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

Inside this issue: Issue XXVII Spring 2016 CSIMA Confer- ence & Pershing John Phelan of MSD Capital Square Challenge P. 3 John Phelan P. 4 Mr. Phelan is Co-Managing Partner of MSD and Co-Founder of the firm. Prior to forming MSD, he was a Principal from 1992 to 1997 Alex Magaro P. 14 at ESL Investments, a Greenwich, Connecticut based investment firm. At ESL, Mr. Phelan was responsible for ESL’s Special Adam Wyden ’10 P. 25 Situation Investments and helped grow the firm from $50 million Marc Cohodes P. 33 to over $2.0 billion in . Prior to ESL, Mr. Phelan was Vice President in charge of Acquisitions (Western Pershing Square Region) for the Zell-Merrill Lynch Real Estate Opportunity Funds. Challenge Ideas P. 44 John Phelan Mr. Phelan began his career at Goldman, Sachs & Co. where he (Continued on page 4) Editors: Alex Magaro Brendan Dawson Adam Wyden ’10 MBA 2016 of Meritage of ADW Capital Scott DeBenedett Group MBA 2016

Anthony Philipp Alex Magaro is a Adam Wyden founded MBA 2016 Co-President of ADW Capital in January Meritage Group, a Adam Wyden 2011 and acts as sole Brandon Cheong Alex Magaro fundamentally- portfolio manager to MBA 2017 oriented the Fund. The Fund is

Eric Laidlow, CFA investment firm, managing focused on maintaining a concentrated MBA 2017 approximately $10B primarily on portfolio of high-quality and high- (Continued on page 14) (Continued on page 25) Benjamin Ostrow MBA 2017 Marc Cohodes formerly of Rocker Partners/Copper River Visit us at: www.grahamanddodd.com Marc Cohodes is a formerRolf General Heitmeyer Partner of Rocker Partners/ www.csima.info Copper River from 1985-2009. He began his career at the Northern Trust Company in 1982 after graduating Babson College with a BS in Finance. He has been profiled in the books; Reckless Endangerment, Selling America ,The Most Marc Cohodes Dangerous Trade. He was the subject of a Harvard Business School Case study on his efforts to expose Mortgage Fraud at Novastar. He resides in Cotati, California, where he runs Alder Lane Farm.

(Continued on page 33)

Page 2 Welcome to Graham & Doddsville

We are pleased to bring you the ment horizons across asset When we inherited Graham & 27th edition of Graham & classes and the return potential Doddsville as editors last year, Doddsville. This student-led in- of businesses with durable we wanted to continue the vestment publication of Colum- competitive advantages. tradition of providing our read- bia Business School (CBS) is co- ership with high quality inter- sponsored by the Heilbrunn Adam Wyden ’10 of ADW views and investment ideas. Center for Graham & Dodd Capital discusses the influence We sought to provide diversity Investing and the Columbia Stu- of an entrepreneurial spirit on of thought and experiences via dent Investment Management his firm and investment pro- our interviews. We hope we Association (CSIMA). cess. Adam walks through past have lived up to those objec- ideas such as IDT and Imvescor tives. Meredith Trivedi, the In this issue, we were fortunate Restaurant Group (IRG.TO) as Heilbrunn Center Director. to speak with four investors well as current theses on Fer- We are honored and privileged Meredith skillfully leads the who offer a range of perspec- rari (RACE) and Fiat (BIT:FCA). to have continued the Graham Center, cultivating strong tives based on their unique paths & Doddsville legacy, and we relationships with some of to and careers in investing. Mark Cohodes shares his look forward to reading the the world’s most experi- experiences from a lifetime of next generation of issues, enced value investors, and John Phelan of MSD Capital short-selling. He offers his per- helmed by three outstanding creating numerous learning discusses lessons learned over spective on the discipline and individuals in Brandon Cheong opportunities for students decades of investing with men- temperament required as well ’17, Eric Laidlow ’17, and Ben interested in value invest- tors such as Richard Rainwater, as the intellectual rewards of a Ostrow ’17. We want to thank ing. The classes sponsored Sam Zell, , and career in short-selling. Marc Brandon, Eric, and Ben for by the Heilbrunn Center Michael Dell. John offers insights discusses ideas such as Home their commitment and dedica- are among the most heavily into the development of MSD Capital Group (HCG) and tion to Graham & Doddsville demanded and highly rated Capital as well as his own devel- Tempur Sealy (TPX). over the last year. classes at Columbia Busi- opment as an investor and PM, ness School. while shedding light on challeng- This issue also highlights pho- As always, we thank our es he sees today in the invest- tos from the 19th annual interviewees for contributing ment management industry. CSIMA Conference as well as their time and insights not only the 9th annual Pershing Square to us, but also to the invest- Alex Magaro of Meritage Challenge. ment community as a whole, Group discusses his many expe- and we thank you for reading. riences, from running a business Lastly, we are proud to include as an owner-operator to invest- in this issue finalist pitches from - G&Dsville Editors ing in early stage companies, current students at CBS who which led him to co-manage competed in this year’s Per- Meritage Group. Alex talks to shing Square Challenge. G&D about -term invest- Professor Bruce Greenwald, the Faculty Co-Director of the Heilbrunn Center. The Center sponsors the Value Investing Program, a rigor- ous academic curriculum for particularly committed stu- dents that is taught by some of the industry’s best practi- tioners.

Howard Marks from Oaktree, pictured Columbia Business School students help here giving the keynote talk at the CSIMA at registration for the 19th Annual Conference in January 2016 CSIMA Conference Volume I, Issue 2 Page 3 Columbia Business School Events: CSIMA Conference and Pershing Square Challenge

Keith Meister of Corvex Management LP delivers his Howard Marks of Oaktree with Bruce Greenwald after keynote address at the 19th Annual CSIMA Conference their keynote interview at the 19th Annual CSIMA Conference

1st Place Finalists Joanna Vu ’17, Melody Li ’17, and Thais Paul Hilal ’92 and Bill Ackman listen and judge student Fernandes ’16 pitch Alimentation Couche-Tard at the 9th pitches at the 9th Annual Pershing Square Challenge Annual Pershing Square Challenge

Judges deliberate at the 9th Annual Pershing Square Bill Ackman and the winning team at the 9th Annual Challenge Pershing Square Challenge Page 4 John Phelan (Continued from page 1) worked as an Analyst in encouraged me to go find good second years at business the mentors. She said one of the school I worked for Richard Division. things about good mentors is Rainwater, and that's where I you can learn on someone met Eddie Lampert. Richard Mr. Phelan received his else's nickel. It's something you introduced me to Eddie. Of M.B.A. from Harvard don't realize when you’re those ten weeks that summer, Business School and younger. But it struck me at a I spent about three or four graduated cum laude with very early age to try to go find with Richard and the rest with distinction and Phi people that were the best in Eddie. Kappa from Southern their particular businesses, and Methodist University with I think my mother pushed me G&D: How did you connect a B.A. in Economics and towards that. with Richard? Political Science. Mr. Phelan also holds a In my real first job, I worked JP: I had been hoping to get John Phelan General Course degree with an uncle rehabbing back to Texas after business with an emphasis in apartments in New York. I was school and I wrote Richard a Economics and doing that during college. That letter. In that letter I told him I International Relations was an eye-opening experience would be willing to work for from the London School of that forced me to focus on free and one of my professors Economics. cash flow every minute of the at Southern Methodist day. It was a very tough University had suggested I Graham & Doddsville business and I was doing a contact him. I told him I just (G&D): To start off, talk number of different things. The wanted to learn from one of about your background and work ranged from running the the best and was willing to your path to investing, numbers to actually doing invest in myself. including mentors and construction work. That influences along the way. teaches you a lot. I also Richard called me on a Friday learned I didn't want to break at like 4:00pm. He said “Hey John Phelan (JP): My mother my back doing that for my John, this is Richard was a very big influence on my entire career. Rainwater.” I thought it was development as an investor. one of my classmates playing a My father was a doctor and, I was fortunate enough to get a joke on me. I used a curse like most doctors job with , which word I shouldn't have and just unfortunately, not a very good was really the first big hung up the phone. A minute investor. My mother, on the company I worked for. At the later the phone rang again: “I other hand, came from a real time, Goldman was still a think we got disconnected.” estate background and focused private partnership. I learned a I'm thinking, “Oh my God, this very much on cash flow. My ton and I had a number of is Richard Rainwater. I cannot parents gave me a Disney great mentors at Goldman believe I just hung up on this stock certificate for a birthday Sachs. I worked with truly guy.” I said, “I'm really sorry, present when I was five years exceptional people there. but my classmates have been old. That got me hooked—I playing jokes on each other, was fascinated by numbers and As great as my experience at and I thought you were one of seeing something trade every Goldman was, it did make me them.” “Oh that's a pretty day. That's what got me into realize that I did not want a good one,” he laughed—he stocks. career in investment banking. was very good about it. Instead of being the person I initially went into real estate, who is on call 24/7 to serve my I flew down to Fort Worth on where my mother taught me client I wanted to be the client. my own dime and met with quite a bit, including two I preferred being a principal as Richard. He said, “Meet with principles: make sure you can opposed to an advisor. I these different guys. You can always pay your bills and debt decided to attend business work with me for a bit and see service and the importance of school and was accepted into if one of them will take you as free cash flow for levered Harvard Business School. The well.” I met with Eddie and a assets like real estate. She also summer between my first and couple of other guys who were (Continued on page 5) Page 5 John Phelan

with Richard at the time. I investment fund and was one our firm without leverage and didn't know a lot about risk of the few people who had have only been 100% invested , but I knew they capital. It was a good time to once in our 18 year history, were analyzing stocks and that have capital. The RTC was the first quarter 2009. I was something I really wanted formed after a number of actually consider cash to be an to do. It was a tremendous S&L’s failed, there were a lot asset class. learning experience. I really of distressed loans, the trading enjoyed working with Richard market for loans was just About nine months into the and Eddie that summer, and I starting to develop, and the job, Zell through his Zell- fell in love with the risk illiquidity was incredible. Chilmark fund started taking a arbitrage business. One of the Having capital at that time and hard look at Executive Life, things you have to be good at being a liquidity provider to which had a large junk bond in the business is the banks was a unique and portfolio. I was asked to work valuation: you need to be able good place to be. on credits that had large real to understand your downside. estate components: RiteAid (RAD), Carson Pirie Scott, I graduated in 1990—not a “...my mother taught Charter Medical—any very good year to graduate company that had a big real from business school, as you me quite a bit, estate component to it. We can imagine. The markets were were trying to value both the bad, the RTC/bank crisis was including two real estate and going concern accelerating and most money value as that was what the managers were having a bad principles: make sure debt was secured by and the year. It was a rough year. Eddie real estate provided your said, “Listen, I don't know if I'm you can always pay downside protection. We lost going to be in business much your bills and debt the Executive Life auction to less have a job for you. It's not Apollo. It was a fascinating clear. You should go find service and the experience and I really learned something.” a lot. I remember looking at importance of free Charter Medical debt which G&D: Did you end up was secured by a large number working with Eddie? cash flow for levered of hospitals. I called Chase and said, “Hey, we JP: I actually graduated assets like real estate. see you guys are the lead bank without a job. It was She also encouraged on this.” They said, “We've got depressing because I didn't plenty of debt for sale, we can expect to be jobless, in debt, me to go find good sell you at 20-30 cents on the and living at home with my dollar.” We came to the parents after graduating from mentors.” conclusion we could've sold Harvard Business School. I four or five hospitals and knew I did not want to go back gotten all our money back at to banking, so I did not do If you go back and study the that price. That's how bad and that. Luckily a couple of the great investors throughout illiquid the market was. guys I had worked with at history—the Medicis, the Goldman in Chicago left the Morgans, the Rothschilds, and Understanding where you are firm to go work for Sam Zell. recently Buffett—these great in terms of seniority in the Bob Lurie had died and he was investors with terrific records and identifying really Sam's right-hand man— share a common trait: they the fulcrum was they were partners. Sam hired were always in a position to be critical, so I started auditing a Randy Rowe, who was the liquidity providers. Each was bankruptcy class at University main person I worked with at willing to hold cash until of Chicago because I wanted Goldman in Chicago. Randy someone was in distress or to learn bankruptcy law. I was kind enough to offer me a under duress, and they could thought it was an important job. Sam had just raised his provide liquidity at very aspect of the work I was doing. second distressed real estate attractive prices. We have run I put together a business plan (Continued on page 6) Page 6 John Phelan

on the side, while I was still Glenn Fuhrman. All those guys really great macro thinkers out working at Zell. I pitched Sam have been very influential for there. He's very good at on the idea of setting up a junk me. And they all have very looking at excesses and bond operation to buy the different approaches. They all thinking through the debt of distressed companies. go about things very implications of them before We had done a lot of work on differently, but I've tried to they happen, when they Pershing Square Challenge over 100 companies. Exec Life take nuggets from each one of happen, and then after. He's runners-up with Paul Hilal owned only pieces of the debt, them and incorporate what really adept at connecting the ’92 (from left to right: so there was a big opportunity I’ve learned from each of them dots. He's a much more top- Chris Andreola ’16, Bran- to make a lot of money. Sam into my thinking process. down guy than someone like don Cohen ’16, Paul Hilal got up and slapped me on the Eddie, who also has a great ’92, and Daniel Rudyak back and said, “You know nose for investments but is ’17) what, congratulations. I wish “If you go back and more bottoms up. you a lot of luck—this is a fantastic idea. I think this is study the great I have a funny story with Sam. great.” I asked, “Did I just get investors throughout He spoke during my first year fired?” He said, “No, you don't at the Goldman real estate have to leave. But you're going history—the Medicis, conference. He looked in the to leave. I already know it. This room and said, “I want all you is a great idea. I don't want to the Morgans, the to know that, within three do this because I want to own years, half of you will no longer and control companies. I'm not Rothschilds, and be working in this department. interested in owning pieces of There is going to be a major companies anymore. I actually recently Buffett— blow up.” This was in the want to buy and control them. these great investors summer of 1987. He was dead But you've got a great idea and on the money. Sam is very I think you should go pursue with terrific records good that way. He's also a very it.” smart deal structurer. He share a common trait: understands leverage points I called Richard, but he had and knows how to negotiate also taken a run at Executive they were always in a very well particularly in Life and already had a team in complex situations. He's a house. So I called Eddie. I sat position to be liquidity consummate deal maker. down with Eddie and gave him providers. Each was my business plan and pitch. He G&D: When did you start said, “Well why don't you willing to hold cash thinking about launching your come on in and do it.” I did own fund? Why did you that with Eddie and ended up until someone was in ultimately decide to join working with him a little over Michael Dell instead? seven years. I started off distress or under basically doing distressed, risk JP: In late 1997, I decided to arbitrage—all - duress, and they could leave ESL. It was a personal type of investing. Then I got provide liquidity at decision. My mother had involved in the emerging passed away very markets debt crisis in 1994. I very attractive prices.” unexpectedly. It was a very did quite a bit in that area with tough thing for me, and it was Eddie. That's how I earned my especially difficult on my dad. I stripes. G&D: Could you talk more decided to take some time off. about working with Sam Zell I'd been working like a I've been very fortunate to through the real estate cycle? machine with Eddie, those have really great mentors at How has he been able to avoid seven years were like dog Goldman, as well as Sam, mistakes and be opportunistic years. He was a demanding guy Eddie, and Michael Dell, whose when others can't? to work for but also a very private investment firm I now smart guy. I enjoyed it, and co-manage with my partner JP: I think Sam is one of the learned an incredible amount, (Continued on page 7) Page 7 John Phelan

but I needed some balance and build. I walked him through my stopped me in my tracks and I I needed to help my father. business plan and he said, said, “Now that's an interesting After a few months, I started “That's interesting. I'm trying question. I didn't really think getting itchy trying to figure to hire a guy similar to Richard about that.” He said, “I'd like out what I was going to do. At to do something like that for you to think about that.” I met the same time, I'd made a me. Would that be of interest with Michael a few more times. decent amount of money and to you?” I said, “No, probably At the end of the day it was didn't feel rushed to have to not. I've got some good trust on both of our parts, and do anything. investors and I am not sure I it worked. He's been a want another partner at this phenomenal partner. I'd make I decided I was going to write a time.” He said, “I got it, okay the same decision again business plan for a multi- no problem.” I said, “By the anytime. It's been a great strategy investment firm, way, I'm happy to give you my partnership with him and similar to ESL. I met with a business plan. It might help you Glenn. number of different successful think through what you want investment people. Some of for your investment office.” Michael was the one that them I knew. Some of them I introduced me to my partner, did not. I said, “I just want 30 Glenn Fuhrman. He was very minutes of your time, and I “I came away with good at matching us up. It was have just one simple question. a hard thing for me to do Tell me why you've been what I call the three because Michael was successful and how do you partnering me up with sustain it?” Richard as well as Cs, which is what I somebody I didn't know. David Bonderman were two of Although we both came from the people kind enough to thought were really the Goldman—and were there at indulge me. I basically keys to success in the the same time—we didn't interviewed different successful know each other. It became fund and private equity investment business: very apparent when Glenn and managers. From those I first met that we had very interviews I came away with Capital, Connections, complementary skill sets which what I call the three Cs, which is really important to a is what I thought were really and Culture. These successful partnership. We the keys to success in the both came from the same investment business: Capital, were the drivers I was Goldman mold: teamwork, Connections, and Culture. able to identify. hard work, intelligent, humble and ethical behavior. It just These were the drivers I was They're probably worked. I think, to his credit, able to identify. They're Michael saw that it was going probably drivers in just about drivers in just about to work and he knew, any business. I was out raising unbeknownst to us, that this my own fund and had raised a any business.” was probably going to be decent amount of money. bigger than what we thought it While I was raising the fund was going to be when we first both Dan Stern and Richard I gave him my business plan. started. Glenn has been a Rainwater gave me a call and He called me about a week tremendous partner and friend said, “You should go meet with later and said, “You know, I and we owe this to Michael. Michael Dell.” I said, “Michael's was reading through your an investor of Eddie's. I don't business plan, and I have a G&D: Could you talk about know that I really want to do question for you. I'm just the evolution of MSD as an that.” Richard and Dan both puzzling on it. I'm curious how investment firm as well as the said, “Just shut up and go do you're better off under the evolution of your role? it.” three Cs by yourself than you are with me. I have capital. I'm JP: It definitely has evolved a I met with Michael and he pretty connected. And you get lot. I used to jokingly say that asked me what I was trying to to build the culture.” That we'd never be more than 15 (Continued on page 8) Page 8 John Phelan

people. Then when we got to have to do is focus on the there any hedge overlays we 20, and I’d said, “There's no investment side. That's really should put on? What do we way we're going to more than what we've tried to create at see across our platform that is 30 people.” Today we're 124 the firm today. I would say our concerning? We have a great people. Initially, when it was roles have evolved to more of vantage point because we get just the two of us, Glenn and I a chief risk officer/chief to see everything across the were involved in every investment officer. We firm. decision. The firm evolved by oversee the portfolios, we us working closely with our oversee the teams, but they're I'm not as deep in the weeds as PMs before we really let them really running independent I was when we started. That's loose. Distinguishing a good businesses, and they're making partly due to the fact that we PM from a good analyst is not the decisions to buy and sell. If have highly capable people that easy. We were on top of there's something in there we who don't need my direct them in the beginning and over don't like we will have a call. oversight. We do still have time we established enough I'm happy to pick up the phone very robust conversations confidence in them that we and say, “Walk me through around investments and could step back. We knew that this and tell me why we've got process. We focus a lot on our they were quite capable. They this position and what's there,” process. I would say I probably didn't need the same sort of because we're trying to risk spend more time now on continued oversight, and we manage the firm, so we're kind culture building and on trying wanted them to focus on of a second layer of risk to develop the firm and our building the business just as we management to their own risk next generation of talent. In were. management. reality, for a firm to be successful you have to create We felt that creating these virtuous circles. We're diversification by strategy and very disciplined. We have a having people who were “It all depends on your good team. We have good focused on their individual culture. We have great businesses was the right way own DNA. Self- investors. We've been to build our overall business. If investing for the long term. All you look at why most awareness is a really this stuff has been built up over managers get frustrated in the important quality to time, and it's self-reinforcing. investment industry it's But you also have to adapt because, as you get bigger and have, as is humility.” constantly. as you scale, you move from picking securities to running I look at the markets today the business. That can end up and I look at the sheer amount taking 30% - 40% of your time. Today we have ten strategies. of information that's thrown at Guys like us, who like to look We sit on the investment us. I look at all this algorithmic at stocks and companies, don't committees for our private trading and the impact that has like reviewing the HR policy, equity and real estate on the market. You better be the vacation policy, strategies. Any illiquid-type very aware of what's going on compensation system, etc. But investments need to go and how it's going to change those are all things you have to through an investment and what the implications are deal with: your interviewing committee process. We spend for you and your business. policy, your training policy, and a lot of time today on our Those are issues we talk about all those operational issues. investment research process a great deal. Today with all the regulation and how to improve it. How and compliance it can be a full do we improve our decision G&D: One element of the time job in its own right. making? How do we do better MSD philosophy that comes with data management? What's through in a lot of your We want to find really good going on in the markets right interviews and writings is a investors and remove the now and how are we certain contrarian streak. Are distraction of running the positioned for it? Are we too there sectors or areas of the business from them, so all they exposed in one sector? Are investment world where you (Continued on page 9) Page 9 John Phelan

