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

Inside this issue: Issue XXX Spring 2017

CSIMA ARGA Investment Management Conference P. 3

Pershing Square A. Rama Krishna, CFA, is the founder and Chief Investment Challenge P. 4 Officer of ARGA Investment Management. He was previously A. Rama Krishna P. 5 President, International of Pzena Investment Management and Managing Principal, Member of Executive Committee, and Cliff Sosin P. 14 Portfolio Manager of its operating company in New York. He led the development of the firm's International Value and Student Ideas P. 28 Global Value strategies and co-managed the Emerging Markets Chris Begg P. 36 Value strategy, in addition to managing the U.S. Large Cap A. Rama Krishna Value strategy in his early years at Pzena. Prior to joining Pzena in 2003, Mr. Krishna was at Citigroup Asset Editors: (Continued on page 5) CAS Investment Partners Eric Laidlow, CFA MBA 2017 Cliff Sosin is the founder and investment manager of CAS Benjamin Ostrow Investment Partners, LLC ("CAS"), which he launched in MBA 2017 October 2012. Immediately prior to founding CAS, Cliff was a

John Pollock, CFA Director in the Fundamental Investment Group of UBS for five MBA 2017 years where he was a senior member of a team analyzing equities and fixed income securities. Prior to UBS, Cliff was Abheek Bhattacharya employed as an analyst by Silver Point Capital, a hedge fund MBA 2018 which invested in high yield and distressed opportunities, as well as by Houlihan Lokey Howard & Zukin, a leading Matthew Mann, CFA investment bank best known for its advisory services with MBA 2018 Clifford Sosin respect to companies requiring financial restructuring. Cliff

Adam Schloss, CFA (Continued on page 14) MBA 2018 East Coast Asset Management

Christopher M. Begg, CFA, is the Chief Executive Officer, Chief Investment Officer, and Co-Founder of East Coast Asset Visit us at: Management. Prior to co-founding East Coast, Chris served as www.grahamanddodd.com a Portfolio Manager and ResearchRolf Heitmeyer Analyst at Moody Aldrich www.csima.info Partners and a Portfolio Manager at Boston Research and Management. Chris is currently an Adjunct Professor at the Heilbrunn Center of Graham and Dodd Investing at Columbia Business School, teaching Security Analysis during the fall Semester. Chris received his BS degree from the University of New Hampshire and holds a Chartered Financial Analyst (CFA) designation since 1998. Mr. Begg is a member of the Boston Chris Begg Security Analyst Society and the CFA Institute. Chris is involved in environmental conservation serving as a Corporate (Continued on page 36)

Page 2 Welcome to Graham & Doddsville

We are pleased to bring you the kets portfolio in Russia when the Tenth Annual Pershing 30th edition of Graham & other investors were fleeing Square Challenge in April 2017. Doddsville. This student-led the region. Windsor Cristobal ’18, Anji Lin investment publication of Co- ’18, and Isabella Lin ’18 share lumbia Business School (CBS) is Clifford Sosin of CAS Invest- their winning pitch of Yum co-sponsored by the Heilbrunn ment Partners shares his highly China (YUMC); Chris Waller Center for Graham & Dodd concentrated and long-term ’18, SK Lee ’18, and HK Kim Investing and the Columbia Stu- approach. He discusses two of ’18 discuss Alaska Airlines dent Investment Management his investment ideas in depth; (ALK); Griffin Dann ’18, Joseph Association (CSIMA). anyone following Herbalife O’Hara ’18, and Vikas Patel ’18 (HLF) or World Acceptance share Corning (GLW); Gustavo Meredith Trivedi, the Heil- In this issue, we were fortunate Corporation (WRLD), especial- Campanhã ’18, Gilberto Giuizio brunn Center Director. to speak with three investors ly short sellers, will be interest- ’18, and Thiago Maffra ’18 pre- Meredith skillfully leads the who provide a range of perspec- ed in this discussion. Addition- sent Dollarama (DOL). Center, cultivating strong tives and investment approach- ally, Cliff provides some unique relationships with some of es. All three apply variations of career advice for aspiring inves- We are honored and privileged the world’s most experi- value investing and fundamental tors. to have continued the Graham enced value investors, and research to find overlooked & Doddsville legacy, and we creating numerous learning opportunities. These invest- Christopher Begg, CFA, of look forward to reading the opportunities for students ments could be stable businesses East Coast Investment Manage- next generation of issues, interested in value invest- in turbulent geographies, misun- ment discusses the benefits of helmed by three outstanding ing. The classes sponsored derstood businesses engrossed investing in “compounders, individuals in Abheek by the Heilbrunn Center in controversy, or compounders transformations, and Bhattacharya ’18, Matthew are among the most heavily that are hiding in plain sight. workouts.” The adjunct profes- Mann ’18, and Adam Schloss demanded and highly rated sor of Security Analysis at Co- ’18. We want to thank Abheek, classes at Columbia Busi- A. Rama Krishna, CFA, of lumbia Business School shares Matt, and Adam for their com- ness School. ARGA Investment Management his thoughts on Sherwin- mitment and dedication to discusses the application of value Williams (SHW) and other high Graham & Doddsville. investing globally, especially in quality businesses that are emerging markets. His time sometimes overlooked. Chris As always, we thank our inter- working with valuation-focused also emphasizes the benefits of viewees for contributing their firms helped inform ARGA’s multi-disciplinary learning, both time and insights not only to approach and the goal to find for life and for investing. us, but to the investment com- value anywhere. Rama discusses munity as a whole, and we the challenges and opportunities Lastly, we continue to bring thank you for reading. of this strategy, including the you pitches from current stu- decision to invest nearly a quar- dents at CBS. In this issue, we ter of ARGA’s emerging mar- feature ideas from finalists of - G&Dsville Editors Professor Bruce Greenwald, the Faculty Co-Director of the Heilbrunn Center. The Center sponsors the Value Investing Program, a rigor- ous academic curriculum for particularly committed stu- dents that is taught by some of the industry’s best practi- tioners.

Student volunteers at the 20th annual Bruce Greenwald with keynote speaker CSIMA Conference, February 2017 David Abrams of Abrams Capital (right) Volume I, Issue 2 Page 3

20th Annual CSIMA Conference — February 3rd, 2017

Keynote speaker David Abrams, Abrams Capital Samantha McLemore, LMM, and William von Mueffling ’95, Cantillon Capital Management, speak on the Behavior Finance panel

Thomas Russo of Gardner, Russo & Gardner, speaks on Attendees networking and discussing stocks after the the “Finding Value: a Global Perspective” panel Best Ideas panel

From left: William Strong of Eschaton Funds, Dominique Mielle of Canyon Partners, Andrew Wellington of Lyrical, and Ryan Heslop of Firefly Value Partners offer their best ideas. Ellen Ellison of University of Illinois Foundation (right) moderates Page 4

10th Annual Pershing Square Investing Challenge — April 19th, 2017

The first-place team, which pitched Yum China, poses The Yum China team (from left): Anji Lin ’18, Isabella with Bill Ackman (left) and the other judges Lin ’18, and Windsor Cristobal ’18

The second-place team, which pitched a short on J.M. Last year’s winning Couche-Tard team (from left): Smucker, poses with the judges Melody Li ’17, Joanna Vu ’17, and Thais Fernandez ’17

Students and alumnus discussing the pitches (from left): Vik Patel ’18, Mahmud Riffat ’14, Eric Laidlow ’17, and Lilia Noack ’18 Page 5 A. Rama Krishna (Continued from page 1) Management, where he A. Rama Krishna (ARK): investment decisions. First, as was Chief Investment Until I went to business school investors, we think of investing Officer and Head — in the 1980s, I didn't know that in companies, not stocks. Institutional and the role of an investment Second, we think the value of International, and research analyst even existed. companies is determined by represented the asset Then I learned you actually get their long-term earnings power management business on paid to analyze and critique and dividend-paying capability. the Citigroup Management other people's businesses. Third, our research analysts Committee. He also Well, that seemed like a lot of focus on understanding long- directly managed the fun—and I wanted to apply the term company fundamentals, Global Emerging Markets many useful learnings from not analyzing investor Equity strategy. Prior to business school in an sentiment. And fourth, our A. Rama Krishna Citigroup, Mr. Krishna was intellectually rigorous portfolio construction reflects Director of International profession. the magnitude of the discount Equity Research, Portfolio to fair value at which we buy Manager, International I started out on the sell side in, as well as the risk that the Equities and Chief because I wanted to forecasts may not be correct. Investment Officer, understand businesses. After Emerging Markets Equities about five years, one of my By incorporating these at AllianceBernstein in clients—now concepts into ARGA’s New York, London and AllianceBernstein—asked me valuation-based investment Tokyo. He has also worked to join them to help build their process, we take emotion out at Credit Suisse First research and manage of investing. The process often Boston, first as an Equity portfolios in global, results in our investing in Research Analyst and international, and emerging currently unpopular companies ultimately as Chief market strategies. Based first and industries. The long-term Investment Strategist and in New York, then in Tokyo benefits of this contrarian Director — Equity and London, I built and led approach have been Research, in New York, Alliance’s international documented by a number of Tokyo and Singapore. research team, along with studies. Mr. Krishna earned a joint managing investment M.B.A./M.A. in Asian portfolios. I found my instincts G&D: How does ARGA Studies with a Japan about the profession were implement its investment Specialization from the right—investing was very approach? University of Michigan in dynamic and challenging. 1987 and a B.A. (Honors) ARK: One of ARGA’s core in Economics from St. Much later, when I had some beliefs is that pricing anomalies Stephen’s College, The career flexibility, I decided to are created by emotions in University of Delhi in 1984. return to what got me into the investment decision-making. Mr. Krishna received the business: investment research. These anomalies provide Prize Fellowship in All I had learned reinforced the opportunities for investors Japanese Business and the importance of research in who can capitalize on them. University Fellowship at building client portfolios. I Our valuation screens and our the University of Michigan knew I wanted to bring proprietary dividend discount as well as the Middlebury together a team of people with model provide a systematic College Scholarship. He the same investment beliefs. way to uncover these was on the MSCI Editorial That’s why I started ARGA. anomalies and measure them. Advisory Board and is a By sticking to our disciplined Chartered Financial G&D: How would you investment process and staying Analyst. describe ARGA and its the course amid short-term investment philosophy? pressures, we remove emotion Graham & Doddsville from investing. (G&D): Can you tell us how ARK: ARGA is organized you got into the industry, and around some enduring We do only one thing at how you founded ARGA? concepts that drive our ARGA: valuation-based (Continued on page 6) Page 6 A.Harvey Rama Sawikin Krishna

investing. The pond that we There’s an important people from Japan, mainland fish in is deeply undervalued behavioral reason: we see China, and India. Our India businesses. Our process begins ourselves as business analysts. office has had people from by running several screens to When you start thinking about Korea, the U.K., the U.S., and identify companies’ long-term companies as stocks and try to Singapore. value: price-to-book, price-to- time their purchase, you end earnings, dividend yields, up not owning the stocks While ARGA’s global team normalized earning yields. Our when they may in fact be most brings diverse perspectives, it screens are only the starting attractively valued—which is is highly consistent in how we point. They simply give us a probably when there’s the look at industries and rich universe of companies on most amount of stress and accounting across geographies. which to focus our research. controversy associated with This consistency is critical in them. By focusing on the comparing company valuations The companies that rise to the business analysis, we detach across the world on an apples- top of our screens, generally ourselves from emotion. Our to-apples basis. We follow a speaking, have some sort of investment process tells us strict set of rules to adjust issue—otherwise, they when to buy and when to sell. different accounting standards wouldn't be so cheap. The in different parts of the world, portfolio construction team Our analysts spend nearly 95% so we can reflect the for each investment strategy of their time developing inputs companies’ underlying reviews the screens, focusing that go into the investment economic value. We are also on the top quintile, then works process. The inputs are all consistent when we evaluate with research management to about company fundamentals global market shares and link assign companies to analysts. and related risks. revenue forecasts for companies within an industry. At this stage, the analyst has While making all these one week to come back with “When you start thinking consistency adjustments is answers to two questions: 1) about companies as time-consuming, it is core to "Why does the valuation look our investment process of attractive?" and 2) “How are stocks and try to time comparing company valuations. the fundamentals of the business likely to evolve over their purchase, you end Also at our core is completely time?” up not owning the stocks aligning ourselves with the interests of our clients. We To implement this process when they may in fact know most firms claim this, well, you need to have the but we have actually turned right kind of people. A number be most attractively down several institutions that of analysts who joined during valued.” offered to take a stake in ARGA’s early stage were ARGA, give us assets to people who I had worked with manage, or even pay for our in the past so they were A unique aspect of our firm is operating expenses. We flatly familiar with the investment we started on day one as a turned them down because we approach from day one. The global firm with two knew at some point, their new analysts that we hire often locations—one in a developed interests and those of our have experience working in market, the U.S. (in clients would diverge. We're analytical roles at various Connecticut), the other in an proud to be 100% privately businesses such as insurance emerging market, India. We owned, with many employees companies, management felt that in today's world, you sharing in ARGA’s earnings and consulting, and private equity. cannot look at any business value. Yes, ARGA’s business We haven't recruited much without having both developed has grown rapidly. But what's from the typical Wall Street and emerging-market most important is that we do sell-side analyst pool because perspectives. We then staffed what we truly believe in: we view our research team as both locations with a very unconstrained investing, where business analysts, not stock global team. ARGA’s the sole focus is valuation pickers. Connecticut office includes backed by research. The only (Continued on page 7) Page 7 A.Harvey Rama Sawikin Krishna

way to do that without company forecasts if they equity, non-U.S. or interference is by being didn't believe their colleague’s international equity, and completely independent. The industry forecast. There’s a emerging-markets equity. Each only people we answer to are level of quality control even strategy today has our clients. before an analyst brings a approximately 50 to 60 company to the research holdings. We do have a highly G&D: What are some of the management or the portfolio concentrated version of our adjustments you make for construction teams for global strategy that has 15 to valuation or accounting across discussion. 20 holdings, but most geographies? strategies are in the 50-60 ARGA’s teamwork philosophy range. In constructing these ARK: Let’s take China also ensures our businesses portfolios, we do not consider Resources Power in China, are well understood by the regional, industry, or stock which uses steam turbines to persons beyond the industry weights of the market generate a portion of its expert. The two or more benchmarks. Of course, our electric power. The company analysts with related coverage clients compare us against depreciates its turbines rapidly hold frequent discussions on benchmarks for long-term over roughly 16 years. The sector businesses, often performance but benchmarks same steam turbines in travelling together to visit are non-factors in our Germany or the U.S. would companies. We believe this portfolio construction. We probably depreciate over 25 teamwork leads to better focus purely on owning the years. So China Resources business insight, and, in turn, most attractively valued Power’s reported earnings better investment decisions. businesses in the world. seem much lower than if you adjusted the turbines’ G&D: Could you talk about G&D: What is your process accounting life to reflect their some of the lessons you’ve of generating ideas? Could you true economic life. If you didn’t learned from investing over walk us through one of those make such an adjustment, you the past couple of decades and ideas? could miss a company with how that’s influenced what you greater earnings power than its do today? ARK: It goes without saying reported numbers imply. that most investors want to ARK: What has stuck with me buy a good business. But the G&D: How do you organize most is that no matter how reality is, for a company with a your analysts given the multiple great the operating leverage in solid management, a strong locations, various markets, and the business, if you have a lot balance sheet and good growth need to constantly adjust for of financial leverage, you might prospects, it's extremely such nuances? never reap the operating difficult to get those benefits. A big lesson for me characteristics at an attractive ARK: We organize our was how to manage financial valuation. We’re very realistic research team by global risk. Even if the financial on what we can buy for our sectors. Typically, more than leverage doesn’t seem high at clients. Almost every candidate one person has responsibility first, if the operating leverage tends to be a company that has for a particular sector, which is high and the business some issue. encourages and facilitates deteriorates faster than you collaboration, both across and expected, then financial What we're doing through our within offices. While it may not leverage starts to grow research is figuring out seem efficient for two people exponentially. Be very wary of whether the issues are to cover a smaller sector, it financial leverage. transitory or permanent. If we ends up being more effective. believe the issue is transitory, These analysts build industry G&D: Tell us about your and the business is attractively models together, and also link portfolio strategies. How many valued on our dividend their individual company positions do you usually target? discount model (DDM), then models. This helps ensure best we consider buying the stock. possible inputs, as the analysts ARK: ARGA has three We invest with a three-five would object to linking primary strategies: global year view at ARGA. We want (Continued on page 8) Page 8 A.Harvey Rama Sawikin Krishna

