Graham & Doddsville An investment newsletter from the students of Columbia Business School Inside this issue: Berkshire Annual p. 3 Volume III, Issue II Summer 2009 Meeting & Heilbrunn Center Reception “Fish Deeper, Fish Alone”—Paul Sonkin The Mother of Dis- p. 11 tressed Cycles-Steve Paul Sonkin is managing mem- because people expect it, I Moyer ber of the Hummingbird Value think it’s not going to hap- Fund. He has worked at the pen. An example that I was Precision Castparts p. 16 SEC, Goldman Sachs, Royce talking about the other day is Apollo Group p. 18 Funds, and First Manhattan 9/11. I think that there are a Company. He holds an MBA lot of commonalities be- Focused on Essentials- p. 20 from Columbia, where he tween Lehman and 9/11. Brown Brothers teaches courses on applied Basically, what happened is Harriman value investing. that Lehman set off a chain reaction – sort of a negative A Quant Among Us- p. 26 GD: What is your take on feedback loop. I think it was Jim Scott the market right now? There a Thursday morning, Octo- th seems to be some diver- ber 11 when the Reserve Michael van Biema at p. 36 gence of opinion among in- Fund announced that they NYSSA vestors currently about had a lot of exposure and Paul Sonkin - Managing Mem- ber, Hummingbird Value Pershing Square P. 34 where we are in the cycle. they broke the buck. I re- Fund. Challenge member that we were think- PS: What’s going on now is ing, “Our cash may not be Editors: that many of the people I am safe.” Wachovia had failed happened after 9/11 – al- though, I think that was Charles Murphy talking to – many smart, and you were having these MBA 2009 savvy investors – think that huge bank failures and the more psychologically driven. world became a very, very You had this huge exogenous David Silverman the second and third shoe is scary place. Everybody event, which introduced a MBA 2009 going to drop. For that rea- son, I think there is a tre- pulled back. The country huge amount of uncertainty Matthew Martinek mendous amount of money just shut down for a quarter, in both cases. MBA 2010 sitting on the sidelines. And, which is very similar to what Continued on page 2 Clayton Williams MBA2010 Welcome Back to Graham & Doddsville Contact us at: [email protected] We are pleased to present investment philosophy, and value investing professor at you with the third edition of at Graham & Doddsville, we Columbia. Paul gives us his Visit us at: Graham & Doddsville, Colum- believe that there is no bet- thoughts on the current www.grahamanddodd.com bia Business School’s student ter way to study investing market environment and www0.gsb.columbia.edu/students/ -led investment newsletter than directly from successful applying Graham & Dodd co-sponsored by the Heil- industry practitioners. With principles to a microcap brunn Center for Graham & this objective, our current strategy. Dodd Investing and the Co- issue contains four inter- lumbia Investment Manage- views with leading invest- Since the application of value ment Association. ment professionals. investing goes far beyond common stocks, Steve The tumultuous market over First, the issue features an Moyer, author of Distressed the last year has only further interview with Paul Sonkin, Debt Investing, sits down reinforced the merits of a managing member of Hum- with us to discuss opportuni- sound, long-term oriented mingbird Value Fund and (Continued on page 2) Page 2

Welcome to Graham & Doddsville (continued from page 1)

(Continued from page 1) Director of General Mo- winner of the second annual ties in the current dis- tors Asset Management Pershing Square Challenge. tressed cycle, and their im- and a former Columbia plications for value inves- Business School professor. Finally, this issue contains tors. articles detailing the numer- Along with providing our ous opportunities in invest- Next, Timothy Hartch and readers with insightful and ment education available to Michael Keller of Brown timeless content, we also CBS students, including this Brothers Harriman Core aim to provide specific year’s trip to the Berkshire Select Fund discuss their investment ideas that are Hathaway Annual Meeting philosophy of focusing on relevant today. Inside are and the Second Annual Per- essential services in a value two condensed student shing Square Challenge. framework. investment recommenda- tions. The first recom- Please feel free to contact us Finally, we talk with Jim mendation is Precision if you have comments or Scott, director of research Castparts (PCP), winner of ideas about the newsletter, at the Heilbrunn Center, this year’s Sonkin Prize. as we continue to refine this about applying quantitative The second recommenda- publication for future edi- tools to value investing. Mr. tion is the short-sale of tions. Enjoy! Scott is also a Managing Apollo Group (APOL),

Paul Sonkin (continued from page 1)

“When people When people are faced with money when they need to caviar. They’re not going to uncertainty, they really spend money. go from one extreme to don’t know how to react so another. You have intelli- are faced with whatever they are doing, What we are seeing with a gent people making intelli- they just stop. They go into lot of our companies is that gent decisions about spend- uncertainty, they conservation mode. I am a people are making necessary ing and there are companies big proponent of evolution- expenditures, but they are that are going to be benefi- really don’t know ary psychology. It is sort of revisiting all of their other ciaries of that. like the fight or flight reflex. expenses. You are still go- how to react so If you are faced with a huge ing to go out to dinner, but Getting back to the 9/11 shock, you get this huge maybe you go out to the analogy, the “next 9/11” is whatever they adrenaline bump and it is less fancy place. In our not going to be as much of a kind of like an automatic portfolio companies, I think shock. If you have another are doing, they response. I think that is that one big beneficiary of horrific incident where what happened in the fourth that is a company called 2,000 people were killed in just stop.” quarter. What I am starting Avantair that does fractional say, San Francisco, the to see now in the press and planes at basically half the country would just react in anecdotal evidence com- cost of NetJets. It has actu- differently because it has ing out of these companies ally been taking a lot of already happened once, and on a grass roots level is that share from NetJets. I think I think that when it happens people are starting to spend this happens at every level. the first time there is this money again. They aren’t People want to downsize a huge reaction. When it going to spend as frivolously little bit, but they don’t happens the second time, as they did in the past, but want to be eating cat food people become desensitized they are going to spend when they’ve been eating (Continued on page 4) Volume III, Issue II Page 3

Berkshire Annual Meeting

I could have sworn I was at generations. The grand- what he intended to do af- a rock show, not an annual mother’s father had been ter the sale, and then to meeting. Yet there I stood approached by Warren Buf- send over three years of outside the Qwest Stadium fett in the 1950s to contrib- financial reports and a brief in Omaha, Nebraska on a ute $10,000 to his original history of the company. “There is no Saturday morning at 6am partnership and had de- Within three days, Bill had a with 35,000 other excited clined the offer. The family response. The offer was ‘hedge fund’ fans waiting in anticipation we were visiting had a simi- significantly lower than the for the doors to open for lar story. Her father was $200 million he had been the 2009 Berkshire Hatha- approached by Warren Buf- offered by investment bank- industry that way Annual Meeting. fett too. He told Warren ers and other furniture re- to come back when he was tailers, but ultimately Bill exists This year, the annual meet- driving a nicer car than him. accepted Warren’s lower ing had a cowboy theme, The irony is that Warren is offer. I was amazed that it separately which couldn’t have been probably still driving a worse took Buffett only three days more appropriate. Our car (he drove a Lincoln to feel comfortable purchas- from the tickets branded us as Town Car until 2001, and ing this company. “partners,” not sharehold- then replaced it with a ‘money ers. And when the doors Cadillac DTS). I wondered Waking up the next morn- finally opened, the stampede how many others had simi- ing at 5am was remarkably management’ for the best seats in the lar stories. easy. I jumped out of bed stadium began. Never did I like a kid on Christmas industry.” anticipate that I’d be com- After the Borsheim’s recep- morning. We arrived out- peting in a foot race against tion, we ventured over to side the Qwest stadium by agile seniors at 7am on a the local Dairy Queen (also 6am. After claiming our Saturday morning for a owned by Berkshire). It seats, we decided to go ex- chance to listen to a pair of was hosting a book-signing plore the exhibition hall. octogenarians speak for 6 with authors who had writ- Two friends stayed behind hours. ten books on Warren Buf- to guard our prized seats. fett. A BBC film crew was Fortunately, I was traveling there filming a documentary. The hall was filled with com- with another student who After indulging my child- panies Berkshire owned, had attended before. He hood sweet-tooth with my including Borsheim’s, Fruit led the way as we weaved favorite DQ Blizzard, I sat of the Loom, Dairy Queen, our way through the crowd down and spoke with Bill NetJets, Justin Boots, See’s into seats 10 rows off the Child about his book: Candy and more. We had Ajit Jain, Adam Weiss ‘96, left side of the stage; a per- “How to build a business our pictures taken with the and Bruce Greenwald at the fect line of sight for the Warren Buffett would buy.” Fruit of the Loom “fruit” Heilbrunn Reception in Oracle. It was 7:15am. Bill Child built RC Willey and the Dairy Queen mas- Omaha following the into Utah’s largest furniture cot. Add in a “Wall St.” Berkshire Annual Meeting The night before, we at- store and sold the company roller-coaster ride to par- tended a shareholders re- to Berkshire for $175 mil- ody the ups and downs of ception at Borsheim’s, one lion in 1995 after being in- “Mr. Market” and the annual of North America’s largest troduced to Buffett by the meeting would have been a jewelers which Berkshire owners of the Nebraska cross between a Disney purchased in 1989. The Furniture mart (as you can Land for investors and a store overflowed with part- guess, also owned by Berk- Star Trek convention, ex- ners proudly bearing their shire). cept instead of speaking in shareholder passes around Klingon, people used words their necks. I asked Bill how Warren had like “margin of safety,” assessed his company. “intrinsic value,” and At the reception, I met a Warren asked him why he “moats.” family represented by three was selling the company, (Continued on page 4) Page 4

Berkshire Annual Meeting (continued from page 3)

(Continued from page 3) We returned to our seats answer format. Questions eager to finally hear him alternated between audi- Then I noticed a press circle speak. The morning began ence members and ques- moving toward us. Before I with a one-hour video col- tions submitted in advance knew it, Warren Buffett was lage of commercials for to three journalists from walking directly toward me. companies Berkshire owns Fortune, CNBC and the In fact, I was in his way. I and small satiric skits. In New York Times. The came face-to-face with my one clip, Warren pretended questions covered every idol and completely froze to be Tiger Wood’s caddie. topic, from improving finan- like a deer in headlights. In another, Warren sold a cial literacy, Berkshire’s ex- Would security jump on me mattress called the Nervous posure to derivatives, Buf- if I said hello and reached Nellie to a customer in the fett’s view on the govern- out to shake his hand? I Nebraska Furniture Mart. ment bail-out, the threat of decided to smile and politely The mattress had a com- inflation, and Berkshire’s step aside. “Those dilly bars partment to store money, investment in a Chinese look good,” he said pointing Berkshire shares, and old battery maker (BYD). The to another member of the magazines. entire time Warren and his crowd as he walked by, “I partner, Charlie Munger, should get one.” The rest of the meeting drank coke, ate See’s fudge followed a question and (Continued on page 15)

Paul Sonkin (continued from page 2)

(Continued from page 2) same view now. You have two really intelligent guys. to it. Mauboussin talks these widely differing views, We were just kind of chat- about is what’s called and because you have these ting and I said, “What do “robust consensus.” You differing views there is a lot you think? Do you think have manias and panics of cash sitting on the side- that it is a head fake or the when you don’t have a ro- lines and one of those two beginning of a new rally?” bust consensus. If you are constituencies is going to be And one of them said it was in a boat and everybody is right. There is either going a head fake and the other sitting in the middle, you’re to be another shoe to drop said it was the beginning of a fine. If everybody goes to or not. But I think a lot of recovery, and they said it at the bow then it’s going to that other shoe dropping the same time. sink. If you have a robust has already been priced into consensus and people’s ex- stocks such that you have GD: Some have speculated pectations are evenly dis- companies that are trading that the recent “robust con- tributed then you’ll have an as if they are going bank- sensus” is more shorts cov- equilibrium, but if everyone rupt. I think it was back in ering their positions and expects the same thing then February when GE was buying back shares in decent you will have disequilibrium. $5.80. It was trading as size. So what happened in the though it was going to go bubbles is that you had this bankrupt, and Citi was trad- PS: Yeah, but we are also disequilibrium and then you ing as if it was going to go hearing that people are had this shock to the system bankrupt. There were a lot starting to put capital to that brought it back to equi- of other companies. Those work again and that stocks librium. companies have rallied off of look cheap. Prices are their lows, but still you have clearly made on the margin What you have now is more a lot of people who still and the volume would not of a robust consensus. Eve- believe it. I was on the be indicative of short cover- rybody doesn’t have the phone the other day with (Continued on page 5) Volume III, Issue II Page 5

Paul Sonkin (continued from page 4)

(Continued from page 4) is going to perform in a re- have gotten killed. I think ing per se. covery, but it will still per- that there are some people form. Or a company like that call these things and GD: Playing devil’s advo- Fortress International, there are some people who cate, very few people pre- which we own, or a lot of are ahead of the curve and dicted this would happen or these other companies will they are lauded as geniuses. that it would be this bad. be able to perform quite A former student of mine But if you didn’t catch it the well, irrespective really of has a $2 million fund and Professor Bruce Greenwald and last time, what makes you what the overall economy was up 40% last year be- Dean Glenn Hubbard think you can predict the does. cause he had one long that macro environment today? As a microcap investor, did really well and one short Columbia Business School is that did really well out of a leading resource for invest- PS: I don’t. I don’t think only five positions. Statisti- ment management profession- that anybody can. What cally you are going to have a als and the only Ivy League you will see is that guys with few of those. Wayne Gar- business school in New York very small funds don’t think zarelli called the 1987 crash. City. The School, where value a lot about the macro envi- John Paulson called the sub- investing originated, is consis- ronment. I could talk about “As a microcap prime crash and made a ton tently ranked among the top the macro environment, just of money. You can’t look at programs for finance in the like I could talk about the those guys. You have to world. Yankee game or whatever investor, what look at the Seth Klarmans the topic du jour is. But who have consistently been when you have a large cap you are looking able to sidestep these disas- fund or a large fund com- ters. You can’t really look plex, you have to really be for is something at the one-offs. able to opine intelligently on where the macro economic where it can We had a horrific year last situation is going because year. We were down 40%, you are the market. If you grow against the just like everybody else. have $20 billion under man- What I find very surprising agement, you are the mar- industry” is that people said for a mi- ket. If you have $20 billion crocap fund, if you were under management, you only down 40%, that was either have a huge position pretty good. The Russell in a lot of tiny companies, in 2000 was down around which case you are fairly 33%. What killed us was exposed to the overall mar- illiquidity. Usually, we are ket or you have concen- what you are looking for is long illiquid names. That trated positions in large cap something where it can usually works out well over companies in which case grow against the industry the long-term as long as you you are really exposed to returns or grow against don’t have any major panics. the macroeconomic envi- negative economic trends. If you want to sell a house ronment. But if you have a What we have experienced today, it is a very illiquid small portfolio with little is that when you have a cri- asset, but if you want to sell companies, you are not as sis, everything is correlated. a house over six months exposed. You don’t really Since June 2007 and until then it is more liquid, de- need to have a view. We very recently, there was pending on the price. It is could get down in a granular nowhere to hide. The only the same way with our way and say that even in a place where you would have stocks. In the short term severe recession that Avan- been safe was short-term they are illiquid, but in the tair is going to perform rela- treasuries. If you were in longer term, they are very tively well – not as well as it equities then you would (Continued on page 6) Page 6