feel like you have a contrarian real estate get hit. What will different years. Let me focus view currently? be the flow through in office, on a private deal we did. multi-family, and industrial? We're one of the big investors JP: I like to call it independent You want to look into where in IndyMac Bank now called thinking as opposed to there's a lack of liquidity or OneWest which was recently contrarianism. We really try to mispricing. Is part of the recent sold to CIT (CIT). In 1990, be as independent in our equity market volatility due to when I was with Zell, we were thought as possible. I don't Middle East Sovereign Wealth looking at RTC banks, and I want to get into a lot of Funds taking their money out remember the Basses made a specific investments and what of equities? fortune on American Savings. we're doing right now—that is IndyMac/OneWest was an for paying customers—but we G&D: On the topic of good investment we did try to look for big dislocations. businesses, when Rainwater phenomenally well on, and I We try to look for places that asked you what was the best think that was a combination other people are running from business you'd ever seen you of good underwriting, good or people don't like. Zell used answered parking garages in management, and a compelling to always say, “I like to look . With the risk/reward. Buying a bank in for trouble.” I think that's benefit of 20-plus years of the first quarter of 2009 was something we try to do, as investing now, would you not a really easy thing to do. well. change your answer? We’re looking for very good businesses with strong We try to think about the long JP: Well at that time I didn't management teams and very term implications of things and know a lot about companies defensible moats. how they're going to turn out. and businesses. I just hadn't That's something that we looked at that many. But it's G&D: Eddie Lampert is spend a lot of time on. Take, really not that hard of a famous for using case studies for example, the sustainability business when you think about and studying historically of a company or business it. It's pretty defensible and you successful investments to model. Today, competitive get the benefit of an increased develop pattern recognition. moats are getting smaller and value in real estate over time, Were you part of this effort at smaller and competition similar to car dealers, for ESL and did any investments tougher and tougher. Trying to example. There's a lot of that you made rely on this find really good businesses that inherent value in the real pattern recognition? can continue to compound at estate there. I would probably high levels is really hard. You answer the same way again. JP: Yes, I was. Pattern have to really think through all I've seen some other great recognition can mean different the risks out there and their businesses, but when you're things to different people. The implications. That's what I put on the spot like that you bottom line is this: good mean by independent thinking. have to think on your feet companies, just like managers, Is there a company or business pretty quickly, and that's the have to experiment. You have immune from technology risk? one that occurred to me at to constantly test new things. Maybe railroads, cement? that time. Sometimes that 30% Think about it. probability case shows up and G&D: Could you talk about you lose $0.25 of earnings or I think there could be some investments that you've been you make a bad investment pretty good opportunities in involved with at MSD that and people just kill the stock. It energy as that is a space which would qualify? doesn't mean your business or has been decimated. We have the company is dead or that been analyzing debt securities JP: We've had a number of it's a bad business. When I was in a number of energy, metals, investments that have gone at ESL I can think of four or and mining companies. We're extremely well. Because I am a five companies that we bought also trying to understand the big believer in pattern two or three times over the knock-on effects of the energy recognition and we have made years. was something downturn. In energy-heavy investments in the same that originally came out of a markets you're going to see company multiple times over distressed investment we (Continued on page 10) Page 10 John Phelan

made. We made a big G&D: What are your when I started, it is investment in their mortgage thoughts on the broader hedge mindboggling. I also think you bonds when they were in fund industry, what the future have a massive asset-liability bankruptcy the first time. We may hold, and whether or not mismatch caused by modeled out every single store it's a good place to start a institutional investors, making and even had a plan for career these days? it that much harder to succeed alternative uses of the spaces. long term. If you look at what That was a company we did a JP: If you applied Porter's Five investors want today I call it lot of work on before Eddie Forces to the the Holy Grail: liquidity, ended up buying it. industry right now, I'm not transparency, high returns, low sure that analysis would volatility, and group validation. When Dominos first suggest you should go running The question is this: Is this goal introduced thin crust pizza the in. You've got massive fee achievable? Does it make market did not react well pressure, so revenues are sense? The only person I can which presented a good think of who consistently gave opportunity as our research you this is Madoff. indicated this would be very “We are very focused successful. I think that history Today it's hard to scale. Unless and understanding why on process, as I believe you become a large firm fast, companies are successful is you're not going to get proper really important. I think you you should focus on service from any of the banks. can learn different things about Unless you're going to be a big different businesses and apply process not outcomes. client, it's going to be really them really well to other Process is the key to hard for you. I could argue that situations. That's something we running less money may be an were able to do. proper risk advantage, candidly, but it definitely makes it harder right G&D: It seems like part of management. There is now. There are a lot of trends building your own moat as an going on now that make the investment firm, to build up a big difference business very tough. You've your own intellectual capital had a lot of smart people come and property. between a wrong into it, making it much harder decision and a bad to find opportunities. You JP: That's what you're trying need to determine what your to do. We are very focused on decision.” real competitive advantage is. process, as I believe you When I look at the industry— should focus on process not and we look at it from a lot of outcomes. Process is the key coming down. You have huge different ways—I've not found to proper risk management. regulatory costs and burdens a lot of people who make There is a big difference plus IT expenses which seem money shorting. I think long/ between a wrong decision and to go up every year, so your short is to some extent just a a bad decision. A wrong costs are going up. You could way to run leverage long. I decision is picking door #1 argue the barriers have gotten think that it's a tough business. when the prize is actually bigger because of the expense behind door #2. It’s a lousy of starting, but when you look With the advent of electronic, result but the fault lies with at the number of hedge funds HFT, and , method. A bad decision is each year that seem to start many smart people believe launching the space shuttle and go out of business, even machines are going to put guys Challenger when the engineers post-2008, you would have like me and firms like ours out predicted a nearly 100% thought there would be a of business. It's going to be chance of catastrophe. The significant drop in the number machine to machine. My own distinction is important of firms and assets. But we did view is the machines are going because it separates outcomes not see that. When I compare to put the machines out of which you can’t control from the number of firms today run business. But the question is process which you can. by smart people compared to when. This may last for a very (Continued on page 11) Page 11 John Phelan

long time. We're seeing a lot For a student, the amazing There are a couple things of interesting anomalies in thing today is the number of driving our decision to take trading. We're seeing new companies that are outside capital. One was a interesting things in stocks that starting up. The barriers to question of whether we were get beat up. I think this whole starting a new company today going to continue to get capital movement to passive and ETFs are so much lower. Google is from Michael. It was pretty combined with the electronic what, a 15 year old company? clear that we had gotten to a trading and the “Holy Grail” I It took Coca Cola over 100 stage where that was probably mentioned earlier that years to have the brand not going to occur anymore investors want today is making recognition Google has. Think Second, we had a number of it really hard to invest actively about it. You can become a people we had worked with on on fundamentals. When you global brand in ten years or investments and they always look at stocks like we do as less. That's unbelievable. I think asked us if they could invest owners of a business as that unless you're really with us, but we declined opposed to pieces of paper to passionate about this business, because we didn’t take outside be traded, it’s a difficult unless this is what you want to capital. We started to find that environment today. do every day, you're better off actually started bothering starting a business today. Find people. I remember we called That doesn't mean you a dislocation and start a one person up whom we shouldn't go into the business, business. worked with on two different but the attractiveness of the situations. He said, “You know industry has declined G&D: It seems like MSD is John, I'd love to work with you significantly from when I doubling down in some ways guys, but I can never invest started. If you're an incumbent on the hedge fund business by with you. Obviously, I can go and you've got a lot of assets, actually growing and taking buy the stock or whatever, but you're in a pretty good place. If outside capital. you guys are really on top of it. you think about how much risk I'd rather really be able to do a new manager needs to take JP: I don't know that we're that.” to really make it, it's quite high. doubling down. We don't think They may make it, but even of ourselves as a hedge fund. We started to realize that our then all it takes is one bad We think of ourselves as an network was inhibited by the quarter or a bad year. If you investment firm. For us, it's not fact that we didn't take outside don't have five to ten years doubling down. We're not money. The other thing we under your belt, if you have a guys who run long/short. We found is when someone invests bad quarter, the fund will see don't use any of the Greek money with you, they help you significant redemptions. With alphabet numbers that out a lot more. One of the pension funds and institutional everyone loves to bandy about. things we did while I was at investors—the whole I still can't get anyone really to ESL was to target a strategic ecosystem, really—moving to explain to me what market group of investors. ESL had a passive, you're going to see neutral means; yet, everybody very good group of investors. this big movement to uses it. It's fascinating to me. We're trying to build the same quantitative trading, and, if that One of the things I have thing at MSD. We want to find lasts for a long time, I think observed during my people who have got good long-biased guys like us are investment career that I think industry experience and are going to be very challenged in is interesting is that the basics like minded. We have a lot of that type of environment. of investing do not change only ex-CEOs, big families, and a You've got to make sure the terminology or lexicon small group of sophisticated you've got the capital, the seems to. VAR, sharpe ratio, institutions that are investors. wherewithal, the strategy, and —whatever They have great industry the ability to wait for that to that means—tail risk, black knowledge and expertise. We end, because I do think it will swans, Sortino ratio. To me want to take advantage of that, end. I don't think it's going to there just seems to be some be able to rely on those end in a pleasant fashion. But perverse human characteristic partnerships, and create our hopefully it'll be a good that likes to make easy things own ecosystem. Look at what opportunity. difficult. Buffett has done with (Continued on page 12) Page 12 John Phelan

Berkshire and his shareholder resonates with yours at MSD? If you're someone who wants base. What should students be doing to focus on macro or you want to prepare themselves for this to trade or you want to do I don't think a lot of managers competitive environment to long/short, that's a totally engage with their LPs much. create value? different environment. Nothing It’s more “thanks for the wrong with it, but you're going money, now let me do my JP: I think it all depends on to be doing different things and 9th Annual Pershing Square job.” We’re trying to include your own DNA. Self- constructing different trades Challenge judges. them whenever we think they awareness is a really important and thinking about your can be helpful. We're trying to quality to have, as is humility. If process differently. You've got build an investment firm which you're someone who is to decide as a student what is different than a hedge fund. comfortable being in a place you’re good at and what We will not just take you’re not good at. I always anybody's money. We're long say to people who come in to term, fundamental, “When you think see me that you have to realize concentrated guys. If you want in our business a really, really to start talking volatility equals about how you create good person is wrong 30% of risk, sharpe ratios, beta and the time. That's a world class gamma, the Greek alphabet, good rates of return investor. Are you comfortable we're not a good match for and how you are going being wrong 30% of the time? you. By the way, you can't be wrong to make a successful in a massive way. It's funny, Buffett in his 2009 annual report said, “Don't get investment, the truth I think you have to be taken by formulas. Investors someone who thinks in terms should be skeptical of history is that it's made by of probabilities. Finding the based models instructed by a right environment for you is nerdy sounding priesthood, positioning your super important. I came from using esoteric terms such as capital where your the school of thought where beta, gamma, sigma, and the we are all generalists. I think like. These models tend to view is subsequently that's a huge advantage. With look impressive. Too often, many hedge funds today, though, investors forget to adopted and acted you’re slotted into a sector: examine the assumption you're the tech guy, you're the behind the symbol. Our advice upon by others. You media guy, you're the is to beware of geeks bearing industrials guy, or you're the formulas.” Same thing applies need to be in front of chemicals guy, and you're going for investors. We're not them.” to learn everything about the formulaic. We're making bets companies in that industry. on things that we think are They've all specialized. We going to happen over time, and where you may only make a still use a generalist model. We I think that's really, really few investments each year and need to go figure out what important. When you think you're not actively trading ponds we're going to fish in. I about how you create good every day—it's not noisy and believe that 80% of the game is rates of return and how you you're not whipping stuff figuring out what to work on. are going to make a successful around the trading floor— We've created our firm to be investment, the truth is that it's that's a value place. We're a very good at figuring out what made by positioning your shop like that. Baupost is a to work on. capital where your view is shop like that. I also have a ton subsequently adopted and of respect for AKO in Europe. You can look at the newspaper acted upon by others. You They are a very good firm and today, or any day, and find four need to be in front of them. do a very similar thing. They're or five things you might want a little more active but really to look at. Which one you G&D: Are there funds whose disciplined, buy and hold type look at and why is really approach to investing investors. (Continued on page 13) Page 13 John Phelan

important. You're manufacturing ideas. You have a set amount of time each day, week, etc. and the market's going to give you opportunities over certain periods of times. What stocks you follow and why, which ones you keep an eye on and why, which ones you actually buy and why, which ones you pass on and why, that's really important stuff. I think certain people have the mental capacity to be disciplined and do that and not need action. Other people “For a student, the need action. If you need action, that's a different firm. amazing thing today is

I also believe that the more the number of new businesses you look at and can compare the better investor companies that are you will become. This is why starting up […] I think we like the generalist versus specialist model. We are that unless you're confident we can get to 80% - 85% of the knowledge base any really passionate specialist has. We can go buy the other 15%. We can go hire about this business, a consultant or whatever we need to get up to speed. If unless this is what you we're monitoring the wrong want to do every day, stocks, if we're not identifying the right things to work on, you're better off because we have small teams, it's going to be very difficult for starting a business us. We force our team to get good at figuring out what to today. Find a work on and how to spend our time well. That's what our dislocation and start a system tries to do. That's one business.” of our views and one of our competitive advantages. G&D: This was great. Thanks again for your time and insights. We really enjoyed it.

JP: Thank you, I really enjoyed it and hope you find my comments useful.

Page 14 Alex Magaro (Continued from page 1) behalf of current and small private equity shop that how much of the growth was former principals of was basically a fundless cyclical and secular or even if Renaissance Technologies. sponsor—they would find there was a secular trend at all. Prior to joining in 2003, he companies and raise money for My hypothesis was that we spent ten years investing in each deal as they went. I were seeing the same private equity and running decided to work with them outsourcing trend that had a small company. He after graduation, but we had an started to take hold in graduated from Harvard agreement that I could look for manufacturing in the 1980s, College in 1993. Alex companies below a certain size now moving into service currently lives in San to buy for my own account. industries. Then, it was just-in- Alex Magaro Francisco, CA with his wife time inventory, now maybe it and three children. I gave myself two years to find was just-in-time people. something before going back Graham & Doddsville to graduate school. I went Companies tended to be (G&D): Can you discuss your through hundreds of staffed for the peaks, and it path to investing? businesses for sale and went was clear that if you could down the road with a couple. make variable some fraction of Alex Magaro (AM): I On one, I pulled the plug that lower probability staffing recognized early that I would because the sellers tried to need, this would be a profit be a horrible employee for extract an “n+1” at the last improving decision. In addition, somebody someday, for two minute. Almost at the end of companies realized there were reasons. First, I really lacked the two years, I came across a potential working capital any political skill to speak of, staffing business. In the mid benefits as they transitioned and second, I never really did 1990s, staffing had some pretty direct employees to temporary well with authority—if I didn’t good tailwinds—and that really workers whose pay could agree with it. Those two things surprised me, so I ended up come with as much as 90-day are almost certainly related. buying it. terms through a staffing Working backwards from that, company. Over time, more I started to ask myself, "What efficiencies became clear— can I do to make a living that “There’s a price that things like workers’ comp, doesn’t rely heavily on political unemployment , and ability?" solves almost any non-economic benefits like giving frequent feedback to I initially concluded that meant quality concern, and I employees, and so on. pursuing either an academic or was able to buy the an entrepreneurial career. It was basically this opinion While being an academic business very that outsourcing would widen probably suited my personality that led me to believe that a bit better, once I got to cheaply...I bought it staffing would have pretty college, I realized that road decent tailwinds for at least actually did require a for 3x EBITDA.” some period of time. reasonable amount of political Obviously, there’s a price that ability. solves almost any quality G&D: What was your concern, and I was able to buy In thinking about the investment thesis at the time? the business very cheaply entrepreneurial path I wanted because it was a small to try to avoid the high death AM: In 1995, according to the company. I bought it for 3x rate of start-ups. If most industry association, staffing EBITDA, of which one-third businesses fail in the first 5 was the second fastest-growing was seller financing and years, then avoid the first 5 industry in the , another third was in the form years, so it seemed to me the between semiconductors and of an earn-out. Outside of the better move was to buy a small software. It is a very negative working capital business and run it. economically sensitive dynamics on the labor, the business, and at that time it mirror image of the benefit the During college, I worked for a was difficult to disaggregate customer got, EBITDA was a (Continued on page 15) Page 15 Alex Magaro

good approximation of cash kinds of value. You can make a that I should try to meet with flows. material difference by going on Jim and Leo, Jim’s pick to run sales calls or personally the fund, to see about a job. That was really why I bought it. spotting errors or otherwise Staffing is not a great business. improving service. When we G&D: Was Jim Simons well It's extremely competitive and were at $20 million and in known by that point? has very low barriers to entry. multiple locations, it started In fact, competitors actually becoming much more difficult AM: He was well known to used to go through our to effect that difference. It me because David had been a garbage looking for leads! Yet, becomes an iterative exercise trader on Renaissance I also needed to solve for a of hiring and training sales Technologies’ execution desk business I thought I could run. people, formalizing and since 1996. I was very aware of For example, I thought it commoditizing an office Medallion’s performance up to would be more difficult to opening, etc., but maintaining that point. purchase a manufacturing quality is a significant gating company with a large factor to maintaining a high G&D: What was Simons workforce, because I thought growth rate. We picked a lot planning with the private it would be pretty difficult for a of low-hanging fruit by virtue equity firm? 24-year-old without political of approaching the business in ability to manage that work a more professional and AM: Jim’s hypothesis was that force. With staffing, I was financially-oriented way than there might be some basically dealing with young our competition, but for us to interesting opportunities sales people, so I thought I scale to $200 million, we following the dotcom would have a chance at being would have had to compete meltdown, and he had been able to do that. with vastly better financed and trying to recruit his old college staffed companies. friend, Leo Guthart, for years We grew the business quickly. to do something together. Leo The business was generating I went to my partner and said had spent the last 35 years $2 million in revenue when I that I thought it was the right running a company whose bought it and within 5 years, time to sell, but her preference principal business was alarm we were generating $20 was to continue with the monitoring systems and they million in revenue. business. In the end, the had just sold it to Honeywell leverage the business was able for something like $2 billion. If G&D: Why did you eventually to take on seemed to me a fair I remember right, that business sell? price for my share of the became at least part of the company. Buying the company platform for what is now AM: I decided to sell it for has worked out really well for Honeywell’s automation two reasons. First, we had had her, although it was a tough business. a really good run and it ten years. seemed to me that we could I met with Jim and Leo, and the easily go sideways or even Around that time, a close meeting went well (which backwards for a long time; and friend from college, David really surprised me), and I was second, I came to the Zierk, now my partner, invited hired as one of the partners at realization that I would me to have lunch with him and that firm. I was honest that I probably have to spend a friend of his. It was a social didn’t have a lot of belief in decades growing it before we occasion, we had a nice lunch, venture-oriented investing, but had enough scale to use it as a and I never thought anything of I couldn’t argue with the fact platform to buy other it. It turned out that David’s that median returns in the businesses and I needed to friend was the son of Jim space over long time periods believe that was achievable in Simons’ old MIT roommate. looked pretty good—even if order to want to spend my Out of the blue about six you considered that it had a career at it. months later, this fellow I’d high beta versus the market. had lunch with called me to say That said, I pretty quickly When a business is small, that Jim Simons was looking to concluded that this style of individually, you can add all seed a private equity fund and investing wasn’t conducive to (Continued on page 16) Page 16 Alex Magaro