to ensure any downside risk For Samsung’s DRAM business, firm, except that we invest in over that timeframe is limited. our analyst’s thesis was unique. public markets at ARGA. We We think about downside risk Unlike most analysts who at behave as though the New as permanent loss of capital— that time were saying the York, London, or Shanghai “What is the downside risk of DRAM cycle would go through stock exchanges will close for losing money when we sell the its typical boom-bust rotation, the next three years, and we stock in three years' time?” our analyst pointed out that won’t have the liquidity to exit. the number of DRAM players We leave no stone unturned in Take Samsung Electronics. It had gone from as many as ten our research. Otherwise, we came to the top of our a decade ago to currently only wouldn’t have the confidence screened list around early three. It’s now an oligopoly. to own the business. We go to 2014. Our analyst spent a The third largest player, work on building detailed week researching Samsung’s Micron, barely made money in industry and company models. business and came back with the best of times and would We talk to company answers to our two questions. set the floor for pricing during competitors. We develop the First, “Why is the stock the next downturn. So even income statement, balance cheap?” A key reason was that though DRAM volumes might sheet, cash flow forecasts by Samsung was losing market be off, our analyst’s view was segment and full company. share in smartphones to Apple. that pricing would not collapse. Its share had tumbled from That meant Samsung or even around 32% to the mid-20%s. peer SK Hynix would end up “We behave as though The smartphone business was making 20%, possibly 30%, a huge cash generator, about margins during the next the New York, London, 60% of Samsung’s profits. downturn. He believed that or Shanghai stock Concerned that this profit would surprise the investment stream was under threat, many community when it happened. exchanges will close for investors had sold off. We thought the analyst’s thesis was plausible, and decided that the next three years, and Additionally, Samsung’s DRAM Samsung justified a detailed we won’t have the semiconductor business was research project. facing an end-market liquidity to exit.” slowdown as PCs slowed and At this stage, we usually reject smartphones became about 80% of companies under saturated. For these reasons, consideration. Companies can As we're doing all this, we almost every analyst covering be rejected for any number of come up with questions for Samsung issued either a hold reasons. It could be structural. management. When we talk to or a sell rating for the stock. If the business faces structural management, we aren’t there The stock’s valuation challenges, we pass, as we to hear a presentation on the collapsed. The second question know the stock will appear parts of the business that are our analyst addressed was, expensive on our DDM once doing well. We’re there to talk “How are the fundamentals of we input our forecasts for about their strategy for the business going to evolve growth and profitability. If the business recovery. We come over time?” The handset business has huge financial back and update our models. business is a consumer leverage, we may pass knowing Then, we talk to an analyst in business. We can't really it may not survive stress over the brokerage community who forecast which smartphone our three-five year time may have a different view of model is going to be successful, horizon. The point is we the company to see if we have so we treat it as a commodity proceed with detailed research a structural flaw in our business, where scale matters. on only 20% of companies. analysis. If we have a structural In that light, even if Samsung flaw, we go back to the margins tanked to 10%, the G&D: What does this next drawing board. stock’s valuation still looked step of research involve? attractive. In the case of Samsung, the so- ARK: This is where we start called “flaw” we heard from behaving like a private-equity brokers was, “why would you (Continued on page 9) Page 9 A.Harvey Rama Sawikin Krishna

not want to wait until you see already declined so much, our shareholders in the desire for the handset business pick up base case upside was very good returns in the long run, if again, or the DRAM business significant, while our stress not outright cash returns. We go through the next up-cycle?” case showed little downside. It felt they’d be forced to do That's music to our ears. was one of those good skewed something about the more Because if you waited for the outcomes that we generally than $60 billion in cash as the good news to come through, look for at ARGA. If we’re business matured. Our analyst you're going to miss the best right on our forecasts, we noted that Samsung rarely part of the upturn in Samsung’s make a lot of money for our made acquisitions, as these had stock price. clients, and if we’re wrong, not delivered great returns in there’s very little risk of losing the past. Viewing management The point is, we’re almost money over time. as good stewards of always buying stocks pre- shareholder capital, the only catalyst or pre-good news. We G&D: One concern that option left as cash builds to all read the same newspapers. investors have had about over $100 billion is to begin The difference at ARGA is we Samsung and the Korean returning cash to shareholders. have a disciplined process from conglomerates is how their which we never deviate, no managers allocate capital, If management did anything matter how we might feel overspending or engaging in right with the business, or if emotionally about the outright related-party capital allocation turned out company. Once we put the transactions. How did you just a bit better than expected, numbers into our DDM, if the think about that when you it would be a big, positive stock valuation looks attractive were evaluating management? surprise. This is an example relative to our computation of where everything in our the company’s intrinsic value, ARK: That was a big concern. analysis pointed to an we consider the stock for our In fact, one of the reasons incredibly undervalued portfolio. For Samsung, our Samsung was so cheap was business for this kind of process indicated more than related to concerns about franchise and strong free cash 100% upside in our base case capital allocation. We had no flow generation, relative to the scenario. crystal ball to forecast what market cap. At ARGA, it management was going to do, always comes down to In addition to a base case that so we focused on obtaining a valuation. normally tilts conservative, we very clear understanding of its do a stress case for every underlying businesses. Our G&D: How do you think company we research. The analysis showed the industry about the politics of Samsung? analyst sometimes finds no dynamics had changed The broader conglomerate downside risk. When that dramatically in DRAM and controls so much of South happens, as it did in the case of even in NAND, becoming very Korea’s economy. Plus, the Samsung Electronics, we pay consolidated. All players now heir to the Samsung empire very close attention. From a appear very focused on was arrested earlier this year balance-sheet viewpoint, we returns, not just growth. It for his alleged connection to a found a company with little became apparent that even if corruption scandal. risk. We saw more than $60 Samsung didn’t act in the near billion of cash that would allow term, management would ARK: Governance is an ample financial stability. Our eventually realize that with its explicit part of the research analyst had pointed out that a cash-generating handset for any company ARGA looks few of Samsung’s smaller business and flexibility to rein at. We even have a checklist businesses were losing a lot of in capex, it was building excess that helps analysts understand money. We concluded that if cash on the balance sheet, companies’ governance issues the core business ever came which depresses returns. and associated risks. Yes, we under serious threat, Samsung identified a large risk with the could immediately shut down We felt the interests of Samsung group that they these two smaller businesses Samsung’s management, the probably have a finger in every to boost profitability overall. controlling family, were at least area of the Korean economy. Because Samsung’s stock had aligned with minority At least in Korea, it's not just (Continued on page 10) Page 10 A.Harvey Rama Sawikin Krishna

the Samsung group that is In emerging markets, there are and China that are as well- exposed to Korean political always going to be situations managed and have as good winds and economy. Other where you could be surprised corporate governance as conglomerates have had similar by risks. Even with Big Four companies in India. Our view is issues. Governance at the audits, there are cases of fraud. that governance is company- larger Korean groups hasn't This is something you do your specific, not geography-specific. been positive in general. best to minimize through Every part of the world, Nick Briody ’18 pitches a serious due diligence. You talk including China, India, Korea, short on Smucker’s at the The Samsung group has never with management and peer and Russia, has outstanding Pershing Square Challenge willfully destroyed value at the companies, seeking to businesses and outstanding Samsung Electronics level. It's comprehend management’s managements running those their flagship company. They’ve backgrounds and motivations. businesses, along with done an incredible job of Still, it’s a risk you always attractive valuations. building a fabulous franchise by worry about. Of course, those taking a long-term view of the very risks can also make stock G&D: Have you ever run into business over the last three valuations very compelling. situations where you find a decades. The good thing about That’s why it’s worth doing good, undervalued company, Samsung Electronics is you deep research. but because of its location, you can't build and run a big, global don’t invest? company unless you have professional managers in each “The reason value ARK: At ARGA, it’s never a of the business lines who know macro view. The only reason what they’re doing. Samsung investing works in the we won’t invest somewhere is Electronics certainly has its if we believe we’ll never get share of high-quality managers long run is because it our money back—if there’s the who we believe will continue doesn’t work all the risk that some country like to run the business well Argentina expropriates our despite the detention of the time.” capital. Beyond that, our focus Samsung heir. is owning attractively valued businesses. G&D: When you’re looking at Interestingly, state-owned emerging markets, how do you companies mostly have a Typically, the only time get confidence in the financials greater degree of scrutiny. businesses get to the valuation and that the business is being Though there are cases of levels that make them properly represented? corruption, with most state- incredibly attractive is when owned firms, there are at least there are all kinds of concerns ARK: There are certainly processes and probably more at the country level. For groups or companies, government oversight in the example, a couple of years ago, particularly in emerging form of regular audits. The less we had 24% of our emerging- markets, where ambiguous regulated countries have markets portfolio in Russia. financials are an issue. These potentially higher risk. That’s a pretty significant typically tend to be private- weighting, especially given all sector or smaller companies. G&D: India is often the news you were reading What we do in these cases is considered as the one regarding sanctions, or about try to understand if the emerging market where Russia going into a massive company has a history of private-sector firms are of recession for a year or two. questionable practices. Have higher quality. In your Our research showed there they changed auditors often? experience, is corporate were businesses in Russia that Do the auditors have governance better in India than would survive a major qualifications? We’re in China or Korea? economic downturn in very constantly on the watch for good shape, even if that these and other early warning ARK: Not necessarily. We downturn lasted for a couple signs. don’t think it’s any better, or of years. Further, when Russia any different, in India. We can would eventually recover, identify companies in Korea those businesses would (Continued on page 11) Page 11 A.Harvey Rama Sawikin Krishna

emerge stronger than ever mode. They were very G&D: When you were because its peers would have methodical and prompt about looking at Russian investments, been wiped out. this to get maximum money was there a focus away from, back, way before other Russian or towards, some of the We embrace stress and banks even thought about natural-resource players? uncertainty—not because we doing this. love them. Our investment ARK: We did have some process forces us to consider The company was not only natural-resource exposure, such businesses because they able to survive a massive particularly Russian oil-and-gas are probably the most Russian recession, but more businesses. These had U.S. attractively valued just when crucially, it emerged stronger. dollar-denominated revenues, they’re subjected to perceived It turned down the Russian very clear agreements on tax or real stress of a significant government’s offer of capital and royalty payments to the degree. By the way, this infusion because their view Russian government, and fairly process is not for everybody, was, once you take that good transparency on capital as you can imagine. It is not fun assistance—as some of the allocation. If oil prices went for most people, even for us at other weaker Russian banks down, their payments to the times. The reason value did—the government could Russian government would investing works in the long run then influence you, like also go down. They’re less is because it doesn’t work all demanding you lend money to leveraged to oil prices than the time. If it did, everybody unappealing groups. Sberbank most other oil and gas would do it. wisely wanted to stay companies worldwide and completely independent. We they’re also fairly well-managed G&D: Could you give us an think Sberbank management is operationally. example of one of those as good as at any bank in the Russian businesses that you felt world today, maybe better. A company like Gazprom has was solid enough to weather They’ve come out of the perhaps among the most the downturn? recession nicely. They’re undervalued energy assets already making ROEs in excess you’ll find anywhere in the ARK: Look at Russia’s largest of 15%. You can imagine how world. It has decent corporate bank, Sberbank, which has they’ll perform when the governance processes, despite close to 50% market share of Russian economy actually picks concerns by some investors. Russian retail deposits and is up. Most other banks are still Yes, capex is high because it’s also Russia’s largest corporate burdened with problems from seeking ways to reduce lender. Pre-recession, this bank the recession. dependence on Europe, so it is was extremely well capitalized spending billions of dollars and, in our view, could G&D: We see that Sberbank building multiple pipelines. The withstand a big increase in still trades below consensus Russian government, as the NPLs. Keep in mind, when you estimates of forward book controlling shareholder, has have a bank that has close to a value. Would you still think it’s the same incentive as minority 50% market share in retail attractive? shareholders to ensure deposits, chances are good Gazprom pays dividends. The that returns will be high. ARK: It’s still a good franchise. government wants those Sberbank had an average But the stock became less dividends too. We like that return on equity of 20% over undervalued than it used to be. Gazprom’s earnings are mostly the past decade. Valuation is always the driving in U.S. dollars. If the local force and there were better currency weakens, there’s little As soon as Sberbank saw what valuation opportunities. We dollar impact. In contrast, local was happening with the did sell out of most of our -currency earnings and Russian sanctions and Sberbank position last year and dividends went up a lot when slowdown, the management used the proceeds to invest in the ruble fell. made sure they could pull back higher-return opportunities. every single loan or credit line Declines in the stock’s G&D: Going back to your possible. They went into a very valuation may make us lessons of being wary of severe damage assessment reconsider the business again. leverage, would you (Continued on page 12) Page 12 A.Harvey Rama Sawikin Krishna

automatically reject companies could differ), it’s sold from the probably isn’t. As Ben Graham that seem cheap because they portfolio. We don’t even once said, “In the short run, are having issues with debt? discuss it. We just sell it. We the stock market is a voting sell even if the stock has strong machine. In the long run, it is a ARK: No, this depends on momentum at that time. weighing machine.” whether the business can handle the leverage under our The reason we sell At ARGA, we happen to favor stress case scenarios. Our immediately is that our valuation-based investing. That stress scenarios help us assess strategies are solely focused on doesn’t necessarily mean we whether, no matter how low owning the most undervalued think the value framework is profitability may go, the businesses in their universe. any better or worse than company we are considering No matter how great the momentum in terms of can still support certain levels stock price momentum at the delivering investment results. of leverage. You make sure the time of sale, there should be There’s a long history of value stress case truly reflects a other more attractively valued strategies and of momentum worst-case scenario. You companies in the portfolio or strategies performing well. cannot forecast events, and in the universe that should do They’ve performed almost there could be a situation a lot better on a three-year identically over the last 45 where things get to that view. years or so. It’s more a extreme worst-case scenario. question of you finding what You always want to make sure To continue the Samsung you believe in and what you your companies can survive. Electronics example, the stock find most stimulating. So it’s a hit the midpoint of the ranking question of temperament— In the case of energy stocks, in our universe in August of how you look at data and for example, when we built last year. At that moment, we figure out how a business our stress case scenarios, we automatically sold Samsung might evolve in the future. assumed $30 oil prices for two from our portfolios. We didn’t years in a row, both 2016 and even discuss it. We just sold You need to determine what 2017. Consequently, we ended the entire position. kind of an analyst you are. up dropping a lot of companies What do you like doing best? that looked really cheap on G&D: Any advice for students Is it trying to forecast whether our initial screens because they who are trying to get into the a fast-growing business can wouldn’t have survived at sub- investment industry? How sustain its momentum? Or $30 oil prices for two years. would you suggest they trying to understand what the develop their investment business should earn over the G&D: One dilemma for a lot philosophy? long run? A career in value of value investors is deciding investing can be stressful. The when to exit an investment. ARK: All of us at ARGA are rewards of exploiting Do you sell when it’s gratified that many investors behavioral anomalies successful, or when some have entrusted us with the compensate for that stress negative news has come out? responsibility of managing their over time, but do you have the financial assets. Here’s my patience to wait for them? ARK: Everyday, we get a list parting advice to students Depending on that, find a place of exactly where every stock in interested in the investment that can serve as a home for the portfolio ranks on profession. First, remember you to develop your industry valuation with respect to our you are purchasing companies, expertise and analyze universe. In a very real sense, not pieces of paper. Second, be businesses. The great that’s a daily reminder of the patient—just because you opportunity for Columbia discipline we need in figured out that a company is MBA students is that you are implementing our valuation- underpriced doesn’t mean that in close proximity to a large based approach. The moment the day after you buy it, all number of firms in the New a stock in the portfolio hits the investors will agree. Third, be York area with a variety of valuation midpoint of the prepared to go against the investment approaches. Once universe (depending on the crowd. If everyone thinks a you figure out your investment strategy, the midpoint rank company is attractive, it temperament, you can identify (Continued on page 13) Page 13 A.Harvey Rama Sawikin Krishna

a number of firms that are three-five year horizon. If closely aligned with your someone had a 12-month objectives. horizon, and that's how they're going to evaluate us, then G&D: How did you figure out we’re probably the wrong what your temperament is? manager for them. We know there will be some 12-month ARK: In my first corporate periods when we do poorly, by finance class in business school, virtue of the fact that ARGA the first thing the professor focuses on the most said was that the value of any undervalued businesses. Value business is the present value of investing doesn't always work future cash flows. As soon as I in the short run. heard that, a light bulb went off. It became very clear how G&D: Thank you so much. to value a business. From day one, my focus has always been trying to forecast what businesses should earn in the long run, then coming up with the present value of that.

