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

Inside this issue: Issue XIV Winter 2012 Interview: P.1 Sam Zell — William von Mueffling — William von Mueffling “Going for “Financial Productivity At a Greatness” Discount” Interview: P.1 Michael Karsch William von Mueffling ’95 Interview: P.1 is President of Cantillon William Strong Capital Management, an investment firm with Interview: P.1 more than $8 billion un- Sam Zell der management. He was previously a Managing Di- Interview: P.2 rector at Lazard Asset William C. Martin Management, where he was responsible for hedge Student Stock P.44 funds. Prior to joining Pitches Sam Zell Lazard, he was with Sam Zell is Chairman of Deutsche Bank in (Continued on page 3) William von Mueffling Editors Equity Group Investments Anna Baghdasaryan (EGI), the private, entre- Michael Karsch — “Be an Editorialist MBA 2012 preneurial investment firm he founded more than 40 Not a Journalist” Joseph Jaspan years ago. Mr. Zell holds a Michael A. Karsch is the Founder bachelor's degree and a MBA 2012 and Portfolio Manager of Karsch J.D. from the University of Capital Management, LP Mike DeBartolo, CFA Michigan. (―KCM‖), a global long/short eq-

MBA 2013 uity investment manager located G&D: Could you tell us a little Jay Hedstrom, CFA in New York City. Mr. Karsch about your life growing up and founded KCM in July of 2000 and MBA 2013 what impact that may have had currently manages approxi- on your future career as an Jake Lubel mately $2.3 billion in assets investor and businessman? across several investment funds MBA 2013 and separately managed ac- SZ: I was born 90 days after Visit us at: counts. Prior to founding KCM, my parents moved to this (Continued on page 11) www.grahamanddodd.com (Continued on page 26) www0.gsb.columbia.edu/students/ Michael Karsch organizations/cima/ William Strong— “Outstanding Assets at Distressed Valuations” Mr. Strong and his partner Sean Fieler manage Equinox Partners, Kuroto Fund, and Mason Hill Partners. He began his investment career in 1970 with Ruane Cunniff & Co., manager of the Sequoia fund. In 1986 he started his own investment firm, Mason Hill, and in 1994 launched the global (Continued on page 19) William Strong Page 2 Welcome to Graham & Doddsville

We are pleasedvery pleased to present to pre- you Michael Karsch, founder and reer. We found Mr. Zell‘s dis- withsent youIssue with XIV Issue of Graham XIV of & Portfolio Manager of Karsch cussion of adapting and investing Doddsville,Graham & ColumbiaDoddsville, BusinessColumbia Capital Management, described through different business cycles School‘sBusiness studentSchool‘s-led student invest--led his firm‘s intense focus on con- particularly interesting. We also mentinvestment newsletter, newsletter, co-sponsored co- ducting thorough diligence and enjoyed learning about his innate bysponsored the Heilbrunn by the CenterHeilbrunn for finding a point of differentia- and consistent ability to recog- Pictured: Bruce Greenwald at GrahamCenter for & DoddGraham Investing & Dodd and tion, while evaluating compa- nize, and then capitalize on, the Columbia Student Invest- theInvesting Columbia and theStudent Columbia Invest- nies in a lifecycle framework. supply and demand imbalances ment Management Conference Student Investment Manage- Mr. Karsch also provided valu- in different markets that other in February 2011. ment Management Association. ment Association. able advice on the skills critical investors had overlooked. The Heilbrunn Center sponsors to becoming one of the best in the Applied Value Investing pro- TOO ADD We have been privileged once the profession and discussed Finally, we are pleased to intro- gram, a rigorous academic cur- Pleaseagain to feel speak free with to contact some of us if the thesis behind his firm‘s duce you to William C. Martin, riculum for particularly commit- youthe world‘shave comments most renowned or ideas investment in Viacom. an entrepreneur-turned- ted students that is taught by aboutinvestors, the newsletter.and are excited We to investor, whose highly successful some of the industry‘s best prac- hopebring you enjoya piece reading of their Graham wis- William Strong of Equinox investing record and unique titioners. &dom. Doddsville as much as we Partners reflected on his early background caught our eye. Mr. enjoy putting it together! career at renowned value in- Martin outlined his strategy of Famed investor William von vesting firm Ruane Cunniff, and investing in companies with -Mueffling Editors, Graham ‘95, a proud & Doddsville graduate the subsequent founding of his compelling growth prospects in of Columbia Business School firm. Equinox Partners‘ strat- conjunction with shorting some and chairman of the advisory egy of investing in high quality of the most overvalued and board of the Heilbrunn Center assets at distressed valuations corrupt companies. for Graham & Dodd Investing, in emerging economies has led shared with us Cantillon Capi- to many years of strong re- We deeply thank these investors tal Management‘s strategy of turns. Mr. Strong discussed for sharing their time and in- investing in companies with some of his current invest- sights with our readers. As high sustainable financial pro- ments in HDFC and Bunas always, we welcome your feed- ductivity. We found his discus- Finance. back or ideas about the newslet- sion of the different business ter. We hope that you find it to Pictured: Heilbrunn Center ―moats‖ particularly insight- We were thrilled to get a be as useful a source of informa- Director Louisa Serene Schnei- ful. Mr. von Mueffling outlined chance to speak with legendary tion about these great investors der at the CSIMA conference in the thesis behind his firm‘s investor Sam Zell, who shared as we do! February 2011. investments in Bank Rakyat, his investing philosophy and Louisa skillfully leads the Heil- Royal Vopak, Oriflame Cos- reflected on the path of his - Editors, Graham & Doddsville brunn Center, cultivating strong metics, and others. phenomenally successful ca- relationships with some of the world‘s most experienced value investors and creating numerous learning opportunities for stu- William C. Martin — “Think Like An Entrepreneur” dents interested in value invest- ing. The classes sponsored by Capital Management, an has also served on the the Heilbrunn Center feature investment firm he boards of CallStreet guest lectures by legendary in- founded in 2006. Prior (acquired by Factset vestors, and are among the most heavily demanded and highly to Raging Capital, he co- Research (FDS)), rated classes at Columbia Busi- founded a number of ByteTaxi (dba Folder- ness School. financial information Share — acquired by and media companies, Microsoft (MSFT)), and including Raging Bull in Salary.com (SLRY— 1997, Indie Research in acquired by Kenexa 2002, and InsiderScore (KNXA)). Mr. Martin William C. Martin in 2004. He served four attended the terms on the board of University of Virginia. Mr. Martin is the Chair- Bankrate (RATE) until it man and Chief Invest- was acquired by Apax G&D: How did you first ment Officer of Raging Partners in 2009. He (Continued on page 37) IssueVolume XIV I, Issue 2 Page 3

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(Continued from page 1) stayed in the US. these investors were doing Germany and France. really resonated with me. He earned a BA from G&D: What led to your Columbia College and move from the sellside to The overriding theme of an MBA from Columbia the buyside? value investing is buying a Business School in 1995. dollar for fifty cents and Mr. von Mueffling is WvM: I realized I loved therefore investing with a chairman of the advisory researching and investing in margin of safety. This prin- board of the Heilbrunn companies, but felt that the ciple is one of the most im- Center for Graham & job of the sellside analyst portant things I took away Dodd Investing at Co- was constrained in the from Columbia. It wasn‘t so lumbia Business School. sense that you typically had much about a particular a sector or small group of style or strategy, as there G&D: Could you tell us a companies to follow. I are many different styles little about your background found this boring and under the value investing ―We believe that and how you first became wanted to broaden the umbrella. there are many interested in investing? number of companies I fol- lowed. I recognized that G&D: Can you talk about different types of WvM: I was very lucky the only way I was going to your specific style of invest- because between my junior make the jump from the ing at Cantillon? moats to be and senior years at Colum- sellside to the buyside was bia College I interned at to get my MBA. This is how WvM: One can broadly found, and that a Shearson Lehman Hutton in I ended up at Columbia divide value investing into investment banking. After Business School. two camps. The first camp moat around a doing that for the summer I is the Graham & Dodd style realized that there was G&D: What do you think which is buying assets at a business should nothing more miserable you got out of your time at discount or cash at a dis- than doing it for two years Columbia Business School count. The second camp is allow it to pro- as an analyst, so I thought that made a difference later the Buffett style, which I about other areas of finance in your career? characterize as buying finan- duce outsized that would be interesting, cial productivity at a dis- margins and won- and research jumped out at WvM: I got much more count. We fall into the sec- me. I didn‘t want to do it in out of business school than I ond camp. We believe that derful returns on New York City, so I ended ever thought I was going to there are many different up doing research with get. There are two main types of moats to be found, capital. The trick Deutsche Bank in Frankfurt. areas where I really im- and that a moat around a In the early 1990s working proved. First, I gained an business should allow it to is being able to in sellside research in understanding of business produce outsized margins Europe for a German bank cycles. I had read a lot and wonderful returns on buy this stream of was not considered a glam- about business cycles in the capital. The trick is being orous job, but it created a past but my own under- able to buy this stream of cash flows at a great opportunity for me. standing of them really de- cash flows at a discount. No one in my office wanted veloped during business Unlike Graham & Dodd discount.‖ to cover any stocks outside school. Second, a real ―light investing where you might of Germany, so at a very -bulb‖ moment for me was look at low price-to-book young age I was able to do taking Bruce Greenwald‘s value companies or net-net research on big companies value investing class and companies, we are trying to that were listed in Europe. hearing some of the best buy high financial productiv- To be able to write, publish, investors in the world ity at a discount to its intrin- and meet executives so speak. Things started to sic value. early in my career was a click for me in terms of de- unique opportunity, which I veloping my own style of G&D: Can you talk about would not have had if I had investing. What many of (Continued on page 4) Issue XIV Page 4

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(Continued from page 3) returns on capital and very some of the companies you high visibility. What is inter- Then there are a group of own and the moats that esting is that both Bank companies where the moat make them attractive? Rayat‘s and Vopak‘s moats is a network. Names we are based on significant tan- own in this area are Right- ―…the best place WvM: Bank Rakyat is an gible assets, yet they still move, the leading property Indonesian bank that has have very high returns on website in the UK and to be in high-ROE one of the highest ROAs for equity. Not all high ROE OpenTable, the dominant a bank in the world because restaurant reservation web- investing is in it specializes in micro lend- site in the US. OpenTable ing. If you think of Indone- ―What is interest- is a destination website names that are sia and the geographic area without physical assets. that you have to cover, mi- ing is that both One of the things happening neither super- cro lending means going to on the internet now is that outer islands and remote Bank Rayat’s and verticals are being owned by expensive nor su- parts of the country. Bank dominant portals. People Rakyat has several thousand Vopak’s moats are do not go to multiple web- per-cheap, where small offices, often as small sites for things like travel, as a kiosk, in such remote based on signifi- dinner reservations, and real the market has a locations. Such a network estate. If there is a domi- would be very hard for a cant tangible as- nant portal then there is a hard time trying company like Citibank to winner-take-all phenome- replicate. This is a huge sets, yet they still non. For example, Priceline to figure out what moat that results in high is the dominant portal for returns on capital. In Indo- have very high re- travel in Europe. Similarly, the right price is. nesia today, just having the Rightmove ―owns‖ real es- infrastructure for a business turns on equity. tate in the UK. The This is where the is a huge moat. It may not stronger these portals get, be forever, but it is today. Not all high ROE the bigger the network ef- best investing re- fect and the higher the prof- Another company we own businesses are like its. turns can be is Royal Vopak. Vopak is the world‘s leader in the ours in asset man- G&D: The Graham & made.‖ storage of liquids at termi- Dodd vision of investing in nals. Finding the space for agement where underfollowed, obscure these terminals and getting companies might say that all of the regulatory approv- you have few as- the companies you look at als is a long and complicated sets. You can have are over-followed and that process. In addition, multi- there are too many eyes national companies that are great returns if looking at them. How do shipping highly volatile you think about this? chemicals or gas want to your physical asset work with reputable compa- WvM: The true cigar-butts nies. The terminals that is truly unique.‖ and underfollowed compa- Vopak owns or has long- nies in the classical G&D term leases on represent a sense are now few and far huge moat that is hard to businesses are like ours in between. You can‘t manage replicate. Vopak is global asset management where a large amount of money and can offer terminals all you have few assets. You and play in that space, and I around the world. This can have great returns if would argue that you can enables the company to your physical asset is truly earn very good returns in have extraordinarily high unique. (Continued on page 5) Page 5

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(Continued from page 4) moats and a very low multi- screening prospective it the space that we play in. ple for high-ROE businesses makes sense to use all of Our job as analysts is to that have structural issues – the tools that are out there. spend the entire day asking neither of these places is But when we set our price ourselves: ―what do we get the best area to search for targets on companies, we and what are we paying for ideas. Rather, the best use PE multiples because, at it?‖ There is a reason why place to look is in the mid- the end of the day, we are large cap pharmaceuticals dle of the pack and to figure equity investors and we are trade at low PE multiples out which of these compa- valuing businesses based on and a reason why Ama- nies is mispriced. the earnings a company can zon.com trades at a very deliver. Even if we are high PE multiple. We all G&D: Do you tend to use looking at a company that Pictured: Benjamin Graham. have to work very hard for price-to-earnings multiples has temporarily depressed our keep. The market un- earnings, we will still be derstands the strengths and ―… when we set pricing it off of the potential weaknesses of various com- earnings power. panies. You have to pay our price targets more for a company with a G&D: Could you illustrate great moat. Tano Santos, on companies, we that with an example? Columbia Business School‘s David L. and Elsie M. Dodd use PE multiples WvM: Oriflame, a manu- Professor of Finance and facturer and marketer of Economics, has done some because, at the cosmetics, has been in exis- great work on high-ROE tence since the 1960s, so investing recently. His work end of the day, we there is a long-term operat- indicates that the best op- ing history that we can look portunities are not in the are equity to in order to gain some high-ROE companies with comfort. This is a perfect the lowest PE multiples – investors and we example of a company these companies usually where there is a disconnect have some structural prob- are valuing between what you get and lem such as a lack of what you pay for. The com- growth, or in the case of businesses based pany‘s share price is the large cap pharmaceuticals, same as when it went public patents that are expiring. on the earnings a in 2006 despite the fact that Tano‘s work suggests that sales and profits have grown the best place to be in high- company can and the company is in more ROE investing is in names markets now than it was that are neither super- deliver.‖ then. The company has expensive nor super-cheap, suffered from three things where the market has a more than others? Is this that have not been in their hard time trying to figure how you screen for new control. First off, Russia out what the right price is. ideas? accounts for approximately This is where the best in- 30% of their sales. They vesting returns can be WvM: For cyclical compa- manufacture their products made. This is where we are nies and turnarounds, price- outside of Russia, and there- generally most successful to-sales is a much better fore there is a currency finding opportunities. What ratio than price-to-earnings. mismatch between part of typically happens is that the Using price-to-book multi- their revenues and costs. market pays a very high ples makes sense if you are This has hurt their margins multiple for fast growing looking at companies that in the past few years as the companies with the best are losing money. From a (Continued on page 6) Issue XIV Page 6

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(Continued from page 5) tion to its brand. G&D: When investing Russian Ruble has been overseas how do you think weak. But the company is G&D: Some investors have about the risk foreign gov- now taking steps to address discomfort investing in di- ernments might pose to this issue by building pro- rect selling companies given companies you own? duction capabilities in Rus- the high rep turnover char- sia. Second, the Russian acteristic of the industry and ―You also have to market for cosmetic prod- multi-level marketing ucts has been weak this past scheme. What would you remember that your year. Lastly, the company say to the critics? benchmark is the Columbia Business School is a was kicked out of Iran, a leading resource for invest- country which accounted WvM: In the senior levels United States, a ment management profession- for only 1.4% of sales. This of these organizations, gen- als and the only Ivy League spooked investors, although erally there is little turn- country with huge business school in New York given the repressive regime over. The most senior reps City. The School, where value in Iran, this should not have are very loyal to the com- problems. We were investing originated, is consis- tently ranked among the top been so much of a surprise. pany. The high turnover recently looking at Oriflame‘s multiple has his- occurs with the lower-end programs for finance in the torically been quite high as reps, typically because a lot Thai banks, though we world. the company is perceived as of them are buying the an emerging markets products for themselves. don’t own any, and we growth company given that There are a few reasons it is the leading player in that investors do not like compared Thailand to Indonesia, Russia, and India. the direct selling model in the United States on a The market has historically the US. First, it is in a secu- paid a high multiple for the lar decline in the US. Direct piece of paper. If I company, so you didn‘t have selling has historically been a margin of safety. But to- an emerging markets busi- covered the names day, you pay only 10x earn- ness – as the market gets and asked you which ings for the company. You more mature, people go to don‘t have to put a high a store to buy things. Sec- country would you multiple on those earnings ond, if you look at the com- to have a lot of upside. Ad- panies listed in the US, would rather invest in, ditionally, the co-founder of every so often one of them the company recently took will blow up, which has you would be shorting 8 million euros of his own tainted the overall industry. the US and going long money to buy shares, and In emerging markets like other members of the ex- India and Indonesia, direct Thailand. Thailand ecutive team also bought selling may be the only way shares. This is the type of that many people have ac- has a current account situation we look for – a cess to these products. So I company with a very de- differentiate between direct surplus, full pressed share price, but selling companies in the US employment, low which has a leadership posi- and in emerging markets. tion in a number of emerg- Part of the reason that Ori- inflation, and other ing countries and therefore flame is so cheap right now solid and sustainable earn- is that mainly Western in- advantages.‖ ings power going forward. vestors own the name, and Oriflame‘s moat is in the 3.5 their judgment has been million reps that promote clouded by US companies WvM: There is no black and sell the company‘s that have had issues. and white answer. It mat- products each day, in addi- (Continued on page 7) Page 7

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(Continued from page 6) live in today is very different and therefore the company ters what country you are from the world 20 years has been a great investment in, what‘s the domicile of ago. for us despite the fact that the company, how big the the Spanish business has company is, and a whole G&D: How does your been stagnating. Part of the macro view shape how you reason that high ROE invest today? strategies have had more ―The single biggest difficulty in recent years is WvM: The single biggest that there are plenty of high thing that has thing that has changed from ROE companies that are changed from when I when I started my investing primarily exposed to the career to today is that the West and cannot grow. started my investing macro environment has enormous risks that are ―Going to the pond career to today is now coming to a head. As a result, I think that there are of low ROE stocks that the macro many more value traps to- day. Until the financial cri- is like going to the environment has sis, every company seem- ingly was growing. In the pond with only one enormous risks that aftermath of the credit bub- ble and in the years ahead, fish. You may get are now coming to a one thing we can say with some confidence is that we lucky and catch head. As a result, I will not have much growth that one fish, but think that there are in the West for some time. If a company has a lot of why would you many more value Western exposure, you have to be able to explain ever waste your traps today.‖ why they are going to grow even if Western growth is time doing it. A low zero. OpenTable and host of other factors. You Google don‘t need Western ROE business will also have to remember that growth to be bigger compa- your benchmark is the nies five years from now, do poorly over United States, a country even though both are pri- with huge problems. We marily exposed to Western time in the stock were recently looking at economies. Another per- Thai banks, though we don‘t fect example is a Spanish market so we don’t own any, and we compared security service company Thailand to the United called Prosegur that we bother looking at States on a piece of paper. have owned for many years. If I covered the names and Prosegur‘s management it.‖ asked you which country realized about ten years ago would you would rather that to be able to grow, it G&D: How do you feel invest in, you would be needed to expand outside about situations where the shorting the US and going of Spain and began making founding family is a major long Thailand. Thailand has the right investments. To- shareholder in a company? a current account surplus, day its cash-in-transit busi- full employment, low infla- ness has leading position in WvM: I think it depends tion, and other advantages. many Latin American coun- who the founding family is One of the things we can‘t tries and is growing rapidly, (Continued on page 8) forget is that the world we IssueVolume XIV I, Issue 2 Page 8

