Graham & Doddsville An investment newsletter from the students of

Spring 2012 Inside this issue: Issue XV Jim Chanos P.1 Jim Chanos — Tom Russo —“Capacity to Tom Russo P.1 Rooting out Fraud Suffer” is Critical P.1 Thomas A. Russo has been a partner at Gard- Alex Roepers P.1 ner Russo & Gardner since 1989. The firm Robert Luciano P.2 has over $5 billion un- der management, and Pershing Square P.4 he oversees $4 billion Challenge as general partner of Semper Vic Partners Finalist Pitches P.6 limited partnerships, as well as in individually Trip to Omaha P.14 managed accounts. Jim Chanos Prior to joining Gard- Mr. Chanos is the founder and ner Russo & Gardner, Tom Russo Editors Managing Partner of Kynikos Mr. Russo was at the Associates, a firm he founded in (Continued on page 31) Anna Baghdasaryan 1985. Throughout his career, MBA 2012 Mr. Chanos has identified and sold the shares of numer- Alex Roepers — Joseph Jaspan ous well-known corporate finan- MBA 2012 cial disasters; among them, Concentration Key

Mike DeBartolo, CFA Baldwin-United, Boston Chicken, Sunbeam, Conseco and to Outperformance MBA 2013 Tyco International. His most

Jay Hedstrom, CFA celebrated short-sale of Enron Alexander J. Roepers is the shares was dubbed by Barron’s as founder and Chief Invest- MBA 2013 “the market call of the decade, ment Officer of Atlantic In- Alex Roepers Jake Lubel (Continued on page 16) vestment Management. Pre- vious employers include MBA 2013 Julian Robertson — Looking for Thyssen-Bornemisza Group and Dover Corporation, Competitive Spirit where he was responsible Visit us at: Mr. Robertson founded the legen- for acquisitions and divesti- www.grahamanddodd.com dary investment firm Tiger Man- tures. Alexander holds a www0.gsb.columbia.edu/students/ agement, one of the first Master of Business Admini- organizations/cima/ funds. Mr. Robertson has trained stration from Harvard Busi- and supported some of the best ness School and a Bachelor managers in the world of Business Administration (collectively known as “Tiger from Nijenrode University, Cubs”). He graduated from UNC- the Netherlands School of Chapel Hill and also served in the Business, which he obtained US Navy. in 1984 and 1980 respec- tively. Alexander is fluent in G&D: How did you get your start in Dutch, German and French. investing and what has shaped your (Continued on page 44) Julian Robertson (Continued on page 53) Page 2 Welcome to Graham & Doddsville

We are pleasedvery pleased to present to pre- you ter for Graham & Dodd Invest- that Apple and Google will con- withsent youIssue with XV Issueof Graham XV of & Gra- ing, outlined his global value tinue to outperform and talked Doddsville,ham & Doddsville Columbia, Columbia Business equity investing strategy. Mr. about some personal qualities School’sBusiness studentSchool’s-led student invest--led Russo noted that he focuses on that he believes are key to suc- mentinvestment newsletter, newsletter, co-sponsored co- companies with high reinvest- cessful investing. bysponsored the Heilbrunn by the CenterHeilbrunn for ment opportunities by manage- Pictured: Bruce Greenwald at GrahamCenter for & DoddGraham Investing & Dodd and ments that possess the Alex Roepers, founder of At- the Columbia Student Invest- theInvesting Columbia and theStudent Columbia Invest- “capacity to suffer” through lantic , ment Management Conference Student Investment Manage- early burdens on reported described his transition from in February 2011. ment Management Association. ment Association. profits in order to advance being “Mr. Divestiture” at an The Heilbrunn Center sponsors their competitive advantage. industrial conglomerate to es- the Applied pro- TOO ADD Before we introduce you to Mr. Russo detailed his invest- tablishing his own firm, Atlantic gram, a rigorous academic cur- Pleasethis issue’s feel freecadre to of contact outstanding us if ments in Nestle, Mastercard, Investments that has had a very riculum for particularly commit- youinvestors, have commentswe would orlike ideas to Martin Marietta, Brown- successful investment track re- ted students that is taught by abouttake a themoment newsletter. to thank We sev- Forman, and E.W. Scripps. cord. Mr. Roepers outlined his some of the industry’s best prac- hopeeral individuals you enjoy who reading have Graham made investment process, which is titioners. &our Doddsville time at Columbiaas much as Business we We were thrilled to speak with centered on staying within his enjoytruly special. putting it together! Jim Chanos of Kynikos Asso- circle of competence and having ciates, one of the world’s most a very concentrated portfolio. -Our Editors, deepest Graham thanks & Doddsville go to successful short sellers and Mr. Roepers described the rea- Bruce Greenwald, Louisa someone we deeply respect for soning behind his investments in Serene Schneider ’06, his contributions to finding and Joy Global and Owens Illinois. Tano Santos, and the en- calling out fraud in corporate tire Heilbrunn Center’s America. Mr. Chanos dis- Robert Luciano, founder and Board of Directors for cussed the early days of his managing partner of VGI Part- their outstanding leader- career and outlined what quali- ners, outlined his investment ship of the Applied Value ties he believes are essential to philosophy, which closely mir- Investing program at Co- being a successful short seller. rors that of . Mr. lumbia Business School. Mr. Chanos also talked about Luciano detailed his investment Their tireless contributions his bearish view on the Chi- theses behind Oracle and WD- to improving the invest- nese real estate market, the 40. Pictured: Heilbrunn Center ment management cur- U.S. natural gas industry and Director Louisa Serene Schnei- riculum at Columbia Busi- for-profit education sector. Our time at Columbia Business der at the CSIMA conference in ness School were greatly School was filled with many February 2012. noted and appreciated. We Julian Robertson, legendary memorable moments and great Louisa skillfully leads the Heil- would also like to thank Heil- founder of , friendships, and we are grateful brunn Center, cultivating strong brunn Center’s small but very talked about his history of to all the individuals who have relationships with some of the capable staff of Julia Kimyaga- mentoring numerous successful made our experience so unique world’s most experienced value rov and Preeti Bhattacharji. hedge fund managers. He also and wonderful. We hope you investors and creating numerous described the need for analysts enjoy reading this issue of Gra- learning opportunities for stu- Noted value investor Tom to focus on companies with ham & Doddsville where we have dents interested in value invest- Russo, member of the Advi- strong management teams. Mr. tried to highlight some of those ing. The classes sponsored by sory Board of Heilbrunn Cen- Robertson outlined his belief special moments! the Heilbrunn Center are among the most heavily demanded and highly rated classes at Columbia Business School. Robert Luciano — “Concentrate Capital In Your Best Ideas”

Robert Luciano, CFA is Luciano spent five years the founder and Manag- as an Executive Director ing Partner of VGI Part- and Investment Manager ners. Mr. Luciano has with Caledonia Invest- over eighteen years ex- ments in Sydney. Mr. perience gained as a Luciano earned his portfolio manager, equi- B.Com and M.Com from ties analyst and account- the University of New ant. Prior to founding South Wales. Mr. Robert Luciano VGI Partners in 2008, Mr. (Continued on page 58) Page 3

2012 CSIMA Conference in Pictures

William von Mueffling and Eduardo Silveira Mufarej Daniel Loeb

Michael Karsch Bruce Greenwald and David Einhorn

And the hundreds of guests and students that made it all possible... Daniel Krueger Page 4 2012 Pershing Square Value Investing and Philanthropy Challenge

Students and alumni gathered on April 25, 2012 for the Fifth Annual Pershing Square Value Investing and Philanthropy Challenge, a value oriented stock pitch competition, co- sponsored by the Heilbrunn Center for Graham & Dodd Investing and Pershing Square Capital Management. The cash prize for the competition is $100,000, half of which is di- rected to the school for philan- thropic purposes, and the re- mainder to the winning teams. would stand on their own and Pershing Square Challenge Finalists Investment Idea The prize structure supports learn to deliver oral investment the goals for value investors of pitches efficiently and effectively. First Place Anna Baghdasaryan '12 Long doing well and doing good. Rohit Dhingra '12 Avon Products (AVP) Throughout the semester, invest- Second Place Jonathan Au ’13 Long William Ackman, of Pershing ment management industry prac- Square, kicked off the competi- titioners generously donated their Arjun Bhattacherjee ’13 Ingersoll-Rand (IR) tion by introducing the team of time and worked closely with the Rory Ellison ’13 judges. Each team then gave teams to provide feedback and Third Place Rod de Crayencour ’13 Long ten minute prepared presenta- suggest further areas of research. Jake Lubel '13 Legg Mason (LM) tion of the idea that they had Grant Smith '12 First place was awarded to the chosen, followed by Q&A. Michael Durand ’12 Long team of Anna Baghdasaryan David Hendrickson ’13 FleetCor Technologies (FLT) The five finalists were selected ’12 and Rohit Dhingra ’12 who from a pool of 36 teams, which presented a long recommenda- Sean Morgan ’12 enrolled in the Applied Security tion on Avon Products, Inc. Robert Fournier ’12 Long Analysis class at Columbia Busi- (AVP). The judges agreed that Ian Holmes ’12 H&R Block (HRB) ness School. This highly practi- Avon had been mismanaged in Kartik Nehru ’12 cal investment management the past and the equity had signifi- course was taught by Profes- cant potential for upside resulting sors Andrew Brenner and from new management imple- Judges Naveen Bhatia. Students menting a turnaround while the learned the mechanics and potential downside was minimal William Ackman Pershing Square Capital philosophy underpinning idea both due to the resiliency of the Anand Desai Eton Park Capital Management search and selection, and the assets as well as the Coty bid. Craig Effron Scoggin Capital Management analytical elements required to They were impressed by the Mark Gallogly ’86 Centerbridge Partners reach defensible conclusion. depth of the Avon team’s primary They were asked to craft com- research and understanding of the Greg Hall Blackstone Alternative pelling written pitches that underlying business (see write-up Phil Hilal Kingdon Capital Management on page 6). Alex Klabin Senator Investment Group LP

Our deepest thanks to Bill Craig Nerenberg Brenner West Capital Partners Ackman of Pershing Square John Paulson Paulson & Co. Inc. Capital, Professors Brenner and Bhatia, the panel of Scott Pearl Seneca Capital judges, and the Heilbrunn Whitney Tilson T2 Partners, LLC Center for their sponsorship of this competition. Page 5 2012 Pershing Square Capital Challenge in Pictures

Professor Andrew Brenner making opening remarks Finalist teams make their case

Pressure is on… Q&A begins

Judges deliberate The Verdict

Team Avon is the Winner of 2012 Pershing Square Capital Challenge Page 6 Avon Products, Inc. (AVP) - Long Winner — 2012 Pershing Square Capital Challenge Anna Baghdasaryan Rohit Dhingra [email protected] [email protected]

Recommendation: At $20 per share, Avon common stock represents an opportunity to buy an $11 billion dollar iconic global beauty products company near its historical trough value. Avon’s extensive distribution net- work in fast growing emerging markets and its resilient and pervasive brand name are valuable assets which have proven their ability to generate significant cash flow over 80 years across multiple cultures despite occasional and significant mismanagement. We see an upside of up to 100% in 2.5 years de- Anna Baghdasaryan is a pending on new management’s skill in improving operations as well as market conditions. second year MBA student in the Applied Value Investing Business Description Program. She is the Editor Avon is the 5th largest global Beauty and Personal Care products company with $11.3 billion in reve- of Graham & Doddsville, nues. The Company is diversified across geographies, with ~70% of sales from fast growing emerging Columbia’s student-run economies in Latin America, Eastern Europe and Asia Pacific. Avon has strong market shares in the value investing newsletter. range of 10-40% in color cosmetics, skin care and fragrance categories in countries such as Brazil, While at school, she Mexico, Russia and Turkey. Large growth opportunities remain as per capita consumption of beauty worked at Cantillon Capital products is still very low in emerging markets, with only $11 dollars per year spent in China on Management, a global beauty products relative to $129 in the UK and $217 in Japan. As a direct seller, Avon is very nimble investments firm and at relative to the big beauty peers as its sales are not reliant on well developed retail infrastructure. We Clinton Group, small-cap believe that the company’s model is very resilient due to the social aspect of their network and pro- activist-oriented hedge fund. vides an employment avenue for women where such opportunities are in short supply.

Investment Thesis We believe that Avon has been poorly run in recent years, with its board showing disregard for shareholders and tolerating revolving-door leadership and major operational faux-pas. Supply disrup- tions, combined with lack of innovation in a key area, skin care, have resulted in market share losses in recent years and have severely impacted the margins. So why are we recommending a buy on this stock at this time? First, we believe that Avon will con- tinue to be a beneficiary of powerful secular tailwinds in emerging markets. Second, we believe that the very credible new management team can pare back its bloated SG&A structure and settle the FCPA litigation that has been costing the company millions of dollars. Third, the new management team can also help mitigate the fulfillment challenges through strengthening the supply chain infra- structure of the company. These actions could result in significantly improved margins and >$8 billion equity value creation in the next 2.5 years, representing an annualized return of 20-35% to sharehold- Rohit Dhingra is a second ers. If the new management proves to be incapable of fixing the above mentioned issues, a strategic year MBA student at buyer like Coty will likely step in.

Columbia Business School. (US$ in mm, except per share data) He has four years of work Capitalization Summary Financials experience in IT Consulting, Share Price $20.00 2010 2011 2012E 2013E 2014E 2015E Equity Research and FD Shares 431 Revenue 10,863 11,292 11,606 12,073 12,670 13,299 Market Cap $8,619 Growth 6.4% 3.9% 2.8% 4.0% 5.0% 5.0% Technology Strategy roles, Organic Growth 6.0% 1.0% 2.8% 4.0% 5.0% 5.0% having worked with Adobe Plus: Debt 3,237 Systems, Amba Research Less: Cash & Equivalents 1,245 Adjusted EBITDA 1,428 1,397 1,422 1,587 1,729 2,034 and Sapient Corporation. TEV $10,611 Margin 13.1% 12.4% 12.3% 13.1% 13.6% 15.3% Dividend Yield 4.5% Adjusted EBIT 1,233 1,158 1,149 1,310 1,440 1,737 Insider Ownership 0.2% Margin 11.4% 10.3% 9.9% 10.8% 11.4% 13.1% Short Interest 2.1% Less: Restructuring (81) (40) (200) (200) (40) (40) Less: Taxes @ 35% (403) (391) (332) (388) (490) (594) Less: Capex (331) (277) (280) (280) (260) (260) Plus: D&A 195 240 273 277 289 297 Less: Net Change in WC (22) (36) (37) (34) (44) (46) Normalized UFCF $591 $653 $573 $684 $895 $1,094 Growth 69% 10.4% -12.3% 19.4% 30.8% 22.2%

Trading Multiples Based off of Base Case Estimates 2012E 2013E 2014E 2015E TEV/Base Case Adjusted EBITDA 7.5x 6.7x 6.1x 5.2x TEV/Adj. EBITDA - Capex 9.3x 8.1x 7.2x 6.0x TEV/Adj. EBIT 9.2x 8.1x 7.4x 6.1x P / UFCF per share 15.0x 12.6x 9.6x 7.9x Issue XV Page 7

Avon Products, Inc. (Continued from previous page) Detailed Thesis Resilient Assets and Significant Secular Tailwinds in Emerging Markets: In skin care, color cosmetics and fragrances, emerging markets still trail Western markets and are projected to grow at high single digit growth rates for several years. Avon gets an “early bird” advantage in emerging economies and offers afford- able, good value products. Avon has very low capital requirements and high asset turnovers, with 20-30% re- turns on invested capital. The company should therefore be able to generate significant amount of cash flow that can be used for buybacks or dividend payments. Many of company’s “reps” are self-users of the products, demonstrating the “pull” that Avon’s brand continues to have in many markets, particularly outside the US.

Red Flags are Opportunities for New Management: Avon has been meaningfully under-earning over the past 7 years with EBIT margins declining from 15.9% in 2004 to 9.9% in 2011. This has resulted from increases in SG&A overhead, legal costs, higher bad debt provisions and misplaced investments. We believe that under its new focused and motivated management, Avon can increase EBITDA margins from current ~12% to ~15% through taking the following steps: Reducing the SG&A overhead: Former employees and industry experts believe that more outsourc- ing and better expense controls can have a sizeable impact. A ~$300m reduction would yield a 30%+ gain in market value at current multiples. Settling outstanding FCPA litigation: Avon has spent ~$250m in FCPA related expenses up to date, and currently spends at a rate of ~$100m a year on this, while corporate penalties in similar past cases have averaged around ~$80m. Among other factors, the size of alleged illicitly obtained profits is a key determinant in FCPA disgorgements. With China accounting for only 2% of sales and virtu- ally no profit, we believe this could have been settled for well under the associated legal spends made. We believe the old management has not expeditiously addressed this issue due to fear of personal criminal liability. Reducing bad debt expense: Avon’s bad debt expense stands at 2.2% of sales, much higher than that of any of its peers. Reinvigorating sales by increasing R&D and optimizing advertising: Company’s R&D is only 0.7% of sales and lags that of peers. We believe that additional investments in product development R&D will allow the company to generate incremental sales as correlation between increases in R&D spend and revenue growth is very strong in the industry. In addition, the company needs to focus on its best selling categories and products and avoid venturing into new areas (such as silver jewelry Silpada line) where it has limited expertise.

Recent Coty bid shows the presence of alternative exit opportunities: We believe Coty would be willing to increase its current $23.25 bid up to 30% more for Avon in its current state if allowed to conduct due diligence. Coty and Avon have little overlap between geographies, selling channel and prod- uct category (Coty’s fragrances are in the premium category while Avon skews mass). Revenue synergies be- tween Coty and Avon are likely be substantial if Coty’s products were to become available through Avon’s extensive distribution network in emerging countries. As Coty is private, it is hard to discern what the imme- diate expense synergies will be, although overtime there may likely be synergies from combining global func- tions, such as IT and finance.

Without Multiple Expansion With Multiple Expansion Valuation 2015E Base Case Adj. EBITDA 2,034 2,034 Forward Multiple 7.3x 9.5x If the company were to implement the recommended TEV $14,842 $19,321 changes, we believe that it would result in an increase Gain to Current 40% 82% in EBITDA margin to 15% by 2015 or to $2 billion, Less: Debt at 12/31/14 3,254 3,254 from current $1.4 billion in 2011. With a multiple Plus: Cash at 12/31/14 2,088 2,088 expansion to 9.5x (the direct seller average), we Equity Value $13,677 $18,155 estimate that a 2.5 year investment in Avon would Gain to Current 59% 111% have a 35% IRR. Implied Stock Price $31.74 $42.13 Gain to Current 59% 111% Investment Risks/Considerations 2.5 Year IRR 20% 35% Unit declines in North America reflect structural issues with direct selling and might affect earnings: Mitigant - Many direct sellers, including Avon in certain markets, are continuing to gain market share in developed economies (examples include NuSkin in Japan and the US, Avon in the UK and Italy, and Tupperware in France and Austria). Sales growth slows in key emerging markets leading to significant business deleveraging: Mitigant: There are many geographies where Avon is underpenetrated and where it can grow the category substantially (India, Middle East, Africa). Page 8

Ingersoll-Rand plc (NYSE: IR) - Long Target Price: $58.00 Second Place — 2012 Pershing Square Capital Challenge

Jonathan Au Arjun Bhattacherjee Rory Ellison [email protected] [email protected] [email protected] Recommendation: BUY

Prior to CBS, Jonathan worked in Leveraged and Acquisition Finance as an Associate at HSBC Securities, where he covered chemicals, and financial services. Jonathan holds a BA with Honors in Business We recommend a long position in Ingersoll Rand (“IR” or the “Company”) stock with a target price of $58.00. Economics and Biology from The stock has an asymmetrical risk/reward profile from current levels with positive operational and cyclical cata- Brown University. lysts to occur over the next 12-18 months. Our target price represents a ~43% upside to the current share price of $40.61, and is based on a 14.4x 2013E P/E multiple (consistent with the current P/E multiple and below the long -term P/E multiple of 16.0x-17.0x for IR stock). In addition, Ingersoll Rand currently trades at a 15-20% discount to its peer group. We believe there are multiple ways to win with Ingersoll Rand. The key investment highlights include the following: 1) Industry Leading Businesses

#1 or #2 Market share across various business segments 2) Significant Free Cash Flow Generation Prior to CBS, Arjun worked in 11.4% 2013E Free Cash Flow Yield Private Equity at Olympus 3) Strong Macro Tailwind Partners. Arjun holds a BA in 70% exposure to non-residential and residential construction end markets (markets at depressed levels Mathematics and Economics that appear to be turning) from Macalester College. 4) Two-pronged Margin Expansion Story

Elimination of one-time costs that occurred last year

Margin accretion through underappreciated operational improvements, continued restructuring efforts and fixed cost leverage associated with volume increases

Business Description

Ingersoll Rand is a global manufacturer/servicer of industrial and commercial products including HVAC solutions,

transport refrigeration, security systems, power tools, and light utility and recreational vehicles. The Company

Prior to CBS, Rory worked in operates in four segments: Climate Solutions (~$8bn in revenue, 11% Operating Margin), Industrial Technologies Private Equity at Leonard (~$3bn in revenue, ~15% Operating Margin), Residential Solutions (~$2bn in revenue, ~5% Operating Margin) and Green & Partners. Rory holds Security Technologies (~$1.5bn in revenue, ~20% Operating Margin) and offers its products under the Club Car, a BA with Honors in Business Hussmann, Ingersoll-Rand, Schlage, Thermo King, and Trane brand names. Ingersoll-Rand sells its products Admin. from the Richard Ivey through distributors, dealers, and large retailers, with no customer accounting for more than 10% of total sales. In School of Business at the addition, Ingersoll Rand has only 10% exposure to Europe on a revenue basis. The Company is based in Dublin, University of Western Ontario. Ireland. Investment Thesis Industry Leading, Growing and Defensible Businesses: Trane holds the #1 position in the commercial HVAC market and is a leading player in the residential HVAC market (one out of every two U.S. commercial buildings utilizes a Trane system). In addition, the HVAC industry has high barriers to entry given that labor is only a small component of overall costs and that established and widespread distribution networks are difficult to replicate. The Company’s Thermo King (20% Operating Margin) brand holds the #1 market share position in refrigerated transport with only one other significant competitor (two out of every three refrigerated trailers are Thermo King). This industry has high barriers to entry driven by the distribution network and longstanding rela- tionships with trucking companies, OEMs, and a large installed base. Schlage, IR’s commercial and residential secu- rity brand, holds the #1 market share position in North America. Issue XV Page 9

Ingersoll-Rand plc (Continued from previous page) The high degree of customization of the business’s products and the network effects derived from longstanding incum- bency and brand loyalty make this market extremely difficult for competitors to enter. IR’s Industrial Technologies segment, which comprises the golf cart, compressor and air tools businesses, also holds #1 or #2 market share posi- tions in its respective niches.

Significant Free Cash Flow Generation: IR converts >50% of its EBITDA into FCF and ~100% of its Net Income into FCF. The Company generated over $3bn of FCF from 2009-2011 despite industry headwinds and trough volumes. For 2012E and 2013E Ingersoll Rand should generate $1.2bn and $1.4bn respectively and Management has demon- strated itself to be prudent with their use of cash repurchasing 36mm shares in 2011 ($1.2bn) which was greater than 10% of the float outstanding and increasing its dividend to $0.64 per year. Management has also guided to a 300-400mm share buyback this year, a number that we view as extremely conservative and likely to be increased.