G&D: Do you think other investors lose sight of this fundamental aspect, of having an idea of what the company should look like in the long run? Or is it apples and oranges because different people have different styles?

ARK: Even though there is convincing evidence that highly undervalued companies should do well over time, most investors are not interested due to the anxiety associated with owning them. This behavioral dynamic is why ARGA’s disciplined process and deep fundamental research, which leads us to buy out-of-favor stocks, should yield good returns in the long run.

Time horizon is an important factor in investing. It depends on the clients you have and whether they share your time horizon. We know we cannot outperform every single year. We tell all our clients that upfront. ARGA is the right choice for clients who have a Page 14 Cliff Sosin (Continued from page 1) earned both a B.S. in I learned a lot at UBS, met The key is finding businesses Engineering (High some great people and really we understand, buying them Honors) and a B.A, in matured. I also was fortunate for less than they're worth, Economics from to have some very good and hopefully holding for a long Swarthmore College. investing results. At a certain time. We try to marry that point though it became clear long-term outlook with a Graham & Doddsville that at a more traditional long- degree of accountability. We (G&D): Cliff, can you tell us short business such as UBS I try to identify why a business is about your background, and wouldn’t be able to invest the going to be successful and try how that led to CAS way I want to; however, I was to formulate that idea into a Investment Partners? trapped at UBS because of my clear hypothesis, enumerate deferred compensation. the predictions of that Cliff Sosin Clifford Sosin (CS): I went hypothesis, and then we look to Swarthmore College and Eventually, the Volker rule for disconfirming evidence to studied Engineering and required the bank to get rid of kill the hypothesis. Economics. I worked for two its proprietary investing years at Houlihan Lokey business. They transferred us To understand our approach, focusing on restructuring. I to UBS O'Connor. That you must appreciate that in wanted to be on the buy side created an opportunity for me this framework a stock price because I didn't like being an to leave and continue getting going down never constitutes advisor. I preferred seeking my deferred comp based on disconfirming evidence. We truth as opposed to seeking an the vesting schedule. I wasn't spend no time worrying about argument. I went to a place rich, but I wasn't poor, so I had stock prices bobbing up and called Silver Point, which is a space to start a business and down in the short to medium distressed lending business. I know that if I didn't attract term. We are indifferent to was in a private lending part of much in the way of assets, I stock price volatility. the business, but negotiating could still eat. private loans didn't suit my G&D: You have five positions. temperament. Part of it was I left UBS in July of 2012 and Is that the level of environmental. It was 2006, so started CAS Investment concentration you want going there wasn't a spread that was Partners the week of October forward? too thin or a company too 9th. People ask, “Why the risky. I found doing these ninth?” The eighth was CS: There is no ideal. That’s private sales very frustrating. It Columbus Day; we were probably towards the higher wasn't a good fit. aiming for the first, but we end of concentration. I think missed. We started with a very about it in two ways. First, if A year later, I started to look small amount of capital and you think about concentration for another job and found my have been fortunate to get in terms of how big a loss way to UBS. There were 35 bigger since then. would you be able to people in the group, mostly withstand and not interrupt split into industry groups. My G&D: Could you walk us some decade-long job was to look at high yield through the CAS philosophy performance, you can come up and distressed, but I also got and strategy in more detail? with a third or a quarter of to spend time looking at your money, which is a lot. generalist stocks. Fast forward CS: It's simple in concept. We That puts an upper bound on a year and a half and the group try to invest in businesses that individual position sizes if you shrank from 35 to nine. I was we can understand and that we recognize that no matter how fortunate to keep my seat. We can get for less than they're much you think you know, also stopped investing in high worth. We're not going to find there's always some probability yield and distressed so I a lot of them because we're of something you never focused on stocks. That's not that clever. We find a few imagined that causes that where I started thinking full- from time to time. Right now, position to be a zero. time about stocks and began, we have five positions of size. from 2008-2012, developing Of those five, three of them You can also analyze the my investment philosophy. date to the inception of CAS. problem empirically. I don’t (Continued on page 15) Page 15 Cliff Sosin

think that managing volatility is limited to the excess that's going to get hit by a a worthwhile thing, but let’s performance of the new idea truck. Something bond-like… use this lens for a second. The over the old idea. There is or better yet a bond. The idiosyncratic mark-to-market opportunity cost. problem is that is really hard, volatility declines so we don't find many. There's proportionate to the square Conversely, if we short a certain amount of looking root of the number of something, we don’t have to and not a lot of finding. To positions you have. If you have sell something so there isn’t make matters worse, the four, you get half the benefit of much opportunity cost. It's a positions we find tend to be having infinity. To get 90% of very small opportunity cost small since you can only the benefit of infinite from the balance-sheet reasonably be short a small diversification, you need 100 perspective. To the extent that percentage of a company’s positions. You get 50 points we can find things to short that shares without taking too for the first four positions and go down, we stand to make much squeeze risk. We've it takes you another 96 money. The question is made a little bit of money over positions to get another 40 whether finding shorts is time but it's certainly not been points. It's just not worth it. A worth it from a time worth the time to date. handful of positions is enough. perspective. The jury is still It forces you to think hard out. So why do we do it? The about the trade-offs you're theory is that every decade or making and allows you to take two, you might come up with a advantage of the handful of “A handful of positions is great short, a la the subprime truly good ideas you have. short or something else with a enough. It forces you to skewed risk-reward. If you're G&D: How do you think think hard about the not looking, you probably about exiting a position and won't find it. If you can maybe entering a new one? trade-offs you're making make a percent every year or and allows you to take two nibbling on berries and CS: I consider opportunity then occasionally, come across cost. You want to own a advantage of the handful an elk, it's worth it. Honestly, I position for the next five-to- don't know whether we'll get ten years. What's a reasonable of truly good ideas you it right. We’ve never taken range of outcomes for both have.” down an elk. I'm not wired to investments? Is it similar? If yes, like shorts. It's hard for me to then more diversification is see them. better. If it's worse, then no. Our shorting is different Why sell the good for the because we're not doing it to G&D: How do you think new? The basic idea is you hedge. We don’t have to do it; about risk and how do you try think about how much money it is intended to make money. to get comfortable with a long you make and how sure you Also, I think over time we have time-horizon given your large are over a long span of time. a pretty good shot at decent exposure with each You try to figure out the best returns from the long side investment? portfolio. Easier said than alone so I tend to be quite risk done. averse with regards to shorting CS: Let's think about risk in because I don’t want to muck two different ways. The risk I G&D: Is your approach up what should be good long- think you’re thinking about is different on the short side? term performance on the long path dependency risk. It's this side. idea that, sure, the business CS: The benefit of shorting is flourished, but along the way that the capital opportunity We have a narrow window of you went broke. I am fairly cost is very low. What I mean things we want to short. We averse to any significant degree by this is that when we buy won't short dreams or of path dependency risk. It's something, we need to sell pyramid schemes, nor highly not to say that we cannot have something to make room so shorted stocks. We’re looking some investment in the the wealth gains over time are for some sleepy company portfolio that's over levered, (Continued on page 16) Page 16 Cliff Sosin

provided it has the right risk- safety is key. Investing is hard. you want to know about the reward. You just can't have As it should be. company before it even enters five of them. You certainly the portfolio? can't have a lot of portfolio G&D: Holding positions over leverage. You’ve got to make the long-term, how do you CS: There's no sense in sure the investments you're protect against thesis drift? putting on a starter position. making are resilient and your structure is resilient. If you CS: It's a risk. You should I've been impressed over the think about our business, the update, refine and improve years how I think I understand whole business is predicated your thesis with time but you something well and then I on the idea of finding investors probably shouldn’t allow learned something I never who are looking for long-term yourself to come up with an knew. But before we buy a compounding. They're willing ever-increasing litany of single share I want to have a to have volatility and not going excuses for a business where hypothesis I've exhaustively to call me every day if we're your understanding is clearly attempted to invalidate, and if down 20% in a month. You’ve not as good as you thought. our hypothesis is right, it’s got to attract the right probable that the returns will investors and build the right You can't judge the be high enough to justify the economic model. We can't probabilities of something opportunity cost of whatever have an economic model unless you can understand the we sell. I've found that with where I'm struggling to keep underlying mechanism. You investing, there's one thing that the lights on if assets are down have to form a view of what must be true and everything 30% or 40%. We've got to would change your mind on else is just noise. There's one have an economic model that the mechanism upfront and thing that matters. Once you works in the worst of times. you look for that. If you find it, nailed that, you can still learn a We’ve got to be flexible. you shouldn’t own that asset. lot more. Inevitably, there will be bumps But it is okay to refine and in the road. enhance your understanding of G&D: Are there industries the mechanism and it is that you avoid or ones that The second way to think about certainly okay to update your your team focuses on? risk is the risk that the understanding as the business investment thesis was wrong. evolves. CS: We try to think about We try to be careful about mental models. Investing is the that. We try to lay out our G&D: Given your applied social science. We try hypothesis in an unvalidatable concentration, how much to develop these tools to form, outline what would adjusting of positions do you break down how complex constitute disconfirming do, particularly if things run or social organizations perform evidence, look for that struggle? and behave in our market- disconfirming evidence, driven economy. We’ll look at enumerate, question and stress CS: We reallocate capital so anything where we can use our assumptions. Pre-mortems we have more invested in these tools but not at things are a good idea; writing down positions we think have a where we cannot. The classic and revisiting any evidence that higher rate of return. Our example of something we doesn’t fit with your margin of error is broad won’t look at is biotech. The hypothesis is a good idea too. enough that 20% up or down ability of some new You also have to watch out for doesn't matter here or there. compounds to cure cancer is all the usual cognitive and If one stock goes up 30% and just not something to which decision-making biases. When the other goes down 30%, we bring any particular you only have five positions there probably is something to expertise. Whereas, an and you're in them for a long do. We adjust for large understanding of “loyalty effect time especially, all these biases movements, but not for small economics” applies to a broad come into play. ones. range of different industries, from wealth management to In the end you are going to G&D: When you're looking at insurance brokerage to make mistakes and you are a new position, how much do subprime lending. If you were going to get unlucky. Margin of (Continued on page 17) Page 17 Cliff Sosin

to think about a circle of spent a lot of time talking work if people try to sell, can't competency, if our tools about the product and the sell, become stuck with explain it, then it's in our circle $100 MSRP. He showed that product and then eventually of competency. on eBay, the same product throw it in the garbage when, trades for 65% of MSRP. That at the same time, there is a I don't have a tool for making a sounds bad. He used that to secondary market where the lot of useful predictions about show how there's no stuff trades above the the future development of significant retail profits. The wholesale price. People are technologies. As far as I'm weird thing is that if you're a not that ignorant. It's not like concerned, technological distributor and you have any one dollar of the stuff trades innovation is drawn out of a volume, you buy at 50% of on eBay; millions of dollars’ hat. My ability to forecast that MSRP. So that seemed to worth is traded on eBay. is very limited, and so if your imply that distributors were Herbalife sells billions so it's business is one predicated on making money even selling on this teeny little piece, but it's how the web architecture eBay. millions of dollars in a works, it's improbable that secondary market. we're going to figure it out. If “I knew the name on the other hand, your That was the string in the business works because people [Herbalife], and watched sweater that I started pulling at love coming to your meetings so to speak. I was also and being part of the the Ackman presentation fortunate to have a friend who organization socially, that's a week or two after it had done some work on it and something that we can figure believed it to be a good out. had been done for business, so he steered me the right direction. John Hempton G&D: We saw, in prior roughly the same reason also put out his somewhat letters, that Herbalife is one of people stop to stare at famous blog post. He wrote your biggest long positions. about going to an Herbalife Can you walk us through the car accidents.” club and guess what? It was research process with that filled with customers. They're idea? If I told you that there was a drinking shakes. I started to loan and nobody wanted it and put it together. CS: It was always on my radar. it was worth virtually nothing, If you did a “Magic Formula” what would the market I spoke to people who are screen, it always showed up clearing price be? The answer experts in the space (lawyers cheap. It was this company that isn't 65 cents on the dollar. and such) who say Herbalife's always grew and had great The answer is closer to two not just a legitimate company, economics, but I had never cents on the dollar. In the case it's the white gleaming example bothered to grab the 10-K. I of Herbalife, you can compare of multilevel marketers in the knew the name [Herbalife], it to furniture. Used furniture industry. They call it the gold and watched the Ackman trades at a much bigger standard. Herbalife’s turnover presentation a week or two discount at MSRP than is the lowest in the industry. after it had been done for Herbalife product. Herbalife's a People love it. It's been around roughly the same reason food. When you're buying food forever. I started noticing all people stop to stare at car on eBay, it's a little weird. these things. accidents. I originally thought There probably should be the Ackman presentation was some discount. This bugged Finally, I sat down and revisited great and I even wrote to one me. It was inconsistent. the section of Pershing of my friends that I thought Square’s presentation where Herbalife was a pyramid You can't have a situation they were quoting this paper scheme but a very profitable where large numbers of people from the SEC’s former pyramid scheme. are buying the product they economic consultant. I read don't want because they want the paper. The legal precedent However, there was something to participate in a money from the Koscot case for that bothered me. Ackman transfer scheme. It doesn’t multilevel marketers is that the (Continued on page 18) Page 18 Cliff Sosin

companies must sell to product is either sold at the It was also very, very cheap so ultimate users. retail price or not sold at all. there was enormous margin of The problem is, we know for safety, and conversely we were Dr. Peter Vander Nat tried to Herbalife that anyone can sell being paid very well for the put some math to the legal it on eBay for 65 cents on the risk. standard. It’s a very sensible dollar. That is different than paper. He says, let's imagine the embedded assumptions in G&D: If multi-level marketing that we consolidated the the model. If you were to just is successful and legitimate, economics of the distributors make that change you can't why do so few brands choose with the multilevel marketer. come up with any way that to operate this way? There'd be a certain amount of Herbalife is a pyramid scheme gross profit, there'd be a in the Vander Nat model. CS: I spent a lot of time trying certain amount of overhead, to understand why this and then there'd be a certain Also, let's look at this in a business works. We are going amount of sales and recruiting Bayesian sense. Just ignore to venture out on the bleeding commissions. If the gross everything you know about edge of what I think I know. profits less overhead cover the Herbalife. Imagine some We are going to enter the sales commissions then the company that's lasted for 37 realm of more conjecture organization is clearly not a years, is publicly traded, exists where I have much less pyramid scheme – after all, it in 90 countries, and has been evidence. If you look at the could work as a consolidated in regulated markets all around sphere of human activity, there entity. Conversely, he posits the world. Is it or is it not a are some activities, such as that if the gross profits don’t fraud? The answer is it may be buying a jet engine, that are even cover the overheads then a fraud but the prior very rational. There are other all the commissions paid are probability that it’s a fraud is activities, such as participating essentially wealth transfer quite low. in your local church, that among the sales people so it is economists would say should a pyramid scheme. Somewhere When I finished going through not exist. in between, there'd be some the Vander Nat paper, I added percentage of the amount paid that to the mosaic of things I might argue that members of out to distributors that comes and decided I was reasonably successful long-term multi-level from gross profit and some confident that it wasn't a marketing organizations are percentage that comes from pyramid scheme. I essentially participating in a social group. new distributors coming in and looked at it in a Bayesian They're identifying themselves going out. He said 50% would sense. The prior probability is as good people through the be an interesting tipping point. low. Ackman presents participation in a social group. evidence it is a pyramid They are doing it for other This is the way that Dr. scheme but we have people and they are doing it Vander Nat tried to put some determined that much of that for themselves. Volunteer fire math to the legal standard, and analysis is faulty (and there departments, church there is an equation that falls were a lot of other issues organizations, and civic out. In Shane Dineen’s part of beside the ones I mentioned). organizations are all the Pershing Square Then you layer the availability organizations where people presentation, he tries to fit of returns, the high price on participate, but not in a strictly Herbalife into this equation. eBay and the perception of this economic sense. What makes Ackman’s team used a bunch as a class act among industry Herbalife special, and what of assumptions and shows veterans, and you come away makes a great multilevel Herbalife's a negative number, thinking it is vanishingly likely marketer special, is that you ergo a pyramid scheme. that Ackman is right. build a belief system around these products. The problem is that the At the time, I definitely did not original paper starts with a understand why it was a good Herbalife is not a purveyor of bunch of implicit assumptions. business, but I was willing to protein powder. Herbalife is an Among the implicit take the trend of 30 years of organization that people assumptions is that the performance at face value. participate in because they (Continued on page 19) Page 19 Cliff Sosin

