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

Inside this issue: Issue XVIII Spring 2013 CSIMA Conference P. 3 Preston Athey Li Lu — Omaha Trek P. 4 — Holding Know What You Winners Longer Don’t Know Moon Lee Prize P. 5 Preston Athey P. 10 Li Lu ’96 is the founder of Himalaya Capital, an invest- Li Lu P. 24 ment partnership focused on both public and private op- Pershing Square portunities in Asia and North Finalist Pitches P. 36 America. Mr. Li grew up in China and was a student Li Lu Paul Isaac P. 46 leader in the 1989 Tianan- men Square protests. Prior to founding Himalaya Capital in 1997, Mr. Li worked in investment bank- ing. He earned his B.A. in economics from Colum- bia College, a J.D. from Columbia Law School, and an M.B.A. from Columbia Business School. Editors Preston Athey Jay Hedstrom, CFA MBA 2013 Preston Athey is a vice (Continued on page 24) president of T. Rowe Jake Lubel Price Group and has led MBA 2013 the $8 billion T. Rowe Paul Isaac — Know Your Style and Price Small-Cap Value Sachee Trivedi Fund since 1991. During Enjoy the Ride MBA 2013 that time, the fund has returned nearly 11.9% per Paul Isaac is the founder Richard Hunt year after fees, making it of Arbiter Partners, a MBA 2014 a superior performer New-York based hedge among its peers. Prior to fund and nephew of Stephen Lieu joining the firm in 1978, noted value investor MBA 2014 he was a contract Walter Schloss. Prior to administrator on Admiral Arbiter, he was the Chief H. G. Rickover’s staff at Investment Officer at the U.S. Atomic Energy Cadogan Management, a Visit us at: Commission. Preston fund of funds. Mr. Isaac www.grahamanddodd.com www.csima.org earned a B.A. in began his career at the economics from Yale Allied International- University and an M.B.A. American Eagle Trading from Stanford University. Corporation. He He has also earned the graduated from Williams Chartered Financial College with Highest Analyst designation and is Paul Isaac Honors in Political a Chartered Investment Economy and was a Counselor. Thomas J. Watson Foundation Fellow. (Continued on page 10) (Continued on page 46) Page 2 Welcome to Graham & Doddsville

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

Bill Miller of Legg Mason chats with a Jane Siebels of Green Cay Asset guest at the 2013 CSIMA Conference Management answers questions at the 2013 CSIMA Conference IssueVolume XVIII I, Issue 2 Page 3 2013 CSIMA Conference—February 1, 2013 at Columbia Business School

Bruce Greenwald and Seth Klarman Jeremy Grantham speaking with Tom Russo

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

Student conference coordinators Matt Christ, Geoff Jean-Marie Eveillard talks with audience members in Abbott, and Ashley Miller deliver opening remarks between panels Page 4 Columbia Business School Trek to Omaha — Fall 2012

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

Meeting the Oracle of Omaha Shopping at Berkshire-owned Borsheims

Dining at Piccolo’s, Warren Buffett’s favorite restaurant Participants pose with “Lulu,” their trusty Omaha bus IssueVolume XVIII I, Issue 2 Page 5 2013 Moon Lee Prize Competition

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

The four finalists Professor Tano Santos

The judges listen intently Paul Orlin Page 6 Motors Liquidation Company GUC Trust Units (MTLQU) - Long David Magid

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

David Magid

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

MTLQU (Continued from previous page) I. The court will likely reject the request. The 2008 UCC-3 Termination Statement, which canceled the lien perfection, was filed erroneously, for a totally unrelated transaction, and by a law firm not representing JP Morgan (the admin agent) in term loan. Further, JPM did not authorize the filing. II. It is undisputed that the term loan was also properly secured by additional collateral, consisting of 26 fixture filings filed by JPM in counties where term loan collateral was located and a UCC-1 financing statement against Saturn as debtor. The value of this uncontested collateral alone was more than sufficient to cover the term loan (book value of $5.6bn 3 days prior to filing). Therefore, a reasonable range of outcomes (i.e. new allowed claims) for the Term Loan Avoidance is between $0 (0% allowed) and $600mm (40%). 2) Nova Scotia Litigation Claim ($2,680 million) In 2003, GM’s wholly-owned, unlimited liability subsidiary, GM Nova Scotia Finance, issued ~$1bn of notes, which were guaranteed by GM. In March 2009, a group of holders of these notes sued GM enti- ties for “oppressive conduct,” as a result of transfers of funds from Nova Scotia Finance to GM. In an effort to settle before filing and keep the Canadian unit out of bankruptcy, holders dropped the suit and released GM from liability in exchange for (i) a $367mm consent fee; (ii) the right to assert $2.7bn in claims against the GM estate (double dip claim plus swap claim). While this is the area with the greatest variability in potential outcomes, there is a strong case that much of the $2.7bn claim will be disallowed: I. The deal was completed post-petition (and backdated) and without court approval. Judge Gerber was “shocked” to learn of the transaction and berated the “lack of disclosure to the court.” II. The “consent fee” of $367mm was egregious and uneconomic. It represented over 35% of the notional amount of notes at issue, as should there- fore be reclassified as a principal pay down. Trust Unit Valuation build-up III. Strong fraudulent conveyance argument: In the deal, Current High Low Implied GM did not receive the reasonably equivalent value Ad'l allowed claims ($BN): 2,635 70 2,151 necessary in any pre-petition transaction. Total Allowed Claims $32,834 $30,269 $32,349 Therefore, a reasonable range of outcomes for the Nova Total Units 32.8 30.3 32.3 Scotia Litigation Claim is between $0 (0% allowed) and GUC Trust Assets (in millions): GM Common Stock: 17.24 27.45 19.17 $1,340mm (50%). This issue is currently in trail before Judge “A” Warrants 15.67 24.95 17.42 Gerber. “B” Warrants 15.67 24.95 17.42 3) Miscellaneous Claims ($1,079 million) Asset Distributions / Unit: The composition of the remaining $1,079mm of claims GM Common Stock: 0.53 0.91 0.59 “A” Warrants 0.48 0.82 0.54 closely mirrors all the claims resolved to date. It is reasona- “B” Warrants 0.48 0.82 0.54 ble to assume these claims will follow the historical resolu- Value of Distributable Assets / Unit: tion pattern (~10%), albeit incrementally more will be al- GM Common Stock: $13.83 $23.88 $15.60 “A” Warrants $8.16 $14.10 $9.21 lowed as it is later in the process. However, this is offset by “B” Warrants $5.13 $8.87 $5.80 fact that the $377mm of these claims are likely all duplic- Total (pretax) $27.12 $46.85 $30.61 itous debt claims, and will be disallowed. Therefore, it is Less: Trust Tax on Capital Gains / share: conservative to assume, for the remaining “other” claims, Total tax / unit ($4.22) ($4.58) ($4.28) Total Value/unit (post tax) $22.90 $42.27 $26.32 $70mm (10% ) – $210mm (30%) of claims will be allowed. Implied % Allowed 50.1% 1.3% 40.9% Combining that analysis , the Trust Units are worth Change vs current 0.0% 84.6% 15.0% between $26 and $43, or up 15 to 85% (see right). Underlying GM Securities are Cheap as Well: While not central to my analysis, the GM securities underlying the Trust are currently cheap, only making the Trust Units more compelling:  Cheap absolute valuation: 4.9x EV/EBITDA – Maint-Capex (20% yield); 1.4x P/B; 9.3x P/E (LTM)  Good business: ~15% ROIC; strong brand power, global presence (#1 in China).  Post-bankruptcy GM has a much stronger balance sheet and improved cost structure.  Levered to continued global economic recovery.  Impacted by temporary bankruptcy overhang, concerns about pensions and weakness in Europe Investors can also hedge out the price risk of these securities, and just invest in the “discount to NAV” type situation that currently exists in the Trust Units. Key Investment Risks  Adverse tax implications of rising GM stock price (mitigant: gains from rising stock price more than offsets losses from increased tax liability).  Timing uncertainly of ultimate claim resolution (likely resolved within year due to trust expiry).  Underlying value of GM securities (margin of safety in both valuation and claim allowance).  Unexpected, adverse ruling from Judge Gerber. Page 8 Precision Castparts Corp (PCP) - Long Arjun Bhattacherjee