Strong Marco Tailwind: Residential security and residential HVAC account for 15% of IR’s total revenues. Residential HVAC is driven by replacement sales (~ 85%) and new construction (~15%). During the recession, consumers deferred replacement with cheaper repairs. Since these repairs only extend the life of HVAC units by 3 – 4 years, a wave of deferred units is expected to hit the market in the next few years. It is important to note that this phenomenon is true even without the assumption of increasing replacement rates (despite rising rates in 2011). Increases in new home con- struction are an added boost—new construction used to account for 45% of Residential sales during peak years (2006/2007) versus 15% currently. Commercial construction is IR’s largest end market. IR is exposed to this expansive market through its Commercial HVAV (Trane) and Security divisions—together accounting for 50% of revenues. Com- mercial construction is at 1975 lows. That said, recent data is pointing to an improving environment. The ABI index has been above 50 for the last five months, non-residential building jobs have increased for the last eight months and non- residential starts were up 27% this March. These indicators all point to an improving end market. Furthermore, IR’s peers have all pointed to strengthening end markets—both Lennox and Carrier pointed to strong commercial HVAC sales and backlog.

Margin Expansion: Analysts are not giving IR benefit for margin improvements because of 2011 missteps (2011 mar- gins hit by one-time R-22 loophole and related $50—$70 million of one-time expenses). However, ·IR’s participation in R-22 market in 2012 alone will contribute to margin improvement. In addition, the residential HVAC segment is still operating well below capacity (65%) suggesting that volume gains will drive operating leverage. The company also has a restructuring initiative in place that will drive operational improvements through better materials management, “Lean” manufacturing and workforce productivity improvements. Valuation: Our target price represents a ~43% upside to the current share price of $40.61, and is based on a 14.4x 2013E P/E multiple (consistent with the current P/E multiple and below the long-term P/E multiple of 16.0x-17.0x for IR stock). Our Downside case, uses a 2013E P/E of 11.0x (2013E EPS of $3.22) and our Upside case uses a 2013E P/E of 16.0x (2013E EPS of $4.57).

EV/EBITDA EV/(EBITDA - Capex) Price / Earnings 2012E Net Debt / Companies 2011 CY2012 CY2013 2011 CY2012 CY2013 2011 CY2012 CY2013 Div. Yield Payout Rat. EBITDA

Emerson Electric 8.0x 8.0x 7.3x 9.2x 9.3x 8.4x 15.2x 14.3x 12.3x 3.2% 46% 0.7x Lennox 10.1x 9.2x 7.6x 12.4x 11.7x 9.2x 18.8x 16.1x 12.3x 1.9% 30% 1.8x Stanley Black and Decker 9.8x 8.0x 7.3x 12.1x 9.2x 8.4x 14.8x 13.2x 11.6x 2.1% 28% 1.6x Dover 8.1x 7.1x 6.5x 9.8x 8.4x 7.7x 14.3x 12.4x 11.1x 2.1% 26% 0.6x Illinois Tool Works 8.9x 8.2x 7.5x 10.0x 9.2x 8.3x 13.7x 13.5x 12.1x 2.6% 35% 0.8x United Technologies 8.3x 7.9x 6.8x 9.3x 8.9x 7.7x 14.6x 14.4x 12.1x 2.4% 35% 0.5x Atlas Copco 10.4x 9.8x 9.3x 10.4x 11.0x 10.4x 14.9x 14.4x 13.4x 3.1% 45% 0.7x Assa Abloy 14.1x 10.3x 9.5x 14.1x 11.6x 10.7x 15.2x 14.2x 13.0x 2.2% 32% 2.1x

Mean 9.7x 8.6x 7.7x 10.9x 9.9x 8.8x 15.2x 14.1x 12.2x 2.4% 34% 1.1x Median 9.4x 8.1x 7.4x 10.2x 9.2x 8.4x 14.8x 14.3x 12.2x 2.3% 33% 0.8x

Ingersoll Rand 7.7x 7.4x 6.6x 8.9x 8.4x 7.5x 14.4x 12.6x 10.1x 1.6% 20% 1.3x Near-term Catalysts 1) Earnings outperformance (our 2012 EPS is ~10% above management guidance/consensus) Recent data suggests top-line recovery is imminent (dealer surveys reiterate end-market improvement) ‒ Q1 results were strong and ahead of consensus but management kept FY2012 guidance in tact Management has already grown operating margins 250bps through 19 value streams with minimal volume improvement (Management indicated 100 value stream potential) 2. Increased Share Buyback Management guided to a share buyback of 300-400mm which we believe they will increase later this year ‒ We assume a 500mm buyback in 2012 3) Increased Dividend We believe management will steadily increase the dividend and target a 30% payout ratio (currently ~20%) ‒ We assume a 25% increase in 2012 Key Investment Risks: (1) slower-than-expected rebound in commercial construction; (2) failure to deliver on pro- ductivity targets; (3) inability to pass through price increases to offset inflation; and (4) continued weakness in residential HVAC replacement rates. Page 10

Legg Mason Inc. (LM) - Long Third Place — 2012 Pershing Square Capital Challenge

Rod de Crayencour, MBA 2013 Jake Lubel, MBA 2013 Grant Smith, MBA 2012

[email protected] [email protected] [email protected]

As of 4/20/12; in USD m except per share data Current Capitalization Trading Statistics Stock Price $25.76 Short Interest 5.4% 52-Week Range $22.61-$37.82 Annual Dividend $0.32 Diluted Shares (M) 139.8 Dividend Yield 1.2% Market Cap $3,601 Avg. Daily Volume (m) 1.75 Cash & Investments ($2,009) Valuation and Target Price NPV of Tax Credits ($914) Trading Valuation Statistic Multiple Revolving Credit Line (Feb13) $250 EV / FY'13 EBITDA $485 5.0x 2.5% Senior Convertible 2015 $1,250 EV / FY'13 Unlv. EPS $2.33 7.5x Other Debt $267 Upside $43 68% Enterprise Value $2,445 Downside $21 -19% Reward/Risk 3.6x Recommendation The common stock of Legg Mason (“LM” or “the Company”) offers a compelling long opportunity. At $26 a share, the market is discounting the past more than the future and fails to recognize the value that lies with LM’s significant tax credits. Once taken into account $6.50 per share in tax assets, LM trades on less than 5x EV/EBITDA and less than 8x cash earnings. We think LM is poised for a rerat- Rod de Crayencour is a ing as soon as the Company’s improved performance starts translating into its reported financials. first year MBA student. Further catalysts that could help close the gap between price and intrinsic value include: improving Prior to Columbia, Rod fund performance at Western, an accretive stock buyback program, and the expiry of Nelson Peltz’s worked as an investment standstill agreement at the end of the year. analyst in a and on a debt restructuring desk Business Description at Credit Suisse. Legg Mason owns a collection of money managers across a wide range of assets classes including Western in fixed income ($442bn AuM as of December 2011), Royce in small caps ($36bn), Permal in fund of hedge funds ($18bn), and ClearBridge in equities ($51bn). Most of these managers have lead- ing market positions within their niche and strong long-term track records. Jake Lubel is a first year

MBA student. Prior to Investment Thesis Columbia, Jake worked as a Legg Mason is hated by the investing community and priced accordingly. This is partially the result of small-cap research analyst at the downfall of a well-known portfolio man- T. Rowe Price. ager and partially a consequence of a num- ber of misunderstandings: Grant Smith is a second Legg Mason owns a diversified collec- year MBA student tion of asset managers that operate participating in the Value independently and transfer a fixed Investing Program. Last portion of their revenue to the parent summer, Grant interned at company. This franchise-like business T. Rowe Price. Prior to model is more robust and has a lower Columbia, Grant worked as operating leverage than competitors. an equity analyst at Ensign Legg Mason has more than $900m in Noisy P&L Obscures Cash Flow to Shareholders

Peak Advisors. tax credits that do not show up on the $0.24 $2.29 balance sheet and are largely ignored $0.13 by the Street. However, the value of $0.08 Net Cash $0.23 Imputed Interest these tax credits currently amounts to Amortization Interest Expense & $0.39 Other close to 25% of LM’s market cap. $1.45 ($0.22) Realized Efficiencies

The recent restructuring program is Adjustment Restructuring for Expenses hurting reported numbers and obscur- Normalized ing the true earnings power of the Tax Rate LTM GAAP Adj. EPS Unlevered company. While the LTM GAAP EPS EPS

1 in only $1.45 (implying a PE multiple of Price / GAAP EPS: Markedly Different Valuation Adjusted PE : 18x), the “owners’ earnings” are close 18x 8x to $2.29 per share for a PE of 8x. 1 Adjusted PE assumes value of tax credit is accounted for separately and EPS are subject to a full 34.5% tax rate Issue XV Page 11

Legg Mason Inc. (LM) (Continued from previous page) Valuation Once adjusted for the value of the tax credits, Legg Mason currently trades at 5.0x FY’13 EBITDA and 7.5x FY’13 unlevered EPS which does not reflect the quality of the underlying affiliates. We estimated the earnings power value of the Company at $43 (70% upside) assuming a 15x mul- tiple on FY’13 unlevered earnings and adjusted for the tax credits and the net cash position. Our sum-of-the-parts analysis which reflects what an informed buyer would pay for each of the affiliates suggests a value of up to $54 (100% upside).

Earnings Power Valuation Sum-of-the-Parts Valuation (70% Upside ) (100%+ Upside) All figures in USD mn, except per share data All figures in USD bn, except per share data Value $ / Share Affiliates AuM % AuM Value $/Share % Total Western Asset Management 442.0 0.69% 3.05 21.82 41% FY'13 Unlevered EPS $317 $2.33 Rod de Crayencour Royce & Associates 35.9 2.75% 0.99 7.06 13% Fair Multiple 15.0x 15.0x Permal 17.8 4.00% 0.71 5.09 9% Enterprise Value $4,762 $34.90 ClearBridge Advisors 51.4 1.50% 0.77 5.52 10% Batterymarch Financial Mgmnt. 17.6 1.25% 0.22 1.57 3% Cash & Investments $2,009 $14.37 Brandywine Global Invest. Mgmnt 33.1 0.95% 0.31 2.25 4% NPV Tax Credits $914 $6.54 Legg Mason Capital Management 8.4 0.93% 0.08 0.56 1% Debt ($1,767) ($12.64) Other 20.8 1.00% 0.21 1.49 3% Additional Value $1,156 $8.27 Total Enterprise Value 627.0 6.34 45.36 85% Cash & Investments 2.01 14.37 27% Equity Value $5,917 $43.17 NPV Tax Credits 0.91 6.54 12% Upside from Current Price 68% Debt (1.77) (12.64) -24% Total Equity Value 7.50 53.63 100% Diluted Shares Outstanding 0.14

Catalysts A number of catalysts will help trigger a rerating of the stock in the near future: Earnings will become cleaner starting in the quarter ended June 2012 as the restructuring process is now completed. This should reveal the true earnings power of the company. Western’s flagship products are now all ranking in the top quartile for 3-year performance which should lead to positive fund flows. Jake Lubel The highly accretive stock buyback program currently in place will support LM’s share price. LM has already reduced the share count by 13% over the past two years but current FCF of 13% offers ample opportunity to do more. Nelson Peltz, who owns 10% of the Company has entered into a standstill agreement with man- agement in exchange for a seat on the Board. Under the terms of the agreement, Peltz cannot publicly speak negatively about management, call for divestitures, or publicly call for further re- structuring. This agreement expires at the end of 2012. Further restructuring at the holding company level of up to $40m pretax could be achieved as LM’s cost structure remains well above its peers in the industry.

Risks 20% Downside in Bear Case Scenario

Sensitivity to AuM flows. Mitigated by lower $2.33 $0.39 operating leverage than peers. We estimate that a 1% change in AuM will have a 1.5% impact on $0.20 EPS (split between .84% on equity assets and Equity 0.61% on fixed income assets). Market $0.14 Decline Equity $0.09 Grant Smith History of poor capital allocation. Miti- $1.50 (20%) Outflows Fixed gated by Nelson Peltz’ presence on the Board. (10%) Income Shut Down Outflows Money funds regulation. This (10%) Market could lead to LM having to shut down the busi- ness entirely, which would impact our fair value Base Case Bear Case estimate by 5% ($400m). Adj. EPS Adj. EPS Continued shift toward ETFs. This is real, $2.33 Unlevered EPS $1.50 15.0x Multiple of Unlevered EPS 10.0x but overshadowing a much bigger trend: the $34.90 Enterprise Value $15.00 rising share of households’ assets allocated to- $1.73 Net Cash Position $1.73 wards investment funds. $6.54 Usable Tax Credit $4.22 $43.17 Equity Value $20.95 Issue XIV Page 12 Page 12

H&R Block, Inc. (NYSE:HRB) - Long

Finalist — 2012 Pershing Square Capital Challenge Robert Fournier Ian Holmes Kartik Nehru Robert is a second year [email protected] [email protected] [email protected] MBA student. Prior to Columbia Business School, Capitalization & Valuation ($MM) Summary Financial Information ($MM) he was an Associate at Current Capitalization FY Ended April 30, FQ3'12 Penfund Management, a Share Price (April 27, 2012) $14.96 2009 2010 2011 LTM $350 million private equity Shares Outstanding 293 Assisted Tax Prep $2,411 $2,268 $2,219 $2,275 Equity Market Capitalization $4,383 Digital Tax Prep 215 216 231 222 fund. Robert holds a Add: Debt 1,296 Ancillary & Other 507 491 462 408 Bachelors of Commerce Less: Cash (1,219) Total Revenues $3,133 $2,975 $2,912 $2,905 from Queen’s University. Total Enterprise Value $4,460 Operating Income $886 $826 $721 $729 Historical Valuation Metrics % Margin 28% 28% 25% 25% 2009 2010 2011 LTM Adjusted FCF $461 $497 $450 $552 Ian is a second year MBA P/E 11.4x 11.7x 12.8x 11.2x % Margin 15% 17% 15% 19% P/FCF 11.4x 10.2x 10.9x 7.9x student. Prior to Columbia Earnings Per Share $1.38 $1.34 $1.26 $1.33 Business School, he was a Dividend Yield 3.8% 3.8% 3.7% 5.3% ROIC 14.3% 13.9% 15.2% 15.9% Restructuring Associate at Miller Buckfire & Co. Ian Recommendation holds a B.S. from Lehigh H&R Block, Inc. (“HRB” or the “Company”) is an attractive investment with near-term catalysts. The University. stock trades at 11x earnings and has a 11% free cash flow yield. HRB suffers from misperceptions around cannibalization of its core business and excessive fear surrounding potential liabilities from a discontinued subsidiary. These fundamental misunderstandings and fear create a dislocation between Kartik is a second year MBA price and intrinsic value. Over the next twelve to eighteen months HRB will achieve significant earn- student. Prior to Columbia ings growth as it benefits from regulatory changes taking place in the assisted tax market. Further- Business School, he was an more, HRB is poised to re-lever its balance sheet and return capital to shareholders. All-in the invest- Associate at Lindsay ment has an asymmetric 4:1 upside-to-downside profile, bolstered on the downside by a 5% dividend Goldberg, a $10 billion yield and a 5% normal course buyback yield. private equity fund. Kartik Business Description holds a B.S. from the H&R Block, based in Kansas City, MO, operates 11,000 assisted tax preparation offices (60% company Wharton School at the owned, 40% franchised), primarily in the . HRB is the largest player in the assisted mar- University of Pennsylvania. ket with 19% market share (its next largest competitors have 3% and 2%, respectively). The assisted tax market is highly fragmented with 76% of the market comprised of independent operators (e.g., CPAs and mom-and-pop seasonal operators). HRB focuses on the lower income segment of the mar- ket and therefore HRB’s main source of competition is the mom-and-pop seasonal operator (CPAs focus on high income filers). In connection with its assisted tax preparation services, HRB also offers a number of ancillary products such as credit cards and debit cards. The Company also offers digital tax preparation software for the do-it-yourself at-home filer. Investment Thesis HRB’s Core Business is Misunderstood: Over the past 10 years there has been a rapid increase in the number of digital tax filings (e.g., TurboTax). The market assumes that this growth is cannibaliz- ing the assisted tax market (e.g., H&R Block). However, closer examination of the data reveals that the growth in digital tax filings is coming purely at the expense of “pen-and-paper” filers. Over the past 10 years, the assisted tax market has remained 60% of all tax filings, while the other 40% of the market has shifted from pen-and-paper to digital. Therefore HRB’s core business, assisted tax prepa- ration, is not threatened by the growth of digital filings.

The Proof is in the Numbers – 10 Years of IRS Filing Data

(% of total filings) Nature of Filing Conclusions 70%  Assisted tax prep is 60% “Do It For Me” (HRB’s core market) NOT in secular decline 50%

40%

30%

20% “Do It Yourself”  Digital filings are cannibalizing pen & 10% paper filings 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Assisted Pen & Paper Digital Issue XV Page 13

H&R Block, Inc. (Continued from previous page) Subprime Overhang is Excessive: Prior to 2007, HRB’s subsidiary, Option One, originated sub- prime mortgages. The subsidiary was shut down in 2007, however HRB’s stock continues to be weighed down by the risk of putback liabilities (i.e., if Option One is deemed to have violated its reps and warran- ties, the buyers of defaulted loans could seek to unwind the purchase). With $36 billion of loans out- standing, the market assumes that the liability to HRB is significant. However, after examining (i) the his- torical loss rates, (ii) recent settlement comparables, and (iii) the risk of corporate veil piercing, we be- lieve the liability is less than $400 million (less than 10% of the stock price). HRB Will Benefit From Regulatory Changes in the Assisted Tax Market: There are two regu- latory changes taking place in the assisted tax market (i) the elimination of refund anticipation loans (“RALs”), and (ii) the national registration process. RALs are a form of payday lending in the assisted tax market. HRB stopped providing RALs in 2010, but HRB’s main competitors, the independent mom-and- pops, have continued to offer RALs; which has put HRB at a competitive disadvantage. However, the FDIC has recently forced all banks to stop offering RALs. Therefore after April 2012, RALs will no longer be available to the mom-and-pop competitors. This is significant because RALs drive traffic to mom-and- pops and account for the majority of their profitability. Secondly, beginning in 2013 all tax preparers must register with the IRS and submit to a background check, pass a competency examination, and achieve 73 hours of continuing education. We believe that the combination of (i) the loss of highly profit- able RALs and (ii) the burden of the registration process will drive the marginal mom-and-pop out of the market and increase HRB’s market share. Due to high incremental margins on an additional filing, even a small increase in market share will drive significant earnings growth. HRB Can Re-Lever its Balance Sheet and Return Capital to Shareholders: The Company is significantly under-levered today. Current Credit Profile HRB’s core business has many characteristics of an 4Q/11 1Q/12 2Q/12 3Q/12 attractive credit (recurring revenue, diverse cus- Capitalization tomer base, high cash flow, leading market share) yet Sr Notes due Jan 2013 $600 $600 $600 $600 it sits in a net cash position. Furthermore, HRB pays Sr Notes due Oct 2014 400 400 400 400 $0.80 in dividends for a 5% dividend yield; therefore FHLB and Other 78 75 105 296 Total Debt $1,078 $1,075 $1,105 $1,296 the pre-tax cost of funding the dividend is approxi- mately 9%. In today’s credit markets, HRB can issue Less: Cash (1,678) (1,013) (573) (1,219) debt at less than 6%. Therefore it is actually cheaper Net Debt ($600) $63 $532 $77 to buyback a share than it is to pay the dividend on Leverage Statistics that share. For this reason a levered share repur- Total Debt / EBITDA 1.3x 1.3x 1.3x 1.6x chase is financially compelling. We believe that man- Net Debt / EBITDA (0.7x) 0.1x 0.7x 0.1x agement will pursue such a transaction within the Coverage Statistics next six months (in conjunction with the refinancing Interest Coverage 10.1x 10.1x 9.8x 9.8x of HRB’s 7.875% Senior Notes due January 2013). Fixed Charge Coverage 5.7x 5.4x 5.1x 4.9x We believe that they will take on an additional $600 million of debt (which would put total debt/EBITDA at 2.0x) and use the proceeds to repurchase stock. The Company’s CEO has recently taken a number of steps to return capital to shareholders including: (i) increasing the dividend by 33%, (ii) selling a non-core asset for $500 million, and (iii) reducing the minimum equity covenant on the Company’s line of credit. Valuation We believe that HRB is worth ~$23 per share, with an upside of ~$28 and a downside of ~$14 per share. With an 11% free cash flow yield, the stock is trading cheap; however our base case valuation assumes that the stock continues to trade at 12x-13x P/E due to the market concerns about subprime overhang (i.e., headline risk). The more significant return-driver is growth in earnings from the current $1.36 per share to $1.73 per share. The growth in EPS is due to (i) higher operating income (driven by regulatory changes) and (ii) lower share count driven by a levered share repurchase transaction. Investment Risks/Considerations Simplification of the Tax Code: Many people believe simplification of the tax code would drive HRB’s customers to do their own taxes. However, HRB’s target customer (the low-income filer) already has relatively simple taxes. The reason they go to H&R Block is because their tax refund check is likely the largest check that they receive all year (50% do not have bank accounts). For HRB’s customers, the risk/reward of doing their own taxes and potentially missing a deduction is unattractive. Return-Free Filing: Return-free filing is where the government prepares your taxes for you and sim- ply sends you a bill. While this system is technologically feasible and has been proposed a number of times, it is overwhelmingly unpopular with the American public. In an October 2011 survey, 73% of Americans said that they would not trust the IRS to prepare their taxes for them, and 80% said that they would not vote for a candidate that supported a return-free filing system. Page 14 Trip to Omaha to see the Oracle Columbia’s team thrilled to meet and have lunch with Warren Buffett

Some of the funniest and most memorable moments from the trip

How about a new jersey for Mr. Buffett? ... Or a shoe shine? Louisa Serene Schneider ’06 teaching Warren Buffett his first yoga lesson

Relaxing on Warren Buffett’s favorite But the best of it all, learning bed at Nebraska Furniture Mart from Warren Buffett Page 15

On behalf of the Applied Value Investing Class of 2012, thank you! You’ve made our time at Columbia Business School one we will always remember Heilbrunn Center’s List of All-Stars

Arnaud Ajdler Crescendo Partners Gavin Albert Soros Fund Management LLC Christopher Begg East Coast Asset Management Avi Berg ’97 Jennison Associates Naveen Bhatia 40 North Industries LLC Ethan Binder ’06 Slate Path Capital Mike Blitzer ’04 Kingstown Capital Management Michelle Borre ’96 Oppenheimer Funds Inc Andrew Brenner Columbia Business School Margaret M. Cannella ’76 CHF International, LLC Jeff Cino ’06 Ramius LLC Mark Cooper ’02 PIMCO Michael Corasaniti ’92 Tourmalet Advisors Wouter Dessein Columbia Business School Cheryl Einhorn Columbia Business School Peter Eliot ’04 Capital World Investors Jefferson Gramm ’03 Bandera Partners Joel Greenblatt Gotham Capital David Greenspan ’00 Slate Path Capital Bruce Greenwald Columbia Business School Andrew Gundlach ’01 Arnhold and S. Bleichroeder Holdings/First Eagle Paul Johnson Nicusa Capital Partners Terrence Kontos ’05 Fred Alger Management Dan Krueger ’02 Owl Creek Michael Mauboussin Legg Mason Ian McDonald Hilltop Park Associates Neal Nathani Axial Capital Management, LLC T. Charlie Quinn ’06 Gardner, Russo, and Gardner Jon Salinas ’08 Marble Arch Investments Tano Santos Columbia Business School Louisa Serene Schneider ’06 Columbia Business School Guy Shanon ’99 Kingstown Capital Ken Shubin-Stein Spencer Capital Paul Sonkin ’95 Hummingbird Fund Joseph Stiglitz Columbia Business School Grant Toch ’04 Steinberg Asset Mgmt Tom Tryforos ’84 Grand Street Capital Martin Whitman Third Avenue Value Fund Artie Williams ’02 Summit Street Capital Dan Yarsky ’06 Morgan Stanley Page 16