the research-driven approach I advance of that, it could be a think the idea was wholly crazy was comfortable with and I way for some of those insiders and after about a year we ended up reverting to more to continue to invest and in started this direct activity. traditional fundamental something they trusted. investing. Further, because Meritage was G&D: So the primary selling essentially captive to point was that direct investing During my time at Topspin, I Renaissance employees, we solved the scalability also got to know Jim and his wouldn’t have the traditional constraint? son Nat better. Nat, who had principal/agent problems you started Meritage in 1997 was find between GPs and LPs. All AM: It was that, but it was looking to take a step back of this is to say we could have also that Jim—rationally— eventually and asked if I would the makings of a minimally- prefers liquidity, and if you be interested in joining compromised investment invest directly, you are vastly Meritage with a view to co- platform. more liquid than if you invest managing the portfolio with in funds. Also, we thought we David, who had started could be more rigorous on risk working with Nat a couple of “I couldn’t understand control and hedging and the years earlier. last point was there was a fee how someone could arbitrage. Paying 1.5 and 20 is a G&D: What was Meritage at lot of return to give up. this point? even come up with an Frankly, we didn’t have to generate the same AM: Meritage was a fund of estimate of what a performance on a gross basis hedge funds. Originally, it was to outperform on a net basis. a P&L line item inside company might print We were able to outperform Medallion. The basic idea was for this quarter’s on a gross basis, so it worked that as Medallion grew, it out better than our started to accumulate some earnings with precision, underwriting case. excess capital. Renaissance believed that it could extend and, beyond that, how G&D: How did you settle on a the duration on some fraction strategy? of this capital and so Nat to handicap what ‘the started to invest it with AM: David and I spend the outside funds. These were market’ would think of first year working together re- uncorrelated strategies and that.” underwriting the were more profitable than portfolio. In addition to the Medallion’s internal cash folks in our portfolio, we management strategies. It However, I didn’t think that a literally met with hundreds of made sense. Meritage was also pure fund of funds could really managers raising capital. My directly investible for be scalable. At that time it impression was that most of Renaissance employees, and so really was a strong strategy for the managers I met were short it was also a way for people to that size, but the perverse -term oriented and, in a way, diversify their own capital. reality of investing in outside that wasn't natural for me to managers is that if you are understand. I couldn't For context, Medallion closed successful in finding talented understand how someone to outside investors in 1993 managers, you can’t increase could even come up with an and started returning capital to your position because they estimate of what a company outside investors in 2002. My close. And given Medallion’s might print for this quarter’s thinking in joining Renaissance performance it seemed earnings with such precision, was if Medallion continued to possible that we would need and, beyond that, how to perform, not only could it scale to be useful. In any case, handicap what “the market” return the outside capital, but my feeling was that if we could would think of that. It was you could also arrive at a point develop a direct investing totally alien to me. What where inside investors were strategy maybe that could give seemed clear, though, was that also capped and if Meritage us more scale. They didn’t investors’ attention would could build a good platform in (Continued on page 17) Page 17 Alex Magaro

start to trail off after about six these cognitive biases as we just to wait a little while. I months, and beyond a year could. don’t recall the other animals people really didn’t seem to he tried this on, but there care much at all. As an aside, when we were still were many, and they all affiliated with Renaissance, we exhibited the same kind of G&D: Were there any other used to get to attend their behavior. Next, he moved on takeaways you came away monthly colloquia where they to humans. with? would invite an academic to discuss their research. Most of Humans are a little more tricky AM: The first observation was the time, the topics were way because they can also reason that if we were going to over our heads but and if you actually want to compete on anything, it was occasionally they would invite understand a time scale that going to be in a fundamental someone whose research a lay might be interesting, the field, and by this I mean deep person could understand. One subject needs to believe you’re analytical research. This was researcher presented his going to make good on your also my background. Clearly, research which attempted to promise. In any case, he spent we weren’t going to compete determine something like an a year setting himself up as a with someone like a Citadel in “internal discount rate” for reliable counterparty to a multi-strategy or a Medallion in different animals. An example group of NYU undergraduates. stat arb. We were mortals and In this case, the experiments we had limited resources. We were of this type: You can thought we had an advantage have $20 today or some larger in capital duration going for us “The final punch line amount of money in a month and we thought most firms or six months or a year, etc. were shorter-term oriented was that in all cases [of There were lots of clever than we were. the experiment], twists in his many iterations to ferret out lots of little nuances, Another observation was that human or lower animal, but you get the point. The if you looked at the embedded results for his subject group incentives many funds had, the subject’s discount were something like 100% these actually drove a short- discount rates. I wish I could term orientation. The fee rate increased with convey how well he presented structure of 1.5 and 20 is a the concepts. It was like a Las modest incentive to generate duration!” Vegas magician act. In his final gains sooner. A related nuance reveal he made the point that was that analysts tended to be the subjects might not paid exclusively out of the of an experiment was necessarily understand finance incentive fee, which levered something like this: you put a and time value of money, so he this behavior. Third, the rat in a cage and train him that ran the same group of contractual terms of the fund every time he hits button A experiments on finance majors (whether we’re talking about and then B, he gets food. Then from Stern. While the finance quarterly liquidity or even you train him that the longer majors had lower discount more modern gated he waits to press B, the more rates, they were still absurdly structures) tend to make the food he gets. By varying the high. The final punch line—and fund favor more front-loaded amount of food payoff per unit I still can’t believe this—was return streams. Our thinking of time waited, you can start that in all cases, human or was that once you layer on an to get an understanding of the lower animal, the subject’s evolutionary time preference rat’s time preference—his discount rate increased with for now versus later, there “internal discount rate.” duration! I mean, you could were lots of reasons to believe argue that in the human case, there could be inefficiency in I don’t recall the details, but the dollars are so small that the medium to long term. As a the rat’s discount rate was the actual quantities of dollars guiding principle, we wanted something crazy—like in matter—why bother with our platform and investing excess of 1,000%. You had to having to remember to track philosophy to resist as many of give him so much more food this guy down in a year for $50 (Continued on page 18) Page 18 Alex Magaro

—maybe that explains why the doing, and, importantly, that in private equity was entirely discount rate is so high. we are attempting to meet relevant. Today, private equity However, the fact that their goals. It also doesn’t hurt is more process-driven. There discount rates increased to have investors who is more focus on deal flow suggested that accepting understand risk and volatility generation, the auction duration was of increasing better than us. processes are more discomfort. competitive, and a lot of a The basic idea was to build a fund’s portfolio can end up If you bring this back to the platform that would be being determined more by hedge fund context, the point appealing to people who really which processes they win than is that a lot of common just wanted to invest and one which companies they want to incentive schemes and fund with as few constraints as invest in. They are basically structures—whether implicit possible. Because so many participating in private equity or explicit—tended to enhance funds were short-term beta. That’s not a bad thing; rather than diminish this oriented, if you couldn’t the return to that beta has cognitive bias. As I spent more produce results in a year or so been good, but that’s why PE time trying to understand then you had to move on. We firm returns are always other elements of standard tried to be a place that you couched in a vintage context processes within fundamental could successfully invest in a and not in an absolute sense. funds, it seemed to me that long-term oriented fashion. Anyhow, back then and at the lots of what was common small deal sizes we were practice seemed to exacerbate G&D: At this point, your considering, there were many this and other biases as well. experience was a few years in possible choices to make. Flow private equity, running a small wasn’t the constraint, the For me, the big lesson was, if business and manager selection investment choice was. that’s the case, there must be and evaluation. Where did opportunities if you can your investment perspective That was why I thought we construct a platform that will stand at this point? Did you had the toolkit to try. Why allow you to lean against biases feel you had enough should public equities be any in general. For us, the most experience? different than private equity? important bias was definitely In both cases we are trying to focusing on time preference. AM: The short answer is no, make predictions about things This was natural for me, but I felt confident that if we that are researchable. Of because I seem to be wired started small, which let us be course, there was no exactly oppositely on time really liquid, we weren’t going guarantee that we’d be good at preference—and unhealthily to take a big risk to try. it. That’s another reason why so. I’m really long-term, and I Ultimately, I think we chose public equity. It’s have to work really hard to outperformance in investing, liquid and so if we stunk at it, bring my time horizon into managing a business, and I’m we could shut it down quickly something that is actually sure lots of other fields comes and easily. relevant. down to judgment. I thought we had a good platform and I Public equities also solved We set up compensation thought I had better than other problems for us. schemes that attempted to average judgment. Depending Because you can easily run a defuse short-term incentives on the day, I still think that. neutral book long/short, the while at the same time pay strategy is less cyclical. That is respect to time preference. I always had an interest in to say, being neutral lets you We have a concentrated investing. I started investing control for the price level of investor base, which personally in the public the market. Other fundamental introduces other risks. markets when I was about 14. disciplines like high yield credit, However, they are patient In fact, I financed a significant distressed investing, and when we struggle, because portion of the staffing company private equity—which are long they also are concentrated in purchase from my personal dominated—will tend to be us, have an intimate investment portfolio. only of cyclical interest when understanding of what we’re Also, I thought my experience they are cheap in an absolute (Continued on page 19) Page 19 Alex Magaro

sense. to disaggregate your returns teens returns investing in between stock selection and credits with very low default So, we started small. The net position. The goal is really risk. Further, if they did investing world has evolved, to disaggregate luck from skill, default, you wouldn’t have but I think a lot of what was but given our slow moving and minded owning the underlying. true then is still true. For concentrated strategy, we still example, the average holding only think that we probably In 2012, we bought our first period in US equities is now have some skill. Track records private company, Columbia just over 4 months. That’s can tell you something, but you Distributing, the fourth largest actually down from when we need a really long history of beer distributor in the US. started, even though there are outperformance to have even a They distribute about 60% of definitely more long-term moderate belief. They’re just the beer in Oregon and oriented hedge funds in the noisy. Washington. It’s a very market today. Obviously, interesting and wide-moated quantitative participation has Another thing that has changed business. I think buying private increased too, and this will is we try to be more companies is a key part of our tend to reduce holding future and a very natural fit for periods. I still believe that our capital and its intent. many fundamental funds are “In 2012, we bought shorter-term. Because we don’t have a our first private com- defined fund life, we don’t have G&D: It sounds like you pany, Columbia Dis- a selling horizon and because started out with some real we have a closer relationship structural advantages. How has tributing, the fourth with our investors, we have a the firm evolved over time? better idea about how and largest beer distributor when they are likely to have AM: We haven’t changed our capital needs. What falls out of investment focus or basic in the US ... It’s a very this is—just like when Meritage process since the beginning, started—we think we have but we have generalized our interesting and wide- some fraction of our portfolio initial hypothesis. Originally, that can sensibly be “illiquid.” we were more focused on this moated business. I time preference, but now we think buying private The experience we have had believe that there are hosts of with Columbia has been great. cognitive biases that can cause companies is a key It’s in our nature to give mispricings and biases that can autonomy to competent, distort research itself, so we part of our future and passionate people. It’s how we have gradually tried to treat our analysts, it’s how we integrate those into how we a very natural fit for treat our management teams, evaluate investments and their and it’s how our investors valuations. our capital and its in- treat us. The team running tent.” Columbia is just first rate. In terms of performance Occasionally, we can help analysis, from the beginning, around the edges or maybe we focused on evaluating opportunistic in cyclical asset help lay out a way to think ourselves in terms of at classes. For example, in 2008- about a problem, but the position level. We pair 2009, credit was a very otherwise it’s their business to every position, long and short, obvious asset class to invest in run. We don’t meddle. We with its beta to an appropriate if you weathered the downturn think they’d agree we’re easy market index. We think that if in a reasonable way, and if you to work with and so we think you don't understand the alpha didn't have all your investors we could be a good haven for that you're generating on a clamoring for their money a family or entrepreneur- position-by-position basis, it back. It was a great owned business or a becomes very difficult to assess opportunity to buy credit and management team in search of your performance. By that I then you could make high a capital partner. mean it becomes very difficult (Continued on page 20) Page 20 Alex Magaro

G&D: When evaluating cash flow yield? I think you in trouble. Meritage’s holdings, it’s quite have to be willing to assume obvious that business quality is that it's going to grow at least Some investors might think very important to you and a little in perpetuity. If it grows that the stock is in fact public that’s not always the case with at around 2%, the 4.5% free and liquid and that they don’t investment firms. Can you cash flow yield delivers you an have to stick with the discuss why you feel business IRR of 6.5%, ignoring leverage investment, so maybe the quality is so important? and assuming you can exit at terminal value is less the same 4.5% free cash flow important. I disagree because AM: We don’t have some occasionally market events will novel way of valuing conspire against you and cause companies. I think most “The great invest- you to “lose time.” Here’s an fundamental investors would example of what I’m talking agree with the view that the ments are the compa- about. If you look at 2014 and value of any company is the nies that are quality 2015, we had a lot of central present discounted value of bank activism and there were the future cash flows—which but aren't yet obvious, big FX moves in lots of crosses includes retiring debt. If you've versus the dollar. An FX ever played with an Excel but those are rare. devaluation can come through spreadsheet, what you earnings and make it look like probably noticed very quickly, When you find one of it’s nothing more than a is it’s all in the terminal value. deceleration of growth. If we those situations, they assume the valuation doesn’t Public markets have generally can be extremely change, although there’s a traded in the mid-teens on a P/ good chance it would contract, E basis over the last 10 years profitable.” the stock will be flat and the or so, obviously ignoring the growth will again become recent financial crisis and some apparent when the company modest excursions here and yield, which maybe isn’t a lock. anniversaries the devaluation. there. The market at the But the point is, if the FX moment is trading about 18x. If We think that a company doesn’t revert, you end up you take the inverse of 18, growing in perpetuity is likely losing a year of returns in the that’s a 5.5% earnings yield. On to be a company of quality. process. In investing, I find that average, free cash flow yields We think that the whole idea you very often lose a year, tend to be lower than earnings of a market multiple at this sometimes several. The thing yields. There are incentives to kind of level presupposes that keeps me up at night is: make accounting earnings look quality. For example, you what if you lose enough years better, businesses often invest would never pay 18x earnings that people start to care about more in capex than they for a company shrinking 1% the terminal value? Obviously, expense in depreciation, and per year. That would be a 3.5% nothing is bulletproof forever, companies generally consume IRR if you could exit the but my view is you want to working capital—just to name position at a 4.5% yield. I think have a very clear opinion about a few. So, maybe the market is a lot of investors are ignoring how long that terminal value is at a 4.5% or 5.0% free cash the terminal value when they secure—but that also doesn’t flow yield. We are ignoring pay certain multiples for mean you’re right about it. leverage in this example, but businesses, because in their obviously the average company relatively shorter time horizon, I don't know how you pick a has leverage—which is to say the terminal value may not be quality company ex ante, but I the unlevered free cash flow relevant. I think that can be a think that most people know a yield is probably lower. valid strategy in the short- quality company when they see term, but I'm just not it and sometimes you have to What do you have to assume comfortable with it because get under the covers to see about the long-term growth of eventually the correct terminal that a company really is quality. the average company in order value may become apparent to The great investments are the to be happy with a 4.5% free other people and then you're companies that are quality but (Continued on page 21) Page 21 Alex Magaro

aren't yet obvious, but those expensive. I can't remember off its debt. It’s still growing are rare. When you find one of the valuation that we sold it at, nicely, so if it can keep that up, those situations, they can be but we held it to a much it might take more like eight extremely profitable. higher valuation than we would years. But the point is that you otherwise have imagined we have you have an eight to 12 G&D: Do you have any would have, and now I think it year view about some examples of companies that is quite expensive, or at least combination of the company’s didn’t appear to be great the last time I checked, when growth prospects and/or the businesses on the surface but you consider they carry 5.5-6x availability and price of credit. subsequent research showed in leverage. that they were? In any case, at this price I think G&D: How do you think it’s hard to underwrite the AM: In our history, I think the about leverage in a business? duration of growth that you best example is TransDigm, would need to have in order which I'm sure you've seen and AM: I think ignoring debt is a to make a good unlevered have had any number of people return. Again, no one may ever discuss. We first purchased the care that the company is highly stock in 2007. “I think ignoring debt levered. We may miss out, but we can't predict when other I was totally amazed that a is a little like ignoring people may care about the fact company could make returns that the company is levered. like this with airlines ultimately terminal value and is The events of 2008 were a determining their economic terrific example of people all of fate. This was totally shocking another example of a a sudden getting religion on to me but only because of my short time preference. how levered some companies own ignorance. The story is were and the reality that it’s now pretty well-known, but It’s very easy to ignore senior to you. there are enormous regulatory barriers around the debt when the I think terminal value and manufacture of aerospace leverage risk explains a lot of parts. However, the revenue company is doing the undoing of Valeant’s equity. cadence of any individual part As the market cap shrank, may not be terribly large or well ... It doesn't investors increasingly focused terribly stable. If you were a change the fact that on this $31 billion bolus of small company with a small debt and rather than thinking portfolio, you would end up you do eventually have about it as a source of future having a really erratic earnings earnings accretion it became a stream. What the CEO, Nick to pay this off—you payable with a due date. 5-5.5x Howley, did was just beautiful. EBITDA of debt (especially By putting a large number of can’t refinance with a low tax rate) is by no these different parts together, means insurmountable, but if whose cadences weren’t forever.” the company has begun to correlated, he ended up with shrink, the equity will have to this totally predictable stream. little like ignoring terminal wait. Obviously, with the That was like corporate value and is another example company’s equity at something alchemy. Because any individual of a short time preference. It’s like 4x earnings, people are part is still erratic and there very easy to ignore debt when questioning its terminal value. are substantial regulatory the company is doing well and hurdles to producing the part, the ratio of a company’s G&D: That brings up maybe it doesn’t pay to compete. The market cap to its debt is high. an interesting point. Many consequence is that It doesn't change the fact that investors who have studied TransDigm has real pricing you do eventually have to pay Buffett and Munger have power across its portfolio. this off—you can’t refinance developed an appreciation for We sold our shares some time forever. So, in the case of a quality which means these ago because we thought it was TransDigm it would take the companies tend to trade at company about 12 years to pay (Continued on page 22) Page 22 AlexHarvey Magaro Sawikin

rich valuations. What happens What does that mean? That company of this stability could to enable Meritage to buy means that, one-sixth of the responsibly manage more. I these quality businesses at time, assuming a roughly think you can get that for a valuations that provide normal distribution, it will while, but for sure there will attractive go-forward IRRs? trade more than 30% lower be bumps. If you can sell the than here, ignoring the drift stock at a 6% yield – which I AM: The first question is what from its expected return don’t think is optimistic in the is an attractive IRR? Most (which maybe is just the context of today’s valuations, people are familiar with the market if it’s fairly valued or you’ll end up with about a 13% Mungerism of preferring the zero which is a common IRR unhedged and it wouldn’t lumpy 15% to the steady 12% assumption for the short run). surprise me if you could end —I think there are issues with My casual observation is, given up holding the position for 10 that, by the way. I’d rather enough time, it will be 10% or or more years. 12%’s that are 10-year 20% cheaper than fair. You just investments than 15%’s that have to have an opinion at that A big part of when we buy are 5’s. Obviously, even with moment. I think it’s much something is that we have an taxes, if you can string two 5’s easier to have an opinion ex ante view about the quality at 15% together, that’s better, about strong companies when of the business and we can but I find that our most limited they are dislocated than weak react to a price. Often there's resource is analytical time. I ones. also an accounting component, think ultimately we will or there's something that is generate more return in Moody’s is trading a little less otherwise obscuring the dollars for our investors this than 20x 2016E earnings. numbers a little bit for a way. Earlier this year it was $83, so period of time. Perhaps there's 15% cheaper. In February, more earnings power available Other than this opinion, by far when there were concerns than is currently evident. If you the most common one is time over debt issuance, you get those things together, then arbitrage. I would also say that could’ve bought at 17x that produces an even better I don't think that the number earnings or a 5.8% free cash result. of great companies in the flow yield (in this case free world that is investible for us is cash flow and earnings are G&D: How do you generate very big. It’s probably in the about the same) and the potential investment ideas? middle hundreds. Over time, company has de minimis as you research more leverage. AM: We don't have any kind companies, you learn a little bit of magic screen. In that first about how they work. You The company has pricing year when I met a lot of learn a little bit about their power. They would say they managers, one of my favorite durability. Some stick out to raise prices 3%-4% a year. questions was “how do you us, and if you just try to stay While issuance may be generate ideas?” and everyone aware of their valuations, the somewhat elevated now, we’re always wants to provide an market will provide you with pretty confident that over long answer that demonstrated opportunities from time to periods of time issuance will some kind of systematic time. continue to rise on average. In capability. I always thought that any case, between volume and —unless you're someone like We can take Moody’s as an price it’s not heroic to get to Renaissance—that was unlikely example. The volatility of this 5% revenue growth. The to be what was actually going stock measured over a 50- to company has about 50% on. 100-day period is about 30%. operating margins. If you inflate Just in February, the volatility the cost base at 3%, you get I think idea generation is very on a 10-day basis was near 7% income growth. If the serendipitous. We call it 50%. The point is that a high company maintains its very contrived serendipity. We have quality company like this has a modest leverage and buys 14 analysts who are all looking volatility of about 30%, even if stock, the effect to EPS should at companies and one company measured over longer term be a bit better – and could be leads to the next, leads to the time periods. better still if you believe a next, leads to the next, and (Continued on page 23) Page 23 AlexHarvey Magaro Sawikin

