Doddsville” – and sory firm. They were exam reluctant to try to tell “a guru to Wall Street’s then 20 years later, the tremely impatient. One them how to run their busi- gurus,” Greenwald is an piece written by Louis thing is that if I look back, nesses, but it seems to me authority on value in- Lowenstein (“Searching for we ran a total of $6 billion that they are much too vesting with additional Rationality in a Perfect in the fall of 1997. Even worried about asset alloca- expertise in productivity Storm”). Buffett himself though we continued to tion, they should be trying and the economics of considered another nine to find three, four or five make money for sharehold- information. value investors. So then the ers, funds were down to good value managers and question arises - why are $2.5 billion in the spring of just stay with them. Maybe there so few value investors 2000. Today we manage they are worried that if they if it makes sense, if the ap- close to $35 billion. So (Continued on page 10) proach makes sense and it what I am saying here is that works? I think the answer it seems to me that it goes is truly psychological, and to show that if you do what that is what I was referring you think is right for the to when I said that if you shareholders, even if they are a value investor, you don’t seem to agree them- have to accept in advance selves, if you think you do that you will lag. And if you what is right for the share- lag, you suffer. Yes, you say holders, in the end, it bene- to yourself, I’m a long-term fits your business from a investor so my day will long-term point of view come, but if it goes on too because $35 billion is not long, it is not only the only a lot more than $2.5 doubt, but there is a genu- billion, it is also a lot more ine suffering associated with than $6 billion. It goes back lagging, and human nature to when Peter Lynch was shrinks from pain. Some- running the Fidelity Magellan times, there are non-value fund. Lynch had a superior investors who tell me, well I long-term track record, but would love to do what you he discovered to his dismay do, but, if I did it and start that the great majority of Jean-Marie Eveillard answering questions after delivering the lagging, either my boss or shareholders of the Magel- keynote address at the 15th Graham & Dodd Breakfast on Oc- my shareholders will fire lan Fund during his manage- tober 18, 2005 Page 10

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(Continued from page 9) JME: Yes, but if you look at or two or three of very pick three, four or five value the U.S. equity market, we difficult economic and finan- managers and stick with are in the midst of what cial circumstances, because them, after two or three appears to be a major and if that were the case, those years the clients will say worldwide credit crisis. In intrinsic values would be at “What am I paying you for?” August, the crisis was identi- least temporarily too high, fied as a sub-prime housing and accordingly, the risks David Einhorn with his Q: I recently read that American problem. Today, associated with our equity parents at the Graham Tweedy Browne opened four months later, it appears portfolio would be bigger & Dodd Breakfast their Global Value Fund, to be a worldwide credit than I think they are. So, to Third Avenue International crisis, and yet the American the extent that we consider is opening their fund, Long- stock market is 5% off its the top-down we look from leaf is opening their Partners high at the end of the fifth a negative standpoint. What Fund, and you just opened year of a Bull market. Ex- could screw up, from the your Global and Overseas cept for the Tokyo stock top-down, the investments funds. Does this mean that market, which I think is we make with a bottom-up investment opportunities about 20% off its high, mar- approach? are beginning to appear on kets in the U.S. and Europe the horizon? and most emerging markets In another respect, we’ve are very close to their high. been in a twenty-five year JME: That is right - I saw the Combined with the fact that credit boom, since the early press release from Third we are in the midst of a 1980’s, interrupted painfully Avenue and I also saw the major financial crisis, it but briefly in 1990. I say press release from Longleaf. seems to indicate that inves- painfully because at the end Longleaf is saying “We see tors, and for all I know they of 1990 you can point to opportunities today.” Third may be right, believe that Rupert Murdoch’s News Avenue and we are saying we’ll get out of the crisis Corp. almost going bank- much more that the market reasonably soon. Other- rupt until the banks, and we is very turbulent. To para- wise, markets would be - although I made the mis- phrase Ben Graham, Mr. much lower than they are take of buying the bonds Market seems to be moving today. So that is why, instead of buying the stock - from fear to greed and back. speaking very generally, we and a few others under- Both Third Avenue and we don’t find a tremendous stood that what they had are saying that maybe there amount of investment op- was a liquidity problem, but will be opportunities if the portunities right now. not an insolvency problem. turbulence continues, but Even on a conservative ba- neither one of us is saying You know value investors sis, the sum of the parts of we see an opportunity right are bottom-up investors, the assets was quite a bit in today. I believe Mason but I do pay some attention excess of the debt. They Hawkins is saying that there to the top-down. First, it simply had a temporary cash are currently opportunities cannot be completely ig- flow problem. Also in 1990 and for all I know, he may nored. Second, the intrinsic is when Sam Zell’s real es- be right. values we establish for the tate empire almost col- businesses we are invested lapsed. So, we have been in Q: Your answer leads me to in or that we consider in- a twenty-five year credit believe that you would cur- vesting in do not assume boom with one interrup- rently be looking at some of eternal prosperity. They tion, which is a truly long the most turbulent areas of assume that the world mud- credit boom. the market right now? Is dles through, which is usu- that true and where might ally what the world does. We seem to be facing a that be? They do not assume a year (Continued on page 11) Volume II, Issue 1 Page 11