view themselves as healthy, identification is fundamental to setbacks. If you focus on the active people. They want to people. There's social good you are doing it helps a lose weight, be healthy and cohesion. lot in terms of working active, and share their through the setbacks. experience, the lifestyle, and its Of course, there are varying benefits with other people. levels of passion. On the The most common failure Think of it as analogous to a lowest level, you've got people mode within Herbalife is for a religious movement or to a who don't know anything happy consumer to try his or political movement. It's very about the mission and lifestyle. her hand at selling only to hard to build these things. In They bought Herbalife learn that it isn’t for them. So, the early days, they die like products once and they used they stop selling and simply fruit flies. Once they grow up, them. You’ve got a whole lot consume the inventory they they last forever; but it takes a of people who make a little bit might have purchased and go lot to get one up and running of money and spend some time back to being a happy and you can’t just start one… doing it because they enjoy it. customer. It's like me buying at least not easily. They like the people involved, five boxes of Cheerios because they think it's important. Then I thought I was going to sell there are the real money Cheerios. Then I decided that “What makes Herbalife makers. For them, it's a job selling Cheerios is not for me. and a mission. It's like being I'll just eat the Cheerios. special, and what makes the priest. a great multilevel Keep in mind Herbalife has a G&D: People don’t just join return policy. If you were truly marketer special, is that Herbalife to try to make duped in this manner—you bought $5,000 worth of you build a belief system money? inventory, tried to sell it, and around these products.” CS: I think people join for a you couldn't—you could lot of reasons. The vast return it to the company. This majority of members are really is a big problem with the bear We came to appreciate that, just discount customers. They argument. It's like if a bank within Herbalife, while there's join so they can buy the robber left a business card, an economic incentive engine products at a discount. Some “Please call if you want your that motivates some, that only join because they like the money back.” Many hedge explains part of the social aspects, the fit camps, funds have bought Herbalife phenomenon. If you think the nutrition clubs, the other products and returned them. about Daniel Pink's work on members to support and This has been well-tested. what motivates people, it is reinforce their nutrition goals, purpose, independence, and etc. Some join with modest G&D: Does the stigma of mastery. In Herbalife, you give income aspirations in addition multi-level marketing deter people a huge purpose. If you to their health and weight-loss investors? sign up for Herbalife and you aspirations, selling a bit to help one person lose 50 friends and family. Some join CS: There are multi-level pounds, the odds are good with the goal of building a big marketing scams that promise that you want to keep business. Some of them the world and die quickly. A participating. You want to find succeed and some of them, new multi-level marketer is a the next person. That would just like any other business, risky proposition for an be a big thrill. don’t. Undoubtedly some investor. What makes people try to make a business Herbalife interesting is that it If you think about it, social out of Herbalife and fail, so has very low attrition, organizations are all over the some of them lose money but compared to other such firms, place. It's only natural that usually not very much. It helps and it's been around a long through natural selection, a lot for those who are trying time. Herbalife's results are companies would realize that to build a business to also love going to be volatile, particularly these mental pathways exist the mission. It is hard to build in small, new markets. It can and you can use them. Group a Herbalife business. There are have attributes that look like (Continued on page 20) Page 20 Cliff Sosin

the ice bucket challenge, the pan. business over the span of ten where it takes off and then it years. You have to like it. You collapses. You've got people who have have to work at it. been doing it for ten, twenty Let’s say you and I both go years. They have built real A common Herbalife success into business. You decide that organizations with real story goes something like: you’re going to go on a diet customers that have real "Hey, I started with Herbalife Antonio Lequerica ’18 and challenge your friends on durability to them. ten years ago because my speaking at the Pershing Facebook to do the same diet. friend had just lost 30 pounds Square Challenge Let's say you have a virality G&D: If someone in your on it and I knew I needed to coefficient of greater than one family thought joining a multi- lose weight. I lost 20 pounds because you've got some hip level marketer was a great and my wife lost 40 pounds. twist on this idea. You're going business idea, what would you to see this exponential growth. tell them? Then I got into the business. I But then you're going to see didn't think I could, but Joe this exponential decline. You CS: They should go for it. The told me that I could. I started stop your diet and run out of only catch is, like any business: talking to people. It was hard friends, then they stop and so it is not easy. If you watch any at first, but I learned how to forth. It's this flash in the pan Herbalife video, often the first do it and that I didn't have to business. thing they say is, "It's not easy. be afraid. There were times I You've got to work really hard didn't think I could ever get Let’s say my business is to at this." I’d also encourage there but eventually I did. Now organize walks near where I them to start slow. Make sure I work full time at Herbalife, I live in Westport. I’m going to they like it and can do it before have a big organization and spend time every day inviting signing a lease on a nutrition make a great living. Last people to these walks, on club for example. That’s just month my check was $7,568." social media but also any other common sense but sometimes way I can, especially in person. people can overcommit. That That's not impactful when one “We’re meeting at 9am on is the only way you can actually person does it. But if you get a Sundays and we're going to go lose any real money in lot of people coming up it's for a two-mile walk.” Then Herbalife. You quit your job, very motivational. after the walk, which, say, lease a nutrition club, then costs $5, I find a comfortable discover that you can’t sell any. There’s a woman I met in Los place and serve shakes. We're Not wise. Angeles. She was the sort of going to have a talk about attractive, personable woman nutrition and health. I'm going If you look at Herbalife people, that everyone wants to be to have people who lost they often start out selling to friends with. She knew the weight tell how they lost someone like their brothers-in school bus schedule. She weight using the product. You -law. That's very common. If would go ahead of the school can see how that is much you look at Herbalife's four buses and chat up all the more durable. People make million members, three million moms. Women would come friends with each other, come basically just buy it for back to her club and they back week after week and do themselves. Of the remaining would have a shake and gossip. the walks. They buy product million, half or more basically A lot of the women wanted to for home use. They lose just sell to people in their lose some weight and would weight and tell their friends. social circle. buy the product for home use. Eventually, I'll get the people She would motivate and coach who were doing my 9am walks The big step you make in them. Some of these women to organize another one at Herbalife is talking to needed extra money around 1pm because I can’t make it. strangers. You need to talk to the holidays so she was able to One of them starts walks in a 40 people a day. Ask 40 people say, "Why don't you go and hit neighboring town and so forth. a day, strangers, of whom at these bus stops. I can't do all So the model duplicates. You least 39 are going to say, “No.” of them." You can see how it can see the difference between If you do that every day, you turns into a nice business. You a durable strategy and a flash in could build a nice Herbalife end up with this amazing group (Continued on page 21) Page 21 Cliff Sosin

of dedicated, talented, gritty, mobility. Compare the role of who really suffer; nobody lends sales people or entrepreneurs. these lenders in society to the to them. importance of chewing gum I think some of people's manufacturers—I think Then, WRLD makes a loan to discomfort is a lack of subprime lending is a far more the remaining 100 of them. familiarity. It wouldn't be important business. Those people get money and uncommon for a Herbalife solve their problem. Sure, they member to want to make an “It's an incredibly pay for it with an interest rate extra $300 around the holidays of 60% on average. But that is selling retail to people they difficult, risky, and a lot better than the know. alternative of not having a car thankless business, but to go to work. Over time, G&D: What about the rest of providing this ladder, some people will renew that your portfolio? loan. The average person from the very bottom to renews twice and is in debt for CS: Herbalife is our biggest 24 months. Almost 80% of position. Everything else is a notch or two above the them will eventually exit the roughly equal. We own very bottom, is incredibly repayment door as opposed to Cimpress N.V. (CMPR), Credit the charge-off door and their Acceptance Corp. (CACC), important for social credit is improved. World Acceptance Corp. (WRLD), and two rental mobility.” Who are the victims here? companies, predominantly When the customer repays, Ashtead Group (AHT.L), Some people don't like the WRLD makes a healthy profit which owns Sunbelt rentals. industry because the interest but the customer got the cash rates are high. But as an he or she needed and his or G&D: Could you walk us industry, there are not reams her credit improved. Tough to through the WRLD thesis? of profits to be made. If you argue that those borrowers look at a typical installment are victims. CS: WRLD gets a bad rap. lender, they are not making Subprime lending, in general, money hand-over-fist. The When customers default, they gets a bad rap. I think that prices are covering their costs experience the discomfort of people tend to confuse their and their losses and create a having debt collectors call desire not to have a society modest profit. These loans are them and further degradation with any desperate people with expensive to originate and to their credit score. But the fact that once people are service, and they have a lot of otherwise, they are better off. desperate, WRLD is a “lender embedded loss due to the risk. WRLD gave them more of last resort.” I think the role They're also small and have money than WRLD received of “lender of last resort” is short duration. To make a back. This is different than extremely important. It gives reasonable dollar profit, you many payday transactions people with nowhere else to need to have a high implied where the lender can often turn an opportunity to borrow rate. profit even when the money to solve urgent needs. borrower defaults. It’s hard to In performing on those loans, Another way to think about argue that the borrowers were individuals can improve their WRLD is to consider 200 victimized. And even if you credit scores, which will people, all of whom have large could, you can't make the ultimately improve problems. They need to repair other 80 loans without creditworthiness in the future. their water heater, or fix their experiencing the twenty who car or, less practical but don't repay although they sure It's an incredibly difficult, risky, emotionally important, they do try. and thankless business, but can't buy Christmas gifts or providing this ladder, from the travel to a friend’s funeral, etc. I'll add one more piece. WRLD very bottom to a notch or two All come to WRLD’s office and is an installment lender, which above the very bottom, is WRLD sends half of them is fundamentally different than incredibly important for social packing. Those are the people a payday lender. Payday (Continued on page 22) Page 22 Cliff Sosin

lenders charge very high average duration of a portfolio Washington. They found that interest rates, typically 400%, of twelve-month, linear indicators of financial suffering, for very short-term loans, two amortized loans is three including phone disconnections weeks on average. Payday months. and job loss, were higher after lenders have an ability to reach payday and installment lending into someone's bank account G&D: What do you think were removed on the Oregon and pull money out. With about increased political side of the border than just a these two features, payday scrutiny and regulation of the few miles away on the lenders can and often do make industry? Washington side of the border money on loans where the where payday loans were borrower defaults. WRLD is CS: A variety of politicians will available. So these studies an installment lender. They paint these guys as evil. It's not support the idea that payday give people longer-term loans hard to find someone who had loans are good for society. with fixed payments. A typical some really bad experience. loan might be $900 payable in Yet WRLD’s net promoter Evidence supports both sides. twelve $100 installments. score is 68%, which is amazing. What I think is clear from the WRLD has no ability to WRLD is very popular with its research is that whether enforce repayment if the customers. payday lending is good or bad, person doesn't voluntarily it is not very good or very bad. repay. The academic work on payday Economists have studied this loans is mixed. There is a too closely and had too many G&D: How does WRLD wonderful piece by John conflicting findings for the collect from customers? Caskey that summarized all the impact to be very strong one academic work and makes this way or another. CS: The most common point nicely. method is paying in cash in Installment lending is far more person. WRLD has expanded On the negative side, there is user-friendly than payday the payment options, and work that shows that the lending. So if payday lending is there are people who pay with career performance of Air at worst a little bad for social check. The customers are not Force members stationed at welfare, I think it's highly all under-banked. There are places with access to payday probable that installment people who pay by phone. loans is worse than ones lending is very good for There's debit card. But WRLD without access. Of course, society. All those people who has no ability to take money that's bad. There is also need cash are served by these out of people's accounts. evidence that different businesses. disclosures about sustained use In the vast majority of charge- of loans by borrowers can Still, obviously, despite the offs, WRLD loses money. The importantly reduce their logic and evidence this is an incentives are well aligned. propensity to borrow. So industry that is under a lot of WRLD wants to make loans those would indicate that scrutiny. The CFPB is clearly of that people can repay. The perhaps payday loans are bad. the view that high-cost short- only way WRLD can get term consumer loans are people to repay them is if the But there is also research that probably bad for consumers. borrower’s income less shows that counties in There is a very lengthy legal expenses is enough to service California with access to discussion we could have the debt. payday lending have reduced about all this but it is too rates of suicide and robbery involved for this interview. I G&D: How long are the loans after earthquakes than other think though it would leave on average? counties which have banned you thinking the risk isn’t as big the product. Similarly, when as it might seem. But it is a big CS: The average loans are Oregon put in place a ban on risk. twelve-month, but they're payday loans, economists used monthly installments. The the occasion to study how the G&D: What evidence would average duration of a twelve- change impacted people right indicate that your investment month loan is six months. The on the border of Oregon and is wrong? (Continued on page 23) Page 23 Cliff Sosin

CS: Not an easy answer. Let’s avoid getting ripped off. issue two years later. Half of start with what the economic their new customers are mechanism is. The managers are also likable former borrowers who return. people because they treat you The largest source of first-time Our hypothesis is that the well. If you are in a Walmart customers is referrals. business has what we call break room and someone says “loyalty effect economics.” It's they have a problem, someone The key to making the business an economic phenomenon in else in the Walmart break work is having this branch The Loyalty Effect by Fred room might say, “You should manager who's ensconced in Reichheld. It describes how in go to WRLD. They treat you the community and can some industries a business in well. They’re friendly. They underwrite carefully. Knowing the upper-right of a 2x2 matrix treat you with respect.” the community is a big of customer retention and advantage because you know employee retention is the When customers have trouble who to avoid. You also have most lucrative. If you can paying, WRLD managers treat this big base of former establish an organization with them well. WRLD runs on borrowers who are both your long-tenured employees and kindness. The way they collect best customers when they long-standing customers, you is to call repeatedly until they have a need and a great source will be much more profitable get the client on the phone. of referrals. It sounds so than your competitors. Eventually, they'll get through simple but these are the and say, "Come in. That's all I “loyalty effect economics.” “Installment lending is ask." You'll come in and they'll WRLD's financial performance say, "Tell me about what over the past 30 years is far more user-friendly happened," and you tell your unbelievable. story. than payday lending. So So, how would we know that if payday lending is at Depending on the this thesis is wrong? Well, circumstances, they can often when we first postulated it, we worst a little bad for say, "I'm looking at your file didn’t have all the facts I and because you've made three shared above, but I learned social welfare, I think it's payments you have some about the importance of highly probable that equity in your loan. If you manager tenure and of renew today, you'll be current referrals and so forth when we installment lending is with us, you can walk out of looked for these attributes as here with $50 and you won't part of attempting to invalidate very good for society. ” have any negative impact on our hypothesis. At this point, I your credit score.” can’t think of any more ways Now let’s look at the to test the hypothesis. So if we installment lenders. WRLD has They don’t force anyone to are wrong or things change, been very successful at this. take out a new loan, but it we’ll probably first detect it if WRLD’s average branch sounds like a pretty good the financial performance got employee has five years’ option for many. The whole worse. A decline in repeat experience. This is business works on friendliness. business or an increase in tremendous. Way higher than The branch manager has been employee turnover would be most other front-line there a long time and knows concerns. Most likely though, employees in most companies the community. People trust to the extent that the or industries. These aren't big you as someone to borrow economics break down, we communities. They know who from because they know that if would see it in the financial is who in town. They know something goes wrong you will performance. your mother. They go to be reasonable. You get this church with you. People come whole base of former G&D: In terms of in and if they're good at it, borrowers who are your performance, WRLD’s traffic is WRLD’s people have some referral sources. They also declining. How much of this is reasonable ability to come back because they might related to competition, underwrite your loan and have some sort of cash flow especially online? (Continued on page 24) Page 24 Cliff Sosin