[email protected]

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

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

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

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

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

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

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

the two, and it was going to (Continued on page 11) PA: Well, it was pretty IssueVolume XVIII I, Issue 2 Page 11

Preston Athey

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

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

Preston Athey

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

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

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

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

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(Continued from page 16) relevant either, as there obvious question: “If this ask other people in the probably isn’t a lot of cash stock is so cheap, why is it industry about the person’s flow, particularly in small- cheap?” The cheaper it is, background and experience. cap mining companies. On the more the market is What is it that the person the other hand, if you can telling you that there is has done that would give value the proven reserves something wrong. If that's you confidence that he or based on takeout prices of the case and you're still she will be a good CEO and other companies in the intrigued, you better dig take the company forward? industry, that's the way a really deep. Maybe what If the person has been at CEO of a competitive firm you'll find is that it's a cheap “The best way to the job for a few years, then might look at valuation. stock because management you can more easily judge You can begin to build a uses all of the cash flow that avoid a value the record. framework around what the company generates to

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

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

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

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

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

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

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

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

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

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

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(Continued from page 26) bunch of different problems. feel comfortable with. They long investing. So, those are So you have to admit the have that $11 billion invest- the three reasons why I just record is impressive. They ment in IBM, which, I can stay away from shorting. also happen to be in the argue, is a technology com- right industry and the right pany. But I can guarantee It was a mistake on my part. environment, and they get that’s not how they think I shorted for a couple of the right support from the about things. It has nothing Pictured: Christopher Davis years. I don’t discard peo- government. Their engi- to do with whether it’s a ple who are really doing of Davis Advisors at the neering culture consistently technology stock or not. 2013 CSIMA Conference. well at shorting – it’s just demonstrates its ability to not me. If I want to add a tackle big, difficult problems. G&D: Buffett admitted in a fourth reason, it is that the It works. So it’s hard not to 2009 Fortune article that he economy overall has been be impressed by the record doesn’t really understand really growing at a com- the guy has. At the time we BYD. pounding rate for 200-300 invested, we had quite a bit years, ever since the mod- of a margin of safety. LL: That is true. Warren ern science technology era. and Charlie have a great So, naturally, the economic partnership and Charlie trend favors long positions knows more about BYD rather than short. than Warren. But I would not bet against the collec- But you cannot live life tive track record of those without making a mistake. “...you cannot live two. It’s not that they don’t Every time I make a mistake make errors from time to I learn something. life without making time. Everybody is capable a mistake. Every of doing that. They have a G&D: How were you able few, but very, very few over to get Charlie Munger inter- time I make a a long investment career. ested in a company like BYD [a Chinese company mistake I learn G&D: Do you see the which manufactures electric quality of BYD cars improv- cars, batteries, electronics something.” ing? and solar equipment] given that Berkshire Hathaway LL: This company is a typically shies away from learning machine. Think technology-oriented compa- about it – they really didn’t nies? get into industry until 10 years ago. They didn’t pro- LL: I don’t think that War- They play in a big field with duce their first car until ren and Charlie are ideolog- open-ended possibilities and eight years ago. They are in ical. Neither am I. It’s real- have a reasonable chance of a market where every single ly how much you know. being successful. As I said, international major brand is The story of BYD is rela- nothing is a sure thing, but competing, with an all-out tively simple. This guy, who this strikes me as having as effort, because it’s such a is a really terrific engineer, good of a chance as any. big market. So they never started the business from Charlie was equally im- had any home advantage just a $300,000 loan with no pressed by the company, whatsoever because China’s additional money until the which then led to the in- auto market started out IPO. He created a company vestment. Berkshire is not completely open with every- with $8 billion in revenue ideologically against technol- body competing. Yet and 170,000 employees and ogy stocks. They’re just there’s a little car company tens of thousands of engi- against anything they don’t (Continued on page 28) neers. He solved a whole Page 28 Li Lu