just by covering enough of a theoretically not as illiquid as it management industry? relatively small universe, you seems. tend to find opportunities and AM: I spend a really large hopefully add to the universe. The opportunity we saw with fraction of my time We keep trying to come up beer distribution was the interviewing people. We are with ideas to organize it more opportunity to buy a company always looking for great formally, but I think good in a very well-protected people. Most of the people we analysts enjoy the freedom and industry. Beer distribution interview are early in their the variety. It goes back to works like a franchise. You careers, and they have typically believing in backing acquire the right to distribute a spent the previous two to six competence and passion with beer in a particular territory years in some combination of capital and autonomy. and that right is more or less banking, private equity, and/or perpetual. It is similar to buying business school. We generally G&D: Could we briefly touch a Dunkin' Donuts franchise. focus on hiring folks that on beer distribution? Given You have the right to operate haven't been trained by other Meritage’s prioritization of your business with exclusive funds. We think our approach liquidity, it must be a really rights in whatever territory is a little bit different and we exceptional business in order you agree on with the are hoping to hire folks before to get you over that liquidity franchisor under certain terms. the preceding firm’s hurdle. investment approach is too Essentially, that franchise is a firmly entrenched in them. AM: Jim has a strong toll road on beer consumption preference for liquidity. I don't in a given geography for the When I first got into investing, feel quite as strongly, but I do brands that are in your the people going into the field have a deep respect for it. I portfolio. That's a very stable, were attracted by the work. think that ultimately you have predictable thing. Another They just thought it was fun. liquidity for a reason. I don't reason that these kinds of What has happened in the think liquidity is an end unto assets are particularly intervening years is that it's itself and I would argue that attractive to us is a very large become clear that investing you have liquidity in order to fraction of Meritage’s capital can be a lucrative career and take an illiquid position— will ultimately be given away, increasingly we are seeing whether that’s funding medical but probably over a very long people pursue investing-related research or buying a private time horizon. careers because it's lucrative company. and not because the work We think that being able to lights up their brains. I think the first question is how generate some of Meritage’s illiquid is the position really? If income through operating Investing is obviously very you own the whole company earnings is a good way to competitive and markets are you would think it’s illiquid. defease that rate of giving. If efficient to the first order. I’m However, if it's very cash we thought we could do convinced we spend really all generative, which is the case in exactly the same thing in public of our time deep in the land of beer distribution, you get equities, then we would always diminishing marginal returns. I substantial dividends. do that. If you could generate try to tell the folks we the same return, with exactly interview that we will probably I would also ask the question: the same shape plus have throw out 80-90% of the work how long does it take to sell a liquidity then clearly that’s they ever do if they work here company? Maybe it takes 12 or superior. Actually, in many —because it’s true—and how 18 months, so the position is ways that’s Medallion. We felt do they feel about that. If they not as illiquid as it might seem. for Meritage to have that don’t really have an interest in Of course, we don't want to return profile, we needed to investing and don’t have a time sell it and we don't have the own the asset. preference that matches ours, need to sell it, and it’s very this will defuse their interest. hard to imagine the G&D: Do you have any advice My point really is this: if you circumstances that would drive for students interested in don’t really enjoy the day to us to sell it, but it is entering the investment day of investing, it’s going to (Continued on page 24) Page 24 AlexHarvey Magaro Sawikin

wear you out and make you G&D: Thank you, Alex. That's miserable. Even if you’re able great advice. Thank you for to retrain yourself to be purely sharing your thoughts and time motivated by money, that with us. motivation will in fact wear off and sooner than you think and then you will hate it. You will be vastly happier in a field that naturally lights up your brain.

The second thing I would say is to pursue an investment firm “[I]f you don’t really that has a style and culture that matches your own. If you enjoy the day to day have to work too hard to adapt the way you think to the of investing, it’s going way the organization thinks, to wear you out and you’re unlikely to be successful in any case. make you miserable.

I realize figuring this out isn’t Even if you’re able to easy. But, instead of trying to figure out the firm’s culture or retrain yourself to be style, I’d recommend first trying to figure out your own. purely motivated by Start with something like: what money, that is it you like about investing? Do you like solving puzzles? motivation will in fact Do you have more stamina to do research than most people? wear off and sooner Do you have a psychotically high level of persistence? Do than you think and you perform better in and like a low or high stress then you will hate it. environment? What is your You will be vastly natural time preference? Are you comfortable with volatility? happier in a field that Are you relationship-driven? Do you prefer to think about naturally lights up the big picture? Hopefully, thinking about this will offer your brain.” some clues about your wiring. Once you have a view about that, then you’ll know what questions to ask of firms to assess the fit from your perspective.

The point of going on interviews isn’t to get the job, it’s to figure out which job you want. The point of interviewing people is not to fill an opening, but to find the person that will improve the organization. Page 25 Adam Wyden (Continued from page 1) conviction ideas. Mr. Price Club and others that always been of interest to me. Wyden previously worked went public, and made other I realized that when I make as a Senior Analyst at SMH public investments while sitting investment decisions I had to Capital, a boutique on public company boards. My carefully factor in human merchant banking firm great-uncle was a visionary psychology and organizational where he focused on who had a nose for good deals behavior—motivations, advisory / principal and was unafraid of reasonable incentives, etc. investing to the lower risk when he had conviction. middle market with sector More importantly, he stressed In the summer of my junior expertise in technology, investing in talented people, year, I interned at a large media, telecom, business and this is something that I investment firm. The group at Adam Wyden ’10 services, consumer carefully weigh when making the firm I was working in was products, and an investment decision. very focused on understanding industrials. Following SMH consensus earnings estimates, Capital, Mr. Wyden was There were other relatives including which companies enrolled in Columbia who gave me stock-holdings as would likely beat the estimates Business School’s gifts over the years and in the short-term. It wasn’t an Accelerated MBA investing was a frequent topic investing approach that had a Program. Mr. Wyden holds of conversation at the dinner long multi-year runway to a B.S. degree in Economics table. I learned a lot from which I was accustomed. The from the University of these conversations and I investment strategy was also Pennsylvania’s Wharton started actively managing my very focused on large School and an M.B.A from own personal account in high companies. I remember Columbia University with school and continued to do so studying Microsoft and SAP concentrations in Finance throughout college and grad and thinking, “How am I going and Accounting. school. to get an edge with these companies?” Graham & Doddsville I went to Wharton for (G&D): Can you discuss your undergrad and decided to After this experience, I background with us? concentrate in Management. I realized that I was better found the analysis of suited to a longer-term Adam Wyden (AW): I competitive strategy very investment approach. A friend come from a long line of interesting. I was interested in introduced me to a merchant entrepreneurs. My grandfather why certain companies bank in New York that was in the steel business and succeed and why others don't. invested through some other family members were in Why companies get certain opportunity funds and I joined the industrial or manufacturing margins and why others don't. the firm after graduation. We sectors. From an early age, I That was what drove my helped put together several was taught that the best path analysis: what makes a business complex deals in companies to wealth creation was to find a good one, why is the ranging in enterprise value a niche in the market and then business competitive, and why from $50 million to $500 exploit it to grow and create is it going to grow? million. I wasn’t able to rely on value. sell-side models. I had to get I also took several on the phone with the My initial introduction to the management courses and Controller or CFO and build was through my learned that management was the model from the ground up. grandmother, who was an more than just HR. Many This experience demonstrated active investor, and still is at investors fail to realize that to me the value of smaller 92. She follows a Peter Lynch companies are run by companies. If a company is style philosophy and invests in managers and boards with very doing $2 million in EBITDA what she knows and what she specific personalities, and you can find a way to add understands. My great-uncle strengths, weaknesses, and an incremental $3 million in was also an active investor. He organizational limitations. revenue that can drive bottom invested in real estate, made What motivates people to line results, you generate real private investments, including make certain decisions has operating leverage. (Continued on page 26) Page 26 Adam Wyden

It was around this time that a AW: Yes, and actually there’s $160 million with $200 million co-worker introduced me to a story related to that in cash and $200 million in the Greenblatt and Buffett investment that helps provide NOLs. I said, “Michael, I know material and I just started context for why I decided to you invested in IDT’s Genie reading everything I could find launch my fund. I was, and still Oil Shale JV. Why wouldn't on value investing. am, involved with a program at you just buy IDT? With IDT, Contemporaneously, I decided UPenn called the Jewish it's trading below cash, it's to return to business school at Heritage Program that Michael profitable, and you would still Columbia. Steinhardt helped found with own 100% of Shale." He the Chabad program at Penn. looked back at me and said, I continued to actively invest in It was through this program "Sounds like a good idea." I’m companies in my personal that I had an opportunity to guessing he made the account throughout my time at meet Michael Steinhardt at his investment in the shale JV Columbia and I launched my personal zoo in Westchester. without looking at IDT and own fund six months after This was in the middle of 2010. was restricted at this point, but graduation in early 2011. I could tell he was very interested. As we were leaving G&D: Why did you decide to toward the end of the day, I launch a fund so quickly into shook his hand and Michael your career? “Many investors fail to starts singing a song. I can’t realize that companies remember the exact lyrics, but AW: Initially, it was basically a the chorus went something cost-benefit analysis on a net- are run by managers like, “IDT is the place for me.” worth basis. I had been successful in managing my own and boards with very I was almost on the floor account during business school howling. You could not invent and the opportunity cost of specific personalities this experience. In my head, not being able to manage my I’m thinking I have roughly 50% own “PA” had grown […] When I make of my net worth in this stock significantly. If I went to a investment decisions I that’s already up 4x. I think it hedge fund, I would not have can go up another 3x to 5x, been able to manage my […] carefully factor in and here is Michael Steinhardt personal account freely, as singing about it. You couldn't most firms implement strict human psychology and make this up. trading policies. I also saw a number of amazing investment organizational At that point, I just focused on opportunities that I wanted to starting a fund. It seemed like pursue—many of which were behavior.” some of the best investing guys smaller cap in nature and too in the business were seeing small for big funds to take what I was seeing. If that’s advantage of. But more happening, I started to think, importantly, I am an In between Michael trying to “Maybe I can do this after all?” entrepreneur at heart. From play shidduch—“matchmaker” selling collectibles on eBay to in Yiddish for all the eligible The collection of assets launching my own car detailing young adults—I managed to beyond the cash and NOLs business in high school, I have get a side-bar with him on the were interesting. The shale always wanted to own and back of the golf cart he was assets were probably worth at operate my own business. motoring around in. We had a least $200 million— the back and forth going about implied value of the Steinhardt/ G&D: One of the big bets that former employees and Rothschild investment in you mention in a few of your different things. At one point, Genie. The patent business early letters was your Michael wryly asked, assets that I thought had value investment in IDT. Can you “Well….what do you like are now worth several discuss that investment? Adam?” I said, “I like IDT.” At hundred million dollars in a the time, the market cap was publicly traded company called (Continued on page 27) Page 27 Adam Wyden

Straight Path (STRP). There entertainment division to But in 2008 and 2009 when was a Video on Demand asset produce television shows and Howard realized his business (Fabrix) that ended up being other mass market media. We was on the line, he was sold for $100 million, as well think at today’s valuation, the ultimately determined to save as a modestly profitable core market is ascribing zero value the company and execute a business. I ascertained there to the Company’s massive turnaround. Howard, was potentially $50 per share entertainment division which his son, and Bill Pereira in value and the stock was will have two full series aired basically cleaned house and around $10. in 2016—one of which is divested a number of the starring Elijah Wood and struggling businesses weighing I also spent time with Howard another 11 projects are in on profitability. They cut $200 Jonas and felt he was a re- various stages of development. million in fixed costs in total. engaged and re-energized The Company executed a executive. He previously sold massive buyback where close an entertainment company to to 25% of the shares were John Malone, so I knew he was “Turnarounds can be retired. Howard also utilized capable of monetizing assets to the advice of Morris Smith, a legitimate buyers. good investments former superstar manager at Fidelity. All of my initial In fact, Howard had recently because many reference checks suggested spun off an interesting that Howard was supremely collection of assets—a investors don't trust refocused on preserving the brochure/outdoor advertising them.” business and his legacy. business and the 4th largest comic book publisher into a By the time I invested, you separate public company f/k/a could already see a few decent CTM Media Holdings. The I also think that Ted Adams, quarters. But the naysayers Company spun off onto the the founder of IDW and persisted, saying the cash on pink sheets and instantaneously current CEO, is a creative the balance sheet was going to traded below cash and was genius that everyone wants to be squandered and today’s run profitable. Howard seized the work with. -rate profits were ephemeral. I opportunity and did a tender pointed out that a private offer for a sizable portion of G&D: Didn’t you have some subsidiary for Howard’s shale the Company. This laser doubts in Howard Jonas? He venture had been established focused capital allocation gave was chairman when IDT had and it would likely be project me the confidence that really started to unravel. He financed as a JV after it was Howard was thinking about had written a book on separated from the holding the world in the right way and depression as well, which company. Nobody cared. was anxious to create might give some investors shareholder value. pause? You could see the cash. You knew shale would eventually Seven years later, we are still AW: I think that for a long be spun off. There were shareholders in the Company, time the IDT business wasn't buybacks underway. The now re-branded as IDW Media emotionally rewarding for him business was producing $2 per Holdings (OTC:IDWM), and and ultimately led to his share in FCF on an annualized are extremely excited about its decision to step away as CEO. basis. With the strong personal long-term prospects. Over the It seemed like he had a need to references on Howard and his last several years, IDW has do more. I think Howard felt motivations, I thought it would managed to grow both lines of like he was taking too much be very hard to impair capital its business organically and from society and not giving permanently with this through acquisition and has enough back. He was also investment. created significant value in involved in a variety of non- profits and valuation. In fact, I business ventures during this G&D: Are turnarounds a think the best is yet to come. time which were sapping a lot focus of yours? And what do IDW recently launched an of his time and energy. (Continued on page 28) Page 28 Adam Wyden

you look for when evaluating me, what is interesting about developments with the cloud them? Rainwater is that he was able and outsourcing. to do all the numbers on the AW: Turnarounds can be back of the envelope and he G&D: Can you discuss your good investments because had all the technical skills you investment process? many investors don't trust need, but he understood Naveen Bhatia, Professor them. If you’ve made the right people and incentives. AW: I do have a lot of filters. I for Applied Security Analysis call that management can be Sometimes there are bigger screen for insider buying, I & II, introduces the finalists successful, you can often make elements than the numbers. spinoffs, IPOs, and any large for the 9th Annual Pershing a lot of money. He was very good at transactions. But the process is Square Challenge recognizing good and bad dynamic. I am always looking. IDT was not actually a people, and that’s something I Someone might pitch an idea turnaround. By the time I have developed great to me, or I might be following invested, they had already appreciation for. an industry and see an divested assets and cut costs interesting new investment to the point that it was already Rainwater also understood from a fund we respect. For generating profits and cash sizing. Richard took big bets. I example, I saw Arnaud Ajdler flow. It was a really great take big bets. Understanding take a position in Imvescor opportunity. There will be that you’ve got to live with Restaurant Group (IRG.TO). opportunities like that again, some volatility if you want That intrigued me. I liked the maybe not as good, but you really great after tax returns people involved, I liked the don't need investments that was another thing that really business, and the valuation was return 15x or 30x. You need resonated with me. I don’t quite low. If the right changes 2x, 3x, 5x, etc. You can get care about volatility in my were made in the business, it that in small cap investments portfolio as much as I care could be an interesting when investors have just about multiples of deployed investment on a risk-adjusted gotten blown out and there is capital across a cycle and basis. I spent time looking at forced selling. limited opportunity for the brands, calling franchisees, permanent capital impairment. evaluating the retail business, G&D: Who were some of and the general strengths and your major influences in G&D: How are you set up weaknesses of the franchise developing your investment from a team perspective? restaurant business. I did all philosophy and investment the channel checks. I spoke to approach? AW: Generally, I do all the former employees about the stock picking myself, but I rely franchisees. The underlying AW: One group of investors I on interns and consultants if I theme was that the brands had really admire is the group am working on a special a lot of value, and with some associated with the Bass project. My investment management changes they Brothers in Texas. There is a strategy, which is to invest in a could open more stores, whole group who are couple of companies a year, increase their packaged foods incredibly successful that lends itself to doing all the business, and eventually sell or worked with them: Eddie work yourself. When you grow the Company through Lampert, Richard Rainwater, make those types of bets, you acquisition. Barry Sternlicht, John Sculley have to be right. You have to of SPO, David Bonderman, be able to know the numbers Today, two and a half years Danny Och, and so on. Richard inside and out. I think my later, we have a new CEO, a Rainwater stands out among investment strategy is better board, and the business that crowd. conducive to having one guy. I is improving dramatically. could see a situation where we While we took a lesser role in I think there are a lot of grow and have a bigger team, this “campaign” since Ajdler people in the investment world but right now it doesn’t seem was in the board room doing that aren’t willing to get their mission critical. On the the heavy lifting, we are not hands dirty. They don’t business side, running afraid to roll up our sleeves. In necessarily know how to enact everything is actually pretty every investment I ultimately change or talk to people. To straightforward given make, one of the boxes that (Continued on page 29) Page 29 Adam Wyden

gets checked off is that if things raising, especially given the G&D: Fiat (BIT:FCA) and go differently than expected, Fund’s strong performance? Ferrari (RACE) are two can I be the catalyst for investments that you seem change? I have launched a AW: You are right that we quite passionate about based number of public campaigns have gotten off to a great start. on the material you shared. It and feel I have been largely We have compounded at 27% seems a key part of the thesis successful effecting change and net to investors with our Day1 is incremental margins. Gross driving positive outcomes. I investors tripling their money margins today are around 50%, also feel that most boards and in five years. We recognize but you think incremental management—when applicable that past performance is no gross margins are potentially as —find that while sometimes high as 75% to 90%. How do my advice and comments are “We have you get there? tough, they ultimately galvanize the right results for the long- compounded at 27% AW: To get to 90%, we have term. to be looking at a seven-figure net to investors […] car, so that’s not necessarily The process can really vary the case with all their units. My though. With a compelling We recognize that research with some very idea, I typically spend at least a knowledgeable former month, sometimes much past performance is executives at Ferrari suggests longer, doing exhaustive work. no guarantee of future the margins on cars are in Sometimes we have been excess of 70%. If you get to sell following the Company for performance, so I just an additional unit from the years. When I see something same facility, you have the that looks really obvious and put my head down opportunity to leverage the compelling, I drop everything fixed costs that are lumped and go to work as quickly as I everyday and look for into the COGS line. Some can. I don’t really rely on investors miss that, in Italy expert networks or secondary the best ideas I can where they're building these information. I do all of the find wherever in the things, there's a variable cost research and digging myself. It of labor and there's a fixed is very hands on—cold calling, world they may be.” cost of labor. Then there’s in-person meetings, visits to depreciation, electricity, the company, customers, production fixed costs, suppliers, etc. guarantee of future insurance, and everything else performance, so I just put my that you are leveraging when G&D: Is your investor base an head down everyday and look you go from making 5,000 cars important part of your for the best ideas I can find to 10,000 cars in the same investment approach? wherever in the world they facility. Not many may be. My passion is really for manufacturing businesses AW: We have around 65 investing. I am not an asset operate with much spare investors, and almost all of our gatherer at my core. So my capacity. When you utilize that capital comes from high net- general approach has just been capacity, margins look much worth individuals. We have a to continuing finding high more interesting. few institutional investors, but quality ideas and compounding the principals of the at a high rate, and eventually G&D: So the materials just institutional investors made the dollars will come. We have aren’t that expensive? the money. We have also been added limited partners of all fortunate to attract some types and sizes over the years AW: The expensive materials capital from a number of hedge and I suspect we will continue largely come from fund managers, which is equally to do so in the future. Just like customization, and Ferrari is rewarding. our stock selection, we are able to secure a large margin focusing on quality over on those. The customer is G&D: Can you talk about quantity. paying a huge markup for the your approach to capital leather and all the rest. With (Continued on page 30) Page 30 Adam Wyden

