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Graham & Doddsville An newsletter from the students of

Inside this issue: Issue XXVI Winter 2016 25th Annual Craig Effron of Scoggin Capital Graham & Dodd Management Breakfast P. 3 Craig Effron P. 5 Craig Effron is the co-portfolio manager of Scoggin Capital Management, which he founded with partner Curtis Schenker in Jeff Gramm P. 19 1988. With approximately $1.75 billion in , Scoggin is a global, opportunistic, multi-strategy Shane Parrish P. 30 Craig Effron event-driven fund. Scoggin focuses on identifying fundamental Jon Salinas P. 39 long/ through three primary strategies including event driven equities with a catalyst, special situations, and distressed credit. Mr. Student Ideas P. 47 Effron began his career as a floor trader on the Mercantile Exchange and New York Commodity Exchange. Mr. Effron received a BS in from the (Continued on page 5) Editors:

Brendan Dawson Jeff Gramm ’03 Shane Parrish MBA 2016 of Bandera of Farnam Scott DeBenedett Partners MBA 2016 Street

Anthony Philipp Jeff Gramm manages Shane Parrish is MBA 2016 Bandera Partners, a the curator for the

Brandon Cheong value fund based Shane Parrish popular Farnam Jeff Gramm in . He Street Blog, an MBA 2017 intellectual hub of teaches Applied Value Eric Laidlow, CFA Investing at Columbia Business School curated interestingness that covers MBA 2017 and wrote the upcoming book “Dear topics like human misjudgment, (Continued on page 19) (Continued on page 30) Benjamin Ostrow MBA 2017 Jon Salinas ’08 of Plymouth Lane Capital Management Visit us at: www.grahamanddodd.com Jonathan Salinas founded RolfPlymouth Heitmeyer Lane in April 2013 and acts www.csima.info as sole portfolio manager to the Fund. Prior to founding Plymouth Lane, Jonathan worked as an analyst at Marble Arch Investments, a long/short manager. Before joining Jon Salinas Marble Arch, Jonathan served as a consultant at ZBI Equities, a long/short hedge fund manager operated by Ziff Brothers Investments. Prior to ZBI, he was an analyst at Festina Lente , a concentrated, value -oriented investment manager, and worked as an analyst in capital markets and research divisions at UBS AG.

(Continued on page 39)

Page 2 Welcome to Graham & Doddsville

We are pleased to bring you the walks through current ideas investing. This year’s breakfast 26th edition of Graham & including Famous Dave’s featured a conversation with Doddsville. This student-led in- (DAVE) and Star Gas Part- Philippe Laffont of Coatue Man- vestment publication of Colum- ners (SGU). agement moderated by Profes- bia Business School (CBS) is co- sor of Co- sponsored by the Heilbrunn Shane Parrish discusses the lumbia Business School. Center for Graham & Dodd origination of Farnam Street Investing and the Columbia Stu- and his focus on becoming a Lastly, we are proud to bring dent Investment Management better learner, as epitomized you pitches from current stu- Association (CSIMA). by and Charlie dents at CBS. We feature final- Munger. Shane explains how ists from the Darden at Meredith Trivedi, the In this issue, we were fortunate these learnings apply to becom- Investing Competition, Colum- Heilbrunn Center Director. to speak with three investors ing a better investor and shares bia Business School’s inaugural Meredith skillfully leads the and the founder of the popular his hopes for Farnam Street CSIMA Stock Pitch Challenge, Center, cultivating strong blog Farnam Street. and its readership. and Challenge at UNC relationships with some of Kenan-Flagler. the world’s most experi- Craig Effron of Scoggin Capital Jonathan Salinas ’08 of Plym- enced value investors, and Management discusses the evo- outh Lane Capital discusses his The three finalist ideas from creating numerous learning lution of his firm and his invest- experiences with varied invest- our classmates include: Marc opportunities for students ment approach from commodi- ment approaches and mentors Grow ’17, Benjamin Ostrow interested in value invest- ties to the . Craig and how his background lead- ’17, and Evan Zehnal ’17 — ing. The classes sponsored offers insights into his risk man- ing up to founding Plymouth Dexcom Inc. (DXCM) Short; by the Heilbrunn Center agement mentality, challenges Lane has contributed to the Nielsen Fields ’17, Joanna Vu are among the most heavily facing the investment manage- firm’s world view and how he ’17, and Adam Xiao ’17 — demanded and highly rated ment community, and creative seeks to invest. Jonathan also Quest Diagnostics (DGX) classes at Columbia Busi- ways to express investment shares current ideas DHX Short; and Justin Hong ’17, ness School. theses while managing against Media (DHXM) and Sequential Zachary Rieger ’17, and Cristó- downside risk. He shares recent Brands Group (SQBG). bal Silva ’17 — XPO Logistics case studies in the event-driven (XPO) Long. space and opportunities he cur- This issue also highlights pho- rently see in distressed credits tos from the 25th Annual Gra- As always, we thank our in Puerto Rico and energy. ham & Dodd Breakfast, held on interviewees for contributing October 9th, 2015 at the their time and insights not only Jeff Gramm ’03 of Bandera Pierre Hotel in New York. This to us, but to the investment Partners discusses his book on event brings together alumni, community as a whole, and we activism “Dear Chairman: students, scholars, and practi- thank you for reading. Boardroom Battles and the Rise tioners for a forum on current of Shareholder Activism” and insights and approaches to - G&Dsville Editors Professor Bruce Greenwald, the Faculty Co-Director of the Heilbrunn Center. The Center sponsors the Program, a rigor- ous academic curriculum for particularly committed stu- dents that is taught by some of the industry’s best practi- tioners.