Jim Chanos

(Continued from page 1) duction into the numbers of if not the past fifty years.” “… I handed out a investing. He is a Visiting Lecturer in two page memo to Finance at the Yale Uni- There was a defining mo- versity School of Manage- the senior banker ment, however, when I real- ment and a graduate of ized Yale University. discussing the impact wasn’t for me. A year into my stint at Blyth, we were G&D: Mr. Chanos, you stud- of buying back stock. working on a recommenda- ied economics and political tion for McDonald’s to issue science at Yale. At what point The senior banker a bond. At that point in its did you get interested in the looked at me with an history, McDonald’s was ? generating a lot of cash and icy stare and stated reinvesting it back into its Jim Chanos JC: My father had been a restaurants, each of which stock market investor since that we were not in generated high returns. But the 1950s, in addition to run- the stock market was valu- ning the family business. He the business of ing McDonald’s at only 8 or drilled into me the notion that 9x earnings despite the to be financially independent, I recommending share company growing at 20-25% would have to work for my- buybacks to our a year pretty consistently self, work hard, save my with real cash earnings. money and invest wisely. He clients; we were in Around this time, I read that began teaching me about the Teledyne and Radio Shack stock market when I think I the business of selling were growing earnings rap- was in third or fourth grade. idly by buying back stock, as From this point onward, I debt. This was my the management of these became fascinated by invest- firms believed that their ing. I was fascinated by the first douse of cold companies were underval- math and the numbers and the water regarding Wall ued in the stock market. fact that you could invest and, This was at a time when unlike with a savings account, Street and I became interest rates were at dou- you might be able to double ble-digits. I ran some num- your money. This was my pretty disillusioned bers independent of the first introduction to investing blue book that the associ- and it occurred in the late after that episode. I ate, the senior banker and I ’60s. I continued to read were compiling, and deter- about investing and took the had learned that Wall mined that instead of the only two undergraduate ac- Street wasn’t debt deal, we should recom- counting classes while at Yale. mend that McDonald’s buy necessarily doing back stock with some of its After I graduated I decided cash flow and cut back its that I wanted to pursue an things in their clients’ expansion slightly. This investment career. I didn’t get could lead to a larger EPS a job offer from any of the big best interest…” increase relative to the New York banks, which in bond issuance and they 1980 were the source of most Dillon’s regional office in wouldn’t have to add lever- of the employment offers. I Chicago. I put in 16 hour age to the balance sheet. joined one of the first invest- days six days a week work- Given where rates were, ment banking analyst pro- ing on deals for senior bank- the impact on EPS from grams with Blyth Eastman ers. This was a good intro- (Continued on page 17) Page 17

Jim Chanos

(Continued from page 16) other. I had a little money vent. While this was occur- buying back stock rather saved and was trading like a ring, every brokerage house “I recommended a short than issuing debt was dra- lunatic in my own brokerage was recommending the position in Baldwin- matic. When I made this account, not making any stock. Although the com- case to the associate, he money. Finally one day, Bob pany was rapidly growing United at $24 based on turned white and said he called me into his office, earnings, those were all non language in the 10-K wanted no part of present- shut the door, and told me -cash earnings because Bald- ing this idea to the senior that he was leaving to start win-United was using gain and 10-Qs, uneconomic banker. Being pretty naïve a retail brokerage firm with on sale accounting when it annuities, leverage and not realizing the politi- a couple of partners. He sold annuities. This ficti- cal implications of such a asked me if I wanted to join tious “gain” was based on issues and a host of recommendation, I handed their new firm as an analyst. the expected persistency of other concerns. The out a two page memo to I could barely contain my the policies and the present the senior banker discussing excitement. value of the estimated stock promptly doubled the impact of buying back spread generated by their on me. This was a good stock. The senior banker One of the first stocks they returns on investment in looked at me with an icy had me look at was insur- excess of the annuity pay- introduction to the fact stare and stated that we ance holding company called outs. The problem was that in investing, you were not in the business of Baldwin-United. Baldwin that they were paying 14% recommending share buy- was growing very rapidly by on the annuities and were can be really right but backs to our clients; we selling annuities that were far too optimistic on their temporarily quite were in the business of sell- uneconomic. To plug the investment return estimates. ing debt. This was my first hole that was developing My first research report was wrong… I went home to douse of cold water regard- within their sub- published in August of 1982. visit my parents for ing Wall Street and I be- sidiaries, the holding com- I recommended a short came pretty disillusioned pany was closing acquisi- position in Baldwin-United Christmas and received after that episode. I had tions. In exchange for the at $24 based on language in a phone call from Bob learned that Wall Street insurance companies’ cash, the 10-K and 10-Qs, uneco- wasn’t necessarily doing the holding company was nomic annuities, leverage Holmes telling me that I things in their clients’ best providing the subsidiaries issues and a host of other was getting a great interest but was instead with overvalued securities. concerns. The stock focused on maximizing fees. However, the regulators of promptly doubled on me. Christmas present – the the insurance subsidiaries This was a good introduc- state insurance G&D: So was it this inci- were becoming wise to the tion to the fact that in in- dent that led to your transi- development as Baldwin- vesting, you can be really regulator had seized tion to the buy-side? United’s stock shot up. We right but temporarily quite Baldwin-United’s acquired a copy of the in- wrong. I put another re- JC: Around this time, I had surance department public port out in early December insurance subsidiaries.” been talking stocks with the files and we were able to of 1982 with the stock at head of retail client broker- see from regulators’ letters $50 and reiterated my the- age at the Chicago office, that they were becoming sis while pointing to addi- Bob Holmes, during my increasingly concerned tional evidence that had lunch hour. That’s what I about the valuation of those come out in the interim. I really enjoyed; going over to affiliated assets held by the went home to visit my par- his office and checking the insurance company. They ents for Christmas and re- market and punching tickers went as far as to imply that ceived a phone call from into the Quotron machine if Baldwin-United didn’t Bob Holmes telling me that to see what was up and downstream additional capi- I was getting a great Christ- what was down. I would tal to its insurance subsidiar- mas present – the state in- look forward to that part of ies, they would have to de- surance regulator had seized my day more than any clare the subsidiaries insol- (Continued on page 18) Page 18

Jim Chanos

“A lot of what (Continued from page 17) that come about? son orchestrating this short- Baldwin-United’s insurance selling pressure across all happens in your life subsidiaries. Baldwin filed JC: In late1983, Deutsche categories of investors was for bankruptcy shortly me. Within a day or two, I is merely Bank came knocking and thereafter. asked me to move to New was summoned to a supe- serendipitous and York to be an analyst in rior’s office and told that my That’s the idea that sort of their new boutique invest- employment contract which really just luck. In a put me on the map. After ment research operation. In expired in October of 1985 that, big New York hedge the summer of 1985, I began would not be renewed. lot of ways, that’s funds to which we had been looking at the Drexel Burn- Luckily, for a year or so I trying to pitch the Baldwin ham companies which Mi- had been talking to a couple the lens through short started calling us to chael Milken was putting of investors who wanted me to run a portfolio of funda- which I look at my see what other companies together through junk were short candidates. I bonds. I was particularly mental short ideas for them. own career. If the had no predisposition to be focused on a real estate Though my bargaining a short seller but I thought syndicator called Integrated power had declined a bit McDonald’s share that there could be a busi- Resources which was play- since I was going to be out ness niche in that arena. ing unbelievable accounting of a job in a few months, buyback episode Maybe I could, as a young games and financing itself they agreed to set up analyst, carve out a good with junk debt issued at Kynikos Associates with me. hadn’t occurred, business by being an institu- 14%. The company would The fund was capitalized with $16 million, $1 million maybe I wouldn’t tional skeptic and come out overpay for office buildings with two or three really and then syndicate their of which was my own, and st have left Blyth and good short ideas that were ownership interest to we started on October 1 , thoroughly researched with wealthy individuals via tax 1985. I’d probably still be the evidence clearly pre- sheltered partnerships in sented and documented. uneconomic deals. Since G&D: What were the doing deals and be This would then be ex- there wasn’t enough cash to early days like? pected to lead to some nice pay their fees, Integrated miserable. To join commissions for the firm. was taking their fees via JC: From 1985 to 1990 a new firm and to overvalued third mortgages was a golden era for short A lot of what happens in on the syndicated proper- sellers because it was a have the first your life is merely serendipi- ties. The company’s earn- highly idiosyncratic, uncor- tous and really just luck. In ings were not only over- related market. Although company I look at a lot of ways, that’s the lens stated but were also heavily the market was slowing, it through which I look at my negative cash flow. I started was dominated by institu- turn out to be an own career. If the McDon- to ruffle some feathers, and tions. If you could make a Integrated put a lot of pres- enormous financial ald’s share buyback episode case that a company was hadn’t occurred, maybe I sure on Deutsche Bank and playing games with its num- fraud was equally wouldn’t have left Blyth and others to muzzle me. Later bers or had some other I’d probably still be doing that summer, there was a serious problem and the good luck.” deals and be miserable. To Wall Street Journal front company then admitted join a new firm and to have page article by Dean Rot- wrongdoing, the stock the first company I look at bart describing an evil cabal would go down quite a bit. turn out to be an enormous of short-sellers who were Meanwhile, the broader financial fraud was equally saying terrible things about stock market had a few pe- good luck. nine or ten great companies riods of run-up following including Integrated Re- some crashes leading up to G&D: For a brief period, sources. According to an 1990. The so-called you also worked for illustration on the inside of Deutsche Bank. How did that Journal issue, the per- (Continued on page 19) Page 19 Jim Chanos

(Continued from page 18) two large clients came for- it could still go down; for was off the charts in this ward and said they believed example, Boston Chicken, time period. It was proba- we were still adding value to Oxford Health, and Sun- bly in the 20% area. Money their portfolio and that they beam were all collapses. So flooded into any hedge fund we had some great years that said they had short- “I believe the despite the bull market. selling skills. By 1990 we Something else that we did were running $660 million NASDAQ or the was to change our compen- and were one of the top ten sation formula for our man- largest hedge funds in the Russell doubled in aged accounts so that com- world. Then it all came pensation was determined crashing down from ’91 to 1991. There was no based on an inverse bench- ’95. After the Gulf War, mark basis. For example, if the Fed eased and the mar- place to hide on the the S&P was up 20% and we ket took off for a good short side. were up 10%, we would be three years until ’94 and paid as if we were up 30% then began to take off again Everything became but alternatively, if the S&P in ’95. I believe the was down 20% and we were NASDAQ or the Russell correlated on the up 20%, we would be paid doubled in 1991. There was nothing because we created no place to hide on the way up. The worse no excess return, or alpha. short side. Everything be- That arrangement saved the came correlated on the way the news a company business as well. We gener- up. The worse the news a reported, the more ated a lot of alpha in the late company reported, the ‘90s so those were some of more its stock price appre- its stock price our best years financially ciated. It was a tear-your- and performance-wise. We hair-out market if you were appreciated. It was still have that compensation a short-seller. With client structure today. Most of withdrawals by ’93 and in a tear-your-hair-out our dollar assets are paid on ’95, we were down to $150 an alpha basis, so the clients million and I was wondering market if you were a like it and we think it’s fair. if I was going to stay in busi- short-seller.” ness. I didn’t want to do G&D: At what point did what a lot of people have were willing to invest addi- you open your long-short done in that situation – tional money. They agreed fund in addition to the short close up shop and start to lock up some additional -only fund? again two years later – be- capital for a slight cut on the cause I didn’t think that was fees. So, in effect, those JC: In 2003, we launched fair to my investors for two clients saved the busi- our first long-short fund – whom I had lost money and ness in ’95. We never really Kynikos Opportunity Fund who had high water marks. looked back. – because we realized that We agreed to soldier on through our research proc- and I paid most of the em- Their timing was exquisite ess, we were coming across ployees out of my pocket because although the mar- a lot of good long ideas for a few years because ket kept going up between upon which we couldn’t act. there were no performance 1996 and early 2000 during This ability to go long acted fees. I had a core group of the dot-com era, it was as an adjunct to our short people who were very loyal again bifurcated and uncor- research. A stock might and stayed with me through related much like in 1985. If this period. Then in 1995, you had a good short idea, (Continued on page 20) Page 20

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“… numerous (Continued from page 19) domestic short fund and the about 20%+ of our ideas collapse and the bonds long-short fund. have some sort of positive studies have shown might fall in price but based analyst report out or the that most rational on the work we have al- G&D: Could you describe CEO is on CNBC or there’s ready done we might think your process in a bit more a takeover rumor. Almost people’s decision- there is some value in the detail for our readers? all of this is noise; there’s firm and that the bonds are just not a lot of informa- making breaks money good. The Opportu- JC: I used to think that tional content in this stuff. nity Fund allowed us to good short-sellers could be But this is the music of the down in an capitalize on these types of trained like long-focused investment business. It’s opportunities. We might like a (more often than not) environment of value investors because it also utilize a pair-trade should be the same skill set; comfortable river that every negative strategy in this fund. For you’re tearing into the num- investor floats down on. If example, for a number of bers, you’re valuing the you’re a short-seller, that’s reinforcement… years we were long Honda businesses, you’re assigning a cacophony of negative and Toyota and short Ford a consolidated value, and reinforcement. You’re basi- You’re basically told and GM. Right now in the hopefully you’re seeing cally told that you’re wrong Opportunity Fund, we’re something the market does- in every way imaginable that you’re wrong short Chinese property n’t see. But now I’ve every day. It takes a certain companies and long Macau type of individual to drown in every way learned that there’s a big casinos. difference between a long- that noise and negative rein- imaginable every focused value investor and a forcement out and to re- In 2005, one of the clients good short-seller. That mind oneself that their day. It takes a that saved us in ’95, inquired difference is psychological work is accurate and what about our interest in run- and I think it falls into the they’re hearing is not. Most certain type of ning a fundamental short realm of behavioral finance. people are in the “life’s too portfolio in Europe with a The best way I can describe short to put up with this individual to drown fund based in London. They it is as follows: almost all of stuff” camp. were willing to finance it in that noise and your readers, and I suspect exchange for a five year you as well, are beneficiaries The other problem is that negative exclusive limited partner of positive reinforcement. there’s an asymmetry on stake. Having been in busi- That is, you’re told early in the return patterns of short reinforcement out ness with this client for life to work hard, study ideas. Because markets many years, we were cer- hard, to get good grades tend to go up over time and and to remind tainly interested in the op- and get into a good school, you need discrete news to portunity and we wanted to and then to do well there affect a short idea, you tend oneself that their see if we could apply our and to get a good job and so to have weeks and months process globally. We and even years when you’re work is accurate on. All of that is a virtuous opened an office in London circle. not making money in your and what they’re for non-US ideas and that ideas. Then when you do too proved to be successful. On the other hand, numer- make money with a short hearing is not.” We found that our ap- ous studies have shown that idea, it happens all at once. proach to company and most rational people’s deci- Here once again, most peo- security analysis could be sion-making breaks down in ple are just not hard wired ported over to non-US an environment of negative to find that asymmetry com- situations. We had a great reinforcement. If you think fortable but good short sell- run. The exclusivity ar- about it, Wall Street is a ers are. Though I listen to rangement expired last year giant positive reinforcement the noise to make sure and so we now have a global machine. When I turn on there’s no new information short fund which we offer my Bloomberg at home at that I need to know, I don’t to clients, in addition to the night, I’m going to see that (Continued on page 21) Page 21

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(Continued from page 20) we look for companies that tures on the concept of worry about most of it. are trying -- often legally but value traps. Probably our You need to be able to aggressively -- to hide the best ideas over the past ten drown out what the Street fact that things are going or 12 years have been ideas is saying. I’ve come around wrong through their ac- that looked cheap and to the view that to be a counting, acquisition policy which actually ensnared a good short seller, in addi- or other means. Those are lot of value investors. The tion to having the important our bread-and-butter ideas. investors didn’t realize that skill set, one must have the In fact, I’ve given some lec- these businesses were dete- right mindset. I believe this riorating faster than their is why a lot of great value “We try not to short ability to generate cash. investors aren’t particularly Eastman Kodak was a great good short sellers. Part of on valuation, though example of that. A few fa- what weighs on value inves- mous value investors were tors is the view that any at some price even buying it all the way down given stock can appreciate reasonably good because they assumed that an infinite amount but can the decline in the business only depreciate in the worst businesses will be would be a slow glide that case to $0. They always would allow the company to have this nagging concern good shorts due to harvest cash flows for the that one bad short idea benefit of shareholders. could bankrupt their firm. I limitations of The fact of the matter is continue to respond to this that, for most declining busi- argument by stating that I’ve growth. We try to nesses, management tends seen a lot more stocks go focus on businesses to redeploy cash flow into to $0 than infinity. In gen- things outside of their core eral, the short side can where something is competencies in a desperate come with a more unpleas- attempt to save their jobs. ant feeling than the long side going wrong. Better In the case of Kodak, they and I think that’s why there took some of their patent are so few short-sellers out yet, we look for proceeds and cash flow and there. invested in a printer busi- companies that are ness, which is another de- G&D: Is there anything in trying -- often legally clining business model. particular that you look for They ended up being deci- to determine if a company is but aggressively -- to mated by their own inven- a good short candidate? tion of digital photography. How do you distinguish hide the fact that When analyzing Kodak as a between a stock that is truly short candidate, valuation overvalued and one that things are going was almost the last aspect that we considered because, might grow into its valua- wrong through their tion? as I said, some of the best accounting, short ideas can look cheap JC: We try not to short on from a valuation standpoint. valuation, though at some acquisition policy or price even reasonably good G&D: Can you talk about businesses will be good other means. Those your valuation framework?

shorts due to limitations of are our bread-and- growth. We try to focus on JC: We look at the same businesses where something butter ideas.” things everyone else does, is going wrong. Better yet, (Continued on page 22) Page 22

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(Continued from page 21) great investment at the right large cap companies. but with the idea that these price and sometimes “value” are moving targets. Balance stocks are too expensive. G&D: Could you talk sheets should give you some On the short side, we’ve about some characteristics sense of intrinsic value on been generalists globally for that would make for an en- the downside. On the up- six or seven years. The ticing yet, in reality, risky side, we have to worry further you look for ideas short candidate? about the unlimited poten- the greater the chance you “Valuation itself is tial. We look at things like will see a unique idea. JC: Open-ended growth market sizes and the law of stories tend to have a life of probably the last large numbers, as to G&D: It seems like you’ve their own. Our celebrated whether companies can initiated short ideas in prac- disaster was America thing we factor into grow their way out of a bad tically every industry. Are Online. We shorted it in accounting situation or a there any industries that ’96 at $8 a share and cov- our decision. Some leveraged situation. On the you gravitate to more than ered our last share at $80 short side, the financials are others for ideas? of our very best two years later. It was often misleading. What never a big position so it shorts have been might appear to be value JC: We’ve historically been didn’t kill us but it was very sometimes is not. A book drawn to financial services, painful for two years be- cheap or value value that is comprised of where companies can really cause people were able to goodwill and soft assets boost earnings by generating make open-ended growth stocks. We look sometimes might not pro- bad loans for a while. forecasts. We try to avoid vide downside support if a We’ve also been in con- those to some extent or we more at the company is troubled. Valua- sumer products, certain get involved further along tion itself is probably the parts of the natural re- the growth curve. business to see if last thing we factor into our source situations (which decision. Some of our very there is something effectively become account- G&D: With short-selling, best shorts have been cheap ing plays) and generally the timing of your idea can or value stocks. We look structurally wrong companies that grow rapidly be particularly important. more at the business to see by acquisition. Where we How do you address this if there is something struc- or about to go see the juxtaposition of a somewhat unique challenge? turally wrong or about to bad business combined with

wrong, and enter go wrong, and enter the bad numbers, that’s really in JC: That is certainly one of valuation last. our wheel house. the valuation last.” the unique aspects of short- selling. It is possible that G&D: Some investors be- G&D: Do you find more lieve in the life cycle of in- when you see something examples of fraud in smaller developing, others are see- vesting in that a company companies? can go from a growth stock ing it as well so at that point you may be unable to bor- to a value stock to a value JC: There is probably more trap – do you look at com- row the shares. This is why evidence in smaller compa- sometimes short-sellers panies that way? nies, but we usually don’t borrow the shares when short many small cap com- they can get their hands on JC: I try not to. Compa- panies due to the restraints nies can certainly go them, even if they are early on borrowing and our size. on the thesis playing out. In through life cycles. I think So it was hard to short people who put themselves the ‘80s and ‘90s, when in- some of those Chinese re- terest rates were high, you in a category of being a verse merger opportunities growth investor or a value were effectively paid to wait last year, though we did out your short thesis be- investor limit themselves. A have a couple. Most of our “growth” stock can be a positions are mid cap or (Continued on page 23) Page 23 Jim Chanos

(Continued from page 22) everyone makes money, but than some other models. cause you could earn inter- if things go wrong, the per- est on the proceeds re- son at the bottom dispro- G&D: What are some of “I teach a class at ceived from the short sale. portionally shares the blame the skills that are essential However, in a rate environ- and the risk. This is why to succeeding in this field? Yale’s Business ment like the one we’re turnover is so high in the School on the experiencing today, initiating hedge fund industry. People JC: I teach a class at Yale’s on a short too early can be try to do carve-outs, which I Business School on the his- history of financial somewhat more painful think are very bad policy. tory of financial fraud. One relative to those prior dec- This model puts all of the of the things I teach my stu- fraud. One of the ades. power of the idea genera- dents, which I also teach my tion, and therefore the alpha analysts here, is that nothing things I teach my G&D: How is your firm generation, with the most beats starting with source junior people in the firm, documents. You have to students, which I different from other hedge funds with respect to sourc- whereas the senior people build a case for an idea, and also teach my ing new ideas? are just doing portfolio allo- you can’t do that without cation. We’ve always doing the reading and the analysts here, is JC: From an approach viewed it the opposite way. work. We’ve had a little point of view, one of the We have six partners at game where we’ve been that nothing beats things that distinguish other Kynikos who have 150 years watching a company that of experience in the securi- just put out its 10K. When starting with source hedge funds from us is that a typical hedge fund has the ties business amongst us and it came out, prominent in we have been together 100 the disclosure was that the documents. You intellectual ownership of an idea separate from the eco- years in aggregate. For ex- company had just changed have to build a case nomic ownership of that ample, my number two has its domicile to Switzerland idea. By that I mean you been with me for 20 years. for a variety of important for an idea, and you have the partners and the Because of our experience, reasons. I told the analyst, portfolio managers at the we generate ideas up at the let’s play a game: call the sell can’t do that top and you generally have top. We are looking for the side analysts and try to ask new ideas and we’ll do the them some questions to see without doing the the analysts, who are more junior at the firm, at the first read-through of a com- if they know that the com- pany’s 10-K and other re- pany, under the advice of reading and the bottom. The way the model works at most firms search in addition to talking their legal counsel, changed work.” is that the guys at the top to people in the industry. their domicile. She said that command the people at the The next step is to then of the eight analysts that bottom to come up with send the idea down the followed the company, it good ideas from which the chain to our research team was the seventh analyst who portfolio managers ulti- to process. I will never had a clue of what she was mately select the additions blame the analyst for a talking about. None of the to the portfolio. The prob- stock that goes against us. others had any idea, which lem with this model is that Putting the stock in the meant they hadn’t read the the profits go dispropor- portfolio is my responsibility document, and that 10K had tionately to the people at and the other senior part- been out for 10 days. This the top of the pyramid but ners’ responsibility. I think happens more than you the risk -- or the intellectual this leads to a better intel- think. It happens because ownership of the idea as I lectual environment at the Wall Street research de- like to call it -- resides at firm. So we get analysts partments are marketing the base of the organization who love working here and departments. The people with the most junior, inex- will stay for 10 or 15 years. with the most experience in perienced people. Conse- It’s a much more stable these departments spend quently, if things go right, model in terms of process (Continued on page 24) Page 24 Jim Chanos