Paul Sonkin (continued from page 5)

(Continued from page 5) picking through our names. growth in the space. Plus, “Our investors liquid. What we are seeing is you get a great management that—name by name—they team. We have companies want us to play at GD: You mentioned Klar- are starting to get picked like this in our portfolio a specific table and man as a positive example. over and the stocks are which are just incredibly Are there any things that starting to perk up. Essex cheap. we tell them that it you are doing to emulate his Crane (HYDQ) got down risk management? to $3 per share and now it Another company that we is going to be vola- is at $5.40 bid and $6.40 own, just to give you a PS: It is not really what we offer, but still down from really extreme example, is a tile. It doesn’t do. There are funds that $8. They put out good re- company called TNR Tech- work all the time, have very open charters and sults and things look good nical (TNRK). They distrib- funds that have relatively going forward – great funda- ute batteries. The stock is but over very long close charters. We have a mentals with a great man- at $8.50. They have very narrow niche that we agement team. 306,000 shares outstanding periods of time it seek to dominate and oper- One of our other names so the market value of ate in. For Seth Klarman, it that we are extremely bull- shares outstanding is $2.6 works.” is like the book Bringing ish on is Fortress Interna- million. They have $2.55 Down the House. These guys tional. They basically per- million in cash so you can

had six different tables and form a lot of technical con- buy the entire business for whichever table that was sulting, construction man- $47,000 dollars and in the hot, they would play at that agement, and server farm last 12 months they have table. Klarman just wants facility maintenance. This is generated $700,000 in oper- to have as many different a huge growth industry. ating income with no debt. tables as possible to play at They have had some prob- It is an $8.50 stock price and plays where the best lems in the past but they with $8.35 in cash – a 15 opportunity is. Our inves- have identified what those cent enterprise value and in tors want us to play at a were and are fixing them. the last 12 months they specific table and we tell We ran some numbers. earned $1.55. We have them that it is going to be The stock is at $1 per share been sitting on the bid and volatile. It doesn’t work all with 12.8 million shares whenever anyone comes in the time, but over very long outstanding with $12.5 mil- to sell, we buy stock. It is a periods of time it works. lion in cash. They have $6 $22 offer so at the offer it Over a ten year period, we million in debt, giving them looks quite different. At are up over 50% while the an enterprise value of about that price, it has a $6 million markets are at 12 year lows. $6.3 million. You can buy enterprise value – just 10x Over the long-term, we the whole business at $6.3 earnings. They had a large expect that we will have million. This is a business dividend a couple of years pretty good returns. If you that will do $80 to $100 ago so they distribute cash look forward ten years from million in sales and they and buy back stock. now, I think the returns are could easily do 5% EBITDA You are able to find these going to be absolutely ex- margins – probably closer to things if you just know traordinary because stocks 10% over time. However, where to look. are just so cheap and the over the last six months, luxury we get is that you’ll they have done $2 to $2.3 GD: So how to do you find see the significant rally in million in EBITDA so you your ideas? the broader market but it figure, even if they do takes a while to trickle $500,000 in each of the PS: I have known TNR for down to our names. So we next two quarters, they are years and years. I have a are able to get some confir- trading at 2x EBTIDA. You database in my head of mation and then we will get all the growth for free – thousands of companies that start seeing some people margin expansion and their (Continued on page 7) Volume III, Issue II Page 7

Paul Sonkin (continued from page 6)

(Continued from page 6) else is. We fish deeper and friend, so clearly your inves- I have been looking at over we fish alone, and I think tor base is important. How the last 20 years. I started that’s really it. We are do you communicate that out smiling and dialing at a looking for companies that issue with your clients? regional office of a wire- are unloved, there is no house, Dean Witter Rey- institutional sponsorship, PS: You need to manage nolds in 1986 so I have been there’s no analyst coverage, your investor’s expectations in this business for 23 years. where there’s very little very carefully. What we try “We fish deeper I have always loved micro liquidity, and where manage- to do is write very honest, and we fish alone, and nanocap stocks. We ment is pretty quiet – they sober letters and we tell don’t really do small cap if have been sort of “run si- our investors that we are and I think that’s you define small cap as $1 lent, run deep.” not the place to put all of to $2 billion. We really your money. You ideally really it. We are specialize at the sub-$100 So you go from unloved, no want to have less than 5% of million, which is the smallest institutional sponsorship, no your net worth with us be- looking for of the small. We are traf- analyst coverage, little li- cause it is a very risky strat- ficking in the smallest 40 quidity, and quiet manage- egy. Of course, we don’t companies that basis points of the U.S. mar- ment, to – these stocks be- feel it’s all that risky. are unloved, there ket where there are still come loved, they get the 8,000 companies. So there institutional sponsorship, GD: I guess that’s a matter is no institutional is still tremendous opportu- the analyst coverage, more of how you define risk. nity. liquidity, and management sponsorship, starts selling the story. PS: Right, the risk of a per- GD: How much capacity is manent capital loss. So, in there’s no analyst there to manage against that GD: Given the segment of terms of risk, it’s the perma- coverage, where kind of benchmark? the market in which you nent capital loss versus vola- operate, do have a higher tility. We think our perma- there’s very little PS: Chuck Royce has had hurdle rate for the type of nent capital loss risk is low, very good performance return you are looking for? but volatility risk is high. liquidity, and managing $1.5 billion in mi- Unfortunately, what we’ve crocaps. Their microcap PS: Clearly, we are always had over the past 18 where fund has a geometric aver- looking for a stock that can months is continually falling age of $200 million and return a multiple on our stock prices. But that cre- management is $600 million under manage- money. We look for situa- ates the opportunity. The ment in just that one fund. tions where the stock could issue is that investors who pretty quiet – So you can run a lot of easily double. With these have just lost money just they have been money. But I think $100 small companies, we’ve seen want the pain to go away. million is a good level for us. stocks go private at double That’s why they sell at the sort of “run silent, We peaked out at $130 where they were trading. bottom. And when things million and now we have We had one that went pri- are going well, it’s like they run deep.” about $50 million. We will vate at 7x and one that just don’t want the juice get back to about $100 mil- went private at 10x, so we taken away. People just lion and then we will start see those from time to don’t want to sell when to give money back. time. Usually, when you see things are going up and these really ridiculous that’s why investors tend to GD: It seems like your moves, the insiders have a sell at the bottom and buy search process is a large controlling interest, so at the top. It’s just human part of where you think you unless the buyer is willing to nature. Look at Fidelity get an edge over the mar- pay up, management isn’t Magellan, it has com- ket. Is that fair to say? willing to sell. pounded at whatever rates it has, but if you look at the PS: Where we get an edge GD: With your strategy, it rates of what investors have is by being where nobody sounds like time is your (Continued on page 8) Page 8

Paul Sonkin (continued from page 7)

(Continued from page 7) Our arbitrage investments Smith Investment Company made, it is half because peo- turn over and convert to for stock. For every share ple get in and out at the cash constantly, so our of Smith, you’re going to get wrong times. portfolio generates cash 2.84 shares of AO Smith, so flow that we can redeploy its kind of a spin-off in that GD: So clearly, illiquidity is into such situations. We sense. However, Smith Paul Sonkin ‘95, Dan Loeb, a particular challenge in have a situation now that Investment Company also and Craig Effron at the managing your portfolio. we’ve been waiting on for a has two or three other busi- Pershing Square Challenge You mentioned earlier that year and we are going to get nesses, which they spun-off you embrace diversification a huge slug of cash from it; into a liquidating LLC. We by holding a relatively large we are going to go from actually made money be- number of stocks. But how cause we were able to cre- do you deal with particular ate Spinco at a negative stocks getting cheaper and “So, with a lot of valuation. And we have a not being liquid enough to these companies, spread on the arbitrage take advantage? which will collapse. the spread PS: A lot of investors will GD: How much work do sell something cheap to buy between the price you put into a name like something cheaper. I don’t that? really see a lot of that be- and the intrinsic cause when something goes PS: It was a big position, so wrong, it’s priced into the value gets wider we put a lot of work into it. stock in this kind of envi- Typically, you start out with ronment. What I see hap- as the business a small position and you put pening in this kind of envi- a little bit of work into it. ronment is, let’s say a stock deteriorates be- As you start to build on the is trading at $8 and has an position, you do more and intrinsic value of $12. Let’s cause investors more work. Eventually, say that, later, the intrinsic your biggest positions are value falls to $6. In this just don’t want to the ones you’ve put the environment, the stock will most work into. go to $2 from $8. So, with own it.” a lot of these companies, GD: Do you think of your the spread between the fund as two different portfo- price and the intrinsic value 10% cash to 20% cash pretty lios – arbitrage opportuni- gets wider as the business quickly. ties and general value op- deteriorates because inves- portunities? tors just don’t want to own GD: What kind of situation it. is it – merger, spin-off, PS: It’s all one portfolio, but SPAC? liquidations are the best GD: So, even if you have places to be. Totally not the opportunity to do that, PS: Actually, it’s a merger/ followed by the market and a lot of times you might not spin-off/liquidation – a little you are doing a pure liquida- because the names are so bit of everything. There’s tion analysis. We’ve been in illiquid? this company called Smith business for ten years and Investment Company that we’ve had just one down PS: Well, one thing we do has always owned a control- quarter in our liquidation is hold cash to redeploy. ling interest in another com- portfolio. But the beauty of That’s one of the advantages pany called AO Smith. arbitrage is that they are not of our arbitrage portfolio. Now, AO Smith is buying (Continued on page 9) Volume III, Issue II Page 9

Paul Sonkin (continued from page 8)

(Continued from page 8) have pricing power, it must as correlated to the market. GD: You made the com- be in a very specific niche However, it can become ment about having a disci- industry. correlated, like in the cur- pline and sticking to it and Professor Bruce rent environment, when about not deviating. A lot PS: For example, a battery Greenwald credit is scarce and deals of guys that have come to distributer we own. I have are broken. So you will get Bruce Greenwald’s seminar seen this business model Bruce C. N. Greenwald some correlation to the class have talked about try- many times in the past. holds the Robert Heil- market in the tails, but arbi- ing to make some tweaks to They carry a lot of SKUs in brunn Professorship of trage is a wonderful place to what they have done in the inventory. If you need three Finance and Asset Man- be. past because of the huge of some kind of battery and agement at Columbia volatility in the market. The you need it tomorrow, you Business School and is GD: A lot of value inves- most popular comment has can get it from these guys. the academic Director of tors have been creamed been, “We’re going to pay a The only other option is to the Heilbrunn Center lately, but that doesn’t mean lot more attention to macro order 2,000 from China for Graham & Dodd they aren’t good investors. now.” Would that send you with a six month lead time. Investing. Described by If you can’t judge a manager running to the hills as an I’ve seen this model many the New York Times as based on recent perform- investor? times; they have a low “a guru to Wall Street’s ance, what should you look ROA, because of all the gurus,” Greenwald is an at to evaluate an investor? PS: It’s like closing the barn inventory, usually about authority on value in- How would you want to be doors after the horse has three years worth. They do vesting with additional assessed? gotten out. Everybody saw it because they are able expertise in productivity the signs, but you just didn’t earn high margins. When and the economics of think there would be this you speak with them, once PS: I think you need to look information. at the process and relate huge catastrophe. There they showed me an invoice the process to what has and are a few guys that had in- where they bought the hasn’t worked historically. surance against a huge catas- product for a nickel and We have tried to determine trophe and a few guys that sold it thirty-five cents. what works, which part of thought there would be a They’ve generated 10% op- the market is the richest huge catastrophe. But I erating margins as a distri- pond to fish in. Then we’ve think it was just a very low bution company. When tried to identify which bait is probability scenario that have you heard of a distri- the best to use – we fish actually played out. So bution company with 10% deep and we fish alone. If would I do anything differ- operating margins? Their you stick to your discipline, ently? I make mistakes every customers are paying for then you won’t get into too day and I try to learn from the convenience. That is much trouble. We stuck to those mistakes. Everybody the type of businesses our discipline and we are makes mistakes, but the fact model that we really look still down 50%, so people that so many people are for and they are out have asked us if we are will paying attention to macro there—and they’re cheap. change our discipline – I said economics…it’s not going absolutely not. I lot of the to be there because that’s GD: You have some ex- damage has already taken where everyone expects it. perience working for the place. Again, it’s this issue SEC. How has that influ- of people just wanting the GD: So with the companies enced the way that you pain to go away, they just you are looking at, you must think about the regulatory don’t want to look at it any- be looking for companies environment? more. Now, we are proba- that can dominate the very bly in the best time in a gen- specific niche industries in PS: In the class that I eration to be investing in which they participate. For taught, I used to bring in an these kinds of companies. these small companies to (Continued on page 10) Page 10