Keynote speaker Philippe Laffont Attendees gather at the 25th Annual addresses attendees at the 25th Annual Graham & Dodd Breakfast Graham & Dodd Breakfast Volume I, Issue 2 Page 3 25th Annual Graham & Dodd Breakfast— October 9, 2015 at The Pierre Hotel

Mario Gabelli ’67 at the Graham & Dodd Breakfast with Professor Bruce Greenwald with Philippe Laffont at the keynote speaker Philippe Laffont Graham & Dodd Breakfast

Sid and Helaine Lerner speak with Heilbrunn advisory Heilbrunn advisory board members David Greenspan ’00, board member Tom Russo William von Mueffling ’95, and Jenny Wallace ’94 Page 4

SAVE THE DATE FOR THE 7th ANNUAL

“From Graham to Buffett and Beyond” Dinner

Friday, April 29, 2016 6 p.m. to 9 p.m.

The Omaha Hilton 1001 Cass Street • Omaha,

Tickets will go on sale in March at www.grahamanddodd.com

Page 5 Craig Effron (Continued from page 1) Wharton School of try my hand at trading right. Business of the University commodities. I said that if I of . didn't do well, I would go to After about a year of managing law school a year later. I did Paul’s money and these other Graham & Doddsville well. I learned a lot about life accounts, I realized that I liked (G&D): Could you tell us and about commodities and doing this more than trading about your background and trading. And I was fairly good commodities. I left and told how you came to investing? at it. everybody I was going to put together a fund called Scoggin Craig Effron (CE): It’s The problem with with my partner Curtis important, because I am not commodities trading is that it Schenker, who is still my the traditional hedge fund ends at 2:30 in the afternoon. partner. Craig Effron story. I didn’t work two years When you’re 24 years old you in and then can get into a lot of trouble if Here’s a key element of our go to . you’re done at 2:30pm unless partnership and how Curtis I went to Wharton for you have something to do. I and I complement each undergrad. I did not get into decided to start learning the other—it’s an important fact NYU Law, but I got into Duke. stock market. I had gone to about Scoggin. Curtis was my I went down to Duke for a Wharton for undergrad and best friend before we started weekend with my parents and somewhat thought I knew Scoggin. He’s my best friend everybody there was 6'4” and what I was doing, but I didn’t still. Curtis and I keep each blonde. I said, "I'm not going to really know how to invest. other grounded. We realize do very well here. Socially, I About five years into trading we caught a 30 year bull cannot go here." My parents on the COMEX, I started market. We weren't that said, "I tell you what, take a doing risk . smart. We happened to have year off, defer, and then money under management, and reapply to NYU a year later That was the heyday of Mike it worked out. Curtis and I and hopefully get in.” Milken. I thought I was a genius don't take ourselves too because every time there was seriously. He has always been During that year, I met up with a deal announced, Mr. Naysayer, and I'm Mr. It’s- two buddies for a card game at automatically—within a Always-Bullish. Penn. They were playing for week—there would be a stakes that I had never even topping bid. Then there would He’s the guy who kept us in known existed. I said, "What be a third bid; it was crazy. business a lot because I do you guys do for a living?" Everyone on the floor knew would've been a lot more One said, "We trade about my success trading aggressive during the commodities. On the floor, we stocks. They all gave me their technology bubble. He said, buy and sell gold and silver. It's money, as my friends, to run “Craig, leave it alone. This is really fun and you should come for free. I did that for a year not what we do. We don’t check it out." and it was fun. I had about 30 know what that means. We’re accounts and I was doing it for not doing that.” And of course I had been working at EF free. later technology blows up. Hutton, which was big in That’s why it works, and that’s everything, but they went Paul Tudor Jones, who stood why we’re still best friends and bankrupt in the ’80s. I had next to me in the ring, was a still partners. gotten a job there right after good buddy of mine and said, school and worked there for a "You know what? Run my Part of this Scoggin charm, if few months. But, then I played money, as well. But one caveat: you want to call it that, is that in this card game and, I want you to charge me a fee." we still are friends first and afterward, went down to the I asked, "Why do you want me partners second. I think it sort floor with my friends. I to charge you a fee?" And, of flows through the whole thought, "Wow, this looks like being as smart as Paul is, he office. The average tenure of a lot of fun." Somehow, I said, “Because if you charge me my analysts here is 10 to 12 convinced my parents to lend a fee, you will pay attention to years. There are a few new me forty thousand dollars to my account first.” He was dead guys who are two or three (Continued on page 6) Page 6 Craig Effron