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(Continued from page 7) to the pond with only one and how involved they are. fish. You may get lucky and WvM: It is different with There are some great com- catch that one fish, but why every company. Since we panies, such as chemical would you ever waste your know who the high ROE company Wacker Chemie time doing it. A low ROE companies are around the based in Germany, where business will do poorly over world, we try to visit them the founding family is heavily time in the stock market so and talk to them over time. involved. I don‘t think you we don‘t bother looking at Take Oriflame for example Pictured: Tom Russo at CSIMA can make a general state- it. Sure we will miss the – we have met with them Conference in February 2011. ment about founding fami- low ROE companies that many times over the years lies. We own a company, become high ROE compa- although we only recently Aalberts, where the foun- began investing in the com- der, Jan Aalberts, refuses to pany. Even if we don‘t in- allow any of his children to ―The most vest with some companies work for the company. He initially, we get to know the thinks that if you have your common mistakes different industry players children work in the busi- well, and knowledge accu- ness then it‘s not a meritoc- that people make mulates over time. racy. in high-ROE G&D: Can you talk about G&D: How does Cantillon your sell discipline? maintain large global cover- investing is age with a small team of confusing high WvM: In high-ROE invest- analysts? Are your analysts ing your time horizon really sector specialists or general- operating margins should be infinite. The fan- ists? tasy is that you never ever and high ROEs sell any of your holdings. If WvM: Our analysts are a company generates very generalists. The problem with a moat. If it high ROEs and does good with specializing in sectors is things with its cash flow that you tend not to have smells like a such as reinvesting in the your eyes open to other right projects or buying sectors. We don‘t have to commodity back stock, they will con- cover the world of stocks tinually grow earnings. for our strategy; we only business but the Your price target, which have to follow the world of you base on next year‘s high-ROE stocks. We do returns are higher earnings, will always be in- not own McDonald‘s, but than a commodity creasing so you will reset given that it‘s a very high- your price target and con- ROE company, we have a business, it is likely tinue to hold the stock. price target on it. For us The poster child for this is there is no point in follow- still a commodity Swedish Match, a company ing low-ROE companies, as which I first invested in it is a fact that low ROE business.‖ 1995 at Lazard Asset Man- companies will underper- agement, and later when I form the stock market over nies, but we would waste a founded Cantillon. It has time. It is like if you are substantial amount of time been one of the most amaz- going fishing for the day and trying to find these compa- ing stocks in Europe during there are two ponds, one nies. that time. The multiple that is stocked full of fish never gets higher than 17x, and the other has one fish in G&D: What is your dili- but every krona of free cash it. Going to the pond of gence process like? (Continued on page 9) low ROE stocks is like going Page 9 ―The next big trended opportunity will be being short U.S. government William von Mueffling

(Continued from page 8) with the returns generated one of the competitors goes to buying back shares. by a company and failed to started to go after market They have actually had to pay attention to the nature share by cutting prices and change the rule in Sweden of the business. There used the whole industry just col- on having negative equity as to be three listed companies lapsed. This is one of the a result of Swedish Match‘s that made sausage casings: reasons that we work on share repurchases, because Devro in the UK, Viscofan ideas in teams at Cantillon – Pictured: Howard Marks, key companies weren‘t allowed in Spain, and Viskase in the we don‘t want to fall in love note speaker at CSIMA con- to have negative equity. So US. Devro had 40% operat- with returns. ference in February 2011. that‘s the fantasy that you ing margins and generated will never have to sell these unbelievable ROIC, and the G&D: Has your strategy of stocks. The reality is that focusing on high return companies do get to be too ―I call our companies changed during expensive. The best exam- your investing career? ple of this is Coca-Cola. In portfolio today 1999 or 2000 it traded at WvM: The one thing that 60x earnings – if you bought the ―dream team has changed is that we keep it then you haven‘t done too raising the bar around what well even though over that of high ROE constitutes a good company. time Coca-Cola has grown I remember one time I met sales and earnings. The PE investing‖ because with the chairman of Hunter multiple has gone from 60x Douglas - a great company at the peak down to where it consists of some that manufactures window we bought it at 13x. We blinds - and he asked me have price targets for all of of the best moat about our strategy. I told our companies and we say him that we invested in high that we hope we never have businesses in the -ROE businesses like his. to sell any of our compa- He asked me what a good nies, but as companies ap- world.‖ ROE was and I told him proach our price targets we 15%, and he responded that sell them and put proceeds market for sausage casings a minimum ROE for a great into names that are far away was highly consolidated. company was 20%. Over from their price targets. When I first looked at it I time, we have come to be thought it was a commodity more in tune with his way G&D: Can you talk about business that was not diffi- of thinking. I think that some common mistakes cult to replicate. I hopped there are enough amazing that investors tend to make? on a plane and went to companies out there where Glasgow to take a factory you can create a portfolio of WvM: The most common tour and learn how sausage 60 names with an average mistakes that people make casing is made. What I ROE in the mid-20% range. in high-ROE investing is learned confirmed my pre- I call our portfolio today the confusing high operating sumptions – this is a simple, ―dream team of high ROE margins and high ROEs with easy business. Still, I walked investing‖ because it con- a moat. If it smells like a away thinking that the com- sists of some of the best commodity business but the panies had such incredible moat businesses in the returns are higher than a margins because this was an world. commodity business, it is oligopoly and convinced likely still a commodity busi- myself this was a good busi- G&D: Are there any situa- ness. Mistakes I‘ve made ness because the returns tions where focusing on have been situations where I were so good. Very shortly ROEs can be misleading? have not adhered to this after we invested in Devro, (Continued on page 10) advice and I‘ve fallen in love Issue XIV ―The next big trended opportunity will be being short U.S. governmentPage 10 William von Mueffling

(Continued from page 9) being smart and having an WvM: If it was just about MBA, there would be a lot WvM: ROE can be mis- of great investors. So there leading if the ROE is not ―If someone tells must be some other quality sustainable. Technology can that is necessary to be a disrupt an ROE. At the you that ―we buy great investor. I think that same time, you can have quality is good judgment. industries that go from low eyeballs‖ and that a An analyst needs the judg- ROE to high ROE through ment to determine that consolidation. A good ex- stock is cheap businesses, moats, and man- ample of this is the US alu- agement teams may not be minum can industry, which based on price to as good as they seem. The was highly fragmented in the eyeballs, ask the problem is that this is a very early 1990s. The industry tough thing to interview for. went through rapid consoli- question ―is buying dation during the 1990s G&D: Any parting words until there were two main something based on of wisdom for our readers? players remaining, Ball Cor- poration and Rexam. ROEs eyeballs a valid WvM: Only follow back- went from very low levels testable investment strate- to roughly 20% after the investment gies. If someone tells you consolidation. However, strategy?‖ The that ―we buy eyeballs‖ and for every example like this I that a stock is cheap based can give you another where great news is that on price to eyeballs, ask the an industry goes through question ―is buying some- consolidation but the return all of the successful thing based on eyeballs a profile does not improve. valid investment strategy?‖ The way many companies investment The great news is that all of destroy high ROEs is the successful investment through making expensive strategies are strategies are known and acquisitions. Heineken‘s known and haven’t haven‘t changed since the core business is an amazing efficient market hypothesis one, but in the late 1990s changed since the was first put out there. The and early 2000s, it was pay- problem is that many firms ing very high multiples for efficient market don‘t pursue these strate- many low-quality brewers. gies, and that these strate- This drove Heineken‘s ROE hypothesis was first gies require a lot of pa- down and destroyed share- tience. When you see so holder value. All of the put out there. The many mutual funds with companies we own throw problem is that 100% turnover, you know off a ton of cash, so you that they are not following a have to know what manage- many firms don’t robust strategy. Most im- ment is going to do with it. portantly, find someone that We spend a lot of our time pursue these you enjoy working with. getting comfortable with And read a lot. what management will do strategies, and that with the cash their busi- G&D: It was a pleasure nesses generate. these strategies speaking with you, Mr. von

require a lot of Mueffling. Thank you for G&D: What makes a great your time. investment analyst in your patience.‖ mind? Page 11 Michael Karsch

(Continued from page 1) called Timberland, and for resume to Chieftain Capital. Mr. Karsch was a Manag- the first time I was able to The three main principals at ing Director at Soros marry my own personal Chieftain were all Columbia Fund Management and view on the stock with MBAs. I was very excited was one of four invest- some of the more system- about joining Chieftain be- ment professionals at atic valuation techniques cause, unlike many hedge Chieftain Capital Man- that I learned in investment funds at that time, it was agement. Mr. Karsch banking. With Timberland, I structured to really teach an began his career as an noticed it had been more of analyst. At Chieftain there investment banking ana- a suburban brand but that it were ten stocks and four lyst at Wasserstein Per- was increasingly gaining people, and I felt like it was ella & Co. Mr. Karsch traction among urban kids a great way to get an educa- graduated Phi Beta as well. I realized this could tion. I stayed there for Kappa with a B.A. from breathe new life into the three years and afterwards Michael Karsch Tufts University in brand. At the time the got an opportunity to work 1990. He obtained his company wasn‘t making at Soros Fund Management Master of Arts in Law much money but I saw its for two and a half years ―Sometimes you and Diplomacy from potential. I started spending before starting my own Fletcher School of Law a lot of time checking out fund. learn things and Diplomacy in 1991 their shelf space at places and obtained his M.B.A. like Foot Locker, cold call- G&D: Could you tell us explicitly... and from Harvard Business ing the company, etc. I about a few of the key School in 1995. ended up paying for busi- things that you learned other times you ness school with profits along the way? G&D: Can you tell us a bit learn things from that investment as the about how you got inter- stock went from about $14 MK: Sometimes you learn implicitly, just ested in investing? per share to $80. I remem- things explicitly, such as ber running in between being told something by a through MK: As a teenager, I started classes at Harvard Business colleague, and other times investing in gold. This was School calling the Charles you learn things implicitly, experience. My during a very volatile time in Schwab phone number to just through experience. the late 1970s, and I proba- find out where Timberland My education involved both education involved bly did all of the wrong was trading. A bunch of my of those things and the key analysis, but it worked both of those classmates and family then is figuring out how to prop- out…and then it didn‘t ended up owning Timber- erly integrate them. Chief- things and the key work out. But the experi- land because of my re- tain taught me that you have ence got me hooked in search. I was really hooked to figure out what your is figuring out how terms of thinking about at that point. point of differentiation is. how to make money in the They felt their point of dif- to properly markets. Subsequently, I At business school, I got to ferentiation was to know started reading about and hear Seth Klarman speak. I their names better than integrate them.‖ following some stocks. At had been more interested in anyone else and have a lot the time I probably didn‘t ―Growth at a Reasonable of discipline. Most of all, have the right reasons for Price‖ investing up to that what they taught me is that investing in these stocks, point, but Seth‘s emphasis you need to know your but nevertheless I thought I on value investing with a stocks cold. We‘d sit down had a method for it. Later, margin of safety made a lot to lunch together and they‘d my investment banking ex- of sense. Seth actually ask many questions, like perience at Wasserstein asked me to interview, but I ―What‘s the growth rate in Perella & Co. helped to for- wanted to be in New York, this company been the last malize my opinions about so he graciously sent my (Continued on page 12) stocks. I found a company Issue XIV Page 12

Michael Karsch

(Continued from page 11) investor until they start los- ing money.‖ Once you start three years? What‘s the living through volatility, you trend in margin? What‘s the ―Simplistically at understand what that ROE? How will they be able means. People have in their to expand that ROE going Karsch Capital Man- own mind how they would forward? What is the com- agement, we seek to like to see themselves as an pany‘s competitive advan- investor, but often this view tage?‖ So I learned from invest on the long side isn‘t consistent with the them that there‘s a method- duration of their capital or ology to analyzing and think- in stocks which are their own temperament. ing about stocks. And I For instance, everyone think sometimes people ascending the lifecy- wants to be Warren Buffett. forget that – they just want cle and short stocks But very few people have to talk instinctively without the temperament, the stom- a methodology behind it. which are descending ach for the investment dura- Having this methodology tion, the capital, or the con- clear in my mind made me the lifecycle. Our viction of Warren Buffett. more thorough and objec- Mike Tyson has a similar tive in analyzing different area of greatest quote that I like: ―Everyone investments. has a plan until they get strength has been to punched in the mouth.‖ So What I learned later from invest on the long side those are just some exam- Stan Druckenmiller at Soros ples of the many things I‘ve Fund Management was to be in stocks which might learned. more creative, to think about the industry before be classified as value G&D: Could you talk a bit the company, and to be about the lifecycle of invest- more thematic, because and GARP and to ing approach that you write stocks are not just a mathe- short stocks which are about in your letters and matical exercise. There‘s a how that applies to the whole group of people who either ―broken mo- checklist that you use in just focus on how cheap a evaluating companies? company is, and there are mentum‖ or ―value others who gravitate to MK: The lifecycle of invest- finding a ―great company.‖ traps.‖ Our area of ing is a framework that In my own view these things discomfort lies in in- states that markets, indus- are relevant, but they‘re tries, companies and stocks hugely overestimated. From vesting (long or short) typically move through 5 Stan I learned to think more stages over time. These creatively about a secular in momentum stocks, stages are: 1) distressed, theme and then how to fit it discarded and/or undiscov- into the overall systematic primarily because ered, 2) value, 3) growth at way of thinking about com- a reasonable price (GARP), panies that I learned at these stocks and busi- 4) growth, and 5) momen- Chieftain. Then over time, nesses attract and en- tum. The lifecycle analysis you learn many life lessons. and an appreciation for a I keep some of these notes courage speculation company‘s evolution on a board in my office to through the cycle often lead remind me of them all the which overrides tradi- us to ask whether a com- time. Stan used to say, pany will be perceived as tional analysis.‖ ―Everyone‘s a long-term (Continued on page 13) Issue XIV Page 13

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(Continued from page 12) this means for our exit an innovator, an imitator, or better (up the cycle) or strategy. an idiot? As an example, worse (down the cycle) over when activist investors first a reasonable investment ho- The key is figuring out what pitched Deutsche Börse, rizon. Simplistically at your point of differentiation they spoke about manage- Karsch Capital Management, is with each idea. Are you ment change, cost cuts and we seek to invest on the long share repurchase. All of Pictured: John Spears of side in stocks which are as- these initiatives were in- Tweedy, Browne Company at cending the lifecycle and ―The lifecycle frame- triguing to value investors, CSIMA Conference in February short stocks which are de- especially because the stock 2011. scending the lifecycle. Our work is premised on traded at less than 12x for- area of greatest strength has ward FCF. The stock had been to invest on the long microeconomics, re- already appreciated by the ―Apple is the ulti- side in stocks which might be flexivity and human time we analyzed the Com- classified as value and GARP pany, so we pondered mate lifecycle and to short stocks which behavior. Determin- whether we could still find a are either ―broken momen- point of differentiation. We stock. We started tum‖ or ―value traps.‖ Our ing where an invest- concluded that existing in- writing about our area of discomfort lies in vestors understood the cost ment resides in the investing (long or short) in cutting and capital allocation interest in the momentum stocks, primarily story being pitched, but lifecycle is more art because these stocks and were not focusing on the company almost businesses attract and en- than science and re- revenue growth story. In courage speculation which other words, investors saw seven years ago, overrides traditional analysis. quires debate about Deutsche Börse as a solid The lifecycle framework is company, but not a growth and we talked premised on microeconom- which variables are company. We have followed ics, reflexivity and human Chicago Mercantile Ex- about what a great behavior. Determining most relevant. So, change since its IPO and we where an investment resides strongly believed in deriva- opportunity there in the lifecycle is more art when thinking about tive exchanges as strong than science and requires the lifecycle, we con- secular growth businesses. was for the iPod if debate about which variables Therefore, we believed in- are most relevant. So, when sider who is on the vestors would reward it addressed the thinking about the lifecycle, Deutsche Börse by allowing we consider who is on the other side of the it to move up the lifecycle market that Sony’s other side of the trade and to GARP and growth. Tim- what their argument is. We trade and what their berland was another exam- Walkman had ad- ask ourselves why the stock ple of the importance of is trading at its current price, argument is. We ask understanding where a com- dressed.‖ whether it can be impacted ourselves why the pany is in the lifecycle as by reflexivity in any way, well, as people thought whether we expect an accel- stock is trading at its things were going very badly eration or deceleration when for them and were bearish it comes to earnings beats, current price, on the company, but in fact and whether this is consis- the brand was being revital- tent with where we think the whether it can be ized. There were a number company is in the cycle. Fi- of mini lifecycles going on nally, we try and think about impacted by reflexiv- within the company, but its how far in the lifecycle each ity in any way ...‖ cycle ended on an upswing company can go and what (Continued on page 14) Page 14 Michael Karsch

(Continued from page 13) their profit. And Priceline get rich figuring out because Nautica took them has around a $25 billion whether Porter‘s five forces ―Just identifying over. Now, related to look- market cap! fit into a given company or ing at where a company is in not. The value-add is on great companies the lifecycle, we use our Another example is Apple. the editorial side. You be- checklist to evaluate all of Apple is the ultimate lifecy- come a superstar by devel- with large moats the components of the busi- cle stock. We started writ- oping and using your own ness, the industry, the man- ing about our interest in the judgment, rather than what around them isn’t agement team, potential company almost seven years textbooks tell you, to figure catalysts, valuation, and ago, and we talked about out what‘s a great stock and enough. In my many other factors. what a great opportunity why. You can start by iden- there was for the iPod if it tifying and learning from opinion, you’re a G&D: Given that you focus addressed the market that great stock pickers. Obses- journalist in that a lot on mid-cap and large- Sony‘s Walkman had ad- sively try and figure out cap stocks, do you still find dressed. At that time, you what they‘re doing. And it‘s case and you will many companies that are in were basically getting the not just, ―oh, I‘m going to the earlier stages of the company for cash, and the follow XYZ investor, and do probably be a lifecycle? And does a com- iPod presented optionality exactly what he does.‖ You pany like Priceline fit the for the company. The big have to try to understand solid role player, bill? debate around Apple now why they are investing in a is: could a technology prod- particular company and not a superstar. MK: Priceline is a fantastic ucts company really be what their point of differen- example of a lifecycle stock. worth $700 billion to $1 tiation is. ... You become a It was a 1999 darling. Eve- trillion dollars? Or, is it just ryone thought that they trading at 10x earnings? G&D: How do you think superstar by were the geniuses of the You could argue that many about the macro picture world. They had this inter- of the financial companies in these days? developing and esting notion of how to do a 2009 represented lifecycle reverse auction. It turns opportunities. MK: We certainly have to using your own out that there was a very take the macro picture into limited niche for it and the G&D: At Columbia we are account in our thinking, and judgment, rather CEO was a big spender who taught to look for compa- that‘s disappointing because got reckless. We started nies with sustainable moats that‘s not what is most fun than what looking at it again when the around the business. But to me about the business. stock had declined almost you tend to be more of a The fun for me is finding a textbooks tell ninety percent from its ―growth at a reasonable creative new idea and realiz- peak. The attraction of the price investor.‖ How do ing that the company has you, to figure out company at that point had you try and blend the two transformed but the market to do primarily with its large together? hasn‘t caught onto the what’s a great NOLs, with optionality on transformation yet. Unfor- the operating business, MK: I‘ve always asked, "Do tunately, in this type of envi- stock and why.‖ rather than any good oper- you want to be a journalist ronment you need to give ating metrics. The company or an editorialist?" Just extra thought to all of the subsequently got rid of the identifying great companies issues affecting the invest- old CEO, was able to turn with large moats around ment landscape. For the the business around, and them isn‘t enough. In my first time, I‘ve considered buy Bookings.com for about opinion, you‘re a journalist hiring a macro analyst who $300 million. Bookings.com in that case and you will could help synthesize all of was a phenomenally suc- probably be a solid role the data points that are af- cessful acquisition, as it now player, not a superstar. I fecting the markets. I don‘t represents two thirds of don‘t think you‘re going to (Continued on page 15) Issue XIV Page 15