(Continued from page 27) tomers, suppliers, and man- LL: Well, management with very little money, and, agement? always has a big influence on in less than 10 years, it’s your success, no matter selling more than half a mil- LL: All of them. I don’t how good or how bad the lion cars a year and has talk to as many investors – business is itself. Manage- carved out a position for very few. I am more inter- ment is always part of the itself. You have to say, the ested in talking to people equation of making the record is not too bad, and who are actually running company successful, so the so there’s something to it. businesses and entrepre- quality of management al- They also have an engineer- neurs or CEOs or just good ways matters. But to assess ing culture and a can-do businessmen. I read all of that quality is not that easy. spirit. They consistently the major newspaper publi- If you can’t assess the quali- demonstrate that they’re ty of management, you may able to tackle really com- have to make a decision in plex engineering problems spite of that. That’s just and come up with very part of the process. So you practical solutions faster, “You can recognize have to figure out other cheaper, and better than ways such as looking at the most other people. That is good ideas by quality of the business, the an advantage in the manu- valuation, or something else facturing economy. reading a great deal until you can justify an in-

and also by studying vestment. G&D: Can you talk about your investment process? a lot of companies If you do have a way to as- sess the quality of the man- LL: Ideas come to me from and constantly agement team, either be- all sources, principally from cause you’re an astute stu- reading and talking. I don’t learning from dent of human psychology, discriminate how they or you have a special rela- come, as long as they are intelligent people – tionship with the people, good ideas. You can recog- hopefully more then you’ll take that into nize good ideas by reading a consideration. Why would- great deal and also by study- intelligent than you n’t you? The management ing a lot of companies and team is part of what really constantly learning from are, especially in makes a company. intelligent people – hopeful- ly more intelligent than you their field.” But, it’s not that easy. It’s are, especially in their field. not that easy to have an in- I try to read as much as I depth, solid understanding can. I study all of the inter- of the management team. esting and great companies, Very few people are able to and I talk to a lot of intelli- cations and annual reports do that. I admire people gent people. You know of the leading companies. I that say, "Hey, look. What- what? In some of those get a lot of ideas out of ever the information, what- readings or conversations, those too. ever the kind of presenta- ideas just click. Then you tion they make, I will never do more research and then G&D: How do you assess be able to learn about man- you get comfortable or you if the management is being agement beyond that. I don’t get comfortable. forthright with you? How know it’s a show for me, so useful is it to speak with the I might as well just discard G&D: Are the people that management? it." I respect that. you talk to fellow investors (Continued on page 29) or are they people like cus- IssueVolume XVIII I, Issue 2 Page 29

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(Continued from page 28) tunity cost. That’s my goal, and there- fore the compensation Investing is about intellectu- G&D: Is your fund open to structure of the fund re- al honesty. You want to new investors? flects that. Over time, I know what you know. You switched into the best com- want to know, mostly, what LL: The fund has been pensation structure I knew you don’t know. If under- closed to new investors for in the industry, the original standing the management nine years. However, we “Buffett partnership formu- team is not in the cards, it’s will open it up a bit this la”. We don’t take any not in the cards. year. We have more op- management fee. We pro- portunities than we have vide a 6% return for free to G&D: What is your do- money around, but that’s our investors and then take mestic versus international 25% after that. I don’t in- allocation? vest anything outside of the

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

(Continued from page 29) 10 years from now? panies are the ones that are while taking a salary of capable of reinventing them- $100,000 per year for more LL: Most businesses are selves and dealing with than 40 years, it’s hard to subject to change if you stay change. Take the example criticize them. with them long enough. of Intel. The whole business There’s not a single business changes every 18 months. G&D: Are there industries that I know of that will nev- Failure to change leads to that you completely stay er change. That’s the fasci- quite a substantial disad- away from? nating thing about business. vantage and yet they’re able Successful businesses have to build their culture based LL: I’m not ideologically some combination of things on that change. opposed to anything. I am against any ideology. Take Samsung – their early [laughs] memory chip business de-

“I think you want to creased in price by 1% every There are lots of things I week, and yet they really don’t know. I’ll be the first avoid wrong developed a culture that one to admit. But it doesn’t precisely deals with that mean that I’m not curious decisions as much change. So when they apply from time to time. Maybe I the same culture to some- know some aspect of the or more than you thing like a cell phone, they story. That little aspect get ahead very quickly. might even constitute the want to get it Now they’re outselling Ap- investment. I don’t know. I approximately ple. So culture really plays don’t want to rule it out, an important role in those but I can say that when you right. If you avoid faster-changing environ- present me an idea, I can ments, enabling certain quickly tell you whether it’s the wrong decisions, companies to always surge a “no” within a few minutes. ahead of everybody else. you’ll probably There are basically three G&D: Do you need to buckets that Charlie has. come out okay over understand the technology “Yes”, “no”, or “too hard”. time.” on an engineering level to Most of the things fall in have a good sense of the "too hard." Some get a risk/reward? quick “yes” or “no”, but if it’s too hard, it’s too hard. LL: It certainly is a plus, So you end up not doing a that enable them to adapt but not a must. If you were lot. You end up really con- to changes better than any- really a great engineer in the centrating on the ideas one else. In each situation, product the business is sell- where you truly have the it’s slightly different. ing, obviously it’s a plus. time and energy to fully But it’s certainly not a must understand the situation Every company in today’s because no matter how better than anybody. age is a technology company good you are at a certain somehow, but the technolo- area, you’re not so good in G&D: How to you get gy may not be on the cut- other areas. The pace of comfortable with the risk/ ting edge, and may not play change is such that whatev- reward of a high tech com- an important role in the er you are now specialized pany like BYD that is under- success or failure of the in will become obsolete. going pretty rapid techno- overall business. But that doesn’t disqualify logical change? Do you you from making a judgment think you have a good sense Successful technology com- (Continued on page 31) of what BYD will look like IssueVolume XVIII I, Issue 2 Page 31