(Continued from page 23) current ones and work your trends, etc. all day long, and much of their time market- way backwards. Read the not have a better idea of “… start first with ing. The junior people are proxy statements that are what is going on at Delta back at the shop doing mod- often neglected and are full Airlines or Japan Airlines. the SEC filings, then els and such, but there isn’t of great information. By Start by reading the docu- much thought going into doing that and by spending a ments of Delta Airlines or go to press releases, this. So I teach my students night or two with those Japan Airlines. Overtime, and analysts: start first with documents, you can have a understanding what to read then go to earnings the SEC filings, then go to remarkably comprehensive and how much time to press releases, then go to view about a company. So spend reading various things calls and other earnings calls and other start there and work your becomes an art as much as a research. Work research. Work your way science. You need to be- out. Most people work “People think we come a good information your way out. Most their way in. They’ll hear a editor nowadays. story, then they’ll read make big macro people work their some research reports, then G&D: When you make they’ll listen to some con- calls, but the fact of macro calls, what primary way in. They’ll hear ference calls, and by that sources do you use? point may have already put the matter is we a story, then they’ll the stock in their portfolio. JC: People think we make don’t. We might read some research It’s amazing what companies big macro calls, but the fact will tell you in their docu- end up with some of the matter is we don’t. reports, then they’ll ments. Enron is a great We might end up with some example – most of the stuff macro calls but macro calls but that’s only a listen to some was hiding in plain sight. function of our calls on the There was one crucial piece that’s only a micro side. China is an ex- conference calls, of missing information, ample. People think we which was the “make good” function of our calls made a big macro call on and by that point in the SPVs that Fastow was China. In fact, our position on the micro side.” may have already running. The reason people on China came from the invested in those and mining and commodity put the stock in bought crummy deals from way out. This way you are stocks in the summer of Enron was that there was a looking at the most unbi- 2009. We were scratching their portfolio. It’s provision that if you lost ased sources first. People our heads trying to figure money, Enron would issue on earnings calls will try and out how in this terrible re- amazing what stock and make you good. spin things, and analyst re- cession the prices for indus- So that was a key missing ports will obviously have a trial commodities were go- companies will tell piece of information. But in point of view. All of that is ing up. Well, we very you in their any case, it was amazing fine, because hopefully you quickly ascertained that how much information was will have first read the un- China, which was 8% of the documents.” out there. Investing is like varnished facts. Primary world’s economy, was gen- a civil trial. You need a pre- research is crucial and not erating 80% of the marginal ponderance of evidence, not as many people do it as you demand for iron ore, ce- beyond a reasonable doubt. think. Because there is so ment, and steel. It didn’t much information out there, take much work from there G&D: Do you recommend it almost behooves people to realize that it was be- investors start with reading to read the source docu- cause of fixed asset build- the newer filings first? ments. If you are an airline out. As we did more and analyst, you could be read- more work, we focused on JC: Yes, look for language ing about airplane orders, the Chinese property sector changes. Read the most traffic trends, fuel price (Continued on page 25) Page 25 Jim Chanos

(Continued from page 24) China real estate, it really Purchase Restrictions and couldn’t believe what derived from our work on (HPRs), which apply for we saw, and then we moved individual companies. second and third homes. to the banks, etc. So it was But people who own more “This is a bubble our work on individual com- G&D: Chinese students than a couple homes are panies that led us to the we spoke with seem to almost always speculators. that has a long way view that this was a macro think that although the real The bulls are saying the gov- problem in China property estate bubble in China ernment will loosen the to go on the market. It was similar to seems to be bursting as we HPRs, but the problem is downside. our work on subprime lend- speak, it may heat back up if that the government doesn’t ing in the U.S. We started the government starts want speculation in real Residential real by looking at the Florida stimulating the market. estate. So I think that’s a real estate market in 2005, What would you say to pretty bad argument. Sec- estate prices, in which was the first to go. I that? ondly, the flood of construc- have an apartment in Miami tion has continued apace, aggregate in China, Beach and I remember JC: That is the overall be- and the unsold inventory is counting cranes along the lief in China. When we first piling up. What if the at construction horizon in 2005 and 2006. started talking about this, speculators turn into sellers cost, are equal to They were just multiplying. my critics said, well, Mr. as opposed to buyers when At the same time, we were Chanos doesn’t speak Man- the HPRs are relaxed? 350% of GDP. The doing some work on the darin and has never been to banks and property compa- China. I said, that’s true, G&D: Do you think the only two economies nies in Florida. We saw that though my clients pay me government is seeing that? the business for performance, not how that ever saw higher was fueling this build out, many visas I have in my JC: They are seeing it, and and then we looked at the passport. Most people who just a few weeks ago Pre- numbers at roughly rating agencies and the big go to China visit Shanghai mier Wen gave a speech 375% were Japan in banks and worked right up and Beijing. That’s like say- saying they are going to the chain and realized it was ing I went to London and keep the restrictions in 1989 and Ireland in a system-wide problem. New York and didn’t see place because they still think The same occurred with the any problems in 2006 and prices are still too high and 2007, and both had commercial real estate mar- 2007. Well, if you had gone they want to stop specula- ket in the 1980s. We out to Phoenix or Las Vegas tion. Anyone who is count- epic property started with Integrated Re- maybe you would have seen ing on the government to sources, the syndicator I them. So the critics, who fix that market is, I think, collapses. So the mentioned, and then tax initially in 2010 said our call counting on hope rather data does not look laws changed in 1986. The was wrong, are now saying than analysis. This is a bub- laws meant that you could “well, there are problems, ble that has a long way to go good for China.” no longer write off passive but the government can on the downside. Residen- losses from real estate reflate and fix them.” My tial real estate prices, in against ordinary income, and response to that is the gov- aggregate in China, at con- that devastated the industry ernment is the one that got struction cost, are equal to as they were just leveraging you into that problem. Peo- 350% of GDP. The only up to buy buildings every- ple in the U.S. always said, if two economies that ever where. So we looked at the U.S. gets into trouble, saw higher numbers at syndicators, we looked at the Fed will just cut rates. roughly 375% were Japan in the savings and loan indus- The problem is that the 1989 and Ireland in 2007, try, and worked our way up government policy has been and both had epic property the system. We’re not loose in China regardless. collapses. So the data does macro people. Even though The one restriction they not look good for China. we have a macro call on have in place is the House (Continued on page 26) Page 26 Jim Chanos

(Continued from page 25) to $180 last year. It’s back growth to be and then they “In China, down to $140 right now, try and figure out how to everyone is G&D: If a collapse occurs, and people are modeling get there. The easiest way will it be very damaging to out their profit forecasts to do that, in an economy incented by GDP. the global economy? based on a range of $120 to where consumption is only $160. Well, what if it gets 30% of the total economy They are fixated JC: Interestingly enough, it back to $30 or $40? You and net exports are deter- may not impact the U.S. all might want to put your mined by the world mar- on growth. In the that much. The U.S. might lower bound a bit lower kets, is to stick a shovel in even be a beneficiary due to here. Everyone’s just look- the ground and build an- West, we go about lower commodity costs. ing at the last four years. other bridge, since that con- our economic lives, The commodity companies The last four years was the tributes to GDP. So a ran- however will be hit hard. I China boom. It was a once dom party chief knows they and at the end of also think the renminbi is in a lifetime build out of will never be sacked if they overvalued. If there is some infrastructure in the most make their GDP targets. the year the depreciation of the cur- populous country of the rency, that could lead to world. After you have your G&D: Why are they tar- statisticians say, cheaper products from third international airport in geting 8% instead of some- China, which could actually Hainan, China, you probably thing like 4%? this year your help the U.S. economy. don’t need a fourth one – growth was 3%. Places like Australia and especially when no one is JC: Because that’s how Canada and Brazil would be using the second one. In they’re compensated. But in China, it’s hit pretty hard, however, this case, things are really These are not profit maxi- because they rely on ex- two or three standard de- mizing enterprises. China still centrally porting commodities to viations from the norm, and doesn’t produce GNP num- China. that’s what you need to be bers, they don’t put out planned. All state looking for. If iron ore figures net of capital depre- G&D: You talked at the prices were $50, I really ciation. If they did, the policy goes Value Investing Congress a wouldn’t care, but at $140- numbers would be much through the few years back about the $180 with more capacity lower because there is so difficulty of investing in com- coming on and lower de- much that needs to be de- banking system. panies with so much of their mand in the future, I think preciated. The problem is profitability tied to com- we’re in for a disaster. that Western investors have They decide what modities. How do you de- fallen for the idea that, if termine what’s a sustainable G&D: But why do you there is rapid growth in this they want growth average price for a com- think the government is country, they must be able modity-focused company? tolerating this? to make a lot of money. to be and then Well, not necessarily. In they try and figure JC: It’s difficult, and you JC: It’s all about incentives. fact, GPD growth in China determine the price based In China, everyone is in- is poorly correlated with out how to get upon a probabilistic range. cented by GDP. They are stock returns. If you were a If you look at the price of fixated on growth. In the European investor in 1832 there.” iron ore in real terms since West, we go about our eco- and you were looking for a the 1920s, it basically traded nomic lives, and at the end great growth story, you between $30 and $45. Iron of the year the statisticians would have invested in the ore is not hard to find, it’s say, this year your growth U.S. The U.S. went through pretty much everywhere. was 3%. But in China, it’s probably the greatest 100 The cost to extract it was still centrally planned. All year period of growth in around $30 per metric ton state policy goes through history from 1832 to 1932, in real terms. In 2005 it the banking system. They and yet, if you had invested suddenly took off and it got decide what they want (Continued on page 27) Page 27

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(Continued from page 26) taxpayers in the donor One of the things they did over that period you would countries are upset, and was to loot the country of have probably lost all of rightly so. In other words, its harvest. Eight hundred “It’s dire for Greece… your money five different the typical German taxpayer thousand died in The new twist in 2011 times. Just because some- is saying, why should I pay that famine of 1941. Almost thing’s growing over the for this? The other thing is every Greek family has is that the donor long term doesn’t make it a the recipient countries are someone who died in that countries installed great investment. upset, too. It’s not as if the famine. So this twist has typical Greek citizen wants opened up a 70 year old their technocrats in G&D: Given your Greek this money. They’re not wound. Keep an eye on heritage, we’re especially seeing any positive results Spain and Portugal because Greece’s ministries to curious about your observa- from the money – it just they’re next. The other oversee tax tions about the situation in goes right to the European issue that is coming about is Greece? banks. It’s not financing any cutting your way to growth. collections and new growth initiatives. I’m Is austerity key to getting interior policy, and JC: It’s dire for Greece. not going to apologize for these countries back on Clearly the European Union Greeks who didn’t pay their track? So far the evidence is that has really hit a has made an example out of taxes or retired at 42. The pretty poor that it is. We nerve. Now Germany the country. As has been stories are out there and may look back and say, said, the problem with the they’re all true. But be that wow, what a policy mistake. is basically EU is that it’s a currency as it may, there are an awful union without a fiscal union. lot of law abiding Greeks G&D: Where do you dominating Europe. The incentives are all who are being destroyed by come down on the nature You ignore that skewed. People who say what is going on in Greece vs. nurture debate? You that Germany suffers from now. The new twist in made a great investment in political calculus at having to share the EU with 2011 is that the donor Baldwin United at 24, a time your peril. All of this these Southern countries countries installed their when many are barely learn- like Greece are missing the technocrats in Greece’s ing about investing. connects to historical point. Germany is very ministries to oversee tax issues, such as how happy to have those South- collections and interior pol- JC: I always used to say, on ern countries in the EU, icy, and that has really hit a the short side, people are the Germans treated because it keeps the cur- nerve. Now Germany is made not born. I’ve rency lower than otherwise. basically dominating Europe. changed my view on that a the Greeks in World If Germany had its own cur- You ignore that political bit. I do think there are War II. Greece lost rency, it would go through calculus at your peril. All of enough asymmetries be- the roof, and harm German this connects to historical tween the long side and the one million people in exports, which are the big issues, such as how the Ger- short side that it makes it World War II out of a driver of that economy. So mans treated the Greeks in difficult for people who are in effect what’s happening is World War II. Greece lost otherwise very bright inves- population of eight that German taxpayers are one million people in World tors, particularly people in bailing out European banks, War II out of a population the value world, who look million.” who’ve lent money to the of eight million. The only at things and see great short Southern European coun- country with a comparable opportunities, but can never tries, which are buying Ger- (and higher) ratio was the get their mind to the point man products. The prob- Soviet Union. In the fall of where they can become lem is that it’s a political 1941, after the Germans good short sellers. I do issue and so many people invaded Greece, they left think, to some extent, the just want to look at it as a the Greek government in- temperament of a good financial and economic issue. tact but they put Reich’s short seller is probably ge- There’s an interesting align- ministers in charge of all the netic. So I think the skill set ment of interests where the ministries to oversee them. (Continued on page 28) Page 28

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(Continued from page 27) G&D: Could you give us becoming one of the most is the same in terms of try- an example of some current expensive fuels and is still ing to do deep research and ideas? the dirtiest. Utilities and “I always used to finding unique value in com- others are rapidly trans- say, on the short panies is the same, the JC: Currently we are short forming from burning coal mindset can be very differ- the natural gas industry in to burning natural gas, side, people are ent. You need to be able to the U.S. for a few reasons. which I do not think bodes weather being told you’re First, there has been a ma- well for the coal industry. made not born. I’ve wrong all the time. Short jor technological innovation changed my view on sellers are constantly being -- fracking -- that has cre- G&D: Haven’t some of the told they’re wrong. A lot of ated displacement. This has stocks of companies in that a bit. I do think people don’t function well in driven prices from high sin- these industries been hit an environment of negative gle digits per MCF of natural hard already? there are enough reinforcement and short gas down to $2 per MCF. asymmetries selling is the ultimate nega- Most of the companies in JC: You have to remember tive reinforcement profes- the natural gas area began that if you are shorting a between the long sion, as you are going an exploration boom that leveraged company, with side and the short against the grain of a lot of has created this glut. These 90% of the capitalization in well-financed people who companies counted on the debt and 10% in equity, a side that it makes it want to prove you wrong. price to remain above $6-7 50% decline in the stock It takes a certain tempera- per MCF. A number of price only wipes out 5% of difficult for people ment to disregard this. companies that had struc- the total capitalization. You who are otherwise tured their balance sheets have to look at the total G&D: How often do you and paid up for acquisitions capitalization. In some of very bright investors, see companies that are with this expectation of these cases the total capi- fudging the numbers able to higher prices are now strug- talization is only down a particularly people maneuver their way out of gling. So they’ve got weak- little while cash flow has in the value world, it? ened balance sheets in a been cut by 75%. This is commodity business that is the reason that some inves- who look at things JC: If a company is very in oversupply, and on top of tors get killed in value traps. fraudulent, it is very difficult that, many of them are en- They look at the stock and and see great short to recover. Where compa- gaged in some pretty egre- they don’t look at the total opportunities, but nies have simply fudged the gious accounting games, like capitalization. They don’t numbers, such as Tyco In- hiding negative cash flows in realize that the debt burden can never get their ternational, they are able to various ways. I think this is forever, meaning it’s not come back but the share- area will be a very fertile shrinking, whereas the eq- mind to the point holders and sometimes area on the short side for a uity capitalization may fluc- where they can bondholders are wiped out. number of years. The good tuate in the market. If the If we end up being right on news is that this happens to cash flows have diminished become good short the fundamentals, it’s very be an amazingly positive dramatically the company’s rare that a company in mid- development for the U.S. ability to service the debt, sellers.” problem can turn itself because energy prices have then the stock going down around. Usually it requires dropped so much. by half doesn’t mean any- a cleansing of the old order As an ancillary development, thing. You could still be at for things to change. Gen- the other industry that gets risk of losing all you capital. erally the problems we see killed by this is coal. Natu- are deep-seated enough ral gas prices are now half G&D: Any other ideas that where they need to con- the price of coal. Coal used we can talk about? front them, pay the eco- to be one of the cheapest nomic price, and move on. sources of energy, but it JC: I think for-profit educa- was the dirtiest. Now it’s (Continued on page 29) Page 29

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(Continued from page 28) analysts that have worked by the companies, to say tion business is a flawed for you? why they are short some- business model. The out- thing. “You need to be able comes are very poor, as I JC: The thing I look for to weather being feel that these degrees are most is intellectual curiosity. G&D: What are some of sold, not earned. Anyone One of the best analysts we the avoidable mistakes that told you’re wrong all that wants to sign up for ever had was an art history you see analysts make? these things can get in, but major from Columbia. She the time. Short tuition is up there with had no formal business JC: One of the biggest sellers are constantly many private schools. Peo- school training. She was so things I see quite often is ple are coming out of these good because she was very getting too close to manage- being told they’re schools with $20,000 - intellectually curious. She ment. We never meet with $50,000 in debt and many was never afraid to ask why management. For all of the wrong. A lot of don’t even graduate but and if she didn’t understand bad asymmetries of being on people don’t incur the debt nonetheless. something she would go the short side, one of the Some of the technical figure out everything she good asymmetries is that function well in an schools do good practical could about it. This is al- we don’t rely on the com- environment of training, but most of the most something that you pany. We can get informa- business has now shifted to can’t train. You either have tion from the company if we negative online degree granting be- it or you don’t. want to, as we can go cause it is more lucrative. I through the sellside. Those reinforcement and remember a couple of years G&D: Who are other in- that are long the stock and short selling is the ago, the head of human re- vestors that you respect? are close to the company sources at Intel was quoted almost never hear the nega- ultimate negative in a front page New York JC: I have a lot of respect tive side in any detail. The Times article saying that if for other investors that biggest mistake people make reinforcement someone came in from an have gone public on the is to be co-opted by man- profession, as you online college, they won’t short side. People like agement. The CFO will even look at them. The David Einhorn and Bill Ack- always have an answer for are going against the types of jobs these gradu- man have been willing to go you as to why a certain ates get are no better than negative and be public. To number that looks odd grain of a lot of well- if they just had a high school the extent that they are really is normal, and why financed people who degree, and yet they are willing to take a controver- some development that incurring all of this debt. sial stand, I think it is a cou- looks negative is actually want to prove you Ultimately defaults will go rageous thing to do. It is positive. so high in the student loan also an important thing to A second mistake some wrong. It takes a area that the federal govern- do because for too many people make is not reading certain ment will see mounting years short sellers have all of the documents. I losses and will change the been demonized for being guide people to always start temperament to student loan program guar- anonymous. We have been with the SEC documents, antee to force institutions one of the few public figures and then go to other disregard this.” to take a bigger chunk of out there. We believe that sources for information. It’s the risk. Once this happens, if you are willing to put an amazing how few analysts the business model is bro- investment hypothesis out actually read SEC filings. It ken. The only reason these there before people with a blows me away. We have companies exist is because face on it, it adds to the the greatest disclosure sys- of the federal loan guaran- overall level of investment tem in the world and people tee on student debt. debate. All kinds of people by and large don’t take ad- are willing to say why they vantage of it. I am a big G&D: What are some own something, but are believer in looking for characteristics of the best afraid, because of retaliation (Continued on page 30) Page 30

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(Continued from page 29) management people as you you fail, no one is going to changes in language in a can. Find out where the hold it against you, and fu- company’s filings over time. investment management ture employers and inves- During the year we were people at your firm hang tors might actually look “If you ever have an short Enron, each succes- out, or join an investment favorably upon it. So if you sive filing had incrementally ideas group. There are lots really want to pursue some- idea and you think more damning disclosure of different doors that can thing, do it while you’re you need to take about the company’s off- open throughout your ca- young – you’ll have more balance sheet entities. It reer. Stay intellectually cu- energy and you’ll be able to career risk to was obvious that internal rious and meet as many take more financial and ca- lawyers were pushing man- people as you can. reer risk. If it doesn’t work accomplish it, do it agement to give investors you still have your whole life early in your career. more detail on these deals “When fortune ahead of you. that were being done, as Life intrudes -- as they felt uncomfortable smiles your way as it G&D: In the beginning of about them. Language does in any business our interview, you men- when you get older changes are not accidental. tioned how your father’s you end up with They are argued over inter- career a number of advice about working hard nally. and working for yourself more responsibilities times, take was important for you in G&D: What is your view your life. What kind of ad- and your ability to on the banking industry to- advantage of it. vice do you give to your take risk diminishes. day? children? That’s when people If you are 25 and JC: I believe that right now grow, that is when JC: Do something you the banking industry is at really want to do. There have a great idea the tail-end of its credit you see quantum are few feelings worse in and you fail, no one problem in the United the world than waking up States. We addressed it leaps and step every morning and not liking is going to hold it before everyone else. I call what you do. Whatever it the ‘pig-in-the-python’, functions in career field it might be, you should against you, and where the python is the do what you want to do. future employers world credit situation. If moves.” Life is too short. The peo- the pig at the end of the ple that are the most pro- and investors might snake is the U.S., the pig in ductive are those that are actually look the middle is Europe, and G&D: What are some of happiest in their jobs and the pig being eaten now is the things that you think find intellectual curiosity and favorably upon it.” China and Asia. business school students stimulation in what they do. who want to follow in your And when fortune smiles G&D: The investment footsteps should do? your way as it does in any management industry is business career a number of extremely competitive. JC: If you ever have an idea times, take advantage of it. What do you recommend and you think you need to That’s when people grow, students do who have not take career risk to accom- that is when you see quan- be successful in getting the plish it, do it early in your tum leaps and step functions job of their choice? career. Life intrudes -- as in career moves. when you get older you end JC: In one word, network. up with more responsibili- G&D: Thank you very Go to as many lunches and ties and your ability to take much Mr. Chanos. dinners as you can. Try and risk diminishes. If you are meet as many investment 25 and have a great idea and IssueVolume XV I, Issue 2 Page 31

