Graham & Doddsville

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

Inside this issue: Issue XXXVI Spring 2019 Yen Liow, Aravt Global 2019 CSIMA Conference P. 3 Yen Liow is the Managing Partner at Aravt Global LLC. Mr. Yen Liow P. 5 Liow directs the firm´s research process and actively researches many of the investments in the portfolio. Mr. Students´ Liow was previously a Principal at Ziff Brothers Investments Investment Ideas P. 15 (ZBI) and a Managing Director at ZBI Equities, ZBI´s equity market-neutral fund in New York. Mr. Liow joined ZBI in Bill Stewart P. 24 2001 and ran a team that oversaw ZBI Equities´ investments in the media, telecom, energy, and agriculture sectors. John Hempton P. 33 Prior to ZBI, Mr. Liow was a Consultant at Bain & Company in its San Francisco, Sydney, Singapore, and Beijing offices.

Yen Liow (Continued on page 5)

Editors: Ryder Cleary Bill Stewart, Stewart Asset Management MBA 2019 William P. Stewart is the Executive Chairman and a Gregory Roberson, Esq. founder of Stewart Asset Management, LLC. He MBA 2019 began working on Wall Street in 1955 as an David Zheng employee on the floor of the New York Stock MBA 2019 Exchange. Subsequently he worked for Spingarn, Heine & Co. as an Investment Analyst, before going Frederic Dreyfuss on to Pyne, Kendall & Hollister, later known as Riter, MBA 2020 Pyne, Kendall & Hollister. He became a Research

Sophie Song, CFA Director at the firm, then President of the MBA 2020 Bill Stewart investment banking subsidiary, and finally Chief Executive officer. Riter, Pyne grew to become the John Szramiak tenth largest NYSE member firm in the years he was MBA 2020 (Continued on page 24)

John Hempton, Bronte Capital Visit us at: www.grahamanddodd.com Rolf Heitmeyer www.csima.info John Hempton is the Founder and Chief Investment Officer of Bronte Capital. Prior to founding Bronte in 2009, he was the youngest Partner at Platinum Asset Management and Head of the Financials group. He was also previously an Analyst and Executive Assistant to the Chief Executive Officer at ANZ Bank, Chief Analyst of Tax Policies in the New Zealand Treasury, and has also served in various positions at the Australian Treasury. Mr. Hempton

earned a B.A. in Economics from Adelaide University.

John Hempton (Continued on page 33)

Page 2 Welcome to Graham & Doddsville

We are pleased to bring you and W.P. Stewart and Com- ued its winning tradition at the 36th edition of Graham & pany, the latter of which was the UCLA Credit Competi- Doddsville. This student-led sold to AllianceBernstein in tion with a first-place pitch by investment publication of Co- 2013. Mr. Stewart shared why Mitchell Aulds-Stier ´20, lumbia Business School (CBS) he focuses on predictable Karthik Kasibhatia ´20, Angela is co-sponsored by the Heil- earnings, how he comes up Qin ´20, and James Shen ´20. brunn Center for Graham & with an earnings multiple, and The team won with a long Dodd Investing and the Co- what he thinks of the retail pitch on Dean Foods´ 6.50% lumbia Student Investment industry. He also discussed Senior Unsecured debt. We Management Association his views on ADP and Disney. also feature pitches by gradu- Meredith Trivedi, Managing (CSIMA). Since our Winter ating Value Investing Program Director of the Heilbrunn 2019 issue, the Heilbrunn Cen- Finally, we had an engaging students Michael Wooten ´19 Center. Meredith leads the ter hosted the 2019 CSIMA conversation with John and Tyler Redd ´19, who are Center, cultivating strong Conference. Hempton of Bronte Capital. pitching longs on Align Tech- relationships with some of John is well-known for his nology (Nasdaq: ALGN) and the world´s most experi- Our first interview is with Yen public (and accurate) calls on Carsales.com (ASX: CAR), enced value investors and Liow, founder and managing both Herbalife and Valeant. respectively. creating numerous learning partner of Aravt Capital. Yen John discusses his approach opportunities for students discussed with us the value of to finding fraudulent compa- We thank our interviewees interested in value invest- having worked under a couple nies, why switching costs for contributing their time ing. of investment legends, the matter, and the benefits of and insights not only to us, importance he places on sys- global scale. He specifically but to the investment com- tems design, and why he only discussed Mattel and provid- munity as a whole. focuses on a specific set of ed additional color on his investment opportunities to variant perception on Valeant. - G&Dsville Editors compound growth over a period of years. Yen shared with We continue to bring you us a couple of his “horses” (i.e. stock pitches from current durable compounders) in Black students at CBS. In this issue, Knight (BKI), GoDaddy we feature the winning pitch (GDDY), TransDigm (TDG), from the 2019 Pershing and Constellation Software Square Challenge where Professor Tano Santos, the (TSE: CSU). Mingming Wu ´20, Laurent Faculty Director of the Heil- Liu ´19, and K.Y. Yong ´20 brunn Center. The Center We were also lucky to profile recommended a long with sponsors the Value Investing Bill Stewart, founder of both friendly activism for Dollara- Program, a rigorous aca- demic curriculum for partic- Stewart Asset Management ma (TSX: DOL). CBS contin- ularly committed students that is taught by some of the industry´s best practitioners. The classes sponsored by the Heilbrunn Center are among the most heavily demanded and highly rated classes at Columbia Business School.

Value Investing Program Class of 2019 Jan Hummel, Paradigm Capital AG, with Professor Tano Santos, Faculty Director of the Heilbrunn Center for Graham and Dodd Investing

Volume I, Issue Page 2 3 Page 3

22nd Annual CSIMA Conference - February 2019

Action-packed annual CSIMA Conference schedule Best Ideas panel with Joseph Fleury ´14, Dennis Hong, and Adam Wyden ´10, moderated by Kristin Gilbertson

Fireside chat with David Zorub ´03 and Ted Seides Conference attendees have a conversation

Fireside chat with Susan Byrne and Jason Zweig Understanding Management Teams panel with David Simon ´85, William Thorndike, and Tracy Travis ´86, moderated by Cheryl Strauss Einhorn

Page 4

SAVE THE DATE

29th Annual Graham and Dodd Breakfast

A Discussion with Cliff Asness of AQR Capital Management

Presented by: The Heilbrunn Center for Graham & Dodd Investing

Friday, October 11, 2019 8:00 a.m. to 9:30 a.m.

The Pierre 2 East 61th Street New York, NY

For inquiries, please contact: [email protected] Page 5 Yen Liow, Aravt Global (Continued from page 1) Mr. Liow earned a I started working when I was to get a summer internship at Bachelor of Laws (Hons.) 14. I worked every summer Ziff Brothers Investments for and Bachelor of and took every opportunity I the remainder of the summer. Commerce from the could find to learn about Ziff Brothers really opened my University of Melbourne in business. It was mostly a lot of eyes to the professional 1994 and a Masters of manual jobs that eventually led investing world. I thought Business Administration to professional internships and hedge funds were traders, (George F. Baker Scholar) opportunities. I bought my first which was not appealing at all from Harvard Business stock when I was 14 (it was to me. What I found at Ziff School in 2001. Santos, an Australian Oil & Gas was a great group of people company) and have been who did deep and creative Mr. Liow lives in investing ever since. research. Ziff had a learning Manhattan, New York with culture in which I spent the Yen Liow his wife and two children. For my undergraduate studies, next 13 years helping to build Mr. Liow serves on the I did a double degree at the an amazing business. Eventually Finance and Audit University of Melbourne in I ran their Technology Media Committee of the Trinity Commerce and Law. I Telecom, Agriculture, and School (NYC), is a board originally started with a triple Energy groups. member of the Success degree – I also studied Charter Network and is a Actuarial Sciences for the first Ian McKinnon was the board member of We.org few years – but I wised up to portfolio manager there. He (Tristate area). Mr. Liow is the fact that it was far too was one of the greatest human an Adjunct Professor at much work and I wanted to beings, coaches and mentors Columbia Business School have some fun. one could ever wish to work and guest lectures for. Ian had a huge impact on regularly at universities After that I went to Bain & my career and remains a close around the country. Company. I started off in their friend. Sydney office and then went to Graham & Doddsville their San Francisco, Singapore While I was with Ziff Brothers, (G&D): Could you start by and Beijing offices over the I also had the opportunity to discussing your background course of five years. Bain was spend time with Eddie and how you got into this an amazing, diverse set of Lampert, who opened my eyes business? practical experiences. But the to case studies. I asked him most important part for my how he developed such an Yen Liow (YL): I´m development was the two incredible business acumen so Malaysian-Chinese Australian. I years that I spent consulting early in his life, and he shared was born in Kuala Lumpur, with Dell Computers. Dell´s with me that he spent a Malaysia, but I immigrated to stock price grew tenfold over substantial part of his twenties Melbourne, Australia in 1976 that period. I learned an and thirties purposefully when I was four years old. My unbelievable amount about training by studying the best dad was a dentist and my mom hyper-growth and what world- investments in history through was a teacher. They didn´t class execution looks like, a case study methodology. I know much about business, which had an important impact took that on. We started but I fell in love with it at a on my focus and philosophy as doing cases internally at Ziff really young age. My best an investor. After Bain, I went and taught our approach at friend´s father was a gentleman to Harvard Business School Harvard Business School in named Peter Gunn; he was a where I graduated as a Baker 2008, and continued the self-made transportation Scholar in 2001. process at Columbia Business magnate in Australia and I was School in 2013. The case study very fortunate that he took me During the summer in between methodology was the most under his wing and became my first and second year at important part of my personal one of my key mentors when I business school, right at the development and is one of the was young. At the age of 15, peak of the dot-com bubble, cornerstones of Aravt Global´s Peter essentially helped inspire the startup that I was interning creation. the next 25 years of my life. at shut down. I was fortunate (Continued on page 6) Page 6 YenHarvey Liow, Sawikin Aravt Global

In 2013, I was a bit over 40 briskly than the broader by competition. We focus on and I had to scratch the itch - market. the small percentage of stocks to find out what it would be that resist those forces, like running my own Over ten years ago, my team primarily economic investment firm. So, in did a deep empirical study on monopolies and functional February 2014, we launched stocks that compounded at oligopolies. That is where we Aravt Global. north of 20% on five- and ten- spend all our time and year rolling periods over the resources. The inefficiency we G&D: What´s the inspiration last three decades to try to exploit is the absence of mean behind the name? understand what drove reversion. performance. We wanted to YL: Aravt means the number deeply understand the patterns When I started my career, I “ten” in Mongolian, which was and if they could be repeated. thought I needed the largest the smallest unit in Genghis possible investment universe Khan´s army and represent to find opportunities. We have our humble beginnings. “We just don´t back learned that in fact the Genghis Khan´s army had opposite is true. We needed 200,000 cavalrymen who situations where the to find a rich vein of repeatable conquered 10 million square win rate is even. You inefficiency in a finite universe miles of the Earth over 30 that we could focus on, so years in the 13th century. This can´t compound capital when price dislocation occurs is relevant to investing because we could exploit it. When the you can´t do something of that if the odds are not well universe is too big, that is an scale by picking fair fights. You unachievable goal. At least it can´t just do common things. in your favor. We´re was for me. The central premise of Genghis Khan´s strategy was looking for unfair fights What we focus on is durable unfair fights. Genghis Khan was where a company´s growth businesses that can successful because he hated compound free cash flow or putting his men in harm´s way, advantage is substantial earnings per share at a healthy and that is the first principle of rate, which we describe as Aravt Global. We just don´t and repeatable.” between 15% and 25%. back situations where the win Durable growth businesses are rate is even. You can´t more predictable businesses. compound capital if the odds This led to over a decade of As investors, we are studying are not well in your favor. examination and dissection history to try to predict the We´re looking for unfair fights, through the case study future. In situations that are where a company´s advantage methodology. Over the past highly dynamic, which I would is substantial and repeatable. few years, we have integrated define as lower quality that knowledge into the businesses or lower quality G&D: Can you talk a little bit processes and culture that industry structures, there is a about the other principles that define how we approach our loose link between history and guide Aravt Global? business. Let me share a few of the future. As such, your ability the elements with you. to predict is low, regardless of YL: Albert Einstein said that how many hours you spend compound interest is the most The first and most important researching. powerful force in the universe. element is game selection. We We agree – we think had to decide where to focus When you spend your time in compounding is the most our efforts. durable businesses that are important framework in highly moated, the opposite is investing. Our business model, Most of the market will revert true. Our job is to find portfolio and structure is built to the mean over time. That is situations where history does around it. We focus on horses, one of the most important hold, and to constantly ensure a sub-genre of durable laws of economics – that that new dynamics do not compounders that grow more excess profits get eroded away jeopardize the durability of (Continued on page 7) Page 7 YenHarvey Liow, Sawikin Aravt Global

that moat. When the moat outsourced trader, in and be patient in deploying our breaks down, our ability to Vancouver. We don´t generally work. predict breaks down. When trade the same day we make our ability to predict breaks decisions. These are culturally G&D: How does valuation down, it is hard to know what important factors. We have play into your approach? to do with volatility. Is it four analysts on our team, plus opportunity or is it risk? Our me as the portfolio manager. YL: Valuation discipline is the portfolio is highly durable and We only need a few great fourth element. We don´t easier (but still not easy) to ideas each year for our invest in all types of growth predict. When volatility hits, at portfolio to stay healthy and stocks, but in a specific type worst we hold through, and at well-stocked. There is no need that we call 20/20s: 20x best we exploit it. It´s a for immediate reactions on forward earnings for 20% profoundly different place, and anything that we do. There intrinsic value per share that is all about game selection. was a 20 month period where growth. Now, obviously Simply put, our stocks may be we only bought one stock. It is valuation is not as simple as volatile at times, but our really hard to build a culture that and 20/20s is not all that businesses, in general, are not. and process where the whole we do, but it is the central team deeply understands the tendency of our portfolio. One In game selection, we also important distinction between central premise we believe is focus on the replication phase intense research activity and that over time, the of a business life cycle. There value-added portfolio activity. compounding of our long are three stages we view as portfolio will revert to the the life cycle of a normal After another detailed study of underlying earnings power business: proof of concept, market returns three years growth of the businesses we replication and maturation. ago, we cut off both tails in our own. If we have done our The first phase has explosive portfolio. Specifically, we don´t underwriting well, the 20/20s outcomes, both up and down. pursue the extreme upside will not only give us downside It is very hard to predict one-year stocks, because we protection into volatile however, with very wide don´t need to - we found that markets, but also the room to outcomes. We focus on the tremendous short-term stay deeply engaged with our second phase: on businesses downside risk exists there, and large investments for many that have won their niche and it usually doesn´t let us size years, which I believe is the can replicate over long periods and stay well-invested for long hardest part of riding horses. of time. periods of time. We adjusted our focus to the compounders While valuation multiples The second element is systems that can still compound at 20%, matter a lot in the short-term design. We´ve created a firm, a 30% or 40%, and where we – they drive stock culture and a process to can be bigger for many years. performance tremendously in support our game selection. We still get the occasional up years one through three – in Great systems design allows 75% to 100% stock in a year, years three and beyond, the for engineering tolerance. but our performance is not impact of a change in multiples, When we are dealing with dependent on it. unless extreme, fades when it capital markets, we need to comes to long-term capital have tolerance for a lot of This brings us to the third compounding. imponderables – mistakes, area, which is portfolio randomness, stress – but still concentration. We developed a The fifth element is duration be able to perform. Our search algorithm that narrows and capture. All of what I´ve organization is built around our universe of 3,000 or so described allows us to hold purposeful preparation and stocks into a far more defined our investments for long error minimization. universe of 200-300 companies periods of time. We focus on that qualify for what we do. growth stories that can Built into that systems design is We then deploy capital into replicate for many years on having a purposeful culture. the best 15-20 of those ideas. end. Roughly a third of our None of us have a Bloomberg This concentrated portfolio portfolio is almost five years terminal. We have an allows us to hold the bar high old (the age of our fund), a (Continued on page 8) Page 8 YenHarvey Liow, Sawikin Aravt Global