Li Lu

(Continued from page 30) that don’t appear to be very your sell decisions? on how a company can de- stable actually turn out to velop a culture to deal with be. LL: One should make sell that. Successful companies decisions on one of three are able to deal with change I think you want to avoid occasions. Number one, if consistently by hiring the wrong decisions as much or you make a mistake, sell as right people, building the more than you want to get fast as you can, even if it’s a right culture, and staying it approximately right. If correct mistake. What do I Pictured: Mason Hawkins of ahead of their competitors. you avoid the wrong deci- mean by a correct mistake? Southeastern Asset Manage- That’s the aspect that really sions, you’ll probably come Investing is a probability ment at the 2013 CSIMA makes them successful. And game. Let’s say you go into Conference. that’s kind of a predictable a situation with 90% confi- aspect of businesses. dence that things will work

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

(Continued from page 31) possibility that “you don’t the whole country could go little less. know that you don’t know.” down!” Everyone was con- Those four things are dis- stantly in crisis mode. All of The third occasion when to tinctly different. In a crisis, the things come out that sell is when you find some- things emerge that test you you don’t normally care thing that is better. Essen- on all four categories. about and normally don’t tially, a portfolio as I said is pay attention to. Normally Pictured: Tom Russo of opportunity cost. Your job Gardner Russo & Gardner For example, during the you think, “Well, that has as a portfolio manager is to nothing to do with my in- and Timothy Hartch of constantly improve on your Brown Brothers Harriman vestment in this company.” at the CSIMA Conference basket. You start with a Then all of the sudden, you in February 2013. high bar. You want to in- “The most say, “Oh Jesus, it has every- crease the bar higher and thing to do with my compa- higher. You do that by con- important thing in ny.” Well, you are right or stantly improving the oppor- our business is you are wrong. That crisis tunity costs; you find some- will put those questions to thing better. Those are the intellectual the test. three reasons that I would sell. honesty. What I That’s why people freeze in the midst of a crisis. People G&D: In your 16 years mean is four freeze because they were running Himalaya, you’ve not intellectually honest experienced three major different things: before. They never quite financial crises: the Asian know what you distinguished certain issues financial crisis of 1997, the or questions and put them dot com bubble burst in know, know what into the appropriate basket. 2000, and the financial crisis If you make an overall judg- of 2008. How have you you don’t know, ment, for example, of how navigated these crises as a the U.S. is going to perform fund manager, and what know what you over time through ups and have you learned from downs, and you go into it them? don’t have to knowing that there is a pos-

know, and realize sibility something much LL: That’s an excellent worse could happen. Maybe question. You know every that there is always it’s small, but when it hap- time that that happens, they pens, it happens. At that always bill it as “once in a a possibility that time, the question becomes century,” except these ma- “Is it an unknown un- jor events happen every five “you don’t know known,” or do you know years in my case. [laughs] that you don’t have to What is interesting about that you don’t know? You absolutely will crisis is that it puts your know.” be asked that question. intellectually honesty to the test. So the financial system might be in trouble. Yes, a The most important thing in Asian financial crisis, all of business needs financing, but our business is intellectual the sudden the world was I suppose if life goes on, my honesty. What I mean is saying, “how much debt do business will be there, how- four different things: know these companies have?! Oh ever it will end up. So the what you know, know what my goodness, they really question then becomes, you don’t know, know what have that much of a depend- “Do I have to know how you don’t have to know, and ence on debt! Oh my God, (Continued on page 33) realize that there is always a IssueVolume XVIII I, Issue 2 Page 33

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

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

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

Start by learning from the of making the best – listening, studying, and reading. But the most investment.” important thing in under- standing the investment business is by doing it. little concession store, a There is no substitute to restaurant, or a small public- actually doing it. The best ly traded company. It way to do it is to study one doesn’t matter. Understand business inside and out for one business and what really the purpose of making the makes it tick: how it makes investment – you may not money, how it organizes its actually invest. But having Page 36

Hertz Global Holdings, Inc. (NYSE: HTZ) - Long

Winner — 2013 Pershing Square Challenge

Richard Hunt Stephen Lieu Rahul Raymoulik [email protected] [email protected] [email protected]

Recommendation As of 4/19/13; in USD m except per share data Richard Hunt We recommend investors buy Hertz stock with a 12-month target Current Capitalization share price of $36, which represents ~52% upside to the current Stock Price $23.72 Richard is a first-year MBA share price. There are four main points to our investment thesis: Diluted Shares Outstanding (M) 462.0 student at Columbia Business 1) The market significantly underestimates the impact of Hertz's Market Cap $10,959 School. Richard is Co-President recent merger with Dollar Thrifty, which marks the completion Corporate Debt 6,545 of the Columbia Student of a ten-year industry consolidation that dramatically improves Cash (1,105) Investment Management the competitive dynamics of the industry Unfunded Pension Liability 227 Association. Prior to CBS, Enterprise Value $16,626 Richard was a Senior Financial 2) The market underestimates the levers Hertz can pull to coun- Analyst at New Constructs. ter the negative impact of falling used car prices Trading Statistics