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(Continued from page 10) investors that if I go down sense my baby. I didn’t worldwide credit crisis. the drain, well it is o.k. as want to just leave it. In The central banks are pedal- long as everyone else is view of the size of assets ing as fast as they can to going down the drain with under management, it was mitigate the damage. This is me. I think that with the odd in a way that there was crisis number six or seven. hedge fund business, at least only one portfolio manager. You had October 1987, you so far, the regulators have I mean myself for twenty-six had 1990, you had the late been careful enough to basi- years and Charles De Vaulx 1994 Mexican crisis, you cally prevent the middle for two years. Of course if had the 1997 Asian crisis, in class from getting involved you have a single portfolio “You know value 1998 the Russian crisis and with hedge funds. But in the manager and he leaves or is investors are the Long Term Capital Man- mutual fund business, we run over by a bus, what is agement collapse. You had have almost one-million left is a big void. Although it bottom-up the bursting of the technol- shareholders in our funds is true that value investors, ogy/media/telecom bubble and while we have some at least in our case, it does- investors, but I do and now the sub-prime institutional accounts and n’t matter who has the big- housing crisis. The odds are some very wealthy individu- gest battalions. What I pay some pretty good that crisis num- als, the great majority of the mean is if I had forty-five ber six or seven in twenty one-million are middle class analysts, we wouldn’t be attention to the years will be gone in a few people. If I screw up, I can doing any better than nine top-down. First, it months, but maybe it will make daily lives difficult. or ten, but I think it is the take longer or maybe the Financial planners have told kind of approach where we cannot be financial system is truly fray- stories about individuals want as many people on the ing at the edges. who did not have a great in-house research staff and completely nest egg, but thought they as few people as possible on I think it is Peter Bernstein had enough of a nest egg to the portfolio management ignored. Second, who said sometimes what retire. They invested the side. the intrinsic values matters is not how low the money with conventional odds are that something money managers who pro- Q: You spoke about risk we establish for truly negative happens - and ceeded to lose 30% to 40% being the consequence, not the odds are pretty low that between the spring of 2000 necessarily the odds. How the businesses we the system blows up - and the spring of 2003. does this thinking come into sometimes what matters is These people had to go your investment process? are invested in or what the consequences back to work, or sell the would be if it happened. boat. JME: Risk to us goes back that we consider For example, if I tell you if to not paying attention to you do this, the odds are I remember the day after I how one does in the short investing in do not one-in-ten that you will lose retired, which was January term. If you go back to assume eternal $50, no big deal. If I tell you 1, 2005, I got up late, took a Berkshire Hathaway’s an- the odds are one-in-one stroll in Central Park and I nual report page that has prosperity.” hundred, even better odds felt lighter than air. The the forty-plus year record in the sense that the risk of responsibility was off my of Buffett, on a cumulative losing is minute, that you shoulders. That is why I basis the record is extraor- die, then the consequences wasn’t particularly eager to dinarily better than the S&P are so drastic that even the come back, but I had been 500, but you can spot four odds as low as one-in-one treated very well here at or five years, I think there is hundred are just not good Arnhold and S. Bleichroe- one year where he is 1,500 enough. der, and also there was a basis points behind the S&P side to it where particularly 500. So he too accepts the I think there is a mindset the old fund, which I have fact that every now and among many professional run since 1979, was in a (Continued on page 12) Page 12

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probably an opportunity to suffer because you will lag. buy more of the stock. The It goes back to what Buffett key distinction is what was saying when he said Marty calls permanent im- something to the effect that pairment of capital , which are investing does not require fancy words for “Damn it, I high intelligence, but it re- made a mistake.” Not a quires some temperament. mistake because I bought a stock at $35 and now it is at Q: On the topic of tempera- $27. I made a mistake be- ment - Buffett has said that cause either my original he is “wired” a certain way. analysis of the business was Do you think temperament wrong or because after I is something you are born started buying the stock, I with or a trait that can be

Jean-Marie Eveillard and (Continued from page 11) failed to observe that the learned? David Winters at a past then you will underperform. business model was chang- Graham & Dodd Breakfast ing for the worse. In this JME: One way to view it is Risk to us is absolutely not case you have to acknowl- in the U.S. and also now in volatility. We always have edge your mistake, sell at a Europe, some people go too this discussion with financial loss, and move on. easily to the psychiatrist, consultants - it is not volatil- because if they do so, it ity. Marty Whitman is un- If you think it is a temporary shows that there is an ex- usual in a sense that there unrealized capital loss, if you pectation that they should are not many value inves- bought a stock at $35 and be happy every day. Of tors who were very good two or three years later it is course, it is true at the practitioners and also could at $27, it becomes painful other extreme. You have write from a theoretical and the great majority of people who tend to believe point of view. Marty, in one money managers get very too easily that life is a valley of his books, makes a key upset. But you have to ask of tears and that one can distinction between what he yourself, “Did I miss some- only be happy in the eternal. calls temporary unrealized thing?” If the answer is, “I The truth is in between, one capital loss , which is you buy don’t think so,” then you has to accept the fact that a stock at $35 and, after a have to accept that fact. one is not happy every day. year or two or three, it is at For example, if you buy a One is not entitled to be $25 or $30. If you think stock for $25 and four years happy every day and I think you have done your original later it is still at $25 and in that as an investor it is the homework before you the fifth year it goes to $50, same idea that we don’t bought the stock in a I don’t think in terms of I need to win every day. We proper manner, if you kept wasted my time for four just need to win over time. reasonably close to the years or it was what some Maybe the people who say, situation as the business investors call stale money well, I cannot afford to be a evolves over time, and if for four years, I say hey, I value investor because my you believe that nothing doubled my money in five boss or shareholders will major has changed for the years and that is 15% annu- fire me, maybe they are worse since you started alized a year and that is fine. right. But I think there is buying the stock, that is also the idea that I just don’t what Marty calls temporary Going back to what I was want to suffer. I remember unrealized capital loss, saying, not that value inves- there was a movie about which is nothing to worry tors are masochists, but that baseball called “A League of about. If anything, it is accepting in advance that (Continued on page 13) every now and then you will Volume II, Issue 1 Page 13