years but basically I have 12 could get involved in distressed lose.” I had to go through this analysts, and six or eight of credit, spin-offs, and whole process for my them have been here since restructuring—anything that investors explaining why they before 2000. It’s a very nice has an event. We went from shouldn't pull their money out. feeling to know that I can go running $3 million to running A lot of them did a year later. on vacation and know that I’m $3 billion by the late 2000s. We blew up after redemption not going to have someone We sort of stopped raising dates so the investors had to blow me up. money because I liked my life wait to redeem. We made and I didn't want to be a most of the money back in Incidentally, the name manager of people; I wanted to 2009, but they were all so “Scoggin” comes from a camp be a manager of money. And, stunned about what had that Curtis and I went to in mostly, I wanted it to be my happened that we lost about . I met him there and we own money. 25% of our capital through reunited at Penn. We started redemptions in 2009. That was Scoggin together with these 30 Then ’08 happened. We had a learning experience for me. accounts, Curtis’s money, and no losing years until 2008. We You don't ever want to have my money. It was about $3 had twenty years where every people think you are what you million in total and that was year we made money. At that are not. Then the Madoff thing how we started in 1988. To point we were up 17.5% net to happened the same year, so put it in perspective, as a investors. 2008 occurs and, they started saying, "Wait a hedge fund with $3 million in minute. Madoff didn’t lose 1988, we were not even the money for 20 years either." I smallest, while the biggest fund “I realized how actually had to explain why I'm was about $80 million. not Madoff to my big investors. fleeting success can be They knew I wasn’t, yet they G&D: At that point, were you had to check the boxes to just focused on ? in a market, whether make sure I wasn't actually Madoff. CE: Yes, that's all we were it’s a stock market or a doing at that point. We were G&D: Were they institutions? up a lot of money in ’89 and in commodities market. September of ’89 the biggest My whole perspective CE: Yes, they’re my big guys, deal in history was United and they were worried that . The deal blew up and on investing has been, they were going to be fired everybody in my world went from their jobs. Imagine having out of business. We went from and hopefully will another fraud that you up 65% to up 20%, which is a invested in. A lot of institutions big draw down, but still up continue to be, not to were invested with Madoff. 20%. Before this, I had been competing to attract the best lose.” The reality is that a lot of the talent, but I couldn’t afford to fund is my money and Curtis’s hire many of them. Now, they depending on which fund you money. If you do the math, we were working for free because look at, we lost between 20% can do much better making they were all out of work. I and 30%. To my investors, I good returns on our own hired a restructuring analyst, a was known as a “Jewish T-bill.” money than with management long/short analyst, and others This is a very bad thing to be fees. Except, this year we are whom I could never have known as—not the “Jewish” losing money. It’s the second afforded before that. part but the “T-bill” part. time we’re losing money since Because when you then have a 2008. We are down about That is when Scoggin was losing year, they say, "Oh my 10%. It's really nauseating really born because we could God, it's not a T-bill." Then because we have done a good now do things besides just get they start to realize, "Wait a job to be down 10%—that’s lucky with Mike Milken doing minute, he's got risk after all. what’s scary. We’ve done very topping bids. We could still do We thought you were really few things wrong, but those risk arbitrage, but now we safe. We thought you couldn't things we have done wrong (Continued on page 7) Page 7 Craig Effron