3) Hertz has strong growth opportunities in the U.S. and will 52-Week Range $10.22-$24.28

realize significant revenue and cost synergies through its acqui- Dividend Yield 0.0%

sition of Dollar Thrifty Avg. Daily Volume (M) 7.7 4) A divestiture of the non-core Equipment Rental segment would Short Interest as % of Float 11.0% unlock substantial value by deleveraging the balance sheet Summary Valuation Business Description 2013e 2014e Hertz operates two main segments: car rental and equipment rental. EV / Revenue 1.5x 1.4x Car rental is the company’s core business – it operates over 10,000 EV / EBITDA 7.4x 6.4x Stephen Lieu locations worldwide and generated $7.6 billion in revenue last year. P / E 12.5x 9.9x The equipment rental segment rents out industrial, construction, and Stephen is a first-year MBA material handling equipment. It generated $1.4 billion in revenue last year. student at Columbia Business School. Stephen is Co-President Investment Thesis of the Columbia Student 1) The market underestimates the industry consolidation’s impact on car rental pricing Investment Management Ten years ago, there were six major rental car companies. Association. Prior to CBS, 100% Stephen worked for four years Since then, there have been a number of acquisitions: Avis 90% in investment banking and acquired Budget in 2002, Enterprise acquired National Alamo private equity. in 2007, Hertz acquired Advantage in 2009, and in the past six 80% months, Avis acquired Zipcar and Hertz acquired Dollar 70% Thrifty. This marks the completion of an industry consolida- 60% tion with the three remaining players controlling 95% of the market. We believe this oligopoly structure dramatically 50% improves the competitive dynamics and profitability of the 40% industry, as the three players can now focus on profitability 30% instead of market share. 20% We’re seeing signs of this already playing out – prior to the 10% closing of the Dollar Thrifty acquisition in November 2012, Rahul Raymoulik Hertz had experienced nine consecutive quarters of pricing 0%

declines and Avis had experienced 11 consecutive quarters of

2002 2005 2000 2001 2003 2004 2006 2007 2008 2009 2010 2011 2012 Rahul is a first-year MBA pricing declines. Since the acquisition closed, pricing has in- 1999 student at Columbia Business creased every month. Enterprise Hertz School. Prior to CBS, Rahul was Avis Dollar / Thrifty a Sector Specialist at Fidelity We believe the market is significantly underestimating the National / Alamo Budget Investments, focusing on the improved pricing environment that has resulted from the Other technology, media, and telecom industry’s consolidation. Management’s EPS guidance assumes Strong Pricing Environment w/ Price Signaling industries. 0% pricing growth. Sell-side consensus estimates assume only “One of the headlines I'd like to make is we don't want to a 1% increase in pricing. Pricing is the single biggest driver of gain share by reducing price. We want to gain share by our model, as a 1% price increase results in a 6% increase in increasing value, and that's how we're doing it.” our target share price. – Hertz CEO in April 2013

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

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

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

Advance Auto Parts (NYSE: AAP) - Long Finalist — 2013 Pershing Square Challenge

Joe Fleury John Gallagher, CFA Seth Kirner [email protected] [email protected] [email protected]

Recommendation: BUY ($ in millions except per share values) We recommend a long position CAPITAL STRUCTURE TTM FINANCIAL METRICS in Advance Auto Parts (“AAP”) Joe Fleury Current Share Price $ 80.00 Enterprise Value/EBITDAR 6.7x stock with a three year target Avg. Daily Vol. (mm) 1.3 Enterprise Value/EBIT 12.0x price of ~$165. AAP trades at a Prior to CBS, Joe worked as an 52 Week Low- High $61-$93 Price/Free Cash Flow 14.1x significant discount to its intrin- analyst at Ionic Capital Short Interest 2% Price/Earnings 15.3x sic value as well as its peers due Management, a multi-strategy Shares - diluted 74.14 ROIC 23% to an inefficient cost structure as hedge fund in New York. Joe Market Cap $ 5,931 Free Cash Flow Yield 7.1% a result of historical strategic (+) Debt 605 holds a BA in Economics from decisions. Our target price (-) Cash 598 Yale University. represents a ~100% upside to (+) Capitalized Oper. Lease (6x)1 1,922 COMPS 2011 2012 the current share price of $80, Total Adj. Net Debt $ 1,929 SSS Growth 2.2% -0.8% = Total Enterprise Value $ 7,860 Total Sales Growth 4.1% 0.6% and is based on a 7x forward (1) 6x lease capitalization is industry standard used by companies, credit agencies, and analysts 2016E EV/EBITDAR multiple (13.6x forward 2016 P/E). We believe that AAP is undervalued with an attractive margin of safety and that there are multiple ways to win with Advance Auto Parts. With management’s current plan, a passive investor could achieve a three year IRR of 20%, resulting in 2015 stock price of about $140. However an activist investor advocating necessary changes in opera- tions could receive a three year IRR of 28%, resulting in a stock price of approximately $165. In addition we be- lieve there is a measure of downside protection because AAP could likely be a takeover candidate if the price dropped below $70. John Gallagher Key Investment Highlights Prior to CBS, John worked with 1) Strong Barriers to Entry the TARP funds at the U.S.  Significant scale needed to compete on a national scale Treasury Department. Before TARP, he worked for the  Economies of scale on sourcing allow AAP to finance majority of inventory on attractive terms Federal Reserve. John holds a 2) Significant Free Cash Flow Generation BS in Finance from George  $400+mm in annual free cash flow; 7% 2012 free cash flow yield Mason University and is a U.S.  Inventory almost fully funded by trade Army veteran. 3) Attractive Growth Opportunities in Commercial

The aftermarket auto-parts industry is highly fragmented   Significant room for consolidation  Growth opportunities in the commercial segment for larger competitors 4) Multiple Ways to Win

 Activist proposal

 Passive investment — recent signs of a turnaround  Merger or buyout

Seth Kirner  Continued share buybacks

Prior to CBS, Seth worked in Business Description Restructuring at Loughlin Advance Auto Parts is a leading specialty retailer of automotive aftermarket parts, accessories, batteries and Management Partners. Prior to maintenance items primarily operating within the United States. As of December 2012, AAP operated 3,794 that he worked at Jennison stores throughout 39 states, Puerto Rico and the Virgin Islands. AAP operates in two segments: Retail, or “Do-it- Associates. Seth holds a BA in yourself” (62% of 2012 sales) and Commercial, or “Do-it-for-me” (38% of 2012 sales). Finance from Northeastern University. Investment Thesis We believe AAP is a great business with meaningful competitive advantages but has been mismanaged, primarily due to underinvestment in its distribution network over the past 5 years. We believe this is the root cause of an approximately 400 basis point EBITDAR differential to O’Reilly Auto Parts, AAP’s main competitor and only direct comp (AutoZone is almost entirely a retail business). This margin gap results in AAP trading at a 6.2x forward EBITDAR versus O’Reilly’s 9.0x, a premium of 50% to AAP. We propose that AAP invest $300mm over the next three years to augment their distribution network, building 6 additional distribution centers. Investing in the dis- tribution network has two positive effects: 1) increases AAP’s ability to raise prices in the commercial segment and 2) decreases AAP’s distribution costs, as costly, rushed deliveries are reduced. We believe the combination of the two will help narrow the 400 basis point EBITDAR gap that currently persists between AAP and O’Reilly and also narrow the valuation gap. IssueVolume XVIII I, Issue 2 Page 39