the actual car, you have to outright stock, but I also own have localized, low-cost remember that the average Fiat. To me, Fiat is more production in South America, selling price is nearly 5x an interesting in many ways. In which is already in a recession, average car. You aren’t paying so this doesn’t feel like a peak the Ferrari labor force 5x what to me. Some of the growth will the GM labor force is being come from China which is paid. We expect that there is “So I think [Ferrari’s] greenfield expansion. Europe is leverage on labor. EBIT margins go from also coming off a cyclical bottom—growing by the mid- I think there has been limited the high teens to teens in many of their major disclosure on this because the markets and certainly nowhere options package hasn’t been around 40% and near previous peak levels. So, set yet and what incentive do it just seems like there is a lot you have to let your potentially higher over more going on to the story customers know they are than whether U.S. SAAR has buying goods at 90% gross time. The business has peaked. margins? gross margins of 50% However, turning to U.S. So I think EBIT margins go and you are layering SAAR, even if SAAR goes to from the high teens to around 15 million, I think the business 40% and potentially higher on 75% incremental can still earn $3 in EPS. We over time. The business has would still be at ~2x earnings gross margins of 50% and you gross margins. It given a potential pullback. are layering on 75% Some folks I have talked to incremental gross margins. It doesn’t take long for claim they can break even at doesn’t take long for the the business to have 10 million SAAR because they business to have 60% gross have improved their cost margins. I’ve looked at the 60% gross margins.” structure. Also, I think SAAR gross margins of other luxury will stay at these levels or goods companies such as slightly below for an extended Hermes, Richemont, and so 2018, we think the business period of time, just like on. For a product with the could produce $6 in EPS. If you housing. I think it was well same brand power, I think put an interest expense below a trend and the Ferrari can improve gross number that I think is reversion to trend could take margins dramatically, which appropriate and you take the several years. Sergio’s plan likely flows down to EBIT. Company’s guided 2018 EBIT calls for SAAR at 16 million High incremental margins can number, I think the $6 in EPS and SAAR is 18 million, so they be really powerful. Look at could actually be conservative. are slightly conservative there Mastercard EBIT margins in Everyone thinks Sergio’s 2018 as well. 2004 and look at them now. I forecast is too high, but I think think part of it is that CEO it's potentially conservative. So I also think that there are Sergio Marchionne doesn't that means we are buying the interesting dynamics in the want to rub it in people's face. company at ~1x 2018 earnings. overall mix. Fiat has exited the I think he wants to keep the Dodge Dart and Avenger bar low so he can keep beating G&D: Are you worried about business. They are saying they the numbers. There are a cyclicality in the U.S.? are not going to compete with definitely a lot of factors at Toyota and Honda rental / play here. AW: Everyone will tell you Uber-style cars geared that the industry has peaked. towards car sharing. They are G&D: We have discussed There’s no doubt the going to do Jeeps and trucks, Ferrari, but you are also very investment is contrarian. which are going to be the last excited about Fiat, correct? segment affected by First, SAAR isn’t necessarily an autonomous driving and AW: That’s right. With apples to apples comparison. electric vehicles. They are Ferrari, I own options and Fiat is more global now. They basically turning into a pickup (Continued on page 31) Page 31 Adam Wyden

truck and SUV business. They Manley/Reid Bigland who run the road. Second, I think tech also have luxury brands FCA U.S. could definitely players will not want to Maserati and Alfa Romeo. manage the whole company. replicate the manufacturing capacity of the incumbents. It Within the group, there is a G&D: There are a few auto requires so much capital. So parts business called Magneti analysts who are quite the incumbents likely have Marelli. It’s a pretty decent skeptical on Fiat, aren’t there? some role, even in this new business selling aftermarket industry structure. Third, the parts. It does €6.5 billion in AW: There have been. But average vehicle in the U.S. is revenue and operates at a 5% some of the skeptics have been 11 years old. In order for full to 6% margin. We think they short since 2006, and some of autonomy to work, the should be able to operate at a the more prominent bears are autonomous units will need to 10% margin over time. At a actually retiring. It’s a hard be able to interact with non- 10% margin on €6.5 billion of space to invest. Another autonomous cars. I don’t see revenue that’s roughly €650 consideration is you have an easy way for that to happen. million of EBIT and at a 10x Sergio and John Elkann saying a I think hybridization happens multiple would be worth €4 to merger with GM would unlock before autonomous vehicles. €5 a share, or $4.50 to $5.50. $10 billion in synergies. Put a For reference, Fiat only trades 10x EBIT multiple on those I also recognize that Fiat is for $8 today! Needless to say, synergies alone and you have very different from our past we think Sergio still has levers $100 billion in value creation successes. With IDT, no one to pull if investor indifference/ across the two companies. If knew about it. With Fiat, intransigence persist. Fiat gets half, you have everyone has an opinion. A ton synergies worth around $30 of institutional investors don’t To me, Sergio is a genius. Many per share on an $8 stock! The want to be contrarian. They investors do not understand math works at synergy splits side with Uber and Tesla and Sergio Marchionne. They didn’t well below 50% as well. fast growing companies that like his presentation, feel like they are well “Confession of a Capital We’ve seen other parts of the positioned for the future. Junkie.” Everyone loves Uber supply chain consolidate, and it Anything with negative stigma and Tesla and companies with seems like the only reason the attached is hard to invest in. I really high valuations. If SAAR top part of the chain hasn’t think we've done a pretty good avoids declining all the way consolidated is ego. You know job trying to understand the back to 10 million, I think they what my grandfather used to competitive landscape, the still make good earnings. say? "Never let your ego get in different macro-scenarios, and the way of your gold." I'm of our corresponding downside Even if earnings come in at $1 the belief that at some point protection. per share instead of $6 in an the gold is going to trump ego. extreme pullback in auto sales, G&D: We imagine it would still be trading around We are also optimistic that consolidation would be great 6x trough earnings. Again, the Fiat will soon be able to return for competitive dynamics. risk/reward seems asymmetric. capital. They are at the tail end Munger has pointed out of an investment cycle. They recently that the car industry is G&D: Are you worried about have invested to grow units the most competitive he has losing Sergio to retirement? from 4 million to 7 million. ever seen it. They have net debt today that AW: He has said that he plans we think will shift to a net cash AW: I agree. I think it’s getting to retire at the end of 2018. I position by 2018. better, and consolidation will think he'll continue to be the happen eventually. But at the executive chairman of Ferrari G&D: Do you think about the end of the day, we just think and remain on the board of threat from autonomous there are too many ways to Fiat. I also think there are a driving at all? win. Fiat has the parts business, couple of guys at Fiat that solid brands with Alfa Romeo, could run the company. The AW: I do. First, I think this Maserati, Jeep, and Ram. They CFO Richard Palmer and Mike scenario is many years down have cash building as a result of (Continued on page 32) Page 32 Adam Wyden

EBITDA growth and the end of an investment cycle, upside to a consolidation scenario, and a really low valuation of 1x 2018 earnings. We haven’t generated great performance on it yet, but we are “Fiat has the parts optimistic. business, solid brands I recognize it may take a while with Alfa Romeo, for people to care, but every single data point that I have Maserati, Jeep, and seen supports my longer-term thesis. Sergio took his 2018 Ram. They have cash plan up in January, a plan that was released in May 2014 that building as a result of no one thought he could hit! EBITDA growth and It is our belief that whether it’s the end of an Sergio Marchionne or Howard Jonas, the best course of investment cycle, action when one bumps into genius is to “hold on tight.” upside to a

G&D: Thanks so much for consolidation your time Adam. scenario, and a really low valuation of 1x 2018 earnings.” Page 33 Marc Cohodes (Continued from page 1) Graham & Doddsville comes to mind. We owned businesses borrowing money (G&D): Can you tell us about 13% of the company when it to buy back stock because your background? We saw that had a $60 million market cap. activists say you should do so you entered the hedge fund Needless to say after making as a very poor use of funds. industry in 1984. How did that 8X our money on it we sold a Time that should be spent on happen? bit too soon. The Sands improving the business is spent brothers have done a heckuva on financial engineering, which Marc Cohodes (MC): I was job there and their dad would is a joke. working for Northern Trust in be very proud of his boys. I 1984. I was only 24 years old guess it wasn't until we first G&D: Do you think people Marc Cohodes at the time and the youngest started dropping bombs on are born with this orientation person the bank had hired into Saddam in 1991 that I got towards the short side? Are the investment department. I incrementally more bearish on some investors quite critical was actually very bullish at the the world. While I was decent and skeptical by nature? Or time. I was able to buy Coca- at finding longs, I haven't been does it develop over time as Cola at a 7% yield, bought into overly enthused in names on you get burned by Walt Disney after they had the long side in quite some management teams lying to been greenmailed by Irwin time. I’ve seen a lot of things, you? Jacobs, and saw a few other but I’ve been very skeptical of interesting opportunities. I what has been going on for the MC: I think it's sort of all of think due to my age and my last 10 to 15 years. the above. I think you are born bullish stance, my colleagues at with a short selling gene, or a the bank really hassled me for G&D: It sounds like you have “genetic defect,” as I like to being too bullish and claimed I spent almost all your time say. You see the world had my fiduciary hat screwed shorting for quite a while? differently. You tend to see on wrong. I was being hassled things through a different and held down by a bank MC: Exactly. The way my prism. You tend to smell culture, and I didn’t like it, so I mind is currently structured, I bullshit better than most, or was looking to move on. see very few opportunities as you can realize someone is longs and I see a whole heck of telling a provable lie. It’s A mutual friend introduced me interesting, as I am probably to David Rocker in 1984. one of the most optimistic Rocker Partners was just “Getting burned by people you'll ever find even starting then and had around though people claim all short $20 million in AUM. At that Data Access opened sellers are pessimistic and evil time, there weren't really large and want to see the world hedge funds that had billions in my mind to the fact blow up. If people took the AUM or even a billion. It was a that a lot of these time to understand the different time. It was pre- message instead of shooting internet, pre-message boards companies and the messenger, the world pre-Twitter, pre-social media. would be a much better place. There was no Reg FD. You management teams could do real, hardcore, pick- When I was a younger guy, I up-the-phone research and are just completely invested a lot of my money at figure it out. It was a very fun, the time in something called energetic, enlightening time. and utterly full of Data Access Systems. It was a

crap.” computer leasing company that The fund’s performance was turned out to be a total fraud. very good for a long period of It was a valuable lesson in my time. It slowly grew through a lot of stuff as shorts. I think life. The investment taught me compounding. In the early while some are drawn to that management doesn’t tell stages, we weren't necessarily activism, buybacks, and the truth. I realized that in bullish or bearish. There were financial engineering, I see order to be serious in this pockets in the market where most of that as completely business, you need to raise we found some great longs. negative. I view crappy your research skills to a high Canandaigua Wine now (STZ) (Continued on page 34) Page 34 Marc Cohodes

enough level to assess People like to talk and people flavor of the day people want management teams and also like to help. It's really a to hear. Investors get excited whether your investment function of being more on the about the “current,” but never mosaic is accurate. ground, keeping your eyes realize what complete business open, asking questions, being failures the guys actually are. It Getting burned by Data Access direct, understanding the happened with the guys at opened my mind to the fact numbers, why the numbers are NovaStar, Media Vision, that a lot of these companies moving, how they're moving. I Lernout & Hauspie, to name a and management teams are always ask myself “does this few. just completely and utterly full make sense?” of crap. Although I lost my ass If you're interested in shorting and I lost money for my stocks, it's very labor intensive. friends, which deeply affected “When I’m looking for You probably have to do 6x me, it paved the way to what I the work that the longs do. ended up doing. You need to shorts, I look for You have to have the courage learn from your failures and career failures. I’m and faith in your work. I used mistakes and I have had many. to say, 96% of the time, you go looking for people home feeling and thinking like G&D: Can you discuss some you're an idiot, and you get of the changes you made to who always mess up. paid 4% of the time. So when your investment process as a you have a good day, you have result? If you mess up once, a great day. But your bad days are numerous. It takes a MC: It taught me the you tend to mess up certain mind and mindset to be importance of rooting through again, and again, and able to deal with that. Most filings and developing an in- people just can't. People have a depth understanding of the again.” great tolerance for losing financials. I'm not an money on longs, but they have accountant, but I do very little tolerance or understand accounting. I I think something that helped temperament on losing and understand when financials me in the past, and continues getting squeezed in shorts. make no sense. In my mind, if to help me, is checking things cannot be explained people's track records and G&D: Can you discuss what simply, that is a signal that you seeing how they've performed. you are up to these days? Are should start to dig because I always like to say, “I bet the you focused on managing your things in general shouldn’t be jockey and not the horse.” personal capital? We know you convoluted or complex. When When I’m looking for shorts, I are still a highly active short someone explains a business look for career failures. I’m seller from your Twitter feed. or an investment thesis to me, looking for people who always and it can’t be explained to a mess up. If you mess up once, MC: The only money I manage 10th grader in a paragraph or you tend to mess up again, and is my son's and mine. I'm less, that’s a bad sign. It was a again, and again. I tend to call it completely out of the hedge combination of looking at the the “Family Tree.” Some fund business, and I thank numbers harder as well as companies brag about our Goldman Sachs for that, which making sure to verify what CEO being Ex-IBM. Years ago is a different story for a some of these management that was a plus, in this different day. Good, bad or teams say. It's much easier period…not so much. indifferent, this stuff is in your now with the internet to figure blood; I just can't get out of it. out what’s what. Many of my shorts over the Names and games just jump years have been management out at me, and given the Another change was improving teams that are repeat remarkable rally and re- on-the-ground research. It’s offenders. Some of these guys, leveraging of the system that very easy to call customers, no matter where they go, hype we’ve seen since 2009, I think call former employees, mark whatever the current product, the opportunities on the short boxes, and things like that. idea, concept or whatever side in the past 12 months (Continued on page 35) Page 35 Marc Cohodes

have been outstanding. Twitter my spots and only answer to compelling shorts. How are is a great forum to go “fishing” myself. you able to do it so with an idea or a thought and consistently in a variety of where it’s ok to speak out. I'm not afraid of anyone. I'm different environments? Many people have come not afraid of clowns who run forward with research on companies. Since I don't run a MC: That's an excellent concepts I have discussed that fund, and I'm a civilian, I'm a question, and I have talked to have truly moved the needle. I free speaker, and I speak some pals about it. Maybe I like am a big supporter of the “free without malice. I can back up short selling because it’s not flow of information” and view what I say. I think there are just blindly plugging numbers it as vital in the marketplace. important opinions and into an Excel model. There’s Silencing critics and attacking thoughts out there. With always management that are “skeptics” is always a Hot something like Twitter, albeit encouraging investors or the Button with me and something kind of new, you find some sell-side to plug in numbers, that turns me on. I used to be really smart people, and I've and I’m more likely to say, on the Yahoo message boards met some interesting folks “This doesn’t make any sense.” back in the day and posted who have very fascinating You always need to “leapfrog” under my own name. You talk viewpoints. They do some very the estimates both up and about the Wild West! You hard and good research. down and work hard to try to never know what you may pick Whether it's people like understand how the business up out there, so keeping an yourselves, who are in college works. open mind while listening and or grad school, or folks reading is important to my working at funds, or wanting Something that just makes me process. to work at funds, there's a real smile and laugh is thinking back grassroots underground of to shorting this company called I spend my days researching, people working their way up Old Country Buffet. It was run analyzing, and trying to figure and thinking critically, and I by a guy named Roe Hatlen. out stuff. I also take care of my view that as something very This was a business that prior son, do some farming, and good for the markets, and very to being public was bankrupt travel. I enjoy spending time good for the system. twice. There’s a reason for with my wife who brings great that, and it’s because it’s a crap happiness to me. I lead a very business. A buffet format interesting, enjoyable, attracts two kinds of people. wonderful existence. I enjoy You have the people who investing as a purist, rather “I think it's a high come in and try to eat you out than running a fund. I don’t of house and home and you have to answer to clients or crime to rip off hard- also have the people who stay manage people. Running a fund working people. I there for three and a half is a very ball-and-chain hours. Either way, it's a flawed exercise. The people who run despise that kind of concept because those types funds earn what they earn, and of people are going to try to deserve what they earn, behavior, and I do get a bargain. You can't charge because there's a lot of enough, you have food cost pressure in the hedge fund look for it. I do sniff it issues, and you can't really business. Short-biased investing grow the business. When you in the hedge fund business ages out.” put leverage on something like you in dog years and I was at it that, you just go broke. for 25 years, so I guess by those standards I am quite old. When the company needed to There's a lot of wear and tear, raise money to grow, certain and you can never really get G&D: Can you discuss your restaurant analysts would say away from it even on vacation. idea generation process? It this is great, they can grow I enjoy my investment seems like most of the hedge from 10 states to 50 states, existence as it currently stands fund industry generally thinks etc. But when you actually where I just pick and choose it's pretty challenging to find think about it, this is not the (Continued on page 36) Page 36 Marc Cohodes

kind of business you want to encouraged the company to way. Is that a theme that you be in. Sometimes there's just a buy back stock at ridiculously have relied on over time? lack of critical thought on high prices. No one stopped to these situations. Although the think that this move does MC: You're right. I think it's a numbers may look compelling nothing to help their business. high crime to rip off hard- in the short term, this is a It’s just levering up to help working people. I despise that business that fails and it fails hedge funds out when it's a kind of behavior, and I do look for a reason. really bad use of their money for it. I do sniff it out. I really, and it could cripple the really, have it out for subprime. I think it's the lack of thought company. I’ve been involved in shorting by current market participants, subprime auto, subprime perhaps due to impatience and Now the stock is down and housing, subprime education, the pressure to perform. the hedge funds and activists subprime consumer lending, There are some investors who who championed the idea are and subprime vacation say, “Although the comps were nowhere to be found. The timeshares. bad, they got better in the critical question was, are second half of the quarter and people going to be renting Analysts plug numbers into a we are optimistic about the model and say "God, this is a trends.” That doesn't mean great business. Look how crap to me unless a “fix” was “Any company with a much money you're making.” made, and in Buffet’s case it Well, you're making money never happened. You can’t let management team ripping off financially short term nonsense jerk you unsophisticated people which, out of a long term trade that that focuses on, to me, is awful. should probably work. I think under the current hedge fund mentions, is bothered I had some hedge fund guy call structure, people aren't patient by, or attempts to me about World Acceptance. enough to see through so- He was telling me what a great called failures. You have to see squeeze short sellers, business it is. I said, "If you it through, or why put in the think they're in a great effort and energy to begin is almost definitely a business, I'm not your call. It's with? You need to have the an awful business, run by awful courage to ride your thought short.” people who rip off financially through. unsophisticated folks."