have been fatal in 2015. market. My whole perspective come back from it, but not on investing has been, and typically. You’re given one G&D: Could you talk about hopefully will continue to be, chance to go out of business how you think about managing not to lose. and that’s it in our industry. the downside in your You can't redo it. 2008 was portfolio? Relatively speaking, making different. People gave you a Matthew Baredes ’17, money is easy. It’s avoiding free pass in 2008. Otherwise, if Matheus Romariz ’16, and CE: Let’s go back to the floor losing that’s important and you lose money of any real Nicholas Turchetta ’17 experience. Managers you’ve much more difficult. This 10% size, you’re out of business volunteer at the Graham & spoken to in the past and with down year is going to cost me pretty quickly. There’s another Dodd Breakfast whom you will speak in the two years of money. I can tell smart guy down the street future are probably “traditional you next year will be a very who has done really well and analysts.” They come from he will take your money. good schools, they learn at Morgan Stanley or Centerview G&D: How much more Partners how to be an analyst. “I’ve learned that competitive is the hedge fund They start becoming investors people tend to give industry now compared with and that’s their thing. I am when you started? totally different. I am a trader. I you a one-year grace am a risk manager. I was very CE: Here is a crazy stat: when successful on the floor because period. They realize I started business there were I didn't go out of business. 300 hedge funds in the world. that the S&P is flat for There are now over 10,000. I remember when I was 23 or We were the 165th biggest in 24, there were the “Michael the year but the real 1990 with maybe $30 million, Jordans” and the “Tom market is not. There 155th in 2000 at around $1 Bradys” of the floor. They billion, and we were 177th in were famous. They were the are 327 stocks down 2008 at $3 billion. No matter big traders who traded how big we got, we never got hundreds of lots. I’m there for this year out of 500 in any bigger relatively. It’s about six to nine months and symptomatic of the issues I’m a little baby trader at this the S&P with a we’re having now in our point. I get tapped on the business. There’s too much shoulder by a veteran trader. handful money in it. He was one of the biggest outperforming.” traders in gold. He taps me on The business was an amazing the shoulder one day and says, business when no one knew "Hey, can I talk to you? I'm difficult year as well. In fact, if what it was. In my world, at wondering if I could borrow we fight back to even in two your age, mediocrity in my some money from you. I had a years I will be happy. The key business made you very little problem: I was short to our business, I’ve learned, is wealthy. People wanted to be gold." Gold went crazy and he this: don't go down. It’s fatal to invested in hedge funds. They went out of business. a lot of firms. The average age didn't care if you were the of a hedge fund that goes out best. They wanted to be in a I said, "I don't have any money of business is seven years. hedge fund; that was the cool to lend you—I'm 23 years We're on our 27th year. That’s thing to be in the ’90s. If you old—but I appreciate that not by accident. We had 20 were just mediocre, making 8% thought." I said to myself, years of never losing. We had a year, people were delighted "Wow this guy was a 2008, we also lost 3% in 2011, because they were doing it in a millionaire." He was looking and now this year: three losing hedge fund as opposed to for money because he went years out of 27. That's how doing it in a mutual fund. Now out of business. I realized how you stay in business. you're in a position where it’s fleeting success can be in a not good to be a hedge fund market, whether it’s a stock A lot of very good investors unless you're really good at it. market or a commodities have blown up. Some have (Continued on page 8) Page 8 Craig Effron

People that were terrible were theoretically have catalysts, deal. Five days later they making tons of money on and that has been a horrible announce a deal with Marriott management fees. That all business this year. (MAR) at $70: a take-under. I changed in 2008; they went had not seen that in 25 years. out of business. Now, in our G&D: Did the catalysts not business, if you’re not in the come through or did the Now obviously there’s more top 20%, you don't make any catalysts not matter much? to the story. Maybe it’s money, and that’s the way it because something is going on should be. Like any business, CE: Some didn’t come in the company that I don't you should be required to be through and some came know about. We thought, in the top percentile of through and ended up with bad “There are three buyers. We performers to remain in results. I’ll give you a case in are going to make a lot of business. That's the new point which I find amazing. money." We lost 10% dynamic, the new normal in my Starwood Hotels (HOT) went overnight on that trade. That's world. If you aren't good at it, up for sale in June. The stock just one example of what is you actually are out of at the time was at $80/share. going on this year. business. Every year, I’ve got Everybody had a break-up to be good again because there value of somewhere between Also, Mylan (MYL) was trying are many options out there. $90 and $105. On June 15th, to buy Perrigo (PRGO) this Whether it’s another hedge when Starwood announced year. It was a big deal. Mylan fund or a quant fund, there are that the company was up for came in hostilely and Perrigo so many options that people sale, the stock was up a little had no defenses. They went say, "Look, we love you as a bit that day. Then the market down to the last week, where person, but you’re making no they needed 50.1% of the money for me." votes to vote “yes” for the deal from Mylan. If you vote Now for 2015, we are down “There are a lot of “yes,” you make $20; it’s that between 10% and 11% at this things out there that simple. If you vote “no,” the point, and we have had very stock will go down and you few redemptions. I’ve learned are scaring me. But, lose $15. There's a $35 that people tend to give you a differential. In the history of one-year grace period. They I’m paid to play, and the world, I've never seen realize that the S&P is flat for people vote without their the year but the real market is that’s what I do. But I pocketbooks under not. There are 327 stocks consideration. Not only did it down this year out of 500 in don’t play with not go through, but also the the S&P with a handful leverage.” deal lost by a lot. outperforming. What I learned was that G&D: Those are companies people like making money, but like Google and Amazon? blew up and the stock was there are things they like down into the $60s. By the more. In this case, they liked CE: Out of those stocks that time the market came back the CEO of Perrigo so much are up, it’s about six that make about a month later, the stock that they felt badly for him. a difference. That's not what I was at $75. They said, "Let this guy try to do. I don't trade Google make it." They hated Mylan's (GOOG) and Amazon In the first week of November guy. I’m not saying I loved him, (AMZN). If I did, I wouldn't management announced there but he was offering me $20 need to be in this business. I’m were three buyers. One is a more than where the stock doing things that are "tricky” Chinese buyer who owns The was trading. They chose not to or “clever,” and not so much Waldorf; one is Hyatt Hotels take the $20 and lose $15 this year, obviously. It’s not (H); and one was an instead. I thought it was a no- just me. Because, as you know, undisclosed name. The stock brainer. It was the biggest my world is getting destroyed. goes from $75 to $78 because position on the street and We are trading on events that it’s going to be an awfully good people got destroyed. Who (Continued on page 9) Page 9 Craig Effron