third is two-and-a-half to five Contrast that with a high G&D: How do you evaluate years old and a third is velocity portfolio, where the management and how does it younger than two-and-a-half work that you do becomes fit into your investment years. The 20/20s combined obsolete quickly. Our insights process? with our game selection allow compound and can stay fresh us to be sized bigger in our in our actionable inventory for YL: Management is very names and stay big for long many years on end. That builds important to us, because periods of time. Four of our patience into our process, but management is the allocator of five oldest investments are still it also permits us to spend a all of a firm´s resources and, in our top five largest holdings, tremendous amount of time over a five- or ten-year holding and all five are within our top on our research. period, they´ve allocated the ten. majority of the capital of a “We compare firm. We look for specific One of the important benefits factors in assessing of duration is tax-efficiency, investing to a management, with the simplest which really adds to our test being ethics. Are we limited partner´s total return professional full- dealing with an ethical over time. It also allows us to management team? Do they have tremendous return on contact sport, and all have a reputation for doing time, which is my next point. professional sports shareholder unfriendly things? The term we use is: is the Once you pull all of this have a high training-to management team handshake together, we´re given a lot worthy or not? more time to do our work in -playing ratio.” the diligence process, which is One mistake I made earlier in area number six. Our portfolio my career was investing in construction allows us to The final element is training. questionable management spend many months on We train deeply, as investing is teams, believing that a cheap individual ideas. Our process is a game that never ends or valuation more than made up both quantitative and stops adapting. We compare for management. We just qualitative. The quantitative investing to a professional full- don´t expose ourselves to that components involve breaking contact sport, and all risk anymore and seek to down all our theses into clear professional sports have a high invest in and support high articulations of growth drivers training-to-playing ratio. We quality people. and what we´re playing for think it´s absolutely critical to over long periods of time. have a high training-to-playing G&D: Do you hedge your ratio. We train a tremendous long portfolio with shorts? Qualitative research involves a amount, and I still think it´s not tremendous amount of enough. YL: Our long and short primary research. We do our portfolios are each designed to own primary research in The case studies I mentioned be standalone portfolios and house, are supplemented by are an integral part of our not hedges, pair-trades, or investigative journalists and training. We generally don´t specific offsets. We look to have an in-house forensic do investment case studies on create a portfolio of high- accountant. We are a single case basis. We´re quality ideas on both sides. comfortable spending a lot of looking for patterns, not single Indeed, we are in the early time on our research as we idiosyncratic outcomes. stages of launching a long only believe if we´ve selected the Clusters of cases are very strategy. ideas well upfront in our important, and we generally do process, then it´s a question of them in batches of three to six. G&D: How does the broader when – not if – our inventory Contrast learning is also very economy factor into the gets deployed into our live important, as understanding investment decision process? portfolio. the counter case will highlight even more what the YL: I think the first and most differences were. important rule in risk (Continued on page 9) Page 9 YenHarvey Liow, Sawikin Aravt Global

management is awareness. it opportunity or is it risk? The balance etc. – it may be a Bank Macro tells us what kind of more explicit you make of America loan, but it´s environment we are currently implicit insights, the better you operating on Black Knight´s in, but it´s difficult to predict will be able to take appropriate software. The business was macro outcomes and a low action and think clearly during originally formed in the 1960s, return on effort. However, times of stress. Trust me, it is but was fully spun off from trying to understand where we still really hard at those Fidelity National Financial are in the cycle informs broad moments, but at least you have (NYSE: FNF) in 2017. risk positioning and tells us a fighting chance. how much of our balance We believe Black Knight has a sheet we should deploy at the G&D: With the market now near monopolistic position in edges. But we are back around all-time highs, do mortgage servicing software, fundamentally bottoms-up in you find the current landscape which is over 80% of total filling our portfolio. for finding long ideas much EBITDA. It has three basic tougher than it was maybe business lines. The first is G&D: Does your process three or four months ago? mortgage servicing software, in change at all in environments which it has 62% market share like Q4 of last year? Is there YL: Well, three or four in first-lien mortgages, going to more of an added incentive or months ago it was amazing. But 70% and 19% market share in rush to get into names when we´re still finding interesting second-lien mortgages, going you see that the market´s ideas, and frankly the best part to 30%. There is a runway for down 10%, 12% in a quarter? about what we do, again going continued market share gains back to our systems, is that we in both segments, but YL: Absolutely. We bought don´t need to find many. As especially in second-lien. It also three stocks in one day. We long as there´s durable growth has mortgage origination did not put the entire positions at reasonable prices, we can software where it´s the second on in one day, but we started engage – or not at all. We are largest third-party platform slowly loading positions as happy owning what we´ve got. after Ellie Mae. The final soon as we saw the market get We don´t have to buy a single business line is a solid data and emotional and the IRRs stock. There´s nothing forcing analytics business that becoming attractive. So, yes, our hand; our portfolio should competes against CoreLogic. we bought a lot of stocks in continue to compound the fourth quarter last year. healthily. We´re comfortable We love subscription-based This was unusual for us and, with our visibility of it. Will it business models. Why? again, we don´t really need to. get hit in a recession? Of Because they are generally But software went on sale, so course, it´ll get hit in a easier to predict and project. we picked up a few stocks that recession. But can we hold We love subscription growth came into our strike zone. Our through in a recession? We businesses and this is one of process allows us to act if we can hold through in a the best we have seen. Black are provoked. recession. Knight is also the lowest churn subscription business we own, That´s also why we focus so G&D: Do you have any new which is also a very strong much on training. It´s one thing positions in your portfolio that indicator of business quality. In to have implicit gut instincts, you think are really good the last 10 years, only one but it´s another thing to have examples of “horses” – significant customer left its explicit knowledge. Case durable compounders that you platform (post GFC), and that studies and deep pattern think can grow 20% or 30%? customer recently came back recognition let you take the to Black Knight after years of implicit and make it explicit. In YL: One investment that we trying to do it internally. It also our business, the toughest made last year is Black Knight has strong pricing power, high moments happen at the (NYSE: BKI), which is a SaaS returns on capital and an bottom of the Nike swoosh, company in the U.S. mortgage amazing management team. when the stock price of one of servicing industry. When you our investments is under a lot get a statement with what you One of the reasons we of pressure. In that moment, is owe on your mortgage, your invested now is that we´re in (Continued on page 10) Page 10 YenHarvey Liow, Sawikin Aravt Global

the midst of a once-in-a- YL: In general, yes, we try to Black Knight´s revenue is generation regulatory change. take a first-person look at the based on the number of Post-GFC, the government software. But frankly, we´re mortgages (i.e. stock) which is significantly increased not making judgments on the very consistent and normally regulations for mortgage quality of the software. We grows 1-2% per year. Even into servicing and originations. This don´t believe that´s an edge. deep cyclical troughs, like increased compliance cost and Even if we got the most today, the negative revenue increased risk of immense fines experienced software impact on Black Knight is quite for non-compliance actually developer to tell us if it´s a minimal. Even on the mortgage increased Black Knight´s good or bad design, that´s only origination side, which is 6% of competitive advantage. part of the equation in revenue, Black Knight has software businesses. Sales and contractual minimums. The Additionally, Black Knight´s distribution is equally as balance sheet is levered software is regarded as the important as the product itself. around three times, which heart and lungs of many banks´ enhances equity returns, but mortgage operations. It´s very it´s a business that can handle painful, if not nearly impossible, “We love subscription- leverage. to rip it out and replace. We love businesses that are deeply based business models. G&D: Any other recent embedded in its customers´ Why? Because they are additions that you´re excited businesses. about? generally easier to All of this is being combined YL: GoDaddy (NYSE: GDDY) under a new leader, Anthony predict and project. We is a really fun one. This is Jabbour. Anthony was another subscription, high- previously the COO at Fidelity love subscription recurring revenue business. National Information Services And it has a dominant position (NYSE: FIS) and has the growth businesses and in their market – it has about experience of running a [Black Knight] is one of ~23% of all domain business multiple times the size registrations and roughly half of Black Knight. We think the the best we have seen.” of new domain registrations in world of him. He´s ethical, the U.S. Its competitive aligned, capable and hungry. advantage comes from its Moreover, the chairman of Black Knight´s software is name recognition and superior Black Knight is Bill Foley, relatively older than some of organic search ranking, which who´s a legendary capital its peers – it´s one of the gives GoDaddy the lowest allocator who has original SaaS companies, customer acquisition cost in compounded capital at high- actually – but it´s just so the industry. teens for over three decades. sticky… it´s not something We think the combination of that banks can easily change. The industry doesn´t really Bill and Anthony puts us in a We´re trying to understand compete on price when it position of tremendous software from the client´s comes to domain registration, stewardship at a reasonable perspective which gives us since it´s a fraction of the cost valuation. insight into its pricing power, of running a business. While stickiness and distribution domain registration is a lower Black Knight trades at 24x model. margin business, it´s an 2020 EPS, compounding its extremely important on-ramp value per share at high teens. G&D: How dependent is this that allows GoDaddy to upsell We think that endures for business on the housing cycle? and cross-sell higher margin many years to come. products. Once GoDaddy has YL: Black Knight has almost its foot in the door with a G&D: When you are looking no correlation with the small-medium business at a software company, do you housing cycle. While mortgage (“SMB”), it then sells services sit down and actually test the originations obviously move up such as website content software out? and down, the vast majority of management software, hosting (Continued on page 11) Page 11 YenHarvey Liow, Sawikin Aravt Global

services, productivity tools and stock has a reasonable the house. It´s a great asset. telephony. GoDaddy has world valuation. It is currently trading We think it should grow free -class customer care that is at 20x current FCF. We see cash flow per share at 30% for extremely good at managing this company compounding years. customer relationships and free cash flow per share upselling products that actually comfortably in the 20s for Content is at an interesting help customers succeed. many years to come. juncture. Content is both niche GoDaddy´s so good at this and scale; Fox is niche and that its customer care team is G&D: We noticed that you Netflix is scale. I think content actually a profit center, not a recently added Fox. What are is completely shifting to one of cost center. your thoughts on linear vs. those extremes, with nothing OTT content creators vs. pure in between. Netflix is currently We think GoDaddy has distributors, and how do you spending $13 billion a year on tremendous secular tailwinds see that landscape unfolding? content. Practically no one else behind it. The internet and the can spend at that level, with need for businesses to have an maybe Disney and Amazon online presence is growing “Content is at an being the exception. But it´s a robustly domestically and really expensive game to take internationally. GoDaddy interesting juncture. on. operates in both jurisdictions and its opportunity to continue Content is both niche The other option is to go in to expand internationally is the exact opposite direction. enormous. There are about and scale; Fox is niche Fox has must-watch TV: Fox 500 million independent SMBs and Netflix is scale. I News is its most important in the world. GoDaddy has property with its broadcast only 18.5 million customer think content is network being number two. relationships today, meaning This is the whole reason why there´s a huge opportunity to completely shifting to Rupert Murdoch sold most of grow the number of customers Fox´s assets to Disney. By the it serves. On top of that, its one of those extremes, way, not many business titans customers are only spending build and break up their $150 per year at the moment with nothing in empires in their lifetime. I have with GoDaddy, so there is also between. Netflix is to tell you, a sell decision at opportunity for further that scale is truly amazing. That penetration with existing currently spending $13 takes extraordinary discipline. customers. But Rupert clearly saw how billion a year on the strategic context was GoDaddy is led by one of the unfolding. You have to be one most capable management content. Practically no or the other, scale or niche, teams we´ve seen. Scott and if you´re neither you´re Wagner, who is the former one else can spend at dead, so he repositioned his CEO of KKR Capstone, that level, with maybe company. The Fox broadcast decided to leave KKR to run network pivoted from general GoDaddy. He recruited top Disney and Amazon entertainment to mostly live notch talent and brought sports, and Fox News several members of his KKR being the exception.” continues to be one of the team over with him, which most important channels in any makes the management team YL: Charter Communications cable bundle. Both are bench very deep. Scott also (NASDAQ: CHTR) is one of absolute must-watch live TV. owns over $130 million of our oldest and largest holdings. They´re at risk of linear stock, so he´s well aligned with The beautiful part about subscriber decline, sure, but shareholders. Charter is that it´s content these are among the last men agnostic. Charter is a pipe – standing and they have We think Scott is a fantastic the most valuable, hard to tremendous pricing power. allocator of capital and that the replicate, fastest pipe – into (Continued on page 12) Page 12 Yen Liow, Aravt Global