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(Continued from page 14) ployment rate is already rary respite because the know when all of this focus pretty high, so how much state of many foreign on the macro issues relating higher can it really go? economies is so poor that to the US recovery will end. There are a lot of other plenty of capital is coming The recovery has been so areas, like housing starts and towards the U.S. dollar. weak that any improvements auto sales, where it‘s start- Four years from now, it seem like a big deal. Are we ing to feel now that we‘re could be very different. on a sustainable path to re- operating at more of a base covery, or not? What will level. The only question is: G&D: Could you talk about the impact of the presidential some of the common errors election be? There are elec- that you see young analysts tions all over the world this ―I think analysts make? year. There is a new regime coming in China. I never spend too much MK: Well, one thing we fully understood what people already talked about is that meant by kicking the can time building mod- too many analysts just try to down the road, but when define a ―good company‖ or you look at the U.S., we‘re els and being my- ―bad company‖ without just growing our deficit every opic in that regard taking a more sophisticated year. So while corporate view. Too many analysts balance sheets look better and they don’t have not experienced a lot and such, is all of this super- of failure and can be ill pre- seded by the fact that our spend enough time pared to deal with it. They debt to GDP keeps growing? have incentive to convince It‘s hard to know. trying to take a themselves that they are doing great and avoid con- G&D: Your fund significantly broader perspec- structive, objective feed- outperformed your peers back. Good analysts realize back in 2008. Are you seeing tive. That’s why we you have to fail and have issues in the macro environ- setbacks in order to eventu- ment that are similar to that try to stress focus- ally succeed. Most of the time, and if so are you posi- people I know who are suc- tioning your fund defensively? ing on an industry cessful have a great deal of perseverance, and they MK: The current U.S. pic- before a specific learn from their problems. ture does not feel like 2008. company.‖ Most analysts are too For one thing, the jobs pic- money-focused early-on. At ture seems to be improving. Chieftain, I knew I would be Credit has not gotten worse, do we have a looming time giving up plenty of money which is a big difference. The bomb that will eventually compared with some of my banks are better capitalized manifest itself in some way friends who went to other and rail volumes are going like in Italy? We all want to places. But that job was up. During 2008, the stock believe that our debt mar- worth an enormous amount market was still going up and ket is safe because the US to me. A lot of young ana- up but the rail volumes had 10 year Treasury yield did- lysts have no idea how to fallen off a cliff and no one n‘t go up even with the rat- behave in a performance seemed to care. Capacity ing downgrade in August review, and they often focus utilization now is at a level 2011. The temptation is to on a very small amount of about where we were right say that these things won‘t money rather than seeing before the collapse of Leh- happen. But we may just be the big picture. This tends man Brothers. The unem- in the middle of a tempo- (Continued on page 16) Issue XIV Page 16

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(Continued from page 15) like right now and why? the various threats are real, to alienate people who but they are hitting Viacom would otherwise become MK: We started buying at a rate of 1% or at most their mentor. Some analysts Viacom stock in the high 2% per year, and I‘m not aren‘t good at managing up- thirties. We believe it is in convinced it‘s going to ac- ward and aren‘t skilled at the value stage of the lifecy- celerate dramatically in the cultivating relationships with cle. People have made the next five years. You can people who are senior to assumption that cable pro- already see Netflix having them. Good analysts show a gramming isn‘t a great busi- some problems with their desire to continuously learn. ness anymore because there model in terms of the busi- Professional athletes are isn‘t much room for pene- ness not scaling as much as amazing continuous learners tration for multi-channel they expected. You also and are so much better at distribution in American have some people who are ―Good analysts show that than stock pickers, and cable. Viacom doesn‘t have worried about advertising yet, the education level of a tremendous international and things like ratings. Rat- a desire to continu- the stock pickers is supposed business either, although ings at Nickelodeon right to be exponentially greater that existing business is now are weak and people ously learn. Profes- than the athletes. growing. People are wor- extrapolate that kids are sional athletes are ried that multi-channel too busy playing on their G&D: With all the data out penetration will actually iPads and therefore don‘t amazing continuous there and all the reading ma- decrease over time due to watch Nickelodeon. I tend terial, what do you ask ana- Netflix, or better antennas, to think ratings just bounce learners and are so lysts to focus on and what do or people moving into their around. When ratings are you tell them to avoid? parents‘ home. Some be- bad, people make up ex- much better at that lieve that the cable opera- cuses and reasons for why MK: I think analysts spend tors or Congress will come that will persist, but I think than stock pickers, too much time building mod- up with an a la carte service, it just fluctuates. In terms and yet, the educa- els and being myopic in that meaning that you won‘t of advertising, 35% of cash regard and they don‘t spend need to buy 50 channels all flows come from predict- tion level of the enough time trying to take a at once. Instead, you could able subscription fees. Yes, broader perspective. That‘s decide to just buy Disney there could be some volatil- stock pickers is sup- why we try to stress focusing and MTV. Some think that ity in the advertising, but the on an industry before a spe- unbundling would kill the impact on cash flow won‘t posed to be expo- cific company. This has be- business model since not be dramatic. The changes come a more complex busi- everyone wants all of these that are taking place now, nentially greater ness over time. It used to be other channels. This has like Netflix, etc., won‘t than the athletes.‖ enough for a professional been brought on by the fact really dent the free cash football player to be over that everyone is basically flow. So, the perception 300 lbs or a professional paying $7 or $8 per month and reality are quite differ- basketball player to be over for ESPN. So, obviously, if ent. 7 ft. Now you have to be 7 you‘re not a sports fan and ft. and fast, or 300 lbs and it‘s a tough economy, that The company has also said quick. Stock-picking is the sounds terrible. But the they are going to redistrib- same way. You need to be reality is if a la carte hap- ute $20 billion in free cash very good with the computer pens, it will be many years flow back to their investors and going through the docu- from now. These compa- over the next five years. ments but you also need to nies have five year contracts This basically means $2.5 be creative. with cable operators. billion in dividends and These contracts actually call $17.5 billion in buybacks. G&D: Could you talk about for price increases, not So you‘re talking about a a particular name that you price decreases. Netflix and (Continued on page 17) Page 17 Michael Karsch

(Continued from page 16) ter. We think there is still of the growth in free cash company that is basically value in the MTV and Nick- flow that I expect. If you go buying itself back over the elodeon brands. Maybe the to a 10x multiple on that, next five years. Despite the industry will go to a la carte the stock is a triple or quad- buyback announcement, the pricing like what‘s happened ruple, with optionality for a stock is flat. So people ei- in the music industry. In takeover. So I just look at it ther don‘t think that free this industry, however, you and I think people are mis- cash flow will come guided and myopic in terms through, or they are being of worrying about the short too myopic… I don‘t really ―Great analysts term ratings. know what their reasoning is. My view is, if advertising see bumps in the Right now they actually Pictured: Marty Whitman, gets worse and cash flows benefit to a degree from Adjunct Professor, Heil- go down, they will have less road as sources of Netflix because Viacom brunn Center for Graham cash for buybacks but they owns Paramount. All of & Dodd Investing, at Gra- will buy back a similar per- pride and those shows and movies ham & Doddsville breakfast centage of shares because they‘ve licensed to Netflix in October 2011. the stock price will be necessary have actually provided some lower. I actually think the very nice cash flows. One free cash flow will grow situations because could say, well what hap- from $2.5 billion to $3 bil- pens if that cash flow stream lion to $3.5 billion over the they understand from Netflix goes away? If next five years. In five that goes away then by defi- years, if the stock is flat, you that this is a nition Viacom‘s core busi- will have a company with a ness must likely be still market cap of $7.5 billion business where the thriving. I‘m not saying that down from $25 billion be- the business won‘t change cause of all the repurchases. best-case scenario ten years out, but investing At that point, the market is a probability business, and would be saying that they is that they’ll be in my opinion, the probabil- will only generate $700 mil- ity of their cash flow going lion in free cash flow when I right 60% of the down by half to two-thirds think they can generate $3 over the next five years billion or so. Therefore, time.‖ instead of going up by 30% there‘s an incredible margin is very low. I haven‘t heard of safety. still have contracts in place a realistic, convincing argu- for five years, and you don‘t ment yet as to how that will You could say, well, if the even know if they‘ll be able happen. stock goes higher they to do an a la carte scheme won‘t be able to repurchase after five years. There are G&D: In our remaining all of those shares. But plenty of forces fighting moments, could you finish that‘s fine. In that case I‘d against it. Finally, a lot of the following sentence? A just sell the stock and make people still watch Nickelo- great analyst… a nice profit. If the price deon and MTV. It‘s not as if doesn‘t rise, you‘re talking everyone is paying lots of MK: A great analyst is a about a stock that in five money for these channels continuous learner. A great years is probably trading at and not watching them. In analyst knows how to get 2.5x P/E. Maybe the world terms of a status quo view, the best out of everyone will be different at that let‘s say that the company they work with. There‘s a point. Maybe it will be has flat free cash flow over tendency for analysts to say, worse, maybe it will be bet- the next five years instead (Continued on page 18) Page 18 Michael Karsch

(Continued from page 17) and be that famous? It is his takes in order to win. ―That investor is so great! choice, and he is willing to I have chosen this industry I‘m going to do what they‘re overcome whatever pain it where the pain is acceptable doing‖ and they look solely for me. That is not to say at outcomes instead of using that this is an easy business. their own brain. In other There is rejection from the words, ―don‘t worship false ―A great analyst market, from clients, from gods.‖ A great analyst rec- peers. I‘ve taken whatever ognizes that this is a men- recognizes that pain I‘ve needed to for 16 toring business and actively years in a row now in order seeks out mentors in order this is a mentoring to continually grow and to become successful. They business and persevere, because this is also understand it‘s a non- my equivalent to his foot- linear progression business. actively seeks out ball. But my impression is When an analyst under- that most young people stands that, they‘re able to mentors in order have a sense of entitlement. think about their game plan They‘ve been told how very differently. They un- to become great they are by their par- derstand that the market is ents. They‘ve gotten into a always improving and their successful. They great school, and then a skill set needs to also. You great business school and can‘t just rely on investment also understand they think that everything banking exercises or Por- will come their way. I think ter‘s five forces to help you it’s a non-linear people felt that way when truly understand what‘s the economy was doing going on at a company. progression great. Factset just said they Great analysts see bumps in lost subscribers for the first the road as sources of pride business. When time in their history. and necessary situations There‘s a high probability because they understand an analyst that the world is only going that this is a business where to get tougher than it has the best-case scenario is understands that, been for the last ten years. that they‘ll be right 60% of I haven‘t seen young people the time. they’re able to change their attitude to reflect this more difficult G&D: Any parting words think about their environment, and I already for our readers? felt they weren‘t tough game plan very enough to face the previous MK: In order to be good at environment. To be good anything, you need to figure differently. They in this business, you must out how and where you can carefully cultivate the im- absorb pain. I have a friend understand that portant relationships that who is a professional foot- will get you to where you ball player. I always say, ―I the market is want to go. To be success- don‘t know how you are ful, you have to be resilient. willing to be tackled by 300 always improving pound people.‖ But he feels G&D: Thank you very that football is where he is and their skill set much for your time Mr. at his best. Where else Karsch. would he be able to make needs to also.‖ the kind of money he makes Page 19

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(Continued from page 1) decided that markets were friend of Warren Buffett.‖ long/short hedge fund perfectly efficient and these At the time, I thought to Equinox Partners. classes were a total waste of myself: ―Who is Warren Mr. Strong graduated everyone‘s time. But the Buffett? I‘ve never heard from Williams College Graham and Dodd approach that name before.‖ I with a BA in Economics to investing made sense to worked at Ruane Cunniff in 1971 and received his me. To make a long story for seven years and then I MBA from Harvard started my own business in Business School in 1979. ―We were drawn to 1986.

G&D: When did you first businesses that had Bill Ruane had taken Benja- become interested in invest- min Graham‘s course in ing? strong competitive business school and had met positions and Buffett while in school. So WCS: When I was ten Ruane had something like years old, my mother be- sustainable, high the Buffett approach to William Strong longed to an investment value investing, which I club. I talked about invest- returns on capital. would define as preferring ing with her and soon de- better quality businesses cided I wanted to buy a We spent most of and managements and will- stock. My uncle suggested ing to pay a bit more for that I buy one share of our time analyzing them. We were drawn to Blackwell Oil & Gas Co. So companies’ businesses that had strong I did… and then it went competitive positions and bankrupt. That was the competitive sustainable, high returns on beginning of my investment capital. We spent most of career. positions and if they our time analyzing compa- nies‘ competitive positions I‘ve always been interested could generate high and if they could generate in investing as well as his- high ROEs for a long period tory and economics. I ROEs for a long of time. That‘s the basic earned a degree in econom- period of time. orientation of how I started. ics from Williams College. One of the first things I After a brief stint in the That’s the basic worked on at Ruane Cunniff Army, I worked as a munici- was Ginnie Mae bonds yield- pal bond underwriter for orientation of how I ing 18%. Those were the Loeb Rhoades & Co. This days of the 15% 30yr non- was in the early 1970s when started.‖ callable treasuries. We also interest rates went up a lot looked at high quality US and New York City de- short, a small New York companies. I remember I faulted on its debt. So I had value investing firm, Ruane worked on Gillette and an interesting initial experi- Cunniff, was looking to hire tried to figure out if 7x ence in the financial mar- somebody out of our busi- earnings wasn‘t cheap kets. I went back to busi- ness school‘s investment enough. Ruane wanted me ness school and they actu- class, and they hired me. to focus on big name US ally taught Graham and That job opportunity turned stocks when I started. I Dodd investing at Harvard out to be possibly the lucki- moved from there onto Business School for a week. est thing that‘s ever hap- smaller cap US stocks as This was probably the last pened to me. I remember well as some European year they ever did that be- interviewing with Bill Ruane companies in the latter part cause, of course, they then and recall him saying, ―I‘m a (Continued on page 20) Issue XIV Page 20 William Strong

(Continued from page 19) recently promoted Daniel of the 1980s. Gittes, who‘s been at Equi- G&D: Could you describe ―So we’re looking nox for seven years, to join the types of businesses you for companies that G&D: Could you talk Sean and me as a Portfolio target for investment? about your style of value Manager. We have 7 ana- have a strong investing and what you lysts who are generalists yet WS: What we‘re really focus on today? have focused industry ex- trying to do is find busi- franchise and a pertise as well. As you can nesses that have a sustain- WS: At Equinox Partners imagine, this kind of work able competitive advantage. strong competitive we apply the Graham style requires a lot of travel: we Bruce Greenwald talks about the power of a fran- advantage. And, in chise. He talks about how the last 10 or 15 only businesses that can invest sustainably at high years, we’ve come returns are adding value when they grow. That‘s a to understand and really good point. We‘ve seen lots of companies that appreciate that if have grown while destroy- you have such a ing value. So we‘re looking for companies that have a franchise in the strong franchise and a strong competitive advan- context of growth – tage. And, in the last 10 or 15 years, we‘ve come to maybe not understand and appreciate William Strong at a CSIMA conference in Feb’2011 that if you have such a fran- specifically in a of buying businesses each travel about two chise in the context of cheaply but with a prefer- months a year and in total growth – maybe not specifi- growth business but ence for better quality see about 1,000 companies cally in a growth business in the context of businesses. What we‘ve a year, though not all are but in the context of done over the years is to unique visits. We think growth, which takes us to growth, which takes take that approach global. we‘ve met and monitor the emerging markets – After looking at Asian some of the best businesses then you have a really pow- us to the emerging companies and resource and managements in the erful investment. The com- companies in the ‘90s, the world and our team is con- bination of a strong fran- markets – then you last step in our develop- stantly on the hunt. chise that generates high ment was in 2008 – when returns on capital and the have a really we made a big foray into We do two other things, possibility of reinvesting a powerful Brazil and in Asia after the which I‘ll mention briefly. large portion of retained world fell apart. At this One is short-selling, which earnings and cash flow back investment.‖ point our scope is basically almost put us out of busi- into that high return fran- the whole world. We look ness in the ‘90s because we chise is a fabulously valuable everywhere to find out- were short during the tech business. That‘s really what standing businesses and bubble. The other thing we‘re looking to find. managements that are we‘ve done is take on a really undervalued. In large exposure to precious G&D: Don‘t these great terms of our investment metals because for a long businesses trade at higher team and process: in addi- time we have been con- multiples? If so, how do you tion to my partner of 17 cerned about the value of get comfortable as a value years, Sean Fieler, we‘ve fiat currencies. (Continued on page 21) Page 21 William Strong

(Continued from page 20) Equinox, we make a tre- know them well and we investor investing in these mendous effort to try to actually have owned some businesses? understand where corrup- of the same positions. tion is, how it works and They‘re helpful in that they WS: Most of the time they how to avoid it. Corruption can help us see the local do trade at higher multiples, is a big problem, not just in landscape from the ground but we are getting paid to emerging markets, but eve- level and they know the find such businesses that are rywhere. people and their back- attractively priced. Rick grounds. We have brokers Cunniff used to call it an G&D: In these emerging locally that we‘ve known for ―Easter egg hunt‖. They‘re economies, do you tend to 15 or 20 years. We know a really hard to find. Some- utilize partnership struc- few brokerage firm research times you find a really great tures or other arrange- folks here and there that business that‘s buried in can help us. Additionally, these other businesses that managements of companies aren‘t so great. Sometimes that we‘ve known for years you find a really great busi- ―We try to look ten will opine about other man- ness in a country that‘s out agement teams. There‘s a of favor. Sometimes you years down the lot of work that needs to be find a really great business in done but we‘ve got a long a bad environment, like road… we’re really record and a pretty good 2008, where investors had a trying to look at the set of relationships now that lot of great opportunities. helps us sort through a lot There are a number of ways structural trends in of this. in which we can find these paradoxes, where you have the country and in G&D: What is one aspect a great asset that‘s selling at of your investment process a really low valuation. Obvi- that business, which that distinguishes you from ously, this doesn‘t happen other firms? very often, so when it does, will help translate we try to buy as many the investment into WS: I think one thing that shares as we can and own distinguishes us is our long- them for a long period of success.‖ term investment horizon. time. That‘s the nature of We try to look ten years the challenge we‘re faced down the road. That trans- with. We‘re trying to find lates into a four to five year outstanding assets at dis- ments to position you bet- holding period. For in- tressed valuations. ter? stance, there‘s a tech com- pany in India that we have G&D: Given the impor- WS: We‘ve been investing met with several times. The tance of emerging markets in emerging markets for a CEO of this company said to your investment strategy, long time – we first went to after one of our more re- are you concerned about Asia in 1994. We‘ve been cent meetings that, based on corruption? going to Brazil for ten years. some of the questions we We‘ve developed relation- had asked, it reminded him WS: I have some bad news ships in a lot of places, some very much of their last for you. Corruption is eve- of which are with other board meeting. Whereas rywhere. It‘s a little more investors. For example, we some other managers may sophisticated in Europe, and have a good relationship have a two or three year if you go to Washington, it‘s with a small value invest- outlook, or maybe even not a pretty picture. At ment firm in Sao Paulo. We (Continued on page 22) Issue XIV Page 22