Advance Auto Parts (Continued from previous page)

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

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

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

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

Estimated Year End 2015 Valuation EBITDAR Bridge

($ in millions) 2012 2016 $ Impact Passive Active Financials Current Passive Activist Sales $ 6,205 $ 7,686 $ 7,908 Gross Profit 3,098 3,843 3,993 $2,000 2016 margin 49.9% 50.0% 50.5% SG&A Active SG&A 2,441 2,933 2,860 Saving EBITDAR % sales 39.3% 38.2% 36.2% $1,800 New $161 $1,803 2016 Gross Improvement vs. 2012 117bps 317bps SSS/ D&A Passive Margin SG&A Store Pricing EBIT $ 657 $ 910 $ 1,134 EBITDAR $1,600 Saving Growth $40 $19 margin 10.6% 11.8% 14.3% SSS/ $41 Store Pricing + D&A 190 235 261 $90 $1,541 $1 Organic Growth + Rent 320 397 408 Store $1,400 Acq. $102

EBITDAR $ 1,167 $ 1,541 $ 1,803 2016 EBITDAR Growth $64 margin 18.8% 20.1% 22.8% 2012 EBITDAR $118 1-yr Fwd EV/EBITDAR Multiple 6.7x 7.0x 7.0x $1,200 1-yr Fwd P/E Multiple 13.0x 14.4x 13.6x $1,167 Enterprise Value $ 7,860 $ 10,789 $ 12,620 Net Debt + Leases $ 1,929 $ 2,281 $ 2,339 $1,000 Stock Price $ 80.0 $ 138.3 $ 166.0 Implied Fwd 6.2X 7.0x 7.0x EBITDAR Multiple Current Stock Price $ 80.0 $ 80.0 $ 80.0 Total 3 Year Return n/a 72.9% 107.5% 2015 Stock Price $80 ~$140 ~$165 3 year IRR n/a 20.0% 27.6% Key Investment Risks: (1) failure to execute commercial business focus; (2) O’Reilly competing for same geo- graphic areas as AAP; (3) consumers shift more towards buying new cars and the age of vehicles on the road declines significantly. Page 40

Dollar Tree, Inc. (NASDAQ: DLTR) - Long Finalist — 2013 Pershing Square Challenge

Jeremy Colvin Eric Lai Akhil Subramanian [email protected] [email protected] [email protected]

Recommendation: BUY

We recommend a BUY on Dollar Tree (DLTR) shares with a target price of $64.75. This target price represents ~40% upside to today’s price of $45.99, and is based on 19.3x forward P/E (consistent with last three year aver- Jeremy Colvin age) as well as $4.90 from a leveraged recap. Prior to joining CBS, Jeremy served as an investment banking Current Valuation Price Target associate and analyst in the DLTR Stock Price Stock Price $45.99 Stock Price $64.75 $60 Financial Sponsors Group at Goldman Sachs. He holds a BA Shares Out. (mm) 227.2 Shares Out. (mm) 227.2 $55 Market Capitalization $10,449.2 Market Capitalization $14,712.2 from Columbia College. $50

Total Debt 271.3 Total Debt 1,500.0 $45 Total Cash 399.9 Total Cash 399.9 $40 TEV $10,320.6 TEV $15,812.3 $35 FY2014E EPS $3.10 FY2014E EPS $3.10 $30 Implied FY2014E P/E 14.8x Implied FY2014E P/E 20.9x Apr-12 Jul-12 Oct-12 Jan-13 Apr-13

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

Akhil Subramanian Investment Thesis

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

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

Dollar Tree (Continued from previous page)

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

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

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

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

Valuation

At 2014E EPS of $3.10 and a P/E multiple of 19.3x (which is in- $3.40 line with 3 year average), DLTR should be trading at ~$64.75/ $0.14 $3.10 $3.20 $0.07 share (including the $1.5bn leveraged recap with a share price $0.09 $3.00 $0.20 ($0.08) impact of $4.90). In order to reach $3.10, we assume relatively $2.80 $2.68 conservative new store growth of (340 stores), 3% same store $2.60 sales growth (below historical average 4.4%), 20bps margin $2.40 uptick (below 2012 improvement) and $500mm of share buy- $2.20 backs. $2.00

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

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

Stanley Black & Decker (NYSE: SWK) - Long Finalist — 2013 Pershing Square Challenge

Arjun Bhattacherjee Rory Ellison Colin Kennedy [email protected] [email protected] [email protected]

Arjun Bhattacherjee

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

SOTP Analysis

($ in mm)

Segment FY14E EBITDA Current Base Case Avg. Comparable Company CDIY 1,144 10.0x 10.0x 10.6x Industrial 737 9.0x 9.0x 9.5x Security 537 1.6x 10.5x 10.8x Corporate Expenses (427) 7.8x 9.8x Total 1,991 7.8x 9.8x Enterprise Value 15,618 19,605 Rory Ellison Current Share Price $76.40 $107.00

Prior to CBS, Rory worked in Dividend / Share 1.96 Private Equity at Leonard Premium / (Discount) to Current 43% Green & Partners. Rory holds a BA with Honors in Business We believe that SWK is in a cycle of suboptimal capital allocation and has significant activist poten- Admin. from the Richard Ivey tial. The Company is a collection of superior market leading businesses whose intrinsic value is obscured by a School of Business at the conglomerate structure. SWK has strong FCF, but currently ~80% of that cash is generated overseas. This dynam- University of Western Ontario. ic coupled with management’s desire to build a ‘diversified industrial company’ forces the Company to undertake risky acquisitions outside of its core competency. SWK has 30% end market exposure to US construction mar- kets, yet due to a lack of managerial focus and execution the Company has struggled to grow organically and is losing share in its core power tools and hand tools segment (CDIY). We believe an activist solution that spins out the SWK Security segment will unlock significant value for current shareholders. In addition, we believe that spinning out security will allow SWK Management to better focus on core segments and drive organic growth initiatives.