G&D: With training and Mark chose vertical market positive change. We obviously learning being such an integral software, which is think TransDigm and part of Aravt´s investment characterized by highly Constellation are fantastic philosophy, are there any key repetitive, subscription-based businesses. We´ve owned both insights you´ve learned by businesses with low churn, for five years and they´re both studying excellent managers? high barriers to entry, small still top-five positions for us. In niches, and tons of companies. addition to that, we´ve tried to YL: Of course. We are He found a vein of high-quality weave a lot of what Mark and students of excellence in businesses and had deep Nick do into different parts of general. There´s just an energy insights on how to run them our own firm´s culture and that gets released by studying better. portfolio design. excellence. That´s why people are so in awe of sports – you For Nick, it wasn´t necessarily G&D: You mentioned earlier Angela Qin ´20, James Shen are literally viewing excellence aerospace in general. His that time allocation is very ´20, Karthik K.S. ´20, and at pinnacle moments. You get insight was specifically that important for your firm. Could Mitchell Aulds-Stier at the to see excellence clash. That is aftermarket proprietary you talk more about that, as Fink Center after winning incredible stuff. aerospace components, well as about your own the UCLA Credit Competi- although not subscription in personal time allocation? tion. One of the reasons I love nature, are subscription-like. investment management so The barriers to entry there are YL: We have a cadence to our much is that I´m literally extremely high, so niches are organization; I believe all getting paid to study business created and driven by FAA organizations should have a excellence. Two of the best regulations. For a substantial cadence. It operates more business managers in the world part of TransDigm´s smoothly that way and today are Nick Howley at aftermarket business, there requires less tactical decisions. TransDigm (NYSE: TDG), an literally is no second-source We have an accountability aerospace company, and Mark provider. As the life of a plane meeting at 8:30 every Monday Leonard at Constellation or of a platform is 20 to 50 morning where we review the Software (TSE: CSU), a vertical years, that’s how long week back and the week market software company. TransDigm ends up providing forward for every team These companies are both the parts - and on a regular member. If there´s a position serial acquirers, and these basis too, through normal that´s being pitched, either for CEOs are both outstanding wear-and-tear and regulatory our inventory or our live capital allocators. TransDigm upgrades. It creates portfolio, then it´s a two-hour has compounded at 30% for 12 subscription-type meeting on Thursday that we years and Constellation has characteristics in an industry keep blocked as a placeholder compounded at almost 40% for that´s grown revenue seat in the team´s calendar. The 12 years. miles at 5.5% per annum for 30 first Monday of every month is years. an entire portfolio review, long We studied them and their and short. When we meet, businesses to try answering With game selection, not only we´re purposeful about two simple questions: How can did they start in fantastic agendas and we always start on an external capital allocator industries, but they’re very time. sustain such extreme clear on what they look for in performance, and can it be their acquisitions. Separately, we have dedicated, replicated into an investment Constellation has done 400 concentrated time for training firm? The first and most deals and TransDigm has done – whether it´s process, case important decision they made 65. To our knowledge, they studies or something else. We was with their game selection. have a near zero loss ratio. usually have two retreats a They chose an excellent How is that even possible in year, with one R&D dive market. That´s why it was so situations of external capital during one of the two retreats. important to us when we allocation? It´s because they´re We do ongoing training all the created Aravt that we’re very disciplined with what they time for process. The process specific on where we spend look for, how they underwrite training for all of last year was our time. and how they implement on primary research. We (Continued on page 13) Page 13 Yen Liow, Aravt Global

brought in investigative huge one because it´s I do daily, I try to read 70-100 journalists and trained our unbelievably disruptive to your books a year. I do not read this team on outreach, email concentration. Texting and IM much because I was born with formation, how they should is even worse. I work in 25- any special skill – it was a skill I attend trade conferences and and 45-minute chunks, and learned 25 years ago and I how they should interact with then I take breaks. I manage make time to use it. management teams and those chunks proactively. primary sources… we spent My third piece of advice is to the whole year training on it. Some people like open do case studies. Deeply study High performance requires environments, but I personally the best and worst breaking processes down to can´t do deep thinking with a investments in history. Even their core elements and lot of noise around me. We´re better, do it with a bunch of rebuilding them to improve an office culture where doors friends. Learn in clusters. This execution. We do this all the get closed when required and business is about pattern time with our processes. open when they´re not. You recognition. The more cases want to be on offense, not you do, the more you can My own time is a blend of defense with your space. I have create conviction around proactive and reactive. a “do not disturb” sign on my pattern recognition. This is Generally speaking, I don´t door and I use it. I silenced the how you learn in dog years. take any meetings or calls in ringer on my office phone. You need to be deeply the morning. I think if you can Flow state doesn´t last for prepared for luck to be be highly focused, creative and more than two, maybe three successful. engaged for three solid hours a hours in a day. Physically, it day, then you´re going to do can´t. So you need to have Fourth, be prepared for the very well in life. My highest control of your environment emotional side of this game. I quality time is between roughly and what you let come into it. don´t think anyone can fully 7:00 in the morning and 2:00 in express to you how the afternoon, so I protect that G&D: Do you have any advice emotionally demanding this time at all costs. We don´t for students interested in business can be at times, and if trade day-of, so I don´t really investment management? you are not emotionally have to fixate on news flow aligned for the game, it can be first thing in the morning. I YL: I have five pieces of very painful. It´s the best journal in the mornings, and I advice. The first and most business in the world for those pick one or two substantive important one is “ea”, which is who are curious and pieces of work that I need to the Polynesian word for emotionally resilient. There get done and I spend my personal sovereignty. You have are lots of ways to make mornings doing them. to completely own your money, but it is really journey. Be accountable for important to find one that fits G&D: You seem to be the your training and your path well with the way that you are type of person who would and don´t cede that built emotionally. You have to think about shaping the responsibility to anybody. Be discover it as early as you can. granular details of your proactive and relentlessly Markets are a very expensive environment for maximum invest in your own training. place to find out who you are. output. What are some of the The quality of your lives I think authenticity and self- things you found to be literally depends on this awareness are absolutely disproportionately effective in decision. You have to own it. crucial for success and the controlling your environment? more time you are Second, do a speed-reading introspective about what YL: First thing, you need to course. We read a lot in this drives your emotions, the manage your email and all of business. Effective reading is a stronger you will be. I don´t your devices. Get your highly learnable skill and it think this is something you can smartphones out of your takes less than eight hours to work out in school. It is office. Turn off the screens become good at it. It is a huge something you just have to blinking at you. Regiment how advantage over time. Besides come to the business to learn. often you touch email. That´s a all of the work-related reading Finally, do not fear your (Continued on page 14) Page 14 Yen Liow, Aravt Global

mistakes. When you enter this industry, you will fail more often and with fiercer intensity than you ever have before. Do your best to fall forward. Learn and move on. Most of what I have shared with you today was learned from mistakes I have made (and I have made a lot of them). Just do not let them stop you.

Having said that, I think investing is the best business in the world. You´re getting paid to learn. I literally think it is Disneyland for curious and competitive adults. It´s a true privilege to be in it. Come in with your eyes wide open, but have fun once you´ve selected your game appropriately.

G&D: Thank you so much for your time.

Page 15

Dollarama (TSX: DOL) - Long with Friendly Activism 1st Place — 2019 Pershing Square Challenge (May 2019)

Mingming Wu, CFA Laurent Liu K.Y. Wong, CFA [email protected] [email protected] [email protected]

Trading Stats (CAD'M except per share) Financials (CAN' M) FY16 FY17 FY18 FY19 6060 1010 ) Market Capitalization 13,054 Revenue 2,650 2,963 3,266 3,549 50 s 50 88 n o Enterprise Value 14,906 Gross Profit 1,033 1,161 1,301 1,393 4040 il 66 li FYE 02/2020 P/E 24.5x GPM 39.0% 39.2% 39.8% 39.3% e3030 m ci 44 ni Avg. 3M Daily Volume 0.88M Operating Profit 549 646 756 804 Price r20 ( P20 e 2 Mingming Wu ´20 Float 96.0% OPM 20.7% 21.8% 23.1% 22.7% 1010 2 m Volumemillions) (in ul o Mingming is a 1st year MBA 52 Week High / Low 54.00/ 30.70 Net Profit 385 446 519 549 00 00 V student at CBS. Prior to CBS, Current Price (4/29/2019) 41.48 NPM 14.5% 15.0% 15.9% 15.5% 4/164/1610/1610/164/174/17 10/1710/17 4/184/18 10/1810/18 she worked at Canada Pension Plan Investment Board in Toron- to, covering global consumer Recommendation and health care equities, and We are recommending a long in Dollarama (“DOL”) with friendly activism. Our 4-year price target is C$81.5, later at the endowment of representing +97% upside and 18% IRR. Memorial Sloan Kettering Can- cer Center in New York. Business Description Founded in 1992, DOL is Canada´s largest dollar store chain with 1,225 stores and 71% market share. It sells general merchandise (46%), consumer products (39%), and seasonal products (15%), with 8 fixed price points from $1 to $4. The company is still managed by the founding family (Rossy), which holds a 7% ownership. There is no superior class voting structure and the shareholder base is diverse.

Industry Overview The Canadian dollar store market started in the 1990´s, decades after the US dollar industry (started by Dol- lar General in 1939). It is therefore relatively unpenetrated and has been growing at a 5.9% CAGR over the past 7 years. Major players are DOL (1,225 stores), Dollar Tree Canada (225), Your Dollar Store with More (112), Great Canadian (121), and Buck or Two (50), totaling 1,733 stores. Alongside industry growth, DOL Laurent Liu ´19 has taken market share from its smaller peers. Its market share among dollar store chains has grown from Laurent is a 2nd year MBA 59% in 2011 to 71% in 2019. student at CBS. He started his career with BCG covering consumer retail and telecommu- Recent Development nication clients, and eventually DOL recently missed sales and EPS consensus by 2%, and revised down its SSSG guidance from 4% - 5% to co-launched a US$125M growth 2.5% - 3.5% in Sep 2018. Share price experienced further weakness after Spruce Point published a short re- stage equity boutique fund port in Oct 2018, which claimed “Our analysis shows that this target (i.e management´s guided runway to 1,700 investing in FinTech and EdTech. stores) is unrealistic, and that the market is already bordering on oversaturation.”

Our Variant View  We disagree with Spruce Point. Using US dollar stores to benchmark with DOL, Spruce Point used either Dollar Tree or Dollar General to estimate DOL´s runway and ignored that DOL is a market leader with 71% market share (much higher than DLTR / DG´s individual market share). Under our Activist Proposal #1, we use the overall US market to estimate the Canadian market potential, and then use the 71% market share to estimate DOL´s potential runway.  We have identified two additional value creation drivers - implementing a zone pricing strategy and building a distribution center. We believe DOL could realize our estimated runway if it adopts Proposal #2 and #3. K.Y. Wong ´20 K.Y. is a 1st year MBA student Activist Proposal at CBS. Prior to CBS, he worked 1) Accelerate store opening from 65 to 130 per year. at buyout PE firm EmergeVest  Current situation: in 2017, the management guided a runway to 1,700 stores through opening 60 - 70 focusing on the industrial sector in Europe and Asia. In the stores per year until 2027. This suggests that expansion speed would be lower than previous years´. coming summer, he will intern at APG Asset Management and Robeco, covering global emerg- 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 ing markets equities. Historical store no. 463 521 564 603 652 704 785 874 955 1,030 1,095 1,160 1,225 Net growth rate 16.3% 12.5% 8.3% 6.9% 8.1% 8.0% 11.5% 11.3% 9.3% 7.9% 6.3% 5.9% 5.6% Net stores opening 65 58 43 39 49 52 81 89 81 75 65 65 65  Our analysis shows that management has underestimated the TAM and the runway could be beyond 1,700 stores. As the US dollar store industry started 5 decades in advance, we use the current penetration rate of the US as a proxy of the CA industry´s potential. The US has 8x more residents than Canada, but 17x more dollar stores. Using US as a benchmark, Canada could harbor 3,443 stores and Dollarama could grow to 2,437 stores, assuming its 71% market share remains constant.  We propose that Dollarama should accelerate store openings from 65 to 130 per year to dominate the best retail locations before peers do, particularly Dollar Tree Canada. In 2017, DLTR claimed it saw the potential to grow its store base in Canada from 225 to 1,000. Per our conversation with DLTR IR, the Page 16

Dollarama (TSX: DOL) - Long with Friendly Activism

expansion plan in Canada is not DLTR´s priority now as DLTR is turning around Family Dollar. “Dollar Tree is just so busy with fixing Family Dollar – once it finishes, it will get more aggressive in Canada.”, an industry strategist explained.  This initiative is practical. Financially, opening 130 stores requires $91mm capex, which can be well covered by the company´s net profit of $549mm in FY19. Operationally, our discussions with former district managers confirmed that DOL is highly efficient in opening stores and has the human resources capability to handle faster store opening. DOL also has strong expertise in finding real estate and can leverage its strong relationship with a board member, who is CEO of SmartCentres REIT.

2) Adopt zone pricing  Current situation: DOL has universal pricing, which means the same products have the same prices across the nation. This ignores differences in purchasing power across provinces (median income difference is as high as 33% across provinces) and operating costs (e.g. Alberta´s minimum wage is 25% above Quebec´s; labor cost accounts for 10 - 12% of a store´s sales). Charging the same prices for different provinces not only means leaving money on the table, but also makes it less economical to open stores in areas with high operating costs.  We propose that DOL adopt zone pricing, a retail practice that divides the market into different zones based on demographics and competitive dynamics, with different pricing in each zone. Based on our interviews with four pricing experts, adopting zone pricing could result in margin expansion of 50 - 500 bps.  Zone pricing has been successfully implemented by other retailers, including Family Dollar, Walmart, and Target. There will be initial costs to implement it (est. C$11mm), with the majority being software investment. However, the net benefit could be C$59mm in the first year.  Convincing management should not be a hurdle - “[Zone pricing] is a concept that we´re not against. But for the moment, it is theory.”, said Neil Rossy, CEO of DOL, during the 12/6/2018 earnings call.

3) Optimize logistics network NL Legends: BC  Current situation: DOL only has one distribution AB (19) Store penetration heat map (102) MB (number of stores per mm people): (107) QC center (DC) in Quebec, creating two issues: (i) the (37) 20 – 29 (344) single DC model creates difficulty in penetrating the 25 – 29 ON PE(5) 30 – 39 west. The heat map shows that the further away from (503) 40+ NS the distribution center, the lower the number of (39) DOL Distribution Center NB stores per million residents (denoted by level of dark- (38) ness); (ii) logistics costs are high, especially for western stores. DOL imports over 50% of goods outside N. America, mostly from Asia. These imported goods are first shipped to British Columbia (BC) and then transported to the Montreal DC through train. The DC later redistributes the goods back to stores in BC, creating inefficiencies.  Benchmarking with both Canadian and US dollar stores shows that another DC is necessary to efficiently serve the entire country. Dollar Tree Canada, with only 225 stores (1/6 the size of DOL), has two DCs in BC and Ontario. Looking at US dollar stores, each DC at Dollar General serves 967 stores on average, while DOL´s DCs serve 1,225. Family Dollar´s DCs are 277 miles away from stores on average, while DOL´s are 726 miles.

 We suggest building a DC in British Columbia to serve BC, AB, SK, and MB. Developed Base - Base - Bear Bull with consultation of logistics experts, our cost-benefit analysis points to net annual Passive Active savings of C$2mm in transportation costs if the sales in the 4 western provinces are #1: New Stores 20 65 130 140 #2: Change in Avg 0.0% 3.0% 3.7% 4.0% held constant. Factoring in store expansion and assuming sales in the 4 provinces dou- Trans. Size 19’ – 23’

ble, the net annual savings could be C$17mm (after C$40mm capex). Change in Volume of 0.0% 0.0% 0.0% 0.5% Trans. Valuation Avg. SSS Growth 0.0% 3.0% 3.7% 4.5% #3: Gross Margin (with 37.6% 38.7% 39.7% 40.8%  Assuming a forward P/E multiple of 22x, we derive a 4-year target price of C$81 under DC Savings) the activist base case. Even without activism, an investment in DOL represents 11% IRR. 2023EEPS $2.00 $2.88 $3.62 $4.02 Under a bear case scenario in which new stores are well under management guidance, Forward P/E 16.0x 22.5x 22.5x 24.0x SSSG becomes 0%, and multiple contracts to 16x, then the IRR is –6%. This suggests an Stock Price $32.0 $64.8 $81.5 $96.5 -27.1% 55.7% 96.9% 132.6% attractive risk/reward profile, with 4x active-to-passive return ratio. Investment Return IRR (4-year) -6.2% 11.5% 18.0% 23.0%

Key Risks and Mitigants  Management may not adopt the plan. Our view: the Rossy family has the experience of successfully partnering with professional investors to create value. The founder sold 80% shares to Bain Capital in 2004 but still continued to hold the CEO role. 3 out of 9 directors on the board are former or current employees of Bain Capital, even though Bain fully exited in 2011, proving the family´s openness to professional investors if they´re able to create value.  Quebec government could oppose shareholder activism. Our view: Quebec government usually only intervenes when labor interests are harmed under activist campaigns. Our plan involves no layoffs or compensation changes, thus should not face resistance.  Economic downturn. Our view: this risk is mitigated, as our regression analysis indicates negative correlation between dollar store performance and macroeconomic factors. Page 17

Align Technology, Inc. (Nasdaq: ALGN) - Long Michael Wooten [email protected]

Michael Wooten, CFA ´19

Michael Wooten is a 2nd year MBA student at CBS and a member of the Value Investing Program. Previously, he worked as an Associate at Corrum Capital Management and as an Analyst at Reicon Capital. Last summer, Michael was an intern at WEDGE Capital in Charlotte.