would think that people would thought they would take the friends, and they’re brilliant throw off $20 and take a $15 money, because everyone guys, who have four or five- loss? But, that’s what we’re takes the money. times leverage now, and I reading now. always wonder, "How do they That’s what I’m dealing with sleep at night?" If, God forbid, G&D: Did they think there this year. The events space has something happens out of the would be additional bidders? been a disaster, an unequivocal blue, the next day they’re disaster. Unless you’re long losing something like 15% or CE: No, we were already past Amazon and Netflix (NFLX) 20%. But look, that’s how they that. We thought initially there and the Jim Cramer FANG were brought up. I was would be. Now it is the last stocks, you’re having a really brought up a different way day; it’s over. Either you take lousy year. If you’re an energy- because I was a commodities the $20 or you table it. In all guy, you’re out of trader where leverage was a my years doing this business, business. Things are bad in bad thing. You could get blown I’ve never seen people not take retail, too. Macy’s (M) is the away by being too big. the money. It was a big gold standard and it is down difference. Not like it was a $2 50% this year. Hospitals and For the last five years, it has premium. It was $20 on a $140 HMOs were obliterated the been fine because the Fed had stock. When things like that last two months, I don't know your back. It's been a very easy happen in my world, it’s hard why. If you’re in the wrong market until this year. Once to make money. I’d make that sectors, you think it is a bear the Fed stopped QE the bet every day of my life. It’s market like 2008 versus the market became difficult. So just how it goes. market being very quietly up what it really shows is that 1%. most of us have just been G&D: Do you know anything gliding along because of the QE about the make-up of the wind at our backs. And now votes? “‘Don’t be so big that QE’s done, that’s why the market has been flat. QE is CE: It was every arbitrageur, where your eyes are over and now we have the representing about 25% of the prospect of higher rates. There float. They voted “yes,” bleeding and you’ve are a lot of things out there obviously. The indexers ended that are scaring me. But, I'm up voting “yes,” which had got to get out. Size paid to play, and that’s what I been a big issue. When I heard your positions so that do. But I don’t play with the indexers were going to be leverage. Now, we do use a voting “yes,” I said, "This is you can withstand modicum of leverage, maybe going to be a no-brainer." 120% gross, but not 300% Every plain vanilla or Fidelity of what happens if you gross. the world had a one-on-one with the CEO on that are wrong.” G&D: Could you go into a bit Thursday of the vote. And that more detail? guy pleaded. He said, "Guys, you are going to end up G&D: You don’t use a lot of CE: Our average exposure is owning Mylan stock. He’s a leverage. Was that a product about 120%. Our net is about criminal; he does terrible of 2008 or have you always 45% long. That's where we things. Perrigo has real brands. been more conservative? usually run. We go as low as Give me a year to make this up 80% gross and 20% long. to you. Just give me that year CE: No, it was a product of We’re always long. You guys and, if I don’t do something in me being on the trading floor should know one thing: the that year, I’ll get another and realizing what can happen. markets go up over time. buyer." They bought into it. All Leverage is a two-edged That's just how it is. If you try the institutions, which are the sword. It’s wonderful when the to play the short game at the main voters, all voted his way, trade is going up, but you’re wrong time, you'll lose money. and all turned on the day out of business quickly when it before the vote. We all had goes the other way. I have You don’t want to be short (Continued on page 10) Page 10 Craig Effron