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(Continued from page 12) said there were at least 20 fund field, most of which are analysts there. The truth is long only. Also, keep in Their Own” where at some they do distressed investing mind that in the words of point a woman says to Tom and you need specialized Paul Isaac, hedge funds are a Hanks, who plays the coach, people for that. Marty has compensation scheme and “Join a value shop. “Baseball is too hard.” Tom also decided to become that indeed a reasonably Hanks replies something to more of an activist, which good value mutual fund is, in Keep in mind … the effect of “Of course it’s we have done very rarely, the end, from the point of hard. If it was not hard then takes a lot of time and en- view of the shareholder of that indeed a everybody would be doing the funds, a very cheap ergy. reasonably good it.” It is the idea that every- hedge fund, because all value thing in life that is worth- Number two, and most investors, whether they are value mutual fund while comes hard. importantly, in the value with hedge funds or with tent, Bruce is definitely on mutual funds, shoot for ab- is, in the end, from Q: You recently hired Co- the Buffett side although he solute returns. If you lumbia Professor Bruce is very tolerant. Some peo- achieve absolute returns the point of view Greenwald as the Director ple on the Graham side are and compound at a reason- of Research. He is one rea- intolerant of the Buffett side able rate over the years the of the shareholder son that many of us choose and vice-versa. You know, difference between you and to pursue an MBA at Co- Buffett has called the pure a long only hedge fund is of the funds, a very lumbia. How do you think Graham style “Cigar Butt” that you are charging 1.25% cheap hedge fund, he will enhance the team investing, which is not very overall expense ratio as you have in place at First flattering, although I remem- opposed to two-and- because all value Eagle? ber Walter Schloss chuck- twenty. You should also ling that he himself thought approach professors who investors, whether JME: Bruce is sixty-one he got more than one good are also practitioners to get years old, and I first met puff every now and then. their opinions on which they are with him several years ago. His However, Bruce has also firms would be good for you hedge funds or entire professional career introduced some refine- to join. has been in the academic ments of his own to the with mutual funds, world, and he was willing to Buffett side and that will be Thank you, Mr. Eveillard. go into the real world, so to very helpful to the analysts shoot for absolute speak, as opposed to the here. Although the in- academic world. He was house staff here does not returns.” intrigued by the idea of be- need to be energized, you ing director of research and, know that Bruce is an ener- in that respect, I think he gizing personality. So, we will do at least two things. are looking forward to his Number one, although of joining the team. To me, he lesser importance, he will is the ideal director of re- help us beef up the research search. department because he knows a lot of people who Q: What advice would you graduated from Columbia offer an MBA student aspir- Business School and were ing to enter the field of in- enrolled in the Value Invest- vestment management? ing Program. I never thought I was understaffed JME: Join a value shop. until I recently met with Keep in mind there are David Barse who is the value shops in the mutual CEO of Third Avenue. He fund field and the hedge Page 14

D.R. Horton, Inc. (SHORT) Joshua Chekofsky November 2007 [email protected] Investment Thesis I advocate a short position in the common stock of D.R. Horton, Inc. (“D.R. Horton” or the Company), as I believe the stock has an intrinsic value today of $7.25 (representing a margin of safety of approximately 40%, against today’s price of $11.86), based upon a Price / Adjusted Book Value analysis; yet, there is risk of 15% upside ($13.75). A six-month timeframe, across which the Company will report its next three fiscal quarters of performance, should be ample for the Company’s homebuilding fundamentals to deteriorate further and for management to make additional impairment announcements. The Company is poorly positioned in the current homebuilding environment. It has significant exposure to the weakest D.R. Horton, Inc. (DHI) geographic housing markets, and owns some of the youngest land supply in the industry, which is at Price: $15.43 greatest risk of loss. Sales orders have fallen dramatically, while cancellations are at abysmal levels. As (Jan. 25, 2008) management pursues aggressive sales to generate free cash flow to pay down its significant debt load, operating margins will deteriorate further. With adjustable-rate mortgages continuing to re-set, the Com- pany’s core first-time buyers will be considerably affected. D.R. Horton will be required to take extensive further impairments on its inventory (homes, land and options). Housing market conditions will continue to be challenging and the timing of a recovery is unclear. The industry is currently mired in a deep cyclical trough, which will likely persist for the foreseeable future. There will be continued margin pressure from increased price reductions and sales incentives, continued high levels of new and existing homes available for sale, weak demand for new home as potential buyers continue to see home prices adjust downward, increased sales cancellations, continued weak housing affordability, and a decline in the availability of mortgages due to further credit tightening. The formerly hottest housing markets are now reeling, a growing number of foreclosed homes will be returning to the market, a sizable level of mortgage loans will continue to default, and it will now take an elongated timeframe for the average home buyer to receive a mortgage. The primary valuation was based upon a Price / Book Value method- ology, in which book value was adjusted for anticipated substantial further asset impairments. A 0.75x multiple (given investors’ weak confidence and the turmoil in the industry) was allocated.