Paul Sonkin (continued from page 9)

(Continued from page 9) five different Buffetts. My you go to work, you’re SEC lawyer to talk about Buffett would be Buffett #1 probably going to need to insider trading and compli- from the Buffett partner- learn to do it in an eighth ance issues. The most in- ship. There’s Buffett the way. Arguing with your teresting thing from that value investor with Berk- boss is just not a good idea. perspective is that every- shire. The third incarnation thing is a grey area. What I is Buffett the rock star. The GD: On that note, maybe James Walsh ‘10 and would try to press upon the fourth incarnation is Buffett you could talk about some Christof Pfeiffer ‘10 students is that one bad that buys and holds busi- of the mistakes you have prepare for their pres- decision could affect the nesses. The fifth incarnation made personally. entation after coaching rest of your career. Before is Buffett the philanthropist. from Paul Sonkin you make any decision, I just So I identify most with the PS: Well, recently, we were want you to hesitate for an first and a little bit with the in cash for so long that as instant and think about what second. soon as we saw opportuni- you are about to do. ties present themselves, we GD: We were hoping to pounced on them. We GD: OK, ground rule: you talk a little bit about your should have waited a little can’t pick Buffett. Who’s involvement with the Per- longer and husbanded the your favorite investor? shing Square Challenge cash a little bit more. [Editors note: Sonkin taught PS: Oh, I wouldn’t have a master class this year at GD: Was that a market picked Buffett. Seth Klar- CBS in connection with the direction issue – mark-to- man. Pershing Square Stock Pitch market – or is it that you and Philanthropy Challenge.] didn’t realize how much the GD: Why do you say Klar- First of all, what did you businesses would deterio- man? You mentioned ear- think of the final output? rate? lier that he is a very differ- ent investor than you are. PS: The quality of the work PS: I think it’s more a mark- What about him – is it his was really excellent. I was to-market issue. There are record? very pleased with the effort some companies we own that most of the students where their business models PS: It’s not the record. It’s put in. have fallen apart, but you’re more the quality and clarity just going to have those, of thought, the discipline, GD: Where do you think particularly in a portfolio of and the creativity. Another students make the most microcap companies. But investor I have a lot of re- mistakes? for the most part, stock spect for is Walter Schloss. prices have really been irra- He kept it really simple, he PS: The most common mis- tional. Stocks are just trad- kept it small, and he has take that students make is ing way below cash on the tremendous discipline. He when a boss, for example, balance sheet or replace- also had a long, consistent asks him for a red umbrella ment value. It’s staggering. track record. I think he had and then he comes back the longest unbroken track with a blue one and an ex- GD: Thank you, Mr. Sonkin. record, I think it was about planation for how it’s going 45 or 46 years. It was to keep him dry. If you about 500 basis points for have seven different teach- 45 or 46 years. And he just ers, you might need to learn kept it really simple; buy how to do something seven cheap stocks. If you ask me different ways. Then you who I admire, I guess it’s can just absorb it and decide Buffett, but I think there are what suits you. Then when (Continued on page 11) Volume III, Issue II Page 11

The Mother of Distressed Cycles—Steve Moyer

the current cycle coming investing in the unsecured For over 20 years Steve Moyer well before it arrived. If we and perhaps even the sec- has become both a leading look only at the increase in ond lien debt of companies practitioner of distressed debt leverage over the last five with a lot of first lien debt investing and a teacher of its years it was foreseeable that potentially very risky. So as methodology and value to there would be a large num- always the issue will come investing strategy. His book, ber of distressed companies down to price relative to Distressed Debt Analy- once we entered into a re- valuation. While it’s really sis, serves as the fundamental cession. Of course, as with hard to generalize, unse- handbook for understanding most other investors, ana- cured paper may need to the particular factors and ap- lysts did not necessarily get cheaper before it pre- proaches that differentiate predict the severity of the sents an attractive risk/ distressed investing. His distin- downturn and that led to reward tradeoff. However, guished career has encom- many funds making invest- the complexity of capital passed both buy- and sell-side ments too early in the cycle structures and existence of positions at Tennenbuam and suffering losses as a CDS should present some Capital Partners, Imperial result. potentially attractive capital Capital, Banc of America Secu- structure arbitrage opportu- “While it’s really rities, Kemper Securities, This cycle will be much nities. hard to Drexel Burnham Lambert and broader than previous ones. First Boston. He graduated It will have a large number GD: Is it a fair statement, generalize, with honors from Grinnell Col- of “fallen angels” like GM then, to say that the fulcrum lege with a Bachelor of Arts and Chrysler and could in- security today lies some- unsecured paper degree in Economics, holds a clude much more participa- where within secured debt? Juris Doctorate from the Stan- tion by the financial sector. may need to get ford University School of Law, The lack of capital market SM: Again it’s hard to gener- a Masters in Business Admini- liquidity will drive a lot of alize, but yes, I think to the cheaper before it stration from the University of restructurings and liquida- extent secured creditors Chicago School of Business tions will become more want a restructuring (as presents an and is a holder of the Char- common if financing for opposed to attempting to tered Financial Analyst desig- reorganizations remains force a sale) they will likely attractive risk/ nation. Mr. Moyer recently sat limited. This cycle may also receive a significant if not down with Graham & be more litigious as capital controlling stake in the reward tradeoff.” Doddsville to discuss the structures have become debtor’s equity more so current distressed cycle, its more complex and credi- than in the past. Given the implications and potential tors fight over recoveries. proportionately large opportunities for value inves- amount of secured debt tors. GD: Comparing the lower today and the low market volatility approach of invest- valuations of firms, it’s prob- GD: Distressed investors ing in secured debt vs. the able that secured debt will were touting the arrival of potentially asymmetric re- often be the fulcrum secu- the next cycle as early as turns of buying bonds how rity. 2006 but to what degree did do you think of value and they expect it to take the rates of recovery in today’s GD: As for the ease of ac- shape we see today and distressed capital struc- cess to capital during the how have the rules of en- tures? bubble what kind of changes gagement changed when do you expect going for- compared to previous dis- SM: There is proportion- ward? tressed cycles? ately more secured debt in many capital structures in SM: I don’t think I’d be going SM: Investors definitely saw this cycle. That will make (Continued on page 12) Page 12

Steve Moyer (continued from page 11)

(Continued from page 11) ten used diversified posi- times having more experi- much out on a limb to pre- tions throughout the capital enced parties leads to more dict there will be less debt structure as a way to man- rational solutions, it can also in capital structures for the age the upside/downside inject a lot of contention foreseeable future. Among tradeoff. Given the severity into the process. So, while other reasons, CDO’s will of the sell-off that’s hap- the exact effect the litigation either disappear or become pened in many investment will have on returns is un- much less viable which will markets generally, a lot of clear, I do expect more in- reduce an important inves- investors are willing to leave ternecine warfare among tor class that contributed to some money on the table in creditor classes given the the last bubble. In addition, favor of lower volatility and incremental complexity in the underwriting pendulum are looking for investment capital structures. Also, as will swing back and leverage styles that they perceive as we get to the recovery ratios, covenants and other offering an “increased mar- phase of the recession, underwriting criteria will gin of safety”. Time will tell more junior creditors may tighten significantly. whether that is a permanent view it as in their best inter- shift in investor psychology est to delay the process GD: How do you think or whether they become hoping that the economic about the margin of safety more absolute return fo- outlook for the debtor will on a distressed investment? cused. improve leading to higher valuations and recoveries. SM: Generally speaking the GD: Intense litigation seems margin of safety in dis- to be a major theme of this GD: The increased competi- tressed investing can be cycle as well. Will this have tion you reference is per- difficult to quantify. Dis- any impact on returns from haps a reflection of the size tressed investing can be as distressed investments? of the opportunity in this much art as science since distressed cycle. How do returns often depend on SM: First to comment on you envision the near-term unquantifiable variables in the phenomenon [of in- growth and success of the the bankruptcy process. creased litigation], part of distressed fund industry? Looking back at the 1990’s the reason you might see and in 2000, the concept of that more is that we have a SM: There’s a growing con- “margin of safety” was not significantly larger group of sensus that there’s going to nearly as important as it is investors that are savvy be a lot of opportunity in today for a lot of institu- about the bankruptcy/ the distressed market. tional investors. The advent restructuring dynamic. In Wilbur Ross’ prediction that of VAR [value at risk] analy- the 1990’s there weren’t as this would be the “mother sis and the focus on return many people that under- of all distressed cycles” is correlation and volatility has stood the bankruptcy proc- probably right. But that to a certain extent changed ess. In the 2000 cycle, many doesn’t mean outsize re- the vocabulary of distressed of the investors of the 90’s turns will be either easy or managers. had left the game, so we certain. Many investors were again left with a rela- have already been burned In past cycles, the combina- tively small number of ex- because they were early and tion of less secured debt, perienced workout inves- the opportunities to reor- structural inefficiencies in tors. ganize are limited due to the the distressed market and limited market for DIP fi- economic conditions re- This time around, we have a nancing. In addition, much sulted in the fulcrum class lot of players that know more dedicated distressed being lower in the capital how to play the game and structure and investors of- play it well. While some- (Continued on page 13) Volume III, Issue II Page 13

Steve Moyer (continued from page 12)

(Continued from page 12) wouldn’t get so bogged that is increasingly difficult. capital has been raised this down in second-guessing a So, it’s no surprise that a cycle so the market may not manager’s strategy and its good number of DIP loans get as technically oversold effectiveness as opposed to we’ve seen have been from as it did at the peak of some focusing on choosing the the existing secured credi- of the previous distressed manager with great experi- tor constituency and have cycles. That may limit over- ence and a proven track used roll-ups of existing all returns as a class and put record. debt as an inducement to an even greater premium on commit more capital. I sus- the specific manager. Going GD: How do you approach pect that trend will continue back to the big picture, the search process for gen- unless asset valuations in- though, if the recession is erating investment ideas? crease. prolonged and capital for HY companies to refinance SM: I’ve had the benefit of GD: Aside from your book remains restricted, there watching an incredible what would you consider as “Wilbur Ross’ will be a lot of distressed change in technology over required reading for today’s paper and that usually leads my twenty year career. We distressed value investor? prediction that to opportunity. have so much access to in- formation and data, it’s fairly SM: I think there’s a lot of this would be the GD: Are there any specific easy to run quantitative substantive literature com- strategies that will return screens as a starting point ing out of bankruptcy law “mother of all more than others or garner for idea generation. But, of firms that is very helpful/ more attention from poten- course, that’s just the begin- useful. There are many distressed cycles” tial capital? ning of the process. The more law firms trying to depth and quality of work establish a presence in the is probably right. SM: There are so many as- required today relative to reorganization field and one set classes from which to the industry norm back in of their chief marketing But that doesn’t choose as an investor in this 1990 is night and day. I also tools is to publish analyses cycle. One driver of returns think utilizing one’s network of legal developments in the mean outsize among these classes may be is critically important. Being field. It’s critical to pay close whether it’s a class that has able to talk to a bunch of attention to changes in returns will be yet to attract a lot of the different people in the in- bankruptcy law and under- capital and thus have a dustry allows for great idea stand any potential impacts either easy or greater chance of getting flow back and forth. on the process. On the ana- oversold. Take, for example, lytical side, there’s some certain.” mortgage securities. There good analyses published by has never been this much GD: DIP (Debtor in Posses- the research departments at distressed mortgage paper sion) financing has made a the different [Wall Street] before. Although some slow re-entry into the mar- firms. Even if there isn’t one dedicated distressed mort- kets. What has to happen on every situation of inter- gage capital has been raised, before DIP loans become est, they can do a good job it’s small relative to the lit- readily available to firms of laying out the issues and erally trillions of potential filing Chapter 11? the analytical approach. supply. That’s why you see the government getting in- SM: Well, if you’re a pro- GD: Finally, if you were a volved in trying to attract spective DIP lender you young analyst graduating more capital to the area. As have to have adequate from business school today, for which strategies will be credit support for your what would you look for in effective for fundraising – I loan. But with so much a firm when recruiting? think if institutional inves- secured debt in place in tors were smart, they today’s capital structures, (Continued on page 14) Page 14

Moyer (continued from page 13) || Heilbrunn Reception

(Continued from page 13) lumbia Business School with national franchises. alumni headed across N However, exactly how SM: Well my view has 10th Street to the Omaha Wells Fargo is different, he changed over the last two Hilton, where the Heilbrunn left unsaid. Greenwald pro- years but one obvious an- Center hosted an alumni vided his own supposition swer in this cycle is you reception and speaker that the difference lies in want to go to a fund with panel. After digesting the Wells Fargo’s decision to locked up capital. There are day’s events and reconnect- manage the company as a a lot of funds with great ing with former classmates, collection of regional banks, analysts that are closing CBS alumni were treated to which provides lower cost their doors due to redemp- an exceptionally thoughtful deposits and better risk tions and there’s nothing panel of speakers that in- management compared to a you can do about that. Being cluded Professor Bruce single national bank model. able to take the long-term Greenwald, Thomas Russo view is critical and locked of Semper Vic Partners, and After Greenwald concluded up capital permits that. You Adam Weiss (CBS ’96) of his remarks, Russo spoke “Many shall be should also try and get a Scout Capital. on the search for value in good understanding of the global markets, and then restored that now investment process at a firm Topics discussed covered a Weiss delivered a compel- – something you may only wide range of subjects from ling speech on the relevance are fallen, and gain from the junior guys if the day’s events and the of Security Analysis 75 years you can find one that will be legacy of Benjamin Graham after its first publication. In many shall fall candid about the reality and David Dodd’s Security addition to highlighting Gra- that now are in versus the party line: is it in Analysis, to the pitfalls of ham & Dodd’s warnings reality one primary decision investing in bank stocks against investing in banking honor.” - Horace maker, how political is the based only on projections of stocks saddled with nonper- process, can you get stuck normalized earnings and the forming mortgages from in an out of favor sector, search for value in global another era, Weiss brought those sorts of issues. Of markets. Greenwald kicked up a quotation he once course, you want to find a off the panel by pointing out heard that had resonated firm that agrees with your that although Buffett gener- with him so much that he investment style and ap- ously shares a great deal of decided to have it framed proach. Ultimately, you the insight and reasoning and displayed prominently in should find good people that underlie his investment his office: “Many shall be with whom you think you decisions, at times it is what restored that now are fallen, would enjoy working and Buffett does not share that and many shall fall that now can learn from because accounts for his success. As are in honor.” Upon reread- there’s no substitute for an example, Greenwald re- ing Security Analysis after that basic element. ferred back to earlier in the many years, Weiss was sur- day, when Buffett told those prised to find that very GD: Thank you very much, in attendance how he was same quotation staring back Mr. Moyer. prompted by a visiting class at him. Even though the of Chicago MBAs in March practice of value investing Berkshire Annual to declare that he would has evolved greatly since the have put his entire net publishing of Security Analy- Meeting & Heilbrunn worth into Wells Fargo that sis, Weiss’ story provided a Center Reception day at under $9 a share. striking example of just how Buffett went on to explain much we have all been influ- On May 2, 2009, after War- that this confidence was enced by Graham & Dodd. ren Buffett concluded the because Wells Fargo is dif- This article was contributed by Berkshire Hathaway Annual ferent than other banks Matt Gordon, MBA ‘10. Shareholders Meeting, Co- Volume III, Issue II Page 15