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(Continued from page 21) in the shareholders‘ well- issues or themes. We are next quarter as an outlook, being. The ROE for an av- global investors but, with we‘re really trying to look at erage Western company few exceptions that have the structural trends in the over the years has been been painful, we‘ve stayed country and in that business, around 12-13%. Now, if away from Japan. which will help translate the you look at the ROEs of investment into success. Japanese companies since On the other hand, we have Fortunately for us, our in- 1928, it‘s 400-500 bps be- gone to India, which offers vestors understand and low that of the Western businesses that have pro- Pictured: Professor Roger agree with our long-term companies. The last 20 duced much stronger re- Murray and investor Robert Heilbrunn with their wives, perspective. years have particularly been turns compared to compa- Agnes Murray and Harriet a disaster for Japanese com- nies in Japan. This is not to Heilbrunn. G&D: Could you talk panies. What‘s shocking is say India doesn‘t have its about some of your major that you had these compa- problems. It has lots of successes over the years? nies with very low profit problems: big, political prob- margins and extremely low lems. But in India, you have WS: Another thing that a company like Sun Pharma- we‘ve done really well is ―...we apply over- ceutical, which is growing at meld together good com- 15-25% per year and gener- pany-specific, bottoms-up arching themes to in- ating net cash while growing research with a thematic that fast! We don‘t own overview of what‘s going on vestment ideas while Sun, but this is a great busi- in the world. For example, ness in an environment we‘ve owned precious met- being very focused on where you can reinvest in a als since the late ‘90s based business with really high on the idea that there are finding good bar- returns. So we apply over- major financial imbalances in gains. We narrow arching themes to invest- the world that are not being ment ideas while being very addressed. Those imbal- down the set of the focused on finding good ances will ultimately cause bargains. We narrow down stress in the financial system universe of stocks. the set of the universe of and that should take gold stocks. About 95% of the from the depressed levels of About 95% of the uni- universe we don‘t even the late ‘90s to much higher bother to look at. We‘re levels. So we‘ve had success verse we don’t even really trying to find great with gold mining stocks and bother to look at. businesses that are cheap. gold itself over the last dec- ade, although that theme We’re really trying to G&D: How would you didn‘t work in 2011. define ―cheap‖? find great businesses One of the other major WS: We look at P/E ratios, successes we‘ve had is to that are cheap.‖ Price/Book, EV/EBITDA – avoid places in the world we use many valuation tech- that are just problematic to ROAs leveraged six or niques. We‘re trying to find invest in. We spent a lot of seven to one. That‘s three businesses that we think can time over the years looking or four times what the lev- generate 15-20% returns, so at Japanese companies and erage ratios would be in the one can work backwards had a really difficult time US or in Europe. This is a from the valuation to see if getting comfortable with business model we‘re not a particular investment managements. They just comfortable with. We think would translate into that don‘t seem to be interested about these types of large (Continued on page 23) Page 23 William Strong

(Continued from page 22) 2.25%. Their reputation is screen out people who type of return. In a rapidly very strong – because their wouldn‘t qualify – they pro- growing business, one can service is so good people file all potential applicants pay a double digit multiple are happy to pay them 10 or based on profession, his- and still enjoy a 20% return. 20 bps extra on a mortgage. tory, and where they come We look at all these metrics They seek to match the from. They know the kind and then think about what durations of their assets and of applicants they want and we can expect to earn from liabilities and thus avoid the don‘t even take applications this business if it continues ―borrow short lend long‖ from anyone else. So they to operate as it has been game that many of their have virtually no loan losses operating. peers play. The company whatsoever. In 2008, when ―Everyone else has done extremely well on the subprime mortgage cri- G&D: Could you share its operational and credit sis hit the US, HDFC didn‘t hates volatility, but some specific ideas with our risk management side. have an asset problem. readers that you find com- They had funding problems volatility is our pelling? HDFC has an unbelievably as the capital markets froze low cost-to-income ratio of up, but they had almost no friend. We like WS: We own an Indian 7.7%, whereas most banks loan losses. HDFC also company called HDFC. It average 40%-50%. They are tries to minimize their inter- volatility.‖ has been in the mortgage incredibly efficient. Assets actions with each customer. origination business for a per employee have grown One way they do this is long time. It is a very suc- from $500,000 in 1990 to through agreements they cessful company and gener- $18,600,000 today. Em- have with large employers ates 20%-plus returns on ployee count has slightly where the employers allow equity. With financial com- more than doubled in the HDFC to take an em- panies in general, it‘s hard same time frame. Average ployee‘s mortgage payment to create a competitive ad- loan size is very small at from a paycheck before the vantage because interest $40,000 per mortgage and employee even sees the rates are what they are and loan losses are four basis money, or they accept post- demand for money is what points since inception! The dated checks from borrow- it is. HDFC has grown its low costs translate into an ers once at the beginning of mortgage book by 24% per incredibly high ROE. HDFC the mortgage. year over the last ten years has such a good operating and they‘ve grown their ratio that we are always HDFC is a company that has earnings and book value at trying to figure out how been growing at a nice clip 20% for the last ten years. they are able to do this. My for a long time. Rapid We‘ve owned this company partner Sean Fieler was in growth does not exist for- on and off for five or six India a few years ago and ever, but one of the nice years and we‘ve known for met with the senior general things about emerging mar- a long time that the manage- manager for their Mumbai kets is that there is a long ment here is key. The man- region, who explained to fairway before the slow- agement has developed a him how they get these low down point. This contrasts very low operating cost costs. The company ap- with America where a com- business. They have a na- proves something like 99% pany can only enjoy a rapid tionwide network of of all loan applications. growth phase for 3-5 years. branches and have a bank They figured out years ago Mortgages as a percentage subsidiary that they use to that they wasted time and of GDP in India have grown help originate mortgages. money rejecting people, so from 4% to 9% in the past They borrow money in the they only let people apply four years, and I would marketplace and price their who they will accept. They guess could likely grow to mortgages with a spread of have all these ways they (Continued on page 24) Issue XIV Page 24

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(Continued from page 23) trucks, minibuses, motorcy- as an investor? 30% before growth starts to cles and Jeeps, are generally slow down. used for productive pur- WS: It‘s a two-sided coin. poses, which makes bor- If you have a perfectly effi- G&D: Emerging market rowers more likely to pay cient market, where busi- stocks tend to be volatile. back the loans because they ness values are always re- ―In our mind the How do you explain to your need the vehicle to run flective of business funda- investors that volatility isn‘t their business. Most of the mentals, then we are out of relative risk always bad? underwriting effort is spent business. If you have a per- evaluating the borrower and fectly imperfect market, equation has WS: Everyone else hates the borrower‘s business where the stock market volatility, but volatility is our rather than the collateral – never reflects fundamentals, changed a lot of friend. We like volatility. agents are sent out to as- then we are out of business. We had sold HDFC in late sess the borrower‘s busi- Markets generally value fun- in the last few 2007 when the valuation ness and its cash flow. damentals properly. Our had gotten rich, but HDFC There is not much competi- job is to find exceptions to years, but it still declined along with the mar- tion from large banks be- this and take advantage of it. ket in 2008, so we were cause the banks cannot un- This is what value investing has a way to go. able to buy back the shares. derwrite like this, so Bunas is all about. HDFC is owned 70%-80% is able to earn very high Emerging equities, by foreigners, so the panic interest rates on their as- G&D: How many positions selling in 2008 was due to sets. Competition consists do you hold and what is the at the valuations international fund managers of pawn shops and loan geographic breakdown? selling the stock. If we get sharks. Blended net interest that we see today another bad period in the spread is currently around WS: We have 51 long po- market, we could see a simi- 9.3%, which is huge. Be- sitions, 14 of which are in of high-single digit lar situation with the stock. cause the collateral is hard the mining space. Our prin- to value and the process is cipal operating business and low-double Another idea we really like messy, management main- holdings are in Brazil, India, right now is a small finance tains a very conservative Indonesia, and other emerg- digit P/Es, are very company in Indonesia, Bunas balance sheet. Bunas has a ing markets. We don‘t own Finance, started as a JV with negative duration mismatch anything based in the US attractive.‖ Manufacturers Hanover – in other words, their as- and have a few small posi- Corporation, formerly a sets mature quicker than tions in Japan and China. NYC-based bank. The sen- their liabilities. The com- Russia and China have been ior management has been pany has virtually no lever- difficult for us to get com- with Bunas for a long time age – banks are often lever- fortable with management and has a solid track record. aged 12 – 15x and other teams, though there are The business has very big financial companies are lev- exceptions. Russia also has spreads because the under- ered at 5 – 7x. Bunas is some bad demographics. In writing process is very diffi- only leveraged at 2x. So China we have a hard time cult to duplicate, as they they are able to generate trying to understand why a lend money to small busi- very high returns – 20%+ business is like it is and ness owners using collateral ROE – without using much where it came from. We‘ve which other finance compa- leverage. seen similar things in Russia nies consider imperfect: – one company we looked used cars and motorcycles. G&D: Given the fact that at has a majority owner It is not hard to value a new the business had been grow- who is Vladimir Putin‘s judo car, but oftentimes it is diffi- ing but that Bunas‘ stock partner. We try to avoid cult to value used vehicles. was flat until approximately these types of situations. These vehicles, consisting of a year ago, was it frustrating (Continued on page 25) Page 25

William Strong

(Continued from page 24) uries are trading given the last. On the short equity side we amount of debt that the US have very little right now. has? G&D: What do you look Where we see a real asym- for when hiring an analyst? metry of risk/reward is sov- WS: We are not only sur- ereign debt. We are short- prised, we are short treas- WS: One of the things that ing low-yielding sovereign uries, so we are losing is really important is the debt in developed markets, money. The irony of the ability to think independ- Pictured: Panelists Mario which is an expression of S&P downgrade of US debt ently. So much of the value Gabelli ‘67, Charles Brandes, our thematic observations. was the rally in the price of in what we do is disagreeing Jan Hummel, and David Win- treasuries. This is similar to with the consensus, so you ters at the ―From Graham to G&D: Can you go into want someone that is com- Buffett and Beyond‖ Omaha some detail on your fortable doing that. Also Dinner in April 2011. thoughts on Europe? ―One of the things important is the ability to be that is really rational and have good WS: We are not surprised quantitative skills. with how events have tran- important is the spired. We have had a G&D: What is the competi- negative view of the man- ability to think tive advantage that sets you agement of fiat currency in apart from others in the the West for some time. independently. So industry? Europe is an example of what we have been worried much of the value in WS: What we do different about. We don‘t have any what we do is from others is to maintain a great insights other than the very long time horizon. In fact that there are funda- disagreeing with the our industry this is a luxury, mental issues that are not as many other investment being addressed. This is consensus, so you firms have clients that do true for the whole devel- not let them do this. As a oped world – we have too want someone that is result of having a very long much debt. This is unlike time horizon, we can sit Brazil, Indonesia, and India. comfortable doing back and try to logically We think the risk in the that.‖ imagine a very different fi- developed world is finally nancial environment than being properly perceived as what happened in Japan the one we are in today. being much higher than it where Japanese bonds ral- We are looking for larger used to be, and the risk in lied every time there was a themes that will produce emerging markets is prop- downgrade. epic investment results. We erly being viewed as having think about the themes that been reduced. In our mind G&D: What advice would we want to be in, and in the relative risk equation you give to students inter- those themes, find different has changed a lot of in the ested in a career in invest- great businesses that we last few years, but it still has ing? want to own. We look for a way to go. Emerging equi- jurisdictions where there ties, at the valuations that WS: My strong advice is to are maximum misconcep- we see today of high-single do what you like to do. I tion and extreme valuation digit and low-double digit P/ think there are too many anomalies. Es, are very attractive. people going into the invest- ment business because of G&D: Thank you very G&D: How surprised are outsized compensation much Mr. Strong. you about where US treas- which I don‘t believe can Page 26

Sam Zell

(Continued from page 1) ―My parents placed Michigan. Then, during my country, so I grew up in an junior year at Michigan, my immigrant household with a an emphasis on friend told me the owners very strong father and a of his apartment building supportive mother. My achievement and planned to tear down the parents placed an emphasis building to construct a new on achievement and had had little regard for 15-unit apartment building. little regard for time spent I said to my buddy, ―We are on fun. That orientation time spent on fun. students. We understand distinguished me from my That orientation what students want. Let‘s Sam Zell peers. I operated under pitch him an offer to man- different rules and different distinguished me age the building and maybe expectations than most of we can get a free apartment my friends. Initially, that from my peers. I out of the deal.‖ We did, was very difficult for me. I and our pitch worked. We wasn‘t very adept at becom- operated under took over management of ing one of the ―in-crowd‖. the building, helped to de- Everybody wants to belong, different rules and sign it and rented out the but I didn‘t feel that being a different units. In exchange, the part of ―the team‖ fit my owner gave us two one- personality. Eventually, I expectations than bedroom apartments in lieu gained the self-confidence to of a fee. We were so good trust my instincts rather most of my friends. at it that the building own- than be influenced by my ers soon gave us the oppor- peer group or by conven- Initially, that was tunity to manage another tional wisdom. building, and then another. very difficult for me. By the time I graduated law I had several businesses in I wasn’t very adept school four years later, we grade school and high managed something like two school. The most notable becoming one of or three thousand apart- developed when I was 12 ments. and going to Hebrew school the ―in-crowd‖. ... in Chicago and living in the During law school, we also suburbs. I discovered these Eventually, I gained started buying buildings. newsstands underneath the Raising capital wasn‘t even elevated train tracks that the self-confidence an issue. The first asset was sold magazines that didn‘t to trust my instincts a three unit apartment exist in the suburbs. In building that cost $19,500 1953, this new magazine rather than be and required only $1,500 called Playboy was published down. That was all it took and I saw a terrific opportu- influenced by my for me to become a land- nity. I would buy the maga- lord. My simple premise zine for $0.50 and re-sell it peer group or by was that I thought I could to my friends for $3.00. do something better with That was my first lesson in conventional that building. I repainted supply and demand. wisdom.‖ the apartments, bought new furniture and doubled the Other businesses I had over ing photos of the kids at rents. the years included selling prom, and selling party fa- book-holder straps to my vors to fraternities and so- G&D: How did you transi- friends in grade school, tak- rorities at the University of (Continued on page 27) Page 27 Sam Zell

(Continued from page 26) could continue to duplicate Arbor MI, buying mostly tion from managing a three double-digit returns in these apartment buildings. If you unit building to managing a ancillary markets. So in the are successful in the first substantial amount of real first phase of my career, I deal, it‘s not too hard to estate a few years later? invested in Orlando, raise the money for the Tampa, Jacksonville, Arling- second deal. Pretty much While I was in law school, ton, TX, Reno, NV, and Ann after that first investment in my father was a jeweler, but Toledo, I never really had he was also a passive inves- trouble raising money again. tor in real estate. After I ―I start by not had bought my first building, paying much G&D: How do you think I came home from school about valuation, whether it‘s one year and I asked him attention to the a real estate or a non-real about his property invest- estate asset, and could you ments. He said he was get- market. I think the perhaps give us an example ting about a 4% return. of your approach? Well, I was getting about a Street reflects the 16% return in Ann Arbor, SZ: I start by not paying MI, from my 3-unit building. value of the last much attention to the mar- Our conversation made it share, but the true ket. I think the Street re- clear to me there were two flects the value of the last different investment worlds value of the asset share traded, but the true out there – major metro- value of the asset may be politan areas like Chicago, may be more or less more or less than what‘s New York, Los Angeles and indicated publicly. In the San Francisco, which would than what’s same manner, I don‘t make always attract a lot of real investments predicated on estate investment from indicated publicly. the assumption that there‘s wealthy investors — and In the same a greater fool out there second-tier cities and uni- who‘s going to buy it from versity towns, which re- manner, I don’t me for more than I paid for ceived little or no invest- it. I look for situations that ment. I developed the the- make investments logically make sense to me. sis that if I was willing to go to these second-tier cities, predicated on the As an example, in 1985 I particularly cities with took over Itel Corporation. growth, I could generate assumption that At the time, Itel had been significantly greater returns there’s a greater the largest bankruptcy in because, frankly, there was the history of the United no competition. fool out there who’s States. Coming out of Chapter 11, the company After law school, I raised going to buy it from still owned a subsidiary that capital to buy my first major leased 17,000 railcars. Busi- building, which was a 99- me for more than I ness had been so terrible unit building in Toledo, OH. that utilization of the rail- That‘s really where it all paid for it. I look cars was 32%. While others started. On that first major for situations that might have considered this a deal, we produced a 19% really horrible situation, I return (as opposed to the logically make sense looked at it and said: ―These 4% my father was earning) railcars are almost new be- and I discovered that I to me.‖ (Continued on page 28) Page 28 Sam Zell ―I reminded myself (Continued from page 27) ket rates. Now, you could schools. The only thing that everything is cause they haven‘t been tell me I‘m a genius but the that‘s relevant to me is re- used.‖ By virtue of this fact, truth of the matter is that dundancy. Everything else is about supply and I bought them at dramati- the information I‘ve laid out if-come-maybe. So, I ac- cally less than their replace- was available to everybody. quired the number three demand. I knew ment cost. I then looked at All anyone had to do was business in the industry, put the broader rail business put the pieces together. the two companies together that when the and determined how many For some reason, that‘s and the revenue was still supply and demand railcars there were, who what I do well. I see things $200 million but the ex- had built them, when they differently. penses were now $85 mil- curves for boxcars had been built and what the lion instead of $100 million. general story of the business G&D: Could you give us We picked up a 15% ex- met, I could make a was. It turned out that in another example where you pense difference, which was 1979, the US government saw something that was all profit, and we became fortune. So I went had changed the tax laws obvious to you but not to the low-cost producer. We and created a special one- others? then acquired the leasing out and bought all year 100% tax deduction for company that was number of the used railcars heavy equipment. Further- SZ: Another division of Itel seven in market share and more, in 1979, the United was in the container leasing became number one in the in America. ... We States had built 120,000 business. At the time, the container leasing industry. boxcars. But between 1979 container leasing industry By virtue of this, we had the did extraordinarily and 1985, the United States was comprised of the lowest costs in the business had built a total of only 20 ―seven sisters,‖ which were and a real competitive ad- well because we boxcars. seven container leasing vantage. companies that represented had bought these In the meantime, demand 95% of the world‘s con- So that‘s the way I look at railcars at for boxcars was as flat as a tainer leasing business. The things. It isn‘t like there are dead man‘s EKG. There- one I acquired through Itel six rules of investing or significant discounts fore, nobody wanted to was number four. This busi- something like that – cer- touch the business because ness had $100 million of tainly there haven‘t been in to replacement cost there was no growth. Dur- revenue, $50 million of my life. One of my criti- ing this same period, 65% of expenses, and $50 million of cisms of business schools is and yet rented the boxcars in the country cash flow. Then I looked at that the definition of an were scrapped. I reminded the number three business MBA graduate is someone them at market myself that everything is in the industry, which had who knows how to do the rates. … All anyone about supply and demand. I roughly $100 million of numbers; they just don‘t knew that when the supply revenue and $50 million of know what the numbers had to do was put and demand curves for box- cash flow. I considered mean. This is the product cars met, I could make a what would happen if I put of business schools empha- the pieces fortune. So I went out and these two container leasing sis on formulas. In other bought all of the used rail- businesses together. All of words, business schools together.‖ cars in America. By the a sudden, I would need only teach how the pieces should time I was done, we owned one shipyard in Hong Kong be put together. But for 92,000 railcars and became and only one shipyard at the me, there is no formula. the largest lessor of railcars other ports throughout the Similarly, I‘m pretty agnostic in the United States. We world, and I would need about industries. We‘ve did extraordinarily well be- only one computer system. been in the container leasing cause we had bought these I don‘t really believe in syn- business, the railcar leasing railcars at significant dis- ergies, such as cross-selling business, the insurance busi- counts to replacement cost and all the other elements ness, the real estate busi- and yet rented them at mar- they teach in business (Continued on page 29) Page 29 Sam Zell