CS: Declining traffic is a issue was primarily attracting help to drive a lot of volume. problem. There are two key new customers who had never They haven’t been tested yet, risks with WRLD. One is the done business with WRLD but there are a lot of shots on regulatory risk. We talked before. goal so to speak, a number of about that a bit. The other is which have been meaningful declining new customers per Now there is a new CEO who for competitors. I am branch. If you look at number is making a lot of progress optimistic that WRLD can The winning team, Windsor of new customers per branch, turning things around. The first return to some of the robust Cristobal ’18, Anji Lin ’18, it declined from 2011 to 2015 initiative was building a website growth of their past. It looks and Isabella Lin ’18, pitching although it has recently been as a driver of branch traffic. like by modernizing its Yum China at the Pershing increasing. There are two Half of customers at some operations, WRLD has been Square Challenge possible arguments for the competitors find the company able to restore volume, so this cause of the decline. through the web, fill out an is inconsistent with the secular application online, and finish disruption concern. One is that instant-decision the transaction in the store. online lending is winning in the WRLD is the only industry marketplace and store-based So WRLD put up a website participant I am aware of with lending is losing. This would be and it helped. Month over volume problems. Everyone a secular disintermediation. month, it gets better, but it else is doing fine. This is The other argument is that hasn’t been a panacea. consistent with the theory that WRLD hasn’t been run very it is not an industry problem well and thus is Then management evaluated but a WRLD problem. underperforming. direct-mail, historically WRLD’s only form of Also, I think it is likely that Two and half years ago, the advertising. Management online underwriting is still a lot company didn't have a website. experimented and found that worse than in-store It had an IR site, but that was shutting off the direct mail in underwriting. If you look at any because the SEC required it. If certain geographies had no online subprime lender, the you were a retail customer impact on new customer rates they charge are far higher who wanted to find a branch applications. That’s how bad it and their charge-offs are far and went to the Internet, that was. higher. The Internet has some information wasn't there. speed and convenience How could this be? Well, it benefits, but as of now I don’t The lack of a website was just turns out that the direct-mail think it is nearly as good at the tip of the iceberg. The program was completely underwriting or collecting. business was undermanaged outdated. I won’t bore you for years. It was basically with the details, but WRLD All of this is evidence that's running in 2015 exactly the was sending the wrong letters inconsistent with the thesis same way it was run in the to the wrong people at the that the Internet's killing the 1990s. In some sense, its wrong time of the month. business. At least today. success without evolving at all Management revamped all of for two decades is a testament WRLD’s direct marketing, and G&D: How sensitive is the to the quality of the business. it helped a lot. WRLD business to But it started to catch up with macroeconomic changes? WRLD, and starting a few Now between the web and years ago, new customers per enhanced direct mail, it looks CS: We think about economic branch began to fall. like WRLD has turned the sensitivity with everything. corner. It looks like it is People think a lot about Importantly, we think that bringing in more customers economic sensitivity when they returning customers, referrals than it is losing so it should be think about credit. Let's start and quality underwriting and returning to growth. But we with that mental model for collections by seasoned will see. The good news is credit. You start out with employees in the branches, the there are a whole host of everyone. You use reputation economic engine, continued to other initiatives that it is in the data to get two thirds of be a source of strength, the middle of which should also people that are prime credit. (Continued on page 25) Page 25 Cliff Sosin

What does it mean to be increase charge-offs across-the seen mixed performance from prime credit? What it means -board and is probably a bigger this. to be prime credit is your risk than changes in probability of defaulting is employment. For a long time, that governed almost entirely a function of my thinking. On average, teams whether you get sick, G&D: Can WRLD potentially are average, but certainly don't divorced, or lose your job. benefit in a downturn, invest in crooks. I thought especially in increased loan about the business first, price Sickness and divorce occur volumes? second, and then management steadily. Losing your job is a distant third. That is changing cyclical. As a consequence, CS: Potentially. If I were to a little bit. Through lending to the two thirds of give you WRLD’s earnings-per- experience, I discovered that it people with good credit, is share growth numbers through matters more than I effectively an actuarial 2012 but scramble the order, appreciated. exercise. It's like insurance. you would not be able to Companies compete price detect the financial crisis. down as low as possible, make There was some harm from “I thought about the a modest spread. Whether rising fuel and energy prices in prime lenders make or lose 2008, but there was good business first, price money on the vintage is largely volume. second, and then driven by whether there is something that causes the job- All told, it was a non-event. In management a distant loss expectations for that pool fact, if I gave you quarterly year to be meaningfully different. -over-year EPS growth from third. That is changing a Namely a recession. It’s pretty the IPO in the early 1990s little bit. Through analogous to P&C insurance through 2012 you wouldn’t be and catastrophe risk. able to pick out any experience, I discovered macroeconomic events. The subprime population is, by Normally, the business is very that it matters more definition, hard to underwrite. under-levered and right now than I appreciated.” So you can create loans with they're profoundly under- substantial margin of safety if levered. WRLD normally runs you do a good job with three dollars of assets and If you read Daniel Kahneman’s underwriting. Also the loans one dollar of equity. At book, Thinking, Fast and Slow, are short in duration so you present, they’re running with he explains why you can better replenish the portfolio with three dollars of assets and two judge people, in fact any new loans fairly quickly if your dollars of equity because they complex issue, by subdividing it original assumptions prove haven't bought as much stock into smaller pieces. The Israeli faulty. So the net of this is that as they usually would. military subdivides personal when unemployment rises, performance into smaller bits WRLD’s credit worsens but G&D: How do you assess in order to find officer the impact is small compared management? When you're candidates and that works a lot to its overall economics. looking at ideas, how better than making overall important is the management assessments, in fact making Interestingly, a shared common team? overall assessments doesn’t factor for WRLD and its work at all. customers are the prices of CS: I'm not very good at food and energy. WRLD’s judging people. I haven't I've tried to use this approach borrowers are on the haggard thought much about in assessing managers. I want edge and that's the whole management, historically. I've managers who are smart, reason why they're coming to watched a lot of investors energetic, honest, humble, and the company. Adding $50 a come to very strong opinions good capital allocators. Those month to their expenses from about management teams. I've are the five sub-attributes of a rising gas and food prices never understood how they good manager that I want. So I impacts all of them. That can had such conviction and I've try to assess them along each (Continued on page 26) Page 26 Cliff Sosin

dimension. The resulting it turns out he said it 40 years giant game where they are just assessment is becoming more ago. betting against one another. of an important factor. I put more weight on it now than I It's brutally hard to come in Nor does it do anything for used to because I've watched every day, do a lot of work social welfare to connect good investments do worse and then throw it out. You can Chicago and New York with a than I hoped because bad make money investing because perfectly straight fiber line, like decisions were made. But I am it doesn't suit people's Michael Lewis describes in still a business- and price-first temperament. It's not natural. Flash Boys. My advice, which I investor. If people really want to do it give to everyone and nobody and they recognize how listens, is don't do what I'm I should add, that I have difficult it is to do, then God doing. Go do something really increasingly focused on overall bless them, but it isn’t for most useful for the world. culture within a firm. By that I people and I have no useful mean the combination of advice if you want to do it. organizational habits, social “We have armies of our norms and incentives that But, if I were to allocate the best and brightest dominate day to day life and resources of society, we'd have decision-making within an way fewer people doing what I wasting their time in organization. Senior do. We'd have lots more management influences culture people doing useful things. It's what is basically a giant but is also an expression of a huge waste. The fundamental game where they are just culture. So you have to assess issue is this: there are limits to them as guiding the system but the amount you can forecast betting against one also a product of the system. the future. Nonlinear dynamic systems are subject to inherent another.” You want an organization that forecasting limitations. Think of prizes frugality, where weather forecasting, because it There's a great book you can individuals feel safe sharing is nonlinear you just can’t read about entrepreneurship their views and making forecast accurately more than through acquisition called HBR mistakes—called psychological a few days in advance even as Guide to Buying a Small Business safety—and where people the amount of computing by Ruback and Yudkoff. For a freely help and support each power and the data quality young person coming out of other. You also want to know explodes. The economy and business school, that’s just a what a firm is optimizing. businesses are even worse brilliant idea. I think it's Sometimes great things emerge because they are under- perfectly reasonable not to when an organization centers specified nonlinear dynamics want to work in a big itself entirely around systems. It’s totally impossible corporation. I can also optimizing one thing. to refine your predictions past understand why people don't a certain pretty rough point. want to go work for some new G&D: Any advice for students startup. It’s too uncertain. But or other young people trying If you have a million, brilliant you can raise some money to to build careers in investment people trying to predict the buy a small robust company management? future of a nonlinear dynamic and then create value by using system using all kinds of your immense talents to run it CS: If you really, really like it computers the outcome you better. One of the best and you're nuts, you can get get won’t be much better than examples in this book is the into this business. I, for one, if you just had a few thousand. acquisition of the leading fire- enjoy it despite its difficulty, For the purpose of capital hose testing company. Using but it's really a waste of your allocation, connecting savers to your brilliance to figure out talents. This is the Charlie investments, we only need a how to do a better job testing Munger view on this. He's few thousand. But we have firehoses helps society use right. He's so frustratingly tons more. We have armies of fewer resources and is an right. Every time I think I’ve our best and brightest wasting incredibly important and thought of something brilliant, their time in what is basically a essential task. If you are (Continued on page 27) Page 27 Cliff Sosin

successful, of course you can expand the business and bring your talents to making society more efficient in even broader ways.

You guys could be very competent at almost whatever it is you choose. If you choose a small enough niche, you could be the best in the world. My point is that if you pick a small niche and bring your talents to it, you can do well and make the world a better place. You can earn a fantastic living and hop, skip, and jump to work every day.

G&D: Great. Thank you so much for the time. Page 28

Yum China Holdings, Inc. (NYSE:YUMC) - Long 2017 Pershing Square Challenge - First Prize

Windsor Cristobal, CFA Anji Lin Isabella Lin [email protected] [email protected] [email protected] Recommendation Key Financials We recommend a long on Yum China Holdings (YUMC) FY16 Result Trading Statistics with a 2-year price target of $45, offering 35% upside from In USD millions Share price $32.99 Windsor Cristobal ‘18 today’s price of $33. We see a bull-case upside of 61% and Revenues $6,752 Market Cap $12,678 Rest. Margin 15.3% Net Cash $964 Windsor Cristobal is a first an attractive upside/downside ratio of 2.7x. We project a 64% EPS upside in the next three years driven by sustainable EBITDA $1,112 EV $11,714 -year MBA student at Co- EBIT $640 Target 2019 P/E 20.0x lumbia Business School. comparable sales growth and margin expansion opportuni- EBIT (%) 9.5% 19E EPS $2.23 Prior to CBS Windsor ties. FCF $428 2Y Price Target $44.64 worked as a Senior Repre- sentative in the M&A and ROE (LTM) 22.7% Upside 35.0% Business Description Key Financials Investments team of Wes- YUMC is the leading operator in the $150B Chinese QSR farmers Limited, Australia’s Bear Base Bull largest diversified conglom- market. It was spun-off from Yum Brands in October 2016 SSSG (Average Next 3 Yrs) (2.8%) 3.6% 4.6% following a recommendation from the activist fund Corvex Unit Expansion (Avg Next 3 Yrs) 3.5% 4.5% 5.5% erate. Restaurant Margin (2019E) 15.1% 17.0% 17.8% Management. The company operates the KFC, Pizza Hut, EBITDA Margin (2019E) 19.4% 19.8% 20.7% Taco Bell, Little Sheep and East Dawning brands in China EBIT Margin (2019E) 10.4% 12.4% 13.4% across 7,663 restaurants in over 1,000 cities. YUMC owns EPS 3-Year CAGR 1.2% 17.9% 21.1% and operates 80% of their network and pays a 3% royalty on 2019 EPS 1.41 2.23 2.42 P/E 18.0x 20.0x 22.0x net sales to Yum Brands. Price Target 25.41 44.64 53.18 Upside / Downside (23.0%) 35.3% 61.2% Implied EV/2019E EBITDA 6.6x 8.6x 9.5x Investment Thesis Implied P/E (excl. Cash)1 14.8x 15.8x 18.0x 1) Ample Growth Runway in an Underserved Note: 1) Includes Balance Sheet leverage upside Market China’s restaurant industry is highly fragmented with Chained QSR formats accounting for only 9% of the Anji Lin ‘18 market. This is compared to an Asia Pacific average of 18% and Taiwan’s average - which we view as compara- ble market with China in terms of culture and food - of Anji (Andrew) Lin is a first- 39%. QSR store penetration also remains low in China: in year MBA student at Co- 2016 there were approximately 270k people per KFC store lumbia Business School. Population served per KFC store in China compared to ~180k in Taiwan and 110k in Hong Prior to CBS, Anji had two 495,225 years of experience in Kong. investment banking and Long term growth opportunity more than four years in We believe there is also a large opportunity to expand into private equity in China. lower tier Chinese cities given the significantly lower QSR 113,117 Anji holds a Master’s De- penetration in those markets. Taking KFC stores as an ex- 72,836 gree from Peking Universi- ample, lower tier cities average around 500k people per Tier 1 Tier 2 Lower Tier ty, China. KFC store compared to 73k and 110k in Tier 1 and Tier 2 respectively. We believe further penetration into lower tier Chained vs Independent Food Service Stores cities present an opportunity for YUMC to almost double Chained Independent

9% its current store base of 7,663 stores in the long-term. 18% 28% Adam Xiao ’17 35% 36% 39% 48% 53% In addition, major transport hubs are also a high growth

area and according to discussions with QSR executives in 91% 82% 72% China, YUMC’s national brand status allows them to secure 65% 64% 61% 52% 47% the most critical sites. With the number of major transport

hubs in China growing at approximately 25% CAGR in the China Asia Singapore Hong South Taiwan Japan USA next five years, YUMC has an opportunity to add 700-900 Pacific Kong Korea Isabella Lin ‘18 additional stores in these locations, based on our estimates. Stores in major transport hubs also typically have sales per store that are double the network average. Isabella is a first-year MBA student at Columbia Busi- 2) High-Return Cash Cow with Attractive Unit Economics ness School. Prior to CBS, YUMC has strong unit economics in both of its major brands. For new unit builds in 2016, KFC and Pizza Hut Isabella was an Associate at cash-on-cash returns were 40% and 26% respectively. Management has done a solid job of keeping returns CIM Group, a $20bn real estate private equity firm. high despite difficult operating conditions - namely following successive food scandals in 2013 and 2014. Before CIM, she worked at Duke’s endowment office, YUMC’s strong cash generating ability has also allowed it to maintain a high ROIC in difficult times. ROIC in responsible for fund invest- 2013 and 2014, when comparable sales declined to as low as negative 20% in some quarters, was 17% and ments and co-investments 19% respectively. In addition YUMC was able to completely self fund its capital expenditure requirements in private equity globally. during this time. Page 29 Yum China Holdings, Inc. - Long (Continued from previous page)

The company’s scale is another driver for continued high returns. Our primary research suggests that YUMC has a distinct cost ad- vantage to McDonald’s due to its scale (3x more stores than McDonalds). We estimate YUMC as having a ~700bp advantage in costs as a percentage of sales relative to McDonald’s in Food and Paper, the largest cost item, and believe this will continue to drive high returns in the future.

Post the spinoff management is now 100% aligned to YUMC, and they are incentivized to focus on KPIs that will drive returns such as same store sales growth and profitability. We are also very encour- aged by the CEO buying ~$3M worth of YUMC shares after the Q1 2017 results and after the share price rose by ~20%.

3) Unique Buying Opportunity to Capitalize on Same Store Sales Growth Recovery We believe the company is at an inflection point and presents a unique buying opportunity. After four years of volatile performance, recent quarters show a stabilizing trend for SSSG. We project faster recovery relative to the street for three main reasons. i) Reduced Risk of Future Food Scandals From our conversations with supply chain experts at large QSR companies in China, we are comfortable that YUMC now has the best processes and systems in place to prevent future food scandals. YUMC has tightened their supplier selection, cut the number of suppliers by half and introduced more transparency giving them direct line-of-sight to primary producers. They have also built an independent team of 200 quality control experts and a dedicated PR team in each city to reduce the risk of future outbreaks. ii) Strong Consumer Brand and Loyal Customer Base We believe that customer loyalty to YUMC’s brands remains high. Our primary research survey with over 700 respondents suggest that customers continue to return to YUMC banners for its convenience, taste and safe food. We think its reputation makes it resilient to short-term fads and trends and will support its continued SSSG recovery. iii) Secular Tailwinds from Delivery and Digital Digital and delivery trends will be a major driver for comparable sales growth. Delivery as a percentage of online sales for Chinese QSR overall was 8% in 2015 and 11% in 2016. During the same period KFC’s digital sales percentage moved from 7% to 10% and Pizza Hut, by our estimates, moved from 14% to 18%. With YUMC targeting a 25% overall digital share of total sales, this new channel will continue to drive SSSG. We also believe that YUMC can leverage its 100M loyalty members and the data they generate to drive SSSG in a similar way to Domino’s Pizza (DPZ).

Valuation Based on our 2019 EPS estimate we believe that YUMC remains undervalued and offers an attractive risk / reward. Our 2-year base-case price target is at $45, offering a 35% upside.