markets over a long period of the tax inversion. It was What students miss a lot is the time. We all watched the ten- because AbbVie was scared of practical matter of the stock. year period from 2000 to getting yelled at by Obama. So For some of the short ideas, I 2010. That was a flat period. I they blew it up. They traded ask, “Do you realize the short had never seen that before. from $250 to $150. Settled interest in this thing?” They Remember, I saw gigantic around $180 for the next two realize there's not just a periods. The ’90s grew at or three months, then went downside of losing X amount around 20% a year, the ’80s back to $260. Now it’s back to in an upside case. When you averaged 10% or 15% a year. $220. What we have learned and the whole world are short So 2000 to 2010 was an here is, “Don't be so big where a stock, you go out of business interesting period. But, yes, your eyes are bleeding and too many times. People your we're low-leverage guys. you’ve got to get out.” Size age often don't understand your positions so that you can technical aspects of the G&D: Building on the topic of withstand what happens if you market. They understand that risk management, let’s are wrong. In Perrigo, we only a stock is not worth $20—it’s consider a situation like lost 50 basis points on that only worth $10. Okay, that Perrigo where what you break, because I knew I didn’t doesn't mean it’s going to $10. thought would happen did not want to be selling it badly. It could go to $50 before it occur. Can you talk about how goes to $10 and does that you think about the next Normally, if we’d been up for mean you made a good steps? the year we probably would decision or not? have risked 1.5% on that trade, CE: I’ve learned over my many that’s how good I thought it Some people will say in years doing this that you never was. It was an overnight binary interviews that their best idea sell the first day of a bad event. bet. That is not a big bet if it was long Apple. I ask, “Ok, That is for amateurs because was 1.5%. But it is when you’re when did you buy it and for there are guys that are so big making a bet on red or black. what price did you buy it? Ok, that their eyes are bleeding $220. Did it go up or down and they have to get out. If you G&D: How concentrated are first?” They usually say, “Well, look at where the stock is on your positions? it went down first.” I say, “Oh, day one versus day 30, 99% of okay. Where did it go to?” If the time every sale you made CE: We have about 20, maybe he says, “To $85 or $90,” that was bad. You wait a month and 30, positions, and our biggest guy is not getting hired then you can reassess. Perrigo are between 5% and 7%. We because he thinks that is okay. is no different. Perrigo opened have nothing smaller than 1.5% He lost half his money on the at $135. I closed my eyes, I or 2%, and we average way to making three times his didn't do a thing. It's now probably 4%. We’re very money. Well he’s out of $150. Now we're getting out. focused on protecting against business at that point. There is We made our $15 back. So the downside, and that drives no more company. It’s easy to now we broke even on the our risk management approach say, “Yeah, I owned Apple at trade, but we lost the $20 we and portfolio construction. $200.” But there is a middle would have made. People have this view of hedge chapter there. It went to $80 fund guys, that they are like first, when Jobs was dying, then People that sold on day one magicians and that there is $600. I don't look at a good and day two and three, are voodoo going on. There is no investor as a guy who has lost kicking themselves. Last year, voodoo. You guys are as good half my money first; that’s AbbVie blew up the big deal as I am at this. Your opinion is terrible. It’s very important to with Shire. Shire went down as valid as mine is. I’ve been understand that every idea $100. If you waited one year, it doing it longer; that is the might be worth five times at was higher than the bid. difference. I’ve seen the some point, but if you lose half examples of ideas from your first, it doesn't really matter. G&D: Is that because of the classes. There are brilliant Hedge fund managers that are tax inversion? people. My analysts are not any good understand that and they more brilliant than you; they have stop-losses where they CE: That’s what it was—it was just have experience doing it. don’t let that happen. Some (Continued on page 11) Page 11 Craig Effron