Berkshire Annual Meeting (continued from page 4)

(Continued from page 4) these two men could sit Tom Russo of Gardner and looked happier than there for so long in such Russo Gardner, and Adam two kids in a sandbox. The comfort with no break. At Weiss of Scout Capital Q&A period broke for a ½ 3:30pm, the Q&A period shared their thoughts on hour lunch and then re- ended and the formal annual the meeting and the endur- sumed. meeting began, whereupon ing relevance of Benjamin the board of directors were Graham and David Dodd’s The most intriguing ques- reelected by majority vote. 1934 Security Analysis. Illus- tions were those Warren Interestingly, a shareholder trating its ongoing rele- didn’t really answer. Who had put forth a motion re- vance, Adam Weiss cited was in line to replace him as questing Berkshire to pro- passages from Security Analy- CEO and head investor? duce a sustainability report. sis that warned against over- There were three candi- This was my first exposure levered institutions. Tom “Our model is a dates for CEO and four for to criticisms against some of Russo explained how his seamless web of CIO, he said, but he didn’t Berkshire’s subsidiaries. best investments had come give any names. Why did he According to the share- from companies that had trust that’s hold Wells Fargo stock? If holder’s representative, grown in value and bene- he could only invest in one there were allegations of fited not only when the deserved on both company, he replied, it labor violations at a Russell market recognized its intrin- would be Wells Fargo. Of Athletics factory in Hondu- sic value, but when the sides. That’s what ras. Several Ivey league company grew and its multi- course, he never said why. we’re aiming for. schools had discontinued ple expanded. How did he evaluate and their use of Russell Athletics The Hollywood incentivize managers? That because of these allegations. Professor Greenwald shared was a great question, he The representative then his perspective on Buffett’s model where responded. “We don’t passed the microphone to a incomplete answers. Why want relationships that are worker from the Russell was Wells Fargo different everyone has a based on contracts,” he factory in Honduras. She from most other banks? said. Charlie Munger added: spoke for 10 minutes in Because it focused on local contract and no “Our model is a seamless Spanish about the cramped economies of scale, he said. web of trust that’s deserved workspace, long hours with Unlike other banks, Wells trust is deserved on on both sides. That’s what few breaks, and anti-union Fargo had concentrated its either side is not we’re aiming for. The Holly- activity. Following her testi- growth in the west, not wood model where every- mony, Warren asked the across the entire country, as what we want at one has a contract and no CEO of Russell Athletics to did See’s Candy. What trust is deserved on either respond. He outlined the made Buffett’s contracts all.” - Charlie side is not what we want at actions they had taken to unique? They incentivized all.” Then Warren cited improve conditions, and managers to not only pur- Munger Peter Kiewit’s contracts how a non-partisan labor sue growth, but to achieve (who founded Omaha’s larg- rights group had been in- profitability. Following the est construction company) vited to monitor and evalu- reception, we drove to the as an example, without ate the conditions. The Nebraska Furniture Mart specifying what those con- motion was then put to a for a western BBQ cook- tracts entailed. vote and defeated. out. I was expecting a large warehouse like Costco and By 2pm, we were all getting Following the meeting, Co- was shocked when we ar- fidgety. I didn’t want to lumbia Business School held rived. At 77 acres, the Ne- miss a word, but my legs a reception hosted by the braska Furniture Mart was were beginning to cramp. I Heilbrunn Center for Gra- not only larger than eight had to get up and walk ham and Dodd Investing. Costco warehouses laid side around. I couldn’t believe Professor Bruce Greenwald, (Continued on page 33) Page 16

Precision Castparts Corp. (Winner of the 2009 Sonkin Prize) Chuck Murphy March 2009 [email protected] Company Description: Precision Castparts Corporation (PCP) manufactures specialized metal components for original equipment manufacturers in aerospace (53% sales), power generation (27% sales), and other industrial (20% sales) markets. While these end-markets are cyclical, a substantial portion (roughly 30-40%) of PCP’s business relies on maintenance and repair-based sales. PCP is or- ganized by product type, including investment castings (33% sales), forged products (44% sales) and fastener (23% sales). Thesis Summary: PCP’s business is misunderstood for two reasons. First, PCP will continue to benefit from the secular shift to high performance materials, such as titanium. This represents an Precision Castparts (PCP) organic growth opportunity of 5-10% per annum, which will at least partially offset cyclical declines. Price: $63.85 Second, a substantial portion of PCP’s sales includes content required by its customers to properly (March 2, 2009) maintain their capital base. Moreover, PCP has dominant market share in its core product areas— FV Target: $90 e.g., as much as ~90% in large-diameter structural castings—and generates 22% returns on invested capital, which have risen with its increasing size. In addition to excellent management, it is likely to sustain these returns on capital due to three structural advantages. (i) Scale and (product) scope economies. Scale enables PCP to offer lower prices than competitors in exchange for four or five- year contracts, which in turn creates higher customer switching costs. (ii) Captive customers. Most parts are custom-designed for specific, precise end-products; OEMs (or ultimate owners) cannot replace them with “generic” substitutes. Front-end collaboration forges trusted relationships. (iii) Proprietary manufacturing processes. PCP’s know-how is a function of unique manufacturing proc- esses, engineering expertise, and custom-tailored equipment and tools. It is difficult to replicate. Valuation: PCP’s current price of $64 implies an extreme bear-case scenario, including (i) a severe downturn followed by no meaningful recovery and (ii) relatively poor sales and margin execution by management. (See reverse-engineered DCF analysis on opposite page). It is unlikely that both of these conditions will present themselves simultaneously in the next cycle, particularly given manage- ment’s stellar execution in the last recession. Assuming a severe downturn with a modest recovery and solid execution, I arrive at a cash flow-based intrinsic value of ~$90 per share. Risks to the upside include (i) consolidation opportunities and (ii) escalating 787 build rates. Risks: A deepening recession would certainly adversely affect PCP’s business but it would not impair long-term cash generation. Moreover, passenger miles flown and demand for electricity have been remarkably stable in prior recessions. Due to its strong competitive positioning, PCP is able to “pass through” commodity price fluctuations directly to its customers, thereby insulating itself from infla- tionary pressures. Catalysts: One of the difficulties of investing in PCP now is that there are no immediately obvious events that will unlock value in the next ~12 months. At the same time, it is possible that EOMs could “push out” or cancel orders, which would probably cause the stock price to fall further in the short term sales prospects. The following is a brief list of potential events that could improve short- term valuation: Competitor has a liquidity problem. Of the available options, Alcoa would be the most likely candidate given that it recently implemented a large dividend cut in order to preserve cash. Regulatory change in the U.S. and/or U.K.. New fuel efficiency requirements for aircraft or other industrial products could cause increased demand for PCP’s products. Fundamental perform- ance beats expectations. Over the medium and long-term, PCP’s fundamental performance should be a catalyst for the stock, as outlined in my valuation analysis above. Assuming no short term catalysts and a difficult industry recession lasting through 2012, investors may have to wait until 2012 or 2013 in order for the market to recognize PCP’s long-term value. In this scenario, the IRR on investing in PCP today would be ~23% (assuming value is realized by 2012) and ~17% (assuming 2013). Growth Drivers: PCP’s growth has been higher than that of its end-markets. The Air Transporta- tion Authority expects global commercial airline capacity to grow at ~3% annually through 2025; similarly, the International Energy Agency expects that world demand for electricity will grow by ~2.5% per year through 2030. By contrast, specialty metal component manufacturers to the aero- space and energy markets have grown at a 10% CAGR over the last 10 years. PCP has gained share, growing at a 20% CAGR—roughly twice as fast as its market peers—over the same period. Back-of- the-envelope analysis suggests PCP’s historical CAGR comes from the following sources: Aerospace/ energy end-market growth: 2-3% per year; Acquisitions: 10-12% per year; Shift to high-performance material: 5-8% per year. Driver #1: OEMs are switching from steel and aluminum to lighter weight composite and titanium parts; this trend is especially pronounced in aerospace. PCP and its peers have benefited from increasing demand for castings and forgings made from composite metals (e.g., titanium alloy) and titanium, which are more difficult to work with and thus require highly- Volume III, Issue II Page 17

Precision Castparts Corp (Continued from previous page) sophisticated manufacturing processes. Fuel efficiency is paramount. Lighter-weight metal components allow end-users to reduce their total cost of ownership. Fuel represents ~30% of operating costs for an average commercial jet liner, whereas maintenance materials are roughly 2%. Increasing demand for com- posite parts feeds on itself. Aluminum corrodes when it is bonded to composite material; thus, by intro- ducing composites, OEMs must employ titanium (which is corrosion-resistant) or still more composites in its place. Titanium usage has doubled from ~8% of the airframe weight on the Boeing 747 to ~15% on the (forthcoming) 787. This has resulted in a 10-fold increase in revenue per ship set for PCP. Driver #2: Consolidation—since fiscal 1998, PCP has spent ~$3.6 billion on acquisitions; based on a partial list 11 out of 20 transactions, it has paid an average multiple of 0.9x-1.1x sales. This multiple implies that 50- 60% (or $3.4 billion) of PCP’s incremental revenue has come from acquisitions. Valuation: Price-implied expectations for PCP are unreasonably low at $60 per share. To produce the current price, one must assume a downturn 2x worse than 2001-2003, followed by an anemic recovery, which results in a top- line CAGR of -1% over the next 10 years. In addition—this part is more far fetched—one must assume management is unable to control costs as well as it has in the past. E.g., although PCP’s sales volumes were down ~20% in 2003, management was able to increase oper- ating margins by 100 bps in investment castings and limit declines to 200 bps in forgings, its most fixed-cost intensive product line. My $90 fair value estimate assumes PCP grows at a CAGR of 4-5% over the next 10-year cycle (versus 20% in the last cycle). Also, I gave manage- ment credit for its proven ability to trim capacity and sticky expenses during periods of falling volumes; still, I assume margins contract modestly during the downturn. Finally, I assume a discount rate of ~10%, gradual debt repayment, and the current fully diluted share count. Page 18

Apollo Group - Short (Winner of the 2009 Pershing Square Challenge)

Apollo Group (APOL) Price: $66.97 Tim Rupert ‘09 ([email protected]) April 2009 (July 17, 2009) Grant Bowman ‘10 ([email protected]) John Piermont ‘10 ([email protected])

Apollo group is priced to perfection while the outlook is far from perfect. In order to maintain its current valuation, APOL must increase its enrollment by more than 70% which implies an unrealistic share of the total addressable market. They must do this in the face of increased regulatory scrutiny, more competition and deteriorating student defaults. There was a critical inflection point in APOL’s business in 2005. Associate students rep- resented less than 5% of the total in 2004, but today represent more than 40% of total enrolled students and more than 50% of new starts. This represents a fundamental de- terioration in the business, as Associates degree students pay 25% lower tuition, are 30% less likely to graduate and have default rates of 27% vs. 7% for Bachelor degree students. As a result of rising defaults, APOL stopped enrolling Associate students at its 2-year school and began enrolling them at the University APOL has traded down to Associate degrees to continue growth of Phoenix in order to conceal them among the larger bachelor degree student body. Despite these efforts, our analysis indicates APOL is in APOL Student Enrollment by Year (000s) jeopardy of violating its Title IV eligibility requirements 200 171k Assoc. in 2009 after reflecting a new default test and rising defaults for all consumer loans. Even if APOL does not violate its re- 150 quirements, it will have to scale back Associate enroll-

100 ments in order to manage its cohort default rate (CDR). The new method for calculating CDRs has extended the 50 default period, which will result in higher CDRs and will 10k Assoc. in 2004 require APOL to track its former students for an another 0 year in order to keep them current on their loans. This 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 will pressure APOL’s margins. The test for cohort default Ass oci a tes Bachelors rates has increased from a two-year test to a three-year 4 Source: Company reports test. Student lenders estimate this will result in a 40-60% increase in defaults numbers. Additionally, performance for similar consumer loans has steadily deteriorated. Losses on credit cards and con- sumer loans have increased by 50% and 70% respectively. For-profit education is perceived to be countercyclical. This has not been the case in past economic downturns. During 2001 to 2003, for-profit education performed well but that was not the case during past recessions. The Education has not been countercyclical during past recessions for-profit education industry

took off in that period due to 30% a rapid expansion of online 25% degrees. The overall educa- 20% tion market did not perform 15% well during that period. If 10% APOL is countercyclical: 5% Why are FAFSA applications 0%

down? Why is APOL having ‐5% 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 to spend more per new ‐10% start? And why aren’t ‐15% APOL’s enrollment counsel- For Profit Total Market 2 year institutions Periods of increase in unemployment or decrease in GDP ors becoming more produc- 6

Source: National Center for Education Statistics, Bureau of Labor Statistics, and the Bureau of Economic Analysis Volume III, Issue II Page 19