INVESTMENT THESIS – BUY: I recommend buying shares of Align Technologies, Inc. (“ALGN” or the “Company”) due to the Company´s entrenched position as the dominate market leader in the fast-growing, yet underpenetrated industry of clear aligner braces. ALGN´s valuation is justified given the Company´s durable competitive advantage and the overall attractiveness of the total addressable market (“TAM”). The recent pullback in ALGN´s shares provides an attractive entry point for long-term investors to purchase a great business 20% below its 52-week high.

ANATOMY OF A GREAT BUSINESS: (Attractive Unit Economics + Large TAM) x Durable Moat = Great Business - Attractive Unit Economics – ALGN has 75% gross margins, getting close to 80% on Invisalign products. Now that the company has reached scale and is almost fully automated, the SG&A leverage means for every $1.00 revenue earned, $0.20 can be reinvested into the business or returned to shareholders. As a capital-light business, its ROIC is very attractive. Adjusting for excess cash, the ROICs are >40%. If ALGN is able to use machine learning/AI to eventually replace doctors in the treatment process, or even some portion of cases, then ALGN would be able to eat part of orthodontists´ 75%+ margin while reducing the treatment cost to end-consumers. - Large TAM – provides a runway for the company to continue reinvesting in the business at high returns on incremental invested capital (i.e. ROIC x Retention Ratio = Sustainable Growth Rate). ~60%-75% of the global population suffers from malocclusion (misaligned teeth). ALGN is the largest provider of clear aligners, with ~70-80%+ market share, yet clear aligners only represent 15% of orthodontic case starts. With recent innovation, ALGN can now treat 75-85% of cases. There are 300M people who could benefit from Invisalign in markets that ALGN is already in. Currently ~12M actively seek annual treatment. - Durable Moat – this is the most important characteristic of a great business because it allows a company to tap the full potential of the Large TAM without losing its Attractive Unit Economics. ALGN´s moat is more than a patent (or 894 patents). It´s comprised of a bunch of small things that, when added up, will be very difficult for competitors to overcome. See below for more details on competition. Page 18

Align Technology, Inc. (ALGN) - Long (Continued from previous page)

INVESTMENT SUMMARY: ALGN is a highly innovative technology company with fully integrated end-to-end digital workflow capability. It also runs the largest 3D manufacturing operation in the world, and which is almost fully automated. ALGN has two primary operating segments: 1) Its Invisalign® System (~85% of revenue), and 2) Scanners and Services (“Scanner”) led by ALGN´s iTero® brand (~15%). Scanners are computer-aided design & computer-aided manufacturing (“CAD/CAM”) machines that dental professionals use for many treatment applica- tions and is fully integrated with the Invisalign System. Invisalign is a Class II medical device regulated by the FDA to treat patients that suffer from malocclusion. The Company has enjoyed explosive topline growth of ~25% over that last 5 years, largely attributable to greater adoption by orthodontists, (“Orthos”) and general practitioner dentists (“GPs”), and very strong international growth led by China, which grew 91% YoY in 2018. International accounts for ~50% of ALGN´s revenue, with China representing 8%. The adoption and interoperability of iT- ero and other scanners has been another significant growth driver for the Company as over 50% of cases are now submitted digitally because it´s faster and easier. Smart phones and Instagram have increased vanity, representing a global tailwind for ALGN as people become more self- conscious about their appearance. Adults who would not have considered treatment for malocclusion using traditional braces increasingly likely to seek treatment due to the more aesthetically pleasing alternative of clear aligners, led by Invisalign. I believe this trend will lead to continual adoption of clear aligners.

Income Statement 2014 2015 2016 2017 2018 Revenue $ 761.7 $ 845.5 $ 1,079.9 $ 1,473.4 $ 1,966.5 Growth 15% 11% 28% 36% 33% Gross Profit 578.4 640.1 815.3 1,116.9 1,447.9 Gross Margin 76% 76% 75% 76% 74% Operating Profit/Loss 193.6 188.6 248.9 353.6 466.6 Operating Margin 25% 22% 23% 24% 24% GAAP Net Income 145.8 144.0 189.7 231.4 400.2 Net Margin 19% 17% 18% 16% 20% GAAP EPS Diluted $ 1.77 $ 1.77 $ 2.33 $ 2.83 $ 4.92 Growth 127% 0% 32% 21% 74% WA Diluted Shares 82.3 81.5 81.5 81.8 81.4 Total Trained Doctors 2014 2015 2016 2017 2018 Total Doctors 94,035 103,830 115,510 132,010 151,665 Case Volumes 2014 2015 2016 2017 2018 North America 338.5 398.4 469.4 631.6 780.7 International 139.5 184.8 239.8 344.8 499.9 Total Case Volume 478.0 583.2 709.2 976.4 1,280.6

COMPETITION & MOAT ANALYSIS: ALGN is currently facing significant competition in the wake of key patent expirations in 2017-2018. While ALGN is no stranger to competition. Patents have historically been an important competitive advantage because they protected ALGN´s process technology around the use of software, allowing digital automation of the treatment planning and manufacturing process. Because competitors could not use the automation techniques to create a series of aligners (~44-50 per case), competing products had to be manufactured manually and were very limited in efficacy and efficiency. Now that those patents have expired, there has been an onslaught of new entrants in the market and more are expected in 2019. The Bear theses on ALGN all look the same: clear aligners are a commodity and patent expirations will bring competition, eroding ALGN´s market share and collapsing the Company´s lofty valuation. Full stop. ALGN´s moat is more than a patent. Plastic might be a commodity, yet ALGN uses a patented material (SmartTrack) for its aligners, so even that might be a stretch. The process of access- ing patients, creating a doctor-approved treatment plan, and then turning that plastic into a series of unique Class II medical devices is anything but a commodity. The Company´s competitive advantage began with its patented process technology, but it has now evolved into a much more complex web of little things, creating a virtuous cycle. In short, ALGN´s aggressive defense of its patent portfolio allowed the Company to have a massive first-mover advantage. Un- der CEO Joe Hogan´s strong leadership since 2015, ALGN´s focus on TAM expansion through innovation has accelerated as embodied by the Company´s sentence “the best defense is a great offense”. ALGN´s innovation separates it from the competition as Invisalign is the only clear aligner product on the market that can treat complex cases, including kids and teenagers with immature dentition (i.e. not done growing). Competitors can only treat minor cases which represent a small portion of the market. Page 19

Align Technology, Inc. (ALGN) - Long (Continued from previous page)

While treating 6.8 million patients since inception, the Company gained deep knowledge on large-scale manufacturing of highly-customized devices in a very short timeframe (< 2 weeks), and with a low margin of error. ALGN now manufactures hundreds of thousands of aligners per day. For comparison, ClearCorrect and Smile Direct Club have only treated hundreds of thousands of patients (according to their websites). This is important because case data collection plays a key role in creating better treatment plans and the automation process and ALGN has made >150M unique aligners since 1999. Akin to the way Google´s search engine gets better over time, ALGN uses data analytics and machine learning to improve its software. ALGN gets smarter with more data it collects and a virtuous cycle follows as Invisalign treatments become more effective and efficient through continual R&D.

8,000K Annual vs. Cumulative Case Starts 1,500K 6,000K 1,000K 4,000K

Volume 500K

2,000K Cumulative Case Case Cumulative 0K 0K

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Volumes Case Annual Cumulative Case Volume Annual Invisalign Case Volume International Domestic

VALUATION: My ~$630 5-year price target is based on a probability- weighted average of 5 scenarios: 1) Blue Sky ($3,000 PT, 2.5% weight); 2) Bull ($1,000, 22.5%); 3) Base ($650, 40%); 4) Bear ($250, 20%); and 5) Super Bear ($150, 15%). ALGN currently trades at an eye-popping 58x 2019E P/E, 39x EV/2019E EBITDA, and 10x forward EV/Sales. As a long-term investor with a 5Y+ time horizon, stock price volatility does not bother me. True risk is permanent loss of capital when you sell. My Base Case assumes there will be 13.7M case starts in 5 years, with clear aligners used in 50% and ALGN serving 40% with an ASP of $1,200. The valuation equates to a 32x P/E or 7.0x EV/Revenue multiple. In my Bear Case scenario of 15% 5Y EPS CAGR, ALGN´s P/E multiple would have to be cut in half (i.e. 30x) in order for this investment to lose money over 5 years. If ALGN´s EPS compounds at 20% and the P/E multiple is reduced by 30%, ALGN´s stock will generate an 8% annualized return, likely outperforming the S&P 500. The Blue Sky scenario has ALGN displacing Orthos & GPs by using A.I. and digital automation to dominate the market. ALGN recently added Microsoft´s Corporate VP of A.I. and Intelligent Cloud Business Development to its board. Eventually the DTC market will take hold, and when it does, ALGN is perfectly positioned to benefit. I estimated ALGN would have 80% of clear aligner market share and ~70% of total orthodontic case starts, while also increasing ASP by eating some of the doctors´ 75%+ margin. The $3,000 PT represents a 7.5x EV/Revenue multiple and 25x P/E multiple. My margin of safety is rooted in: A) my belief that ALGN´s durable competitive advantage is intact despite patent expirations; B) the size and underpenetrated nature of the TAM despite increasing levels of industry adoption, and C) the fact that ALGN has historically compounded revenue in excess of 13% in every 5Y period despite periods that include the Great Recession, intense competition (e.g. 2006), and initial technology that could only service a small fraction (25-35%) of the overall TAM. ALGN is a much stronger business today than it has ever been. Page 20

Carsales.com Ltd (ASX: CAR) - Long Tyler Redd, CFA [email protected] Vs. NTM Capitalization (AUD Ms) Metric Cons. Key Statistics $18 CAR (AUD) 30x Price $13.50 ADTV ($Ms) $12.8 Fwd P/E FDSO 243.8 Sell-Side B/H/S 9 / 3 / 2 $16 Fwd EV/EBITDA 26x Market Cap $3,291 23.7x Div. Yield 3.3% Net Debt 413 Short Interest 6% $14 22x Enterprise Value $3,704 16.3x 52 Week High/Low $16.45/$10.56 Tyler Redd ´19 Historical & Forecast 2017 2018 2019E 2020E 2021E 2022E $12 18x Tyler is a 2nd year MBA student Revenue (AUD Ms) $372 $444 $506 $561 $614 $672 at Columbia Business School. Vs. Consensus 3.1% 5.8% 7.6% $10 14x Prior to CBS, Tyler was a Senior Adj. EPS $0.49 $0.54 $0.54 $0.63 $0.72 $0.81 Analyst at Privet Fund Manage- Vs. Consensus 0.6% 4.9% 8.9% ment, a small-cap activist fund, $8 10x and a Financial Institutions M&A Look Thru EBITDA Growth 6% 14% 9% 14% 12% 11% Apr-16 Apr-17 Apr-18 Apr-19 Analyst at Raymond James. While at CBS, he interned at Opportunity Summary Aravt Global and Sunriver Over the past ~12 months, CAR has produced weak consolidated results driven by cyclically-linked poor per- Management. Tyler is a member formance from the company´s non-core display advertising and auto finance segments. While these headlines of the Value Investing program. have driven the ~25% peak-to-trough decline in the stock, CAR´s core competency, its ability to drive actionable leads to Australian auto dealers, continues to expand. Dealer and private seller revenue are growing at HSDs while CAR´s 4x web traffic lead vs. the combined sum of its Australian auto peers is widening. The market´s overreaction provides the opportunity to acquire at a reasonable price (1) a dominant online platform which has built up unassailable networks effects in a large market and (2) a portfolio of nascent, 20%-50% annual growth, international marketplaces. I arrive at a 6/30/22 base case price target of AUD$22.5 per share, providing a 75% total return and a 21% IRR opportunity.

Business Description CAR is Australia´s dominant online portal to access the largest pool of buyers and sellers of autos. The U.S. analogy is if CarGurus, Cars.com and Autotrader were a single site which generated roughly 2x their current EBITDA margins. Carsales monetizes its platform through listing fees, fees for actionable leads as well as through display advertising. The company also has a partial stake in an Australian auto finance company where its lender partners take the balance sheet risk. Carsales operates less mature, high-growth auto marketplaces in South Ko- rea, Brazil, Chile, Argentina and Mexico where it has #1 or #2 market positions in each geography.

Variant Views 1) Recent weakness in non-core display advertising and auto finance is largely linked to challenging Australian economic conditions. CAR´s stock declined ~25% from its August 2018 peak after reporting weak FY2018 earnings at the end of August. While CAR´s core domestic segments (dealer and private seller leads) have continued to perform well, the company´s Display and Finance segments have suffered. Poor performance within both segments is

Australian New Car Sales vs. 15% CAR Stock Price 45% 10% 30% 5% 15% 0% 0% (5%) (15%) (10%) Australian New Car Sales YoY (30%) CAR Share Price YoY (RHS) (15%) (45%) Apr-16 Oct-16 Apr-17 Oct-17 Apr-18 Oct-18

linked to cyclical conditions within the broader Australian economy which will eventually reverse. Declining Australian home prices has led to weakness in the rest of the economy, including new car sales which recorded a full-year decline for the first time since 2014. Economic weakness has flowed through to ad spend which was down 7% in 1Q19. Auto OEMs and new car dealerships have reduced their marketing budg- ets, directly impacting CAR´s high incremental margin Display revenues. At the same time, Australian credit conditions have tightened, particularly in auto lending where YoY originations have been negative YoY since mid-2017. CAR´s unique competitive position in Australian online auto sales will allow it to continue to generate an increasing number of finance leads and capture a high share of Australian auto-related ad spend as the economy turns.