Supporting Points / Catalysts • Any further negative economic and industry performance releases will lead to a de- crease in the Company’s stock price. • The Company recently reported that cancellations increased to 48% in the 9/30/07 quarter, which is dramatically higher than the 30% to 40% in prior quarters. The Com- pany’s backlog no longer provides accurate visibility on future revenues. Cancellations should continue to remain at heightened levels. • D.R. Horton has significant exposure to the weakest geographic housing markets including California, Arizona, Nevada and Florida. Moreover, the Company maintains a very young land supply, relative to other home builders. This land which was purchased in 2005 and 2006 in formerly hot markets is at significant risk of impairment. • D.R. Horton has a heavy debt load. Any further deterioration in performance could lead to debt downgrades, and extensive impairments will reduce the borrowing base. This leads to broken financial covenants and lower liquidity. • D.R. Horton’s target customer base has been greatly affected by tightening in the mortgage market, as the Company’s focus is on first-time buyers and first time move-up buyers (with most homes priced below $250,000).

Business Description D.R. Horton is the largest homebuilding company in the country based on homes closed during the 12 months ended 6/30/07. The Company constructs and sells homes through its operating divisions in 27 states and 83 metropolitan markets. Homebuilding operations include the construction and sale of single- family homes with sales prices generally ranging from $90,000 to $900,000, with an average closing price of $261,600 during the nine months ended 6/30/07. Approximately 80% of home sales revenues were generated from the sale of single-family detached homes in the 9 months ended 6/30/07, with the remainder from the sale of attached homes. DHI Mortgage, a wholly-owned subsidiary, provides mortgage financing services to purchasers of homes it builds and sells.

Historical and Projected Performance The Company’s performance has deteriorated over the last several quarters. Sales and operating margins for the homebuilding operations have dropped precipitously, and results for the financial services busi- Volume II, Issue 1 Page 15

D.R. Horton, Inc. (Continued from previous page) ness have followed in concert. The Company has aggressively moved towards selling its inventory, to work “Sales orders down the glut of supply, which has lowered its average selling price and operating margins. The fall-out from the exuberant rise in homebuilding activities will take time to work its way through the system. Until have fallen dra- the demand/supply imbalance is corrected and selling prices stabilize, performance will continue to be de- pressed. Further compounding the problem, the Company will very likely have to recognize significant matically, while additional impairments on its inventory (homes, land and options), as management realizes that losses will be worse than expected. It is assumed that industry fundamentals will remain weak across Q4 2007 and FY cancellations are 2008, and that the situation won’t stabilize until 2009. Revenue and margins are projected to improve in 2009, towards the levels reached in the earlier part of this decade. at abysmal lev-

Valuation els.” Given the weak recent EBIT growth, poor pre-tax ROTC, and heavy debt load, the EV/EBIT valua- tions produce low intrinsic values. The historical EV/EBIT analysis produces a value of $5.45 to $9.30. The Projected EV/EBIT analysis produces a value of $6.20 to $8.60. A more robust approach for this inventory-intensive business is a Price / Ad- justed Book Value analysis, which produces a target price of $7.25. Impairments on homes is driven by the perception that 20% of the 6/30/07 homes inventory book value is at risk, as D.R. Horton has aggressively moved towards price slashing, which may create a price-cutting war. The Company’s core first-time buyers are seriously affected by the recent credit crisis. The estimate for the decline in homes inventory is estimated to be negative 20%. The level of impairments on the land (held for development, under development, and in development) is assumed to be triple this dollar amount, as land prices change at three times the price of homes, given that the Company prices land on a residual basis, after development and construction costs. Options on land/lots are assumed to be worthless, as these contracts were entered into at the peak of the real estate boom. The impairments are tax-effected at a discount to the 37.5% tax rate, “A more robust given the risk and elongated timeframe to reap the deferred tax asset benefits. With the current turmoil in the housing sector and the lack of investor confidence, it is assumed that the market will allocate a 0.75x approach for this multiple. An upside risk scenario is also calculated. inventory- Risks to Thesis : The prices of homebuilder stocks have fallen substantially already this year, and any positive national economic activity news, housing industry news, or peer earnings releases could spur an upward intensive busi- bounce in stock prices. The level of housing starts (i.e., new construction activity) has already decreased significantly from levels in previous years as homebuilders have shifted focus towards working through the ness is a Price / excess supply of inventory on the market. Although the Company has high leverage, the majority of the debt does not mature for a few years, and D.R. Horton has been generating strong cash flows from operations Adjusted Book recently, albeit through very aggressive pricing and weak gross margins. A significant decline in long-term interest rates (and correspondingly in mortgage rates) would increase housing affordability, as well as lead Value analysis, to inventory burn and a return to price appreciation. which produces a target price of $7.25.” Page 16 Macy’s, Inc. (NYSE: M) Long Del Anderson, CFA [email protected]

Current Price (1/25/2007) : $22.47 Intrinsic Valuation Range : $37.00 ($34.00 - $45.00) Margin of Safety : +60% (base case)

Thesis Summary: Macy’s is a long because of:

Horizon mismatch : Macy’s shares have been punished due to slow sales growth at rebranded May stores; however, the near-term focus of many analyst models fails to capture a “sweet spot” in which sales growth normalizes at these stores throughout 2008 and beyond, improving returns and turnover. Impact : True demand in new markets is presently undervalued Downside Protection : Recent investments in revenue optimization systems and “service culture” will improve margins in the event of a full-blown downturn, while Macy’s ownership of most of its stores provides a tangible floor of $14 for the stock price. Additionally, middle-market retailers (including Macy’s) have outperformed both lower- and higher-end peers significantly during each of the past three Fed easing cycles. Impact : Sensitivity to downturn low relative to peers Total Enterprise Value Calculation Stock buyback : Macy’s repurchased 22% of shares outstanding Share Price (01/25/08) $22.47 in 2007 out of strong free cash flow, and has made a commit- x Shares Out. 433.0 ment to maintain its investment grade rating while repurchasing = Market Capitalization ($MM) $9,729 ~5% of shares during the coming year. In retrospect, Macy’s + Net Debt 10,456 could have purchased some shares at lower rates, but it still = Total Enterprise Value (TEV) 20,185 represents a long-term positive for equity holders given that shares were purchased well-below my intrinsic valuation. EV/EBITDA 5.6x Impact : EPS to be amplified 5%+ as share count contracts 52-Week High $46.51 52-Week Low $21.31 Bottom line : Macy’s may decline modestly with retail peers in the near term, but this represents a buying opportunity. Over two-year Forecast & Consensus horizon, Macy’s will be a strong outperformer from current levels. EPS P/E Concensus Current* $2.18 10.3x $2.19 Background: FY' 2009 $2.41 9.3x $2.37 In late 2005, Federated Department Stores (now Macy’s) acquired a key competitor, the May Company, doubling its store count in FY' 2010 $2.72 8.3x $2.62 largely untapped markets and adding 15 new states to its territory, FY' 2011 $3.03 7.4x $2.90 making it a truly national brand. Subsequently, the firm has real- *Current (FY' 2008) ends on 1/31/2008 ized administrative synergies in excess of initial plan but sales Valuation Methodologies growth at rebranded stores has lagged. Free Cash Flow to Equity (base case) $37.00

Private Market / Reproduction Value >>$35.00 Market Misperception: Comparable Multiples (14x Fwd P/E) $34.00 Macy’s shares declined throughout 2007 on recession fears and concerns about poor performance at acquired stores. In one sali- Liquidation Value $15.00 ent example, former Marshall Field’s shoppers in Chicago began Upside FCFE: $45.00 +100.3% boycotting rebranded Macy’s stores; however, I believe it won’t be Downside FCFE: $18.00 -19.9% long before these protesters trade their picket signs for Macy’s Upside / Downside Risk Ratio 5.0x cards. At present, sales at “new Macy’s” stores are lagging be- Retail Malaise & Post-Merger Comps Hurt Macy's in 2007 cause shoppers are not used to Macy’s promotional style (no 20% coupons), sales associates are unaccustomed to Macy’s brands 10% Retail Peer Group and regional merchants have not fully adapted Macy’s product 0% lines to local consumer tastes. All of these issues are temporary. -10% On the operational front (gross margin, SG&A expense, systems integration), Macy’s has delivered as promised by the merger. -20% Thus, I believe that the first evidence of a sales revival at the -30% -32% Macy's, Inc. new stores will be a strong positive catalyst for the company. -40% -37% -50%

Jul 2007 Jan Jan 2007 Jun Jun 2007 Jan Jan 2008 Apr Apr 2007 Oct 2007 Nov 2007 Feb 2007 Feb 2007 Mar Sep Sep 2007 Dec 2007 Aug Aug 2007 May 2007 Volume II, Issue 1 Page 17

Macy’s, Inc. (Continued from previous page)

To test the impact of the current sales drag, I modeled sales by region and store type based on growth projections using pre-merger sales data. Assuming a conservative -10% sales drag at the rebranded stores, Macy’s revenues will be impaired by $1.1 billion during 2007. However, this bodes well for the future, since it means that current sales numbers are temporarily suppressed. As customers adapt to Macy’s strategy, the sales drag will narrow and total sales will increase rapidly in 2008 and beyond. The table below forecasts sales for Macy’s major divisions, with an estimate of the gap between new and legacy stores. The sales growth estimates for legacy divisions are conservative and well-below Macy’s historic organic growth rate of 4.3% over the past seven years.

Sources of Macy's Sales Growth CY (Legacy v. May stores) 2006 (A) Growth (%) 2007 (E) Growth (%) 2008 (E) Growth (%) 2009 (E) Growth (%) 2010 (E)

Bloomingdales 2,317 6.0% 2,456 3.0% 2,530 4.0% 2,631 3.5% 2,723 Macy's East 7,193 2.5% 7,373 2.0% 7,520 2.0% 7,671 2.5% 7,862 Macy's West 6,002 3.0% 6,182 2.0% 6,306 2.0% 6,432 2.5% 6,593 Macy's South & Florida 5,564 -5.0% 5,286 -1.5% 5,207 2.0% 5,311 2.5% 5,443 Macy's Central & Midwest 5,444 -2.0% 5,335 0.0% 5,335 2.0% 5,442 1.0% 5,496 Macy's.com 450 50.0% 675 25.0% 844 20.0% 1,013 15.0% 1,164 Less: Lag from legacy May Stores* 11,601 -11.4% (1,105) -5.6% (416) -4.4% (217) -3.7% (147) Total Revenue Projection 26,970 -1.5% 26,564 3.4% 27,471 3.4% 28,392 2.9% 29,135 * Sales growth lag relative to growth rates at legacy stores. Scuttlebutt Research Support: Interviews with buyers at Macy’s and Bloomingdales, visits to rebranded stores and some entertaining hours online reading blog posts and online consumer chatter about Macy’s brand yielded several key insights: 1) According to buyers, sales at rebranded stores are lagging legacy stores by ~10% overall and up to 20% in some re- gions, although sales of exclusive brands (inc. Martha Stewart) were strong companywide. Over the holidays, the gap between legacy and rebranded stores declined. 2) Rebranded stores have the potential to deliver results on-par with legacy Macy’s stores. Longtime May employees believe that their customers are no different from Macy’s target customers, so localization strategy should yield results. 3) Consumers’ online sentiments are getting better. One enlightened poster even noted that “ My rage at the Marshall Field's takeover diminished when I visited Macy's…. To my surprise, they retained many MF touches. I’ve seen nothing but improvement in the store.”