Apollo Group (Continued from previous page)

Associate degrees are the educational equivalent of subprime tive? Public universities pose a threat to APOL and the for-profit education industry. Our 2006 APOL Cohort Default Rate (CDR )Percentages primary research with a board member Public 2‐Yr 3.4% 3 Year Test 1 Year Test and graduate of one of APOL’s for-profit 6.4% Public 4‐Yr competitors indicates that public universi- 7.2% APOL 4‐Yr ties are a real threat. Our contact indi- 27.4% APOL 2‐Yr cated that: “You can do everything at Est. Pro Forma the University of Minnesota that you 35.8% Low can do at [For-Profit school]. That 40.2% High wasn’t the case 8-12 twelve years 0% 10% 20% 30% 40% 50% ago. The only reason I didn’t go to U. of 5 Source: Department of Education and our estimates M. was I had a job and didn’t want to lose it. There was just no flexibility. Now there is. U. of M. will take the students back that it lost to [For-Profit School].” We’ve spoken to a number of public universities Per student valuation summary that have online degree programs. In 2002, only Per Student Valuation Analysis: Comments/Assumptions 15% of public universities offered online degrees, Average Revenue Per Studen t $9,500 LTM of $9,448 Average Discount (475) LTM discounts of 4.8% today that number is above 60%. For-profit com- Net Revenue $9,025 Instructional Costs (4,000) LTM of $4,013 petitors are also an increasing threat. The number Contribution Margin $5,025 of new for-profit schools has doubled since 2000. % Margin 56% Ann ual Marketing Expenses: This manifests in increased pressure for leads. Our Marketing Cost Per New Start $2,700 LTM of $2,735 Required Starts 76% Given 55% churn, must start 0.76 students per year to maintain en rol lment primary research with for-profit lead generators Ann ual Marketing Expenses $2,052 indicates that the typical number of bidders has G&A / Student $600 LTM of $659 greatly increased and that leads prices have in- Pre‐tax CF Per Student $2,373 Taxes (@38%) (902) creased by 50%. A/t CF Per Student $1,471 Discount Rate 8.0% 10.0% 12.0% APOL’s growth has been achieved by rapidly ex- Implied Value Per Head $18,391 $14,713 $12,261 panding its enrollment staff. We don’t need to get Note: This assumes APOL maintains 1 student into perpetuity and reflects required annual into the enrollment tactics, but let’s just say these marketing expenses to offset churn

counselors could sell Mexican timeshares. APOL is 19 vulnerable to competition because it does not pro- vide attractive value to its customers. An “education” at APOL costs more than at public universities, yet students receive less support and are far less likely to graduate. The best evidence of APOL’s customer value proposition is its dismal retention rate, which is the lowest among all reporting online colleges. Its reten- APOL offers dismal customer value proposition tion is also lower than no- torious high churn indus- Average tuition $15,500 tries like diet programs $13,046 and fitness centers. You’re $10,400 more likely to stay with $6,585 Their slogan should be: Jenny Craig than APOL. $2,402 Pay More. Get Less. Importantly, this results in APOL 2‐Yr Public 2‐Yr APOL 4‐Yr Public 4‐Yr NFP 4‐Yr APOL having to continually Sources: US Department of Education Institute of Education Statistics, College Entrance Examination Boar d and Un iv ersity of Phoenix. Tuition figures are for in‐state en rollments. Graduation rates Retention rates (new starts) replace its student base.

APOL 4% APOL 28%

For Profit Colleges 25% Online Colleges 56%

Online Collegs 37% U of Arizona 80%

Public Universities 55% Other High‐Churn Industries

U of Arizona 56% Diet Programs 30%

National Average 57% Pre‐paid wireless 50%

Private Colleges, NFP 64% Fitness Centers 60% 10

Source: National Center for Education Statistics and Digest of Education Statistics (Dept. of Education). Source: National Center for Education Statistics and Digest of Education Statistics (Dept. of Education). Page 20

Focused on Essentials: Hartch & Keller of BBH Core Select

Timothy Hartch and Michael priority is to preserve capi- estimates. Keller, CFA, are co-managers tal and our second priority of the BBH Core Select Fund. is to grow it. These dual MK: We use an intrinsic Mr. Hartch received an A.B. objectives drive our focus value framework. Most of- from Harvard University, on market leading busi- ten, this means we are using where he was elected to Phi nesses providing essential a DCF or economic profit Beta Kappa. He also received products and services. model. We augment these an M.B.A. and J.D. from the methods with other ap- University of Michigan. Mr. MK: And, by the way, most proaches such as backward Keller previously worked for of the $5 billion in equities valuation analyses that use KeyBanc Capital Markets and that we currently manage is the current price to deter- earned a B.S.E. from Princeton from our private wealth mine what growth and prof- University. management business, al- itability assumptions—as though the mutual fund is well as returns on capital— growing steadily. are embedded in the stock GD: You’ve noted in the price. A current example in past that the BBH Core which we have used this Select investment criteria approach is Dell. Dell is grew out of Brown Broth- facing a horrendous hard- ers Harriman’s successful ware environment and weak M&A advisory and private “We have a cul- corporate PC spending, but equity activities. Are there our work suggests the mar- other ways you are influ- ture that ket is pricing in negative enced by being part of this growth into perpetu- firm? emphasizes ity. Essentially, the company is being valued as though it Timothy Hatch (top) TH: Yes, several members integrity and is a run-off business, and we and Michael Keller of our equity investment feel that’s unjustified. (bottom) - co-managers team including me began capital preser- It’s true that we will look at of the BBH Core Select our careers here at BBH in comparable private transac- mutual fund. M&A and private equity and tions, mostly as a sanity the Fund’s investment strat- vation. We try check. It is not the primary egy reflects that heritage. tool. It is just to supple- Brown Brothers Harriman to keep things ment the DCF valuation to is also a privately owned make sure we are not arriv- bank and we have a culture simple, avoid ing at a value that is grossly that emphasizes integrity inconsistent with actual and capital preservation. big risks and transaction multiples. We try to keep things sim- ple, avoid big risks, and fo- focus on what is GD: That said, given falling cus on what is important. transaction values in the The Core Select investment important.” current environment, how strategy was originally de- have you adjusted your pri- signed for clients of our vate market value estimates? private wealth management Are you finding that your business, many of whom are GD: It seems like there intrinsic value estimates owners or former owners might also be a link in terms have changed much in the of private businesses. They of valuation. In addition to last year? tend to understand and ap- DCF, I’ve read that you also preciate our criteria and use private market values to MK: As we define it, intrin- share our goals. Our first arrive at your intrinsic value (Continued on page 21) Page 21

“BBH Core Select” (continued from page 20)

(Continued from page 20) usually not relevant to how don’t often find ourselves sic value is not a rapidly much a company is worth needing to screen for new fluctuating number. It is a today. ideas. Not every company relatively fixed conception and industry fits the stan- of value. Valuation models TH: Also, our process is dards we are looking for. themselves don’t yield any not just about valuation. It’s Some companies are not certainties – false precision about fundamental analysis going to make the shopping and overly optimistic as- and due diligence. We don’t list now or ever. Given our sumptions can undermine spend much time trying to objectives, we like to have the exercise. Looking at guess about macro factors. reasonable visibility into “As a general comparable transaction mul- We maintain an exclusive what a company will look tiples can bring you back focus on our investment like 10 or 15 years down point, we spend down to earth. Also, it’s criteria, and we try to as- the road. Not many busi- wise to examine the embed- sess the risks outside of nesses offer that. We are zero time focusing ded marginal returns on management’s control. It’s investing in tremendous capital in the forecast period how you would think if you franchises with durable on historical to make sure you have owned 100% of a business. competitive advantages. valuation ranges made realistic assumptions. We approach public equity The idea is to stimulate investing with the same long GD: It sounds like your in- for companies or thought and protect against -term strategy. vestment criteria are mostly some of the common short- qualitative (e.g., loyal cus- industries. How comings you find with DCF GD: How do you proceed tomers, essential products, modeling. with due diligence in the etc.). Is that right? the market valued large cap space? Where do Complexity in modeling can you think you are getting an TH: I think you are correct a company ten be the enemy of clear think- edge over other investors? to say that our criteria are years ago is ing. We often gain greater Is it more in the valuation largely qualitative. We start insights from simple models, or the screening process? by figuring out which are usually not rele- such as one we use that the right businesses. Then distills our forecasts into an TH: Because we focus on we look closely at manage- vant to how much IRR calculation showing our large cap public companies, ment to see if they are good prospective returns from there is only so much addi- allocators of capital. Finally, a company is today until an exit a few tional information you are we look at price. Price is years out. We assume that going to get from meeting really the third step, but still worth today.” the cash flows during the with management. Also, if a critical step, in our proc- holding period either pay you are doing work on eBay ess. down debt or are used to or Microsoft, you may not repurchase shares. Here, have the same kind of ac- MK: Often qualitative fac- we’re asking the question, cess to senior management tors will get you to the “If you were buying the that you might find in the quantitative. There is quite whole business, what sort of small cap space. So we do an overlap between a com- return could you reasonably as much work as we can pany’s returns on capital and generate?” The higher the with a company and then its qualitative characteristics, better – we like to see re- find former executives, cus- such as industry structure turns at least approaching tomers, competitors, and and competitive position. the mid teens. other knowledgeable indus- try participants that can GD: Can you think of a time As a general point, we provide additional insight. when you have waived one spend zero time focusing on or more of your criteria and historical valuation ranges MK: I think it’s important, why? for companies or industries. too, to understand that our How the market valued a criteria create a fairly small MK: I wouldn’t say company ten years ago is set of opportunities, so we (Continued on page 22) Page 22

“BBH Core Select” (continued from page 21)

(Continued from page 21) companies aside, most of and operations supplies to “waived.” But as an exam- the others are trading be- industrial and commercial ple, we own positions in tween 50-70% of intrinsic businesses. Grainger has two oil and gas compa- value. been the dominant company nies—XTO and Occidental in its space for decades, yet Petroleum—despite the fact GD: How does this com- it still has less than 5% share that their revenues are pare to other companies on of a $140 billion market. largely determined by com- the shopping list that are We think Grainger has an modity prices. not in the portfolio? opportunity over many years to double or even “Our investment TH: In other words, these TH: There are many busi- triple its market share. Rela- decisions don’t just are companies that might nesses that we follow that tive to its competition, the fall short on our “loyal cus- right now are trading below company has a broad prod- come down to the tomers” criteria. Their our intrinsic value estimates, uct line, great geographic products are have-to-have but our investment deci- coverage, and significant companies but they are commodities. sions don’t just come down scale and purchasing power. to the companies’ discount discount to MK: Both XTO and Occi- to intrinsic value. It’s also GD: Does Grainger have a dental acquire and exploit the quality of the business intrinsic value. It’s loyal customer base? proven resources rather and the risks. Right now, I also the quality of than taking wildcat explora- think we have the opportu- TH: Yes, Grainger has a tion risks. Nor are they nity to buy some of the best strong customer value the business and focused on the downstream businesses at very reason- proposition that generates side of the business where able prices. For example, repeat purchases. From a the risks. Right margins aren’t very attrac- late last year we purchased customer’s perspective, 40% tive. Both companies have Dentsply (NASDAQ: of the cost comes from the now, I think we very low finding and devel- XRAY), which is the leading process of purchasing sup- opment costs and the ability provider of consumable and plies, rather than from the have the to increase production sub- other products to dentists. actual cost of the supplies opportunity to buy stantially over the next dec- This company has a power- themselves. Grainger helps ade. And if you pick up ful sales force, strong reduce the process costs. some of the best Occidental’s annual report brands, and a broad product You can’t take for granted and read it, you will be very line. Dentistry is also bene- things like the fulfillment of businesses at very impressed with manage- fiting from very positive purchase orders, which can ment’s emphasis on return demographic trends, which be a huge headache. If a reasonable on invested capital. should fuel increased de- customer goes to a local mand from developed and distributor for a critical part prices.” GD: How large of a dis- emerging markets. Histori- —and they don’t have it— count is the current portfo- cally, Dentsply’s share price then that person has to lio selling at versus your reflected these many posi- spend more time looking estimate of intrinsic value? tives and traded at lofty around for it. Grainger cov- multiples. But currently ers 99% of the country and TH: Of the 30 companies in Dentsply is trading at $26 is able to offer a higher level the portfolio, there are two or under 14x this year’s of service, including one-day that have balance sheet is- EPS. Our intrinsic value delivery, which its competi- sues —those would be Lib- estimate is north of $40. tors can’t match. erty Media Interactive and Another high quality addi- Aflac— and they are both tion to the portfolio last GD: Have you ever looked trading at about 30% of our year was W.W. Grainger. at Pool Corporation intrinsic value estimates [as They are a leading distribu- (NASDAQ: POOL)? It has a of March 31st 2009]. Those tor of maintenance, repair (Continued on page 23) Page 23