(Continued from page 28) other interesting story. In league told me that there ness, the agricultural chemi- November of 1986, a col- was a wire and cable distri- cals business, the oil and gas bution company for sale. business, and I could go on The company had done very and on. well and the price was 2x ―We don’t invest in book. Sam Zell buying G&D: Are there any indus- high tech, simply something at 2x book was tries where you‘re less extraordinarily difficult for comfortable investing? If because we don’t people to conceive. The there are, why is this the seller told me I had a week case? understand it and to decide and there was no chance for negotiation. I SZ: We don‘t invest in high because it’s valued worried about it for six tech, simply because we days. Then, on the seventh don‘t understand it and be- on if-come-maybe. day, I realized that there cause it‘s valued on if-come- ... I can do much were really two assets for maybe. Maybe I‘m a good sale – the business and prognosticator of value but I better Anixter‘s ownership inter- would tell you that I can do est in a distribution pipeline much better prognosticating prognosticating that determined the fate of value on something I under- other manufacturers. This stand than on companies value on something I pipeline was a key determi- that are valued by a third nant of these manufacturers‘ party. That‘s really key to understand than on ability to sell their products. how I look at things. I‘ve companies that are Once I thought about the never been willing to de- acquisition as buying a key pend on a third party to valued by a third distribution pipeline, rather value my investments. I than just a distribution busi- have to value them myself party. That’s really ness, the values changed and I have to look at my dramatically. The company investments as though I‘m key to how I look at we bought on January 1, going to own them perma- 1987 had $600 million in nently. That‘s a very differ- things. I’ve never revenue and $36 million in ent perspective than valuing been willing to operating profit. We still investments as though I‘m own Anixter today, and it going to own them until I depend on a third produces $6 billion in reve- determine it‘s the right time nue, earns about $300 mil- to sell. Generally speaking, party to value my lion per year and operates we start by focusing on the all over the world. It‘s been fact that we‘re going to own investments. I have a phenomenally successful the investment forever. In deal really just by taking that some cases we have done to value them myself pipeline into consideration, this. and I have to look at and expanding it when ap- propriate. G&D: Can you provide an my investments as example of a company When I bought that busi- you‘ve owned for a long though I’m going to ness, we had operations in period of time? the US, Canada and a small own them operation in England. I was, SZ: We own a company permanently.‖ and am, a great believer in called Anixter, which is an- (Continued on page 30) Page 30 Sam Zell

(Continued from page 29) less than 20% of the stock have to pay as much as globalization. Consequently, ownership. Hopefully, I competitors in taxes and we I thought it was critical that create and provide the kind could acquire and operate this company expand world- of leadership that adds ex- businesses with that in wide. The problem was ponential value – enough mind. that this kind of expansion that people are willing to was extraordinarily expen- follow my direction. Following the 1990 real es- sive. When I bought Anix- tate collapse, there was no ter, I acquired it in a manner G&D: Could you discuss source of capital available to such that it could be a sub- some of the different busi- real estate – the S&Ls were sidiary of Itel. So on top of ness cycles you‘ve experi- broke, the banks were Anixter, you now had rail- enced and how you adapted broke and the insurance ―It’s not my car and container leasing to each new development companies had backed away businesses and a dredging that followed? from the asset class. The personality to be business, each of which public markets became the were large cash flow and SZ: A lot of things have only viable option. Thus, in passive. Where I depreciation-generating changed. I went from buy- 1988, I wrote an article en- assets. Over the next three ing up distressed real estate titled ―From Cassandra, can control or years, I think we spent $300 in the ‘70s to building indus- With Love…‖ where I laid significantly million rolling out Anixter trial companies in the ‘80s. out what I thought would worldwide. If I had tried to In 1981, Congress changed happen to real estate over influence the do that with Anixter as an the law on net operating the next ten years. This individual company in a pub- loss carryforwards. Up until included my expectation of direction taken by a lic market, I would‘ve gotten that point, you were al- the monetization of real slaughtered, but hidden un- lowed to use NOLs forward estate and the creation of a company, my der all of these other busi- or backward three years. modern REIT era. From judgment - at least nesses as a smaller asset, no Then, in 1981, because 1960 to 1990, REITS were a one really paid attention. there were all of these backwater with capital allo- so far - has proven We gradually sold the other busted REITs with NOLs, cated to the entire industry businesses of Itel as we they changed the laws to amounting to $6 billion. to be on the better grew Anixter to the point allow companies to use the Sure enough, 1991 was the where it was a viable inde- NOL deduction 15 years beginning of the modern side of good. You pendent company. forward. As far as I was REIT era. I created three of concerned, they instantly the largest REITs and be- don’t necessarily G&D: Is it fair to say you changed the value of every came a spokesman for the always see potential invest- NOL. Yet, when I looked at industry, serving as its rep- have to have ments in the context of the stock prices, there was resentative in the interview absolute control.‖ control, where you have the never any value given to with Standard and Poor‘s ability to effect change? these deductions. We when they were deciding bought Great American whether to include REITs in SZ: It‘s not my personality Management, which was a the S&P 500. In 1999, we to be passive. Where I can busted REIT with $127 mil- then created Equity Interna- control or significantly influ- lion in NOLs. Itel had $450 tional because we felt that ence the direction taken by million in NOLs. We also the monetization of real a company, my judgment - bought New Corp, which estate that was occurring in at least so far - has proven had $250 million in NOLs. the United States would to be on the better side of Then we monetized all ultimately occur in the rest good. You don‘t necessarily these carryforward deduc- of the world. have to have absolute con- tions through the ‘80s. So trol. I manage/chair five or again, we had a comparative G&D: How has your six public companies with advantage because we didn‘t (Continued on page 31) Page 31 Sam Zell

(Continued from page 30) would be 50/50 by 1990 – tion, redundancy, and barri- method of investing evolved 50% allocated to real estate ers to entry were viewed as over the years? and 50% allocated to assets critically important. in other sectors. We began SZ: Well, as an example, in applying our same principles I had an inherent skepticism ‘80 and ‘81, we no longer to non-real estate asset of marketing because I felt liked the real estate busi- classes. Ideas like consolida- that it wasn‘t measurable. ness for various reasons. My philosophy was to invest We had been a great benefi- in businesses that served ciary of inefficient markets. ―I had an inherent externally created demand – However, the creation of businesses where I didn‘t the HP12 and other tech- skepticism of have to generate demand. nologies changed the playing As an example, in the mid- field. All of a sudden, a bro- marketing because I 80s, I bought the largest ker in New York could send dredging company in the out 27 different packages felt that it wasn’t world because I knew that and elicit bids. Prior to that, measurable. My every day the rivers and the there was little or no com- harbors are silting, creating petition. Secondly, we had philosophy was to demand for the product I always taken advantage of produced. That‘s been the long term fixed rate debt, invest in businesses way we‘ve always func- but in the early ‘80s, the tioned. banks and the insurance that served companies started shorten- We were also very focused ing terms and putting in externally created on creating verticals that kickers. So the world as we demand – businesses work. In the early 1980s, perceived it changed. In we bought an agricultural addition, in roughly 1980, where I didn’t have chemicals distribution com- we started to see assets pany. Then we went to a trade for a combination of to generate demand. bankruptcy court and their economic value and bought an ammonia nitrate their tax benefits. As far as As an example, in plant in Iowa. Then we I was concerned, tax bene- went to Canada and bought fits were what you received the mid-80s, I a source of potash. We in exchange for the lack of bought the largest rolled it all up together into liquidity in real estate, not one company and found that an additional value element. dredging company in it was much more efficient than the disparate parts. We came to the conclusion the world because I Eventually, we took that that, ―If we were really good company public. at the business of real es- knew that every day tate, then we were also These are all pretty simple good businessmen.‖ The the rivers and the concepts from my perspec- very concepts and ideas that harbors are silting, tive but I live by them. influenced the way in which we invested our capital in creating demand for G&D: Do you have an- the real estate industry defi- other example of a unique nitely applied in non-real the product I investment opportunity that estate industries. So, in presented itself due to a 1980, my partner Bob Lurie produced.‖ shift in an economic cycle? and I decided that our firm (Continued on page 32) Page 32 Sam Zell

―In the early 1990s, (Continued from page 31) -market, so I tried to figure for roughly three years, out ways to preserve the from ‘88 to ‘91. I would when I was again SZ: As was true for my principal of the asset for the buy a building from a bank philosophy of being the first seller and still make the deal and they‘d ask, ―How about buying up all of the national real estate investor work. It basically amounted three more?‖ At some in second-tier cities, I‘ve to lowering interest rates point I stopped to question distressed real always been willing to shift on the debt to the point my thesis, but I went my ideas and criteria, but where you could almost through my whole thought estate I could in the I‘ve also always believed in carry it or you had a defined process once again and re- US, I kept looking what I‘m trying to imple- carry. We realized that if mained confident that I was ment. In the early ‘70s, buy- we could accumulate assets right. over my shoulder ing apartments became too - particularly in an inflation- expensive so I started fi- ary time - with cheap fixed G&D: We‘ve touched on asking myself, nancing builders to build rate debt, it was hard not to this already but could you apartments. By 1972, eve- make a fortune. talk a bit more about how ―Where is everyone ryone believed the world you value assets? was going to grow to the When people looked at our else?‖ It’s not that I sky; there were cranes on performance during the SZ: It starts with replace- like competition, every block. But I knew ‘70s, they always asked, ment cost. In other words, that supply and demand ―How did you pick all those if we take the example of but you do start to were out of balance, and I ripe projects?‖ But the the Anixter pipeline, there stopped backing developers. truth of the matter was that was no physical pipeline, but wonder why you Then, seemingly overnight, I created $3 billion worth of I could figure out what it market sentiment shifted, 5% fixed rate debt in an would cost to replicate that continue to be the and in 1973, everyone inflationary environment of pipeline. I‘ve bought all seemed to believe there 10, 12 or 13%. In this situa- kinds of real estate at below only game in town. was no future. Asset prices tion, it was hard for it not replacement cost, before ... At some point I plummeted, and I realized to work. And yet, like many considering the value of the that this didn‘t make sense others in my career, most land. Ultimately, what does stopped to question either. So, I began aggres- people thought I was crazy. it cost per square foot to sively acquiring property, I‘ve spent my whole life lis- build the property and what my thesis, but I financed very cheaply, to tening to people explain to is your cost basis? take advantage of what I me that I just don‘t under- went through my thought was a once-in-a- stand, but it didn‘t change Another question to con- lifetime distressed opportu- my view. Many times, how- sider is how difficult a par- whole thought nity. ever, having a totally inde- ticular business or real es- process once again pendent view of conven- tate market is to enter. I Between ‘73 and ‘77, I ac- tional wisdom is a very spoke a lot about the inter- and remained quired $3 billion worth of lonely game. net during the ‘90s. I real estate. The banks had a thought it was a lot like an confident that I was problem carrying a large In the early 1990s, when I interstate highway except amount of distressed real was again buying up all of that a highway has limited right.‖ estate with so many proper- the distressed real estate I access. The internet had no ties in foreclosure. They could in the US, I kept look- limitations to access. weren‘t looking to make ing over my shoulder asking Therefore, an internet- money. They were just myself, ―Where is everyone based business is totally trying to mitigate the losses else?‖ It‘s not that I like vulnerable. One of my pro- their real estate loan portfo- competition, but you do tégés created Groupon and, lios were expected to gen- start to wonder why you although he has the first erate. In those days, institu- continue to be the only mover advantage, the reality tions didn‘t have to mark-to game in town. And I was -- (Continued on page 33) Page 33 Sam Zell

(Continued from page 32) to how the plan is actually Offer.‖ I started Equity with Groupon is that there‘s going to be executed. Office and built it into the no barrier to entry for com- largest real estate company ―… it’s all about petitors. G&D: Two critical yet in the world. Every quarter, sometimes forgotten char- we conducted a detailed replacement cost – I don‘t know how to answer acteristics every investor valuation of the company, whether it be the question any more con- needs is a sense of when to so we felt confident we cisely than to say it‘s all sell and the confidence to knew the true value of the ephemeral about replacement cost – follow through. Can you business. Then one day, whether it be ephemeral talk about your timely sale someone made us an offer replacement cost replacement cost like the of Equity Office Properties that was significantly greater Anixter pipeline or brick in 2007 and how you gener- than our own internal analy- like the Anixter and mortar replacement ally determine when to sell sis – an offer we couldn‘t cost – and barriers to entry. an asset? refuse. Many people pipeline or brick You have to ask yourself, thought at the time that and mortar how difficult is it for some- SZ: In the case of Equity selling Equity Office was a body to compete with you Office, it was a ―Godfather very hard decision for me. replacement cost – and what is your compara- But it was a relatively easy tive advantage. decision because the dispar- and barriers to ity in our valuation versus G&D: Are there any other ―… one of the the bidder‘s was so great. entry. You have to key tenets of your invest- Of course, a bidding war ment process? greatest risks of any began with a second bidder, ask yourself, how and the disparity got even investment is difficult is it for SZ: I philosophically be- greater. So number one, I lieve that if you can‘t deline- point to what I would call execution risk, and I somebody to ate your idea in one or two the ―Godfather Factor.‖ sentences, it‘s not worth think it is highly compete with you doing. I‘m the Chairman of Number two, some busi- everything and the CEO of overlooked. I have nesses have lifelines and and what is your nothing, which means that others don‘t. I think Anix- the people who work for great respect for ter continues to grow be- comparative me come to see me with cause it provides a very execution risk and advantage.‖ ideas all day long. My crite- valuable service. This isn‘t rion is if they can‘t concisely always the case. For in- explain their idea, then I am always sensitive stance, we started a com- throw them out of my office to people coming pany called Adams Drugs, and tell them to come back which created the over-the- when they can. Simplicity is up with ideas that counter drug Mucinex. The critical. entire premise for develop- don’t have all of the ing that business was that Additionally, one of the there were a series of greatest risks of any invest- t’s crossed and i’s drugs, such as Aspirin, that ment is execution risk, and I were grandfathered by the think it is highly overlooked. dotted with respect FDA. The second largest I have great respect for exe- to how the plan is drug was the expectorant cution risk and am always guaifenesin. The FDA stipu- sensitive to people coming actually going to be lated that if you could take a up with ideas that don‘t pre-FDA drug and prove have all of the t‘s crossed executed.‖ efficacy through clinical tri- and i‘s dotted with respect (Continued on page 34) Page 34 Sam Zell

(Continued from page 33) ereign debt crisis in Europe, ago – maybe 15 or 20 years ―Jack Welch once als, then you were granted a are you interested in invest- ago – that European banks monopoly. Somebody came ing in Europe? had ―hidden reserves.‖ said, ―Either you’re to us with the idea to con- What in the world were duct clinical trials, we SZ: We don‘t view Europe ―hidden reserves‖? They number one, funded them and we proved today as a particularly good were money that banks kept efficacy. As a result, we investment opportunity. I for a rainy day, but that number two or were given exclusivity for think there‘s just such a high wasn‘t disclosed to share- production of the drug and degree of uncertainty com- holders. You simply could- you’re in trouble.‖ I thus the company did ex- bined with a historical ap- n‘t do that in the United certainly endorse traordinarily well. But I proach by European compa- States. In the same manner, recognized that this was a I think European accounting that sentiment. I business that could easily be is suspect. Finally, I can‘t subject to competition, and come up with a reason why am a great believer that it was a little bar fly in a ―We’ve been very Europe should grow. And, land of giants. How were involved in in the end, as an investor, in competition and we going to compete with you have to have growth. Pfizer or any of the big emerging markets, Europe is great for castles, I’m particularly OTC drug companies? We cheese, wine, and après-ski interested in couldn‘t. As far as I was particularly Mexico, though! Likewise, I have no concerned, selling Adams interest in Russia at all. All competition for two or three years after we Brazil and one has to do is think about had proven the concept and Yukos. If Russia can do you. For me, I’d generated revenue made all Colombia. These what they did in the case of the sense in the world. are enormously Yukos, they can do anything. like a monopoly. If Jack Welch once said, powerful growth G&D: Are there any coun- I can’t have a ―Either you‘re number one, tries or areas that you find monopoly, I’d like number two or you‘re in markets. In the particularly attractive? trouble.‖ I certainly en- an oligopoly. As an dorse that sentiment. I am case of Brazil, the SZ: We‘ve been very in- a great believer in competi- volved in emerging mar- investor, I am tion and I‘m particularly country is self- kets, particularly Mexico, interested in competition sufficient in fuel, Brazil and Colombia. These constantly focused for you. For me, I‘d like a are enormously powerful monopoly. If I can‘t have a water and food, growth markets. In the case on competition monopoly, I‘d like an oligop- of Brazil, the country is self- because I think it is oly. As an investor, I am and has a trained sufficient in fuel, water and constantly focused on com- food, and has a trained ex- not necessarily petition because I think it is executive class, and ecutive class, and is growing not necessarily always ra- at something like 4% a year. always rational.‖ tional. As a matter of fact, it growing at I think Brazil is probably the often times it is irrational. something like 4% a best single major market in There‘s nothing worse than the world. to be in a competitive situa- year.‖ tion with an irrational com- G&D: Can you provide an petitor. example of a current invest- ment in Brazil? G&D: Given your firm‘s nies to be much less trans- expertise in distressed in- parent than American com- SZ: We started BR Malls, vesting and the ongoing sov- panies. It wasn‘t too long (Continued on page 35) Page 35 Sam Zell

(Continued from page 34) We‘ve done hundreds of maybe +200 bps relative to which today is the largest transactions and I take investment grade debt, then shopping center company in great pride in the fact that for the next level it was ―Any time you go the country. Same store people are willing to do another +200 bps and so on sales are 12-14%. Compare repeat deals with me. It‘s as you went up the risk into emerging that to a top-performing US very common for us to get scale. shopping center company phone calls from previous markets, you are where same store sales are partners who want to intro- Today, there are investment trading the rule of at 1-2%. We also have a duce us to new opportuni- grade spreads and then homebuilder in Brazil. ties. Then, of course, there there are 1,400 bps spreads. law for growth. When you look at the num- are about 30 or 40 manag- All of the past incremental- bers, you discover that Bra- ing directors who work in ism, at least at the moment, Anybody who thinks zil has seven million units of my office, and they in turn is gone. Therefore, I‘ve pent-up demand. Just like have contacts and those never seen a market better that they could go with dredging, it makes a big connections generates ideas. for investing capital in high difference if you‘re building We‘re very opportunistic yield debt instruments or into a Brazilian into a scenario where pre- and we‘re very comfortable high yield debt instruments court and be existing demand exists ver- looking into new ideas. We with kickers. There is a real sus trying to generate de- have resources in a wide shortage of cash and appe- treated like a local mand. variety of industries so we tite for risk in that arena. can learn a lot about a busi- Note that this is a change is very naïve. The G&D: Have you found ness pretty quickly. We‘ve from only a few months ago. Brazilian and other Latin also been in many indus- same thing is true American governments to tries, so a lot of what we In March of ‘09, you could be investor friendly or oth- know or have learned in the buy anything at an unbe- of Mexico. You erwise receptive to outside past is transferrable. lievably cheap price. By have to start with investors? June of ‘09, everything was G&D: A lot of readers are trading at a premium, and selecting a good SZ: Any time you go into also interested in current this continued to be the emerging markets, you are ideas. Could you talk about case until maybe six months partner who can trading the rule of law for any current investments ago. Early in 2011, there growth. Anybody who that you like? were a lot of cases where protect you or who thinks that they could go the value we had assessed into a Brazilian court and be SZ: In keeping up with the for a particular investment is strong enough to treated like a local is very environment today in the was X and it was trading at give you a real, naïve. The same thing is US, we are primarily provid- 2X or X plus 20%, particu- true of Mexico. You have ing debt to the non- larly in the more liquid debt credible perspective to start with selecting a investment grade world -- markets. That phenomenon good partner who can pro- distressed debt instruments, has certainly changed in the of any situation.‖ tect you or who is strong debtor-in-possession financ- last six months. In May or enough to give you a real, ing and anything else oppor- June of ‘09, companies were credible perspective of any tunistic. Changes in the last selling junk bonds at 5% or situation. few years have brought 6% and those same bonds of about a tremendous bifurca- the same company trade at G&D: How do you or tion. If you‘re an invest- 12% today. your team typically generate ment grade company, you investment ideas? can get all the capital you We did a deal last year want, and at these rates it‘s where there was a company SZ: I have a pretty good practically free. In the past, with $130 million of debt address book and a lot of if a company was sub- coming due. The company people call me with ideas. investment grade, it was (Continued on page 36) Page 36 Sam Zell