people go out of business worth X and is trading half of killing us. because they say, “Well, it’s X, you’re wrong. Something is worth $200. It is trading now missing. You find out later G&D: When you generate at $120. I’m not getting out what it was. The market is high returns do you typically here. It was just $150.” Then it always right and it tells you it is have a few big winners? goes to $90, then the next right. Once in a while, you’re crash comes, and then you’re smarter than the market. Not CE: Out of our 30 positions, out of business. So we have a much. So my analysts all realize ten are meaningful, and of the pretty hard stop on things they need to have a stop point ten we hope to have three or here. because if they don’t, they'll four that are home runs. A get married to it. home run means up 50% to When one of my analysts 100%. Year to date, three out comes up with an idea I say, I will revisit something after of our top five positions are “First of all, one to ten, how I’ve got out of it, because you down 50%. We didn’t ride it all much do you like it?” If it's not find, when you have sold a the way down, but that’s at least a seven, I don’t do it. If where they're down now. it’s a nine or a ten I say, “Okay, Micron Technology was at I want to know right now at “If I can't trade $36. It’s trading at $15. YPF is what price you’re selling it and an oil company in Argentina, at what price you’re admitting options and limit my down from $27 to $15. The you’re wrong.” I want to do last one, Applied Materials, was this when we are unemotional. losses, I've got to bring an arbitrage deal that blew up. Investors have a tendency, and Three of our biggest positions so do I, to marry positions. my gross down got destroyed. That’s never You think a stock is your wife, because I don't want happened to me during all my your girlfriend. It’s not. Stocks years of investing. don’t know you own them. to get caught in being They really don’t. But when G&D: What do you think you own a stock, it’s like your long common stock went wrong with the Micron girlfriend, you can’t get rid of investment? Was it increased that stock. It’s true, and that is that can go down a lot competition? an emotional response that we all have. more than the options CE: Micron is crazy. We can. Options are owned it two years ago. We If I said on day one, “Hey, you have owned it for a long time. like this stock ABC? Our wonderful vehicles.” We bought it at $15; we sold target is $70, it’s trading at half at $30 and kept half. Up $40. Where are you admitting until three years ago, there you're wrong?” I want to position, whether it’s been were many players in this know. There’s no discussion good or it’s been bad, that you space. They always competed that way. If it goes down that have a liberated feeling. You on price, and they always blew amount, whatever it is that can look at it objectively. You everybody up. It got down to they say, I get the message, and are no longer married to it. three: Samsung, Micron, and at that moment I’m getting out But when hope becomes a Tsinhgua Unigroup. We said, because I don’t want to think, strategy, you’re lost. “Finally. Price rationality. “Well, stay with it because, There’s no way they're going they’re wrong. The market is This year, the times that we to break price. They’re having getting it wrong.” I hate that lost, it hasn’t been one name. a great run here. They’ll just comment, “the market is That’s the crazy thing. It’s been keep price and it’ll be good.” wrong here.” The market is a menu of things that have Then Samsung ruined it for never wrong. gone wrong. So, I can’t say I’ve everybody. Once Samsung I learned it in the commodities been killed in one name. I lost started a price war everybody business and re-learned it in 80bps here, 60bps here, and all joined in and now prices in the stock market. When you of a sudden we’re down 10%. MRAM and DRAM have gone own a stock that you think is And the hedging has been down by half. We figured, (Continued on page 12) Page 12 Craig Effron

“Finally, three rational pricers.” buy those options because I CE: Yes, all the time. For We were wrong. There are was paying way too much for example, in SunEdison, people only two. That was a big them, a dime more than did not understand the problem for us. they're worth. A dime on ramifications of this deal. If $0.38 is a gigantic move. But SunEdison does not go G&D: How do you decide I’m playing for dollars here. So, bankrupt, it means they’re when to sell? You mentioned I bought thousands and going to be okay. They may asking analysts for stop losses. thousands of , have a 10 or 20 year life now. $4 or $5 calls, while the stock The stock is a long term CE: Micron is a good example. was trading at $4. Then luckily, option. It is worth much more We bought one- and two-year a month later, Bank of America than they think it is worth. LEAPS in 2013, because it was went from $4 to $7 overnight. Today, Sun Edison changed the very volatile stock. We had All the calls at $0.48, which deal with Blackstone on its already bought shares before were worth only $0.38, were debt, so the stock is up $1.00. at $7 and it was up 100%. The now trading at $3, and the Options players didn’t LEAPS that we paid $3 for guys who gave them to me got appreciate that this is no were trading at like $17 or destroyed. Options are always longer a candidate for $18. We sold the LEAPS and mispriced to some people who bankruptcy. When that bought short term options don’t understand optionality. happens all the calls are long struck at $25. So we use term options and they should options a lot to limit our risk Another good example, be priced higher. when they’re priced SunEdison is in the news right appropriately. now. We bought a boatload of I have a lot of notional $3.00 and $3.50 calls last exposure sometimes, but I’m When the VIX is trading at 11 week. The bet was very simple: only risking X. When we are or 12 for the general market, half the world is betting it is invested in a stock that has you can do tons of wonderful going to go bankrupt, while vols in the high teens or low things with options. When it is half is betting it isn’t. The short twenties, we will almost always trading at 19 like it is today, a interest in it was forty percent. use an in-the-money call. If we lot less so. It's hard. If I can’t I might be wrong here, but I’m get a terrorist attack one night trade options and limit my saying the option is mispriced. I and DuPont goes from $70 to losses, I’ve got to bring my can buy calls that look really $60, we are in the money $5. I gross down because I don’t expensive, trading at one know what I'm risking and I’m want to get caught in being hundred vol again. And, again, still controlling all the shares long common stock that can they’re a dime more than they because there is about ninety go down a lot more than the should have been. So we percent delta to the stock. It options can. Options are bought a boatload and just sold gives you a lot of sleeping wonderful vehicles. about half of them for about ability. I don’t need to go out I took courses in Wharton on $1.00 profit on a $0.40 call. and hedge my book when I options pricing, I learned all know all I can risk is $5, but I the theoretical models. That’s It’s a great risk/reward. We have an upside of infinity if not what I’m talking about. I’m were risking $0.40 to make $1 DuPont does well. Mega-cap talking about actually versus paying $3.20 for the stocks have very low vols. understanding what they mean. stock and maybe losing $3. Another crazy thing regarding In 2008, Bank of America had Now one hundred vol is really options: where in the world, as traded down to $4/share, like high, but they still did not a value of an asset goes higher, it was going to go bankrupt. understand that if it didn't go does cost go lower? They had calls that were bankrupt it was going to be a If your house doubles in value, trading at one hundred vol, long term option now on they require double the which is humongous. The $5 SunEdison. insurance payment to insure call was trading at one hundred your house. In the S&P, and vol. That meant, instead of G&D: Do you use options a stock markets in general, as paying $0.38 I was paying lot in the event-driven space prices go higher, vols go lower $0.48. People were thanking because option pricing cannot and the price of options get me for putting in an order to effectively price a future event? cheaper. It’s totally counter- (Continued on page 13) Page 13 Craig Effron