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(Continued from page 22) rials and Martin Marietta. had problems in its $65 bil- similar franchise in the pool Again, we like both busi- lion investment portfolio. It construction and mainte- nesses a lot, but right now holds over $8 billion of jun- nance supplies distribution we just own Vulcan. ior debentures issued by business. European financial institu- MK: We pay almost no tions. Investors have been TH: We have in our small attention to sector weight- concerned that some of cap team. As I recall, they ings relative to indices. these financial institutions also have strong manage- Some over-weightings in might fail. ment and an enviable com- our portfolio might not be petitive position. But I’m surprising given our criteria MK: A critical difference “We have not sure about the steady- and objectives—for exam- relative to most life insurers state number of pools in ple, we own a number of is that Aflac’s exposures are purposefully only this country or the opportu- food and beverage compa- capped. You can have a run nity for market share gains nies in the consumer staples on a life insurer if customers invested in over time. Accordingly, sector. But it is not a the- cash in their policies. But there may not be as much matic call. It’s simply an that can’t happen to Aflac. financial services certainty about the long outgrowth of applying our Most of their policies, like term outcome as with investment criteria and in- cancer insurance in Japan companies with Grainger. sisting on a discount to in- and disability insurance in strong franchises trinsic value. the U.S., have a defined pay- GD: What about the other out for a particular event and balance 130—the “rejects,” if you TH: We are careful about and no surrender will? concentrations of risk. For value. Aflac knows the sheets. It is example, right now we have maximum payout at the MK: Just to clarify, yes, approximately 15% of the origination of each pol- because Aflac there are roughly 150 com- portfolio invested in insur- icy. The real risk – because panies on our wish list, in- ance companies, including of the long-lived liabilities started with a cluding the companies in the three property and casualty and potential for losses in strong balance portfolio. As for the 120 companies (Berkshire the investment portfolio – is that aren’t in our portfolio Hathaway, Chubb, and Pro- that Aflac could fall out of sheet that it are not, we don’t think of gressive). Since hurricanes line with statutory capital them as “rejects.” It would and other catastrophes can requirements and need to should be able to be more accurate to think hurt property and casualty raise additional capital at of them as our “bench”— companies, we might not exactly the wrong time, survive the current companies we would like to add a fourth company with which would be dilutive to storm.” own. In a lot of situations, that kind of exposure. current shareholders. the bench companies have a close counterpart in the GD: The other insurance GD: Why are you comfort- portfolio. company in your portfolio is able with this risk? Aflac. As you mentioned TH: An example is Waste earlier, Aflac is currently TH: When we made our Management. We really like facing some balance sheet initial investment in Aflac the long term outlook for challenges. several years ago, it had a the waste industry. The strong capital position and a other leader in that industry TH: Aflac is a provider of conservative investment is Republic Services. At the specialty medical and disabil- strategy of matching assets moment, we have chosen ity insurance in Japan and with liabilities and purchas- Waste Management, but the U.S. The core operating ing only highly rated securi- Republic has capable man- business is performing quite ties. Aflac also did a good agement and good assets well despite the recession, job of avoiding the sub too. There is a similar but like many other insur- prime problems that caught situation with Vulcan Mate- ance companies Aflac has (Continued on page 24) Page 24

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(Continued from page 23) avoid forced sales, but it is restrictions against building many other companies. not managed to a specific a new landfill. We think of What Aflac didn’t foresee is minimum, nor would we be them as very real assets— that so many of the world’s disappointed if the cash bal- both operating assets that leading banks who are the ance swelled. In 2006, we generate cash for the busi- issuers of these debentures had over 10% cash at one ness, but also as stores of would run into serious point, but generally it has value that can be priced well trouble at the same time. been well below that level. over time. Real estate is However, because these another asset class that can banks are so important to GD: On a related note, protect against inflation, but “If you look at the the world financial system, what do you think about we don’t own any REITs in governments have rushed to gold? Some value investors our portfolio at this time. businesses we own, their aid with additional seem to have caught the capital. Accordingly, most gold bug. What is your view GD: Do you have a view on you will see of the junior debentures on that thesis? On one inflation? companies that that Aflac owns probably hand, gold has no intrinsic will not default. Aflac’s core value; on the other hand, it MK: We worry about rising really have out- business also continues to could be an attractive hedge inflation and are aware of grow rapidly and is ex- against inflation or devalua- the potential for monetary standing quali- tremely profitable. Manage- tion. debasement, but our equity ment expects net income of investment team doesn’t ties—have-to-have over $2 billion in 2009 be- MK: I tend to agree with make specific inflation fore- fore investment losses. your comment that, first, casts. That’s not part of our products and ser- That means that Aflac can gold doesn’t have a measur- investment decision making vices, large cus- absorb significant invest- able intrinsic value and, sec- process. ment losses without having ond, you have to store it tomer bases, high to raise additional capital, as and insure it. Given the TH: Our view is that a busi- long as the losses don’t all choice, I think we would ness that provides essential retention rates, come at once. We have generally prefer other “real” products and services and purposefully only invested in assets that generate cash has a strong competitive good returns on financial services companies flow. Think about our two position is a pretty good with strong franchises and energy names or Vulcan hedge against inflation. capital, and ample balance sheets. It is because Materials, which has 13 bil- Consider a company like after tax free cash Aflac started with a strong lion tons of aggregates in Coca-Cola with superior balance sheet that it should the ground. These compa- brands, great global distribu- flows.” be able to survive the cur- nies have assets that can’t tion, and relatively low pri- rent storm. be duplicated and demand vate label penetration. In an GD: Turning to portfolio for those assets will grow inflationary environment, construction, some value over time. Waste Manage- Coca-Cola should be able to investors have advocated ment is another example. raise prices to offset rising holding cash in this environ- The company owns 273 input costs. Companies ment. What is your phi- landfills with an average with weaker competitive losophy on holding remaining life of 40 years. positions won’t have that cash? You are currently at People don’t usually think luxury. High inflation is not 6%, is that correct? about it this way, but these good for financial assets in landfills are not just holes in real terms, but we think our MK: Our cash right now is the ground. They are portfolio would hold up below 5%. Cash is an out- unique assets that are diffi- relatively well. growth of securities selec- cult to replicate. Not sur- tion. Generally we keep prisingly, there are all kinds MK: The thesis for gold enough cash in the fund to of zoning and environmental (Continued on page 25) Page 25

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(Continued from page 24) We record in writing our immaterial, but we listen starts to make sense if you due diligence findings. We with an open mind. You believe we are heading to- also prepare a detailed writ- guys probably know this wards hyperinflation. ten investment summary for better than I do from your each company. The invest- courses, but there is a well- GD: Names like eBay, Intuit, ment summary describes documented behavioral bias and Dentsply are not neces- how the business compares towards explaining away sarily traditional hunting against each of our invest- negative inputs. We want grounds for value investors. ment criteria. The summary to know the short stories also identifies the key risks on our companies. TH: We think our approach for each company and the is pretty differentiated. Our big variables outside of man- GD: I gather that position “On this subject, business criteria are differ- agement’s control. We try size is a function of discount ent from what other value to avoid companies with to intrinsic value but also though, our think- investors use. If you look at high severity risks, even if something you have called the businesses we own, you they are low probability “durability of the franchise.” ing is different will see companies that risks. Putting down our How do you assess the lat- from many other really have outstanding analysis in writing makes it ter variable? qualities—have-to-have easier to recognize when investors. We see products and services, large there has been an adverse MK: The primary metric for customer bases, high reten- development or when our determining position size is margin of safety as tion rates, good returns on original thesis is not playing margin of safety. On this capital, and ample after tax out. Also, having clear cri- subject, though, our thinking having two free cash flows. We are teria is empowering to the is different from many other proud of the businesses we investment team. It gives investors. We see margin of components —it own. We think they will junior people more ability safety as having two compo- should be thrive over many years. to challenge senior people nents —it should be re- without making the discus- flected, first, in the business reflected, first, in MK: We also look for busi- sion personal. You’re abso- and, second, in the price. nesses with hidden assets lutely right—you don’t want We are not strictly buying the business and, and “optionality.” You to fall in love with your in- $1 for $0.50. Absolutely, we mentioned Intuit. Intuit is a vestments. want that price discount. second, in the company that is pursuing But we also want a margin several promising growth Our intrinsic value esti- of safety in the business price.” initiatives in healthcare, mates also provide objectiv- itself. The durability of the online banking, and geo- ity. Last year we sold all of franchise refers to the graphic expansion. The our Western Union shares strength of the competitive company is spending money based on price. It’s an ex- position and the certainty of in these areas, but we aren’t cellent company, but the the outcome. For every giving them any credit for market price rose above investment, we want to be these investments in our our intrinsic value estimate. certain that our capital is intrinsic value estimates. It's At the time, Western Un- protected against a perma- nice to get the upside for ion’s business was flourish- nent loss and we want an free. ing and its share price didn’t opportunity for significant look like it was reflecting capital appreciation. GD: How do you avoid fal- the potential for any cyclical ling in love with companies or long term challenges. GD: Thank you, Mr, Hartch that meet your criteria and and Mr, Keller have performed well? MK: When we come across negative feedback about one TH: We try to be very ob- of our companies, we al- jective with our process. ways investigate. Often the criticism will prove false or Page 26

A Quant Among Us—Interview with Jim Scott

Jim Scott is Managing Director at the Heilbrunn Center. It’s on a lot of different compa- for General Motors Asset been wonderful. He is a nies. So the best way to Management. Previously, Mr. great guy to work with. take advantage of that is Scott was President of Quanti- diversify and to control risks tative Management Associates, GD: Which finance courses or the factors you are not a subsidiary of Prudential Fi- did you teach at Columbia? predicting. So a lot of it is, nancial, where he managed a “what can I predict, what team overseeing $45 billion in JS: Corporate finance, secu- can I not predict?” And you enhanced equity index, value, rity analysis, an M&A semi- protect yourself against the balanced, and long-short nar, PhD seminars—this, stuff you can’t predict. It’s funds. Mr. Scott is a graduate that and the other. just a very useful discipline of Rice University and holds an and it is not one that is M.S. and Ph.D. in Economics GD: The Heilbrunn Center widely appreciated in the from Carnegie Mellon Univer- takes a different approach non-quant community. “As a quant … you sity to efficient markets than traditional corporate fi- Although it’s increasingly so. are dealing with a nance. Since you’ve seen We’ve got a good manager GD: Can you describe your both sides, I wonder what is in the UK, who is purely a lot of low quality background and your role in your perspective on that? fundamental guy. 20 stocks, the Heilbrunn Center? OK? Or 30 stocks. He information. So JS: I believe there is money comes in every morning and JS: Let me start off earlier. I to be made by active man- pulls up a screen and he the best way to didn’t always have the title agement. I prefer a fairly looks at the marginal contri- take advantage of of professor, but I taught for disciplined approach, a bution to tracking error on about 20 years. I started as quantitative type of ap- every stock in his portfolio. that is diversify grad student and visited at proach. But certainly since So he knows where he is Stanford and then came to I’ve come here, I’ve come to taking his big bets relative to and to control Columbia. I left in 1987. better appreciate fundamen- what he believes the market Not that I was off the pay- tal approaches, value ap- is judging him against. And risks or the factors roll but I was off the tenure proaches. I think there are he will trim his position if he track. Then I was working at strong growth managers thinks his confidence is not you are not Prudential in their asset too. It’s a different disci- in line with that marginal predicting...And allocation group. That even- pline. contribution to tracking tually grew into a quantita- error. So you are seeing you protect tive equity shop with some When I was teaching corpo- much more quantitative asset allocation. I was Presi- rate finance at Columbia, tools being used by funda- yourself against dent of that, we formed a most of it was based on mental guys. And by value subsidiary. And then, when I valuation theory. Everything guys as well. the stuff you can’t retired from that, my wife had to do with the valuation said, “You have insufficient of a company. I was heavily At the same time, what you predict.” interests.” And so I asked influenced by that. So when are seeing is the quants are my buddy Tony who needed I came back to develop a becoming more and more somebody to do equity quantitative strategy, initially fundamental. Doing more here, that was about three it was value-based. Net pre- industry analysis, sector years ago, and I started do- sent value, book value— analysis, trying to dig inside ing that. stuff like that. As a quant … income statements, and I guess I should make a things like that. There are Before that, when I was point here. You are dealing always going to be people retired, I talked to Bruce with a lot of low quality on either extreme but you Greenwald. And he said, information. Because you’ve are seeing a bit of a conver- come be research director got not much information (Continued on page 27) Page 27

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(Continued from page 26) manager. In a way, you short-term oriented for self- gence. And I’m trying to could see how that could preservation. Which is not manage money and make encourage less risk taking. to say you can’t utilize the money, what are the tools same skills, but you have to at my disposal, how can I JS: No, this is a very aggres- be much more careful about make the best use of what- sive manager. He has had a portfolio construction if ever information I can gen- stellar track record. He has your ideas have longer pay- erate. So you are seeing that won all sorts of awards for outs. So I think they are sort of thing. high returns which you both consistent and the don’t get by not taking risk. notion that, “hey this is a GD: Talk about risk metrics He just wants to know cheap asset, I’m going to “What you are you’re looking at. Do you where they are and how buy it and I’m going to make tend to use industry Stan- heavily he is exposed on a lot of money one of these seeing is the dard BARRA risk factors or individual names. Because he days,” is very appealing and I do you have your own risk looks at his portfolio in think right. It’s just that to- quants are models that you use? terms of individual names. It day today’s institutional makes sense. If you are tak- marketplace, and to some becoming more JS: At my former shop, we ing three times as much risk extent the mutual fund mar- had used BARRA risk fac- on this one stock, which ketplace, it is somewhat and more tors initially. We moved you are no more confident more difficult to actually fundamental. away from BARRA’s be- in than this other stock, use. cause we thought they were then you want to straighten Doing more universally used. We didn’t things out. GD: Knowing that, have you know what kind of factor tried to construct time arbi- industry analysis, exposures they were giving GD: A lot of value investors trage portfolios? Do you us. We moved to much will say things like, “market talk to your clients and say, sector analysis, more explicit consideration risk isn’t price risk, that’s here is an opportunity three of risk where we knew ex- not the real risk,” and years out, here is the model trying to dig inside actly what we were control- “volatility is your friend.” that will help us generate income ling. We controlled for in- But if you plot that against alpha in the long term, but dustry, sector, size of posi- BARRA risk factors, it just in the short term you might statements, and tion, growth rate, etc. We looks like you are taking on not like the way it looks? knew that if we got far away more risk. Whereas they things like that.” from our benchmark on would claim they are not. JS: Three years is a little those dimensions, one, we How do you reconcile short for some of these weren’t sure how good our those viewpoints? strategies. It is a hard ques- alpha was, how well we tion to answer. Most institu- could predict, and so we JS: Both things are correct. tions say they have long decided to focus the alpha To a large degree, it is mat- time horizons. But at the by controlling those things ter of time horizon: how end of the day, you had bet- where we felt we had pre- long do you as a manager ter keep performing. dictive ability. The way I do have to produce good re- risk control is, “how do I turns? If you have the luxury GD: What about this insti- best focus my portfolio to wait five to seven years tution? How long would you where my skill is? How do I for a big payoff, then the say is the time horizon control those things that I way you view risk is differ- here? Are you managing know can hurt me and ently than if you are report- primarily on behalf of Gen- where I don’t have a lot of ing to institutions that get eral Motors’ pensioners? confidence in those predic- really upset if your three tions?” year track record slips. As JS: And for a lot of other the markets have become clients as well. I don’t want GD: Interesting what you more institutionalized, man- to get into it, but I will tell said earlier about the UK agers have become more (Continued on page 28) Page 28