(Continued from page 35) willing to take. I knew that I exposure I am taking. negotiated with the banks could always survive the Investors stumble when until it was a week before good days, but the critical they take risk and don‘t the debt‘s maturity and the element is to be able to receive commensurate re- banks rejected the com- ward. Investors stumble pany‘s proposals. The com- when they get bull-headed pany then had a week to ―The definition of a or when they shift to doing ―I’ve always been a decide how they were going something that is outside of to meet that maturity. We great investor is their core competencies. great believer in provided them with $130 My success has been related million in return for an at- someone who starts to being a very good ob- logic. I have a lot tractive assemblage of op- server, having opinions and portunities. It wasn‘t like by understanding the being willing to implement of common sense our deal was more or less them, and understanding expensive; it was the only downside. You must and believing in the Bernard and I see things deal on the Street. make the judgment Baruch saying ―nobody ever differently. Many went broke taking a profit.‖ G&D: What is it about in advance as to how people see your personality or process Lastly, in the simplest phi- that has allowed you to be much downside risk losophical phrase, I‘ve al- problems, but so successful? ways believed in going for you are willing to greatness. I‘m highly moti- entrepreneurs see SZ: Number one, I always vated and I‘ve always been seemed to have a lot of self- take. I knew that I highly motivated, not neces- solutions, and confidence so I didn‘t pay could always survive sarily because it translates that’s really what I attention to conventional into dollars, but because wisdom. Number two - you the good days, but there‘s a great satisfaction in do. I recognize may have heard the quote, achievement. I think, more ―common sense isn‘t so the critical element than anything else, that is differences that common‖ - I‘ve always been what has always driven me a great believer in logic. I is to be able to and been a major contribu- other people don’t have a lot of common sense tor to my success. and I see things differently. survive when the seem to see.‖ Many people see problems, market isn’t doing G&D: It was a pleasure but entrepreneurs see solu- speaking with you, Mr. Zell. tions, and that‘s really what well or the Thank you. I do. I recognize differences that other people don‘t investment isn’t seem to see. performing. I always Third, and most impor- tantly, what I have been able focus on how much to do is to assess risk and exposure I am reward accurately through- out my career. The defini- taking.‖ tion of a great investor is someone who starts by un- derstanding the downside. survive when the market You must make the judg- isn‘t doing well or the in- ment in advance as to how vestment isn‘t performing. I much downside risk you are always focus on how much Issue XIV Page 37

William C. Martin

(Continued from page 2) was an intersection of my perience. Most notably, I become interested in invest- passion for technology and spent nine years from 2000 ing? the markets. to 2009 on the board of Bankrate, during which time WCM: I started investing After selling Raging Bull and the company grew from a when I was 10 years old; my prior to starting Raging roughly $20 million market first stock was Hershey Capital Management in cap to a $570 million sale to Foods. My grandparents 2006, I started my own in- private equity. Again, it invested my college money dependent research com- was nice to have such men- with Mutual Series, which pany in Princeton, where I torship at such an early was run by Michael Price. wrote an investment news- point in my career. In this He was literally one of the letter. Of course, I no case, I got to see share- William C. Martin first investors I was ever longer write newsletters but holder friendly corporate exposed to, via his letters this business ultimately grew governance in action. All of ―Being an entrepre- which I read when I was a to include InsiderScore.com, the directors owned a ma- kid. From there, I attended which is an analytics and terial amount of stock and neur has really taught the University of Virginia. In research tool that is today there was a true, long-term me a lot about the my sophomore year, I be- used by approximately 250 focus towards building came president of the stu- hedge funds and mutual value. In contrast, at some importance of having dent investment fund. The funds. I am still an owner of the companies where we capital for the fund was pro- of InsiderScore.com, but I have been activists, the the proper patience vided by John Griffin of Blue am no longer involved in the board members often own Ridge Capital. Like Price, day-to-day operations. little to none of the com- and perspective. John Griffin‘s approach to pany‘s stock, so there is no investing, particularly on the G&D: Your background urgency or alignment of Wall Street is so fo- short side, was very influen- clearly sounds unique and incentives with stockhold- cused on quarter to tial to me as I was beginning differentiated. ers. I think these entrepre- to learn and think about in- neurial and hands-on experi- quarter issues, but vesting. WCM: Being an entrepre- ences are a differentiator neur has really taught me a for me. businesses do not After my sophomore year I lot about the importance of took a bit of a career detour, having the proper patience G&D: What led to estab- move as quickly as as the company I had started and perspective. Wall lishing your own investment in my dorm room, online Street is so focused on firm? the whims of inves- finance site Raging Bull, at- quarter to quarter issues, tors. It takes time to tracted $2 million in venture but businesses do not move WCM: Writing my invest- financing from internet incu- as quickly as the whims of ment newsletter for a num- roll-out a new prod- bator CMGI. My partners investors. It takes time to ber of years helped me to and I left school and ended roll-out a new product, hire develop and refine my ap- uct, hire a new ex- up raising another $20 mil- a new executive, or turn proach to investing and lion in financing less than a around a company. I also build a documented track ecutive, or turn year later, ultimately selling think the creativity of being record. I eventually felt it the company in early 2000. an entrepreneur is valuable was time to take the next around a company.‖ It‘s safe to say we gained when you‘re thinking about step, which was to manage quite an education in a short investing, particularly in outside capital. We period of time, both on the small to mid-cap companies. launched Raging Capital up and the down of the cy- It helps you to see what‘s Management in April 2006. cle. Like many of the compa- possible and think creatively nies I have been involved about a situation. G&D: Can you tell us with, either in terms of start- Finally, I have also had some about your firm and what ing or funding, Raging Bull public company board ex- (Continued on page 38) Issue XIV Page 38

William C. Martin

(Continued from page 37) creativity in order to con- of what we do. We esti- has changed since you nect the dots and find com- mate that we have gener- started it? panies that can really show ated on average more than break-out growth. Usually 1,500 basis points of alpha WCM: We are based in those ideas represent about per year on the short side. Princeton, NJ, manage $275 a third of our capital. We For example, in 2011, our million, and are entering our don‘t have a set limit on strategy was up over 30% ―We try to short the seventh year of business. that amount, but usually net of fees, and we made these ideas are harder to 69% of our returns on the largest, most diversi- ―We look for com- find, and they are typically short side. The short book higher risk so we size them usually has around 40-50 fied basket of what panies undergoing a bit smaller. names in it spread across 50 we believe are management or to 70 points of gross expo- Our other area of focus on sure. We don‘t believe in crappy, overvalued, board changes, com- the long side is finding deep using ETFs for shorting, as value investments with a we view that as lazy. We fraudulent, funda- panies where there is catalyst. I‘ve always enjoyed also don‘t use derivatives to hunting for out of favor create synthetic short expo- mentally-challenged activism (sometimes stocks. Of course, along sure. We try to short the the way I‘ve made my share largest, most diversified businesses, and then our own), or a com- of mistakes and invested in basket of what we believe try to size them ap- pany with a chang- plenty of value traps. There are crappy, overvalued, are certainly a lot of cheap fraudulent, fundamentally- propriately in our ing technology or stocks out there, and a lot challenged businesses, and of them are cheap for a rea- then try to size them appro- portfolio so that we product cycle.‖ son. Further, corporate priately in our portfolio so governance is very poor and that we can sleep well at can sleep well at The team includes two Co- hard to change at many night and be emotionally lumbia Business School companies. Over time, I neutral. We don‘t want to night and be emo- graduates, Wolf Joffe and have learned from my mis- be over-thinking and worry- Fred Wasch, who is our takes. Today we look for ing about one or a few large tionally neutral.‖ CFO, as well as Allan Young beaten down stocks, but shorts. and Matt Furnas. ones that have a clear cata- lyst. We look for compa- Whereas on the long side On the long side we usually nies undergoing manage- we try to connect the dots, hold 30-35 names. Our top ment or board changes, read a lot, and talk to many 10 ideas typically represent companies where there is people to source ideas, on half of our capital, so we do activism (sometimes our the short side we try to be take larger positions when own), or a company with a more systematic and me- we believe we have a clear changing technology or thodical in terms of screen- edge and conviction. We product cycle. These posi- ing names. For example, focus on two general areas tions are typically weighted over the years we‘ve built a on the long side. The first is higher because the down- proprietary key word data- emerging growth businesses, side is often protected by base for SEC filings which where we can hold the com- the company‘s cash buffer includes approximately 500 panies for a few years and or what we think is a high keywords of names of insid- ideally make ―multi-bagger‖ intrinsic value. ers, auditors, or terms that returns. It is a very entre- raise our level of interest. preneurial approach to public The short book is a very For example, a term like market investing. We try to important, and probably the ―preferred ratchet,‖ which leverage our network and most underappreciated part (Continued on page 39) Page 39 William C. Martin

(Continued from page 38) panies to miss their 2011 10 you often see in venture WCM: Shorting fraudulent -K filing deadlines. That‘s capital, can indicate distress, Chinese companies that exactly what happened as as the reset provision can were listed in the U.S. was eight shorts in our portfolio be toxic on the wrong bal- one of our biggest winners had trading halted in Q2 ance sheet. One of our over the past two years, and 2011 alone due to account- senior analysts, Allan Young, accounted for nearly 40% of ing irregularities and govern- has a forensic accounting our short side profits in ance issues. Some of these background, and he will 2011. We started sourcing stocks now trade for pen- regularly go through the some of these ideas one-off nies, if at all. most interesting hits. That‘s in the Spring of 2009 from one of the ways we have the SEC filing alerts I talked G&D: This was clearly a sourced ideas on the short about earlier, as promoters very big opportunity that side. who had previously been you spotted. Do you try to ―Shorting fraudulent involved with sham Internet find themes around which G&D: How does your companies began to get to invest or do you see a lot Chinese companies team split up industry cov- involved with Chinese re- of one-off opportunities? erage and the opportunity verse mergers and IPOs. that were listed in set? By the end of 2009, we had WCM: On the long side, systematically looked at all it‘s very company-specific the U.S. was one of WCM: We‘re generalists 600 Chinese companies and a matter of connecting who seek out value wher- who had listed in the U.S. the dots. Over time, 70% of our biggest winners ever it may lie. In the last We narrowed this list down our average gains on the over the past two year, some of our biggest by focusing on auditing long side have been long positions were a copper firms, EBITDA margins vs. term capital gains, so out of years, and ac- wiring company, a generic peers, accounts receivables a portfolio of 30 longs, you pharmaceutical company, an metrics and a number of don‘t need all that many counted for nearly asset manager, an insurance other risk flags. In some new ideas each year. On company, a telecom equip- cases, we hired MBA stu- the short side, we have a lot 40% of our short side ment company, an advanced dents in China to help us more names and we turn wound care business and with deeper field diligence, them over more frequently. profits in 2011.‖ pre-IPO positions in Face- such as taking pictures of The short side often has book and LinkedIn. We products in stores. We one or more macro or bas- also helped a company, ended up building a diverse ket themes as part of it, but SMG Indium (Ticker: SMGI), basket shorts around this that‘s just a component of a go public that is stockpiling theme. broader book with 40-50 a critical metal called In- individual shorts. Another dium, which is used in LCD, We began pressing this bas- example of one of our suc- LED and solar technologies. ket trade after one of our cessful short themes was a Each member of the team shorts, Rino International, a basket of some 15 targeted has specific areas of exper- Nasdaq-listed Chinese com- regional banks with specific tise, but they are not limited pany, admitted to fraud in geographic and construction in what they can work on. late 2010. Further, in De- lending exposure that we cember 2010, the SEC sanc- shorted in 2006 and 2007. G&D: In your recent quar- tioned a U.S. auditing firm, This contributed to a strong terly letters you write about Moore Stephens, which year in 2007, when we re- successfully shorting a few prompted us to note in our turned 35% net with half of Chinese companies earlier year-end letter that we be- our gains coming from the this year. Can you tell us lieved that greater scrutiny short side. how you came up with the over auditors would cause idea? many of these Chinese com- (Continued on page 40) Page 40 William C. Martin

(Continued from page 39) bit of ―financial engineering‖ dramatically more competi- G&D: What do you think that made their same store tive today than it was five is the next big short oppor- sales numbers look tempo- years ago. It is no longer tunity in the market? rarily good when they went the greenfield market op- WCM: I‘m not sure I have public. We recently cov- portunity it once was, as a that crystal ball. However, ered this short for a nice lot of companies have now today we do have a quarter gain, but it remains on our adopted cloud-based solu- Pictured: Bill Ackman, who of our short exposure in radar. tions. Further, at their cur- sponsors the Pershing Square commercial REITS. We rent size, they are a sub- Capital Challenge at Columbia view much of the group as G&D: Was your decision scale competitor competing Business School, in April 2011. still facing fundamental head- to close your short position against the likes of Taleo winds while also being very based on a feeling that there and SuccessFactors. In our exposed to any increase in was no longer a big down- view, Cornerstone is many interest rates or spreads. side or less of a downside at years away from gaining Their stretched valuations the current $16-17 price true operating leverage be- and levered-balance sheets range? cause any incremental gross leave them with little margin dollars are going to have to for error. We have also WCM: In short, we are go back into R&D and sales been shorting some of the not yet convinced it‘s the and marketing just to try to smaller cap rare earth min- next Rainforest Café, so gain scale. They‘re already ing companies. Another area we‘re erring on the side of in a bit of a catch-22 be- where we have spent a lot conservatism by booking cause growth is starting to of time as of late is on re- our gains to date. Remem- decelerate and they‘re los- cent IPOs with very frothy ber, if Teavana can maintain ing money. Management valuations. This isn‘t neces- current returns on invested can either show the operat- sarily companies like capital and scale from 160 ing leverage on the bottom LinkedIn and other high to 500 stores this could be line by slowing growth, profile deals. Rather, a very valuable business. So which is the reason for the there‘s a whole group of you have to give some big valuation multiple in the companies below the radar. credit to that optionality, first place, or they can For example, one of our even if we don‘t believe erode their bottom line best shorts last year was that‘s likely at the moment. further to reaccelerate Teavana (ticker: TEA). growth. They went public with 160 G&D: Could you give us stores and a $1 billion mar- another example of a com- G&D: What kind of impor- ket valuation. The com- pany you have shorted? tance do you place on meet- pany‘s pitch was: we have ing with management teams high returns on capital and WCM: A current short is of companies you‘re either now we‘re going to deliver Cornerstone OnDemand long or short? exceptional square footage (ticker: CSOD), which is a growth, growing to 500 nearly $1 billion market cap WCM: For most of the stores over the next few talent management software companies on the long side, years. In contrast, our company. It is on an ap- we meet with management view was that this was not a proximate $80 million reve- regularly. Our sweet spot breakout retail concept, a la nue run rate. This is an in- on the long side is $250 Lululemon or Chipotle, as dustry I know very well due million to $1.5 billion mar- evidenced by the unimpres- to my time spent on the ket caps that are under- sive same store sales board of Salary.com, which covered both by big manag- growth, declining productiv- competed with Corner- ers and by Wall Street ana- ity at new store locations, stone. Cornerstone‘s indus- lysts. For the most part, and the fact that there was a try of talent management is (Continued on page 41) Issue XIV Page 41

William C. Martin

(Continued from page 40) take a lot of the ―trap‖ risk defined downside risk, and we‘re important sharehold- out of that value equation. you can serve as the catalyst ers for these firms so we get to unlock value. We often pretty good access to man- Credibility and track record feel comfortable over- agement. On the short side, are very important for activ- weighting these types of we rarely speak with man- ists so we‘ve been focused, positions in our strategy, to agement. Sometimes we will particularly early in our ca- a point where we could meet with them to gut check reer, on hitting singles and have 8-12% of our capital in Bill Ackman and David Ein- our thesis. doubles so that we can a single name. Thus, if horn at G&D Breakfast in show that we can add value we‘re successful in catalyz- October 2010. G&D: Could you talk about and do the right things, but ing the situation, we can add your efforts where you take also that we are serious and a lot of incremental alpha. on more of an activist share- will flex our muscle if neces- ―Boiling it all down, holder role? sary. To the extent that G&D: Could you talk a you start gaining some suc- little bit about your due we believe there’s a WCM: We view ourselves cess in this area, the next diligence and valuation ap- as active and engaged owners project should become eas- proaches? tremendous amount of businesses, and we‘re of- ier, because you can walk in of option value in ten communicating and the door with credibility. WCM: We like inexpen- working with our portfolio sive assets and options, but having the ability to companies. For the most One activist project we‘re we don‘t have hard and fast part, these are constructive, involved with today is MRV valuation rules. Said an- walk into that value productive, and low profile Communications (ticker: other way, a stock doesn‘t conversations. At times MRVC). While the stock is need to have a certain PE to trap situation and be though, we do find ourselves essentially a net-net, this is fit in our portfolio. For in situations where we need also a company that has example, a recent invest- the catalyst. You can to exercise our ownership destroyed a lot of capital ment is a company called take a concentrated rights in a more vocal and over the years. You would Pacific Biosciences (ticker: direct manner. not have wanted to be a PACB). They are one of a position, with fairly passive investor in this com- number of companies that I think the biggest opportu- pany. Like other engaged have gone public in the ge- well-defined down- nity with activism is with the shareholders, we have nomic sequencing space. value traps. There‘s no pushed MRV to return a Genomic sequencing is quite side risk, and you can shortage of cheap stocks out substantial amount of capital interesting but it‘s an indus- there, particularly in our to shareholders, take steps try that‘s still in its infant serve as the catalyst market cap sweet spot. to divest assets, and to re- stage. We bought a block of to unlock value.‖ These are companies with structure the board. We Pacific Biosciences at the material revenues, oftentimes are the largest shareholders end of December in a tax- hundreds of millions of dol- in the company and we‘re loss sale at a roughly $140 lars of cash on their balance pushing to see further pro- million market cap for a sheet, but they just don‘t gress at the company this company that has spent have the necessary scale to year. over 10 years developing its drive bottom line returns for technology with premier shareholders. We‘re not Boiling it all down, we be- Silicon Valley venture back- interested in being a passive lieve there‘s a tremendous ing. It had raised $400 mil- investor in this situation. To amount of option value in lion as a private company the extent though that we having the ability to walk while building its technology can utilize activism to serve into that value trap situation and another $200 million as our own catalyst and gain and be the catalyst. You when it went public. So we at least some control over can take a concentrated were buying it for about our destiny, we believe you position, with fairly well- (Continued on page 42) Issue XIV Page 42