2) CAR´s core Australian auto classifieds business remains a dominant, capital-light marketplace which can compound earnings in the HSDs. (i) Highly attractive metrics: CAR´s core domestic business generates 55%+ EBITDA margins and >300% returns on tangible capital. (ii) Established network effects: On the supply-side of its marketplace, 95% of Australian dealers list on Carsales.com, and the company has the largest pool of dealer inventory in the country. On the demand- Page 21

Carsales.com Ltd (ASX: CAR) - Long (Continued from previous page)

side, CAR dwarfs competitors in terms of consumer aggregation and generates the highest ratio of website unique visitors relative to home market population of any of the international auto classifieds. This high quality pool of potential leads is what allows Carsales to effectively monetize its dealer base. (iii) Pricing power: Carsales regularly achieves pricing increases. Similar to other dominant marketplaces, CAR is able to increasingly monetize power users though providing additional tools and features. (iv) Growing intrinsic value through cycles: Carsales continues to grow web traffic and post YoY growth in dealer and private listing revenue despite challenging Australian economic conditions. (v) Multiple failed market entries by competitors: CAR has fended off multiple well-funded entrants. Most recently, Carsguide.com relaunched as a 50%/50% JV between News Ltd and a consortium of auto dealers. The renewed company offered free leads for a period of time but was still not able to permanently dent CAR´s model. Feb-19 Feb-19 Minutes: CAR Continues to Grow the Demand-Side of its Platform During Challenging Economic Conditions Website Avg. Minutes Carsales 20% 40% Australian Auto Visits Visit Visited vs. 15% 30% Verticals (Ms) Duration (Ms) Competitor 10% 20% 5% 10% carsales.com.au 11.0 7:45 84.9 0% 0% carsguide.com.au 4.6 2:59 13.7 6.2x (5%) (10%) pickles.com.au 1.1 8:40 9.2 9.3x (10%) (20%) Australian New Car Sales YoY drive.com.au 1.5 1:36 2.4 35.6x (15%) (30%) Carsales.com.au Web Traffic YoY (3 Month Rolling Avg, RHS) (20%) (40%) Source: Similarweb Apr-17 Aug-17 Dec-17 Apr-18 Aug-18 Dec-18 3) The value of CAR´s stakes in rapidly scaling international auto marketplaces is underappreciated by investors. Carsales is unique among the global auto marketplaces (more akin to the general classifieds “Big Three,” Schibsted, Naspers and eBay) in owning a portfolio of #1 market position, international businesses. Webmotors, CAR´s 30% owned Brazilian marketplace (accounted for under the equity-method), is Brazil´s #1 auto vertical, grows revenue 30%+ annually, and is generating 60%+ incremental EBITDA margins. SK Encar, CAR´s 100%-owned South Korean marketplace (Carsales only recently consolidated SK Encar´s results after acquiring the remaining 50.1% stake it did not already own), continues to grow ~20% annually while producing ~50% EBITDA margins. In total, CAR´s international auto marketplaces operate in economies which are 4x the size of the Australian market. These international subsidi- aries are likely to grow revenue and EBITDA at a 20% and 30% CAGR, respectively, and represent 30% of CAR´s value by 2022.

Investment Playbook Negative Australian cyclical conditions will normalize at some point. In the meantime, CAR´s core Australian marketplace compounds earnings at HSDs while its international marketplaces grow at a 20%+ CAGR. High growth international assets contribute to 25%+ of EBITDA by FY2023 which generates a modest valuation re-rating for the total company.

Valuation I utilize a sum-of-the-parts analysis incorporating NTM metrics (FY2023) to arrive at a 6/30/2022 base case price target. A 15x multiple on Core Domestic EBITDA is at the lower range of the multiples of mature global peers. 18x and 25x multiples on % of Total SK Encar and WebMotors 2023 EBITDA are below the (Look through metrics, $Ms AUD) FY2023 Multiple Value Value valuations of rapidly growing peers such as Schibsted´s Core Domestic EBITDA $ 242 15.0x $ 3,628 64% recent spin. As a sanity check, the 6/30/22 price target of Domestic Investments + Finance EBITDA 27 7.0x 189 3% AUD $22.62/share represents a 25x multiple on my Total Value of Domestic Businesses $ 3,817 68% FY2023 EPS estimate of AUD$0.90. SK Encar EBITDA (Korea) 61 18.0x 1,105 20%

WebMotors EBITDA (Brazil) 24 25.0x 608 11% Key Risks (i) Shifts towards programmatic ad spend may hurt CAR´s Other International Revenue 38 3.0x 113 2% ad pricing. I model lower growth than historically Total Value of International Businesses $ 1,826 32% Enterprise Value $ 5,643 100% experienced. (ii) CarGurus announcing they will enter Australia would FY2022 Net Debt (59) be a negative ST for CAR´s stock. However, Auto Market Capitalization $ 5,584 Trader UK has shown just how difficult it is to unseat 6/30/22 Target Price per Share $ 22.62 Total Return (Including Dividends) 74% a dominant #1. (iii) Gumtree (Australia´s largest horizontal) has had suc- IRR 21% cess in private market auto listings. Page 22

DeanLions Foods Gate Entertainment6.50% Senior Unsecured (NYSE: LGF.A) – Long - Long 12018st Place CSIMA - 2019 Stock UCLA Pitch Credit Challenge Pitch Competition — 1st Place (March (Nov. 2018)2019)

Mitchell Aulds-Stier, CAIA Karthik Kasibhatla Angela Qin James Shen, CFA [email protected] [email protected] [email protected] [email protected]

Recommendation Mitchel Aulds-Stier ´20 We recommend buying DF 6.50% 2023 Senior Unsecured bonds at the current price of $66. The bond offers Mitchell is a 1st year MBA student a compelling risk versus reward profile due to the following: i) Dean Foods is accelerating progress on cost at CBS. He was previously an Associate with PNC Mezzanine cutting initiatives, ii) long-term industry demand and cost stabilization, iii) the market has overlooked actiona- Capital. Mitchell will be interning ble growth opportunities, and iv) DF is cash flow positive, has ample liquidity for the near-term, and strong with DG Capital Management and Sycale Advisors. liquidation value.

Business Description Dean Foods is the second largest US-based processor and distributor of dairy products. Its products include branded and private label fluid milk (68% of 2018 sales), ice creams (14%), and creamers, etc. DF operates 58 production plants around the country and a fleet of 5,000 trucks. DF´s 2018 revenue was $7.7bn, and adjusted EBITDA was $136mm. Recent updates: on February 26, 2019, DF did the following: i) engaged Evercore to explore strategic alternatives, ii) announced dismal Q4 earnings primarily driven by increases in transitory, fuel, and resin costs, and iii) suspended its dividend to preserve cash to affect turnaround initiatives. The bond price fell 6% on the news.

Investment Thesis: Karthik Kasibhatia ´20 i) DF is Accelerating Progress on Cost-Cutting Karthik is a 1st year MBA student at CBS and was at the Fixed Efforts Income Prime Brokerage at Bar- Dean Foods started implementing $150 million in cost clays in New York prior to Busi- cuts in 2018 and aims to finish the initiative by 2020. The ness School. initiatives include: 1) facility rationalizations, 2) implementing a flatter, leaner and more agile organizational structure, and 3) optimization of spend management. The market may have priced in a worst-case scenario given the sharp decline in margins (23% in 2017 to 21% in 2018) and EBITDA decline. However, DF´s cost-cutting initiatives have accelerated in Q3 as DF closed down plants (7 plant closures in 6 weeks (3Q18); 14 total facility closures in the past 18 months). Given its improved cost-cutting efficiency, DF is expected to generate 100bps improvement in gross margin and 40bp in G&A margin improvement, which should improve EBITDA and cash flow. Angela Qin ´20 Angela is a 1st year MBA student ii) Long-Term Industry Demand & Cost Stabiliza- at CBS. Previously she worked at tion Mizuho Securities Asia in the Fixed Income Trading department. While DF´s volume softness has continued (private label Angela will be interning at TCW declined by ~3% and branded by ~5%), DF´s pricing of over the summer. both branded and private label as well as margins over milk all appear to have stabilized since October per IRI data. This indicates that the pricing battle among large grocers has at least temporarily subsided. Additionally, margins over milk have stabilized. On the cost front, oil price stabilization should help control transportation, logistics, and resin costs. Moreover, US farmers have over- supplied milk for the past few years. The supply of milk has been rising at 1% vs. demand shrinking by 2% YOY. The improvement in milk production per cow should mitigate the inflationary impact and stabilize future milk prices. James Shen, CFA ´20 James is a 1st year MBA student at CBS. Previously he worked at iii) The Market Has Overlooked Actionable HSBC in the fixed income trading Growth Opportunities team and balance sheet investment Dean Foods has a track record of growing nascent brands. For example, DF rapidly scaled its 2002 acquisition team. James will be interning at Cornerstone Research over the of Silk from $30mm to $350mm of revenue over the course of three years. Silk eventually became a $2bn summer. revenue brand before it was sold in 2013. DF acquired multiple similar scale, emerging brands last year amid a shift in consumer preference, including: 1) Good Karma Foods: Flaxseed-based milk alternatives ($18mm annual sales), 2) Uncle Matt´s: Organic Juice Maker ($10mm annual sales). Market share of milk alternatives was approaching 10% in 2018 and CAGR is expected to be 5-10% over the next several years as alternatives take share from dairy milk.

Page 23

Dean Foods 6.50% Senior Unsecured – Long (Continued from previous page) iv) CF Positive, Ample Liquidity & Liquidation Value DF was cash flow positive in FY2018 and, as of February 22, 2019, DF had over $144M of liquidity. Additionally, DF owns critical milk processing infrastructure given that it controls 1/3 of the U.S. milk capacity (58 processing facilities and 5,000 refrigerated trucks, of which it owns the majority); as such, there is a high probability that DF will be maintained as a going concern OR most of its assets will remain in use, irrespective of which corporate entity owns the assets. Primary research indicates that DF´s truck fleet, which is principally comprised of high mileage 28-foot refrigerated trucks (i.e. ´Reefers´ w/ mileage of roughly 250-300k and approx. 5-7 years of age), would yield between $40k and $55k in a Ch. 7 liquidation. Also, over 50% of the liquidation value comes from cash and A/R. As a going concern, even with a 50% valuation discount to peers (5.0x EBITDA), DF´s bondholders would likely recover close to market value of the bonds. Lastly, the Company has $83M in NOL´s and tax-loss carryforwards that would enhance bids in a dis- tressed sale.

Capital Structure & Covenants On Feb. 22, 2019, DF completed an amendment of the credit agreement for its receiva- bles facility, which included an extension of the maturity date from Jan. 2020 to Feb. 2022. DF also refinanced its ABL revolver. Under the new $265M ABL facility, DF must meet a 1.05x fixed charge coverage ratio, which is tested when liquidity is less than $100M or, once DF pledges certain of its facilities, the lesser of 50% of the bor- rowing base and $175 million. Because FCCR is defined as EBITDA less CapEx to fixed charges, DF will likely to be unable to meet a 1.05x FCCR and is thus unable to draw on the revolver fully. However, DF has ample near-term liquidity (>$144M) available.

Key Risks and Mitigants 1) Continued Vertical Integration Among Retailers: WMT could continue building its in-house dairy processing given the benefits of vertical integration as well as its: i) better / more cost- effective distribution capabilities, and ii) larger and more efficient dairy processing plants (average DF vs. WMT plant production is gallons: 40M vs. 125M). However, WMT´s shareholders would likely not be pleased with such poor use of capital (razor-thin margins and capital-intensive business that should be outsourced).

2) Continued Price Competition Among Retailers and Private Label Risk: While pricing has stabilized in recent months according to IRI data, with retailers challenged by online and grocery delivery competitors, such retailers may resume their pricing war for foot- traffic drivers such as bread, eggs, and milk. This could drive increased penetration of DF and non-DF private label, further deteriorating DF´s branded product offering (primary research indicates that DF breaks even on private label).

Page 24 Bill Stewart, Stewart Asset Management (Continued from page 1) there. The firm was sold have now more than hence I figured I ought to learn in 1973. He joined Ruane doubled their investment. something about this industry. Cunniff and Stires as Vice Chairman. Graham & Doddsville I started going to night school (G&D): Could you tell us in the city instead of attending In 1974 he founded W.P. about your background and the University of Maine. I went Stewart & Company as a how you got into investing? through various floor positions Bill Stewart broker dealer and at the Exchange, started investment advisor, which Bill Stewart (BS): I got into developing a business, and became a publicly traded investment management by became a broker on my 21st company on the New York accident. I initially took a birthday. I learned enough Stock Exchange in 2000. temporary job on the floor of about research to go out and At the time it went public, the New York Stock Exchange start seeing companies, visiting the firm had $12 billion in as a page boy in 1955 while I management, doing assets under management was waiting to start college at spreadsheets, and writing up in separate accounts, as the University of Maine. It reports on stocks I liked. I was well as US and European turned out that I liked what I selling these ideas to dentists, registered mutual funds. saw on the floor and I decided pharmacists and furniture From the firm´s founding that I should learn that dealers. in 1974 to 2013, the year in business. At the time, I was which the firm was planning to be a Forest Ranger The market environment was acquired by and had no interest in relatively quiet. IBM was the AllianceBernstein L.P., investing. But after watching stock of the decade, growing W.P. Stewart & Co. the money being made by at 14% a year and trading at 50 outperformed the S&P 500 smart investors, I decided that times earnings, the average Index by an average of 430 if I played it right, I could buy ratio for good quality growth basis points annually, net my own forest. In time, along at the time. Many companies of fees. with others, I was eventually were growing at 7% per annum able to buy several of them as and trading at around 25 times After the sale of W.P. well as a farm and turn them earnings, much higher than Stewart & Co. to over to conservation groups to today. IBM was at the top of AllianceBernstein in 2013, manage in perpetuity. the list of what we considered Bill formed WPS Advisors high-quality growth companies, Ltd., a Bermuda company. G&D: What was it about your along with National Cash A group of analysts was time as a page that made you Register, American Home assembled to pursue an realize this was the industry Products, Merck, Pfizer, investment philosophy you wanted to be in? Abbott and General Foods. similar to the one that earned Bill´s clients over BS: It was a time you probably This was around the time 16% a year after fees for can´t even imagine. There when Ben Graham said that he the 38-year history of W.P. were no phones on the open would only invest in high- Stewart and Co. The new floor, let alone cell phones, quality growth companies if he business was domesticated because no electronic could, but generally speaking to the US in 2017, as communication was permitted. they were too expensive, and Stewart Asset There were telephones around he´d have to amortize a lot of Management, LLC, an SEC the rim of the floor, but P/E ratio. He took a 7-year Registered Investment nothing in the middle, nothing look, and if he envisioned a Advisor. Over the four and at the posts. If you wanted to market multiple of 17 in the a half years since its do serious trading, you had to terminal year and was paying inception, the new firm has physically be on the floor to 50 times up front, amortizing continued to grow its see your counterparts and deal that was too big a headwind. clients´ portfolios at a rate with them directly. I saw some So, he concentrated on what slightly faster than its smart guys doing things I came to be called value stocks. predecessor did. Initial thought were interesting, while clients of the new firm making a lot of money at it; (Continued on page 25) Page 25 Bill Stewart, Stewart Asset Management