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(Continued from page 1) as they become more effi- ready affected much of the Sequoia Fund. Mr. cient. It’s amazing to see world. Some of these Russo is a graduate of the kinds of costs that can brands have widespread Dartmouth and has an be removed from a business awareness because they MBA and JD from Stan- (e.g. energy, water, packag- were originally colonial ford. ing) even while addressing brands, such as Unilever or corporate social responsibil- Cadbury. Some of these GD: You are well known ity. There is an interesting businesses have even pre- for investing in high quality, transition that is taking place dated Communism. For high cash flow generative where a company like Nes- example, Nestle has had a companies with a long-term tle, Heineken or Unilever presence in the Czech Re- focus. Yet some of these can take hundreds of mil- public for decades. British- companies, like Nestle and lions of dollars out of the American Tobacco had the “Many companies Heineken, have become business because they have tobacco monopoly in China will try to invest giants in their respective chosen to operate in a so- before Communism. Simi- industries. Does it ever cially responsible way – i.e. larly, Chesterfield was the smoothly over time concern you that maybe in a waste less water, use less brand of choice in an East- with no burden on few years they won’t be energy, less plastic, etc. ern European country (I able to grow at a rate that believe Romania) before currently reported could provide satisfactory Then the question becomes Communism. It is amazing investment returns? that of the reinvestment that now when people in net income, but the possibilities and corporate these countries have the problem is that TR: My feeling is that there culture. The corporate opportunity to purchase is still so much white space culture is key to making whichever products they when you are trying that is addressable for these sure Nestle stays on track. choose, they go back to the to invest in a new companies. In the newer Management must continue brands that have been his- markets that these compa- to think of the owners torically in the region, even market, smooth nies do not yet dominate, when they reinvest and not though those brands haven’t investment spend- there is a lot of capacity to reinvest in a way that en- been advertising for 70 grow. If you scale Nestle sures that management can years. ing really doesn’t from 1991 to today, the own bigger cars or afford Company’s returns have other luxuries. The three prongs that I look give you enough compounded at approxi- for when investing in a busi- power to make an mately 14%. In 1991 they GD: There was an article ness are: the fifty cent dollar could not sell in China and in bill, the capacity to reinvest impression. You had a pretty small business around a few months back in great brands and the end up letting in a there. Russia had just ago about how Nestle is “capacity to suffer.” The opened up, India was not making investments in Africa “capacity to suffer” is key lot of competition yet engaged, there was no that will provide no near because often the initial presence in Vietnam, and term return but should pro- spending to build on these that will drive down they hardly had a pulse in vide significant return over great brands in new markets future margins.” Brazil. Africa was also not the longer term. What is has no initial return. Many developed. These are now your take on the subject? companies will try to invest the areas where they can smoothly over time with no commit the most capital in TR: Africa represents a burden on currently re- search of new business. great opportunity for pa- ported net income, but the tient firms like Nestle. The problem is that when you Additionally, in terms of the quality that I look for in are trying to invest in a new traditional markets that managements is the market, smooth investment Nestle already dominates, it “capacity to suffer.” They spending really doesn’t give is still the case that Nestle’s have “capacity to reinvest” you enough power to make returns extracted from because they have brands an impression. You end up these businesses can grow whose awareness has al- (Continued on page 32) Issue XV Page 32

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(Continued from page 31) summated. At that point, interchange fees for debit letting in a lot of competi- you are at risk, because you cards. Ironically, the real tion that will drive down don’t have control over protagonist in that story future margins. If you’re how the parent company was presented as the small smart, like Starbucks was in treats the subsidiary and the merchant. But the truth is, “I thought China for instance, then you subsidiary may no longer for the small merchant, the invest a lot of money up- possess attractive reinvest- benefits of a debit transac- MasterCard was front to build your store ment opportunities. tion outweigh those of a presence, distribution, ad- credit card or check. De- the preferred al- vertising, etc. Then you GD: Given your focus on spite that, debit fees were become a first mover and global multinational compa- reduced by 70%. The mar- ternative at the your brands become identi- nies, do you also try and ket reacted with a sharp fied with a particular prod- look for smaller companies share price sell-off due to a time for a few uct category. that might be acquired by fear over the loss of reve- one of these multinationals? nue. Visa dropped even reasons. For one, GD: Do you like investing further than MasterCard in small foreign subsidiaries TR: I have owned such because they were the it was cheaper. of large multinational com- businesses that have been dominant player in this area. panies that trade separately acquired. For example, I We invested in MasterCard. That valuation from the parent? owned Cadbury. The very domestic nature of Kraft I thought MasterCard was was 12x forward TR: I used to years ago. In ultimately compelled the the preferred alternative at many situations they end up purchase of Cadbury. At the time for a few reasons. year’s earnings. being acquired by the parent the end of the day, Kraft For one, it was cheaper. company. Additionally, you realized it needed more That valuation was 12x for- For a company used to be able to acquire international exposure ward year’s earnings. For a those subsidiaries at a lower which it thought it could company with a capacity to with a capacity to price. But I found that if the obtain on the back of the grow like MasterCard, that parent did not buy the com- infrastructure that Cadbury was simply too low a valua- grow like Master- pany and the market ma- had. It is a tough way to tion. MasterCard has a tre- tured, the lack of reinvest- grow though. mendous amount of interna- Card, that was ment opportunities became tional exposure – relatively a problem. For example, at GD: What was your view more than Visa. Master- simply too low a some point Unilever Indo- on the Cadbury acquisition? Card also had a recent man- nesia will no longer be able agement change. Ajay valuation.” to reinvest in Indonesia at TR: While sorry to lose Banga, the new CEO, has a attractive returns, and then the future returns Cadbury global background and is you are capital trapped. promised, I was pleased by very smart. For example, the deal’s timing. The acqui- he is now negotiating with GD: Would the parent sition gave cash at a time the Indian government to then come in and try to when two companies that have a state stored value essentially “steal” the sub- were new to the portfolio card that is biometrically sidiary at an unfair price? were struggling because of identified. If the govern- temporary setbacks in ment wants to transfer TR: There have certainly North America. One of money to a part of the been a lot of lawsuits associ- those companies was country that is very poor, ated with that question. For MasterCard and the other the risk of theft of cash is example, Sears Holdings was Anheuser-Busch. very high right now. With attempted to buy its Cana- MasterCard and Visa to- the biometrically identified dian subsidiary. There were gether suffered because of card, you can secure your a lot of lawsuits back and the Durbin Amendment that remittances from the gov- forth and it was never con- was intended to regulate (Continued on page 33) Page 33

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(Continued from page 32) Nestle. For our lifetimes, articles about children dying ernment in a way that isn’t American Dairy will proba- from toxic chemicals in the currently available. I think bly have the capacity to re- milk. That just should not MasterCard will benefit invest, but at the end of the happen with Nestle. Nestle enormously from Ajay’s day, it will stop having an cannot afford the risk of global agility. You have to opportunity to deploy capi- using questionable inputs for remember that eighty-five tal in China. And then the their products because their percent of the world’s com- question becomes, what will reputation is of paramount merce outside of the United the company do with the importance. I can evaluate States still uses cash. Com- cash? It doesn’t have a the ability of some global merce outside of North brand that it can take firms to reach local cultures America is also a fraction of around the world and de- because I can see the back- what it will become. ploy capital behind its future grounds of management and growth. their capacity to reach vari- GD: Do you feel comfort- ous cultures. For local firms able investing in some for- however, it is much harder eign-domiciled companies to evaluate management given that the rule of law in “In my portfolio, culture. certain countries is not strictly enforced? 60-65% of the GD: Can you talk about your thesis for Martin Mari- TR: Well, I’m not as com- assets are in non- etta and the offer for Vul- fortable as those who have can? expressed their comfort U.S. companies. through higher allocations TR: Martin Marietta’s busi- to such countries in their But what you ness, stone quarrying, tends portfolios. In my portfolio, toward natural monopolies. 60-65% of the assets are in have not seen is It is very expensive to haul non-U.S. companies. But stone on a truck and stone what you have not seen is many non-U.S., isn’t valuable enough to al- many non-U.S., emerging low it to recoup shipping market companies. One of emerging market costs. Within 25 miles is the reasons is due to rein- about the only distance that vestment risk. For example, companies. One you can draw from to get there is a big dairy company stone. In most urban areas, called American Dairy in of the reasons is that 25 mile radius is an China. I could invest di- area where it is not likely rectly in China through due to that new quarries will be shares in that business. zoned. So if you own a However, I don’t need to reinvestment risk.” quarry in an urban region, because I already “own” you have a very valuable exposure to Chinese dairy asset. That is what inter- through Nestle. Nestle is a Cultural values are also very ested me in the business a big player in dairy. So I have important. In developing long time ago. Of course, a big position in dairy in markets, the people who like so many things in this China run by a group I are driving these arguably business, this awareness know and like. I could sup- faster growing businesses wasn’t a piece of independ- plement my position, as I are sometimes willing to cut ent inspiration. I was work- often do, but I chose not to corners. For example, ing at the Sequoia Fund in buy American Dairy because speaking of the local dairy 1984, and I happened to I have more confidence in market in China, every few look at a research report the management team of months you read newspaper (Continued on page 34) Issue XV Page 34

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(Continued from page 33) do you think about such result operate with their lying around the office from exogenous drivers for a high fixed costs at a fraction a few years earlier that dealt business? Similarly, how do of their scale. Pricing has with a crushed stone com- you think about other com- pany, Vulcan Materials. My modity-related companies colleagues at Sequoia said like BHP that have signifi- that they used to have an cant scale in certain mar- analyst that loved the busi- kets? “For Martin Marietta, ness and who did research it has been amazing on every quarry that Vulcan TR: For Martin Marietta, it owned. It was a family con- has been amazing how the how the post-08 trolled business, and I liked post-08 trauma has affected the fact that they would be its business in a way that has trauma has affected careful with the way they never surfaced before in its its business in a way deployed the capital. The history. There are three work the analyst did legs to this business: com- that has never showed most of the quar- mercial building, residential ries were free from compe- building, and infrastructure. surfaced before in its tition and the company They kind of follow different clearly made a lot of money. cycles. We have been going history... This would Once clued into the busi- through a terrible funk in typically be the kind ness’ unusual economics, I terms of job growth, but then wondered if there during this downturn the of business that one were companies other than government has still never Vulcan in the business. Af- released the extraordinary would expect to have ter reading that report and appropriation intended for doing a lot of research my- roads, so the infrastructure ‘Keynesian leverage’ self, I subsequently invested industry has been starved. during a national in four or five related com- This would typically be the panies in the crushed stone kind of business that one downturn.” business. The work others would expect to have had already done at the “Keynesian leverage” during Sequoia Fund provided the a national downturn. Simi- base for my investment the- larly, the commercial con- actually not gone down in sis in Martin Marietta, and struction industry is dead - the face of this due to Mar- then my contribution to my more than dead, really - tin Marietta’s pricing disci- investors was to try and find because so much of the pline and the fact that price other smaller companies business was dependent on elasticity for their stone is both here and abroad, trad- people who overstated their very low. Volumes have ing at even lower valuations businesses’ vitality during just come down by virtue of because they were not as the run-up to the collapse. the fact that the three well known. Overtime I They were building buildings sources of demand for their bought shares of Ready Mix that weren’t sufficiently product are soft at the same Concrete, which was lo- leased by using easy money time. cated in Ireland. I also that made these businesses bought shares in a French appear to be much better Regarding other extractive company that was in the than they actually were. Of industries, such as New- same business. course, the market reversed mont, BHP and Anglo- and these companies fell. American - those are really G&D: Pricing for Martin Residential construction has based more on global mar- Marietta is still likely driven not come back. Their stone kets for commodities. by macro concerns. How quarrying businesses as a (Continued on page 35) Page 35

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(Continued from page 34) merger-related documents, they hoped for a loose Jus- Stone provides somewhat of the thought behind the ac- tice Department, which a natural monopoly which quisition of Vulcan was Vul- would have allowed them to protects the pricing a little can’s initially. But now Vul- shift some operations to a bit but most industrial com- can finds itself flat on its third party trust that would modities are priced on the back both due to the ex- have been accommodating treme leverage it took on from a pricing standpoint. when it acquired Florida What’s clear today is that Rock at the peak of the Justice Department has “Now Vulcan finds market, and due to its heavy taken a very strong turn itself flat on its back exposure to the Florida and against approving such California markets which transactions. A joint ven- both due to the turned down particularly sharply beginning in 2008. extreme leverage it Martin Marietta has now “When Vulcan first proposed merger with Vul- took on when it can under their terms and it proposed merging has become a big fight. The acquired Florida difficulty with such a merger with Martin Mari- is something that Vulcan Rock at the peak of discovered following its etta, they hoped acquisition of Florida Rock. the market, and due The process of putting Vul- for a loose Justice can and Florida Rock to- to its heavy gether generated much Department, which exposure to the lower profits than initially hoped for due to the Justice would have al- Florida and Department’s demands that lowed them to shift Vulcan quickly sell certain California markets operations to a bona fide some operations to competitor. Instead of con- which turned down trolling more of the market a third party trust where they had picked up particularly sharply additional exposure through that would have Florida Rock, Vulcan was beginning in 2008.” forced to sell to somebody been accommodat- else who wanted to stay in or even enter the business. ing from a pricing margin. While I recognize the scarcity that can be When Vulcan approached standpoint.” driven by emerging market Martin, they had initially demand met by fixed scale, I thought that any divestiture have chosen not to risk an could be spun-out into a ture now seems dead on investment in these busi- new leveraged entity which arrival. nesses, because commodity would be a price-taker in prices are notorious for those markets. In a sense, a Vulcan is now arguing that if being unsustainable. joint venture would have the acquisition of Vulcan allowed them to gain more were to move forward, Jus- G&D: What is your view scale in the combined Vul- tice would require massive on the offer by Martin Mari- can/Martin markets. When divestitures in arms-length etta to buy Vulcan? Vulcan first proposed merg- transactions with a third

ing with Martin Marietta, (Continued on page 36) TR: According to all of the IssueVolume XV I, Issue 2 Page 36

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(Continued from page 35) ingly global consumer loyal- had completely forgotten party over a very short ties. Jack Daniels is a terri- about for the moment was compliance time period. fic brand and the company that the company still had Vulcan believes this will ef- has been run by a share- very solid brands in Jack fectively provide the busi- holder minded family. In Daniels and Southern Com- ness foundation for a new 1987, I was surprised to see fort. So I saw a core busi- player in their own very Brown-Forman shares ness that was still very consolidated markets. This plunge 40% because a brand strong and a company that Pictured: Tom Russo at CSIMA could disrupt the term called California Cooler that had dropped a lot in value. Conference in February 2011. structure of the existing they had earlier acquired At this time, early 1997, I industry and create margin- had seen at that time an did a lot of research on the destroying competition in company and realized that what are already quite investors were unfairly dis- agreeable markets from a “[In Brown- counting Brown-Forman pricing standpoint. The Forman] I saw a due to a misperception markets wherein Martin and about the state of its whis- Vulcan compete today tend core business that key business. For a while, a to be duopolies with very certain segment of the fine structures. This was was still very strong population (mostly around the reason that Vulcan pro- Wall Street) had moved vided for not having ap- and a company away from bourbon and proved the deal. moved towards wine that had dropped spritzers and those sorts of Several of Martin’s and Vul- things. But the fact was that can’s large shareholders, a lot in value. the rest of the population in most notably Mason Haw- the United States had not kins of Longleaf Partners, At this time, early moved away from bourbon. have come forward to ex- It seemed that Wall Street press support for Martin 1997, I did a lot of analysts had extrapolated and its offer. It is not clear research on the their tastes to the rest of to me that this threat from the world. So as I men- market disintermediation company and tioned, Brown-Forman’s through Justice Department stock price collapsed follow- sales of assets to a new realized that ing management’s efforts to competitor will not threaten diversify the business by to disrupt the structure of investors were buying California Cooler. the industry. In my opinion, Missed in all of this was that it’s probably worthwhile for unfairly Brown-Forman still sold Vulcan shareholders to wait around four million cases of on giving approval to the discounting Brown- Jack Daniels annually in the deal until they see what the US, which alone I thought Justice Department will re- Forman due to a justified an intrinsic value quire. worth twice the share price. misperception Moreover, the company G&D: What is the thesis about the state of sold an additional half a mil- behind your investment in lion cases internationally. Brown-Forman? its whiskey As I was analyzing the com- TR: Brown-Forman is a business.” pany in 1987, the manage- family controlled, very long ment described plans that term minded company unexpected decline in ship- would reorient the company which owns a portfolio of ments. What the market (Continued on page 37) brands that enjoy increas- Page 37 “The next big trended opportunity will be being short U.S. government Tom Russo

(Continued from page 36) segmented their brand and to expand internationally, created different price TR: That was certainly the which would cost them points for Jack Daniels. But case with E.W. Scripps. money and negatively im- E.W. Scripps Company de- veloped Scripps Network Interactive, a subsidiary it spun off about four years ago. Nearly 15 years ago, Scripps’ parent company “Importantly, considered developing a new network. The family Brown-Forman that controlled the company bought into the vision of a had the “capacity network that combined home and garden channel. to suffer” in this This was something that had not been successfully done manner because it before but they believed that it could be done and was family Pictured: Tom Russo and Jean-Marie Eveillard, at a CSIMA were willing to tolerate up to $150 million of cumula- conference in February 2011. controlled via A tive reported operating pact near-term reported the real story is that they losses to make it happen. and B shares earnings. Importantly, now sell over five million So Frank Gardner and Ken Brown-Forman had the cases of Jack Daniels inter- Lowe, two superb execu- which allowed the “capacity to suffer” in this nationally. When they tives of the company, began manner because it was fam- started this journey, they to pursue this vision of a Brown family ily controlled via A and B only operated in four large new network with $150 shares which allowed the international markets in- million in operating ex- control.” Brown family control. Folks cluding England, Australia penses at their disposal. at Brown-Forman realized and Germany. Now they’re They spent maybe $2 mil- that around 4 million cases in 18 markets wherein they lion in the first year, about of bourbon sold in North sell over 100,000 cases each $15 million the next year on America was a great busi- year. They were one of the hiring people, etc. The third ness, but it wasn’t going to first companies in which I year, their operation was get much better. There was invested that believed in the even more fully developed however a very large oppor- concept of suffering through as they began the produc- tunity abroad. In 1987, some burdens on currently tion process in earnest, so Brown-Forman was in four reported profits in pursuit they invested even more markets and the company of future success and fully in the business. In the resolved to invest interna- growth for the company. meantime, the new network tionally to drive growth in Additionally, they realized hadn’t yet generated any its worldwide business. It that they could do this with- revenues! E.W. Scripps, was at this moment that I out the risk of losing the thanks to its separate news- invested in Brown-Forman. company due to the family’s paper and television busi- Fast-forward to today -- controlling stake. nesses which had been gen- they still sell about four and erating about $350 million a a half million cases of Jack G&D: Was the “ability to year, was still making a Daniels in North America, suffer” also behind your profit – albeit reporting a but this business is probably thesis in investing in E.W. declining one – as invest- more profitable today than Scripps? (Continued on page 38) it was because they have Issue XV “The next big trended opportunity will be being short U.S. governmentPage 38 Tom Russo

(Continued from page 37) ness to suffer through that fund through which you ment in the network grew. period of reported profit could short some of those Though earnings declined in declines in pursuit of a busi- companies that you have the early stages, Gardner ness that they were willing determined to be of low and Lowe ultimately spent to “build to last.” quality? the right amount and now Scripps Network Interac- G&D: During your career, TR: I’ve been very fortu- tive, the company they built, you have been very consis- nate in having been pro- earns over $500 million in tent in uncovering and in- vided the capacity to wait EBITDA and is worth over and take my time in earning $7 billion. If a corporate returns. The problem with raider had come along dur- “I’ve been very short-selling is that it is ter- ing the early stages of the ribly event-driven. To be build-out and sold this fortunate in having really successful at short- Home and Garden Network selling, one typically would because it would have been provided the place a bet based on analysis probably increased near capacity to wait of a soon-to-be relevant term reported profits but it problem. For example, a would have surely de- and take my time in short seller may believe a stroyed all of what was, at company is going to reveal a the time, a positive NPV earning returns. problem with their receiv- business. ables accounting when they The problem with report their quarterly num- G&D: In the past, when we bers. It creates an urgency have heard you discuss the short-selling is that that is different than the spirits business or other it is terribly event- kind of duration I can enjoy businesses, you have fre- with the businesses that we quently stressed the impor- driven. To be really own. To get short-selling tance and power of brands. right, it is very time specific. In the case of this nascent successful at short- Moreover, the structure of network, however, where a shorting is such that the risk brand did not yet exist, how selling, one typically of being squeezed is so in- did you gain comfort that tense that you can’t put too those early investments by would place a bet much money into any given Gardner and Lowe would based on analysis of short. For a hypothetical not destroy value and would example, if I’m thinking of in fact add value? a soon-to-be using a short position to hedge Nestle, I would have TR: That was the hardest relevant to establish a very large part of my whole evaluation number of positions, given of the company. Along the problem...To get our large long position in way, we did start to see Nestle. So you have to sig- some early indications of short selling right, it nificantly and frequently this being a promising in- is very time worry about timing if you vestment for E.W. Scripps, want to establish a meaning- such as some buzz being specific.” ful short position. generated about the new brand. Indications like these Here’s another example of a still don’t mean success is a vesting in high quality com- similar dilemma inherent to certainty. What was certain panies. Have you ever con- shorting. I probably would was the family’s and man- sidered launching a hedge (Continued on page 39) agement’s collective willing- Page 39 “The next big trended opportunity will be being short U.S. government Tom Russo

(Continued from page 38) the owner uncomfortable to perience and lessons not have gotten the timing the point that he was actu- learned, are to be respected of shorting Diamond Foods ally losing his sleep and ap- rather than ignored simply right. I met the manage- petite. The owner decided because you cannot quantify ment of Diamond Foods to fire this Director, despite them. when they were very small. all of his successes at the I felt that they had a good company, because as the G&D: When you spoke to story but I just got a funny, owner told him, he was the value investing class at “All of Freddie uncomfortable feeling about “too old and too rich” to be Columbia, you spoke about the people running the com- losing sleep and appetite the important nuances be- Mac’s moves were pany. This was when it was over anything. Charlie then tween Kraft and Nestle. $17 a share. Then the stock explained to the person Could you describe some of done to meet the went from $17 to $90! who asked the question that the nuances for the benefit That would have been a he was just uncomfortable of the readers? market’s near painful short, even though with owning Freddie Mac the shares ultimately did term, and it wasn’t worth their TR: When I discussed decline precipitously. worry. He explained that Kraft last year, I expressed

management- with scale and time, the my observation of the chal- Thinking about that uncom- growth Freddie had demon- lenges and constraints that created growth fortable “feeling” I got from strated in recent history they face. Their three core meeting a management team would basically no longer be businesses – domestic expectations for reminds me of a profound available and that Freddie crackers, domestic cheese, point that Charlie Munger had begun to accumulate and domestic meat – hap- the company.” made at a Wesco annual more mortgages on its bal- pen to be the grocery cate- meeting about six or seven ance sheet in lieu of securi- gories most exposed to years ago. Charlie talked tizing them. According to private label competition in about the value of beliefs Charlie, management had the US market. Cheese is versus the conviction of also inappropriately denied cheese. The consumer be- knowledge. Someone dur- recent purchases of high lief that there is no ade- ing that meeting asked yield junk bonds of a to- quate substitute for cheddar Charlie why he had sold bacco company. All of cheese isn’t high enough to Freddie Mac because shares Freddie Mac’s moves were support pricing over the of Freddie had really rallied done to meet the market’s commodity costs. The since Wesco’s sale. Charlie near term, management- same is true for the cracker looked at him for a long created growth expecta- and meat businesses. So moment and said, “Because tions for the company. Kraft tends to be more we felt like it.” Charlie explained that he commodity-oriented. There Charlie then mentioned a just couldn’t invest in a are nevertheless still a num- friend of his who owned a company with a manage- ber of other products large private business which ment team that was cor- within the company that are had a director of marketing rupting an otherwise good valuable, such as Chrystal who had done a better job business and was not honest Light. It’s not that the for the company than any- and frank about its moves. shares won’t perform rela- one ever had. The owner tively well, it’s just that called this director one My sense about the people there’s an omnipresent do- morning and told him what at Diamond Foods couldn’t mestic pressure on the a great job he had been do- be modeled or quantified, three key pillars of Kraft’s ing and how terrific an em- but I stored it away without business. The solution as ployee he was. But the immediately acting on that they saw it was to expand owner also told the Direc- hunch. Feelings like these, offshore and diversify their tor that there was some- enhanced by years of ex- (Continued on page 40) thing about him that made Issue XV “The next big trended opportunity will be being short U.S. governmentPage 40 Tom Russo