We have assumed no P/E multiple expansion from the 20x level today. As the company has almost $1B of net cash, we believe that excluding cash and adding moderate leverage (~2 turns debt to EBITDA) the P/E ex cash is around 16x. We have a bull-case upside of 61% and a upside/downside ratio of 2.7x.

Key Risks Key risks to our thesis includes future unforeseen food safety scandals; shifting consumer preferences to new healthier concepts; labor and rent cost inflation; and a failure to turnaround the Pizza Hut brand which has been in SSSG decline in the last 10 quarters (except Q1 2017). We are comfortable that these risks are being addressed by the company and we have run downside scenarios that support our view that the risk-reward profile remains attractive.

Page 30

Alaska Airlines (NYSE: ALK) - Long 2017 Pershing Square Challenge - Finalist

Chris Waller SK Lee HK Kim [email protected] [email protected] [email protected]

Recommendation We recommend a long position with a 5-year price target of $218.1, giving 154% upside. Chris Waller ‘18 Chris is a first-year MBA Business Description student at Columbia Business ALK operates Alaska, Virgin America, and Horizon Air, mak- School and the Co-Founder ing it the 5th largest carrier in the US. Its strategy is to be the of plural, a small hedge fund. national carrier for west coast customers. Along the west Prior to CBS, Chris worked coast, they have 57% passenger share in Alaska, 52% in Wash- in a global equity fund at ington, 39% in Oregon, but just 11% in California. California is Goldman Sachs Asset Man- agement. He graduated from a huge opportunity, with 2.4x annual passengers than the Oxford University with de- other 3 states combined. ALK’s low cost structure gives it the grees in Economics and Man- highest ROIC and EBIT margin among its peers. agement. Investment Thesis The street underestimates how much market share Alaska will profitably gain in California over the next 5 years as it becomes the dominant west coast carrier. We think this is an up to $3bn incremental revenue opportunity on current com- pany revenues of $7.6bn.

1. Alaska’s costs for the same economy class seat are lower than the street realizes and this will enable it to gain more market share. Seung-Kwang Lee ’18 Reported Cost per available Seat Miles (CASMs) are misleading: Our ‘Normalized CASM’ figures include only SK is a first-year MBA stu- dent at Columbia Business mainline flights and adjusts for flight length and School. Prior to CBS, SK space allocation to first, business, and econo- worked as an auditor at PwC my classes. This shows that for the same New York, covering compa- economy class seat on the same distance nies in financial services in the flight, Alaska has a 7% cost advantage over US, HK, and the UK. He Southwest, 22% over American, 33% over graduated from NYU Stern Delta, and 37% over United. We have not School of Business with de- seen any research that adjusts for all of these, grees in Finance and Ac- particularly allocation to different classes. We counting. think this is because this allocation adjustment has to be estimated due to the lack of compa- rable data. Nevertheless, it is crucial and is why the street misunderstands Alaska. For example, Alaska typically allocates 74% of its space to economy seats, while Southwest allocates 93% of space. Since First and Busi- ness class seats take up more space, Alaska’s cost per seat will naturally be higher. This does not necessarily reflect an input cost disad- vantage. Our ‘normalized’ CASM adjusts for this and shows that Alaska actually has a cost Hyung-kyoon Kim ‘18 advantage for the same economy seat. Com- paring economy ticket prices for different airlines on the same routes shows that Alaska is indeed able HK is a first-year MBA stu- dent at Columbia Business to undercut its rivals and take market share. School. Prior to CBS, HK worked as an investigator at Alaska’s cost advantage is sustainable and comes from its homogeneous and young fleet, which order Korea Stock Exchange, evalu- ating corporate disclosures books show will actually increase, as well as its labor deals and higher productivity. These give it lower and delisting distressed com- ‘Normalized’ CASMs vs the Big 4 carriers of 0.8¢ on fuel, 1.7¢ on crew, 0.3¢ on maintenance, and 1.0¢ panies. He graduated from on others. Korea University with degree in Business Administration.

Page 31

Alaska Airlines (ALK) - Long (Continued from previous page)

2. The street underestimates how much capacity Alaska could gain at key airports (LAX and SFO).

Our primary research reveals that while LAX is considered “gate-constrained”, Alaska is in Terminal 6 and it would make sense for them to lease Delta’s 4 remaining gates in T6 or the 3 gates American has temporarily leased from United in T7 as it undergoes its own renovations. Both Delta and United are struggling because of their higher cost structures, and this is how Alaska’s lower costs translate into higher market share. Our Base case includes one of these and is worth an additional $511M revenue over the next 5 years on top of $256M organic growth. In our Bull case, Alaska secures 13 new gates by building the ‘Terminal 9’ that LAX is looking for over the next 5-6 years.

At SFO, we model Alaska gaining 3 gates by 2019 at the expanded T1 based on our primary research. This adds $349M of incremental revenues over 5 years on top of $235M of organic growth.

3. Railroads Mark II: Industry consolidation and growing demand could lead to much higher profitability.

Like in railroads, 9 major carriers have consolidated down to 4. In our Bull case, we model less capacity meaning industry load factors (utilization) increase by 5pp over the next 5 years from 84% today to 89%. The higher revenues drop through to a 37% increase in EBIT. Costs are fixed as the margin cost of an additional pas- senger on an empty seat is close to zero. We also think that while Alaska was too small for Buffett, it is the natural acquisition target for American or Southwest.

4. An activist investor could help Alaska realize its unique potential to become the dominant West Coast player. Alaska has hinted they are looking to expand the east coast. This is a mistake as they do not have as big a cost advantage there. Focusing on California should be the top priority. There is the opportunity to: i) Swap gates - Gates in California are more valuable for Alaska than other airlines, and the opposite is true on the east coast where other carriers fly routes like New York/London. United, for exam- ple, recently gave 3 gates at LAX to American in return for gates in Chica- go. Alaska should look to do these types of deals now that it has gained 50 slots in a very slot-constrained New York through the Virgin America acquisition. ii) Alaska now has slots at 3 New York and 3 Washington airports. It is more cost efficient to have these at one airport. iii) Alaska should explore opportunities to feed Delta in Seattle.

Summary Alaska is the low cost provider in a commodity industry. It has the unique op- portunity to become the dominant player on the west coast. Risk/Reward is skewed very much in favour of a long position. Page 32

Corning (NYSE: GLW) - Long 2017 Pershing Square Challenge - Finalist

Joseph V. O’Hara Vikas Patel R. Griffin Dann [email protected] [email protected] [email protected]

Key Statistics Key Financials & Ratios Monday, April 17, 2017 Actual Actual Actual Actual Est. Est. Est. Est. Est. All figures are Core accounting except where noted 2013 2014 2015 2016 2017 2018 2019 2020 2021 Revenue 7,948$ 10,076$ 9,800$ 9,710$ 10,264$ 11,132$ 11,822$ 12,522$ 13,481$ Fiscal Year-End December Gross Profit 3,368 4,348 4,212 4,128 4,434 4,778 5,115 5,474 5,875 Joseph V. O’Hara ’18 Ticker GLW EBITDA 2,509 3,349 3,262 3,187 3,355 3,632 3,945 4,221 4,484 Current Price $26.32 Operating Income 1,507 2,149 2,078 1,992 2,111 2,291 2,506 2,715 2,910 Joseph is a first-year MBA Diluted Shares Out 1,020 Net Income 1,797 1,976 1,882 1,774 1,834 1,995 2,199 2,402 2,584 Market Cap 26,846 EPS 1.23$ 1.44$ 1.41$ 1.57$ 1.70$ 1.95$ 2.27$ 2.60$ 2.93$ student at Columbia Busi- Cash & Equivalents (5,291) ness School. Prior to CBS, Total Debt 3,941 Adj. Op. Cash Flow 2,879 4,944 3,461 2,732 3,550 3,800 4,112 4,424 4,771 Enterprise Value 25,496 Capital Expenditures (1,019) (1,076) (1,250) (1,130) (1,500) (1,500) (1,600) (1,600) (1,600) Joseph spent four years Adj. Free Cash Flow 1,860 3,868 2,211 1,602 2,050 2,300 2,512 2,824 3,171 working at T. Rowe Price 2-year Price Targets & Total Returns P/E 21.4x 18.3x 18.6x 16.8x 15.5x 13.5x 11.6x 10.1x 9.0x as a US Equities Associate Base Case $38.50 P/FCF 20.2x 9.5x 16.0x 18.8x 13.9x 11.7x 10.2x 8.6x 7.3x Analyst. He graduated Total Return 51.4% EV/EBITDA 10.2x 7.6x 7.8x 8.0x 7.6x 7.0x 6.5x 6.0x 5.7x Swarthmore College with a Bull Case $49.50 Revenue Growth 4.5% 26.8% -2.7% -0.9% 5.7% 8.5% 6.2% 5.9% 7.7% Total Return 93.2% EPS Growth 16.0% 16.8% -1.5% 10.7% 8.3% 15.3% 15.9% 14.7% 12.8% B.A. in Political Science and Bear Case $19.50 FCF/Share Growth 36.9% 111.2% -40.3% -14.9% 35.4% 18.9% 14.9% 18.1% 17.7% Total Return -20.8% ROE 8.5% 9.2% 10.0% 9.9% 10.5% 11.8% 13.2% 14.4% 15.5% Ancient Greek. ROIC 6.7% 13.7% 8.0% 6.2% 8.3% 14.9% 11.0% 12.7% 14.3% Recommendation Corning is a high-conviction long because the market is undervaluing the core earning assets of the enterprise, misunderstanding the drivers of returns on capital, and overlooking the organic growth potential in optical fiber and Gorilla Glass. Sector-dedicated analysts on both the buy and sell-side routinely undervalue Corning at moments of product cycle inflections — with a mature display market, secular growth in optical, and new markets in Gorilla Glass, Corning is at an inflection. Corning has $2.27 of 2019 earnings power of per diluted share and should trade at 17x that number for a $38.50 price target for a 51.4% total return over two years.

Vikas Patel ’18 Vikas is a first-year MBA student at Columbia Busi- ness School. Prior to CBS, Vikas spent three years as a Senior Analyst at Millen- nium Management. He earned his B.B.A. from the University of Michigan with concentration in Finance & Accounting.

Investment Thesis

1. The market’s valuation of Corning’s cash-generating assets is cursory and indefensibly low

Corning has publicly committed to returning its excess cash over the next 3 years via a capital allocation plan announced in 3Q15. From FYE 2016 through 2019 Cor- ing is set to return $7.4bn through share repurchases and double-digit annual dividend increases — in total, GLW is returning over 27% percent of the current mar- Griffin Dann ’18 ket cap. Griffin is a first-year MBA student at Columbia Busi- Cash on a balance sheet is less valuable than earning ness School. Prior to CBS, assets — this is not a revolutionary statement. A private Griffin worked as an Ana- lyst at Birch Grove Capital equity buyer could pocket Corning’s cash and realize a and in the Financial Re- purchase multiple on the actual cash-generating assets of structuring group at Houli- just 13.5x. This approach is still justified for public mar- han Lokey in London. He ket investors because of management’s commitment to earned his B.S.C. from the returning their excess cash. Because we know excess Wharton School with a cash will be returned, we also know that the market will concentration in Finance. be forced to re-evaluate the multiple it is putting on Corning’s cash-generating assets. 2. Corning’s ROIC is inflecting upward and justifies a P/E Page 33

Corning (GLW) - Long (Continued from previous page) multiple in the high-teens

Based on our expectations for a continued ROIC inflection and the historical relationship between GLW’s returns and its P/E multiple, we believe GLW deserves a multiple in the high teens.

This ROIC expansion has three core drivers. On the balance sheet side, returning cash and earning into the DTA account for roughly a third of the expansion. The remainder is driv- en by Corning’s unique ability to grow sales without incremental capex spend. For exam- ple, Corning’s first $400m in auto glass sales require no capital investment in new tanks due to their patented fusion manufacturing process. 3. The market is overlooking significant secular growth opportunities in optical networking and Gorilla Glass

Secular growth in demand for optical fiber: Corning’s first fiber opportunity was long haul — that passed in the 90s. As the creation of data and demanded speed of access have grown ex- ponentially, there is significant demand for back haul fiber to replace copper wiring. As you can see in the bottom right of this slide, Corn- ing’s value proposition in back haul is powerful. For a higher up front cost, Corning offers a lower total cost of ownership, a longer life-cycle, vastly improved network security, and virtually unlimited bandwidth. Based on widespread market commentary, carriers will continue to shift their mix of capex spending toward Corning’s value-added product offering. As this has happened historically, Corning gained market share among carriers like Verizon, AT&T, and others. We believe this trend will only accelerate going forward because Corning is the high-quality supplier in a highly inelastic market with little spare capacity. Validating this non-consensus view, Corning recently announced a major deal with Verizon to supply 12.4 million miles of their optical fiber for a $1.05bn minimum commitment as an initial stage in their 5G rollout.

Free-option in Gorilla Glass for autos: We believe the market has not factored this into their estimates at all because of the sheer size and com- plexity of the opportunity. The auto glass market has not seen major innovation in over 65 years and Gorilla Glass is vastly superior vs. tradi- tional soda-lime glass – it can cut a car’s weight by 1.5%, double window strength, and triple clarity and visibility for the driver. Gorilla Glass is already in 6 cars, and OEMs have been actively considering where to add it in their lineup for a number of years. Full penetration will result in a doubling of Corning’s total consolidated reve- nues. While that sounds like a mind-boggling statement, there are two key things to remember: (1) auto glass is a free-option for current investors, and (2) everyone we spoke to throughout the entire auto supply chain expected Corning to ultimately succeed in penetrating this market. If you’re only focusing on the display market and iPhones, you’ll never see this coming. Page 34

Dollarama (TSE: DOL) - Long 2017 Pershing Square Challenge - Finalist

Gustavo Campanhã, CFA Gilberto Giuzio, CFA Thiago Maffra, CFA [email protected] [email protected] [email protected]

Recommendation KEY METRICS We recommend a long on Dollarama (DOL) with a Price as of 04/14 C$ 117.00 Div Yield 0.4% price target of $225 (92% upside potential in 5 years, Gustavo Campanhã ’18 52w range C$ 86.57-118.11 Buyback LTM 5.4% 14% IRR), a compelling investment opportunity with 5 ADTV $43 M Consensus P/E (NTM) 26.7 Gustavo is a first year MBA times reward to risk. We believe EPS can triple to Market Cap C$ 12,523 B Our Estimated P/E (NTM) 22.8 student at Columbia Busi- ~$10 over the next five years due to new store open- Debt C$ 1,328 B 3y average 25.2 ness School. Prior to CBS, ings, same-store-sales (SSS) increase from higher priced EV C$ 13,851 B EV/EBITDA (NTM) 17.9 Gustavo was an Equity products introduction, and buybacks from the strong 3y average 17.3 Trader at Verde Asset Management, a US$ 10 cash generation from legacy stores; at 19x forward EPS – contracting from current 26x – DOL is worth $225 billion hedge fund based in HIGH STORE COUNT AND SSS GROWTH COMBINED Brazil. This summer he will in YE 2021. WITH STOCK REPURCHASE ENABLES EPS TO be interning at Somar CONTINUE TRIPLING OVER THE NEXT 5 YEARS Capital Partners in New Business Description DOL is a high-growth Canadian based discount retail York. EBIT Margins: Earnings growth 2016YE – 2021YE chain with 1,100 stores, C$ 3 B in sales, that com- stable at current pounded EPS at 32% CAGR over the last 5 years. DOL level 22% 1.65 10.19 stores are appealing to both low and middle-class con- Number of Stores: 2.07 sumers, with clean and well-stocked stores, selling Store count up from 1,095 to 1,700 in 5 2.60 products priced from C$ 1.25 to C$ 4.00 with a low years 21% CAGR

reliance on lower-margin items such as consumables, a SSS growth: 3.87 vs. 16% 5.0%/year consensus key component of the American dollar store model. (Nominal GDP +1%) DOL has consistently doubled sales and tripled EPS and 32% EPS Share buyback: CAGR since every five years since it was founded in 1992. 5%/year 2010 Current New SSS Buybacks Projected Investment Thesis year Stores Growth 5 Years Gilberto Giuzio ’18 1) DOL has a superior business model that is Gilberto is a first year MBA misunderstood by many, who label it as another dollar Dollarama has almost a monopoly: big-box retailers student at Columbia Busi- store. DOL has a 15% net margin, vs. 5-7% of Compa- ness School. Prior to CBS, don’t carry the same cheap but good assortment, and Gilberto worked with Oil rables, explained by (i) upstream integration: product other dollar store chains are dwarfed by its scale and & Gas for Schlumberger developer, importer, and retailer; (ii) operational effi- don’t carry many categories due to pricing Business Consulting and ciency, with focus on the finest details; (iii) price points GRILL CLEANERS worked in the treasury of up to C$ 4.00 allow inflation pass-through plus a C$ 8.00 department of Itaú. more flexible mix to drive traffic. This summer he will be During our field trip to Canada to visit stores, competi- interning at BofA Merrill tors and talk to customers, DOL’s efficiency was visible: C$ 4.00 Lynch in São Paulo, Brazil. taller shelves, inventory on top of them, frequent re- (same item as Canadian Tire) stocking, consistent shopping experience, and conven- ient locations. Margins are driven by such details. Amer- C$ 2.00 ican dollar store chains make $15 EBIT/sqft on average while DOL makes $56 EBIT/sqft.