William C. Martin

(Continued from page 41) OpenTable (Ticker: OPEN) past one of the big risks for 70% of its cash on hand and to restaurant owners. pharmaceutical companies less than 25% of total in- has been that they had to vested capital for a company G&D: Can we talk about build expensive, FDA- with really good management another one of your firm‘s approved manufacturing and breakthrough technology positions? facilities. The industry is in a very competitive and now moving towards out- young industry. But, it‘s also WCM: Our current largest sourced, custom-batch Pictured: Steve Eisman at the burning a lot of cash and the position is ATMI Inc. (ticker: manufacturing, which is Columbia Investment Manage- competitive and adoption ATMI). The company pro- similar to the semiconduc- ment Conference in February risks are significant. In our vides specialty gas and mate- tor foundry model. ATMI 2011. eyes, though, if we size this rials used to manufacture has some relevant technolo- position correctly, and at gies that they have been cost this was a less than a 2% ―In this business, we able to apply to this nascent portfolio weighting for us, market. We estimate that this is an attractive value really do try to wipe revenues for this business stock – not to mention a line grew substantially in compelling tax loss trade. our minds clean of 2011 to over $40 million, up from $10 million in 2010. We generally have models past mistakes. This is The investments in this busi- for important positions, but not to say that we ness have depressed profit at the same time we sub- margins in recent years, and scribe to Warren Buffett‘s don’t try to learn that should begin to reverse view that if you can‘t figure it as the unit reaches profit- out on the back of envelope, from our mistakes, ability in the near future. a big spreadsheet model is We also think there is ineffi- not going to give you the but as with golf, you ciency in that the semicon- right answer either. But, ductor analysts who follow modeling is important when need a clear and con- the company have not done you need to dive into the fident mind to be suc- in-depth work on the life details on a position and to sciences business. confirm or deny a hypothe- cessful in an ever- sis. For example, we own The second growth driver the TARP Warrants in Hart- volatile world.‖ for ATMI is driven by the ford Insurance (Ticker: HIG). company‘s relationship with This is a complicated com- semiconductors. This is a Intermolecular (ticker: IMI), pany, and we have spent a lot good annuity-like business, a company that went public of time modeling out their and the boom-bust charac- in November. Intermolecu- annuity exposure to under- teristics as a volume-based lar has pioneered a new stand the potential risks and supplier are less intense method of research and rewards in the position. than for the rest of the in- development for semicon- Additionally, we also spend a dustry. ATMI has a $700 ductor companies. What is lot of time on the phone, million market cap and underappreciated is that aiming to get that nugget of nearly $150 million of net ATMI owns 14% of the insight that provides clarity cash and investments on the company and has a strategic for an investment. For ex- balance sheet. It trades at supply relationship with ample, our analyst Matt Fur- roughly 5x EV/EBITDA. Intermolecular, so as new nas recently called over 100 The company has two inter- chips are designed on Inter- restaurants to better under- esting growth drivers. First, molecular‘s platform, we stand the value proposition ATMI has incubated a life believe ATMI is poised to and importance of sciences business. In the (Continued on page 43) Page 43 William C. Martin

(Continued from page 42) G&D: Can you talk about ness was that I would turn win a lot of new supply busi- some mistakes you‘ve made into one of those managers ness. We should start to over the years? who‘s overly focused on see the benefit of this mar- short-term performance to ket share growth as produc- WCM: Where do I begin! the detriment of long-term tion of 28 and 22 nanome- In this business, we really do returns. In fact, the oppo- ter chips begin to ramp, as try to wipe our minds clean site has happened in that I we have recently started to of past mistakes. This is not believe the regular perform- see. In fact, what was most to say that we don‘t try to ance reporting structure has intriguing for Wolf as he learn from our mistakes, but been a positive construct was researching ATMI was as with golf, you need a for me. Specifically, as a that he found himself piecing clear and confident mind to ―long-term‖ investor, I together the market share be successful in an ever- found I was often willing to puzzle for some of the in- volatile world. Our biggest look past a company‘s bad dustry participants with frustration last year was numbers or ignore my gut. whom he spoke. Normally actually in one of our activ- Now, I have no excuse— ist positions, Moduslink intellectual honesty has ―I believe the regular Global Solutions (ticker: been forced upon me. My MLNK). We helped to put job each day as a portfolio performance someone on the board that manager is to look for the was very capable and who best places to put my capital reporting structure was working to add value, to work, and avoid and has been a positive but in our view, manage- manage the risk. Our port- ment was more interested folio is still dominated by construct for me. in collecting their salaries true long-term or con- than unlocking value. trarian ideas, but a lot of the Specifically, as a Worse, as one of the first intellectual dishonesty has activists in, and with the been rooted out. ―long-term‖ investor, board protected by stag- gered terms, we underesti- G&D: Thank you very I found I was often mated how long it would much, Mr. Martin. take to create change. Ulti- willing to look past a Important Disclosure: mately, we grew tired of the Mr. Martin provides advisory services through his investment advisory firm, Raging Capital Management, company’s bad position and exited it – LLC and only to qualified investors. This is not an offer of sale of securities or any other products to any person. which is one of the benefits Investing in products managed by Raging Capital Management, LLC involves significant risk of loss. Past numbers or ignore of this business: you are performance is not a guarantee or a reliable indicator of future results. There is no guarantee that the investment always free to wipe the slate strategies discussed will work or are suitable for all investors. Each investor should evaluate his or her my gut. Now, I have clean of your frustrations ability to invest on a long-term basis, especially during periods of downturn in the market. and get back to focusing on This article contains the current opinions of Mr. Martin no excuse— which are subject to change quickly and without notice. new ideas. This article also reflects Mr. Martin‘s verbal and written responses to specific questions asked by the interviewer and should not be considered a complete description of intellectual honesty the strategies, methods of analysis and risks associated G&D: Can you talk about with Mr. Martin‘s investment philosophy or those of Raging Capital Management, LLC . Forecasts, estimates, has been forced an area where you have and certain information contained herein are based upon proprietary research and should not be considered as improved since starting Rag- investment advice or a recommendation of any particular ing Capital Management? security, strategy or investment product. upon me. ‖

it‘s the other way around. WCM: I‘ve always thought That makes us pretty ex- of myself as a long-term cited about our investment focused, value investor, and edge. frankly one of the worries I had when starting my busi- Page 44

BJ’s Restaurants, Inc. (BJRI) - Short Michael Yablon

[email protected]

($ in MMs USD except per share data) Current Capitalization Multiples Summary Financials Share Price as of 1/27/12 $48.91 LTM 2011E 2012E LTM 2011E 2012E Basic Shares Outstanding 28 EV/EBIT 40.4x 40.2x 35.0x Revenue $582 $621 $704 Diluted Shares Outstanding 2 EV/(EBITDA-CapEx) NM NM NM EBIT $41 $41 $47 Market Capitalization 1,454 EV/EBITDA 22.5x 20.9x 18.0x EBITDA $73 $79 $92 Cash and Equivalents 40 FCF Yield NM NM NM EPS $1.04 $1.11 $1.26 Capitalized Leases 237 P/E 47.0x 44.0x 38.7x Enterprise Value 1,650 P/Book 4.6x 4.6x 4.1x EBITDA-CapEx ($10) ($9) ($10) Trading Statistics Returns Free Cash Flow ($22) ($24) $18 52-Week Low-High $32.84-$56.64 LTM 2011E 2012E Float % 87% ROIC 11% 12% 11% Book Equity $319 $319 $354 Short Interest % 16% ROE 12% 10% 10% Total Assets $467 $460 $540 Borrowing Cost ~50 bps ROA 8% 7% 7% Divident Yield 0% 0% 0% Recommendation: BJ‘s Restaurants, Inc. (―BJ‘s,‖ ―BJRI‖ or ―the Company‖) represents an attractive short investment with near-term catalysts. BJ‘s operates a chain of casual dining restaurants and trades at a premium valuation. The stock currently trades at 47x LTM earnings but is forecasting just 13% growth. Fur- thermore, BJ‘s growth is dependent on a maturing base of restaurants and its ability to secure large restaurant spaces in high traffic areas while improving unit economics and returns on its capital in- Michael is a second year tense business. The Company‘s execution to date has been strong, creating high expectations and no MBA student participating in room for a decline in same store sales or margins. BJ‘s success has been driven in part by preferential the Applied Value Investing terms received from its largest supplier who is also its largest private shareholder. This supplier only Program. While at school, operates in California and Nevada where BJ‘s is reaching saturation. BJ‘s margins will decline as it he has worked at two value- expands away from this supplier out of its highly concentrated base in California. I projected the oriented hedge funds. Prior Company‘s growth out until 2020 to show the extreme and unrealistic bullishness implied by the to enrolling at Columbia stock‘s current price. I believe the fair market value for BJRI today is $22/share. Business School, he was an Business Description investment banker focused BJ‘s Restaurants, Inc. owns and operates 116 casual dining restaurants in the United States, including on mergers & acquisitions. 56 in California and 24 in Texas. BJ‘s offers American-style comfort food in large restaurants that Michael holds a BA from average 8,000 square feet. BJ‘s competitive positioning is best described as a ―premium‖ casual dining, Columbia University. with a typical restaurant build-out cost per square foot similar to Cheesecake Factory and PF Chang‘s but with average meal prices in line with Applebees, Chilis and TGI Fridays. The company was Michael was the winner of founded in 1991 and is based in Huntington Beach, California. the 2012 Moon Lee Prize Investment Thesis for his pitch on BJ‘s Same Store Sales Set to Decline as BJ’s Restaurant Base Matures: BJ‘s states that its restau- Restaurants and was the rants grow fastest from the time they open until year four. As the base of BJ‘s restaurants matures, 2011 winner of the Sonkin fewer locations as a percent of its total restaurant count will be in this honeymoon, high-growth pe- Prize for his pitch on riod. This decline will reach its lowest level in Q3 of 2012 when the percent of growth locations will Madison Square Garden. have fallen from 35% to 21%. This natural maturation process has affected peer‘s same store sales (including Cheesecake and PF Chang‘s) once they reached 110 units. BJ‘s has historically outper- formed peers on a same store sales basis (―SSS‖) and this strong performance has driven revenue growth and fueled bullish projections. Any reduction in same store sales will undermine the growth story and reduce BJ‘s high multiple. The Jacmar Relationship – BJ’s Largest Supplier is also its Largest Private Shareholder: BJ‘s margins and returns are artificially high, aided by the fact that BJ‘s largest supplier is also its largest private shareholder. Jacmar, along with its CEO, owns 11% of the company down from 16% last year and 53% in 2000. Jacmar‘s CEO, a BJ‘s board member, was a big seller in 2011, reducing his position by 32%. Jacmar only operates in California and Nevada and this explains BJ‘s disproportionate con- centration in these states versus its peers. The Jacmar relationship has allowed BJ‘s to bill less in a quarter and make it up later when earnings have improved. As evidence of this in 2008 and 2009, Jacmar‘s growth in cost of sales moved inversely to the growth of total cost of sales. This relation- ship led BJ‘s to disproportionately expand around Jacmar, who only operates in California and Ne- vada, and is part of the reason BJ‘s margins outperform peers. BJ‘s growth in California is nearing saturation and new units in other regions of the US will have a negative impact on margins. Peers Have Struggled to Grow Past 200 Restaurants, making BJ’s Projection of 300+ Locations Unlikely: Large casual dining chains have historically been unable to grow to 300 restau- rants, while maintaining margins and returns, and ultimately do not live up to their high multiples. Issue XIV Page 45

BJ’s Restaurants (Continued from previous page) 10 years ago, three companies traded above 40x earnings, Cheesecake Factory, PF Chang‘s and Califor- nia Pizza Kitchen. However, in 2001 each of these firms had many fewer units and therefore a much bigger runway for growth. Cheesecake Factory had just 41 units, PF Chang‘s 52 and CPK 71. By the times they reached BJ‘s current restaurant count, the multiples better reflected their limited growth opportunities, with the average multiple of the three equaling 28x. With 116 units, BJ‘s multiple is not justified given its current stage of growth. A decade later, which is how long it will take BJ‘s to reach 300 units, growth has stagnated for these three competitors around 200 units and the stock prices are either flat or way down. Since passing the 110 location threshold, Cheesecake Factory, PF Chang‘s and California Pizza Kitchen‘s stocks have returned 2.3%, (7.2%) and 1.1% on an annualized basis, respec- tively, with CPK‘s return calculated inclusive of its take-out premium. The US Real Estate Market and Mall Infrastructure Cannot Support 300+, 8,000 Sq. Ft. Lo- cations: The Company thinks it can get to 300 units, but the question becomes at what size restau- rant. Smaller restaurants have worse economics because less square footage prevents the restaurant from effectively leveraging the fixed cost of the kitchen. The current format requires a large space (>8,000 sf) in a high traffic area. If BJ‘s is forced to open smaller locations, returns will suffer. Like Cheesecake and PF Chang‘s, BJ‘s expansion has centered around large malls due to their traffic density. But there is limited space in Class A Malls and significant competition over a dwindling supply. According to the International Council of Shopping Centers, the national vacancy rate at the top 80 regional malls by size rose to 9.4% in Q3:11, the highest level in 11 years. The ICSC also reported that the total num- ber of shopping centers in the US has not grown in three years. The dearth of quality sites has re- stricted PF Chang‘s and Cheesecake Factory‘s growth. Unit growth at these peers has slowed over the last few years well below BJ‘s target of 300 restaurants. PF Chang‘s has added only 4 units since the end of 2009 for a total of 201 and Cheesecake Factory has 154 large-format units. In its Q4:10 earnings call, PF Chang‘s cited the scarcity of quality locations as limiting the opportunities for expansion. Mediocre Return on Capital with No Barriers to Entry: Assuming a ten year life for new con- struction (per the Company‘s depreciation schedule), the average pretax IRR for a restaurant is 32%, which assumes that no capital improvements are made over the course of ten years. This return is around the 25%-30% range the company touts to the street as its target for new restaurants. However, when G&A is allocated on a per store basis returns drop to 16%, and when taxes are applied the return drops to 12%. BJ‘s returns are above its cost of capital but nowhere near the 25% it projects to the street. Granted, the company will be able to leverage its G&A expense over a bigger base of restaurants over time, but at square footage growth of 13%, this margin expansion will not have an impact in the near term. In reality, margin compression will likely offset G&A leverage and value creation will be flat to moderate, especially compared to high multiple companies that do not require heavy capital invest- ment to fuel growth. Valuation BJ's Restaurants DCF and EPS Valuation Summary To value the company I projected earnings out to 2020 in Street Bullish Likely three different scenarios. Each DCF scenario assumes a Case Case Case discount rate of 8%, using a mid-year convention, and ap- DCF $46.00 $28.00 $20.00 (1) plies a conservative 17x multiple to 2020 net income. The Normalized EPS $3.88 $2.75 $1.91 EPS Multiple 13.0x 12.0x 11.0x Street Case illustrates the unrealistic assumptions implied by Implied Price - EPS Mult. $50.44 $33.00 $21.01 the current stock price. BJ‘s must grow to 300 restaurants Implied Price - Avg of DCF & EPS $48.00 $30.50 $20.50 while increasing gross margins to 22.5% (up from 20.5% Current Share Price $48.91 $48.91 $48.91 Upside/(Downside) 1.9% 37.6% 58.1% currently and well above its peer average of 18.5%) and have (1) Average of 2011E-2020E Projected EPS Estimates SSS of 4% until 2014 and 3% thereafter. In the Bullish Case, which represents a best-case scenario for BJ‘s, the stock is worth just $31/share. In the Likely Case, restaurant growth stops at 220 locations, above peers like Cheesecake Factory, PF Chang‘s and Califor- nia Pizza Kitchen, while margins decline slightly to 20.0% and SSS grow at 3% until 2015 and 2% thereaf- ter. A short of BJ‘s is protected by the Company‘s maxed out unit economics and slow, self-funded growth. Investment Risks/Considerations The Multiple Continues to Defy Gravity as the Internally Funded Growth Strategy Takes Time to Unravel: Mitigant - SSS will decline in 2012 and BJ’s will have just 13% square footage growth, meaning the multiple is unlikely to expand rapidly and will more likely shrink It’s Too Soon to Short the Stock - Market Cap is just $1.5B: Mitigant: Unit productivity is essen- tially maxed out and it is very unlikely that BJ’s will be able to comp +5% over the next two years. If margins or SSS decline, the growth story will be undermined and the stock will fall hard. One doesn’t have to wait for the unit growth to slow to see that the stock is overpriced. Page 46 Chicago Bridge & Iron Company N.V. (NYSE: CBI)

Noah Snyder, [email protected] Capital Structure Guidance, Estimates, and Consensus Multiples and Share Price Price $42.00 Revenues 2009A 2010A 2011E 2012E 2013E Multiples 2009A 2010A 2011E 2012E 2013E Shares Outstanding 99.8 Guidance $4,300-$4,700 $5,200-$5,600 NHS Adj. P/E 17.0x 22.4x 15.9x 11.6x 9.6x Market Capitalization $4,192.2 NHS $4,557 $3,642 $4,613 $6,044 $7,692 Consensus P/E 17.0x 22.4x 16.7x 13.9x 12.2x Cash $539.9 Consensus $4,557 $3,642 $4,548 $5,572 $6,473 NHS EV/EBITDA 8.0x 9.9x 8.6x 6.7x 5.5x Total Debt $80.0 Consensus EV/EBITDA 8.0x 9.9x 8.8x 7.2x 6.3x Net Debt ($459.9) EPS 2009A 2010A 2011E 2012E 2013E Enterprise Value $3,732.3 Guidance $2.40- $2.50 $2.75-$3.05 Dividend Yld 0.5% NHS $2.47 $1.87 $2.65 $3.61 $4.39 Consensus $2.47 $1.87 $2.52 $3.02 $3.43 52 Week High $45.12 (1.2%) 52 Week Low $23.88 135.0% EBITDA 2009A 2010A 2011E 2012E 2013E Volume (3 months) (000's) 1,095 NHS $466 $376 $435 $559 $674 Volume (3 months) (000's) $45,990 Consensus $466 $376 $425 $518 $596

Company Background: Founded in 1889, Chicago Bridge & Iron N.V. (―CBI‖ or ―the Company‖) is an integrated engineering, construction (―EPC‖) and design company with a major portfolio of 2,000 patented energy technologies, delivering comprehensive solutions to customers in the energy resource industry. Essentially, CBI specializes in build- ing football stadium-sized liquefied natural gas (LNG) facilities and cross fertilization and synergies across CBI‘s busi- Noah is a second year MBA ness segment is allowing the Company to win a disproportionate amount of new energy projects. During 2010, CBI student. As an MBA he has executed 700 projects in ~70 countries and >80% of its backlog is non-US. Nevertheless, the Company remains a interned at East Coast Asset very misunderstood equity story. Management, Columbia (Wanger) and Halycon Asset CB&I Steel Plate- Legacy CBI (120 years). Global fabrication/construction of storage tanks & steel plate structures. Management. Prior to school, 1H ‘11: 40.4% of revenues, 51.7% of EBIT, 10.2% EBIT Margin. he was a long/short investment analyst for Arlon Group. He CB&I Lummus (E&C)– Traditional engineering, construction, and design services for upstream & downstream holds a BS in Finance from the energy infrastructure facilities. 1H ‗11: 49.3% of revenues, 24.2% of EBIT, 3.9% EBIT Margin. University of Illinois- Champaign/Urbana. Lummus Technology- High quality hidden gem. >2,000 proprietary gas processing and refining technology patents. 1H ‗11: 10.2% of revenues, 24.2% of EBIT, 18.9% EBIT Margin. Michael won second-place at the 2012 Moon Lee Target Price and Valuation Competition for his pitch on CBI is a long with a ~$60 target price or ~40% upside. Target price is based on two proprietary methods of valua- Chicago Bridge & Iron tion: 1) Sum-of-parts and 2) Share of global LNG spend. Company. Sum-of-Parts: CBI has three distinct, yet somewhat overlapping business segments. I modeled out each segment based on its current backlog and I layered in potential new awards based on various end markets. For EBITDA mar- gins I used guidance of Steel Plate 7-10% and E&C 3-6%. I used 2013 as I think this is a mid cycle year and I applied EBITDA multiples of 7-9x 2013 EBITDA based on business quality and barriers to entry for each segment. Steel Plate should trade at 8x EBITDA as it earns ~10% EBITDA margins and it is a low cost producer of steel tanks/storage with fabrication all over the world which would be costly for a new entrant to replicate. CB&I Lummus (E&C) should trade at 7x EBITDA, or in-line with historical engineering multiples as this segment earns mid-single digit EBITDA margins just as its comps do. Finally, Lummus Tech. should trade at 9x EBITDA as it is a higher quality reoccurring licensing

Sum of Parts Valuation Mid LNG Cycle Valuation 2013 EBITDA Multiple Segment Value % of EBIT Enterprise Revenues Revenues Margin EBIT Multiples Value CB&I Steel Plate $311.9 8.0x $2,494.9 LNG Potential $6,500.0 79.3% 8.0% $520.0 8.0x $4,160 CB&I Lummus (E&C) $213.2 7.0x $1,492.6 Other Big Projects $500.0 6.1% 4.0% $20.0 8.5x $170 Lummus Tech. $148.4 9.0x $1,336.0 Book & Burn $1,200.0 14.6% 10.0% $120.0 9.0x $1,080 Enterprise Value $673.5 $5,323.5 Total $8,200.0 100.0% 8.0% $660.0 $5,410 Net Debt ($459.9) Net Debt ($459.9) Equity Value $5,783.4 Enterprise Value $5,869.9 Diluted Shares 99.8 Target Price $57.94 Target Price $58.81 business with >20% EBIT margins. Share of LNG Spend: Most analysts expect only ~$200-250bn LNG spend, however my proprietary ―project by project‖ research concludes there is >$300bn of worldwide LNG projects on the horizon and most of them will be required just to fulfill Far East demand. I conservatively estimate CBI‘s share of LNG spend will be at 13% vs. a 11.7% share in 2010 even though CBI is winning a disproportionate share of new pre-feasibility and design studies. I use historical average EBIT margins and different EBIT multiples for earnings power based on certainty of revenue realiza- tion.