(Continued from page 39) Kraft owned. So the sale price received was based on business beyond those three historical earnings before major domestic pillars. considering the tax affects They’ve finally done that “I am intrigued by on the sales proceeds. with the massive restructur- Warren made a comment at ing of the business, whereby Pepsi although I the time that Kraft had in the costs they’ve taken out fact sold the business for may point to higher returns don’t think that the something like 6x operating on those commodity- carbonated drinks income. My investors by oriented segments. They contrast effectively bought further believe that the busi- industry has come the DiGiorno business nesses they have acquired in through our stake in Nestle. the international markets to terms with its We were provided with will power up reinvestment. that opportunity because This remains to be seen as it sugary past and somebody was desperate can be challenging to merge for a strategic reason to cultures when a company present. There are consummate an acquisition tries to buy growth. an increasing and sacrifice valuation for the DiGiorno brand. G&D: When Kraft splits number of places into the separate publicly G&D: What are your traded North American- that charge soft thoughts on Pepsi? focused and globally focused companies, will you take a drink taxes and try TR: I am intrigued by Pepsi look at either of the shares? although I don’t think that to limit consumer the carbonated drinks in- TR: It’s a bit of a hodge- intake of sugary dustry has come to terms podge, especially if I care a with its sugary past and pre- lot about culture. There drinks. I think that sent. There are an increas- are a series of leaps of faith ing number of places that that are required of one for there are other charge soft drink taxes and this investment. I’ll proba- try to limit consumer intake bly take a look at both of shoes to drop on of sugary drinks. I think that the stocks and would be there are other shoes to delighted to be positively the carbonated soft drop on the carbonated soft surprised… drinks category and drinks category and so I have avoided owning the Warren Buffett outlined his so I have avoided company, though this is own frustration with the from someone who owns Kraft situation a couple of owning the tobacco companies and spir- years back. His frustration its companies! was in part specifically re- company, though However, if we were to see lated to Kraft’s selling of a spin-off of Frito-Lay from what was believed to be one this is from Pepsico, that could be quite of their crown jewels, Di- someone who owns interesting. I went to a Giorno, to Nestle. The Pepsi meeting a few weeks CEO of Kraft claimed that tobacco companies ago and I was struck by the Kraft had received a very ongoing reality that there is high exit EBITDA multiple. and spirits no peer competitor in Frito- But this was backward look- Lay’s market. It’s in a league ing. The selling price also companies!” (Continued on page 41) didn’t account for taxes Page 41 “The next big trended opportunity will be being short U.S. government Tom Russo

(Continued from page 40) whiz-kid scientists in flavor brate the “capacity to suf- of its own. To the extent and technology, specifically fer” and the ability to take that a category competition in the area of taste recep- the long view. However, in was developing in the form tors. They say that the some cases, the fully private of Diamond Foods, that’s mouth has 17 taste recep- nature of some companies gone by the wayside. Aside tors for bitter and only two may mean that mistakes can from that, Frito-Lay’s route for sweet. This is because get buried because there is system, its innovations and humans have to survive, and no publication. Within a the continued consumer things that are bitter are public company, if you go demand for its products are things that kill you while out and say you are going to a powerful force in the US things that are sweet don’t come out with a brand new and abroad. or rather do so more product and it flops, people As an aside, if you’re going slowly. What Senomyx within your company have to be a high conviction in- tries to do is override the to address it, come to terms vestor who intends to hold requirement to get sweet by with it, and learn from that positions for a very long deactivating taste receptors, experience. When deci- time, you should be sure to “If you’re going to so you can meet your desire sions at a fully family- get out and see the busi- for sweet at much lower controlled private company be a high ness. By doing so, when the doses. Foods can then con- are made and they fail, I market panics, you can fall tain fewer calories without don’t think the institutions conviction back on the confidence you losing any of their taste. learn as well from those gained from witnessing first- The problem is that Seno- experiences. Mars is not investor who hand how the company is myx gets to learn at Pepsi’s nearly the company it could building out its business in expense. What Senomyx be, and arguably should be, intends to hold key growth markets. Along does for Pepsi in terms of given what they started with these lines, I was in Angola compounds developed, is 40 years ago – premium pet positions for a to investigate the expansion proprietary, but what Seno- food, premium confection- of SAB-Miller’s distribution myx scientists learn is not ary products, ice cream very long time, there and in a modest out proprietary and hence over novelties, etc. of the way community, a time shared, ingredient- you should be sure small bodega was selling based competitive advantage G&D: What are your Johnson & Johnson, Marl- will likely remain short- thoughts on Danone and to get out and see boro, Nestle and, sure lived. the yogurt category? enough, Frito-Lay branded the business.” products. Frito-Lay is quite G&D: Given your interest TR: I love the yogurt cate- a franchise. in Cadbury, is Mars a com- gory. However, I have pany that you would own if found as an investor that G&D: What do you think it ever became public? Danone has been more ex- about Pepsi’s collaboration pensive than Nestle for with Senomyx to focus on TR: Absolutely! Mars most of the time that I’ve the discovery, development, would be an interesting been investing. Danone has and commercialization of company if it were publicly done a great job with the sweet-enhancers and natural traded as it fits right into my yogurt category. I like that high-potency sweeteners wheel-house. They have with CEO Frank Riboud, the with the intent to bring to businesses in pet food, company has become very the marketplace a lower- global confectionary, ice entrepreneurial. However, calorie drink? cream treats, rice, etc. The the company has a feeling of company is family-owned, having a more personality- TR: I am not sure the bat- however Mars has not been dependent future vs. Nestle, tle over CSD market share as well run as possible over where the culture of innova- will be over by sweetener most recent time. I cele- (Continued on page 42) selection. Senomyx has Issue XV “The next big trended opportunity will be being short U.S. governmentPage 42 Tom Russo

(Continued from page 41) rents that are going to be ness, and Carlsberg has felt tion is more institutional- asked of cosmetics compa- the effects of this. Carls- ized. Within Danone there nies as we move forward. berg’s new management has is a huge tribute to the vi- Do I think beauty matters? done a fine job … it’s more “What has kept me sion of one man. I don’t You bet. There’s a lot of the corporate structure that think it’s a given that they money to be made in re- has concerned me. away from the will be able to find a succes- lated products. Unilever sor with similar vision or makes gobs of money G&D: You are one of the cosmetics charisma to succeed that through the sale of Axe, a most celebrated value inves- one man. Reckitt Benckiser companies has been body spray that males start tors, but you did not start was very well run for a dec- using at an early age because out at Columbia Business their route to ade but its charismatic, they think it will help them School. How did you first driven and talented CEO do better with young ladies. get exposed to value invest- market. recently left and Reckitt’s As an investor, something ing? shares have since lan- like this is great – it is some- Historically this has guished. thing that people will spray TR: Despite the obvious on every day with hope! shortcoming of not having been a department G&D: Have you ever been the full value investing im- interested in owning compa- store-driven G&D: You have been a mersion offered at Colum- nies in the cosmetics sec- long time investor in Heine- bia and spearheaded by Pro- business, which has tor? ken. Have you ever been fessor Bruce Greenwald, I interested in Carlsberg? was fortunate to have taken been an TR: My investors indirectly Jack McDonald’s class at own a third of L’Oreal TR: I have invested in Hei- Stanford Business School. increasingly difficult through Nestle. I’ve never neken shares since the early Professor McDonald was a owned any of these compa- 1990s. I have had no invest- lone voice at Stanford in place to be. nies directly. What has ments in Carlsberg. As value investing. The other kept me away from the cos- Declining foot much as I like family owner- “finance” classes were all metics companies has been ship because it gives a man- concerned with greek let- traffic into their route to market. His- agement team the “capacity ters and “provable certain- torically this has been a de- to suffer,” Carlsberg is ties” that I do not believe to department stores partment store driven busi- owned by a foundation, be reliable. A very influen- ness, which has been an which is not an ownership tial event in my life was reduces opportunity increasingly difficult place to structure I have embraced. Warren Buffett’s visit to be. Declining foot traffic It is a very different beast. Professor McDonald’s class to market.” into department stores re- The kinds of demands and in the early 1980s. Today, I duces opportunity to mar- standards that come from a am quite fortunate and ket. Other store-based foundation versus a family- privileged to serve on the concepts are emerging like owned company versus a Advisory Board of the Heil- Sephora. The internet is public company are very brunn Center for Graham & now an emerging channel. different. The brand Carls- Dodd Investing at Columbia For instance, Birchbox is a berg exists in many devel- Business School and have new startup in this category oped and emerging markets, been quite fortunate to have that could be disruptive – but in no market are they been so been affiliated with people pay a fee to sign up the commanding story, ex- the school. In addition, in and get monthly deliveries cept Russia. The company’s recent years, I have been of sample products deliv- market share in Russia is so assisted in my efforts by ered to their door. The big, that there is a lot of excellent work from one of problem with the old model country-specific risk. Russia Professor Bruce is that people now don’t go recently went nuclear with Greenwald’s program’s to the department store as new taxes on the beer busi- (Continued on page 43) often and I’m unsure of the Page 43 “The next big trended opportunity will be being short U.S. government Tom Russo

(Continued from page 42) pret this to mean that busi- How important has being “The concept of graduates, T. Charlie Quinn. ness isn’t personal. I think outside of New York been it’s just the opposite. The for you? turning down noise G&D: What is the best best businesses are very piece of advice you have of Wall Street is personal. It’s all about the TR: The concept of turning ever received? culture, the people, and the down noise of Wall Street is

something that I leaders. something that I appreciate TR: Most of the good ad- by the training I received at appreciate by the vice I’ve heard over the G&D: What are some the Sequoia Fund. The ab- years has emanated from things that you think have solute detachment from training I received Buffett. “Do what you like contributed to your amazing Wall Street there was amaz- to do because you will be success? ing. Our offices were at at the Sequoia better at it” is something he 56th and 6th Avenue in says often that I’ve taken to Fund. The absolute TR: I think the fact that New York, but it could have heart. Another good piece Warren Buffett and his part- been Topeka, Kansas for of advice of his that I’ve detachment from ner Charlie Munger exist how little contact we had followed is “pick your he- has been so valuable for the with the Street. I never saw Wall Street there roes.” While Warren is my investors who seek to in- a salesman come through “uber hero” for investing, vest for the long term. Had the door. If you are located was amazing...I within my operating com- they never existed, the con- in New York and you have pany teams I’ve picked Peter cept of buying great busi- 16 Wall Street analysts never saw a Brabeck who was CEO and nesses for the long term, coming through your door is now Chairman of Nestle. salesman come and staying the course each day, what is that going Here is a guy who has re- through thick and thin kind to do to your capacity to through the door. formed the culture and ex- of investing would have stay the course with a com- pectations of an already been ravaged by efficient pany? You would have an If you have 16 Wall great company into some- market theorists. You eroding stream of banter thing that is better. An- would not be able to find that you would have to steel Street analysts other good piece of advice patient capital to pursue this yourself against. That was of Buffett is to stay within style of investing. Due in what Sequoia fund offered. coming through your circle of competence. large part to Buffett, people To see patient investing Lastly, he has said “you can’t your door each day, know it is possible because actually succeed was proof make a good deal with a it has been done. This has that this way of doing things what is that going dishonest person.” I don’t allowed me and others who could work. They accom- think that the people in cor- do what I do to have the plished this in New York, to do to your porate America are dishon- privilege to striving to fol- not Tennessee. So future est, but they are driven by low similar goals and objec- investors should realize that capacity to stay the incentives that make them tives. My clients have been it is more about maintaining less owner-minded. You an extremely important part a detached frame of refer- course with a have seen Buffett focus of my success. They have ence than it about the spe- more on private businesses, company?” been willing to give me the cific place where you many of these being family “capacity to suffer,” which is choose to work. companies, as these people exactly what I ask from the haven’t yet developed bad managers of the companies G&D: It was a pleasure habits. It all comes down to we own. speaking with you, Mr. people. At the end of the Russo. Thank you very TV show “The Apprentice,” G&D: Mason Hawkins much. Donald Trump, when he’s talks about how being lo- about to boot somebody, cated outside of New York always says: “nothing per- has helped him think inde- sonal, it’s only business.” I pendently of the Street. think many people misinter- Page 44 Alex Roepers

(Continued from page 1) 80 different companies that nomic trough. This formula G&D: Following your time operated in 40 different really didn’t appeal to me. at Harvard Business School, industries on two conti- Additionally, as I knew well you worked for Thyssen- nents. I arrived at Thyssen- from my experience with Bornemisza Group, an in- Bornemisza and spent four divestitures, once you own dustrial conglomerate. years helping the top man- a company it takes a long What triggered that deci- agement in Monaco rational- time, usually a year, to sell sion? ize its portfolio of compa- it. These were two things – nies. My official title was high entry valuation multi- Alex Roepers AR: While still at Harvard Director of Corporate De- ples and the difficulty to exit Business School, I spent my velopment but I was basi- – that I really didn’t like summer interning at Dover cally Mr. Divestiture. Every about the private equity Corporation, a publicly time I showed up at a sub- business. “My official title listed conglomerate where I sidiary company, the em- was involved in mergers & ployees knew their company G&D: Did these experi- was Director of acquisitions analysis. I really was for sale. I was involved ences shape your decision became intrigued by what it in a lot of transactions to move to the investment Corporate took to buy a company where we were selling com- business? from the perspective of a panies in order to pay down Development but I business owner. So, during debt and streamline the AR: Beginning in about ’86 my second year of business was basically Mr. company. I held that role or ’87, I started to present school, I focused on any during the bull market of ideas outside of my normal Divestiture. Every classes related to buying and 1984 to 1988, which was a areas of divestitures and selling companies – tax fac- period of a tremendous acquisitions of entire com- time I showed up tors and business decisions, number of IPOs and corpo- panies for the portfolio. I real estate, corporate fi- rate activity. Specifically, started to present ideas at a subsidiary nance and others. private equity activity also about taking smaller, “toe- increased greatly during company, the hold” interests – two to five I immediately looked for a these years. Thyssen- percent positions – in much employees knew career opportunity where I Bornemisza was basically a larger publicly traded com- could do the same thing. large private equity portfolio panies that I identified as their company was My boss at Dover had previ- that was selling its portfolio being very attractively val- ously worked at Europe- companies into a favorable ued. In these situations, we for sale.” based Thyssen-Bornemisza market. I learned a lot wouldn’t have to pay a con- Group, which was a larger about valuing companies but trol premium and we company than Dover but I also learned to dislike a wouldn’t have the illiquidity privately held. My back- few things. For example, that came from being a ma- ground was quite suitable when we bought companies, jority shareholder. Further, for Thyssen-Bornemisza. we had to pay a premium we also didn’t lever the po- They had offices in Monaco, for control. Further, one sitions. I presented 26 of Amsterdam and New York. has to consider that financial those ideas over two years. I wanted to work in New buyers typically add signifi- The market crashed in ’87 York but I would also be cant financial leverage to a and eventually 10 of the 26 able to use my Dutch, company, on top of intro- companies were acquired by French, German and English. ducing an illiquidity factor other companies. They Dover was operating highly and are more likely to buy- indeed had very attractive efficiently whereas Thyssen- in at the “high point” of the sum-of-the-parts character- Bornemisza was twice the cycle regarding valuation. istics whereby a private eq- size of Dover but had a This is because banks lend uity firm or another corpo- more complex portfolio. procyclically and are unlikely Thyssen-Bornemisza owned to extend loans at an eco- (Continued on page 45) Issue XV Page 45

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(Continued from page 44) licly traded stocks -- in a ers. To put some generic rate buyer could acquire the very concentrated manner, labels on the strategy, the companies and profitably with position sizes equiva- goal was to be a really con- break them into smaller lent to two to five percent centrated, value-oriented pieces. So I demonstrated stock picker in the mid-cap that even in the public mar- “My stated approach arena. The portfolio was kets, I was able to identify was to invest in a lim- fully up and running in the companies that represented middle of 1989. solid value. Additionally, the ited part of the uni- other 16 companies which Fairly quickly after officially were not taken over per- verse of publicly launching the fund, the junk formed quite well as many collapsed and had specific identifiable cata- traded stocks -- in a Drexel-Burnham went into lysts ahead of them. very concentrated bankruptcy. The fuel for private equity disappeared I measured my pro forma manner, with position and investor interest in mid- record from the 26 compa- cap, “LBO-able” companies nies I had recommended, sizes equivalent to dissipated. So my portfolio which was good enough went quickly out of favor in such that it allowed me to two to five percent late 1989 and money ro- go out and raise some tated into defensive names money at the age of 28. ownership-- in com- like Phillip-Morris and Proc- Raising money after the panies that specifi- tor and Gamble. It was a crash in ’87 was like trying prelude to what was com- to raise money in 2009. It cally demonstrated ing. 1990 was an economic was very hard, particularly disaster: we had the Savings as I didn’t have much money features that would and Loan Crisis, a huge re- of my own and no record cession, a 30-40% decline in other than this pro forma be attractive to pri- the housing market, fol- record with the 26 stocks. I lowed by an oil shock and did, however, get backing vate equity firms or the Iraq War. It was several from the CEO of Thyssen- strategic buyers. To years of misery leading into Bornemisza. In addition, my 1992 and people became former manager at Thyssen put some generic la- disillusioned with equities. moved to Geneva and be- That set up a 200% rally in came the head deal-maker bels on the strategy, the S&P and a phenomenal for Carlo de Benedetti, who five year period of activism, was the equivalent of Carl the goal was to be a takeovers, and corporate Icahn at that time. That led action. My approach did to additional funding. After really concentrated, very well from 1992 to convincing a Dutch bank to value-oriented stock 1997. In fact, the conditions provide backing, I officially today seem quite similar to launched Atlantic Invest- picker in the mid-cap those of 1992. I believe that ment Management. I raised 2012 to 2017 could be an- eight million dollars in total, arena.” other phenomenal period which wasn’t a lot, but still for the equity markets, for felt like quite a success and ownership-- in companies activism, takeovers and cor- was certainly enough to get that specifically demon- porate action because we going. My stated approach strated features that would have had, similarly, several was to invest in a limited be attractive to private eq- years of misery since late part of the universe of pub- uity firms or strategic buy- (Continued on page 46) Issue XV Page 46

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(Continued from page 45) insurance companies. What pacted during particularly 2007. you really have to watch for fearful periods. I’ve dealt is if there’s a tsunami effect with a fair number of mar- G&D: What about macro that could result from fail- ket conditions over the past concerns such as the histori- ures related to sovereign 23 years and in our main cally high debt levels for the debt that will affect the fund, we’ve returned 9x the S&P 500 returns, net of fees, major sovereigns? Could Pictured: John Spears of with a long-only portfolio of something like this provide a Tweedy, Browne Company at strong enough overhang to “From day one – I US stocks. This perform- CSIMA Conference in February impede a potential bull mar- ance was achieved without 2011. ket? learned this in the tech companies, IPOs, over- levered companies or any ‘80s – we have not AR: It certainly is an issue. pure commodity oriented exposure, but just with Let’s not forget, though, that invested in levered “A primary deter- we have historically very low companies that you and I interest rates. So if you look entities that lack can understand. minant of which at the total debt service bur- transparency, which den in relation to GDP, it’s G&D: Do you still form stocks become a the core of your portfolio not much different than it include banks, bro- was in 1982. The market is with a keen eye toward core holding in the staring at the debt to GDP kerage firms and in- takeover targets or has that figure a bit too much. The shifted a bit over time? portfolio and re- aggregate amount of debt is surance companies. certainly a concern. I’m all in AR: A primary determinant ceive a higher capi- favor of politicians who try What you really of which stocks become a to reduce spending and bring core holding in the portfolio tal allocation are the budget in line. This is an have to watch for is and receive a higher capital issue, but it’s primarily an if there’s a tsunami allocation are the predict- the predictability issue for people who hold ability and reliability of the bonds. Eventually, it does effect that could re- company’s cash flows. A lot and reliability of become an issue for all asset of qualitative thinking goes classes if it spirals out of con- sult from failures re- into our stock selection the company’s trol. That is an assessment process, including a thor- we have to make. I do not lated to sovereign ough understanding of what cash flows.” think however that a major the company does, how problem like the events of debt that will affect many customers they have, 2008 is likely in the foresee- the economy and how many regions, how able future. many products, what kind of corporate earnings products and whether or If you look at the European not the product has a reve- sovereign debt situation, it’s via a credit crunch.” nue stream derived from a primarily an issue for the large installed base. For bond holders in those coun- example, if you sell an eleva- economy and corporate tries as well as the banks and tor, you have a contract to earnings via a credit crunch. insurance companies that maintain the elevator. A We monitor these issues hold the bonds. From day mature elevator company daily. From our perspective, one – I learned this in the gets 75% of its earnings however, we are investing in ‘80s – we have not invested from the installed elevators very solid companies that in levered entities that lack that operate whether the are always profitable, even transparency, which include though they can be im- banks, brokerage firms and (Continued on page 47) Page 47 Alex Roepers

(Continued from page 46) lined the types of companies Concentration is a core “The first part of building is half empty or not. that you like and the ones aspect of our philosophy, So I’d much rather invest in you avoid. Could you talk a and very important to out- our investment an elevator company than in little more about your in- performance over time. an office furniture maker, vestment philosophy and Quite often we have 20 philosophy, which doesn’t have a reve- how you construct your good ideas but we believe nue stream derived from an portfolio? that we’re going to do bet- which is very installed base. If we find ter with the top five than important, is companies trading at a low AR: The first part of our the next 15. Our flagship valuation on predictable and investment philosophy, Cambrian Fund typically concentration of reliable cash flows, with a which is very important, is holds six stocks. That cer- strong balance sheet, it will concentration of capital in tainly restricts the amount capital in high become a large percentage high conviction ideas. A lot of capital we can manage, of our portfolio. Then of people pay lip service to but we are comfortable conviction ideas. we’re looking for multiple that and end up having port- with that; in fact, we’ve had catalysts. An elevator com- folios with 100 stocks, with to close our funds to new A lot of people pany that we like, Schindler the top 10 each represent- capital in the past. We are Elevator, is insider con- ing maybe 4% of the portfo- most focused on com- pay lip service to trolled so it’s not a takeover lio. In our case, the core pounding capital over time, candidate and therefore activity is typically 6 stocks, making money for our cli- that and end up becomes a smaller percent- with a range of 5 – 8 stocks. ents, and we are working to age of the portfolio. At We understand that such create a 30+ year record having portfolios present, Schindler is too concentration is often per- that will establish a legacy expensive for our valuation ceived as being “too risky” that can stand up well with 100 stocks, metrics, but we constantly for many investors. How- against the great investment monitor it should it become ever, we feel that it is actu- track records out there. with the top 10 cheap enough. In general, ally less risky because we nine out of ten companies know our portfolio inside G&D: How does your each representing that we own have no insider and out. Six stocks require a philosophy differ on the control and as such they’re tremendous amount of fo- short side? maybe 4% of the more likely to be taken over cus and research, as well as if they stay at a low valua- universe definition and disci- AR: We have a long / short portfolio. In our tion for an extended period pline to avoid the risk that fund called AJR, which is our of time. Thus passage of comes with concentrating other US product. The fund case, the core time at a low valuation, as- capital. Therefore, we avoid has been around for 18 suming reliable cash flows roughly 80% of the public years and has compounded activity is and a durable franchise, stock universe by excluding at 13% vs. 8% for the S&P ranks as an important cata- financials and high tech, high since inception. In this fund typically 6 stocks, lyst. However, we look for product liability-related we have 15-16 long posi- other catalysts as well, in- companies, small companies with a range of 5 tions and 25 - 30 short posi- cluding asset divestitures, due to the liquidity risk is- tions. The 15 long positions smart synergistic acquisi- – 8 stocks.” sues, and the very large are 80-100% of capital, with tions, share buyback pro- companies because we don’t no leverage used, and the grams, dividend initiations, have any significant edge. top 6 of those companies analyst upgrades, insider Our edge and our ability to are the same 6 holdings in buying, judicious capacity do due diligence is really our long only Cambrian expansion in growth mar- concentrated in this well- product. The other 9-10 kets and others - the more defined universe of compa- long names are value- catalysts the better. nies with a $1 to $30bn oriented ideas that we like market cap. G&D: You broadly out- (Continued on page 48) Issue XV Page 48