G&D: It sounds like there can DVDs from a red kiosk or not? It turns out many of these are be cases in which there is a It may be a dying business, so it terrible businesses. You vast divergence between doesn’t make any sense for the wouldn’t pay much of a expectations when one company to lever up to buy multiple to sell drugs on the investor is plugging numbers in back stock at a very high price. corner. You have great on a spreadsheet while That is probably the dumbest margins and make all sorts of another is thinking about the think they could have ever money until you are arrested business and the underlying done. It just shows that or shot. It’s just not for me. reality of the economics. management had no ability to You have a number of people engage in forward thinking in focused on the great ROE or MC: I think right now there is running their business. They ROI, but I think it’s a crap a huge lack of critical thought. just kowtowed to a bunch of business over the long-term More people need to ask hedge funds looking for short- because the company can be "Does this make sense? How term performance in a dead regulated out of business and does this make sense? What end stock. the management team is simply really is the end game here?" in it to enrich themselves while G&D: It also seems like you not caring what happens to its I don’t know if you have are very attracted to situations customers or the effect it has looked at Outerwall (OUTR), in which the consumer is being on society. but activists got involved and taken advantage of in some (Continued on page 37) Page 37 Marc Cohodes

G&D: It’s interesting that We have a great company here chicanery to recruit and now many people typically refer to and I work hard every day to that the recruiting mechanisms short sellers as short term in frustrate and make the short’s were gone, there wasn’t a nature. The edge you have life miserable." I saved the chance in hell they could make referred to a few times is transcript and printed it. I post their numbers. At the time, the taking the other side of longs it on Twitter every now and estimates were $8-$9 dollars, who are overly focused on the then. I said to myself “I need to but the actual EPS has come in short term returns of the get to know that Rat Bastard. around $4. business. He sounds like a guy for me.” For me, it was purely a bet MC: I’m not a short term guy. Any company with a against the geometric I’ve never viewed myself as a management team that focuses progression that the bulls were trader or market timer. I have on, mentions, is bothered by, counting on. Management was to rely on the business getting or attempts to squeeze short hyping an MLM structure in serious trouble, getting sellers, is almost definitely a selling garbage products into impaired, filing for bankruptcy, short. As a CEO, you shouldn't China where there was no real or fundamentally changing. The worry about the shorts. You demand. When an MLM goes ballgame is nine innings and I bad, recruiting goes bad, have to have a vision. I have to incentives go bad, the money think it through. I have to trail goes bad and people stop research it. I have to do things “I prefer situations in working for Nu Skin and go like that because I have every which I can have five work for Amway, Herbalife, or factor known to man working whomever. against me including the shooters on the target upward bias of the market. I Nu Skin could go out of also have to be comfortable rather than one.” business tomorrow and no being in the minority. one would miss them. Analysts were recommending the stock G&D: What was your insight using estimates and theories on Nu Skin Enterprises (NUS) should just run your damn that were completely and that allowed you to have such business. Run it hard, do the utterly out to lunch. If your an improved view relative to best you can. At the end of the producers aren't making all the bulls? day the numbers will prove money, they'll move on to the out, good or bad. He got my next thing. The bottom line MC: I have no thought or attention when he started with Nu Skin is there's just position on Herbalife, but multi pounding his chest and baiting nothing there. With Nu Skin, -level marketing (MLM) the folks who were short his you're selling face creams to businesses are very dangerous stock. Chinese people who have very structures. It's a model where, little money for food, let alone when things are good, they get As I’m following the company, this garbage. It's been really better, and when things get they announce a huge amount good, and I still think it has a bad, they get worse. There's of Chinese business out of way to go, and I think nothing in between. In MLM nowhere and the stock goes management is clearly full of land, you are either going crazy. I thought, “Hmm, this is crap. So, until proven forward rapidly or you're going interesting.” I didn’t get otherwise, there's no reason backwards. involved until the stock broke for Nu Skin to even exist. when they got busted by the The thing that caught my eye Chinese and had to settle an G&D: MLMs seem to lend on Nu Skin was that they have investigation. The company themselves to the on the a complete joker, buffoon, and claimed it was not a big deal. ground research you spoke clown running it. A guy named But I looked at the MLM about. Were you able to Truman Hunt. He got on a structure with its reliance on conduct any investigative conference call and said, "I China, and I said numbers here research to give you an edge? don't know why in the world are just way, way too high. anyone would short our stock. They had used all sorts of (Continued on page 38) Page 38 Marc Cohodes

MC: John Hempton had some admire Elon Musk. He is a I’m short Toronto/Canadian/ excellent research out there chippy guy who doesn’t take Alberta real estate through on empty factories in China shit and in many ways that’s being short Home Capital that I thought was needle ok. He needs to execute, Group (HCG). Last July, they moving. I think, at the time, the though, and people seem to copped and admitted to $2 stock was in the mid-to-high love his cars, but the stock and billion of mortgage fraud, forties, and it backed up my the cars are not for me. which was brought to their thesis that a lot of their claims attention by a whistleblower. were just lies. I can't really add value to the The company has no controls. debate on that company. I It has no systems. They take You can also look on Google generally try to avoid positions zero reserves. They missed Earth at where the company in biotech or high tech origination numbers for the claims their facilities are. One situations. It can be last six quarters with all sorts was 60 miles south of Siberia. unanalyzable in certain ways. It of excuses. I think it’s an You think to yourself, man, becomes very hard to prove incredible short because if the that's kind of a funny place for or disprove in the short term. I market were to cool, they a plant. Who knows if it even prefer situations in which I can would have a big problem. exists? have five shooters on the Management lies at every turn target rather than one. For and their financials The evidence forced me to example, with Canadian misrepresent their business. bring an even more skeptical housing, I think I can win on a The turnover at their “risk” viewpoint to the company. I bubble, on fraud, on lack of department is of interest to think it's a little bit of reserves, on the me as well. everything with Nu Skin. It's macroeconomics, on money balance sheet, management, laundering. There's a zillion When you take no reserves in structure, where they do their ways I can win. Canadian subprime mortgages, business, their rhetoric, the you can run any drawdown quality of dopes who follow G&D: Speaking of Canadian assumption you want and the and recommend the stock. In housing, that is clearly a company will not have a particular, Tim Ramey who is passion of yours. Do you mind business. It will be gone. I think one of the three worst analysts discussing your views? it’s a question of when, not if. I’ve ever come across in my So, I happen to love HCG as a life. For him to be touting Nu MC: Canadian real estate is short. Skin was another tell. really something. Canadian real estate, ex-Toronto and G&D: What do you think is G&D: Do you have any Vancouver, is not doing well at the misperception here? Are thoughts on Tesla given how people fooled by a low price- popular that has been within “I like to short to-book valuation? the short selling community over the past few years? complete pieces of MC: Well, I think their book is overstated and unstable and MC: I have no position in garbage with with that being said it trades at Tesla. I've never had a position fraudulent 1.8x book here with Wells in Tesla. I mean the Fargo at 1.4x and Bank of fundamentals are the management and America at 0.9x. The company fundamentals in terms of their is sitting on $50-80 million in losses and things like that. I horrifically bad losses of short-term find Elon Musk to be a investments they've made that polarizing figure, both long and balance sheets.” they won't run through the short. I think Elon should be a P&L because they don’t want little more thick-skinned with all, but Vancouver, which is to take the hit. Also, when you the critics and focus more on very hard to play publicly, is don't take reserves your book his business. Investors should the money laundering mecca of is overstated. I don’t think be entitled to say whatever North America. Toronto real their loans are good, so I don't they want about the company. estate is also really something. believe their book at all. That said, in some ways I (Continued on page 39) Page 39 Marc Cohodes

Their book value is around company to put the mortgages the guy drunk?" "Hell yeah. He $1.6 billion. They have $25 back to. It is one of the great was drunk on 15, but now billion of loans, and I don’t setups I have seen over the last we're 23." "What are you think they are good loans. 15 years. HCG’s CEO, Gerry waiting for? Why do you keep They have about $800 million Soloway, is an absolute serving him?" "Well, you could in loans in Alberta unsecured coward. In one of his previous have told me that at 13 drinks. subprime housing which I think roles 25 years ago, Soloway I keep serving him because he is an issue. They have $1.5 shorted his own company’s keeps paying." Eventually it billion in fraudulently stock into a Dutch tender and changes and that’s what I am underwritten mortgages and he covered by issuing himself waiting for. they won’t quantify the warrants. He was slapped by potential losses. They're hitting the OSC and has recently G&D: Are there other the last quarter with 13 bps in announced he is retiring. I say companies that you think have provisions. In the US, when he is a coward because in past overextended themselves in things went bad in subprime, conference calls he made every lending operations? You were provisions went to 12%-17%. excuse as to why he was recently mentioned in a The consumer in Canada is missing numbers and it turned Bloomberg article about Signet leveraged far beyond where out to be mortgage origination Jewelers (NYSE: SIG). the US consumer was in 2007. fraud. This kind of stuff would Canadians take out home not play to U.S. investors but MC: Well I think SIG is a great equity lines of credit, second different places have different short because I'm not a fan of mortgages, and private rules. roll-ups in general, and I’m mortgages, so the slightest tip definitely not a fan of roll-ups in the price of housing, in retailing. Except for auto especially in Toronto, is going “You have to have a parts companies, they tend to to completely and utterly put fail in retail. I think SIG is a this thing into the soup. lot confidence in cross between Conn’s, which Shadow banking in Canada will is a subprime lender for home one day unglue the country but yourself. You have to appliances, and Jos. A. Bank regulatory capture and money believe that you're and Men’s Wearhouse. I laundering seems to be saving believe Signet makes 60-65% of them for now. right and everyone's their money from lending and their extended warranty Everyone thinks they can time wrong. You have to be program. Why you need an it. Everyone thinks they know extended warranty on jewelry exactly when it's going to able to deal with is beyond me. That's the happen. No one is that smart. dumbest thing I've ever seen. When things happen, they adversity and have a Oh, it includes “free ring happen at lightning speed, clear mind.” sizing.” Come on now. I was without warning or notice and born at night, but not last it tends to be wicked. So HCG night. is the pure play in subprime lending in Canada, generally I don’t care about the analysts It’s a hedge fund hotel name. Ontario. There's no real pure who plot their numbers and You have an activist or play in Vancouver to my claim it’s cheap. The stock is wannabe activist involved in knowledge. going to go to a very, very low the thing. It’s covered by retail number one day and I am analysts who do not G&D: With the fraudulent patient. If HCG wants to buy understand the weird mortgages, are there any back stock and try to squeeze accounting associated with contingent liabilities associated shorts, that’s fine with me. I subprime lending. Analysts with those? Can they be put will wait them out. The second think they are recommending a back to the company? that credit spins in Canada, retailer. You actually have a everybody is going to get shut retail rollup with low quality MC: By the time the market off. It's akin to serving a guy 23 brands. I actually don't view it turns, there will be no drinks at a bar. I’m asking "Isn't as jewelry retailer; I view it as (Continued on page 40) Page 40 Marc Cohodes

a retailer of trinkets that uses Before I short anything, I have month. This forces you to cut subprime finance techniques to a few protections. First, I losses fast which again I am not make their sales. So their always assume the short can a trader and don’t mind being business model is not that of a double on me. I size the down for a while if I think I can traditional retailer. I view that position accordingly. Second, I make 50-90%. as a very bad mix. Everyone on guard against “thesis creep.” If who loves the the thesis changes, you better G&D: It seems like quite the stock misses that there are get the hell out. If you don’t, challenge to balance conviction CFPB issues with the company you'll clearly get buried. As with flexibility. How do you as well. long as your thesis is pretty achieve that balance? good and your analysis is right, I think there’s a huge you can hang in there. Third, I MC: I think that’s hitting the misperception of exactly what never, ever, ever get involved nail on the head. You have to this thing is. Specialty retailers in what I would call open- have a tremendous amount of trade at much higher multiples ended situations. I've never confidence in your research. compared to a subprime been short a drug company You have to have a lot lenders with jewelry or that can theoretically solve a confidence in yourself. You trinkets as collateral. In big problem. I have avoided pie have to believe that you're jewelry, Tiffany and Blue Nile -in-the-sky names. To use an right and everyone's wrong. are struggling, but Kay, Jared, analogy, I’m not interested in You have to be able to deal and Zales are somehow climbing into a tree and with adversity and have a clear succeeding? I think that’s due wrestling the jaguar out of the mind. to their financing arm and tree. I'm interested in aggressive extension of credit. someone shooting the jaguar I am lucky to have a wonderful I think there are some big time out of the tree, and then I will son, who happens to be risks with the company and go cut the thing apart once it disabled. I have watched him they seem to be very hits the ground. Instead of grow up and face adversity on concerned about the skeptics open-ended situations, I like to a day-to-day basis and he never and again are using money to short complete pieces of complains, and tackles things buy back their overpriced garbage with fraudulent head on. He inspires me to no stock…good luck to them. management and horrifically end and whenever I think I bad balance sheets. I look for have things tough, I always G&D: There’s that famous change, I look for “if this goes think of him. Seriously, it’s Keynes saying about the away tomorrow will anyone probably the greatest thing market staying irrational longer miss them”? What do they do that has ever happened to me. than you stay solvent. From a well? Some would view it as a process standpoint, what do hardship, I do not and it gives you do to ensure you don’t In terms of timing, I think if I've me great strength. face really large, painful mark watched these companies long to market losses before you enough that I can get close on There’s been situations when I are able to see your thesis timing it properly, but if I do had to have conviction that come to fruition? it’s generally lucky. I normally strategic buyers were wrong, lose first then hopefully win. I like when Intel & Microsoft MC: I have been carried out do look for breaks in the took a stake in Lernout & many times. I know few fundamentals first before I dive Hauspie. When bulls said "Do professionals who haven't. It’s in. When the market begins to you know more than Intel on difficult to have hard and fast care is anyone’s guess. Lernout & Hauspie?" I said, "I rules. When you short stocks, don't know more than them, you get involved on a carnival I’m not particularly worried but I know that Lernout's a ride that's called 'anything about mark to market losses. I fraud, and Intel doesn’t know goes,' which includes buy-ins, do this personally, not for a the first thing about financial manipulations, fake tenders, fund. I think one of the frauds.” That's the attitude you and all sorts of shenanigans problems with investing now is need to have, because which can cause stocks to people have to be tracked otherwise, you will just get gyrate in a crazy fashion. week to week and month to carried out to the sea, and (Continued on page 41) Page 41 Marc Cohodes

that's a really bad feeling. The level. World Acceptance’s is a zero. I wouldn’t bet against Lernout experience taught me average cost is probably $80 Krensavage. We worked on a lot but we went from being versus the current price of AAII Pharma together when he buried alive to making it out ~$38. HCG has just finished a was on the sell side and it which was a miracle in itself. Dutch Tender. Every one of went Bankrupt. VRX has a The pressure to cave was these hucksters who've done good chance of going in that enormous but thank God it buybacks have seen these direction as well. went bust. things blow up in their faces. The activists force I have been involved in what I That's why I always say, "Don't management teams into doing call the “Poor Man’s Valeant” try this at home." You have to something dumb with their and that is Concordia be genetically flawed to even money so the activist can sell, Healthcare. They are more want to try to do this. It’s very, but then the rest of the levered than VRX and their very difficult. Short selling shareholders in the company strategy is being run by ex- serves a great function in the are left holding a company Biovail guys who to me are in marketplace in terms of free loaded up with debt. way over their heads. They flow of ideas, and the people have overpaid for acquisitions who do it should be respected A lot of these energy and have recently missed instead of trashed, threatened, companies were initiating huge numbers. I don’t think their beaten up, manipulated against, buybacks and look where it got assets are worth the debt by a and run-in, not to mention them. I think companies should long shot and they seem more sued, or investigated. I have borrow money to expand their than lost. They are concerned been all of those. It's not fun, businesses, to hire people, to about the shorts and have lost but you have to have skin as grow organically, not to engage focus in running their thick as an armadillo and be in buybacks or roll up overleveraged business. Their able to look at them and spit. acquisitions. When your conference call transcripts business is not doing well from given their leverage levels are It's not for everybody. It's a a fundamental perspective, the worth a listen. dying art, as evidenced by only last thing you're supposed to three or four short-dedicated do is buy back stock. Financial G&D: Are there any other funds still active in the market. engineering is a byproduct of shorts you’d like to discuss? It's like mining with a pick and low rates. Bad outfits need to shovel, instead of a bulldozer. and should fail. Cheap money MC: I'm very intrigued with It's not an easy thing to do. lets these guys manipulate Tempur Sealy (NYSE: TPX) as numbers and earnings for a short. I haven't talked G&D: You mentioned that much longer than need be and publicly about it yet. I've been management teams attacking this is why the economy is in short this thing 5 or 6 times in short sellers is a strong signal “muddle.” my life, and it’s been good to to you. Do you rely on any me. When they first went other signals? Too much of a G&D: Have there been public I noticed the top two focus on capital return to situations that you sourced guys in management wore shareholders seems like it through ill-advised buybacks or wigs. I am 10/10 in shorting might be one for you? rollup acquisitions? Anything guys who wear wigs. It’s like Valeant (VRX) or in another indicator of mine. I MC: I'm very against buybacks. healthcare more broadly? don’t know what it is with guys I think buybacks should only be who wear wigs but they make used as a last resort. There are MC: Well, I'm not an authority great shorts. very few examples of buybacks on Valeant. There are people I having actually worked over respect who are long this At the end of the day, they sell the past 18 months. Over the thing. That said, the guys I foam mattresses. TPX is a last year, so many pieces of know who are short this are commodity business. They sell garbage that I’ve been short lethal. The smartest pharma foam and now everyone can have announced or completed guy I've ever come across is sell foam. You can buy foam in buybacks. Nu Skin was buying Mike Krensavage. He's smarter a box. You can buy foam at back stock at 2x the current than heck. He thinks this thing Costco. You can buy it (Continued on page 42) Page 42 Marc Cohodes

everywhere. There's nothing G&D: Given your activity on saying that @Mega_Man_2 is magic about what they do. The Twitter, we’d love to know very good. bed industry grows about 1%- who some of your favorite 3% a year. The share has been folks on FinTwit are. Who are It’s good for people to lurk and taken and I think the road for some of the folks you benefit monitor what these people say them ahead is rocky. the most from following and and how they think. It can who is underrated? serve as a starting point before TPX is a sales-driven model. In you do your own work. a sales driven model, when you MC: In general, I find a lot of miss on revenue, you tend to these guys on Twitter to be G&D: Would you like to close miss for 3, 4, 5 consecutive very, very sharp. I think with some words of advice for quarters. When they beat, the @donutshorts would be my students, especially aspiring opposite happens. This past first choice. He is outstanding. short sellers? quarter was the first quarter of That guy is dogged. He knows misses. The stock is down, but what he's doing. He's smarter MC: One important thing to it could get more than cut in than heck. He's experienced. understand is that there are half from here. The company is When I grow up I want to be many easier ways to make a highly leveraged and activists as smart as him. living than shorting stocks. If are involved. They threw in a you want to make a lot of new board and a CEO who is a money on Wall Street, former rental car guy. I have “It’s important in this shorting stocks is not what you no respect for players who want to do. I short stocks encourage the company to business to do it your because I really enjoy it. You take on more leverage to buy have to love the work and the back their worthless stock. own way. Be yourself. challenge. At the end of the That's what the company has day, I feel good cracking the been doing. If they want to buy Have an identity. code and getting to the the stock here, great, I'm Have a plan and be bottom of these scams. If you selling it to them. I like TPX as don't have a passion for it, you a short. you. Win, lose, or will get worn out and you shouldn't do it. If you follow I also like two bust Canadian draw, do it on your what you are passionate about online gambling roll-ups. in your investment career, Intertain (IT) and Amaya own terms.” money and success should and (AYA) are both worthy here. will follow They are both over-levered and run by “shady characters.” I'll give you some of my Lastly, it’s important in this The CEO of AYA is on “leave” favorites in no particular business to do it your own for an insider trading order. @AZ_Value, way. Be yourself. Have an investigation. After buying the @Whipsawcap, identity. Have a plan and be world, Intertain now wants to @KennethCosco, you. Win, lose, or draw, do it sell itself. I think digging into @Nevadaturkey, on your own terms. For better the capital structure of both of @Tysoncapllc had this BOFI or worse, there is only one these outfits will be rewarding. dead to rights. David Einhorn, Mike These two remind me of @RetardedBearcap is really Krensavage, Jeff Ubben, children who take out a puzzle, good. I’ve known , Jim Chanos, spread it all over the room and @SpartucusZoro forever. Roland Keiper, Stan after 20 minutes say I am done. There’s one guy who will Druckenmiller. Be your own The house is a mess and no probably write a book or a person because otherwise it one wants to clean it up. movie on Canadian housing just all gets diluted and you Canada seems to love rollups. and that’s @SCooper. There’s can't beat the market or do When they go bad, they can go @CarringtonLedge, exceptional things over time. really bad. I like these two as @HardcoreValue, You're just an imitator and shorts. Time will tell. @AC_ECO. It goes without there's too much group think.