Industry Analysis: Retail stocks are out-of-fashion at the moment, creating a buying opportunity for the shares of several companies (Macy’s, Nordstrom, JCP); however Macy’s is particularly well-suited to outperform given that its stores are less-concentrated in the bubbliest housing markets and that under 15% of sales come from home essentials. As a purveyor of reasonably-priced quality brands, Macy’s stands to benefit in a downturn relative to higher-end peers (i.e., pinched Saks/Nordstrom shoppers would feel comfortable being seen at Macy’s). As of 1/25/2007 Volume Valuation Leverage Operating & DuPont Metrics Enterprise Total SalesPrice/Earnings EV / Price / FCF Dividend Debt/ Interest S&P Gross Oper. Sales Asset Equity Company Name Value Sales Growth Current Forward EBITDA Book Yield Yield Assets Coverage Rating Margin Margin ROE Margin Turnover Leverage

Macy's Inc. (M) 21,973 26,878 (1.8) 12.0 10.8 5.6 1.2 4.5 1.9 36.2 4.7x BBB 40.2 8.3 10.2 = 3.3 1.0 3.1

Peer Summary Analysis %xxxx%%%x %%%xxx Median 13,248 17,336 6.7 16.3 14.3 7.9 2.5 -3.4 0.9 25.0 6.6x - 32.2 7.37 20.5 4.2 1.6 2.7 Target Corp. (TGT) 57,380 63,207 11.4 15.7 14.2 9.0 2.8 -0.1 0.9 32.7 4.2x A+ 30.2 8.5 19.0 = 2.2 1.6 2.7 Sears Holdings Corp. (SHLD) 20,322 51,777 (2.0) 19.8 23.2 6.0 1.3 6.9 0.0 13.6 8.9x BB 26.3 4.1 10.9 = 0.9 1.7 2.8 Kohl's Corp. (KSS) 15,560 16,417 10.9 12.6 11.6 6.8 2.6 -3.2 0.0 20.0 10.9x BBB+ 34.2 11.6 20.4 = 3.7 1.6 1.9 TJX Cos. (TJX) 14,371 18,256 7.5 17.0 14.9 9.6 6.5 5.0 1.1 12.4 25.5x A 24.1 6.2 26.6 = 7.1 2.8 3.2 J.C. Penney Co. Inc. (JCP) 12,124 20,134 3.6 9.7 9.9 5.5 2.2 -3.5 2.3 27.3 4.2x BBB- 37.1 9.5 33.1 = 4.7 1.5 3.1 Nordstrom Inc. (JWN) 10,842 8,945 8.7 13.5 12.3 7.3 6.8 -4.6 1.3 38.1 15.9x A- 37.6 10.7 45.0 = 2.3 1.8 4.2 Saks Inc. (SKS) 3,169 3,238 15.5 40.9 30.2 14.4 2.3 -27.8 0.0 24.6 1.5x B+ 36.2 2.2 2.8 = 5.8 1.2 2.2 Dillard's Inc. (DDS) 2,940 7,441 (1.8) 28.1 54.2 5.6 0.6 -7.1 0.8 25.5 1.1x BB 29.5 0.6 6.6 = 8.2 1.2 2.4 Source : FactSet Daily Prices, Capital IQ, Reuters Global Fundamentals, First Call Estimates

History also suggests that the freefall of retail stocks may be nearing its nadir. During the past two consumer downturns (1990, 2001), general retail stocks fell ~40% from peak-to- trough and they reached bottom within a month of the official start of the recession. Macy’s shares hit a cyclical low three months before the 2001 recession after falling 50% during the preceding year. Such statistics are meaningless from a fundamental perspective, but they do suggest that the majority of the losses associated with a recession may be re- flected in Macy’s share price already. Page 18

Short Netflix (NFLX) at 21.75 — Price target $16

Avram Drori November 2007 [email protected]

Netflix (NFLX) Price: 21.75 (Jan. 25, 2008)

Investment Thesis: Simply put there is no reason for Netflix to exist. The business model is fundamentally anachronistic

and the company is destined to become a marginal player within the medium term. Cable, satellite and telcos have achieved penetration rates of advanced video on demand services in ~75% of their cumulative territory, implying ~65% of American Households can watch video on demand (VOD). VOD has incremental costs of essentially nil and the immediate gratification provided by the model is superior to Netflix’s 1 day turnaround. Additionally, the company has been late to recognize this and continues to spend money to attract new customers. The economics of new customer growth are ex- “Simply put tremely unattractive and as customer usage of the service declines, there will be a self-selection process whereby only the heaviest users of the service (and therefor the most costly to the company) will there is no rea- maintain their service. Due to stagnating growth and shrinking margins, I have assigned a price target of $16, representing ~30% downside from current levels. However, because of the high short position son for Netflix to (~24% of float) and the relatively volatile nature of the stock (beta=2.2) there is a meaningful risk of short term trading losses due to potential short squeezing and the stock could trade up to $25 (15%), exist. ” but given the poor fundamentals, I expect any uptick in the stock to be a temporary trading move, not a fundamental revaluation with the ultimate downward catalyst coming when they announce Q4 numbers and the damaging impact of their new marketing strategy and unattractive incremental sub economics flows through to their financials.