Graham published a formula phase for a long period of growth per annum, net of fees, with his idea of fair P/E ratios time. since we started Stewart Asset relative to underlying growth Management four-and-a-half rates: 8.5 + twice the future Going back over 50 years, years ago. Our initial clients in growth rate. I began to look we´ve never had a sharp fall in the new firm have already just for companies that were earnings power behind our about doubled their capital. priced below his clients´ portfolios - what recommended levels and tried Buffett calls “look-through” G&D: Was there anything in to work out for myself what earnings. Our portfolio proved particular that convinced you constituted an appropriate P/E to be much less cyclical than that predictable earnings ratio. My Security Analysis the S&P 500, for which the growth was the way you course at the New York annual rate of earnings change, wanted to look at investing? Institute of Finance was taught up or down, can be very by one of Graham´s partners dramatic. The look-through BS: When I first started out, I at Graham-Newman, and he earning power growth behind took lots of courses on was basically teaching Graham our clients´ managed accounts analysis and accounting and & Dodd´s philosophy. I took has averaged about 15% a year thought I could find great his teachings to heart and for over 40 years now and has value. Some things worked but started building out a very never declined. That earnings other things didn´t – and I concentrated portfolio of growth drives performance in really disliked the ones that companies, only eight different the long run. didn´t work. Earnings shortfalls businesses, albeit in different were almost always the reason industries to provide some an investment didn´t work out. diversification. “At the time, I was Everything we do when investing people´s capital is G&D: Is that portfolio planning to be a based on compounding. The construction still what you´re whole reason for being in the Forest Ranger and trying to attain? investment world is to had no interest in compound money. We all BS: Roughly 5-10 years after know that 7% per annum that first portfolio, I realized I investing. But after doubles in about 10 years and needed to have a bigger 15% a year more than doubles investment universe. Having a watching the money in five years. I want that magic portfolio of eight companies is working for me all the time. maybe a little bit too being made by smart concentrated, so we increased The thing that screws up our portfolio size to 15-20 investors, I decided compounding is down years. In companies. In fact, we still have that if I played it order to harness 15-20 stocks in our clients´ compounding, I wanted to portfolios today, consistent right, I could buy my make sure I didn´t have those with what we´ve done for down years in earnings. There more than 40 years. own forest.” are only two variables in this business: future earning power I adopted a value approach, but and future P/E ratio. I believed one that requires highly Our goal has always been to and still believe that we can get predictable earnings growth, double our clients´ money a pretty good handle on future with the goal of having a very every five years, which is earning power in a very limited concentrated portfolio with compounding at a little less number of leading businesses. aggregate earnings that go up than 15% a year and we´ve P/E ratios are considerably every year. That means that if done that since we´ve been in more volatile and tougher to you pay too much, it still gets business. At my old firm, we accurately forecast – though cheaper next year. That´s our ended up with an average of we try. In all 38 years at my hedge. In a cyclical, you never 16.2% appreciation per annum last firm, W. P. Stewart & Co., know when the next cycle will after fees for 38 years. As of we had about 15% to 16% occur, and you can be out of last week, we were at 16.3% compounded growth per (Continued on page 26) Page 26 Bill Stewart, Stewart Asset Management

annum in underlying earnings should be with the low interest earnings power projection. It power, basically more than rates we have today. If we say comes down to earning power doubling every five years. The a company is going to be per share. after-fee rate of return for our worth a 30% premium, we´ll portfolio was similar. The use a 22x multiple in the We then take a market performance of the portfolio model in the terminal year, and multiple and, because our followed the performance of then discount the resulting companies typically grow twice earnings; to be sure, they value, plus accrued dividends, as fast as the overall market, weren´t the same in every year back to present value. We are market leaders, have great because they can get out of discount at 8% to 10% even if balance sheets, and have whack with each other, but the Treasury market yields less outstanding management over the long run that´s what than 3%. So that´s probably teams, we´ll come up with a it averaged out to. too high a discount rate. But premium multiple. In a few that´s a margin of safety and it cases there might be a This method works, and it´s a goes back to Graham and discount, but generally simple one. First, you find a Dodd. You want a margin of speaking it´s a premium. small group of great companies safety in everything you do. and get to know them very, Mathematically, if a company is very well. Then, you evaluate “Everything we do growing twice as fast as the them. We have a strict market, the near-term P/E appraisal system and we when investing people´s multiple premium amortizes forecast earnings over five very quickly because the capital is based on years. For 99% of the public earnings grow. companies, you can´t do that compounding. The very well because they´re very Typically, we´ve been giving volatile, but a few of them are whole reason for being the growth businesses we pretty predictable. These invest in a 10% to 50% companies typically have a in the investment world premium to the market, commanding position in their depending upon how well we markets and showcase great is to compound think things are going to go for profitability as well as a high that company five years from degree of predictability. They money.” now. I guess the highest also have great management in terminal multiple we have is depth and wonderful balance We then want to buy stocks 26x for Amazon, in five years. sheets. When a business meets well below their fair present It´s currently at about 60x our these criteria, you can start value as a further cushion. This idea of current capitalizable appraising value five years out. is not a science but more of a earning power. guessing game. We try to Once we find a business that make the best guesses we can, G&D: In terms of earnings we like with predictable but you need those cushions. predictability, how do you earnings growth, we´ll then analyze a company like work with the spreadsheets. G&D: Can you go into more Amazon, which five years ago We use all our qualitative detail on what you call the looked much different than work and interviews with appraisal system? When you´re what it does today? management to try to estimate digging into a company, what earnings in five years´ time, as does it look like? BS: Obviously, Amazon Web well as the terminal growth Services is huge and is the rate. We then evaluate a BS: You might start out with most profitable division now. prospective premium or the addressable market, then These situations are dynamic, discount versus the market as get to how many units a so you make the best guess a whole, for which we also company will sell, what the you can and try to be more on forecast a multiple. Right now, value per unit is, and what the the conservative side when it´s an easy 17x, in line with margins are going to be. figuring out what all these the historical average and Ultimately you build a five-year things are likely to be worth, probably a little lower than it model and come up with a final but the lovely part about a (Continued on page 27) Page 27 Bill Stewart, Stewart Asset Management

model is that it´s not fixed. It BS: Absolutely. For example, in year 5 which, by the way, may be a five-year model, but take the retailing section, isn´t really that high. We have you can change it every day. which is huge, but where the capitalizable earnings per share What you´re really doing is margin is only about 7%. For of a bit more than $140 in the laying out your decision tree marketplace products sold by model´s terminal year, 2024. A and adjusting it. You can come 3rd parties, they don´t take in terminal multiple of 26x gives back saying, I think I got this a the sales price of the products us a price that, discounted little high, or that a little low. sold, but they record their back at 9%, yields a present It´s not fixed. In essence, commission on the sale, which value of $2,250. That´s why we´re always operating with starts out at 100% gross profit. it´s our largest position and the best guess we can make. If That business is booming for has been for a long time. it changes weekly, it changes them. Now they invest a lot of MasterCard is our second weekly. It doesn´t usually it away, but you have to try largest position and, including change weekly, but it could. and make an assumption about at my old firm, we´ve owned Nobody´s got a lock on what´s actual future earnings power. MasterCard since they went right, a model is only a model public. and it´s not fixed in stone. G&D: Before we go into Sometimes, nothing´s changed “Frank [Rooney] was individual positions, can you but you changed your mind. talk more about your analytical That´s good. The purpose of one of the great process and the way you make the process is to bring out our assumptions? Do you have best guesses. Everything we do retailers and I learned analysts by sector in your firm? is guessing. I think we all get a little carried away with the a lot from him. We´d BS: We have 5 investment science of the matter, because drive around the people, excluding me, and we there are lots of formulas, always have a team of two on whereas you´re essentially country, go into the each investment: one does making a guess. primary coverage, and another parking lot of a is the backup, to ensure In essence, we´re looking at continuity. We have a small investment opportunities as a shopping center, and operation, but it works. Each businessman would look at analyst is a generalist and is them. We´re thinking about he could tell me the getting out there asking buying a business today for average annual questions, visiting management, $100 million and figuring out digging around. whether or not we could sell it income of the people for $200 million five years G&D: You ran a firm for 38 later. We make reasonably who shopped there years before this and now you conservative guesses, and as have this new firm, which is I´ve mentioned we have just by the size of the only four and a half years old. succeeded in growing look- Can you talk about what grease spots in the through earnings behind our prompted the change? clients´ portfolios every single parking lot.” year. That´s very important. BS: I had partly retired from We try to have one of the two the old firm in 2001 and then big variables reasonably under Web Services is another big fully retired in 2004. Yet, by control. operation as we discussed, and 2007 the new management they´re also getting into was having some problems and G&D: Coming back to retailing with their own stores, the board asked me to come Amazon, are there certain which may, in effect be mini back. Initially I didn´t want to, assumptions that you and your distribution centers. It´s very but I did come back and stayed team think about in terms of dynamic, which is one reason with them until what the company will look why we still assign Amazon a AllianceBernstein purchased like in five years? relatively high multiple of 26x the company in 2013, which (Continued on page 28) Page 28 Bill Stewart, Stewart Asset Management

was probably the appropriate You don´t put an extra point management team and it just thing to do. They seem to be on or take a point off, but didn´t work out? happy at AB. management gives you conviction. We always ask BS: Oh, sure. I´m always After the sale, I wanted to go ourselves “Do we want to be telling our guys, success in this back to retirement, which I did in this business?” Coming back business is three steps forward for a few months. Then the to what I already said, when and two steps back. You don´t former CEO of W. P. Stewart you´re investing you have to just keep marching on in a & Co. and I thought we might think as a businessman buying a straight line, although start a new investment business, and then ask yourself thankfully we´ve had far more manager. I love being in the “Do I want to be in this successes than failures. market trying to figure out business with these people? what´s happening next ; but Did they seem like they´ve got G&D: How long do you these very smart young people their heads screwed on right? typically hold an investment at Stewart Asset Management Are they long-term thinkers or for? are doing the heavy lifting now, are they opportunists?” That´s not me. the type of thing you want to BS: My horizon is 10 to 15 know. Then, if the questions years on average, and at least 5 G&D: How important is are answered positively and years. We held major positions management when it comes to you want to be in this business in retailing for the better part looking at a stock? with these people, you end up of 20 years - great growth asking if you want to be in this businesses like Walmart and BS: Ben Graham always said business with these people at Home Depot in their dynamic “don´t count management this price? You apply the whole growth years. My best ever twice”. The projected numbers appraisal process and get to would be Melville Corporation: will reflect the management´s your discounted present value 26 years at 26% per annum. It performance, which means you – what Graham used to call was phenomenal. don´t have to re-evaluate “fair value,” a price that a management. share seems likely to sell at on Melville went from a little shoe the way up or down within a chain headquartered in New That being said, I learned as a reasonable period of time. York to becoming the 10th young analyst that management largest retailer in America. is not a given. It´s dynamic. This process is very different That was a great story. My The management team than the one from the typical interest started when I saw an changes, individuals change, value shop, where you´re article in the Times saying policies and procedures primarily looking at the balance Frank Rooney had been change, unforeseen challenges sheet and underlying earning appointed President of Melville. develop, opportunities occur. I power. They´re often seeking a I knew it was a sleepy shoe think you´ve got to look discount to tangible value, retailer and the only thing it people in the eyes, talk to which is also a very valid way had going for it was its strong them, and get a feel for their to play. Such shops usually balance sheet. I called Frank to personality. To me, investing is have a huge number of stocks congratulate him on his new all about people. Good and use good theory in job but also asked him “What managers doing a great job. I general, so if they´re wrong on is a smart Wharton School want to know that some names it averages out. graduate like you doing at a management is going to We take the opposite point of crummy old shoe company?” achieve its plan, and I need to view. We have a very narrowly He said, “Well come on up make a judgment on that. -focused portfolio where we and I´ll tell you.” They had There are people you end up have to be right more often. their office in Midtown trusting and other people who, Sticking with really fine, Manhattan. I got in a cab and when you walk out of their particularly well-managed went over there, and he offices, the hair on the back of businesses helps us do that. explained to me how shopping your neck is standing up. I centers were pushing Main think good management is G&D: Are there any instances Street off the map and would vital. where you had conviction in a go up all over this country. (Continued on page 29) Page 29 Bill Stewart, Stewart Asset Management

Frank already knew that Saks, from him. We´d drive around several hours and have lunch. JCPenney, Sears and the likes the country, go into the It might work, I don´t know. would become the anchors in parking lot of a shopping these centers. But nobody center, and he could tell me The CEO has a vision and I dominated the space between the average annual income of wrote a letter to him the the anchors yet. the people who shopped other day. I want to get more there, just by the size of the flavor on his vision. They only So, he figured, if he could grease spots in the parking lot. have a small percentage of the control a shoe company, that market right now so if he´s would be a good place to start, G&D: Do you have an opinion successful, it could be one of because everybody needs to on the future of brick-and- those companies that enables have shoes. Eventually, his goal mortar retailing? you to make a 10x, 20x return was to dominate the space on your money in future between the anchors like BS: Brick-and-mortar retail is decades. nobody else had done, and gradually declining. Yet, I´m through multiple acquisitions, looking for the next thing I also see some things that including chains like CVS and that´s going to happen. On one bother me, such as stock Marshalls, and fast store hand, some shopping center buybacks. RH bought stock growth, he did it. developers are putting medical back at a good price and it has centers in, and other things gone higher, but there´s a lot G&D: At what point did you like that, which I think is of debt. When they were in sell your position in Melville? working well. Some retailers their high-growth phases, are developing stores as mini companies like Walmart, BS: I sold my position in 1972, distribution centers as part of Home Depot, and Walgreens having held it for about 11 or the evolving omni-channel just focused on building their 12 years. It went to 40 times trend. businesses and put all their earnings and I felt it was too cash flow into that. They didn´t expensive. I wrote a report On the other hand, you are try to buy much of their own saying I loved the company but seeing some disrupters, like stock because they needed the price was too rich. And Restoration Hardware. They every penny to build another then it fell down to about 12 are creating stores that attract store, another distribution or 15, during the big crash in you. You want to go there center. Yet Restoration 1974 and it briefly dropped to because, for example, they´ve Hardware borrowed a lot of $5 a share. We bought back a got a restaurant and people to money and seems to be a little lot more stock and then it show you how to decorate bit capital constrained now, went to the hundreds from your home. People go there as despite a huge addressable there. a destination, and they can´t market. get that from Amazon. Best Frank retired at 65, following Buy is becoming another They seem to have a winning the institution of a rule defining destination store. Both are formula, but the debt may be 65 as the mandatory omni-channel operators. constraining growth. They´re retirement age that he only growing sales at 7% or established 20 years earlier. At Restoration Hardware is doing 8%, why not 12% or 15%? It´s that point, we sold all of our well and growing very nicely. still a relatively small company, stock. Frank, by the way, went Our guys here are taking a but I like to spot opportunities on to work for Warren Buffett look at it and are planning at that stage. for the next 18 years or so. I another visit with the company called to congratulate him on next week. It seems they are I think Costco knows just how his 80th birthday and he said, trying to do something to do it. It´s been a major “You know what Warren just different. They´ve opened position of ours for years. A gave me for my birthday? A maybe a couple dozen stores large part of its profits come new 20-year contract.” around the country, which are from the fees that they charge attracting people from a wide for all those membership cards Frank was one of the great area. It´s a destination. You go being renewed every year, retailers and I learned a lot there, drive there, spend which constitutes a recurring (Continued on page 30) Page 30 Bill Stewart, Stewart Asset Management