Investment Merits Backlog Surge Not Priced In & More to Come– YTD 2011 new awards are ~$7bn compared with $2.3bn for the corresponding 2010 period. Over the last six months CBI has booked >$5bn of new awards, yet the stock re- mains at mid July levels. Subsequent to Q2 ‘11, CBI has been awarded an LNG construction project in Gorgon, Aus- tralia ~$2.3bn, >$1bn of tank work in Asia-Pacific and an additional $500mn of Kearl oil sands work bringing CBI‘s backlog to ~$9.3bn. This is nearly an all-time high, but equity traders have not priced in this recent surge. Investors are now paying ~4x backlog EBITDA (using historical ~10% EBITDA margin) and getting all future earnings power for free. Issue XIV Page 47

Chicago Bridge & Iron (continued from previous page)

Entering Golden Age of Gas Use- Oil‘s share of total energy is now 34% vs. >45% in the 1970s and due to eco- In China, which is now the nomic, environmental or energy security concerns nat gas will continue to steal share of total energy consumption from largest energy consumer coal and oil. In China, which is now the largest energy consumer worldwide its current 5 year plan (2011-2015) calls for nat gas to move from 4% of energy consumption to 9%. To accomplish this China will need to import considerable worldwide its current 5 year amounts of LNG as it is impossible to generate sufficient nat gas internally. In addition, with US supply being geographi- plan (2011-2015) calls for nat cally constrained due to lack of export, CBI Tech. will benefit from the nat gas renaissance in the USA as the cost curve has shifted downward making domestic natural gas ~10x cheaper than crude oil for the foreseeable future. Japan‘s nu- gas to move from 4% of energy clear meltdown has lead to surging nat gas demand as only 10 of Japan‘s 44 nuclear generators are operating and Ger- consumption to 9%. many has agreed to cancel its nuclear program by 2022 (20% of supply). Globally, leaders are reassessing nuclear plans and shifting consumption towards natural gas. Over the next decade nat gas will continue to take share from coal and nuclear power as it produces ½ the CO2 and it is cheaper and more abundant than it has been in decades. CBI will be a In 2010, CBI enjoyed a ~48% huge beneficiary of this secular shift in global energy markets. market share in LNG storage Barriers to Entry in LNG– As most of the end market demand drivers can not produce nat gas internally the gas will units along with ~9% of total need to be processed, liquefied, and imported through LNG. Driven almost entirely by Asia-Pacific demand for Austra- LNG liquefaction spend. CBI lia LNG, there will be 13-5 huge LNG projects sanctioned over the coming three years and global LNG spend could is now winning a disproportionate share of new LNG liquefaction investment.

reach >$50bn by 2013. CBI can complete an entire CBI is positioned to benefit from this shift with competitive advantages as one of only ~5 companies that can effectively LNG project and now 25% of compete for >$300bn of Australian and global LNG investment that will be required over the next 6 years just to meet EBIT comes from recurring nat gas demand. CBI enjoys a ~48% market share in LNG storage units along with ~9% of total LNG liquefaction spend. However, CBI is now winning a disproportionate share of new LNG liquefaction investment. CBI has already completed high (~20%) EBIT margin a ~$1.5bn fully integrated Peru LNG liquefaction project below budgeted time and cost proving that CBI can execute an technology business. entire LNG project and CBI is no longer just a storage tank builder. Additionally, CBI has teamed up with Chiyoda

(Japan) and Saipem (Italy) in forming CJV, a JV which is a premier worldwide LNG liquefaction team. Finally, CBI has scale, relationships and know-how, providing CBI w/ insurmountable barriers to entry in competing for $5bn facilities. Sustainable cash flow stream Misunderstood Business Quality- In late 2007, CBI made a game changing deal in acquiring Lummus for $820mn. with minimal CapEx ($50mn/ Lummus Tech. has patented proprietary technologies for refineries which helps upgrade thicker, lower quality energy yr) leading to a ~20% FCF resources along with key strengths in ethylene and olefins conversion technology (OCT) in gas processing markets. This diversified CBI‘s business model allowing CBI to complete an entire LNG project and now 25% of EBIT comes from yield in 2013. recurring high (~20%) EBIT margin technology business. By bundling and offering technologies and E&C services, CBI can further differentiate itself from many of its competitors in winning new projects. CBI now boasts a more steady, sustainable cash flow stream with minimal CapEx ($50mn/yr) leading to a ~20% FCF yield in 2013. However, CBI is yet Currently doing feasibility to re-rate vs. the E&C sector, nor have investors been able to see the ―new‖ CBI fire on all cylinders. Attractive Valuation– CBI is trading at 12.2x 2013 Consensus P/E and ~9.6x 2013 My EPS, or at the low end of studies on several >$1bn LNG historical trading range of 10x-25x. CBI is cheap as changing energy consumption will be secular and not cyclical or projects….which the Company based solely on commodity prices. As CBI‘s business model is design/engineering heavy, CBI consumes little capital (CapEx = ~1% of sales) and its cost structure is flexible as engineers can easily be hired and fired. Industry standard for will probably win E&C con- construction contracts has also moved to cost plus from fixed price and CBI has executed on this de-risked business tracts for over the next 2 years. model with nearly three years of flawless execution.

Catalyst Rich Story– CBI is currently doing feasibility studies on several >$1bn LNG projects including Yamal, Ar- CBI will have ~$1.9bn of row, and Browse which the Company will probably win E&C contracts for over the next two years. On top of that CBI is realizing >$500mn per quarter in ―book and burn‖ nat gas and petrochemical projects in the US due to the US shale capital for shareholder value gas revolution. CBI has several project in its pipeline which can help investors unlock value. creation.

Potential Value Creation not Baked Into Estimates– Finally, CBI has cash of $540mn and only $40mn maturities in 2011 and 2012, respectively. CBI should generate an additional ~$650mn of FCF over the next five quarters and CBI also has a $1.1bn untapped revolver which won‘t expire until July 2014. CBI is well positioned to make another sizeable deal in niches that round out its product offering or the Company can buy back shares with its 10% share buyback in place. As CBI is comfortable at 25% of Debt/EV this means CBI has ~$1.9bn of capital that it can use for shareholder value creation. By using $1.5bn to acquire businesses at 20x P/E along with $400mn for a share buyback (10% out- standing approved) this would allow CBI to add an additional ~$15 of shareholder value.

Investment Risks: Cost overruns: Industry standard now cost plus vs. fixed price. CBI >50% cost plus contracts vs. 10% in 2005. Short term misses due to delayed investments. Oil prices weaken globally. Competition picking up in less differentiated projects. Overwhelming efficiency gains and/or tighter EPA legislation lead to reduced need for fuel power. Page 48

Hewlett Packard (HPQ) - Long

Michael Zapata [email protected]

______ticker: HPQ mkt cap: $55.8b price: $28 intrinsic value: $51 upside: 83%

Michael is a second year MBA student participating in the Applied Value Investing Program. While at school, he has worked at a value- based hedge fund. Prior to enrolling at Columbia Business School, Michael Recommendation served nine plus years as a Hewlett Packard is a buy at $28 with an intrinsic value of $51 for 2014, representing an 83% upside. A Navy SEAL officer. Michael downside scenario, with flat line EBIT and a low 6x EV/EBIT represents an 18% upside to $33. holds a BS from Texas A&M

University. Key Points

Why Undervalued? Michael was selected as a finalist of the 2012 Moon Key management concerns- three CEO change in the past year Lee Prize for his pitch on Uncertain long-term plan– PC business spin, caused fear and confusion Hewlett Packard. Losing market share- Servers Poor acquisitions- $10 billion Autonomy bid

Strong Industry Leader HP is the global leader in PC, Printers, Servers #2 market leader in Networking and Management products #3 market leader in Operating System and Storage Tremendous brand recognition and economies of scale

Strong Financial Position Strong Cash Flow Generator- $13 billion in 2011, 14% FCF yield Ability to pay down debt Steady share repurchases and stable dividends Stated the current focus on paying down debt and increasing sales force and R&D in 2012

Potential Catalyst Primers New CEO, $1 salary, performance based bonus, will provide clarity and focus Strategic roadmap pending announcement in 2012 Activist investor recently appointed to BOD

Issue XIV Page 49

Hewlett Packard—Long (Continued from previous page)

Executive Summary

Thesis Hewlett Packard is a strong cash flow generating, market-leading company that is being punished by the market for recent company announcements and multiple CEO changes. The sell off has been overdone, with HP stock moving from the year high of $50 to the recent low at $22 in September. The current price of $28 represents an opportunity to buy HP with a 45% margin of safety to its intrinsic value. Overall, the underlying business has not changed, the company has recently appointed a focused, goal oriented CEO, has appointed a seat on their board to a prominent activist investor, and is primed to communicate a long-term strategy that will provide a well-defined road ahead for investors to regain confidence in the company.

Summary The current state of the IT industry is stable and across each of HPs segments, the company is reposi- tioning its foothold to propel the company forward through its focus on short and long-term strategic implementations. HP is a world leading company with brand, economies of scale, and customer captivity represented through it market leading positions in PC, printers, and server divisions.

From a management standpoint, the incoming CEO, Meg Whitman, will allow the company to be focused by providing the structure needed through the pending release of its strategic vision. Additionally, while only on a performance based salary for the first year, the CEO will look to fewer headlines, which will benefit HP as this will be a positive sign that the company is moving forward and management is not hindering growth.

Organically, the refocus of HP on its hardware division, while working to increase its software sales across its business segments, will provide a clear picture to both its customers and the market. The commitment to its PC segment will allow the company to move forward to provide a comprehensive ecosystem for its customer base. Additionally, the increase in the critical operating expenses of research and development and sales staff will provide short and long-tails to supporting HP‘s focus and dominance in the IT industry.

Growth wise, although overpriced, the recent Autonomy acquisition provides the company a spring- board to the higher margin software sales. Autonomy will increase HP software sales by 33%, which will affect the bottom line. The company will also allow HP the opportunity to cross sale the unstructured search software into its hardware and server divisions. This is a great starting point for long-term HP opportunities.

Financially, HP generates strong cash flows and is dedicated to the return of a strong balance sheet, which translates to a commitment to pay down its debt. Ms Whitman has stated that the company will not make any major acquisitions in 2012. With a 14% FCF yield, HP is well positioned. Additionally, with the appointment of activist Ralph Whitworth to the board, HP working to provide confidence to investors, as the company will likely pursue additional options to return capital to shareholders.

HP is the world leader in PC, printer, and server sales, and the number-two leader in server and net- working sales. The company is primed to grow software sales, which will expand margins and increase the potential for higher multiples. At the current EV/EBIT of 6.7x (and P/E of 6.2x, record lows of past 20 years), resulting in a $28 stock price, HP represents a compelling buying opportunity with a 45% MOS and 83% upside.

Potential Catalyst HP‘s recent appointment of Meg Whitman represents the beginning of an HP turnaround. However, due to potential Euro and macro headwinds, the decision to increase operating expenses to expand the sales force and research and development, and the current higher debt, the potential catalysts will be slow burning until Ms Whitman communicates HP‘s long-term vision in 2012. This pending catalyst, couple with aligned and diligent actions across HP, will convey a roadmap and clear vision to investors, who will be able to invest with confidence in Hewlett Packard. Page 50 Hankook Tire (000240 KS) - CBS Finalists at WIN Conference Young Ju Ko Jane Wu Sachee Trivedi Jing Wu [email protected] [email protected] [email protected] [email protected]

Investment summary Key stats Year to 31 Dec 2009 2010 2011F 2012F 2013F Close Price KRW 42,750 Young Ju is a first year MBA student. Revenue (KRW b) 5,145 5,813 6,647 7,354 8,324 Pricing as of Prior to school, she was an Nov 8 2011 investment analyst at Blue Pool Growth (%) 15% 13% 14% 11% 13% Total market Cap KRW bn 6,207 Capital and Citadel Investment Diluted EPS (KRW) 2,356 3,017 3,111 4,186 5,468 Total market Cap USD mn 5,589 Group in Hong Kong. She holds a Growth (%) n.m. 28% 3% 35% 31% Enterprise value KRW bn 7,088 P/E (x) 18.1 14.2 13.7 10.2 7.8 Avg daily turnover (3M) USD mn 40 BBA from Seoul Natl. University. EV/EBITDA (x) 7.4 7.2 7.2 5.5 4.5 12M Range (KRW) 27,200-50,000 P/B (x) 3.1 2.6 2.2 1.9 1.6 Total shares Out. (mn shares) 145 ROE (%) 18.6% 20.0% 17.5% 20.0% 21.7% Free float (%) 52% ROIC (%) 16.3% 18.8% 17.0% 19.9% 23.1% Net debt (FY11, KRW bn) 881 Div yield (%) 0.8% 0.8% 0.9% 1.2% 1.6% Net debt / equity FY11 47% Net gearing (%) 56.9% 46.0% 47.0% 27.1% 18.7% KRW/USD exchange rate 1,111 Recommendation: Jane is a first year MBA student. We recommend buying the Hankook Tire share (Hankook or ―the Company‖) because we believe Prior to school, she was an equity market is underestimating the product price growth potential of Hankook led by improvement in research analyst with CLSA in Hong brand value. Our target price is W71,000 (13x 2013E PE) implying 66% upside. Kong. She holds a BEcom degree from Tsinghua University and a master of finance degree from Company Description: University of Melbourne. She is a Hankook manufactures radial tires for passenger cars, truck and buses. In 2010, Hankook‘s global CFA charter holder. production capacity was 80mn units with the largest production facility located in Korea (45mn) fol- lowed by China (30mn) and Hungary (5mn). Replacement tires (RE tire) account for 65% of revenue and original equipment tires (OE tire) account for 35%. Hankook makes 80% of revenue from over- seas market. Hankook is No.1 player both in Korea and China with 52% and 19% market share, re- spectively. Hankook‘s global market share is 3.1% (7th ranked). Hankook‘s customers are Hyundai, Volkswagen, Ford, BMW, Toyota and Audi.

Sachee is a first year MBA student. Investment Thesis: Prior to school, she was a Product price growth potential on the back of improving brand: In the past, Hankook has consultant at KPMG in London. She holds a masters degree in electrical not been a price setter for the tire industry but has followed the industry leaders‘ (such as Michelin, engineering from Univ. of Maryland Bridgestone) pricing policy. However, the trend is likely to change because Hankook enters a virtuous and a bachelor‘s degree in electrical cycle on the back of strong growth from emerging markets and improved brand image. The expansion engineering from Indian Institute of of customer base to the leading auto makers such as BMW and Toyota in 2011 sets a favorable pric- Technology. ing environment for Hankook. We expect Hankook will be able to achieve 9% ASP growth during next 3-5 years vs consensus estimates of 2-3%. In 2010, Hankook‘s implied ASP (total revenue / total capacity) was still 50% lower than the top tier tire companies indicating there is an ample room for Hankook to raise product price.

8 Years

1941 2003 2004 2005 2009 2011

Jing is a first year MBA student. Prior to school, she was an Toyota VW Ford General Audi A3 associate in Investment Banking Founded In talks with 62 Years Modeo Motors BMW Mini BMW 3 Series at Royal Bank of Scotland in Cooper Hong Kong. She holds a Bachelor of Economics & Why 9% growth? Hankook today is the Bridgestone in Japan in 1980s: We believe Hankook Finance from University of today is comparable to Bridgestone in 1988 based on the size of business. From 1988 to 1998, Bridge- Hong Kong. stone was able to grow its revenue at 13% CAGR . Considering a stable volume growth (4%) during that period, it implies Bridgestone was also able to raise ASP (either through a voluntary price hike or through product mix improvement) at c9%. This supports our price argument of 8-10% for Hankook for next five years. Furthermore, Hankook has a stronger volume growth outlook than Bridgestone because of much larger emerging market exposure (37% vs Bridgeston‘s 19%). The stronger demand in emerging markets can lead to a more favorable pricing environment.

Bridgestone Hankook Bridgestone Bridgestone US$ Mn (1988) (2010) (2010) CAGR from 88-98 Revenue 5,276 5,813 32,617 13% Operating Profit 567 536 1,897 13% Net Profit 190 147 1,127 16% Total asset 5,285 4,979 30,850 12% Issue XIV Page 51

Hankook Tire (continued from previous page) Product price growth will lead to margin expansion: We forecast 9% increase in ASP across all regions will lead to 2ppt gross profit margin expansions in 2012-2013 because of lower rise in unit cost- growth(5%). This will lead to 32% and 29% bottom-line growth in 2012 and 2013, respectively. We are not taking any bet on the foreign exchange rates. However, highly likelihood of Rmb appreciation could

2011F 2012F 2013F 2011F 2012F 2013F ASP increase in local currency 9% 9% 9% Volume (k unit) 85,200 87,180 92,100 ASP per tire (USD) 61.8 67.0 72.3 % change 6% 2% 6%

Cost per tire (USD) 50.5 53.1 55.6 Gross profit (KRW bn) 1,036 1,265 1,502 % change 9% 5% 5% Gross margin 28.0% 30.0% 31.7%

Gross profit per tire (USD) 11.3 13.9 16.7 Net profit 441 584 752 % change 4% 23% 20% % change 1% 32% 29% surprise on the upside.

Valuation: Our 2-year price target for Hankook is W71,000 per share, representing 66% upside from the current price of W42,750. We have applied current FY2011 PE multiples (13x) to FY2013E earnings to arrive at the intrinsic valuation of Hankook in 2 years. The base case assumes an annual ASP growth of 9% from 2011-2015, the bear case assumes 3% and the bull case assumes 12%. Based on these cases, we believe Hankook is worth between W29,000~W99,000 (risk reward –32% ~ +123% off of the current price of

W42,750) with upside/downside ratio at 4x.

Risks: Sharp rise in rubber price: Rubber costs (both natural and synthetic) accounts for 50% of raw mate- rial cost and 20% of revenue. If rubber price goes up too quickly, Hankook may not fully realize benefit from price increase.

Currency risk Hankook is short position of US dollars (raw material cost is mostly denominated in USD) and long position of Euro and other foreign currency. If KRW depreciates 10% against USD, im- pact on EPS is -24% assuming KRW stays flat against other currency. Against Euro, if KRW depreciates 10% , impact on EPS is +4%. Get Involved:

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Graham & Doddsville 2012 / 2013 Editors

Anna Baghdasaryan is a second year MBA student in the Applied Value Investing Program. She is currently interning for Cantillon Capital Manage- ment, a global equity investments firm. Prior to Columbia Business School, Anna worked in strategy and business development, and investment banking. She can be reached at [email protected].

Joe Jaspan is a second year MBA student in the Applied Value Investing Pro- gram. He is currently working part-time for a value-oriented hedge fund in New York. Prior to Columbia Business School, Joe worked in private equity and investment banking. He can be reached at [email protected].