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

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

Incremental Upside: RMT RMT Value Creation $7.57 4.8x Total Value $116.53 Premium to Current 53% Up/Down Business Description SWK provides power and hand tools (50% of revenue), industrial and auto repair tools and engineered fasteners (28% of revenue), and mechanical access solutions and electronic monitoring systems (22% of revenue) globally. IssueVolume XVIII I, Issue 2 Page 43

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

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

Current Share Price $76.40 $107.00 RMT Value Creation $7.57 Dividend / Share 1.96 Total Equity Value $116.53 Premium / (Discount) to Current 43% Premium / (Discount) to Current 53% Outside Executive / Board Member We also believe that an outside Director would be beneficial to help expedite the process to unlock hidden value for SWK shareholders. A potential candidate for this position is Edward Breen (the former chairman of Tyco, where he oversaw several spin-offs and breakups of divisions). Risks Failure of Activist Campaign: 30% exposure to US construction markets and growing emerging markets present a clear path to near term earnings growth. A 9% FCF yield is an effective floor. Page 44

Yum! Brands, Inc. (NYSE: YUM) - Long Finalist — 2013 Pershing Square Challenge

Omar Elangbawy Ranjan Ramchandani Andrew Woodruff [email protected] [email protected] [email protected] Capitalization Trading & Liquidity Implied Multiples Stock Price $65.04 Name Yum! Brands 2012 2013 Shares Outsanding 449.9 Ticker YUM Revenue $13,633.0 $14,053.0 Market Cap $29,261 Date 4/19/12 EBITDA 2,758.0 2,983.0 Omar Elangbawy 52-Week High $74.75 EBIT 2,227.0 2,264.0 Cash $776 52-Week Low $59.68 Omar is a second-year MBA Debt $2,942 Free Float (m) 449.5 Insider Ownership 0.3% EV / Sales 2.3x 2.2x student. Prior to Columbia, he Minority Interest $158 Short Interest 2.3% EV / EBITDA 11.5x 10.6x worked in Private Equity for Enterprise Value $31,585 Daily m Volume 2.9 EV / EBIT 14.2x 14.0x FLAG Capital and interned as an analyst for a small-cap, value- Recommendation oriented hedge fund. Omar We recommend a long position in Yum! Brands, which we believe is undervalued due to its suboptimal operating holds a BA in Economics and a structure. Given the predictable, steady cash flows in the U.S. and Yum’s broad international footprint, we believe BS in Computer Science from the inherent stability of the business lends itself to an asymmetric risk-reward profile. While the short-term focus the University of Pennsylvania. on recent food safety and avian flu scares in China has depressed the stock price, our view on the long-term sus-

tainability of the business makes a stake in Yum! an attractive proposition.

Our thesis revolves around two drivers of value. In order to capitalize on the value creation mechanisms we’ve identified, an investor would need to take an activist stance and create his/her own catalyst. The crux of our thesis is as follows:

1) Yum’s operating structure exposes US investors to a high degree of emerging markets risk. A

spinoff of Yum’s domestic operations into a separate entity from the high growth international

business would allow investors to more efficiently define their risk tolerance . Ranjan Ramchandani  Yum U.S. - a stable, highly cash-generative business focused on returning capital to shareholders Ranjan is a second-year MBA  Yum International - a growth-focused entity working to expand Yum’s footprint in developed and student focusing on healthcare emerging markets outside of the U.S. management and  A split would allow investors to better allocate their risk between two fundamentally different risk / entrepreneurship. Before growth profiles. We believe the split would reverse an estimated 25% discount on the combined entity. school, he worked for 3 years in the New York office of the 2) A spinoff would drive increased management discipline, improving the likelihood of capitalizing Boston Consulting Group, on operational improvements within each entity to drive both top-line growth and margin ex- where he will be returning after pansion. graduation.  Yum U.S. - Continue to focus on innovative product development and franchise-level operational im- provements while also improving G&A efficiency.

 Yum International - Invest in smart growth in underpenetrated cities in China. Capitalize on largely un- tapped India and RoW opportunity. Consolidate suppliers and rationalize supply chain logistics where possible to improve margins.

Business Description

Yum! Brands is the world’s largest quick service restaurant company with over 39,000 stores all over the world. Stores are both corporate owned and franchised under three main brands: KFC, Pizza Hut, and Taco Bell. In addi- Andrew Woodruff tion to these brands, Yum also owns a number of smaller, local brands primarily throughout China. Approximate- Andrew is a second year MBA ly 75% of revenues and operating income comes outside the U.S., with China making up about two-thirds of that student. Before CBS, Andrew amount. Approximately 80% of Yum’s stores are franchised or licensed, leaving 20% corporate owned. worked three years in emerging Financial Summary Year Ended December 31, Quarter Ended: markets sales & trading for J.P. Morgan. He has worked as an 2007 2008 2009 2010 2011 2012 Revenue $10,435 $11,304 $10,836 $11,343 $12,626 $13,633 analyst for two different long/ % Growth - 8.3% (4.1%) 4.7% 11.3% 8.0% short equity funds over the past Gross Profit 2,662 2,839 2,902 3,223 3,486 3,781 year. He has also passed all % Margin 25.5% 25.1% 26.8% 28.4% 27.6% 27.7% three levels of the CFA exams. G&A 1,293 1,342 1,221 1,277 1,372 1,510 % Margin 12.4% 11.9% 11.3% 11.3% 10.9% 11.1%