Company Overview: Netflix provides online subscription services for DVD’s. Customers log on to their website and select movies or TV shows they would like to watch and the company ships out the DVD’s to the customers via US Postal Service. There are no late fees and the company has several pricing plans and fee structures but their most popular allows for unlimited rental per month, with up to 3 DVD’s at a given time for $16.99/mo. No pricing plan charges late fees.

Investment Thesis: *The company has already experienced their strongest growth phase. The initial ramp is rolling off and revenue should peak in ’08. Management is seeking to initiate a second stage of growth where they will attempt to distribute videos online. The company will not be successful in this endeavor because they have no competitive advantage (and importantly, unlike MSO’s and telcos, they don’t own the pipes into consumers homes and ISP’s can prioritize their traffic over NFLX downloads). Additionally, the company lacks sufficient scale with content producers to negotiate favorable on-line distribution terms.

*The subscriber economics are becoming increasingly unattractive. Because the company continues to spend aggressively on both attracting new customers (SAC continues to rise and Volume II, Issue 1 Page 19

Netflix (Continued from previous page)

even if management gets it under control, the levels are unsustain- able) and continued churn make per sub economics dilutive to the overall company. Manage- ment could throttle back on SAC and milk the company for cash flow and possibly generate meaningful cash flows, but they have given no indication of their willingness to do this.

*The eventual emergence of a “Based on the new DVD technology will increase the costs associated with fundamentals of meeting customer needs. For the medium term (until a winner in the HD-DVD/Blu-Ray format conflict emerges) the company will have the company and to purchase both formats, as well as traditional DVD formats. This will squeeze margins and I estimate an incremental 300 bps of margin compression from this dynamic. deteriorating

subscriber eco- Valuation: *A $15 price target is based on a (generous) 8x multiple off ’08 EBITDA-an analysis of variation nomics the long around multiples demonstrates the potential conservatism of this estimate term prospects *Based on the fundamentals of the company and deteriorating subscriber economics the long term prospects of the company are poor. From a trading perspective the stock is volatile and the of the company position could see upward pressure, but long-term downward catalysts should come when damaging impact of the company’s marketing efforts flow through in Q4 numbers. Additionally, are poor.” continued price wars with Blockbuster and Wal-Mart will provide an inevitable downward catalyst (these price announcements have occurred every few months for the past two years).

* My $15 price target is based off an ’08 P/E of 18 (weighted 40%), an ’08 EBITDA multiple of 8x (weighted 40%) and potential for near term trading up to $25 (weighted 20%) to achieve the $16 level. Page 20

“Innovations in Investing” — Industry Networking Night and Panel

Industry Networking Series Greenwald, who is the observation is that “the big with Professor Bruce Robert Heilbrunn Professor are getting bigger.” As an Greenwald, William Von Muef- of Finance and Asset Man- example, he observed that “There is no fling (’95), and David Green- agement at Columbia Busi- hedge fund firm Citadel cur- span (‘00) ness School and Director of rently has 86 investment ‘hedge fund’ indus- the Heilbrunn Center for professionals on the ground On October 30 th , over two Graham and Dodd Invest- in Asia. The next five of von try that exists hundred students, alumni, ing . Mueffling’s observations and faculty filled every spare included: separately from square inch of the large hall Mr. von Mueffling kicked off at the Columbia University the discussion with a Letter- • Given the explosive the ‘money man- Club of New York on West man-style list of observa- growth of alternative asset rd agement’ indus- 43 Street for a night of tions on major changes in classes, investment manag- learning and networking. the investment industry. ers must employ more try.” sophisticated risk manage- Professor Bruce Greenwald He began with a question: ment processes. —William von opened the panel discussion Which asset class do you • Pensions and endowments by contrasting the evening’s think has grown the most in are now among the largest Mueffling enthusiastic crowd with a the last three years? People investors in hedge funds. somewhat different audi- shouted out answers, which • Some alternative invest- ence. “No one sat in the ranged from index, interna- ment strategies are al- front row,” he observed, “at tional, and various hedge ready obsolete, such as my executive seminar at fund strategies. The answer convertible arbitrage, sta- Harvard Business School.” was a strategy he termed tistical arbitrage, and Indeed, it was standing “low octane alpha”— macro. quantitative investing strate- • Long/short equity is large gies that deliver roughly a and growing but offers a few hundred basis points of lot of market correlation, excess return over a market whereas some firms benchmark. (including Cantillon) offer their clients “pure alpha.” Next, on a related note, von • John Paulson’s success in Mueffling pointed out that shorting the sub-prime clients are more sophisti- mortgage market demon- cated than in the recent strates that securitization past. “The customer base (and other forms of finan- knows the difference be- cial innovation) creates tween alpha and beta, which opportunities for alpha. is an important change.” • Investors’ return expecta- Third, Mr. von Mueffling tions are out of touch David Einhorn and Whitney room only to hear a panel advised that the distinction with the reality of today’s Tilson discussion on innovations in between hedge funds and market. Underscoring this investing, featuring former traditional buy-side firms point, Mr. von Mueffling students William von Muef- may no longer be valid. observed that equities fling (’95), founder, Presi- “There is no ‘hedge fund’ have returned an average dent and CIO of Cantillon industry that exists sepa- of just 3.5% per year since Capital and David Green- rately from the ‘money 1998 (excluding divi- span (’00), Managing Direc- management’ industry— tor at Blue Ridge Capital. dends). they are one in the same.” The panel was moderated by Professor Bruce Mr. von Mueffling’s next (Continued on page 21) Volume II, Issue 1 Page 21