Alex Roepers

(Continued from page 47) on at the time. I was basi- stocks. The NASDAQ was but which didn’t make it into cally by myself and then I up 25% in the first three the core long group because added one analyst and then months of 2000 and we they’re either not as diversi- another. The late 1999s were down 10%, so we had fied, they have significant tech bubble was a challeng- underperformed by 35% insider ownership or they ing period for our funds. I against this index. By the have enough financial lever- had clients telling me that end of the year, we were up age such that we are not they didn’t understand why 55% and the NASDAQ was comfortable making it a core our fund was flat, so I had down 40%. In the last nine position. to ask them if they knew months of 2000, our out- what they were invested in. performance was massive, On the short side, we are I remember asking them if and our strong performance “The late 1999s diversified and the portfolio they thought it was a good continued into 2001 and is actively traded. We find idea that Cisco was trading 2002. That really helped tech bubble was a at 25x revenues. I’ve saved launch our business. We short ideas from our long challenging period universe. While doing peer a lot of clients a lot of grew from $100M AUM in analysis, we will find compa- money by asking them to 2000 to $1.5B AUM by mid- for our funds. I nies that are over-levered, simply relate the market 2003. We closed our U.S. poorly run, overpaid for a capitalization of the compa- funds in July 2003. Soon had clients telling poor acquisition or ran up to nies they were investing in after, I hopped on a plane to the high end of their valua- to the revenues of those Asia with one of my ana- me that they didn’t tion range. Sometimes they companies. I would point lysts. I had never been are pair trades and some- out that IBM has traded there before but knew it understand why times they’re stand-alone between 1-3x revenues for was important to under- ideas that come from the the past 20 years. They stand the significance of our fund was flat, analysis of our long ideas. could see that an invest- China. By late 2004 we These positions are actively ment in Cisco at that time started a fund to focus on so I had to ask traded, with a stop-loss to was merely speculation, not Japanese and European ensure appropriate risk man- a sound investing strategy. I companies. Within six them if they knew agement and with a typical engaged in these discussions months we had raised $1.5B position size of one to two with clients partially to jus- in AUM for this new fund. what they were in- percent. While on the long tify why I was severely un- side we’re concentrated with derperforming and partially G&D: Can we talk a bit vested in.” a one to two year time hori- to warn them about the about the 2008 downturn zon, on the short side we’re companies in which they and how you positioned the diversified with a time hori- were investing. In ’99, we fund at that time? zon of two weeks to two actually managed to do sur- months. prisingly well and even made AR: We foresaw many of some money on our shorts. the issues that caused the G&D: You mentioned Cam- In fact, we were rated num- crisis, though we never en- brian and your US-focused ber one by Nelson’s ranking visioned it was going to be hedge fund AJR. Could you of money managers. as vicious as it was. We talk more about how your were early in betting against firm developed and the vari- The inflection point came in Fannie Mae and Freddie ous funds that you offer? March of 2000. It’s very Mac, as we started these important to understand short positions in 2003. AR: The strategy has been that when there is a com- These companies lacked the same since day one. I modity boom or a technol- transparency and had only started the firm with a sharp ogy boom it draws the wind 1.5% equity against a giant focus on US stocks because out of other market seg- pile of mortgages. Addition- that’s all I was able to focus ments; in this case value (Continued on page 49) Issue XV Page 49

Alex Roepers

(Continued from page 48) earnings in a down econ- the next few years as global “We foresaw many ally, the implicit government omy. 2009 favored highly electrical demand grows, guarantee was for mortgage levered, deep cyclical com- particularly in emerging of the issues that holders, not the equity hold- panies. Companies like Cat- economies such as China ers. While we had these erpillar were up 140% from and India. Peabody Energy caused the crisis, positions right and were March to September 2009, says that global coal demand short all the way to the bot- but more defensive compa- will grow by 1.3 billion ton- though we never en- tom, our long-bias in mid-cap nies were flat. Nonetheless, nes over the next five years, companies obviously hurt us we were up 60% in 2009 which is more coal than the visioned it was going in the late 2008 and early with our concentrated long United States produces in a to be as vicious as it 2009 period. Money was only fund and we did it with year. China is a big part of coming out of the market a more defensive portfolio. the story, as 70% of its elec- was. We were early and whatever stayed in the This allowed us to outper- tricity needs come from market rotated to the largest form in 2010. Over the coal. China has gone from in betting against of large caps. We had dis- past three years, our con- being a net exporter to a proportionate underperfor- centrated long-only fund has net importer of coal. Also, Fannie Mae and mance as this occurred, but compounded at 38%. Joy Global’s earnings were Freddie Mac, as we then disproportionate out- flat in the ‘Great Recession.’ performance as we came out G&D: Can we talk about a It’s hard to find another started these short of it. The one thing that we few of your current invest- capital goods company that learned after the crisis was ments? weathered the storm this positions in 2003. that we could better manage well. That is because Joy our exposure. When volatil- AR: One of our larger generates about 60% of its These companies ity in the form of the VIX is revenues from an installed holdings today is Joy Global. lacked transparency high, it creates a lot of op- It is a Milwaukee-based base worth tens of billions portunities, whereby one can company that makes high of dollars. That equipment and had only 1.5% buy good companies at cheap productivity coal-mining and operates in extreme condi- prices. During the 2008-09 surface mining equipment. tions and has wear and tear equity against a gi- crisis, the S&P was down Coal is not everyone’s fa- and constantly needs to be 40%, but the top 30 stocks, vorite fuel, but it provides rebuilt with strong, recur- ant pile of mort- which make up roughly one- 40% to 50% of the fuel for ring spare parts demand. third of the market cap of electricity generation in this Joy also has thousands of gages. Additionally, the index, were only down employees around the globe country. Right now there is the implicit govern- 18%. The rest of the S&P weakness in the U.S. coal supporting the equipment of was down on average over market because we had a the BHPs and Peabodys, ment guarantee was 50%. A lot of people were mild winter and natural gas among others. Joy Global gun-shy going into 2009. We prices are super-low thanks makes sure the equipment is for mortgage hold- ended up with a defensive to the shale boom and the up and running but they portfolio coming out of the advancement of hydraulic don’t take on the risk of ers, not the equity crisis. Everything came down fracturing. As a result, utili- operating it. All the com- so hard and indiscriminately ties are switching from coal pany needs to grow EPS is holders.” that we were able to buy to natural gas when it’s pos- for worldwide coal produc- great companies cheaply at sible. However, coal will tion to continue to increase. that time. We bought continue to be a very im- Finally, Joy Global has a Smuckers and Thermo-Fisher portant fuel not only in the strong competitive position Scientific – these are compa- United States but globally. with enormous barriers to nies that hold their own very According to BP, coal ac- entry. Two Milwaukee- well even in a bad economy. counts for 30% of global based companies, the other We were able to buy these energy consumed (including being Caterpillar subsidiary companies for 6-7x EBIT transportation) and it will Bucyrus International, con- while they were still growing continue to take share over (Continued on page 50) Page 50 Alex Roepers

(Continued from page 49) backlash against fracking. Joy is also supplying mid tier trol the market – it’s a du- Any significant legislation mines with equipment from opoly. No one else in the (although none is expected a China based company it world can make these until after the Novermber recently acquired. Caterpil- pieces of equipment. At 2012 election at the earli- lar, incidentally, agreed to Joy’s factory, in order to est) could impact the price buy Bucyrus for 10x for- support the stamping equip- of natural gas. Second, natu- ward EBITDA vs. the 6x “I think people ment used to construct the ral gas trades for several EBITDA multiple that JOY equipment, JOY has a 200 multiples of the US price in trades at today. In our view, overestimate the feet deep concrete founda- markets such as Europe and it would make strategic tion beneath their machines. Asia. It will take time for sense for a company like impact of the Regulators will not provide this to close. Komatsu to buy Joy, or per- approval today for a plant haps later on for Joy to buy warm winter and requiring 200 feet of con- G&D: How much of Joy Komatsu. It’s a chicken and crete. Global’s sales and earnings egg game that will go on for extrapolate low are tied to China? the next few years as Joy G&D: In a recent interview works to become bigger natural gas prices for Graham & Doddsville, Jim AR: Direct China sales are than Komatsu in terms of Chanos talked about his only 15% of the Joy Global market cap. Of course, it’s into perpetuity, negative view of the coal story at this point. The hard for a non-Japanese industry due to fracking. China real estate boom is an company to buy a Japanese which I see as the How do you respond? issue for investors in real company, but they want to estate companies and devel- stay out of the hands of primary reason for AR: I would say that he is opers, and for those compa- Komatsu. Komatsu would be smart to pay attention to lower coal very focused on the U.S. I nies making wheel loaders have great respect for Jim and other products directly the current weakness in Joy’s share price. Joy is not production. Chanos but I do believe tied into Chinese construc- natural gas prices will not tion. China’s electricity insider controlled. We have seen the industry con- Natural gas stay low forever. Addition- need is un-mistakenly tied ally, there is a ton of U.S. to GDP, growth in its total solidate in the past few years. Terex, a company production can electricity production that is population, a rising middle tied to coal and there will class and salary inflation, out of Westport, was in- change very continue to be a large which allows people to buy volved with heavy equip- amount of coal production more things like air condi- ment and had become a big quickly.” to support this. The U.S. is tioners that require a lot of competitor to Caterpillar in also exporting much of its energy. Electricity use in some areas. coal production. While Joy China overtime will go up, Global’s U.S. business is therefore coal production Terex got into some trou- down, its total business is and use of coal will go up. ble due to high leverage and up because its international Coal production is an issue put it’s hydraulic excavator side is strong. I think peo- in China because the gov- unit on the market. Cater- ple overestimate the impact ernment has decided to go pillar looked at it, Joy of the warm winter and from 11,000 mines to 4,000 looked at it, and Bucyrus extrapolate low natural gas mines by 2015, by shutting ended up buying this prized prices into perpetuity, the least productive and Terex unit. At that point, which I see as the primary most dangerous mines that we invested in Bucyrus, reason for lower coal pro- lacked proper structural sensing that eventually Cat- duction. Natural gas pro- support. The remaining top erpillar could acquire Bu- duction can change very tier mines need the auto- cyrus. Now Joy remains quickly. For starters, there mated equipment that Joy standing as the only pure is a lot of environmental Global and Bucyrus supply. (Continued on page 51) Page 51 Alex Roepers

“Now Joy remains (Continued from page 50) and a take out candidate. plastic. Even ‘new age’ play mining equipment busi- The most likely buyer for drinks are in glass, because standing as the only ness that is a perfect fit for this company would be glass has a premium feel. Komatsu or one or two someone like Berkshire Overall glass packaging us- pure play mining other strategic buyers. Joy Hathaway. OI owns 81 age trends are very favor- should have $1.4 billion in glass plants. The glass bot- able in emerging markets equipment business operating profit for FY 2013 tle is used for food, beer and stable in developed and the company is valued and wine and other high end markets. Pira, a consultant, that is a perfect fit at $9.5 billion or 6.8x EBIT. drinks. Everyone agrees projects that glass packaging This is a very attractive glass is the preferred pack- will grow more rapidly than for Komatsu or one valuation for this franchise. aging for consumers. Glass beverage cans or metal Bucyrus was bought for is used to package some- packaging through 2015. or two other strate- more than 12x EBIT. thing like 98% of wine, 80% The industry’s pricing of liquor, and 50% of beer in power is solid and it has gic buyers. Joy GD: So assuming there’s mature markets. These high EBITDA margins. no strategic buyer, what do numbers switch around a bit should have $1.4 you think the market is depending on the economic It’s a matter of good execu- missing in this story? environment, but the tion and smart acquisitions, billion in operating changes are relatively minor. and it helps to have the Depending on where you winds of a strong economy profit for FY 2013 AR: People are expecting that earnings will come build it, it can take up to at your back. We have in- $200 million to build a new vested in OI four times over and the company is down for the cyclical (not secular) challenges Mr. plant. You can’t ship glass the past 20 years, and we more than 300 miles be- have made money every valued at $9.5 bil- Chanos mentioned. For the bears, Joy’s shares are pric- cause it’s prohibitively ex- time on it. This stock cra- lion or 6.8x EBIT. ing in peak earnings per pensive, so geographical tered during the financial share of $7 or $8, so it’s coverage and distribution crisis and we invested in the This is a very at- trading at 10x peak earnings. are quintessential. Owens stock at $13, after which it But, in our view, these are Illinois has 19 plants in the ran to $38. We are now tractive valuation not peak earnings. We see U.S., 30% market share one of the largest share- Joy’s earnings trending up globally and 40% to 100% holders of the company. It for this franchise.” over time. They had one market share in key mar- has had a tough run re- flat year in earnings in the kets. cently, but that’s why it’s Bucyrus was bought Great Recession. Caterpil- one of our largest holdings lar earnings were down GD: Hasn’t there been any again. If you look at earn- for more than 12x 60%. Sales were down secular decline in glass us- ings now, this company is nearly 40% at Caterpillar, age? getting treated as if it’s an EBIT.” while sales at Joy were flat. airline stock that is going from high profits to massive AR: Yes – it has been mas- losses. This company has sive. There were advances in plastic bottling technology always been profitable. GD: Is there another com- in the 1980s which led to a Currently, it is making more pany you could tell us surplus of glass bottlers in than $800 million in EBIT about? the market at that time, and and that can go to $1.2 bil- industry consolidated from lion annually. The problem AR: Owens Illinois is an- 20 suppliers to 3 that con- in 2011 was that they finally other large holding that trol more than 90% of the saw higher volumes, yet we’ve had for awhile. They US market. Volumes are were caught with having a are the largest maker of pretty stable now, however. reduced manufacturing foot- glass bottles in the world. It In wine for example, you print and inventory. As a is a very unique franchise aren’t going to switch to (Continued on page 52) Page 52 Alex Roepers

(Continued from page 51) sense to take on a reason- result, they were forced to able level of debt. For exam- GD: What kind of qualities ship glass over greater dis- ple, a fixed rate mortgage do you look for in your ana- tances, which increased lysts? shipping costs significantly “Overall glass pack- and really damaged the AR: I always look for hon- second quarter of 2011. aging usage trends est people who enjoy the This did not change our research process. In fact, thesis at all. Their earnings are very favorable we have six Columbia MBAs were $2.37 per share last on our team. I think Co- year. I think they will have in emerging markets lumbia Business School does $3.00 in earnings in 2012 a nice job training its stu- and we see this company and stable in devel- dents. There is a strong getting $3.40 in earnings the focus on value investing that next year. The company has oped markets. Pira, breeds strong analysts. I am more than $4 in earnings always looking for an analyst power and it’s share price a consultant, pro- that has a private equity could potentially double in investment mentality on the next year. jects that glass publicly traded companies. We do intense research and GD: So you think the mar- packaging will grow get to know the customers, ket is singularly focused on the plants and everything current earnings and not its more rapidly than else we can before we buy future potential? shares in a company. In beverage cans or order to get conviction on an investment idea, you AR: I think there are few metal packaging people who appreciate this need to do a lot of work. So I look for people that unique franchise as we do. through 2015.” It’s not a growth business, really want to do this work but it’s a great moneymaker. that costs no more than and who are intellectually We try to evaluate high 25% of your income, to buy curious about this. quality companies with your first house makes strong franchises that make sense. But many of the fi- GD: Any parting words of money in any kind of envi- nancial problems in the wisdom for our readers? ronment, and I believe world have been due to Owens Illinois and Joy are entities taking on way too AR: Do something that two examples of that. much debt. In terms of you really enjoy, and be managing money, don’t use honest, hardworking, and GD: You’ve seen a number margin debt. The compa- trustworthy, and things of different market cycles. nies that we own have very should work out very well What advice do you have manageable debt, if any. I for you. You should do for younger analysts? always look closely at the something you love to do, interest costs on the debt because you’re much more AR: The four letter word related to EBITDA. Many likely to succeed at it. that messes up households, refer to this as the interest There’s nothing like having a governments, and compa- coverage ratio. Our compa- spring in your step on your nies is “debt”. If you can nies must have at least 4x way to work because you stay away from debt you EBITDA as compared with like what you’re doing. net interest expense, and will be much better off. Of most have a far greater course, there are some G&D: Thank you very cushion than that. situations where it makes much. Page 53

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(Continued from page 1) right age, certainly. But greatest analyst of all time, investment philosophy? what really made me was Steve Mandel.

the realization that I could JR: Well it started with my hire really good young peo- G&D: So many of the peo- father, who was an interest- ple. When we started Tiger ple that worked at Tiger ing guy. He was a very au- Management, I did that. Management have gone on thoritarian figure, but he One of them, John Griffin, to be extremely successful wanted me to learn a num- used to teach a security investors in their own right. ber of different things. He analysis course at Columbia What was the process and showed me how the stock Business School and now the training like here for tables worked in the paper, guest-lectures there. John young analysts? and I got interested in an and I are still great friends. early age and we worked on There was a big age differ- JR: It was sort of a melting a few stocks together. He ence between us but we’re pot. I was so much older Julian Robertson was in the textile business still close. When he left to than they were, so they had but he was a really good “But what really go on his own, I didn’t han- to have a father-like opinion investor. I joined the Navy dle it particularly well. If I of me. They thought I had a made me was the after college, as I had been had been smart I would unique touch or something, in the ROTC in college. realization that I have taken a piece of his so they would put me on a Prior to the Navy, I never action. We’re probably plane with one of them, could hire really really had any sort of re- better friends now though who would act like a camp sponsibility. But upon join- good young people. than we’ve ever been. He’s counselor to keep me from ing the Navy, I literally had going to host my 80th birth- getting in trouble and we’d 700 million pounds of TNT When we started day day in June. His son and go to Japan and see what we and an atomic bomb under Tiger Management, I my grandson are great could learn. We were buy- my command. I enjoyed the friends. I was talking to ing a stock in Korea, and responsibility. After the did that. One of John the other day about things were so new about it Navy, my father wanted me how we’ve never really that the paper called the them John Griffin to get some training in New given anyone too much too broker and asked who was York before I went to a used to teach a soon that they couldn’t han- buying that stock. And the brokerage firm down south. dle. But I said, the trouble broker told them about us security analysis That was 55 years ago, and was, I tried to rehabilitate a and said that since Tiger I’m still here. I’ve adored course at Columbia lot of people who, for one was buying so much that he New York, and if I could reason or another, didn’t was too. So they didn’t Business School and force everybody to do it, I’d have it. So I’ve made some really know what was going force them to grow up in a now guest-lectures mistakes on that. But our on over there either! It was small town in North Caro- young people were really just a gold mine. lina and then eventually there...” great. And good ones begat come to New York. even better ones – even G&D: If someone brings an

today, we still do! So I’d say idea to you, what are the G&D: What do you think the success really belongs to first few things you want to explains your incredible the young people who know? success? worked here. John Griffin,

Andreas Halvorson, Lee JR: The first thing is, is the JR: Well I started at the Ainslie, and probably the (Continued on page 54) Issue XV Page 54 Julian Robertson

(Continued from page 53) just an extraordinary com- they’re trading at 12x earn- management decent and pany. They just have ideas. ings for a company with honest? A lot of people They don’t have any facto- amazing products. This year don’t really care about ries. They just have great will see the Apple television that. The way to look into ideas and then outsource all set. I’m almost sure of that. that is to do some dili- But when the stock skids, it gence. Are they actively likely won’t be a massacre “We had fantastic involved in their commu- “The first thing is, is because they have so much nity? You should try and the management cash. analysts and I find folks who know them and see what they think. decent and honest? A G&D: Could you give us a found I could Of course, you also want general sense of what you lot of people don’t count on their to investigate the growth think an analyst should look possibilities. We had fan- really care about at first and what should get earnings tastic analysts and I found I that. The way to one most excited about a could count on their earn- particular stock? projections. So I ings projections. So I sort look into that is to do of turned from a cheap JR: I’d say if you have an sort of turned some diligence. Are skate investor, one who idea that company manage- from a cheap was focused on low multi- they actively involved ment is comprised of really ple stocks, to one inter- great people, you should skate investor, one ested in real growth in their community? look hard at that stock. But who was focused stocks. Today, in my opin- You should try and keep in mind that people ion, the world’s cheapest can change too. For exam- on low multiple stock is Apple (editors find folks who know ple, Steve Jobs was not a note: the interview was them and see what great person in many re- stocks, to one conducted when Apple spects before he was fired, traded at $450). If that they think. Of according to his biography. interested in real company had existed in the course, you also want growth stocks.” 1970s, it would be trading G&D: Aside from honesty at 5x what it currently is. to investigate the and other important core analytical attributes, what For years I’ve had a fund growth possibilities.” do you look for in an analyst that I’ve put money into in when you decide to seed case of a real crisis. I’ve their manufacturing so that their fund? put TIPS into that portfolio they really don’t take too and I’m convinced now much operating risk. JR: Competitiveness. Is he that they’re a disaster. a competitor? Does he get There’s just no yield at all. G&D: When would you into the batter’s box and You’re taxed on the yield. sell Apple? crowd the plate to intimi- So I’m thinking very seri- date the pitcher? I use that ously of shifting all of my JR: Well, there will be a as an analogy but I believe TIPS into something like time to sell the stock, of that athletics actually do Apple or Google. Apple is course. But right now, (Continued on page 55) Page 55 Julian Robertson

(Continued from page 54) and you have to keep track most similar to you in terms mean a lot. For instance, of that. We’re going to of investment style? Mandel is a fabulous athlete back a new fund and I think and particularly strong in you’ll hear about it in two JR: I think a lot of those tennis and squash. He or three months. This fund guys gravitated toward Ti- picked up golf and now he’s will be managed by a team ger Management because good at that too. Griffin of people who we’ve vetted they had similar investment plays everything. Really all and who we think are very philosophies. I would say “Is he a of those analysts I men- good. We’ve had some that there are many more tioned earlier have been losers along the way. similarities than there are competitor? Does good athletes during their differences between all of lives. But there are cer- Something else we do, by us. I would say, though, that he get into the tainly exceptions to that and large, is that we test some writers out there will batter’s box and too. A whole bunch of most of the people who try to determine a correla- funds have been successful come to work here. This is tion between the portfolios crowd the plate to with no jocks involved. a psychological test that of the various “Tiger Cubs” lasts for about three hours. or Tiger Seeds. We can intimidate the I should also mention that If the results of that test show you figures that just pitcher? I use that all of those guys have a real aren’t consistent with how blow that right out of the interest in making this world successful managers would water. On the other hand, I as an analogy but a better place. Mandel is on think about and respond to think almost all “Tigers” had the National Board of Di- the questions asked, then sensational 2007s and rea- I believe that rectors for Teach For we feel we’re doing a bad sonably good 2008s but not America. Griffin is a foun- job with those people who very good 2009s and 2010s. athletics actually der and Board Chairman for have come to work for us. You could say there’s obvi- do mean a lot.” something called iMentor, We’ve had flops take it and ously some correlation but which is a huge mentoring great managers take it, so it’s not that. It’s just that organization here in New we’ve been able to extract a our fundamental risk pa- York. Lee Ainslie has done lot of useful information rameters were similar. a lot and Andreas is getting about our people from that into it in a big way. That’s test. It’s something that G&D: Analysts are bom- another interesting aspect helps prevent us from seed- barded with so much infor- to those who have been ing a fund run by someone mation today, what do you successful investors. Look who wouldn’t be all that think they should focus on at . He’s quite good. The test tries to as- to most effectively allocate a philanthropist. sess whether a person is their time? thoroughly honest or if G&D: In addition to a they’re trying to game the JR: I would say that hedge competitive spirit, how do test. The questions are fund investing is, in another you decide which analysts worded in such a way that sense, the antithesis of base- are good enough for backing they help us do that. ball. You can hit .400 and from your fund? not make much money if G&D: Of the “Tiger Cubs” you’re not playing in the big JR: Well it’s based on who that you’ve mentioned, is leagues. But if you play in has given you the good ideas there one that you feel is (Continued on page 56) Issue XV Page 56