(Continued on page 43) Page 43 Marc Cohodes

If you want to get in this business, you can understand how these people have gotten there, but you need to develop your own style, your own abilities, your own way of doing things, and make sure no matter what you do, you do it on your own terms. Don't do it someone else's way. That's a true problem. Don’t just watch the talking heads on CNBC – and just blindly follow what the talking heads say. Kevin O’Leary as an “expert and market commentator” tells you how “infomercial” the markets have become. It’s not that simple or easy. Think for yourself is always a great place to start. Just think it through, do it yourself, and do it your way. Long or short.

G&D: That's wonderful advice Marc. Thanks for your time. What’s the best way for people to find you and follow your investment related thinking?

MC: You can find me on Twitter, @AlderLaneEggs. Page 44

Alimentation Couche-Tard (TSE: ATD.B) - Long 9th Annual Pershing Square Challenge—First Place

Thais Fernandes, CFA Melody Li Joanna Vu [email protected] [email protected] [email protected]

Investment Thesis Summary  High-quality business misunderstood by the market: Convenience store seg- Ticker ATD.B ment generates stable/high FCF while fuel margin isn’t correlated with oil price Price (CAD / USD) 57.97 / 45.21 ThaisMarc Fernandes Grow ‘17 ’16  Best positioned player to consolidate a highly fragmented market Shares Outstanding (M) 569.2 Thais is a second-year MBA student and a member of  Management has a proven track record of making accretive acquisitions with Market Cap ($M) 25,736 Value Investing Program at integration expertise and we expect them to continue to do so Net Debt 1,777 Columbia Business School. Enterprise Value ($M) 27,513 During the summer, Thais Investment Recommendation We recommend a long on Alimentation Couche-Tard with a target price of ROE 5Y Avg 21.4% worked for First Manhat- CAD83/USD65, which represents a potential 44% upside. ATD is a great oppor- ROIC 5Y Avg 12.8% tan, a long-only equity fund. tunity to buy a high quality, recession resistant business that is thinly covered, flies ROCE 5Y Avg 17.7% Prior to Columbia, she was under the radar and lead by true value investors. Dividend Yield 0.47% a partner at Brasil Capital, a long bias hedge fund. Company Overview ATD is a Canadian company that grew up internationally in the US & Europe to become the world’s largest c-store and gas station operator. Over 10,000 stores generate revenue from transportation fuel and convenience stores, which grow organically year after year. ATD operates under brands Circle K in US (No.2), Couche-Tard in Canada (No.1) and Statoil in Scandinavian Europe (No.1).

Investment Thesis A. Resilient retail cash cow  The convenience store (“c-store”) business is misunderstood by the market. C-store is gaining market share from other retail formats driven by the increasing consumer preference of convenience, especially for the millennial generation. At ATD, C-store contributes to >50% gross profit and has very stable gross mar- Melody Li ’17 gin (~34%) over years. C-store revenues experienced positive SSS growth (3%/1% in ’08/’09) during the recession, evidence of the business’ resiliency. C-store segment’s resiliency and stability contribute to a consistent Melody is a first-year MBA >100% FCF conversion and >20% ROE. student at Columbia Busi- ness School. Prior to CBS, she worked in sell-side equity research including Oppenheimer & Co. and Brean Capital and real estate private equity at ACE Capital in New York.

 Fear of fuel margin decline is unwarranted. Bears argue that fuel margin will get squeezed as oil price recovers, however, our analysis shows that fuel margin is not correlated with oil price but rather driven by fundamental and bottom-up factors such as operation profitably at the store level and local competition. Our variant view on fuel margin is: fuel margin will stabilize at 18.5cpg (cents per gallon) near-to-mid term and will trend upward driven by pricing control shifts from big oil to operators like ATD, more sophisticated pricing strategies, rising operating costs, and industry consolidation. Joanna Vu ’17 B. Best positioned to consolidate  The US c-store / gas station industry is extremely fragmented with over 60% of stores Joanna is a first-year MBA owned by moms and pops student at Columbia busi- ness school. Before CBS,  Only four players are capable to consolidate the US industry: 1) 7-Eleven, a she worked at Colony complicated holding that doesn’t exactly love the gas station business; 2) Marathon Petro- American Homes and leum (Speedway) and 3) ETP/Sunoco - two integrated downstream oil companies going Colony American Finance, through operational issues right now. ATD is the only well-positioned consolidator. portfolio companies of  The c-store consolidation story looks a lot like that of the drugstores in the Colony Capital. She is 90’s, when chains started dominating over the mom and pops. ATD currently has a simi- currently an intern at lar market-share as CVS in 1995 (3.5% vs. 4.2%). Since then, CVS compounded at a 18% Litespeed Partners, an CAGR and reached 20% market-share today. Drugstores and c-stores bear similarities in event driven hedge fund. the sense that scale is crucial for success for such a low margin business, we see no rea- son why ATD cannot follow in CVS’s footsteps. Page 45

Alimentation Couche-Tard (TSE: ATD.B) - Long (Continued from previous page)

 Scale is also hard to replicate as it takes a lot of time and effort to build a substantial size. ATD took 15 years in the US with several small, medium and large acquisitions to reach 3.5% market share.  Additionally, by entering Europe in 2012 with the acquisition of Statoil, ATD built a new and very exciting platform in an opportunistic time when Big Oil is exiting the retail side of the business due to the oil crisis. As a matter of fact, ATD recently announced two acquisitions – one in Ireland and one in Denmark. C. Best-in-class management with integration expertise  In 1980, Alain Bouchard purchased one convenience store in Canada. Today the company owns over 10,000 stores globally. Alain has a lot of skin in the game as most of his $3 billion net worth is invested in the company. As a matter of fact, all 4 co-founders own 20% of ATD’s stock  A top ten shareholder told us that they only get to speak to IR twice a year. A current shareholder has been trying to meet Alain for years, with no luck—this indicates that management is more focused on the operational aspect of the business than wall street  Decentralized business model empowers business units of 600 stores to react to local challenges immediately. The VP of ac- quisitions told us that he is able to buy single stores in a pre-defined box without management approval, thus cutting down on the slow bureaucracy that oftentimes plague large organizations  Management consistently acquires at below industry multi- ples. ATD buys when others aren’t buying and are disciplined enough to walk away when the price is not right. For example, in 2012 during the US MLP buying frenzy, ATD found opportunities elsewhere, in Europe  Management is disciplined with debt but not debt adverse. History shows that ATD is not afraid to lever up for a transformative acquisition but quickly pays down the debt to be ready for the next deal  Management has an in-house M&A team to reduce financial advisor fees Why Now 1. ATD will beat estimates—Three deals of $2.5Bn in last 6 months are not included in consensus estimates 2. Over-levered US MLPs must sell assets to pay down debt—Catalyst for accretive acquisitions in sought after markets 3. Low oil prices forcing European oil companies to sell non-core assets—Another catalyst for accretive acquisitions Risks 1. US fuel margin will deteriorate as oil price recovers—Fuel margin is not correlated with oil prices and will stabilize near-to-mid term and trend up- wards 2. Acquisitions to support growth is unsustainable—ATD can grow organically and does not have to acquire to grow. Given the fragmentation of market, we see a long runway for ATD to further consolidate and management has proven track record of making accretive acquisitions 3. Competition from big box retailers intensifies / price war—Big box retailers failed in gaining market share in the pharmacy business, expect a simi- lar story in gasoline 4. Succession of leadership—Alain Bouchard is still more active in acquisitions than ever after stepping down as CEO. He personally mentored CEO Hannasch 5. Growing electric cars will hurt traffic to gas stations—If the most optimistic forecast is correct and half of the cars sold in the US is electric by 2025, the number of non-electric cars will be ~260mm by then (still a higher number than the current ~250mm that exists in the US) 6. UBER taking some customers away – what matters for gas stations are the miles driven, which doesn’t change because of UBER. The average “UBER driver” – male, middle-age, low income that can’t afford to lose time - is exactly the main consumer target for convenience stores

Valuation & Scenario Analysis We value ATD using sum-of-the-parts. 1. The legacy part of the business provides stable and consistent free cash flows. Factoring in the 3 announced acquisitions (Esso, Topaz, Dansk Shell), dropping fuel margin to 18.5cpg, and assuming 1% fuel volume organic growth, produces a 33% upside for the Legacy business. 2. Adding on the acquisitions part of the business ($4bn acquisitions in 2 years) gets us to our price target of CAD83/USD65 (44% upside).

Page 46

Charles Schwab (NYSE: SCHW) — Long 9th Annual Pershing Square Challenge—Second Place

Chris Andreola Brandon Cohen Daniel Rudyak [email protected] [email protected] [email protected] Recommendation Schwab is a secular grower with a wide moat, which Key Financials & Ratios Other Metrics has allowed it to earn a ~20% return on equity, on Market Cap / Price 37.0B / $27.99 P/B 3.2x average, for more than 25 years. Since its IPO in ROCE TTM 11.4% 10yr Avg P/B 4.1x Chris Andreola ’16 1987 the stock has compounded at ~18%/year. Chris is a second-year From 2008 to 2015, its earning assets (float) grew Avg ROCE (1992-2015) 19.7% NIM 1.6% MBA student at Columbia from $44 billion to $172 billion, and its total client Forward P/E 22.6x Cost of Funds 0.08% Business School. Prior to assets grew from $1.1 trillion to $2.5 trillion. How- 10yr Avg. Forward 22.1x Debt/Equity 7.7% CBS, Chris spent four ever, operating income has only risen by ~12%. As a Pre-Crisis Forward P/E Range 21-25x Div. Yield .84% years working at Syncarpha result, SCHW's return on equity in 2015 was 42% Capital. He graduated from below it's long run average. This is because SCHW Schwab Historical P/E Lehigh University with is very sensitive to changes in the Fed Funds rate as degrees in Finance and it invests client cash in 2yr duration, liquid securities. Mechanical Engineering. It also charges management fees, which it has had to waive in order to give clients a positive yield. These waivers reduced earnings by 36 cents/share (fully taxed) in 2015. As a result, a 100 basis point increase in the Fed Funds rate would more than double SCHW's earnings.

However, at 21x forward earnings, it trades at a ~20% discount to its 25 year average (excluding 1998-2001, when it averaged 58x earnings). This is also the low end of the pre-crisis (2004-2007) for- ward P/E range of 21-25x.

Brandon Cohen ’16 The street is too short-term focused, providing the opportunity to buy a great franchise at a very reasonable price. Our Brandon is a second-year base case analysis results in a 20.4% IRR over a 5 year hold period and assumes that interest rates only rise by 100Bps over MBA student at Columbia 5 years. Business School and is managing partner of Abrika Business Description Capital Management, LP, a Schwab makes money by 1) investing client cash (float) in loans and securities, 2) fee-sharing with mutual funds offered on its long biased, value oriented platform, 3) charging money market management fees, and 4) collecting trading commissions. investment management company established in Investment Thesis 2008. He graduated from 1) High Quality Business Washington University in SCHW holds $2.5 trillion in client assets, > 4x more than TD Ameritrade and >8x that of Etrade. As a result, it is able to St. Louis summa cum laude spread the fixed costs of marketing, technology, branches, and call centers over a larger base of assets. Due to its scale with degrees in finance, advantage, SCHW can charge less per account than it costs TD Ameritrade and Etrade to maintain each account, while still economics, and accounting. managing to achieve 36% operating margins. This allows it to provide better services at lower prices, which creates a virtu- ous & sustainable cycle. SCHW is able to collect more assets, increasing its cost advantage, allowing it to provide even bet- ter services over time.

SCHW's cost of deposits are substantially lower than banking peers, including Wells Fargo, because its customers view brokerage cash as convenience cash. If they haven't simply forgotten about the cash build from dividends, interest payments, sold securities or matured securities, they want the cash available for the next time they decide to make an investment decision so aren't worried about transferring it out to make a few extra basis points. Currently, SCHW's cost of funds is 8 basis points.

As a result of its competitive advantages, SCHW has grown client assets from market share gains alone by ~7%/year for the last Daniel Rudyak ’17 15 years. Growth from market share gains Daniel is a first-year MBA was even higher in the earlier years, and has Feldberg Fellow at Columbia been positive every year. Since 1993, it has Business School. Prior to grown its share of investable wealth in the CBS, Daniel worked on the US from 2.5% to 7.5%. In addition, its exist- buy-side at Guggenheim ing assets tend to grow by ~60% of the Partners and on the M&A total return of the S&P 500. team at Houlihan Lokey. He graduated from USC We believe over the long-term SCHW can cum laude with a degree in grow client assets by a minimum of 7%/year finance. (3% from market share gains

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Charles Schwab (SCHW) — Long (Continued from previous page) and 4% from organic growth of existing client assets) and through operating leverage (expenses grew at a 2% CAGR over the last decade) can grow earnings by 10%+ annually, holding rates constant.

2) Money Market Sweep Opportunity Since the financial crisis, ~$70 billion in yield insensitive cash has built up in Schwab money market funds, where Schwab earns 17bps on cash. If that cash were instead on the bank balance sheet, Schwab would earn its 160bps spread. However, in order to move the cash to the balance sheet, Schwab must build $5 billion in equity on its balance sheet to maintain its targeted 7% leverage ratio. Schwab plans to retain future earnings to build that equity capital. We expect this will take less than five years. That alone will grow EPS by 48 cents/share. The ROIC on this balance sheet investment will be ~13%, with no risk. However, if interest rates rise, that ROIC will increase substantially as the 160bps bank spread could trend closer to the 2008 level of 367bps.

3) Free Option on Rate Rise In the last period of rate rises from 2004 to 2008, the Fed Funds rate rose from 1.4% to 5.0% and Schwab’s NIM rose from 2.1% to 4.3%. Based on end of year 2015 client cash balances, Schwab would be trading at 8x TTM earnings today if interest rates were at 2008 levels. Zero interest rate policy is responsible for Schwab’s currently depressed ROE, which is 42% below its 23 year average. Avg. Yield on Interest- Earning assets Fed Funds Rate 4) Free Option on Advice Growth Avg. Interest on Only $193 billion of SCHW $1,359 billion in retail client assets are ad- Funding Sources vised by a SCHW advisor. Advised assets have been growing by 15%/ year over the last five years as SCHW is making a large push into this area. Each additional $100 billion in advised assets generates $460 million in revenue (46bps fee for advice, on average). That translates to ~22 cents/share in EPS.

Valuation In the long run, we believe SCHW can grow by ~10%/year organically. It pays out about 1% annually in dividends based on todays purchase price. There- fore, We think the total return an investor can expect, giving absolutely no value to the money market invest- ment opportunity, the option on rate rises, and the option on advice growth, is ~11%/year.

If over the next five years, SCHW grows by 10% organi- cally, reinvests all earnings into the business for the money market sweep opportunity, and we get a 100bps increase in the Fed Funds rate (which is roughly the consensus), we think SCHW will earn ~$2.80/share. At 20x earnings (discount to past trading range), the stock would be worth $56/share. This would result in a 16% CAGR. We think that is highly attractive given the low risk nature of the investment and con- servative assumptions used.

Key Risks

Risks Mitigants Negative Risks Will customers take cash out Savers will always need brokerage accounts, and given Schwab’s scale advantage, if Schwab can’t earn of their brokerage accounts? a reasonable ROE for an extended period of time, nobody else in the industry can, so pricing in other areas will need to evolve to maintain a viable business model. Cyber Security What if Schwab’s customers This risk is pertinent for any financial institution. But Schwab’s scale allows it to spend more than financial data is compromised? competitors to defend against this risk. New Entrants What if competition / new Schwab’s scale has given it an edge in adjusting to new technologies, e.g. E*trade was 18 months technology enters the market? earlier to online trading, but Schwab just copied them and continued to dominate. Schwab was also

New Regulations What if new regulations re- Schwab is the most conservative bank in the industry and as a result, we expect regulators will treat duce Schwab’s ROE? it accordingly. It is still only 1/10ththe size of Wells Fargo, so does not pose the same risks to the financial system. To the extent our forecasts are correct and it grows the balance sheet significantly, minor tweaks to the business model will be a nice problem to have. Page 48

Advance Auto Parts (NYSE: AAP) - Long 9th Annual Pershing Square Challenge Finalist

Jordan Barron Nielsen Fields, CFA Noah Scherz [email protected] [email protected] [email protected] Recommendation We recommend a long on Advance Auto Parts Trading Statistics (AAP) with a price target of $280, offering 75%+ Jordan Barron ’17 upside from today’s price of $161 with desirable upside/downside dynamics (3.8x). We believe Jordan is a first-year MBA EPS can double to ~$16 over the next four to student at Columbia Busi- five years via multiple operational improvements; ness School. Prior to CBS, Jordan worked as an En- at 18x forward EPS – which contemplates zero gagement Manager at L.E.K. multiple expansion – AAP is worth $280 in 2019. Consulting, a global man- Return Expectations agement consulting firm. Business Description This summer he will be Advance Auto Parts is an aftermarket auto parts interning at AUA Private retailer serving the do-it-yourself (“DIY”) and do Equity in New York. -it-for-me (“DIFM”) market across a nationwide network of ~5,200 stores. The company oper- ates under four banners, Advances Auto Parts, Auto Part International, Carquest, and World- pac, the latter two being acquired in the Compa- ny’s 2014 acquisition of General Parts Interna- tional. Over the past several years Advance has underperformed relative to peers on multiple operational fronts for no structural reason. Activist investor Starboard is now catalyzing change and has brought in a new CEO with req- 2015 – 2020 Diluted EPS Bridge (Base Case) Nielsen Fields ’17 uisite experience to fully utilize the company’s Nielsen is a first-year MBA existing asset base to unlock significant value. student at Columbia Busi- ness School. Prior to CBS, Investment Thesis Nielsen was a Co-Portfolio 1) Strong Industry Tailwinds in a Highly Manager and Senior Ana- Fragmented Market lyst at Summit Global Man- Advance operates in an industry driven by agement, a long biased hedge fund. This summer strong secular tailwinds as the company benefits he will be interning at from growth in miles driven and longer lasting Headlands Capital in San cars (i.e., favorable vehicle age fleet dynamics). Francisco. The top three players in the space currently have a ~33% share of the DIY market and ~12% of the DIFM market and the fragmented landscape offers ample opportunity to consolidate competitors.

Vehicle Fleet Age 2) Operational Improve- Adam Xiao ’17 ment Opportunities are Lev- ers for Value Creation Despite favorable industry dy- namics, Advance has underper- formed relative to competitors O’Reilly (ORLY) and AutoZone Noah Scherz ’17 (AZO) in total shareholder re- turn over the past 10 years to Noah Scherz is a first-year MBA student at Columbia the tune of 350% and 400% re- Business School. Prior to spectively. During this time, Ad- CBS, Noah worked as an vance has seen market share loss on existing assets, lower margins, higher working capital needs and lower Associate at American organic new store growth resulting in lower overall and incremental ROIC’s and thus a lower market multi- Securities, as New York ple. We attribute this underperformance to a lack of execution on one key front, distribution capability. By based private equity firm. improving its supply chain proficiency progress in part availability, same store sales growth, margin, and work- This summer he will be interning at Surveyor Capi- ing capital efficiency should follow. tal in New York. i) Distribution Capability: In both the DIY and DIFM sales channels, the first question a customer asks is “do you have the part” and specific to the DIFM market “can you have it to me within 30 minutes”. If you are Page 49

Advance Auto Parts (AAP) - Long (Continued from previous page)

Advance you want to be that customers “first call” and get that part out to the customer as soon as possible. We believe O’Reilly is the leader in part availability due to nearly 100% of it’s stores receiving daily deliveries from its DC’s and HUB’s. The GPI acquisition in- creased the number of Advance DC’s from 12 to 50 and will enable the company overtime to achieve daily delivery similar to O’Reilly. ii) Same Store Sale Growth & Margin Improvement: The market has grown consistently between 2% and 5%; however Advance has seen lower comparable, and recently negative, same store sales growth due to missed sales opportunities from to a lack of part availa- bility. Operating leverage on negative sales has been a margin headwind. By improving its dis- tribution capability and thus part availability, Advance would begin to capture the natural low to Comparative EBITDAR Margins mid-single digit growth of the industry resulting in $2 of incremental EPS by 2020 at today’s mar- 650-750 bps gins. margin disparity

However we believe Advance has substantial room for improvement on today’s margins. Ad- vance’s EBITDAR margins fall between 6.5% to 7.5% below its competitors for no long term structural reason. The DIFM mix relative to O’Reilly – which has significant DIFM exposure – is minimal while independently owned stores account for ~250bps of the margin differential. Ad- vance will let these independently owned stores roll off over time. A 6% EBITDAR margin im- provement would add more than $6 of incremental EPS by 2020. iii) Working Capital Efficiency: Our final point on operational execution relates to working capital. Over the past 15 years, the large competitors have financed an increasing portion of their inventory through vendor financing. As the GPI acquisition is digested, leverage decreases, and same store sales increase, Advance should be able to drive AP-to-inventory higher and pull out roughly a $1b in cash while reinvesting organically in new stores. Importantly, with 100%+ AP-to-inventory, AutoZone and O’Reilly are effectively paid for growth, and improving working capital efficiency dramatically improves incremental ROIC.