revenue stream. That´s a We´re looking for great Nevertheless, we are still beautiful story. Amazon is now management, a great balance looking for faster earnings per following that concept with sheet, and a high degree of share growth, because the Amazon Prime and delivering predictability. Obviously business mix is changing, and an awful lot of stuff for the deciding what´s a high degree they should double their money. of predictability is subjective earnings over the coming five and I don´t want to attach too years. G&D: Do you think there are much scientific methodology to pockets of retail that are still it, but we need to be able to G&D: Do you think there are insulated from Amazon? make a best guess. Like any threats to that business? anything else, it takes open BS: I´m sure there are, eyes and hard work. BS: Maybe no major threats, although I´m not sure what but there are still some minor they are. I´d love to find out. “The average baseball ones, mostly from the four or Williams-Sonoma seems to be five other companies doing it. doing a good job . Drugstore hitter can only hit Also, there are new ways to businesses on the other hand provide these services that are will probably face more about .255 and that´s being introduced by various competition from Amazon. software vendors all the time. been the average...for Yet ADP has a commanding Retail is a big part of the market position and they are economy and it´s constantly years and years. Yet a holding or even increasing changing, which provides couple of guys can hit their market share, even opportunity. I think there´s though they have to fight for it. always going to be opportunity the ball a lot better, in retail. I´m not sure where it The nice thing is it´s a is. I would hope that our young and they make the big relatively small part of analysts shake the trees. I´m anybody´s expense. And once not doing that. I read books bucks. I think our you´ve got their system, taking and magazines and keep my it out to save a few percent on eyes open, looking for ideas, business is similar.” this thing, which is a tiny cost but I´m not shaking the trees anyway, may not be nowadays - though I do attend G&D: You´ve held ADP for a reasonable. The inertia there is virtually every research while. What do you like about a positive, although there are meeting in person or by the position? definitely people shooting at conference call. them. They´re good at BS: ADP is one of our major reinventing themselves and I can tell you that there´s positions – our seventh or coming up with new ways to probably 20 stocks out there eighth largest position. I´ve answer their market´s that are going to double in the owned it for decades. It has demands, or even attack new next year. Big stocks. I don´t recurring revenue and is the ones. know what they are though, largest player in the payroll and which keeps me going. It´s HR services business. It´s very They weren´t doing HR for a such a fascinating business. well managed, with a lot of long time, but they moved into lovely recurring revenue that that field and it´s working well G&D: How do you harmonize increases gently. It´s a very fine for them. It´s a stock you keep. finding an opportunity but also business, but the negative I would´ve said 10 years ago placing a high degree of there is that it´s grown so big they couldn´t pass the test and importance on predictability? that the growth rate is going continue growing at the size to be slower. Revenue growth they´re at now, but they keep BS: You have to have is going to be about 6.5% per finding ways to do it. That´s predictability. We´re not just annum for the next five years, why we still hold a sizeable buying a concept; we´re buying which may be the slowest of position.^ established businesses. We anything in our investment look for leaders in their field. universe. (Continued on page 31) Page 31 Bill Stewart, Stewart Asset Management

G&D: Could your share your terrific. This is why it looks BS: I think the fundamental view on Disney, which I think attractive to us, even with reason for investing hasn´t is also among your largest relatively modest top-line changed at all: people put holdings? growth. Their margins are money at risk to make a going to be under pressure return. And people haven´t BS: We recently increased over the next two years, changed much. Yet, the size our position in Disney, which maybe three, because of the and scope of this business has looks like it could be a new operations. We have to changed phenomenally. relatively slow grower yet is look through that because if still a very strong company. It we were to wait until they´re My dad used to say that every is dominating in its business. already successful, we´ll miss once in a while, the market has They may be over the top most of the prospective gain. If to shake out the grocery regarding streaming as they´re they mess up, we might lose a clerks. It was grocery clerks putting billions into it now, but little bit, but if they are then, hedge funds now, but within four or five years it successful, we will make a lot. they act the same way and could pay off very handsomely It´s a great global company, panic when the market´s for them. I´m not suggesting one of America´s best, with a down. But instead of selling they´re going to be as big as lot of good properties. That´s when the market´s down, it´s Netflix, but they´re going to be why it´s our fourth largest time to buy things cheaply. a serious competitor in five position. And when the market is up, years, especially given their it´s time to think about selling. very broad base around the G&D: Do you have any Human beings tend to go the world. favorite investing reading other way. That´s why having material? great conviction in what They have their basic growth Graham called a fair “central business with the movies and BS: Philip Fisher´s book value” for each current and parks that generates a lot of Common Stocks & prospective investment is so money, and we think that the Uncommon Profits is obviously important. new streaming business is great. Everyone should read going to have fair growth and MacKay´s Popular Delusions Human emotions are still the will make them a better and the Madness of Crowds to same, but there is just company in five years. Yet they see how crazy markets can get tremendous efficiency today. have a relatively low multiple sometimes. Charles Ellis´ You can now execute orders of 14.7x this year´s earnings, Classics is a very worthwhile in milliseconds or even while we think they´ll be compendium of instructive nanoseconds, and we have lots worth 17x 2024 projected EPS. stories put out by the CFA of trading machines working That gives us a discounted guys. with algorithms nowadays, but present value of about $160. I still think it´s the same game Furthermore, if they do what I read quite a few trade played on a much bigger, they say they can do and magazines to see what´s going broader, and faster scale. actually succeed, it´ll probably on. I also try to read blogs on Looking for great growth like be a 24x multiple by 2023-24. businesses we´re interested in. we saw in Walgreens, But right now, it´s selling at For example, I´ve been trying Walmart, Amazon, Alphabet, 8.9x our 2023 earnings to follow the Boeing 737 issue Apple or Home Depot is the forecast. With the shares at by going through pilots´ blogs reason I am doing this. I´m not around $113, there is a lot of to see what´s happening and here to try beating the next appreciation potential there. what they think is right or buyer down the street by an wrong. eighth of a nanosecond or Disney is a company which is trade a thousand times a day probably a lot better than G&D: What do you think has to make it up. Automated people think it is. We have been the biggest change in trading is fantastic, but it´s a good friends in Hollywood investment management since different business. who really know the industry you first entered the industry? well and they think that Furthermore, there is a huge Disney´s management is move towards passive investing (Continued on page 32) Page 32 Bill Stewart, Stewart Asset Management

because most people can´t I would say it´s business school This is a fun business as far as beat the averages but, cases in real time. The best I´m concerned. I know there honestly, a few people can. part of the business was always are people who are miserable The average baseball hitter can growing with the companies in it, but you´ve got to feel it´s only hit about .255 and that´s that we invested in and visiting the right place for you. I´ve been the average, within a them regularly. Of course, the had a lifetime of fun doing this, couple of points, for years and other side of the coin is that met wonderful people and years. Yet a couple of guys can stocks go up and down, and helped a lot of clients hit the ball a lot better, and always will, which can be both substantially improve their they make the big bucks. I exciting and depressing. prospects in the process. think our business is similar, Personally, I find it exciting and What could be better? and there will still be people interesting. It is never boring - flocking to the investors who frightening sometimes, but G&D: Thank you so much for can do it well. Typically, never boring. your time. though, those individuals stop taking new clients when they So many people are stuck in get to a certain size, because jobs in which they are size can be a restraint. advancing well financially but are not happy. They´re bored I think opportunities to invest yet they stick with it because in good companies still exist. they can´t afford to leave. I True, you can´t really buy made lots of money, thank good businesses dirt cheap God, but I´ve always had anymore, but you can buy challenges and always had fun. them at a reasonable price. I In this business, you have the like to think in terms of opportunity to never get earnings yields and compare it bored. For sure, there are 20 to a 10-year T-Bond, whose big stocks out there that are 2.6% yield is going to be fixed. going to double next year, and Compare that to buying an the challenge is to go out and average S&P 500 stock at 18x find them. I think that challenge current earning power, which is wonderful, and you never is a 5.6% earnings yield today, get all the way there. You can it can double earnings to always improve your provide an 11.2% earnings yield methodology, there´s always in 10 years (or an average room to do a little bit better, earnings yield of about 8.4% to go an extra mile. If you´re over the coming decade). talking to a company that That´s a lot of edge in favor of you´ve really got a good story stocks. from, you want to check with a competitor, talk to customers; G&D: Do you have any advice you can always go deeper and for MBAs going into learn more. The job is never investment management? done.

BS: If you have the right Developing conviction is mindset, it´s a wonderful possibly one of the two or business. It´s constantly three most important things challenging and fascinating. You you can do when you´re are visiting the companies forecasting the future and you you´re investing in and it do that every day. You´re means meeting smart people, never going to be right all the seeing great businesses being time, so when you´re wrong, built by a team or a man or you bite your tongue and then woman who has fresh ideas. go on to the next prospect. Page 33 John Hempton, Bronte Capital (Continued from page 1) Graham & Doddsville Neilson, an investor frequently my case, it is usually a company (G&D): Can you start with likened to Warren Buffett. that makes a widget that is a your background and tell us small yet important part of a how you got into the Kerr worked at BT Australian bigger thing, has high switching investment business? Funds Management in the costs, and has incrementally 1970s and became the best- improved over time. I call this John Hempton (JH): I performing fund manager in the trifecta. There´s an old started my career as a Australia. He left BT to start saying for this: “There are Treasury official in the Platinum Asset Management in riches in niches.” government department that 1994, which George Soros advises on tax policy. I was invested $400m in as seed Warren Buffett does this all working for Ken Henry, one of investor. George eventually the time. Buffett talks about John Hempton the two geniuses I´ve worked took his money out at $2bn, the six big non-insurance for in my life. He was the most with Platinum displaying the businesses that were about 70- influential government official best performance within 80% of the non-insurance in Australia over the last 30 Australia. profits at Berkshire. One of years and was responsible for them, International much of Australia´s economic Having Platinum as my first Metalworking Companies, positioning. He was running interview was lucky. I went makes tiny cutting tools that the tax policy division at the into the interview completely go on the end of blades. If you time I became the internal unprepared and started ripping can make a cutting tool that expert on tax avoidance – or into NTT Docomo. NTT speeds the whole factory up, accounting tax guru – which Docomo had invested $217m you can charge a lot of money. later benefitted my career in an Australian company You get pricing power from greatly. called Davnet, which I believed being a small part of the bigger to be a fraud, and which later thing, and the switching cost is I became interested in money went to zero. Now, NTT high because you have to management because I had a Docomo was the dominant reprogram all the computer- friend who inherited some mobile phone company in driven blades. IMC has a 45% money and had a bad financial Japan, and $217m is not a operating margin, which is advisor. I started thinking diabolical amount of money. almost twice the margin of about how to help her manage But it was a diabolical sign, a Apple. It´s an astonishingly her money better and did a lot sign of stressed capital good business. of research on stocks and allocation. Unbeknownst to me portfolio theory. I also started at the time, NTT Docomo was Another example of a great a personal account on the side. Platinum´s largest holding. A market is the seed business, in I did many stupid things in my good piece of advice for fund which Monsanto, Corteva, and personal account, but it was a management interviews is to Syngenta are the three big time when mistakes were work out what a fund players. Their goal is to mix forgiven due to a strong manager´s largest holding is two closely related species to market. and, if you can spell out the create offspring that are better bear case properly, you´ll than either parent and are I kept applying to jobs in fund probably get the job. I walked either infertile or marginally management but was out of that interview with the fertile. Because the hybrid is unsuccessful no matter how job. essentially infertile, farmers hard I tried. Then one day I using the more efficient seeds was on the ferry in Sydney, G&D: That´s fascinating. How must keep buying seeds, which coming back from the beach, would you describe your allows for private sector- and a woman sitting next to investment philosophy? funded R&D. This R&D is me turned out to be a relatively efficient: over the headhunter. She liked me and JH: The first question Kerr past 50 years, US corn yields immediately arranged an Neilson asks on any business are up by about 10x. Better interview for me. I literally got is, “What makes you want to seeds give companies more off the ferry and walked into own this in the next two years, pricing power, and with more an interview with Kerr five years, and ten years?” In pricing power companies can (Continued on page 34) Page 34 John Hempton, Bronte Capital

spend more on R&D, creating make any component for a almost went bust. Now the a virtuous circle. Tornos lathe. Consequently, question is what will happen in there is no maintenance the mobile industry. The Another attractive company in required; the lathes repair marginal cost of a mobile an attractive niche is Givaudan. themselves. The third problem phone call looks like zero. Givaudan is based in is that Tornos´ customers are Even though internet capacity Switzerland and is the world´s the most sophisticated keeps going up, there´s no dominant flavors and precision manufacturers in the excess capacity in mobile yet fragrances company – a small world. They can work out so that has been saving mobile part of a bigger thing. For what it costs to make a lathe companies. But imagine 5G example, if you buy a tub of and negotiate on price. Finally, does everything that is yogurt, the flavor is critical; if capital equipment is a highly promised – which is infinite the flavor changes one day, cyclical business. Tornos bandwidth for your mobile – customers might switch provides a piece of capital and the excess supply drives brands. Selling the flavors to equipment used to the price to zero. It´s a high the yogurt company turns out manufacture capital equipment fixed cost business and to be a very profitable business without any maintenance everyone could go bust. with unexpectedly high stream and which is bought by switching costs. sophisticated people with very G&D: Are there any other strong buying power. It´s a things you look for in a The last example is Spirax- truly horrible business. company? Sarco, which makes steam traps, the cast metal bits we “In my case, [I usually JH: Steve Mandel at Lone Pine use to separate steam from said the very best businesses in water. They have a margin want to own] a the world reach a global scale comparable to Apple´s because and share the benefits of that it´s a trifecta business. That´s company that makes a scale with their consumers. an iconic business to me. widget that is a small Charlie Munger only owns three stocks directly: G&D: Does the company have yet important part of a Berkshire, NewsCorp, and to be a small part of a bigger Costco. For Costco, he bought thing? bigger thing, has high a position large enough to be guaranteed a seat on the JH: Yes, and I will give you an switching costs, and has board, and the outcome has example. The worst business been astonishing. It has model I have ever seen is that incrementally improved reached a global scale and has of Tornos, a company based in over time. I call this the shared the benefits of that Switzerland that makes high- scale with its consumers. precision blades including Swiss trifecta. There´s an old Costco has a 12% gross margin -type lathes, machines used to and a 2% net margin. That´s work materials such as metal saying for this: ´There pretty hard to compete with. If or wood in specific pieces. you are a distributor and set Their biggest customer is are riches in niches.´” up shop on Amazon, the fee Rolex, which has 180 Tornos for Fulfillment by Amazon is machines for making watch about 15%. Amazon is parts. As such, you can say that The worst kind of business is developing on a global scale Tornos makes products that one with a combination of high and also shares the benefit of are a big part of a small thing. capital costs, low running that scale with its customers. costs, and competition, But Costco has a cost Tornos has several problems. because at some point the structure that beats Amazon´s. The first is that these lathes competition will come, there are absolutely beautifully made will be excess supply, and the G&D: How do you find and basically don´t wear out. price will drop to the marginal companies that fit the The second is that anybody cost. An example is the investment criteria you who has a Tornos lathe can telephone industry, which described? (Continued on page 35) Page 35 John Hempton, Bronte Capital