2) Market underestimates DOL’s growth runway, focusing on aggregate Canadian demographics instead of local statistics. Our variant view is 3,000 stores in the long run vs. the 1,700 long-term store guid- ance. Worth noting, this target was raised by the company from 1,400, in the last week of March. Management has been consistently guiding conservatively along company’s history. Canada has half the number of dollar stores per capita compared to the US and the market thinks this difference cannot be closed entirely because Thiago Maffra ’18 Canada has a lower population density, but this lower density is due to its huge non-populated area with people concentrated in four small regions. The US, on the other hand, is more of a “small town country” as only 52%

Thiago is a first year MBA of the US population lives in cities larger than 20 thousand people, whereas in Canada this number is 67%. Given student at Columbia Busi- how the Canadian population is distributed, you need logistics and scale to cross the distance among urban ag- ness School. Prior to CBS, glomerations, but you could operate even more dollar stores per capita than the US penetration suggests (an Thiago was the Proprietary assumption we do not factor in our thesis). We believe management can reach 1,700 stores in 5 years, a level Desk Manager at XP Inves- that would represent an increase from 50% to 70% of comparable US penetration levels. Aside from new store timentos, the largest inde- pendent broker-dealer in openings, for the next 5 years, we are confident on a 5% SSS growth. Historically, management has delivered Brazil. This summer he will from 4 to 7% SSS and we believe they will continue to do so, by improving product mix. be working at XP Inves- timentos office in New 3) High barriers to entry due to double cost advantage (on scale and sourcing) protects DOL’s cur- York. Page 35

Dollarama (DOL) - Long (Continued from previous page) rent high profitability. It would be hard for other players to compete DOL’s margins SSS GROWTH away without enduring a long period of pain. Any contenders would have to deal with an 800-pound gorilla that has: (i) 1,095 stores across all Canada’s provinces, Ticket Size 7.1% almost an oligopoly if you factor that the second player, Dollar Tree, only sells C$ 6.5% Traffic Increase 1.25 products and has around 224 stores (up only from 210 last year, not a significant 5.4% 5.6% 5.7% growth given their more aggressive plans some years ago); (ii) international direct sourcing of more than 50% of merchandise, that avoids the middlemen, combining 4.4% 3.8% 5.2% 4.2% margins along the chain; and (iii) five distribution centers to support efficient invento- 5.2% 5.5% ry management. 4.0% 2.1% 1.4% 1.9% Even for an established American chain, the barriers to entry in Canada would still be 0.2% 0.2% -0.2% high, as one must: (i) relabel all its product assortment to include French; (ii) adapt its assortment to please the educated but relatively low-income Canadian consumer 2011 2012 2013 2014 2015 2016 (even Walmart is a little fancier in Canada); (iii) find convenient real estate locations SSS growth of 5% (vs. 6.2% hist) sustained by improvement as DOL has; and (iv) establish cross-border logistics. For instance, Dollar Tree still of product mix (inclusion of higher value products) uses third-party distribution centers, leaving margin on the table. Expanding to Cana- da would take a long time and would burn a lot of cash (let’s remember how Target failed miserably trying to accelerate its expansion in Canada). About some more STORE COUNT GROWTH differences, US chains have different mixes, with a higher proportion of consumables to (i) attract traffic, and (ii) comply with food stamps “SNAP” rules (50%+ consuma- Consensus bles or carrying select products including perishable foods). More consumables Above consensus 9% vs 5% cons. “artificially improve” metrics as SG&A as % of sales, but weigh in more square feet 1,694 needed to carry these lower margin items. 9%

4) Meaningful downside protection with compelling cash flow generation 1,095 provided by strong new stores unit economics, which have 38% IRR and a 3-year payback. We still see ample room to further increase store count while maintaining 704 profitability. In addition to the new stores unit economics, DOL has an efficient capi- 1,095 tal allocation: with such high returns, it is not surprising that the company has been 704 able to grow while generating solid cash flows, which have been returned to share- holders via stock buybacks, as evidenced by the 22% reduction in shares outstanding 2011 Today 2021 since 2011. DOL grows with low capital needs, and if the company halts expansion, Our expectation of 1,700 stores represents 9.1% 5Y CAGR (vs. the legacy stores would continue driving sales and profits with very low CAPEX. 5% consensus), a number in line with the past five years

Valuation Given the high cash flow conversion, we valued the business based on earnings mul- tiples. We modeled our Base Case with 1,700 stores in 202, what still holds room 350 DOL RETURN SCENARIOS for growth in the future, as we have a 3,000 stores TAM. This growth represents 300 Bull Case: C$308.00 9.1% 5Y CAGR (vs. 5% consensus). We also assumed a SSS growth of 5% (in line with the 6.2% historical average) and kept EBIT margin constant at 22%. Even with a 250 Base Case: C$225.00 good long-term growth perspective, we compress the exit forward PE from 26x to 200 19x, a conservative assumption given the compounding nature of this stock. 150 For our BULL CASE we considered 2,000 stores in 2021, with a SSS growth of 6% 100 Last: C$117.00 (which is still below historical level) and a multiple compression from 26x to 21x.

In the BEAR CASE, we model a 30% downside. This is with forward PE coming from 50 26x to 16x, and cutting EBIT margin from 22% to 18%, with zero store count

growth, and only 2% of SSS growth (GDP nominal growth is projected at 4%). 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Key Risks and Mitigants Competition from dollar stores & big-box retailers: DOL has 4x the combined number of stores and lower COGS compared to other dollar stores who have not shown capacity to grow facing DOL’s competitive advantages. Also, DOL has a relatively low product overlap with big-box retailers and better price for the small number of similar products.

Competition from online retail (e.g. Amazon): DOL’s products have a low unit price, making it more difficult for online retailers to compete. Its average basket is C$ 13 while Amazon requires C$ 35 per purchase to qualify for free delivery (C$ 25 for Prime members). Be- sides that, DOL has been increasing its low-cost white label merchandise from 20 to 25% of SKUs, making it difficult for customers to find similar products elsewhere with competitive prices, even online. Moreover, DOL’s brick & mortar locations are a key defense from online competition as they have convenient locations that attract high levels of foot traffic.

Other risks: Vulnerability to FX fluctuations (that DOL hedges the next 12 months of imports, and for permanent level shifts, DOL has the ability to increase prices due to its multiple price points); Labor cost increases; Import taxes (that would impact all other retailers, and DOL could pass through via price points flexibility); Key managers leaving (what is a low risk given managers have a lot of skin in the game, owning 10% of the company, with the Rossy family having 50% of their C$ 2 B wealth in stocks of Dollarama). Page 36 Chris Begg (Continued from page 1) Trustee of the Trustees of me. I read and reread ready to take a leap and start a Reservations and co- everything I can that both company in order to be more founder of Humans for Warren and Charlie put out in control of my own destiny. I Oceans (H40), a nonprofit there. There were probably had assets that were willing to organization created to ten to fifteen other investors come with me from my earlier support ocean that were instructive and I relationships, and Amory really conservation. would attempt to reverse supported my decision, so in Chris Begg engineer what they did, and try 2008 we launched East Coast Graham & Doddsville to understand how they Asset Management, and it’s (G&D): Can you tell us a little achieved their superior results. been almost nine years now. about your background and What was their edge? What what led you to where you are was the one thing that they G&D: I know you said you today? were particularly good at? I had assets that were willing to tried to get to the point where move with you, but in taking Chris Begg (CB): I got into I was able to deduce, "Okay, I the plunge and starting your the investment business in see how their thinking own fund, how did you know 1994, after undergrad. I started produced that investment idea you were ready? working for a small and does that align with the investment firm in Cape Cod, way that I think?" That was my CB: I guess the hardest part of where I grew up, and I knew process. I spent ten years just starting, whether it be a fund right away that I loved the honing my temperament and or an investment management challenge of investing and all the while figuring out what firm, is having trusted partners, solving puzzles, but I wanted to kind of investment philosophy clients, and assets that are find an analyst position and process made sense for going to support your effort. somewhere near Boston. me. Certainly, value investing There are a lot of great was the logical outcome of investors that just don't have I had an opportunity to join a that, and then more the track record or the assets firm called Boston Research specifically, what made a lot of to make that leap. I am grateful and Management where I spent sense to me is buying great that my circumstances leading ten years. It was a great businesses that you can own up to the launch helped pave opportunity and afforded me for a long time, and allow the way. I had worked with a the time to read a lot, study compounding to do the heavy handful of partners and clients businesses and business lifting. That was an important for over ten years and as soon models, and most importantly realization. as I was ready, they said, learn what kind of investor I "We're coming with you, was. During those formative I eventually wanted to move wherever you end up.” That years, and this is advice I on to keep learning and was really the added comfort always give my students, it is growing so I was looking to level that I needed, and I felt in important to have a mentor take the next step. I was my heart I had the investment and/or great heroes. If you introduced to a company management background to don't have the former, the called Moody Aldrich Partners. run what I thought would be latter is really important. Pick They were looking for an intelligent strategy. Looking the right heroes in investing, someone to work with Amory back it has really been the and in life, and then learn as Aldrich as part of a longer- journey that continues to be much as you can from them. term succession plan on the the reward. Even the Over my career, I have been strategy he had stewarded for challenges have enriched the lucky and grateful to have over thirty years. Amory is a path—I remember that first mentors, but heroes are great investor with an year in ‘08/’09 was pretty available to everyone and the impressive long-term track harrowing—both to get things reservoir of their wisdom is record so the opportunity to set up operationally just as the infinite. learn from him was a logical market was dropping next step. precipitously everyday. So my As for heroes to emulate, advice for students that feel Warren Buffett has and However, after a little over a this is your calling—stay lean continues to be that light for year it was clear that I was (Continued on page 37) Page 37 Chris Begg

and as Joseph Campbell has tough environment? The into compounders, but they said, “Follow your bliss.” fourth is the system advantage: currently are average Is it adaptive? Does it foster businesses that have an G&D: Can you talk about persistent incremental average return on invested your investment philosophy? improvement? The fifth is the capital. Something is changing commander advantage. Ideally, or transforming in the business CB: There are three we want a founder. We want a or the industry, however, and categories of investments that founder or a founder-like we think it is going to produce I've thought about, and it's leader that's running the better returns that aren't how I’ve structured the business, and running it like an currently priced in. Security Analysis class that I owner. We found most teach at Columbia. They are success with founders, but if compounders, transformations, we find a leader that has been “What we're looking for groomed to steward the and workouts. Two-thirds of are businesses that are our investment ideas have advantaged business and act come out of the compounder like an owner, that works too. getting better, where category. What we're looking The ownership leadership trait for are businesses that are needs to be deeply imbedded they have some type of getting better, where they have in the culture and is not always model that’s sustainable some type of model that’s portable. sustainable for a long period of for a long period of time, time, and where the moat is We find that most companies going to widen. Because of that are either playing a finite game and where the moat is moat, they earn high returns or an infinite game. James going to widen.” on capital that we think will be Carse wrote a wonderful book sustainable in the future. on this very topic called Finite and Infinite Games. The infinite We focus on three types of What we're looking for with game is where the time transformations. Secular compounders are upstream, horizon is very long, if not transformations are going to often invisible and intangible eternal, for the way the be where you have a post- advantages that lead to a visible business is being run. It's being industry consolidation, where downstream propensity to run for the next generation, the remaining players are going achieve superior economic versus some quarterly or five- to enjoy better pricing power returns. The upstream year objective. Certainly, there and more rational decision- advantages we focus on are is a plan and there are goals, making around competition, five-fold. In The Art of War, Sun but there's a big difference and the returns are likely to Tzu rote that the five most both in the culture and how get better. The market important parts of assessing they think about the business struggles to see around these the potential of an army on a when the business is run for corners and struggles to value battlefield are the the infinite game. Think them effectively. Systemic topographical advantage, the Berkshire, Colgate, and transformations are where morale advantage, the Danaher. There's something there's a true system change in meteorological advantage, the very different about those the organization, typically system advantage, and the businesses than what you'll find driven by a new process or commander advantage. Those where the leaders are trying to new leadership. Like Danaher five are perfectly suited for solve something over a shorter with their Danaher Business what we're looking for in a horizon. That's what we're System. The third is business. looking for in the compounder separations. Separations are de category. -mutualizations or spinoffs, The topographical advantage is where there's a real inflection the moat. The morale With transformations, these point in both how the owners advantage is the culture. The are businesses that are going are being incented and how meteorological advantage is through an inflection point of capital is being allocated. resilience—how have they change. Our best Usually, there's a real done and will they do in a transformations eventually turn mispricing that exists with (Continued on page 38) Page 38 Chris Begg

separations where there are years. The frictionless ideal is maybe everyone is ignoring? some forced sellers because the one-decision type. Why is this business hiding in the company is too small to be plain sight? That's the hardest owned by a large institutional G&D: In your 2015 letter, you one to answer because owner. We saw this recently spoke about the power of sometimes we don't know, but when LiLAC Group came out compounding, and the we try to understand why we of Liberty Global, which was a difference between logarithmic have this opportunity to own forced sale for a lot of growth and linear growth. Do this mispriced asset. Or maybe institutions. you think that compounders we don't and we're wrong. are underappreciated? Do you Workouts are what we call, think there is a market I think it's important to our “60-cent dollars.” This is not misperception there? efforts that we're constantly just about grabbing net-nets, learning and building our where there is a true value CB: In that letter, I talked reservoir of knowledge on proposition and existing about what we call the “twin great businesses, businesses margin of safety, but where we lights” of the investment that are transforming and can’t definitively answer if the process: the quality of the getting better, so that we can dollar is growing. We don't do business and the quality of the value them on a process-driven a lot of workouts internally. investment. We're always basis. If we’ve done the work They've always been a small looking to understand the best on the business quality side we proportion of the portfolio, businesses in the world, can act when the price is and now they're almost non- regardless of price. We want there. existent in our concentrated to know them well so that portfolio, because it's harder when there is a potential To answer your question as to to get the time horizon right opportunity, whether it be an if I think compounders are on businesses that aren't overall market sell-off or underappreciated and do I getting better. Also, the something specific that might think there is a misperception declining businesses are likely be temporary, we’re aware. there—the short answer is to get worse more quickly. yes. I think many investors focus where there is a strong Many of our mistakes have “We find ‘three-decision contrast and ignore businesses been where we thought we that are getting better bought something with a stocks’—buy, sell, and incrementally without a lot of significant margin of safety noise. while knowing that it might be then figure out what to a melting ice cube. We thought do with the proceeds— G&D: Is there a company that it might weaken, but not for a fits the situation you just long time out. But then it are not as ideal as described? accelerated a lot faster than we thought it would. That's finding businesses that CB: Well sure, we have been one of the big lessons we've we can thrive with over talking recently internally learned over the last five years. about Sherwin Williams, which We don’t play much in that many years.” after reviewing some of the space, although it's a well- numbers continues to impress travelled space for the hedge me. Sherwin Williams is a great fund community as often there Now, the quality of the company that has compounded can be the perception of investment has a lot to do with at 22% or so since the catalysts that help serve price. The price you pay will recovery of 2009. You go back investors looking for shorter- determine your rate of return. over, say, a thirty-year period, term payoffs. We find “three- But also, with the twin lights of you're looking at a company decision stocks”—buy, sell, the quality investment, we're that's compounded at around and then figure out what to do looking at margin of safety. 15.5%. High returns on with the proceeds—are not as We're looking to understand invested capital of 30% or ideal as finding businesses that why it might it be mispriced. better, and a great distribution we can thrive with over many What do we understand that system. A product where (Continued on page 39) Page 39 Chris Begg