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(Continued from page 27) least considering industry- panies like that, you can you personally they have a type models or super indus- focus on their normalized very long horizon. Although try type models. To an ex- earnings are, what their maybe it is getting shorter. tent, industry models have assets are, stuff you can see When times get tough, hori- been in place for a long time pretty well today. What zons get shorter. because many value factors Graham would say—or “To an extent, work best within industries what Greenwald would GD: Any reactions to the or within sectors than say—is pretty good infor- industry models recent Dave Swensen inter- across them if you are look- mation. Because it is near- have been in place view in the WSJ? The re- ing for shorter-term or term and it is more tangible. porter asked him if endow- even medium term payoffs. for a long time ments should change their But there have been explicit OK so in that part of the portfolios to be less volatile models of different indus- market, you use value met- because many in the short run. Swensen tries. rics more because that was fairly adamant that— makes more sense. When value factors work regardless of current mar- Backing up—first generation you get out here to the high ket conditions—the horizon quant was, you run a regres- growth rates—that is sort best within indus- hasn’t changed, therefore sion, you figure out what of hopes and dreams. Price tries or within the portfolios shouldn’t. So the coefficients are, and that to earnings ratios, or price that is the ideal, right? tells you what you should to book ratios, can be very sectors than across be using to generate alpha. high and yet you can make JS: To a degree—to the Second generation gets money by buying those them if you are degree that it is really imple- much more complex and stocks. So it is more of a mentable. I mean, every- starts dealing with different Buffett notion that you are looking for shorter body faces pressures. Fortu- ways of looking at different willing to pay for growth. nately, we didn’t have those types of stocks. Third gen- The way we implemented it -term or even kinds of problems. Not by a eration I guess is, within a is—we called it the news medium term long shot. quant portfolio, forming factor. We’re looking for what might be … sort of news of a fundamental na- payoffs.” GD: When you’re con- robotic industry analysts. ture that should affect the structing models. You men- So, you’ve got your model present value of future cash tioned quant moving more for a particular industry. flows for growth companies. in a fundamental direction. OK? And that was the main Do you have very specific What I have tended to favor thing we focused on. So the models for different indus- and actually we perhaps question is, what’s news, tries, or subsectors, or do pioneered this—we cer- and how does it evolve over you use low price to book tainly thought we did at the time if government rules which tends to work across time and most of our clients change, or whisper esti- industries so you’ll use that, thought it was unique—is mates go out of style be- or do you look at different we just started out from a cause … variables for industries ver- basic PV formula. And said, sus chemicals or pharma OK, if you look at this for- GD: Reg FD. you might look at different mula … think of a Gordon things? Dividend Discount Model. JS: Yeah, that sort of stuff. You’ve got dividend divided So it’s a question of what’s JS: Let me talk about the by discount rate minus the news. And so, in that part of industry in general, and then growth rate. If the growth the market, you still have I will turn to my approach. rate is zero, it is just divi- some value metrics, but you What you are seeing in the dend or earnings divided by focus more on news met- industry is that more people the discount rate. So what rics. You are more like a are either moving to or at that’s telling you is, for com- (Continued on page 29) Page 29

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(Continued from page 28) the price. And conversely, I know the name and I know growth stock investor. You they leave the party for it is what they try to do. It want to know what’s driving some of these stocks that is typically your long-run those hopes and dreams. are subsequently going to fundamental, your value And in the middle, it turns have hard times. So they sell investors and your good out you need a little of those and they drive prices growth investors. And there both. The way we ap- down a little bit. When we are a lot of investors who proached it was very much started looking at it though don’t fit either of those clas- finance based and econom- that lens, it is pretty clear— sifications neatly. They just ics based and how do we at least it is clear to us, it is look for stuff they think is build in ways to measure not clear to some of the cheap. They are looking at “Momentum is what theory is telling us academics yet. Momentum balance sheets, they are neither over- should matter. It still works. is neither over- looking at industries and extrapolation of past results how industries are moving, extrapolation of GD: And you found a good nor is it under-reaction to and they may be in stocks way to quantify the news news—it is smart people an index provider might past results nor is based information? moving prices before others classify value or might clas- figure it out. sify growth, but they are it under-reaction JS: Some of it is real simple, really looking for fundamen- such as analyst earnings esti- In my work here, as I talk to tal economic value. And to news—it is mates. This relates to some a lot of these managers, I sometimes they don’t fit smart people of the work I’ve done with initially tried to talk to them some of these metrics. And the Heilbrunn Center. I in those terms. Some of I’m a little hesitant to name moving prices started out trying to test them got it. It is clear that individual managers just whatever behavioral theo- that is what a lot of them given my position here. before others fig- ries were really important. are doing. And that’s the Were people over- reason they are successful. But they are out there and I ure it out.” extrapolating past results or A really good fundamental like some of them a lot. were they slow to act? guy is really trying to look One of the interesting Were they too conservative out as far as they can into things I’ve discovered here … what was going on? I had the future. I think some of is how some of these guys a great grad student who them have better insights aren’t looking at individual worked on this with me, a than get into their portfo- companies they’re looking PhD student, Jorge Murillo. lios. Because sometimes the at industries, and they’re portfolios don’t control for looking at capital flowing We were looking at mo- these uncontrollable or un- into and out of industries, mentum, which you can predictable risks. And so and they’re doing a lot of either explain as overreac- their good ideas are may be industry dynamics, and tak- tion or under-reaction to influencing market prices ing advantage of that in in- news. And that under- and driving momentum but teresting ways. One of the reaction to news came out they may not be capturing things I’d like to do if I could of something like prospect the full advantage of that. ever get the time enough to theory or something. And do it is to figure out how we finally found that actually GD: What types of inves- quantitatively how to ap- neither one of those is what tors are these? Could you proach some of those things is going on. There are some put a face on who these because I think quants can smart investors out there momentum guys or smart learn a lot from savvy funda- who are six months, 12 guys are? Are these like the mental guys. months or 18 months ahead Tiger Managements or tiger of the market. And they see cubs of this world? GD: Have you noticed a that this stock is going to common intellectual thread outperform significantly, JS: Yes, exactly. I’m not you seen in good fundamen- they buy-in, and they affect really familiar with them but (Continued on page 30) Page 30

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(Continued from page 29) So there are different ways The fundamental guys are tal managers and good to intelligently look at risk more difficult. And the most quant managers? If you and build a portfolio. But difficult are the guys who knew nothing about their generally I am looking for are pretty good but can’t portfolios but only knew someone who has some of explain what they are doing. how they described them- that—some intelligence in Those are tough. You push “You can still get selves and their process— that respect. And if you just for transparency but some what do you look for? let things fall out as they of the times it is very diffi- yourself in trouble may, then I would certainly cult to obtain. if you overweight JS: What I look for is a sen- argue for a smaller alloca- sible economic story and tion to that manager no GD: There are investors one factor way intelligent use of data. As matter how good they are. who have seven to 10 you know, data is very im- If you put too much of your stocks in the portfolios. Is beyond all bounds portant for fundamental money with that manager, that just unacceptable to guys and quant guys. If they you can get your head your framework? of what you can are looking at shipping in handed to you. and out of Los Angeles or JS: There are lots of ways to predict. And some the West Coast ports— GD: How much transpar- make money in this world people still do well, that’s interesting. Par- ency do you require of your and that is too few for my ticularly if you see they do managers? taste. By a long shot. How that. They claim that right and make money do I know if they are smart in the process. So the first JS: Equities are relatively or lucky? You just can’t tell they are just two things are a sensible easy. I mean, we know eve- as an outsider. economic story and good rything they hold all the picking bottom up use of data. time. We can see their per- GD: Specific quantitative formance hourly if we so approaches. What do you stocks and these And I tend to still be inter- want! But, you know, we think about the magic for- exposures just fall ested in portfolio construc- have other things to do. mula? tion because I think you can out—but still get yourself in trouble if Transparency of process is JS: Well I think it is very you overweight one factor something you always want. simple. Certainly institution- sometimes they do way beyond all bounds of With quants, the tugging ally that would not fly. Be- what you can predict. And match is a little more clear cause people believe there too.” some people still do that. because the quant isn’t go- is more at work than that. They claim they are just ing to turn over the com- They may be wrong, but picking bottom up stocks puter code to you. That is generally people want multi- and these exposures just fall not fair to ask. But you do ple metrics to value. As far out—but sometimes they want to know, what is the as profitability is concerned, do too. It’s a problem. So I intelligence being brought you need information about like to see some risk con- in? How do the risk con- stability and predictability of trol. Quants typically con- trols work? What are the future profitability as well. In trol industry, sector, size— alpha signals? How do you today’s environment, one of stuff like that. The good construct them? What is the major mistakes some fundamental guys, they con- most important? How do value guys have made is trol some things differently. they evolve over time? Just insufficient concern about They may be concerned a whole series of issues that corporate liabilities. And in about macroeconomic risk, you can ask without asking part, that is due to lack of about a recession or expan- them to divulge some im- transparency in the account- sion, or about commodity portant trade secret. ing data, which has really prices risk. badly served investors. (Continued on page 31) Page 31

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(Continued from page 30) security. Transactions cost And there are a lot of differ- are very important, espe- ent tools out there. And GD: What goes into a great cially if you have a risk con- some of the players are quantitative investment trol product. Because the deciding they can use sev- process? Is it model building lower your tracking error— eral tools. to capture alpha? Portfolio for example, 5 bps or construction? Risk Manage- 10bps—it can make the GD: Getting back to the ment? Trading and imple- difference between huge Heilbrunn center, are there mentation? commercial success or not. directions you’d be inter- “A lot of large So you need to really focus ested in seeing it go? Obvi- JS: It’s a good question. And on what’s the best and most ously we don’t do a lot with managers use net the answer is: everything effective way to trade. It’s a quantitative approaches. matters. You need some continual battle. Your approach is very dif- present value fundamental insights on how ferent than a lot of the you are going to capture GD: What are your things they teach us in the techniques, but alpha. And then once you thoughts on applying quanti- Value Investing Program. have that, you build a proc- tative approaches to funda- you don’t want to ess around that. And it can mental value approaches? JS: Yeah, and I think the over rely on that either be a high tracking Value Investing Program has error process or a low JS: Some are moving more been tremendously success- because you don’t tracking error process. But towards that. And I see ful. The kind of insights peo- it ought to be dependent on more moving towards that ple can generate coming out want to neglect where you’re trying to gain every year. And does it limit of there are extraordinarily your alpha. For example, returns? Well, arguably not. valuable. I’m going to be the balance that model I laid out earlier Because arguably you’re just teaching some lectures at about growth rates is a limiting risks that you don’t Columbia soon—they’re sheet— process that is really a core know how to predict. I not actually in the Value particularly the process to both growth and think it makes sense to do Investing program but value stocks, so what that it. But do I think it makes they’re going to be about liabilities.” argues is a fairly risk con- sense to do it in as explicit a portfolio construction—and trolled process. way as a quant? No, I don’t I think some of those ideas think so. I think it’s useful in could be powerfully intro- Given that, everything you the way that some of these duced to some of the stu- said matters. You want the managers have quantitative dents in the program. best sources of alpha you tools that tell them when can get. First, you want the they’re wandering away And you’re starting to see best source of alpha. Sec- from the market in some value managers using a vari- ond, given your source of sense. That’s useful—and ety of quantitative tools, alpha, how do I best pack- they should pay attention to particularly the larger ones. age it? What can I predict that. A lot of large managers use and what can I not predict? net present value tech- And how do I control those GD: Why hasn’t it happened niques, but you don’t want things I can’t predict? So it’s sooner—that fundamental to over rely on that because all portfolio construction. and quantitative investors you don’t want to neglect And then there’s turnover. are comparing notes more? the balance sheet— How frequently should I particularly the liabilities. turn this portfolio over? JS: I think it is happening. I We’ve seen financial institu- Well, turnover depends on think it’s happening more tion after financial institution the decay rate of your alpha. and more. And I don’t think imploded. Certainly they And it also depends on your it’s going to stop. You are all—or a lot of them— transactions cost. And all of know, because it’s a com- use screens of various kinds, those things determine how petitive game and the ques- using the types of value long you are going to hold a tion is—how do you win? (Continued on page 32) Page 32

“Jim Scott” (continued from page 31)