JH: We find them in different Trex, which makes plastic These businesses are fragile ways. Many times, we find decking, has the same margin because the customer is them by accident. We like to as Apple. Trex´s return on getting ripped off, and the day scan for companies that have a assets is 27% and return on Good Morning America runs a massive margin. Sometimes, equity is 47%, and both of story on them, everybody who it´s a really good business that these metrics are increasing. bought one of these things will fits one of our models. feel like an idiot. Sometimes it´s a cyclically Another example is a Finnish good business. At one point elevator company called Kone. G&D: What do you do if BHP, a company that digs up Elevator companies make all something stands out but dirt and loads it onto a ship, their money on maintenance doesn´t fit into one of your had a margin of 65%. Put except in China, where all the categories of business models? another way, BHP had a higher money is made on capital margin than Louis Vuitton, equipment. Elevators have JH: If I can´t fit it into a model which sells $3,000 handbags maintenance schedules, and I understand, I just ignore it. but has a lot of SG&A and thus the person buying the elevator a net margin of only about wants the lowest price for the G&D: Bronte´s website states 20%. Of course, BHP´s margin elevator but doesn´t care that the firm´s aim is "To bring was cyclically high because about the maintenance originality back into the there was a shortage of iron investment process." What ore capacity. does that mean to you? “The problem with the The most common explanation JH: One of the weirder things for massively high margins is distributor model is about our firm is that we high priced selling through usually don´t use the sell side. distributors. The business that it´s a fantastic We really try to find every model of many companies is to business until it´s not. position ourselves. When it find a group of trusted comes to brokers, the best intermediaries who advise These businesses are signals come from the most customers to buy the crooked brokers, as a crooked company´s product despite the fragile because the broker is a really good sell high price, with the company signal. The broker in The Wolf kicking back a part of that customer is getting of Wall Street would have been my best friend because profit to the intermediaries. ripped off, and the day it´s easier to find shorts My favorite example is Trex, a Good Morning America through crooked brokers. company that makes plastic decking. With a wooden deck, runs a story on them, The only time I use the sell you need to paint or oil it side is when it doesn´t agree every year. Otherwise, it will everybody who bought with me. The only brokerage rot and fall off. Now, if you notes I´ve read this year are hire a guy to fix the deck, he one of these things will the various sell cases on GE. will give a quote on the The reason is that I´m wooden deck and suggest this feel like an idiot.” instinctively long GE. plastic product which removes Ultimately, the short thesis is the need to regularly oil the contract. This makes the that the incentives are terrible deck. He will then quote a elevator business very inside GE: the top had an price that is a bit more profitable, because the person incentive to bake their expensive than the timber that installs the elevator numbers for years, with the decking and will even show doesn´t pay for the top five people at GE having you the quote from the maintenance. been paid a billion dollars over decking company, but he will the last 15 years. My problem be getting a kickback. Trex´s The problem with the with this is that most of these gross margin is 43% and EBIT distributor model is that it´s a businesses are now valued at margin is 25%. In other words, fantastic business until it´s not. less than 1x-1.5x sales. They (Continued on page 36) Page 36 John Hempton, Bronte Capital

should be worth more than babies happy. In China in About a year and a half later, that. Manufacturing the particular, the one child policy Mattel sold the Learning dominant jet engine in the translates into a four- Company for one dollar. world is going to be a grandparent policy. The one Mattel gave away 25% of its profitable business because big thing going against them is stock but its stock dropped there are only two jet engine a new competitor: computer 75%. The reason was, in manufacturers and there will games. To be blunt, computer addition to the bad capital not be another entrant for a games are better than toys. allocation decision, it was a while. Internal incentives were sign that the business was the undoing of that company. Though Mattel was dealt a bad going down. The company had The older I get, the more I hand, they still played their revealed its own weakness. realize incentives are more hand poorly. When the powerful than I recognized. PlayStation One came out in G&D: It seems like you have a 1994, then CEO Jill Barad natural tendency to be G&D: What do you consider figured that she had to get into skeptical. Can you tell us how to be good management? the computer game business. you became interested in While the company´s girls toys fraudulent companies? JH: There´s a Warren Buffett were doing okay, they could view of the world which is to see the boys toy division going JH: As Ronald Reagan said, buy good companies at away. Because Mattel wasn´t "Trust but verify." If you start reasonable prices and hold going to be able to build a off with tax avoidance, you them for very long periods of computer game business, they work out that people are liars. time. However, it´s very hard went to buy one instead. In 1999, after I joined Platinum, to work out what a good Mattel was highly valued at the there were many obviously company is. The biggest time, so they offered stock to fraudulent technology stocks in problem that management of computer game companies. Australia. This was the height such companies has is what to Every computer game of the dotcom bubble, and at do with the excess cash. company that Mattel the height of any bubble there Sometimes, management approached said no, and the are always frauds. One of them mistakes position for genius. reason was Mattel couldn´t was called VoiceNet, which They think that the golden offer a currency that the was the most important stock goose is there because they computer game company was in my entire career even are such good managers, but in willing to accept. This is like if though I could only short fact they´re just in the right newspapers offered eBay about half a million dollars´ place. They then go buy stock; eBay would look at worth of it. VoiceNet claimed something inferior and them and say, "No, we´re out to be a speech recognition discover it´s almost impossible to destroy you." software company and even to buy something as good, made it into the Australia then all sorts of bad things Eventually, in 1998, one index. happen. company agreed to accept Mattel stock. It was a company VoiceNet claimed to have a lot Additionally, companies that called the Learning Company of sales in Chile and claimed to are in decline do stupid things. that made silly computer have one of the big Chilean Bob Dylan once sang, "When games like Space Invaders, telephone companies as a you´ve got nothing, you´ve got where a six plus a five fell customer. One of my friends nothing to lose." I wrote about down and you had to type 11, spoke Spanish and we decided Mattel over the weekend. or you would get wiped out. to ring every investor relations Mattel is in a difficult position; The Learning Company was a department of every Chilean they have a couple of things fraud: it had fake accounts and telephone company and try to going their way but have one fake stores, but it had a feel- confirm that VoiceNet actually massive thing going against good story because it was sold software. It turned out them. The biggest thing going computer games and they didn´t. We later their way is that people are education. Basically, they were confirmed that VoiceNet had a getting richer, and richer bringing nothing in exchange computer shop in Santiago people spend more on keeping for 25% of Mattel in stock. selling shrink-wrapped (Continued on page 37) Page 37 John Hempton, Bronte Capital

software, with the sales signed JH: We don´t actually have CEO says there is ten million off as software sales. very good timing mechanisms. ounces of gold in the ground – We short really dodgy up from one million ounces – VoiceNet did a one-month companies, companies that are and the market believes him, road show with another worth close to zero. The that stock is going up ten-fold. company called Lernout & problem is that normal math I started 5% short and quickly Hauspie, which had a $3bn rules don´t apply here; the found myself 50% short. My dollar market cap. Now, I can´t most you can make is 100% fund is down from 100% to tell if a company is a fraud right because a fraudulent company 55%, and the fund is now away, but if I spend a month on valued at $5bn will not make almost 100% short, which the road with the company, I you 10 times the money as a means I´m going bust on a would work it out. Plus, if a fraud valued at $500m. But if single stock. company stayed on the road management is good at telling with a fraud, then that lies, they can go up 10 times. It could have been even worse. company must be a fraud too; My favorite example of that is The biggest gold mine fraud in that was my logic. a gold company I once shorted. history was Bre-X, which said This was a Mark Twain gold it had 180m ounces of gold in Lernout & Hauspie was the mine: a hole in the ground with the ground. None of it was stock that changed my life. It a liar on top. there, but the stock went to was the biggest tech stock in $30bn. It ended when the Continental Europe and was “Additionally, Chief Geologist fell out of the one of the hottest darlings of helicopter and his body was the dotcom era. It made companies that are in eaten by tigers in the speech recognition software Indonesian jungle. That´s a true and had both Microsoft and decline do stupid story. Even though the Intel as investors. It´s pretty things. Bob Dylan once company was a fraud, I hard for a tech stock to fool would´ve been wiped out if I Microsoft and Intel, yet it sang, ´When you´ve got were short Bre-X. You can´t managed to do just that. They be short a stock and survive a had this room with a whole nothing, you´ve got 200x increase. wall of computers and you talked into a microphone and nothing to lose.´” There is actually no way you the computers would do the The first indication of fraud can time shorting. What we do speech recognition. Then they was that the CEO started his is we only have 20 bps put your sample through a career working for Stratton positions and our big, hairy, translation program, and the Oakmont, which is the broker audacious goal isn´t to time it, program would convert it to of The Wolf of Wall Street. but to find every such another language. They were But I wanted to be really sure, company in the world and play demonstrating the Holy Grail so I hired a professional the average. Our shorts look of speech recognition in 1999. panner to pan the creek below terrible if you look at them It turned out all that was done the hill, because if there´s gold individually, but if you look at by a man behind the curtain, in the hill, then there must be them on average, they look literally the Wizard of Oz. The gold in the creek below the hill great. If a company has a lot of man behind the curtain just as the hill had been eroding for debt, it has a hook to reality typed it in; everything else was years. The panner panned for a since the debt needs to be an illusion. This introduced me day and found no gold. After repaid one day, but many to a community of short this, I shorted this gold companies have no hook to sellers. company to the tune of 5% of reality. the fund. G&D: Are there short G&D: What led you to short positions that haven´t Nine times out of ten, that Valeant? materialized? How do you company is going to go to zero factor timing into your very fast and I´m going to JH: Valeant was complicated in decision to short a company? make 5%. But one time out of many ways. The first problem ten, the CEO will lie. If the was that we regarded several (Continued on page 38) Page 38 John Hempton, Bronte Capital

people involved in Valeant as genuine expenses, not just JH: No, unfortunately. We fraudsters. We keep a things that were one-offs. At shorted at $130 on the way database of bad characters for this point, we knew that they up. We then shorted a bit the short side and we follow were lying to Wall Street. more. It went from $130 to them from company to $257, and then back to $9. We company. One of the directors “Drugs are a fat exited at $15, which was still of Valeant had been the fine. I think it should go bust, director of a company called margin business that but surprisingly or not, they´re Heart Tronics, whose other well-funded. It´s very hard to principal is currently in jail. people will lend to at go bust when people will roll That director never disclosed very low interest rates your debt without looking. this on her career history, and she wasn´t obliged to: SEC law for long periods of I find it bizarre that people are tells you how far you have to still lending to Valeant. Drugs go back with directorships. time. Even if you´re are a fat margin business that Yet, the fact that she had been people will lend to at very low a director of a fraudulent insolvent now, you interest rates for long periods company was enough for us to of time. Even if you´re might be solvent in the take a solid look. insolvent now, you might be future, because solvent in the future, because The second thing was that sometimes things do go right. Valeant was trading at 10x sometimes things do go Donald Trump getting elected revenue. Sun Microsystems is something that went right was trading at 10x revenue at right. Donald Trump for Valeant because it meant the end of the dotcom era, and less pressure from the US subsequently went from $64 getting elected is government on drug prices. to $2. In an interview, Scott McNealy, cofounder of Sun, something that went G&D: Can we discuss once said, "At 10x revenue, to right for Valeant Herbalife and how you give you a ten-year payback, I ultimately decided to go long have to pay you 100% of because it meant less there? Can you also comment revenue for ten straight years on the previous discussion in dividends. That assumes I pressure from the US regarding third-party have zero cost of goods sold, intermediary structures? zero expenses, and zero R&D government on drug for the next 10 years, yet I can JH: Yes. Herbalife came about maintain the current revenue prices.” a different way. When I was run rate. What were you young, I taught Economics at a thinking?" It´s one of my Valeant still had businesses that University in Western Sydney favorite quotes. enjoyed such margins. The for a year. I lived on the Wall Street Journal found out outskirts of Sydney in a house Additionally, though Valeant that ripping people off on owned by an Avon lady. She was making a loss, their Syprine was extremely was the most successful Avon adjusted accounting said they profitable, but it was also lady in the Southern were making a 55% margin. unsustainable; it was so Hemisphere and was selling There aren´t that many unethical that the U.S. about $250,000 worth of Avon companies that make a 55% government became their per year in the late 1980s. The margin. Google makes roughly enemy. outskirts of Western Sydney 20% and so does Trex, which are much like the Inland we discussed earlier. At 55% G&D: Did you short Valeant Empire area in California. It´s margin and 10x sales, we tried when you found out about about an hour and 20 minutes´ to work out what the company Philidor, the fraudulent drive from town, so the was telling us to ignore in the specialty online pharmacy that husbands were away 11 hours adjusted accounting. We found sold Valeant drugs? a day, and the wives were left out that they were ignoring stuck in suburbia with two (Continued on page 39) Page 39 John Hempton, Bronte Capital

kids. And if an Avon lady merchants, but most of it was knocks on their door, she because people fail at being a would of course get invited in, Herbalife distributor, but if because the client is lonely. they do stay, they stay a long This lady sold vast amounts of time. So over time, the makeup, but what she was proportion of distributors who really doing was selling makeup stay will increase. plus social reassurance. The real product is the social I also asked distributors what reassurance and community their retention rate was with feeling. downstream distributors. I have seen the books of seven Herbalife fit that model senior distributors and every perfectly. Bill Ackman says that one of them had a book that weight loss products cost was better than the twice as much at Herbalife company´s. Of course, there is than at Walmart, so one would a selection bias since people rationally buy them at with good books are more Walmart. In reality, customers willing to show them. Still, it are buying weight loss remains that a business that products plus the real product sells physical goods along with of social reassurance. community support often proves to be a very good Once I recognized the model – model because it implies high which I knew worked – and switching costs. realized that the company was honest, I went on to prove it. I was perfectly happy having an The easiest way was to get to oversized position and ended know some senior distributors up selling a lot as the stock and have a look at their went up, although I regret downline. If a customer orders almost every sale. But it´s an $5,000 and never orders again, open-ended fund, and if we had that looks like the hypothetical 25% in Herbalife, I might have customer Bill Ackman had a hard time explaining that invented. If a customer orders to my clients. $70 a month for five years, that looks like the customer I G&D: Thank you so much for had in mind. your time.

Bill Ackman also assumed that all the downstream distributors are being ripped off. If the downstream distributors buy $10,000 worth of Herbalife one year after another, they are clearly not being ripped off. The company publishes the distributors´ retention rate. When Mr. Ackman started talking about Herbalife, the retention rate stood at 49%. It´s now about 65%. Part of the increase was due to reforms that got rid of the rip-off Get Involved:

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Graham & Doddsville Editors 2018-2019

Ryder Cleary ´19 Ryder is a second-year MBA student. During the summer, he worked in Equity Re- search at JP Morgan. Prior to Columbia, he was a Captain in the Infantry branch of the US Army. Ryder graduated from the United States Military Academy at West Point with a BS in Systems Engineering with a mathematics concentration. He can be reached at [email protected].

Gregory Roberson, Esq. ´19 Gregory is a second-year MBA student and a member of Columbia Business School´s Value Investing Program. During the summer, he worked in the Investment Banking Division at Goldman Sachs & Co. LLC. Prior to Columbia, he worked as a corporate attorney specializing in mergers & acquisitions and corporate finance. Gregory studied finance and economics at the University of Cincinnati and received both his JD and LLM (Taxation) from Georgetown University Law Center. He can be reached at [email protected].

David Zheng ´19 David is a second-year MBA student. He spent last fall through this summer working as a Consumer Analyst at Balyasny Asset Management. Prior to Columbia, he was a Portfolio Manager at Peak6 Investments focused on single-stock volatility and special situations. David studied economics, political science, and business institutions at Northwestern University. He can be reached at [email protected].