EBIT 1,369 1,497 1,681 1,946 2,114 2,271 % Margin 13.1% 13.2% 15.5% 17.2% 16.7% 16.7% EBITDA 1,911 2,053 2,261 2,535 2,742 2,916 % Margin 18.3% 18.2% 20.9% 22.3% 21.7% 21.4%

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Yum! Brands (Continued from previous page) Investment Thesis

1) Rationale for spinoff  Current operating structure is an inefficient capital allocation vehicle. Yum’s International operation is concen- trated in China, a market that entails significant upside but also significant volatility. By contrast, the US business is largely franchise-owned and generates stable, high-margin revenues. Yum! investors are obliged to participate in risk inherent in the emerging markets portion of the business and cannot choose the level of exposure to this risk relative to the stable US business. Consequently, we believe the combined entity trades at a discount. A spinoff of the US operations would close this discount.  The spinoff is feasible from an operational perspective. Yum! US is organized by brand vertical, whereas Yum’s International divisions (China, India, and YRI) are organized by geography. Management teams and supply chains are already totally distinct. Additionally, financials are reported in line with our proposed spinoff structure, allowing investors transparency into forecasted NewCo results.  From a governance perspective, there are few impediments to a successful spinoff. Ownership of Yum! is con- centrated among institutional shareholders (>70%), insiders hold a very small percentage of the firm (less than .3%), and short interest is low. The Board is up for re-election every year and the proxy statement indi- cates no active poison pill mechanism.

2) US opportunities  Yum’s US brands have continued to innovate, both in terms of product development and in terms of operating model improvements. The introduction of the Doritos Locos taco in 2012 by Taco Bell was widely regarded as one of the most successful product launches in QSR history, and Taco Bell is on track to sell 500 million units in 2013. KFC will soon be making a shift to a largely boneless menu, a change it believes will align its menu closer to the tastes of younger consumers. Pizza Hut has shifted many of its locations to a “Delco Lite” model, cutting the store footprint in half and focusing on delivery/carryout operations.  Yum US lags its peers in terms of G&A as a percentage of US sales. While this metric is highly sensitive to fran- chise mix and same-store sales, it is indicative of the fact that there are opportunities for increased G&A effi- ciency. Yum US’ brand vertical operating structure has created duplicative functions (HR/IT/Finance) across business units; centralization of these functions could drive synergy value. Furthermore, menu rationalization at the brand level could allow for more efficient use of corporate ad dollars, driving increased top line. We believe the combined effects could generate an additional 200bps in margin over the next two to three years.

3) International operational improvements  China will continue to be a growth engine. Yum! is the market leader among QSR chains but is still underpene- trated in “lower tier” smaller cities, implying significant room for growth. Additionally, Yum!’s recent acquisition of Little Sheep, the world’s leading hotpot chain, suggests opportunities for growth through M&A.  Management’s focus on China growth has come at the expense of capitalizing on rest-of-world opportunities. A spinoff would allow management to focus on expanding Yum’s footprint in other developing markets, particular- ly in India. Management guidance suggests India system sales growth will top 40% per annum over the next several years. India is also a candidate for a first major toehold for Taco Bell abroad, as pilot locations in Delhi have proved extremely successful, likely due to the relative familiarity of Indian consumers.  The historical focus on China growth has also led to a “long tail” of international markets in which Yum! has a limited presence. A more concentrated approach to expansion in these markets will drive enhanced synergies at the franchise and corporate level as penetration in these markets approach scale. Valuation Our model assumes the two business units, Yum! Intl. and Yum! US, will each trade at a more appropriate multiple in line with their individual growth/risk prospects. Given the inherent stability of the US business, we have assumed the business will trade at 11x EBITDA, which is below some of the larger QSR chains in the US that have a similar mix in terms of franchised vs. company-owned stores (e.g. McDonald’s). For Yum! International, we believe the growth pro- spects in China and RoW would allow the company to trade in-line with its competitors with a similar growth profile at 15x EBITDA. As a result, we believe an investment in Yum! Brands represents an attractive investment opportunity for an activist investor with 50-70%+ upside in two years (price target of $100-$110 per share by 2015). Key Investment Risks Given the scope of the proposed activist maneuver and the size of Yum! ($30B), the spinoff proposal could encounter resistance from management and the Board. A proxy contest could be a protracted and difficult endeavor, though the concentrated institutional ownership and relatively lax anti-activist governance provisions mitigate this risk. The investment is also exposed to operational risk for both the US and International businesses. Though we believe the US business is largely stable—particularly given its high proportion of franchisee ownership—a secular trend toward healthy eating could negatively affect system sales. Yum’s brands are attempting to preempt this with healthier menu options (e.g. the Cantina Bell menu at Taco Bell). Internationally, the business is subject to the volatilities of emerging markets—regulatory, food safety, political, and currency risks—and to competitive threats from other multinational and international QSR chains. Nonetheless, we believe the existing infrastructure and store footprint mitigate these con- cerns to a certain extent. Page 46 Paul Isaac

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

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

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

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

(Continued on page 50) There were other red flags Page 50 Paul Isaac

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

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

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

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

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

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

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

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

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

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

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Graham & Doddsville 2012 / 2013 Editors

Jay Hedstrom is a second-year MBA student and a member of the Heilbrunn Center’s Value Investing Program. During the summer Jay worked for T. Rowe Price as a Fixed Income Analyst. Prior to Columbia Business School, Jay worked in investment grade fixed income research for Fidelity Investments. He can be reached at [email protected].

Jake Lubel is a second-year MBA student and a member of the Heilbrunn Center’s Value Investing Program. During the summer he interned at GMT Capital, a long-short value fund. Prior to Columbia Business School he worked under Preston Athey on the small-cap value team at T. Rowe Price. He received a BA in Economics from Guilford College. He can be reached at [email protected].

Sachee Trivedi is a second-year MBA student. Over the summer this year, she in- terned at Evercore Partners in their Institutional Equities division as a sell-side research analyst. Prior to Columbia Business School, Sachee worked as a consultant in KPMG’s Risk Advisory business and at Royal Bank of Scotland in London. She can be reached at [email protected].