(Continued from page 31) back into more cyclical ing stock prices. So that’s metrics that have worked in names. And the jury is out one of my areas of interest. the past. And there are two on that one. It’s a very diffi- views on that. Some think cult time. It’s a very uncer- GD: What’s your philoso- they are very helpful be- tain time. So far, the govern- phy on sharing research? cause they help you focus ment actions have stabilized Let’s say you come up with on things that may be useful. the bond market to a de- a fresh insight about what But they may also leave out gree and some large finan- drives momentum, for ex- “So far, the gov- some things that may be cial firms. But we have not ample. It’s nice to publish it important. Some fundamen- moved much beyond that. – but it’s also nice to cap- ernment actions tal value managers actually And the problem now is the ture it yourself. use optimizers. And they real economy. If you look at have stabilized the may not follow them, but some of the really dis- JS: Well, I think you can use they look and see what tressed fixed-income— it both ways. It’s a general bond market to a they’re suggesting. And they some of the stuff that looks rule—particularly if you are degree and some might tweak their portfolios like it has some life—it was starting an investment to get closer to the bench- a great buy in October but shop—it’s very useful to large financial marks they’re being judged it’s not so good now. publish. It gives you a lot of against. And really I’m talk- credibility and if it’s an ac- firms. But we have ing more about from an GD: Let’s talk about your cepted piece, it’s a good institutional perspective role here at General Motors marketing tool. Secondly, if not moved much because that’s the world I’ve Asset Management. you publish, aren’t people lived in. going to steal your ideas? beyond that. And JS: I’m the Equity Guy. We To a degree, yes. But could the problem now GD: What about the types manage equities for a num- they copy your investment of things you think look ber of different pension process? No. I mean, you is the real econ- really interesting? programs and we also do could have a quant come in derivatives of various types here and tell you exactly omy.” JS: Well, I agree with Bill – futures, swaps, options, what he was doing and you Gross – that TIPS look ex- etc. We use external man- wouldn’t do it. Because if traordinarily underpriced agers and manage three you’re good enough to du- right now. The inflation pro- different strategies in our plicate it, you wouldn’t. tection is essentially just offices here. They’re all Because you’d have your being given away. Although largely quantitative because own ideas about how you’d I’ve noticed that since he we haven’t got a huge staff change it and tweak it. And came out with that state- of analysts. So that’s the way so people try to keep these ment the spread between to go in that situation. ideas proprietary but most 10 year TIPS and treasuries of them are pretty much has widened. Some people GD: Can you talk about out there in the public do- may have followed his sug- some of the research you’re main anyways. So, can you gestion. So that’s pretty currently interested in? give your research away? A obvious. A bet that a num- little bit, but not too much. ber of people have made JS: I’m still really interested If you’ve done the re- recently is on quality—solid in this momentum idea. Be- search—you wouldn’t pub- companies with good fran- cause as far as I can tell, lish all of it anyways—and chises and strong balance nobody has come up with a are there things in there sheets that look kind of good notion of what drives you can use to make bullet proof relative to the momentum. And so I’m still money? Generally, yes. Also, recession. Those stocks looking at that—and what I you’ll know more about have gotten bid up. People think it is good value guys how to take advantage of are wondering when to go and good growth guys push- (Continued on page 33) Page 33

“Jim Scott” (continued from page 32) || “Berkshire” (continued from page 15)

(Continued from page 32) Berkshire Annual Meeting It helped me realize that if these insights than other (Continued from page 15) there was one underlying people. So it’s also useful in -by-side, it probably had its theme to the weekend, it developing and changing own zip code. Talk about was the value of trust. The your process. economies of scale! original partners trusted Buffett with their hard- GD: Any advice you’d have On the way to the airport earned money, and Buffett for us as we’re starting out? the next day, we drove by in turn held that level of Buffett’s house and Kiewit trust in the managers of JS: It’s a tough time—it’s a every company he has ever very tough time. Starting owned. He trusted Russell your own firm is difficult. Athletic’s management to You need that first inves- “Trust is not make the right decisions in tor—and then not only that, Honduras. He trusted Bill but you need to grow something that Child to continue to run RC pretty quickly. As I say, one Willey exactly the same way of the surest ways to do it appears explicitly in after he bought the com- in “quant land” is to publish. pany. He trusted all of his If you look back at a lot of a p/e ratio or a dis- managers and that trust these large successful quant manifested itself as stable, funds, a lot of them were count rate. It’s not predictable cash flows. started in exactly that way. You need some way to es- something you can But trust is not something tablish credibility. So work- that appears explicitly in a p/ ing for another firm is a model in an excel e ratio or a discount rate. good way to do it, but it’s a It’s not something you can longer trip to getting there. spreadsheet. And model in an excel spread- I think this is a difficult busi- sheet. And it’s certainly not ness to break into although it’s certainly not something that can be quan- the Applied Value Investing tified in a contract; which program seems to have something that can presents amateur investors done pretty well relative to like me with a challenge. If most because it is a very be quantified in a trust is so important, how small community. I think this do we identify and value it? is a great business, though. contract.” I suppose that is the art of You have so much fun. investing, and why “value” There’s always something to investing is a bit of a misno- learn. And it’s really hard— Plaza – about a 10 minute mer. After all, Benjamin you’re gonna lose a lot. And drive apart. You could eas- Graham didn’t title his book everybody knows that. Your ily imagine Warren skipping “the value investor,” he peers know that. And your into work. He had a gor- called it The Intelligent Inves- clients know that. geous brown house with a tor. barn-style roof, but it was GD: Thank you, Mr. Scott. certainly not the type of This article was contributed by palace you would expect Brandt Blimkie, MBA ‘10. one of the world’s richest men to own. What shocked me the most was the lack of a visible security presence. No fence. No moat. He obviously trusted his neighbors.

Page 34

Second Annual Pershing Square Challenge

mented that the idea was The five teams selected as “extremely well re- finalists presented their in- searched.” vestment recommendations to a distinguished panel of Next, Matt Gordon, Renata hedge fund portfolio manag- Motta, and Carlos Medeiros ers, including: Bill Ackman presented First American and Paul Hilal of Pershing Title Company (FAF). The Square, Craig Effron of team argued that the core Scoggin Capital Manage- title insurance operation ment, John Griffin of Blue was depressed due to the Ridge Capital, Douglas sharp decline in home sales. Hirsch of Seneca Capital, However, the team noted Dahlia Loeb of Reveille that even following the de- Capital, and Daniel Loeb of cline, sales were at the same 2009 Pershing Square Winners: John Piermont ‘10, Tim Rupert Third Point LLC – as well as level as in the late 1990’s ‘09, and Grant Bowman ‘10 with Pershing Square Founder Bill Columbia’s own, Professor when they conservatively Ackman. Bruce Greenwald. Each estimated earnings power of On April 3, Columbia Busi- group made a ten minute around $155 million (versus ness School held the finals presentation followed by -$117 million in 2008). The for the Second Annual Per- fifteen minutes of follow-up team applied an EBT multi- shing Square Value Investing questions from the panel. ple of 8x to their estimate & Philanthropy Challenge. of normalized earnings for The event marked the cul- Ivan Andreev, Eric DeLa- the core business and used Pershing Square mination of the three- marter, and Richard Tosi the market valuation for the month competition among made the first presentation publicly traded subsidiary Challenge Winners 42 teams of first and second of the day, recommending First Advantage (FADV). 2008 year CBS students. Per- the purchase of Lender Under this scenario, the shing Square founder and Processing Services (LPS) market was valuing the re- Tim Rupert ‘09 CEO Bill Ackman launched with a target price of $50. maining Information Ser- the Challenge in 2008 to LPS is the largest mortgage vices segment at only 2.2x Grant Bowman ‘10 build upon Columbia’s value processor in the U.S., han- its $319 million trailing investing tradition and instill dling over one-third of all EBITDA. Applying a more John Piermont ‘10 a deeper commitment to originations, mortgage proc- normal multiple gave the Philanthropy among the essing, and default services. stock a substantial 20% to 2007 next generation of business The team felt that the stock 70% margin of safety. Shilpa Marda ‘09 leaders. was “unloved, neglected, and misunderstood” by ana- The third group recom- The Challenge grew dra- lysts due to its exposure to mended the short sale of matically from its first year, the mortgage industry. Apollo Group (APOL), the involving 124 students in a However, they believed that parent company of the for- special master class led by the company’s scale gave it profit University of Phoenix. CBS alums Paul Sonkin and an entrenched competitive The group members, Tim Caryn Zweig. The class advantage in a favorable Rupert, John Piermont, and taught a Graham & Dodd industry environment. In Grant Bowman gave a spir- framework for search and their view, the company was ited argument that the mar- valuation strategies, and well positioned to make ket’s belief that the stock students further benefitted money despite, or indeed, was countercyclical was a from extensive mentoring because of the poor per- fallacy. First, nearly all of from twenty practicing in- formance of the underlying the company’s recent dustry professionals. mortgages. Mr. Griffin com- (Continued on page 35) Page 35

“Pershing Square Challenge” (continued from page 34)

(Continued from page 34) ness traded at a similar mul- and third place were growth has been in Associ- tiple to Lamar Advertising, awarded to Clear Channel ate degrees, which now the market value of the ra- and Jack in the Box, respec- make up 40% of enrollment dio business was only $800 tively. The first place award “Last year we – up from 5% in 2005. million, despite generating was given to Tim Rupert, provided angel These degrees have lower an estimated $865 million in John Piermont, and Grant tuition and graduation rates 2009 EBITDA. The team Bowman for their analysis of financing. This and carry a much higher argued that this was far too Apollo Group. The winning default rate. In fact, the high conservative and that the team received a $25,000 year it is mezza- default rate (27.4% versus debt had significant asset check from Pershing Square an average of 6.4% at public protection. After comple- that they could then direct nine. Next year, I 4-year universities) had menting the group’s to an area of their choice at placed the school’s Title IV “incredibly impressive analy- Columbia Business School. am expecting the eligibility under review, with sis,” Mr. Ackman said that Mr. Ackman was very competition to be 80% of the firm’s revenue at the judges would “have pleased with the growth and risk. The team argued that their own competition to success of the competition like a Berkshire the competitive situation see who gets to hire the stating, “Last year we pro- had also worsened with 60% presenters.” vided angel financing. This Hathaway annual of public universities now year it is mezzanine. Next offering online degrees and The final presentation by year, I am expecting the meeting.” more than twice as many Troy Scribner, Meghan competition to be like a for-profit competitors than Baivier, and Duncan Wel- Berkshire Hathaway annual in 2000. The group believed stead was the recommenda- meeting.” that with APOL, both stu- tion of Jack in the Box dents and investors “paid (JACK) with a target price more and got less.” Mr. of $30 per share. The team Ackman commented that believed that the nation’s the research was “very fifth largest burger chain had thorough,” but Mr. Griffin strong core restaurant op- cautioned that the stock erations, significant asset was very expensive to value, high growth in its short, with an annual cost of Qdoba chain, and a catalyst 22%. to unlock value as the com- pany refranchises more Next, Christof Pfeiffer and company-owned locations. James Walsh recommended The firm’s real estate was the purchase of Clear Chan- valued at $15.2 per share nel senior secured term based on recent transac- loans that were issued in tions, and an earnings connection with the com- power valuation of the cur- Pershing Square Judges: Paul Sonkin, Daniel Loeb, Craig Ef- pany’s 2008 LBO. The debt rent stand alone restaurant fron, Caryn Zweig, Douglas Hirsch, Dahlia Loeb, Kevin Oro- was currently trading at operations amounted to Hahn, Paul Hilal, Bill Ackman, Bruce Greenwald, and John forty cents on the dollar, $13.45 per share. The team Griffin. implying an enterprise value attributed additional value of $6.7 billion. However, of $4.5 and $5.1 per share the team calculated the for refranchising and firm’s value at a minimum of growth, respectively, and $12 billion. Under this then subtracted $8.5 per analysis, the debt offered an share in debt. IRR of 30% per year over three to five years. Assum- After a brief consultation ing that Clear Channel’s the panel of judges returned outdoor advertising busi- with their verdict. Second Page 36

Van Beima at NYSSA

Last year was a rough one he said. “If there is a low vantage. Once that arbitrage for even the top value inves- degree of error and you buy opportunity disappeared, it tors. On Jan. 27, Michael it at a significant discount, reappeared, and the fund van Biema, a former Colum- you are an intelligent inves- manager was able to make bia Business School profes- tor.” money off of the same play sor and current principal of two more times. “That “We always think van Biema Value Partners, Another misconception that should not be happening,” presented his ideas at a value investors have is that said van Biema. But people of value investors New York Society of Secu- they will always do better are seeing nice returns as a rity Analysts meeting on than the growth guys. Not result of these arbitrage as protecting cash, how investors should view so, said van Biema. “We opportunities.” risk and reward to prevent always think of value inves- because we buy at making repeat mistakes. The tors as protecting cash, be- van Biema is also looking to a discount to the title of the talk: “A Snowball cause we buy at a discount Asia for investment ideas; in in Hell,” after the new War- to the intrinsic value, so we October, the firm started a intrinsic value, so ren Buffett biography, “The should lose less than the separate Asia fund. van Snowball.” market. In fact, that couldn’t Biema said that huge oppor- we should lose less be further from the truth,” tunities are arising due to Risk and reward is the key he said. In periods of ex- people’s expectations; eve- than the market. metric upon which invest- treme irrationality, the per- rybody is focused on high ment professionals evaluate formance of value investors growth companies. They are In fact, that the quality of investments, can be even worse than the missing out on the relatively couldn’t be further said van Biema. market’s. But as long as you slower-growth companies, “Unfortunately, it doesn’t are a patient investor, said which are still growing at an from the truth.” appear that we have a terri- van Biema, it shouldn’t mat- uninterrupted rate of 12%. bly good understanding of ter over the long term. van what that means,” he said. Biema’s fund was down 22% van Biema ended the discus- “Very brilliant people have last year. That performance sion with the idea that tried to understand the re- still made it the second-best brighter times are ahead. lationship between risk and performing value fund, be- Prior to the beginning of return and have failed horri- hind Jean-Marie Eveillard’s significant market disrup- bly.” First Eagle Global. tions, van Biema said he grew wary because he no- van Biema said that the fail- Another problem is con- ticed that small value man- ures of late have happened tinuing to believe in the ra- agers were all starting to in large part because inves- tionality of the markets. Just converge. He looked back tors don’t properly under- because markets have be- to historical data, and no- stand risk. Informational come inefficient and mis- ticed that the periods where risk, in particular, has played priced does not prevent value investors had corre- a large role in the root of them from becoming more lated predicted significant the various financial crises irrationally mispriced. “The economic declines. The over the past 100 years. van fixed income markets dis- good news, however, was Biema believes that to coun- prove the theory that mar- that after those periods, teract informational risk, kets behave efficiently,” he returns tended to be very good value investors should said. But smart investors positive for the next two to pay attention to the degree can find value in those ineffi- four years. His conclusion: of error they put on their ciencies. One of van Biema’s “Now is probably a pretty valuation. “If an investment fund managers discovered good time to start a value has a large degree of error an arbitrage opportunity in fund.” in it, you are better off to the fixed income markets, moving to something else,” of which he then took ad-

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