regulation makes it difficult to CB: If I could have one idea. Price is going to transport impedes e- superpower as an investor, it determine that rate of return, commerce players from would be revealing IRRs. which is going to drive our sell entering the competitive There's an inherent IRR for discipline. landscape. They are a local every single investment that champion as Bruce Greenwald you can look at based on your Most of our sales are where a has written about in time horizon. That is the target compounder that was playing Nick Briody ’18, Fernando Competition Demystified. They investment’s essence. The job an infinite game becomes more Concha Bambach ’18, Vy continue to win with the of the analyst is to reveal that finite and their moat appears Huynh ’18, and Daniel Le- professional painter in the local return expectation within to be weakening because of Blanc ’18 posing after the market. some type of acceptable sector-related and Pershing Square Challenge probability range. environmental-related That should be in your innovation. Maybe a universe of great companies, The job of the portfolio competitor is reducing the and it's just that valuing it manager is to allocate capital entropy and friction costs that today is a challenge when you to those IRRs that are most exists in their vertical and they look at a company that's deserving—meaning most are going to be exposed to a grown earnings from $4 in asymmetric. It's just as simple threat that they cannot 2009 to $12 now. Where is as that. Now, in practice, this compete effectively against. that $12 going to be in that proves very difficult because Think of brick and mortar next year or so, now that you're dealing with lots of retail; anything that a scaled e- we're nine years into a unknown information. We're commerce player can do will recovery. Valuing companies not talking about deterministic likely be at a lower cost. deep into a recovery, outcomes. We're talking about GEICO has been devouring the particularly if they're cyclical, probabilistic outcomes. But entropy of higher-cost auto becomes more challenging you can build a range of insurance sold through brokers right now. probabilities, a range of IRRs for over 80 years. that are within your comfort The questions for me on level and that can prompt you G&D: You had mentioned Sherwin have a lot to do with to take action or not. that so much of finding a great where are we in the cycle, and compounder is related to what's this look like? Are we Back to your question about qualitative and intangible buying something at more than sell discipline. If we're revealing features. How do you assess 20x earnings? Are earnings the IRRs, and a true IRR of them and test their resilience? peak earnings? Or are we mid- anything we own is sub- cycle, and with this acquisition optimum, meaning it's CB: As we take an idea of Valspar, the company can appreciated to a point where through the process, the first gain more synergies and the future IRRs will be low, or thing we do is a first-principle extract the next five-to-ten below something else we can exercise of trying to years of additional growth? It's own, it might be deserving of a understand what the business an interesting one to solve. sell. With companies that we is solving for. What entropy Recently, some of my students like and we've been involved in exists today that they are going pitched Sherwin Williams and I for a long time, we'll allow to reduce for the benefit of think this is just the kind of them to stay in the portfolio a their customers and all compounder business we love, bit longer. In other words, counterparties of the one that is found hiding in plain we're comfortable with some organization? MasterCard and sight. lower IRR investments that we Visa have been devouring the know and like as anchor entropy of cash toward more G&D: Earlier you mentioned positions. For example, efficient credit and debit waiting for the right price. As a Colgate may get expensive transactions. That's the corollary, when do you think from time to time, but it number one thing that we ask about selling these great provides some asymmetry to ourselves. businesses? the portfolio, meaning very little downside despite the If the company we are looking upside not being our best IRR for is the entropy point and (Continued on page 40) Page 40 Chris Begg

has a fortunate pricing much further out. Ideally, we underappreciated how big umbrella, we typically will start we've found a business that the market opportunity was right there and focus on why thinks outside of time. for what they’re doing, but we this advantaged moat should Managers feel like they're continued to follow it. persist. We prefer to own stewards of the organization businesses that deserve the and they're going to hand it off We got back involved in 2014, right to win because they are to the next stewards. It's a but over the last year, we've fostering a win with all their very different mindset. Look at been increasingly counterparties, including Berkshire, or Danaher, or the uncomfortable with our checks society at large. Liberty businesses, or Amazon. regarding the company’s focus Bezos said it recently, it makes on shorter-term profitability at Now, the second thing we do a huge difference when you're the expense of long-term is gather evidence through talking seven-year numbers resilience. The culture felt like primary research. Here we talk versus the time horizons on it was getting more fragile in to counter-parties to get which competitors focus. the sense that they were being answers around business more vocal around their quality. Customers, former leverage and their pricing employees, competitors, “...we're looking at the power. Today we feel there is people that are somehow a large observation effect that involved in the vertical in some qualitative factors that exists and creates additional way. It’s all very important. we think are going to fragility that was not there in They can be anecdotal, but I 2014. We still believe this is a think collectively once you've drive the long-term great business run by done all your work, it fills in a competent management, but very clear picture. At that success of the business. we have chosen to step aside. point, we're building a model. We're looking much Given the polarization on both We're also reading the typical sides of this argument, I would 10-Ks and 10-Qs. You're further out. Ideally, prefer not to say much more. starting to build the bottoms- We are fortunate as investors, we've found a business up picture of the company. particularly in public liquid that thinks outside of markets, to change positioning The third thing we do is to reflect changes in our inputs categorize the investment. time. ” and not to get hung up with all Does it look like anything that the behavioral biases and we've looked at in the past? friction that come with Then we take it through the G&D: Are there any names defending one’s ego. steps of our twin light process, that you would like to explore? looking at the quality of the You’ve discussed TransDigm in G&D: Speaking of behavioral business and the quality of the the past, there is a lot of biases, how do you guard investment, to finally arrive at tension in the stock right now, against them? some range of IRR that we and we’d love to hear your have confidence around. thoughts. CB: It's a good question. I recently talked about this at G&D: You're typically looking CB: Sure. We got involved in the CSIMA Conference. There five to ten years out. Does that TransDigm in 2009. We were are a couple of valuable depend on whether managers fortunate enough to speak resources when it comes to are playing a finite game or an with someone that had been behavioral biases: Cialdini's infinite game? involved in bringing TransDigm work on the influence of public and knew the business psychology in human decisions CB: Yes. Although we assess well; we understood the and Charlie Munger’s speech IRRs at the five-year duration, business model. We owned it on the “Psychology of Human we're looking at the qualitative through 2012 with an Misjudgment.” I believe there factors that we think are going extraordinary return, but we are three big systems or to drive the long-term success sold in 2012 because we felt it phases in regards to this. The of the business. We're looking was fully-priced. In hindsight, first one is instincts, the Page 41 Chris Begg

second is reasoning, and the you remove the obstructions well, anything we sell could go third is insight. of the instinct and misjudgment on to be a perfectly good process. That's how I think investment. We only have a With instinct, the big thing about that decision framework few slots in our portfolio and you're trying to solve for is and therefore the objective is from time to time, the bar we how do I remove the obstacles the perfection of insight. set is higher than for what we that impede my ability to get already own, and therefore we to the second phase, which is “What we're all looking move on. what Kahneman calls system- two thinking. Many things get for is a differentiated Phillips 66 is the other one. in the way: ego, self- Since we got involved in 2012 preservation, hierarchy, insight that comes when it's been a very good territorialism, and ritualism. you get through the investment for us. However, These all impede your ability we feel the next ten years are to make rational decisions. reasoning process, when less clear on a decent proportion of their business, What we try to do is think you remove the particularly, refining. I think about the many obstacles that obstructions of the there is a lot of uncertainty get in the way. It can come around energy and what that down to lots of behaviors that instinct and will look like in the future, impede good behaviors. Are because companies are finding you taking lots of meetings misjudgment process.” a very real technological cost with the same people and curve coming from solar. you’re exposed to groupthink? G&D: In what other instances Phillips 66 has a great business You can make a very, very long have you had to reverse your in chemicals and likely will be list, and I think it's a very good thinking like you did with fine, but we think there are process to go through to TransDigm? Are there flags other places to allocate capital constantly re-check where you that help you recognize when where the probability range is are obstructing your ability to you need to reconsider? going to be more attractive for be rational. us. CB: We recently sold two In the second phase of businesses which we owned G&D: You’ve mentioned reasoning, you’re also trying to for years. The first one is IBM. probabilistic outcomes and remove blind spots in your As we understood Amazon asymmetries, could you discuss process. I think about it almost AWS more and more, we how you think about risk and in terms of a hologram: you're became increasingly less position sizing in the portfolio? trying to create this view to comfortable with IBM's see the entire question or competitive advantage long- CB: In our Partner’s Fund, we investment idea from every term in enterprise. We felt we own anywhere from eight to angle, so that you're viewing owned it cheap enough; fifteen positions. Ideally, it'd be this hologram three- especially with the buyback, on the lower end of that if we dimensionally with zero blind there were multiple ways to had a high confidence in a few spots. It's hard to do, but win. But the problem with IBM number of asymmetric ideas, building a reasoning process to is that it’s become more path- but we typically own more help achieve this outcome is dependent around how ideas as we move through a one of the most important successful they will be in AI. cycle and things become more parts of decision-making. We don't like path-dependent expensive. That's where we outcomes. We'd rather have are today; we are balancing a Then you want to get to the many ways to win. There are few more names as prices have final stage, which is a true, still some path-dependent moved higher and margins of differentiated insight. What outcomes that could be very safety have been reduced. we're all looking for is a good for them. differentiated insight that But I think the most important comes when you get through It is important to note that if thing when you own a the reasoning process, when we have done our initial work concentrated portfolio is to (Continued on page 42) Page 42 Chris Begg

understand the probability space. That's what an insight is. improvement. We think there range of the outcomes and You're going into the realm of are a lot of outcomes that what the low end of that range the unknowable by reasoning could happen in their end looks like. We will bypass through it and assessing all the markets, but because their many great investment ideas if probabilities, and realizing that system is completely adaptive, we think there's even an it's not path-dependent. There resilient, and moving, they're infinitesimal potential for a are a lot of outcomes where able to continuously react, zero, because it's just not you can win. That’s how you change course, and get better something we can underwrite. get comfortable. That is how every day. That's what gives us We prefer downside you look beyond the world’s the confidence that they're probabilities where if it is a fixed limitations and your own, going to continuously solve for zero it means it is a 0% IRR, those finite outlines and their end-markets. They have but a 0% IRR still keeps our boundaries. done that for over 30 years. capital intact. When you think about the G&D: How do you think The importance of seeing the investors that understood about cash in the portfolio, and world through a lens of Amazon in 1997 and the years do you look at it as an asset probabilities is something that that followed, that investment class or as dry powder for has been reinforced by didn't look like anything where future opportunities? studying the quantum world. a value investor could When you look at quantum recognize a pattern. It was CB: For our partner strategy, mechanics, there's a whole different. It was a scale which is an institutionally world that, to me, seems so economic shared model. oriented strategy, we think well-aligned with investing. The Maybe it looked like GEICO or about our portfolio as a fully big take-away is that this whole Costco, but it didn't look like invested mandate. Now that world of quantum mechanics is the kind of things we were told being said, at any one time, we a probabilistic world. You to look for as value investors. could be 0% to 20% cash, but don’t know where any sub- cash is not a strategic particle is located, you just As you go into the field of investment where we're trying know the probability of where investing, your best insights, to time the market. Yet if the it might be. I think you'll find your best ideas are not going world goes crazy, as it the uncertainty that physicists to look like what some of your inevitably does, we will not deal with is very similar to the heroes had invested in before. make uneconomic or irrational uncertainty that we face in You're going to have to find investment decisions for our investing. We're dealing with new ways to think about it. partners. Therefore a larger so many things that are The map will not be found in cash holding may be warranted unknown and unknowable, and any book on investing but temporarily. we're building these more likely found in the book probabilistic scenarios based of nature. Sometimes we don't have a on all that information. replacement for a position that G&D: We've focused a lot on we're selling. We want to keep G&D: You mention in your compounders. Could we buy and sell decisions very letters making rapid, highly discuss some positions that fit separate. We recently had a consequential decisions with your other models for couple of sales in the portfolio, incomplete and potentially investing? which frees up more cash than erroneous data. How do you we have good ideas to put to get enough conviction around CB: Of course. We've work. We can reallocate to an idea? recently added Danaher. You existing ideas, or we can hold a could argue that Danaher is a little bit more cash in the CB: The Harvard Professor compounder, but we look at meantime until we finish and bridge-playing expert Danaher as this constantly working on something that’s in Zeckhauser stressed the evolving, systemic the final stretch. unknown, unknowable, and transformation. We love the unique; I think you want to be mindset of the culture with G&D: Sounds like you find able to build a bridge from that regard to continuous inspiration across many (Continued on page 43) Page 43 Chris Begg

disciplines. How do you put Also, how does what you've lot of important and timeless things on your reading list, and taught us relate our decision- insights in Eastern philosophy. how has this shaped your making framework and What you find when you start ability to frame investments? investing?” to contrast Eastern versus Western philosophy is that CB: I started a process almost It's something we do weekly Western thinking is where ten years ago where I set aside and it's fun because it's a multi- we're trying to project a model a quarter's worth of ancillary disciplinary habit that fosters onto the world, and we're reading material around one some creative thinking. trying to see how our model topic. During that three-month Throughout the week between or our projection aligns with period, I would read as much conversations about business- the way we think things should as I could on a subject, and do specific objectives we will tend be. Oftentimes, the reality is a deep-dive around one to revisit further questions and far off. In contrast, Eastern particular topic. I also allow insights somebody has read on philosophy is much more myself to touch the other the subject. Subjects are about aligning yourself with the mediums that are related to typically in the large data sets constancy of change, and that subject, especially in the of physics, biology, and human looking at things from the arts. Whether it be fine arts or history. potentiality and the propensity visiting libraries and museums, of the outcomes. I fully immerse myself in that G&D: It would be great to topic. I think it allows one to hear any advice you may have We added Amazon to the slowly build both breadth and for students or for people portfolio this year, and it was depth. interested in the industry. one of those investments that we were fighting our own The quarterly letters I have CB: What I love about the biases versus understanding written at East Coast have Columbia students is that you the propensity and the been an output that came from have a lot of fanatics and potentiality of the outcome this process and that quarter's individuals that are similar to that was staring us in the face. reading. Over the last year, I've us and approach learning with My advice is that there's just so switched the quarterly letters enthusiasm. Many of the much important information in to a year-end letter just from a students have such a deep level Eastern philosophy that you time management standpoint of curiosity and I think that's can contrast against the basic and will reignite an interim just so important. It was what scientific-method-reasoning memo writing process in attracted me to teach there process and arrive in a very between year-end letters. and feed off that energy of different place from your learning. Curiosity is the first peers. That's something that The other thing that we do bridge. has helped me a lot. If I had here is something we call known earlier, I would have "What I Learned This The second bridge is creativity. had many more years of these Weekend," where analysts Fostering curiosity, but also important books memorized in submit a brief write-up on creativity in how one should my head. Monday morning on a subject think, because it's going to be where they take the team building these mosaics of G&D: That's great. Thank you through the “ADEPT” information that leads to so much for taking the time to framework. ADEPT stands for: creative insight. Anything that talk with us today. Analogy, Diagram, Example, can help foster those two Plain English, and Technical things is really important. The description. Then we added arts and sports are a great way “BE ADEPT,” which we call to practice creativity and hone “Be memorable” and “Evolve that creative spirit toward our process.” That translates mastering some craft and to, “Have we memorized what entering a flow state. you've now taught us in some mnemonic or other way— On the reading side, over the some memory palace way? last couple of years I've found a Get Involved:

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Contact Us: [email protected] Graham & Doddsville Editors 2016-2017 [email protected] [email protected] Eric Laidlow, CFA ’17

Eric is a second-year MBA student and member of the Heilbrunn Center’s Value Investing Program. During the summer, Eric worked for Franklin Templeton Investments. Prior to Columbia, he was an equity research analyst at Autonomous Research and a senior port- folio analyst at Fannie Mae. Eric graduated from James Madison University with BBAs in Finance and Financial Economics. He is also a CFA Charterholder. He can be reached at [email protected]

Benjamin Ostrow ’17

Ben is a second-year MBA student and a member of the Heilbrunn Center’s Value Invest- ing Program. During the summer, Ben worked for Owl Creek Asset Management. Prior to Columbia, he worked as an investment analyst at Stadium Capital Management. Ben gradu- ated from the University of Virginia with a BS in Commerce (Finance & Marketing). He can be reached at [email protected]

John Pollock, CFA ’17

John is a second-year MBA student. During the summer, John worked for Spear Street Capital. Prior to Columbia, he worked at HarbourVest Partners and Cambridge Associ- ates. John graduated from Boston College with a BS in Finance and Accounting. He is also a CFA Charterholder. He can be reached at [email protected]