“Innovations in Investing” ( continued from page 18)

(Continued from page 20) or bad fundamentals, the Mr. Von Mueffling closed his more likely you are to dis- remarks with some advice cover an instance of hard for MBAs aspiring to a ca- wiring.” reer in investment management. “Don’t ask about compensation—prove your- Second, Greenspan dis- self first.” Asking about cussed the virtues of ex- compensation, he quipped, ploring investment opportu- “is an immediate disquali- nities in nontraditional ar- fier.” eas, such as in developing countries or asset-backed Next, David Greenspan securities. Regardless of the shared his thoughts on terrain or subject area, three common Greenspan advised the audi- particularly important for Jean-Marie Eveillard and Pro- “ingredients” in his most ence to “think about unique realizing investment oppor- fessor Bruce Greenwald successful investment ideas: elements that you can bring tunities. to the table.” He also ob- 1. Identifying Instances of served that nontraditional First, intangible assets. “Profit levels around the “Opportunities are “Investor Hard Wiring” areas often involve com- 2. Exploring Nontradi- plexity, which can create world are higher than ever, local in nature. opportunities for investors. tional Areas but are they sustainable?” Recognize that, 3. Elongating the Search Finally, Greenspan suggested Professor Greenwald sug- Process that he has benefited by gested that one cannot an- and fetch informa- lengthening his search proc- swer this important ques- Mr. Greenspan summarized tion without first under- tion that is un- the first ingredient by point- ess for uncovering new investment ideas. “I am con- standing the intangible as- ing out that, “When inves- sets, such as organizational available to most tors stop thinking, it creates stantly filtering the world, looking for signposts of in- capital, that are associated investors.” opportunities to make with service-based indus- money.” For example, in vestor hard wiring or com- plex—and therefore poten- tries. According to —Prof. Bruce 2004, Greenspan and his Greenwald, the world is not colleagues noticed that Fiat tially misunderstood— situations.” Ultimately, yet sophisticated in judging Greenwald was one of the least recom- the worth of intangible as- mended stocks in Europe. In Greenspan’s goal is to find opportunities with a lack of sets, which creates opportu- general, the automotive nities for investors. sector had fallen out of fa- economically motivated buyers and sellers. vor, and investors com- Second, franchise value. plained that Fiat’s balance Professor Bruce Greenwald “Opportunities are local in sheet was in disarray. In nature. Recognize that, and 2005, the company hired a wrapped up the panel discussion with a series of fetch information that is new CEO who embarked unavailable to most inves- on a series of positive re- comments on ways investors can generate alpha in tors.” structuring efforts. How- ever, at the time, investors today’s market. His comments were united by a Third, growth. “Investors failed to appreciate these frequently misjudge the developments, which cre- common theme: know (exactly) what you are buy- value of growth—it is simply ated an opportunity for done wrong.” Greenspan. In summary, ing. In particular, Professor Greenwald outlined three Greenspan noted, “The -G&Dsville longer the period of good types of knowledge that are Volume II,I, Issue Issue 2 1 Page 22

The Heilbrunn Center Goes to India

Professor Bruce Greenwald spent two weeks in January traveling across India to discuss Value Investing, Globalization, Corporate Social Responsibility, and Competitive Strategy with a number of Indian business audiences. Professor Greenwald began his tour of India speaking at the Corporate Governance and Social Responsibility Conference organized by The Chazen Institute of International Business at Columbia Business gave a talk on Globalization to School. approximate 50 professionals at the Ahmedabad Management The discussions focusing on Association. Greenwald then value investing began in earnest traveled to New Delhi, where before a room of over 170 he was a panelist at an investing individual and institutional forum sponsored by Reliance investors in Mumbai. The Mutual Funds, a large mutual seminar was organized by local fund company in India. There, investors Chetan Parikh of he discussed the importance of Jeetay Investments, Sanjay Bakshi local/regional economies of scale of Tactica Capital Management in building defensible business and Dhananjay Lodha. models and encouraged Indian Greenwald conveyed Columbia’s companies to pursue regional modern view on Graham and strategies that can leverage the Dodd Investing – speaking to the economics of large fixed cost audience about valuing growth in infrastructures. Throughout the terms of return potential and trip, Professor Greenwald met not paying for growth in with several Indian companies, businesses where franchises do including pharmaceutical not exist. He pointed to companies, retail companies commodities such as steel or textile manufacturers, financial cement as examples of such services institutions, private businesses. We hope that the investors, real estate late January decline of the Indian development firms and noted stock markets is uncorrelated to that he was impressed by the Professor Greenwald’s January quality of management within 8 t h remarks about not the companies and enjoyed their overpaying for non-franchises discussions about strategy. and that exercising valuation -G&Dsville discipline is as important in India as in any other global market. The Heilbrunn Center for Graham & Dodd Investing is a During his next stop, Professor If you have questions or ideas premier knowledge center for the practice and theory of Greenwald taught Value about other international activities, investing. Building on Columbia Business School’s re- Investing at the Indian Institute please contact the Heilbrunn nowned history in value investing and finance, the center furthers new developments in investing and imparts the of Management- Ahmedabad to Center at: original principles of Security Analysis authors Benjamin approximately 40 students and [email protected]. Graham and David Dodd. Get Involved:

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