Julian Robertson

(Continued from page 55) ing of money is scary, but perhaps Google, are there the big leagues and you that is what they are doing any other stocks or indus- hit .400, you’re going to to get out of it. tries that you find particu- make big money. With larly appealing today? hedge fund investing, you “...I would say that get paid on your batting JR: I love WuXi average irrespective of the hedge fund investing (pronounced WOO-shee; Pictured: Professor Roger “league” in which you’re is, in another sense, ticker: WX) which is a Chi- Murray and investor Robert playing. So go where the nese-based employment Heilbrunn with their wives, pitching is the worst. Go to the antithesis of base- agency for PhDs, primarily Agnes Murray and Harriet Heilbrunn. the minor leagues; go to ball. You can hit .400 in the drug industry. Phar- Korea and China now. maceutical companies can There are 1,000 fraudulent and not make much employ a Chinese PhD living companies and 1,000 fabu- in China for about one fifth lous stocks! I once found money if you’re not of what a US PhD would somebody to whom I gave playing in the big cost. So I think its business this pitch who said, “Gosh, I of somewhat disintermediat- should go to China!” Then I leagues. But if you ing the pharmaceutical- reminded him about his play in the big focused PhD market is a family. He replied that he good one. The company’s was about to get married to leagues and you earnings are certainly in- a Vietnamese woman who hit .400, you’re going creasing beautifully at about would love to live in China. 20% a year and it still sells at So we backed his fund in to make big money. 10x earnings. It was ush- China. I think our Chinese ered to the IPO phase by With hedge fund in- fund, which should officially probably the best venture launch in May will be a good vesting, you get paid capital firm in the world, one because we have a man- General Atlantic. ager on the ground there on your batting aver- who’s talented and loves the age irrespective of G&D: Can you talk a little business. about your investment phi- the “league” in which losophy? G&D: What is your view you’re playing. So go of the current macro situa- JR: I believe that the best tion and how is it shaping where the pitching is way to manage money is to your investment strategies go long and short stocks. the worst. Go to the today? My theory is that if the 50 minor leagues; go to best stocks you can come JR: I’m the only person in up with don’t outperform America, outside of Stan Korea and China the 50 worst stocks you can Druckenmiller, who has now.” come up with, you should some worries about the US be in another business. printing money. Europe That being said, there are also scares me. The print- G&D: Besides Apple and (Continued on page 57) Page 57 Julian Robertson

(Continued from page 56) Hathaway annual meeting you did your work you “For my shorts, I look long periods of times where for the first time this year. would be better off invest- the 50 worst companies will ing in a $25 million hedge for a bad management outperform the 50 best. G&D: What do you look fund. It’s much easier to team, and a wildly Always of particular impor- for in your shorts? turn $25 million into $100 tance to me at any company million than it is $100 mil- overvalued company is the quality of people at JR: For my shorts, I look lion into $400 million, and in an industry that is the company. Still, this is for a bad management team, it’s a lot easier to turn $100 declining or not an infallible way of look- and a wildly overvalued million into $400 million ing at companies. I am company in an industry that than it is to turn $1 billion misunderstood. For reading the Steve Jobs biog- is declining or misunder- into $4 billion. I think the instance I think REITs raphy right now and am at stood. For instance I think focus on large, institutional- the point where he got fired REITs are jokes. People ized funds is a temporary are jokes. People look from Apple. One takeaway look at them for yield, phenomenon. The good at them for yield, I have is what a difficult per- which in a sense they pro- people will be looking for son Steve Jobs was when he vide. But, I think about this smaller funds. which in a sense they was a young guy. He like I think about printing provide. But, I think seemed to have changed money. As long as people When I was managing dramatically as he got older. keep printing, things go al- money I felt that if we could about this like I think right until something blows keep enough people, and about printing money. G&D: What advice do you up. The REITs are the that the caliber of our peo- As long as people keep have for young analysts and worst because they pay high ple was good, then it didn’t business school students? dividends and when they matter how much money printing things go don’t earn enough to cover we managed. But the truth alright until something JR: Peter Lynch’s books the dividend they issue of the matter was, when we have some great insights stock. were finishing, we had blows up. The REITs would be great for anyone nearly $40 billion ($20 bil- are the worst because to read. Here’s a ‘small- G&D: Many think that the lion in assets under manage- world’ story for you. My hedge fund industry is ment levered 2-for-1) to they pay high neighbor who lived across changed dramatically over invest. Even if we had 400 dividends and when the street from me in Salis- the last few years in terms positions, we would have they don’t earn bury, North Carolina went of the difficulty in raising had to put $100 million in to Columbia Business money now, as compared to each position. It’s hard to enough to cover the School. He roomed with five to ten years ago, as the find that many $100 million dividend they issue Warren Buffett when he industry has become more positions that you really was there. The reason I institutionalized. What are want to invest in and that stock.” bring this up is that Warren your thoughts? you can get into and out of. is just so disciplined, smart, It’s tougher the bigger you and sound – these factors JR: I think this is true, but get. are really what makes him it is nonsense on the part of great. People should look the buyers. They act as if G&D: Thank you very at some of the things he’s you have to have $100 mil- much Mr. Robertson. done in his career and try lion in assets under manage- to emulate him. I’m actually ment to be brilliant. The going to the Berkshire truth of the matter is that if Issue XV Page 58

Robert Luciano

(Continued from page 2) one. We assembled a many fund managers have Luciano is a CFA Char- group of highly focused, money under management terholder and a Fellow of highly talented people who, that can cause them to em- the Financial Services along with me, are equity bark upon what Warren Institute of Australasia. partners in the firm and Buffett calls “the institu- have a very substantial tional imperative”. It is im- G&D: Could you talk a little amount of their own and portant to have the right bit about the background of their families’ net worth VGI Partners? invested in VGI and the “When you manage Robert Luciano Fund. This creates a very RL: VGI was founded in unique alignment of interest, billions of dollars, the early 2008 at what turned which is so important and out to be the early stages of yet so few people have it incremental capital the global financial crisis. As these days. It’s one thing to that you raise can one of my good friends said have money invested in the at the time, we couldn’t have funds that you manage; it’s become lower quality chosen a better time or a another thing to have the worse time to start an in- vast proportion of your net and is more difficult vestment management firm. wealth invested in the funds We started managing money that you manage. That fo- to manage. Every for wealthy families and indi- cuses your attention very viduals and that remains our substantially and it causes incremental billion client base. Our focus is on you to focus on preserving becomes harder and concentrating our capital in capital first and foremost, our best ideas. We had and then secondly, on gen- harder to manage as some attributes that we erating returns on a risk wanted to incorporate from adjusted basis. So it ensures size is an anchor on our experience over the last that you think about Ben 10-15 years in the investment Graham’s great concept of performance” management industry and margin of safety all the time. take some of the positives For example, we don’t allow people and infrastructure, and learn from the negatives, personal trading at VGI, the right investment phi- and really go back to the which means that everyone losophy and alignment of basics of what absolute re- here focuses exclusively on interest, which goes hand in turn investing is all about. what we’re doing. We are hand with the right compen- We wanted to ensure that looking for high quality com- sation policy, and the right we as principals had close panies and high quality in- capital meaning the right alignment with our investors, vestments. We limit the investor base. That’s diffi- so we invested in the same amount of capital we raise, cult for many managers to funds or vehicles that they aiming to manage money put in place and particularly were. We also wanted a only for people who share as they continue to grow, it structure that was skewed our time horizon and invest- becomes very complicated. toward performance and not ment philosophy. That’s on maximizing management wonderful for us because it G&D: A lot of fund manag- fees. We are focused on means we have an excellent ers we speak with often say returns, and on the alignment client base that understands that finding patient capital is of interest between the man- our style of investing, and one of the biggest challenges ager and the client. That’s when there is volatility, we in investment management. the crux of what VGI is are not worried that we’ll What is your secret sauce? about, and what its modus have upset investors. That’s operandi has been from day a key issue these days, when (Continued on page 59) Issue XV Page 59

Robert Luciano

(Continued from page 58) focus all of our research and stocks because we don’t RL: Part of it is simply that continuous learning efforts think it makes any sense. we manage just under $300 on a relatively small number We want to concentrate million and have grown or- of great businesses. We capital in our best ideas, and ganically and via client refer- have six people on our in- we think over time this will ral. When you manage bil- vestment team, so we can give us a superior return to lions of dollars, the incre- harness a large amount of the market or a portfolio “A great investment mental capital that you raise resource and focus on a that has a high degree of can become lower quality number of companies, so we diversification. Most impor- is one you’d never and is more difficult to man- can build up knowledge on tantly, that superior return age. Every incremental bil- specific companies very rap- will be achieved with lower have to sell. It’s an lion becomes harder and idly. As time goes by your risk, because we understand harder to manage as size is knowledge on these compa- the companies in depth and asset that you an anchor on performance. nies increases and this im- we have selected them one bought at a reason- We have decided to close to proves your understanding by one. We think we re- new investors when we on how the business makes duce the risk in our portfo- able price and reach around money, its sustainable com- lio by ensuring that we only $1 billion under management, petitive advantage, the indus- invest in high quality busi- which continues to and the reason for that is try structure, the company’s nesses and we define risk as that we like to invest 50% of financial statements and its the permanent loss of capi- deliver a return that our capital in our top 5 ideas. future earnings power. It tal, not as standard devia- So with $1 billion, an average allows you to bring a lot of tion of return. you are pleased core position size is going to things together and that’s with. Its return ex- be around $100 million, and particularly helpful during G&D: Would you explain a for some small to mid-size times of volatility when share little more about your in- ceeds your hurdle companies it becomes diffi- prices can fall sharply, and vestment criteria? cult to invest more than this the rest of the market is rate, whether that’s due to liquidity constraints fearful, you have the courage RL: A great investment is and other factors. of your convictions and be- one you’d never have to a property, a pri- cause you’ve done your sell. It’s an asset that you G&D: Would you explain work and your analysis, you bought at a reasonable price vate business or a the reasons why you prefer can buy more. That’s one of and which continues to de- listed security.” to run a very concentrated the key Graham tenets - that liver a return that you are portfolio? you need to understand the pleased with. Its return business, to back your con- exceeds your hurdle rate, RL: We subscribe to the viction and your analysis, and whether that’s a property, a Buffett and Munger philoso- even if the market disagrees private business or a listed phy, where one of the key with you for a period of security. When it comes to tenets is concentration of time, allocate your capital stocks, what we’re looking capital in your best ideas, and accordingly. If you don’t for are companies that we we believe in concentrating know the companies well, it’s can understand that have in our best ideas for a num- very difficult to gain the con- relatively simple and ber of reasons. For instance, viction to buy more when straightforward business we can only analyze and the price falls sharply. We models and attractive indus- know so many companies in realize that we have finite try structures. We don’t detail at a single point in capital, so to optimize our like complexity in terms of time. Also, by concentrating return on capital we allocate conglomerates or opaque our capital in our key ideas our efforts and our capital financial institutions. We we are hopefully able to opti- towards our best ideas. We then narrow this list to find mize our return on capital. are not going to spread the companies with a truly sus- Concentration allows us to portfolio across 50 or 100 (Continued on page 60) Page 60

Robert Luciano

(Continued from page 59) nological innovation. Sus- businesses we’d like to own, tainable competitive advan- tainable competitive advan- and sometimes price gets in tage. I think you can only tage is very important, and the way of that. Sometimes ascertain whether the com- the key is to buy it at the it’s our own fault where we “Investing is one of petitive advantage is truly right price. If you overpay don’t want to pay up for a sustainable by understanding for a wonderful business, great business and the stock those wonderful ca- the business model and in- you can generate low or just keeps going up or we dustry structure. If you can even negative returns for a simply miss it. Sometimes reers where the find a company that has a very long time. Investors in we find them through sustainable competitive ad- Coca-Cola would have ex- screening, other times we more time goes by, vantage and you can buy it perienced this if they paid find them from speaking the better you get, at a reasonable price, then around 50x earnings in the with other companies. We you’re on your way to a late 1990s. You could have typically conduct more than unlike an athlete successful investment. bought Coke stock then and 350 company meetings a made no money for over 10 year either through com- that has a finite G&D: But wouldn’t those years. I guess this perfectly pany visits, conference calls, companies be priced at an highlights Warren Buffett’s or one-on-one meetings at career.” appropriately high valuation? point about “paying a high conferences. We regularly price for a cheery consen- ask companies who their RL: In a normalized market sus.” key competitors are and environment, yes, this is who in the industry they usually the case, particularly G&D: Where have you recommend that we speak if it is a well known stock. typically found your best to. We ask management However in the past few ideas? Do you run screens? who they respect and ad- years, you have been able to mire and which other com- buy some of the best com- RL: There are a variety of panies we should be speak- panies in the world at sig- ways we come across our ing to. So there is no single nificantly marked-down best ideas. A lot of it is approach, there is no single prices. One of our largest comes through general technique. Sometimes we positions is The Coca-Cola knowledge and combined may have an idea for a long Company which was trading experience. I’ve been look- time, for example Colgate- in the low $40s in late ’08, ing at public securities since Palmolive which we have in early ’09, and that stock 1996 and reading hundreds the portfolio. We have until only just recently has of annual reports, as well as been long-term admirers of been trading at a consider- Outstanding Investor Di- the company, and for what- able discount to intrinsic gest, Graham & Doddsville ever reason didn’t buy it value. Coca-Cola is one of and other investing publica- during the financial crisis. the greatest businesses in tions. So our knowledge of The stock got quite expen- the world that epitomizes securities has accumulated sive at one point, and then sustainable competitive ad- over time. Investing is one there was an opportunity to vantage. Our job is to find of those wonderful careers purchase Colgate in August companies that have these where the more time goes 2010 when there was some characteristics and buy them by, the better you get, concern over what we at a reasonable price. So unlike an athlete that has a thought was not a serious for our investments, we finite career. Charlie matter. There was the de- look for companies that are Munger and Warren Buffett valuation of currency in relatively easy to under- are a testament to this. Venezuela and also threat of stand which often means They have gotten better as competition from P&G avoiding some companies they’ve gotten older. So I which we assessed to be whose businesses are ex- guess it’s collective learning temporary and not material tremely vulnerable to tech- – we have a short list of (Continued on page 61) Page 61

Robert Luciano

(Continued from page 60) recurring revenue at the date & Support fee has to valuation so this gave us core of the business model. evolved to being the biggest an opportunity to buy the We like recurring revenue component of Oracle’s stock at very attractive lev- businesses in general, revenue. The Update & els. This is an example of a whether it’s in software, in Support revenue for Oracle company that we had on financial services, in media is linked to the initial pur- our watch-list, we missed an or in healthcare. We don’t chase price of the software, initial opportunity, but we tend to do top-down analy- and is about 22% of the pur- continued to watch it, and sis, but rather focus on bot- chase price per annum and when the stock was sold off tom-up analysis - we focus indexed to inflation. it was a very quick decision more on companies than Roughly 96-97% of Update to build a substantial posi- industries per se. Having & Support contracts are tion in Colgate. It’s impor- said that, we are very mind- renewed annually; the small tant to keep watching great ful of longer term trends, so amount that is lost is usually businesses because invaria- for instance an ageing due to M&A and bank- bly you get these opportuni- demographic is a very pow- ruptcy. So what they’ve ties over time. erful longer-trend trend in done is built up this recur- many Western countries. ring revenue stream. In G&D: Are there any indus- So we’re mindful of secular 2001, recurring revenues tries that you find yourself trends or shifts in terms of were $3.5 billion while one- investing more than others? industries or sectors that off revenues were $4.5 bil- we can invest in, and I think lion. In FY 2011, the recur- RL: We avoid certain in- it is important to be mindful ring revenues were $14.8 dustries and therefore, by of these types of secular billion and new software doing that, we tend to focus changes that are going on, fees were $9.2 billion. The on what’s left. We avoid but we don’t invest based delta between $3.5 and banks and insurers because solely on those criteria. $14.8 billion has a gross of their complexity and profit margin of about 90% opaqueness that makes it G&D: Could you talk and the incremental gross difficult to forecast the about some current ideas? profit margin is even higher. earnings power of these businesses and to ascertain RL: One of our key posi- G&D: So what is the mar- what their true intrinsic tions is Oracle Corporation. ket most concerned about value is. We don’t feel we We think Oracle is an ex- in pricing this stock? have any adequate edge to cellent business, and par- price those securities with ticularly attractive at these RL: We like Oracle along the amount of information prices. It’s a stock that is with SAP because they’re available in the public filings. out of favor with the mar- both mission critical soft- We also tend to avoid re- ket. We’ve owned it from ware businesses that have source companies because the high teens and it’s about established a very strong we find it difficult to value $30 at the moment. Oracle recurring revenue base. them due to the uncertainty dominates the industry in They are must-haves for of longer-term commodity relational database software. large global corporations prices. It is one thing to It has evolved substantially and it’s very hard to dis- have a sense of volume; it is in the last 15 years from lodge Oracle or SAP once another thing entirely to try selling software on a one-off they have been installed. to ascertain what the longer basis to selling software The market is likely focused -term price of a commodity with a recurring revenue on some weakness in new will be. We currently do stream attached to it in the software license sales for have a focus on business form of Update & Support Oracle, as it can be a driver service software that has fees. So effectively the Up- (Continued on page 62) Issue XV Page 62

Robert Luciano

(Continued from page 61) we assume that the company profit margin goes unno- of near term results, but if no longer grows its 2011 ticed in a 120 page report. It you’re looking at it on a free cash flow in perpetuity reminds me of McDonald’s, longer term basis, the recur- you’d still get a valuation that how the market was ob- ring revenue stream and its is around the current stock sessed about food prices a growth are far more appar- price. We think that is re- few years ago while forget- ent. Oracle recently ac- markable, because you don’t ting that McDonald’s was quired Sun Microsystems, one of the most diversified and the market initially was “What sometimes property owners in the concerned about this acquisi- can happen is that world. The high food prices tion because Oracle was were somewhat relevant as effectively buying a hardware analysts can be- they would affect the fran- company that was not mak- chisees, but to be obsessed ing any money. The market come stuck in a cer- with them didn’t make much was worried that the com- sense. What sometimes pany was “deworsifying” but tain way of analyz- can happen is that analysts it turned out that the com- can become stuck in a cer- pany ended up reducing cost, ing a company, and tain way of analyzing a com- cutting out unprofitable reve- the same analysts pany, and the same analysts nue and ended up acquiring cover the same names for Sun for what looks like less cover the same many years, and they some- than 2.5x EBIT which is a times just don’t pick up very attractive acquisition names for many gradual shifts in business price. That concern faded models. They focus on the away, but another concern years, and they data that they have popu- may be that the management lated their models with and team is shrinking the revenue sometimes just they miss the new data. base of Sun as it gets rid of don’t pick up grad- non-essential revenue lines G&D: Is there another and low margin products. It ual shifts in business name that you are currently appears to concern people excited about? that the hardware revenue is models. They focus shrinking, and I think there’s RL: WD40 is a global con- a broader concern that the on the data that sumer products and brand arrival of cloud computing management company. The would dislocate Oracle’s they have popu- vast majority of WD40’s dominance in relational data- lated their models revenue is generated from bases. What we’re focused selling cans of the world on is this remarkable in- with and they miss famous WD40 branded crease in the recurring reve- industrial lubricant (G&D: nue stream, which has only the new data.” WD40 stands for Water accelerated post the financial Displacement, 40th attempt crisis. The recurring revenue get that type of margin of which was the laboratory was $8.3 billion in 2007 and safety in many stocks today. name used by the chemist grew to $14.8 billion in 2011, We read a 120 page report who developed the product and we’re looking for a num- on Oracle from the sell-side in 1953). ber of around $16 billion in a while back that had no 2012. That’s a staggering mention of the recurring WD40 manufactures the growth rate on a revenue revenues! I don’t understand WD40 concentrate inter- line that has a gross profit how such a large revenue nally to protect its secret margin of over 90%. Even if base with such a high gross (Continued on page 63) Issue XV Page 63

Robert Luciano

(Continued from page 62) thing for a takeout pre- would be successful in in- formula. WD40 ships this mium, and we think this vesting or in business. I concentrate to external mono-line business with no don’t think that this is a ‘aerosol fillers’ and out- debt and high cash flows is a career that you can force sources the majority of the standout candidate to be upon yourself, because it is manufacturing of its product taken private. something that you have to to third parties. As a result be genuinely interested in. WD40 has only two employ- G&D: You started VGI My advice would be to learn ees in its manufacturing op- Partners in Sydney initially, from Charlie Munger and erations. This asset-light given your background. Warren Buffett, read all business model enables How did you decide to their speeches, and read all WD40 to operate with very open a NY office? the original Buffett Partner- little capital and only 334 ship and Berkshire Hatha- employees. RL: We have primarily way letters. I would also focused on equities outside highly recommend reading WD40 generates greater of Australia since our found- Phil Fisher’s “Common than US$1,000,000 in reve- ing in 2008 because the op- Stocks and Uncommon nue and US$171,000 in EBIT portunities internationally Profits.” That would be a per employee. These met- have been so substantial. As very good place to start. rics are particularly high for we became better known to The teachings of Ben Gra- an industrial company and investors, we have had ham go hand in hand with highlight how management more interest from outside the teachings of Warren operates the business. of Australia and we came to Buffett, and the “Intelligent WD40’s outsourced - the realization that we Investor” is a must-read. I manufacture business model needed to have a base in would also spend as much means that it has lower fixed either the US or Europe to time as possible studying operating costs than a typical help us grow and allow eas- accounting. It is something manufacturing company. ier access to companies and that I feel a lot of modern This allows WD40 to shut management teams. We finance courses underesti- down production rapidly had a choice between New mate. One of the keys to when there is a sudden drop York and London and we being a successful analyst is in demand, as we saw in decided to work closely understanding accounting 2008/2009, which helps pro- with a large investor in New and financial statement tect WD40’s profit margins. York. New York is a great analysis, and that is vastly WD40’s dividend payout place to be and we also get underappreciated. I was ratio is around 50% which terrific access to first class trained as an accountant; we think is impressive and it graduates who can poten- some of our team members is now embarking on sub- tially join us and help us were trained as accountants stantial share buybacks. Last grow VGI Partners. too and four of the Invest- year, WDFC bought back ment team, including myself, $41 million of stock on top G&D: Any advice for stu- have completed the CFA of paying dividends, for a dents thinking about enter- program which puts a lot of total return of capital to ing the investment industry? emphasis on financial state- shareholders of $60 million, ment analysis. Finally, don’t which we think is extraordi- RL: I think that this profes- focus on the monetary out- nary. The stock at these sion largely chooses you. come, if you are a good levels is still undervalued at a Most people who I think analyst the monetary out- 7% free cash flow yield for a have become successful in come will find you. company with such high qual- investing have shown char- ity characteristics. At this acter traits at an early age G&D: Thank you very point, you’re not paying any- that suggested that they much, Mr. Luciano. Get Involved:

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Graham & Doddsville 2011 / 2012 Editors

Anna Baghdasaryan is a second year MBA student in the Applied Value Investing Program. While at school, she worked part time for Cantillon Capital Management, global investments firm and the Clinton Group, a small- cap activist-focused hedge fund. Prior to Columbia Business School, Anna worked in strategy and investment banking. She can be reached at abagh- [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].