We believe the new CEO, Tom Greco – known as an “operators operator”, supported by an upgraded board with supply chain and change management experience give Advance the highest probability of closing the operational gap to peers. Several conversations with PepsiCo board members confirmed that Greco is a strong operator, has experience running one of the most difficult supply chains in the world, and comes from an organization with a history of placing successful leaders throughout the retail industry.

3) Improving Unit Economics Can Supercharge Growth At current working capital levels, we estimate that the 5-year unlevered IRR for new units falls in the mid-single digits. However, if the company can achieve O’Reilly-like levels of inventory financing, these returns jump to the 30%-40% range. This dynamic can set off a chain of value creation whereby new units become more attractive, the company accelerates its store (1) growth, the earnings growth-rate accelerates, and Comparative P/E Multiples Comparative EV/EBITDAR Multiples the multiple rerates higher.

4) Great Business Selling at a Fair Price Since it’s recent selloff, the company trades at a steep discount to peers on both a P/E & EV/ EBITDAR basis. We believe a multiple rerating is possible and can contribute to additional upside. However, more importantly, we believe that the current discount represents a meaningful margin of safety for investors entering at the current (1) price level. Based on adjusted net debt, calculated based on 6.0x LTM operating rent expense

Valuation Based on multiple valuation methodologies and scenario analyses, we believe that Advance remains undervalued and offers an attractive risk / reward: In our base-case scenario, we believe that the company offers ~75% upside through 2019, equating to 16% IRR over 3.5 years. The resilient business model supports limited downside risk in our bear case, leading to a 3.8x upside / downside ratio. Im- portantly, significant possible upside from a multiple re-rating is not contemplated in our valuation analysis. Further, the opportunity ap- pears attractive given the multiple levers for value creation and the clear catalyst for change in the newly appointed CEO.

Key Risks Risk of e-tailing: Customers continue to prefer picking up in-store where they can interact with knowledgeable salespeople, even when they order online; hurdles are higher in the DIFM where retailers deliver to commercial customers up to three times per day - this is exceedingly difficult to replicate without a broad / distributed retail footprint (even for Amazon). Choice of CEO: The chief concern is that Tom is not an “auto parts guy”, however Pepsi Alums have been successful throughout the retail industry and former colleagues confirm Tom is a talented, blue collar operator which is exactly what Advanced Auto Parts needs. Page 50

Alcoa Inc. (NYSE: AA) - Long 9th Annual Pershing Square Challenge Finalist

McCoy Jen, CFA Austin Kim Audun Nordtveit [email protected] [email protected] anordtve-

Executive Summary 1) Robust margin improvement potential (the largest business line in the value-added segment, Arconic, has a 10% EBITDA margin lag relative to PCP, which features a similar product catalogue) McCoy Jen, CFA ’17 2) Misunderstanding of quality nature of Alcoa’s core businesses 3) Aluminum market may remain oversupplied, but alumina should be supportive (China will likely replace its high cost McCoy is a first-year MBA student at Columbia Busi- smelters, but China does not possess domestic bauxite supplies) 4) Security is currently significantly mispriced (Alcoa is spinning off Arconic in 2H16 and has not yet filed its Form 10) and ness School. Prior to CBS, McCoy worked at UBS, one can purchase the upstream business for free at current valuation

Brean Murray and Fidelity. Key Statistics Financial Summary He holds a BS in Finance and International Business from NYU’s Stern School of Business.

Investment Recommendation We recommend a long position on Alcoa with a 2018 price target of $16, representing 60% of upside to current valuation and a 19% IRR. Alcoa’s share price reached a peak of $17.60 in November 2014 but recent financial underperformance driven by the decline in aluminum and alumina pricing has led to investor flight despite a compelling split of the company in 2H16. On one side, a new standalone value-added company (Arconic) can leverage recent acquisitions and improve margins, Austin Kim ’16 while the upstream segment will be a pure play aluminum/alumina company investors get for free. Austin is a second-year MBA student at Columbia Company / Situation Overview Business School enrolled in Alcoa is an integrated upstream and downstream aluminum company. Its upstream business consists of bauxite mining, alu- the Value Investing Pro- mina refining and aluminum smelting. The bauxite and alumina business is structured in a 60% owned JV called AWAC, gram. Prior to CBS, Austin where the remaining 40% is publicly traded as Alumina Ltd. on the Australian stock exchange. The upstream segment ac- worked at and counted for about 50% of EBITDA in 2015, but the trend is curtailment of capacity and low capex into this capital intensive during this past summer, part of the business. The value added business (Arconic) produces rolled products, aluminum components for the road he interned at Invesco. He transport industry, and higher-end engineered products, mainly to the aerospace sector. The value-added business has been holds a BS from UC Berke- invested heavily into over the past two years, and is the new driver of growth for Alcoa. ley’s Haas School of Busi- Alcoa is spinning off Arconic in the second half of this year (the company is aiming to begin trading as two entities in 2H16) ness. and has not yet filed its Form 10, which will provide pro forma financial information for the separate business entities (AA is aiming to file the Form 10 in 1H16). The lack of visibility into segregated financial information and the difficulty of ascertain- ing even the most basic of financial metrics, namely ROIC, due to the opaque nature of consolidated financials are the sources of our contrarian view.

Investment Thesis 1) Arconic’s robust margin expansion opportunity: The Engineered Products & Solutions (EPS) division within Ar- conic has significant margin expansion potential with EBITDA margins running at 10% lower than those generated by PCP. We believe that a substantial portion of this gap is transitory and can be closed over time.

Audun Nordtveit ’17 Audun is a first-year MBA student at Columbia Busi- ness School. Prior to CBS, Audun worked at Norges Bank Investment Manage- ment. He holds an MS in Industrial Engineering and Technology Management from the Norwegian Uni- versity of Science and Page 51

Alcoa Inc. (AA) - Long (Continued from previous page)

2) Aluminum muddies the quality of AA’s core businesses: Our team completed numerous conversations with the top institu- tional shareholders of Alcoa and it was immediately evident that the average investor oftentimes quotes AA’s lackluster consolidat- ed ROIC as a proxy of the supposed “low quality” nature of the business. We believe that this is greatly unfounded and primarily driven by the value-destructive nature of the aluminum business. In fact, the core franchises of Alcoa are quality business generating returns in the low to mid teens. For Alcoa, Returns on Incremen- tal Invested Capital are more salient than ROIC (given that there is no split of debt and book equity by business unit in AA’s consoli- dated financials; this is the primary driver behind why top share- holders and the company themselves have not been able to articu- late an ROIC figure on a business unit level) and upon completing an analysis of the trailing 15 years, you can clearly see in the exhib- it to the right that the core franchises of Alcoa, EPS, GRP and Alumina generate robust ROIICs in the low to mid teens, while Aluminum has generated substantially lower returns of -20%.

3) Alumina business is quality asset: while aluminum pricing has collapsed, bauxite & alumina pricing have proven to be more resili- ent with China remaining a net importer of both materials. This is due to the lack of bauxite mines in China. Assuming no new re- serves are discovered, China’s current run rate will exhaust current proven reserves within 14 years. Additionally, given the export ban in Indonesia in 2014 along with the 3 month ban of bauxite in Malay- sia, Alcoa is well-positioned to continue to sell bauxite/alumina, due to operating in the bottom quartile of the cost curve (exhibit to the right; AWAC has invested into a JV, Ma’aden, in Saudi Arabia, which will operate as the lowest cost refiner in the world). Regardless of how aluminum pricing behaves, bauxite/alumina will remain a pre- cious input that China will need over the long term, which substanti- ates sell-side estimates of 5% - 7% demand growth in bauxite per year moving forward.

4) Valuation:  Sum of the Parts Valuation: we believe Arconic’s intrinsic value is ~$14. We valuate the upstream business at $2.1, which is ~$0.30 higher than AWAC’s publicly traded price. As a sanity check, we note that we have only ascribed $.30 to the aluminum business, which is easily exceeded by the replacement cost of its assets (replacement value is pertinent due to the fact that in our analysis, we have determined that the aluminum business has not been able to generate returns on capital above its cost of capital)  Base Case Returns: relative to current pricing of $10.01, our target price of $15.91 represents ~60% upside and ~19% IRR (2018).  Upside / Downside Ratio: our Upside Case yields a price target of ~$24 (+140%) and our Downside Case yields a price target of ~$7 (-31%), which implies a favorable Upside / Down- side Ratio of 4.5x.

Key Risks:

Potential sell-off of Upstream Co post spin-off for uneconom- ic reasons  Security is mispriced today due to lack of segregated financial information for the Upstream Co & Arconic (Form 10 will not be filed for another few months)  Post spin-off, we believe that the market will better appreciate the value of Arconic and have greater visibility into the underly- ing value of Upstream Co Page 52

Alliance Data Systems (NYSE: ADS) - Long 9th Annual Pershing Square Challenge Finalist

Simon Bennaim Deepak Prasad Nick Turchetta Adam Walder [email protected] [email protected] [email protected] [email protected]

Recommendation ADS is a BUY with a target price of $370 per share (~73% upside) assuming a P/ FCF exit multiple of 15x. A reasonable bear case yields 25% downside rendering an Simon Bennaim ’17 upside-to-downside skew of 3:1. Simon is a first-year MBA student at Columbia Business School. Prior to Business Description CBS, Justin worked as an Investment Alliance Data (“ADS” or “the Company”) is the leading integrated provider of pri- Specialist at J.P. Morgan. This sum- mer, he will be interning at XL vate label card services and marketing and loyalty solutions. Originally a card ser- Catlin. vices business, ADS has been transformed to a unique platform that seeks to en- hance end customer loyalty through a synergistic combination of three services- based businesses: private label credit cards (“Card Services”), marketing and data analytics (“Epsilon”), and loyalty solutions (“LoyaltyOne”), to a variety of a corpo- rate customers.

Having compounded revenue and earnings at a ~20% CAGR since 2007, ADS now generates more than $7 billion of revenue and $1.4 billion of pro forma 2016E EBIT. Its integrated network includes approximately 18,000 employees globally serving over 1,500 companies consisting primarily of large consumer-based businesses.

Revenue Contribution EBITDA Contribution

Deepak Prasad ’17 24% 18% Deepak is a first-year MBA student 44% at Columbia Business School. Prior to CBS, Deepak spent six years 26% 55% across venture capital, M&A, and IT 32% consulting.

Card Services Epsilon LoyaltyOne Card Services Epsilon LoyaltyOne

Investment Thesis 1) ADS has a sustainable competitive advantage via its fully integrated platform that should afford continued market share gains as customers seek end-to-end marketing solutions. Each of ADS’ segments are strong on a standalone basis and have grown in excess of industry as each is highly differentiated. Card Services offers private label cred- it card programs to smaller customers, primarily specialty retailers, with smaller receivables portfolios (average of $100mm). These retailers tend to lack in-house marketing teams and so, benefit from ADS’ data analytics and marketing capabilities. ADS’ cards are often the third or fourth credit card in a consumer’s wallet and as such, the consumer tends to maintain Nick Turchetta ’17 balances. As such, ADS generates very healthy fees and net interest margins on its receivables portfolios, as manifest by its Nick is a first-year MBA student at industry-leading return on assets (6.5% three-year average) and operating margins (36% three-year average). Second, Epsilon Columbia Business School. Prior to is the only end-to-end marketing and loyalty solution provider in the market. Epsilon has capabilities in all major segments CBS, Nick worked at Fidelity Invest- ments in global asset allocation. This including email marketing, customer loyalty, marketing database, customer engagement and agency services. Epsilon has summer, he will be interning at competition in each area but its one-stop solution resonates with companies’ chief marketing officers seeking one provider American Century Investments. for all marketing and loyalty needs. Finally, LoyaltyOne, which operates Canada’s leading coalition loyalty program, has domi- nant positioning in Canada with 70% household penetration and has fast-growing nascent operations in other markets such as Latin America.

That said, the real platform value is ADS’ ability to leverage transactional data to curate credit card programs and marketing platforms. Theoretically, every Epsilon client can be a Card Services client and having a customer embedded in both plat- forms creates a high level of stickiness. Currently there is 15% customer overlap between the two businesses but this figure should be able to appreciate meaningfully over time. Recent customer wins speak to the strength of ADS’ comprehensive model. For example, ADS won the contract to provide card services for Wayfair, an e-commerce retailer, Toyota, an inter- national auto manufacturer. Both clients were existing Epsilon customers and chose ADS’ Card Services given their satisfac- tion with ADS’ marketing efforts. E-commerce and auto are verticals to which ADS is underpenetrated. ADS should contin- ue to attack a larger addressable market by virtue of its strengthened integrated platform. Adam Walder ’17 Adam is a first-year MBA student at Columbia Business School. Prior to CBS, Adam worked in the private 2) Secular trends are moving towards private label credit cards from general purpose cards; the Company equity division at Allianz Capital should disproportionately benefit from these tailwinds given its data-driven marketing solutions. ADS’ sepa- Partners. This summer, he will be rate businesses have secular tailwinds that should drive top-line organic growth of over 10% over the next five years. Cus- interning at Stelliam Investment tomers are very focused on the shift from traditional marketing to data-driven targeted programs which are delivered by Management. Card Services and Epsilon. SKU-level data allows tailored advertising and promotions, which has yielded private label growth of 3x that of general purpose cards (e.g. 3% same-store sales at a retailer would translate to roughly 9% growth in private label card transactions). ADS is also picking up share gains as they are able to take on 12-15 new clients per year represent- ing an additional 10% organic growth. In the marketing segment, digital advertising is growing at a mid-teens CAGR and over

Page 53

Alliance Data Systems (ADS) - Long (Continued from previous page) time, digital spend should eclipse traditional spend. ADS has added capabilities, largely through acquisition, to be well-positioned in digital.

3) Management should continue to create value through savvy capital allocation. The management team at ADS is led by Ed Heffernan, a best-in -class CEO with an outstanding track record. Since Heffernan’s arrival at ADS in 1998, he has transformed the company from a singularly focused private label card services company to a full-service marketing solutions provider through several strategic acquisitions. Under his leadership, ADS ranks in the top 1% of S&P 500 companies in terms of shareholder returns, compounding at a rate of 21% p.a. since its IPO in 2001.

Heffernan has an incredible track record of accretive capital allocation, particularly during the last reces- sion. During the depths of the crisis, Heffernan instituted a massive repurchase program to take advantage of trough valuations and repurchased ~30% of the Company’s shares (see accompanying chart). These shares have compounded at an average of 22% p.a., creating tremendous shareholder value. Notably, Hef- fernan views the current environment as the most favorable since 2009 for repurchases and accordingly, has instituted a $1.0 billion buyback for 2016. With Heffernan at the helm, management should continue to create value through clever return of capital, including share repurchases and acquisitions.

To drive continued growth, management is focused on aggressive, but profitable growth. Heffernan is specifically targeting 8-10% top-line organic growth per year and 10% free cash flow growth per year.

4) The business model is defensible to withstand another recessionary environment. The current valuation already implies a bleak mac- roeconomic outlook. ADS has recently sold off to a 2.5 year low driven primarily by concerns related to its credit card receivables portfolio and is now trading at trough multiples such as 12.7x forward P/E, which is in line with credit card peers (despite ADS’ higher profitability) and well below multiples that its marketing services peers (e.g. Interpublic, Experian) enjoy. To this end, as ADS is composed of three businesses, the investor community tends to have issues appropriately valuing the Company; ADS occasionally trades at a premium like a marketing or fin-tech company and otherwise, at a discount like a credit-bearing institution. Currently, ADS has been given a valuation similar to that of a credit card peer and so, is not being given sufficient credit for its marketing and loyalty businesses.

However, ADS’ diversified business model provides downside protection. While Card Services is a pro-cyclical business closely tied to macro data around consumer spending, Epsilon and LoyaltyOne are generally non-cyclical and tend to grow during downturns as they offer fairly cheap alternatives to custom- ers seeking low marketing spend. With respect to ADS’ receivables portfolio, we stress-tested the Company’s balance sheet using charge-off levels generat- ed during the financial crisis, and concluded that the Company should be quite profitable even assuming elevated charge-offs. In fact, a 50 bps increase in net charge-offs decreases cash EPS by ~10%. Further, ADS maintains a fortress balance sheet, is conservatively levered and generates significant free cash flow. As such, there is a real margin of safety at the current share price.

Valuation Our $370 target price is based on a DCF using an exit multiple of 15x P/FCF (five-year historical average) and a discount rate of 10%.

Our projections assume sales growth of 12% CAGR through 2020 reflect- ing continued strong organic growth in Card Services, Epsilon and Loyalty- One and incremental cross-selling revenue capture. In Card Services, provi- sions are based on expected charge-offs of 5.5%, which should closely reflect normalized levels. There should be margin improvement at Epsilon via more favorable product mix, as its higher-margin digital agency business contributes a greater proportion of EBITDA. Finally, in line with manage- ment’s historical actions and guidance, the Company buys back $1.0 billion of common stock per year.

Our bear case valuation employs an exit multiple of 10.5x P/FCF and a discount rate of 10%. Sales growth broadly decelerates to 8% CAGR through 2020 attributable to increased competition. Provisions then corre- spond to expected charge-offs peaking at 9.3% as they did during the crisis. In this scenario, ADS’ pro forma share price is $158, which implies ~25% downside.

Key risk to thesis and mitigants (-) A macro-driven decline in consumer spending could yield elevated losses in the private label portfolio. Further, the market could then be difficult to access. Mitigant: Having stress-tested ADS’ receivables using recessionary charge-offs, the Company maintained significant profitability. We expect that a 1% decrease in consumer spending would have a 2% effect on ADS’ revenue. Also, generally consumer balance sheets and spending patterns are healthy and show little signs of deterioration. ADS was also able to access the capital markets during the crisis; 67%+ of its receivables funding are long- term. ADS has diversified its funding sources to be less reliant on ABS by using certificates of deposit.

(-) “Plastic cutting” in the U.S. could pose as a secular headwind in the card business. Mitigant: One-third of Card Services’ sales do not employ a physical credit card; 40% of credit sales are currently conducted online. ADS’ private label cards are compatible with applications such as ApplePay. Get Involved:

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Contact Us: [email protected] Graham & Doddsville Editors 2015-2016 [email protected] [email protected] Brendan Dawson ’16

Brendan is a second-year MBA student and member of the Heilbrunn Center’s Value Investing Program. During the summer, Brendan was an investment analyst at Thun- derbird Partners, a London-based global long/short fund. Prior to Columbia, he was a member of the investment team at the UVA Investment Management Company as well as an investment analyst intern at Slate Path Capital. Brendan graduated from The University of Virginia with a BS in Commerce. He can be reached at [email protected].

Scott DeBenedett ’16

Scott is a second-year MBA student and member of the Heilbrunn Center’s Value Investing Program. During the summer, Scott was an investment analyst at Maverick Capital, a New York-based long/short equity fund. Prior to Columbia Business School, he worked at Lightyear Capital, Citigroup, and Morgan Stanley. Scott graduated from Prince- ton University with a BA in Comparative Literature. He can be reached at [email protected].

Anthony Philipp ’16

Anthony Philipp is a second-year MBA student and member of the Heilbrunn Center’s Value Investing Program. During the summer, Anthony was an investment analyst at Blue Ridge Capital in New York. Prior to business school, Anthony worked as a private equity associate at Flexpoint Ford in Chicago, and before that as an investment banking analyst at Centerview Partners in New York. Anthony graduated from the University of Illinois at Urbana-Champaign with a BS in electrical engineering. He can be reached at [email protected].