intuitive. which we do all the time, and they’re even less appropriately that saved our month. We priced? We were talking about So, my Nirvana was during didn’t lose any money in how options are priced, but 2012 – 2014 when the market August because we had puts LEAPS are multi-year. was going up slowly every day. that went from $1 to $20 from Vol was 11, I could go long all both the volatility aspect and CE: LEAPS are a wonderful the stuff I liked and buy the price aspect. That hadn't vehicle. The problem that guys Attendees at the Graham & protection on the market for in my world have is liquidity, Dodd Breakfast cheaper than it was a year quarterly or annually. What earlier when the market was “Another crazy thing you have to be careful of is lower. It’s insane. How can the having a mismatch of what you market be less risky at today’s regarding options: own versus your liquidity price than it was 20% lower? terms. Long-term, locked-up where in the world, as money doesn't really exist That’s how I made all my a value of an asset much in my world anymore. money, by getting very long in Also, LEAPS have different stuff that I loved, and being goes higher, does taxes. There’s a dirty little short the market an equal secret about our business. You amount through very cheap insurance cost go should ask managers what puts because they were their after-tax returns are. For mispriced. What happens to lower? If your house example, if I talk about making vol when the market goes 17% net, I'm a fraud. I made down? doubles in value, they 17%, but it was almost all short require double the -term in those days. Now, Joel G&D: It goes up. Greenblatt was always an after insurance payment to -tax guy. He traded LEAPS all CE: A lot. So you get the vol the time because he said, “I'm expansion and the delta insure your house. In not paying taxes at short-term expansion by the market going rates.” He made more than I down making your puts more the S&P, and stock did because he was paying 20% worthwhile. It’s like a triple and I was paying 50%. whammy in your favor, and yet markets in general, as it happens. prices go higher, vols G&D: His stated number in his book is 40%. G&D: Maybe if it was a go lower and the price situation where earnings were CE: You're right, and he's the growing more quickly than the of options get best there ever was. It was market was appreciating? But 40% on a long-term basis. The that wasn’t the case in 2012 cheaper. It’s totally guy’s a tax genius. He was a and 2013. Wharton five-year guy and he counter-intuitive.” learned about accounting. I CE: Even if that’s the case, I said, “Oh, making money is don’t care. The minute the happened to us since 2008. great.” I was a dumb guy, and market blows up, for whatever Remember that insurance is he always said to me, “You're reason, delta expands and vol cheaper as the market goes not tax efficient.” I just wasn’t expands. You have a 2x reason higher, not more expensive, thinking because I was making why it works. Your puts, which which is a wonderful thing. these very good headline were at 12 VIX go to 22 VIX. numbers. That alone is a home run. Plus G&D: With respect to you have it working because incentives, people get paid on a When you play in my world, the market is going down. yearly basis, so managers only which is event-driven, if there’s When the market blew up in look out on a yearly basis. Do a takeover tomorrow I can’t August that was the prime you think that creates an even be long-term. It’s over. What example. We were long a ton more skewed incentive am I going to do about it? A lot of puts for August expiration, structure for LEAPS, so that (Continued on page 14) Page 14 Craig Effron

of what I did wasn’t my world is beyond what I than Bill, but equally decision. I’m not a stock understand now, but I know impressive. Dan is a great guy picker, remember. I’m an event one thing: there’s going to be who has done extremely well. picker. We’ve done more an end to this. I thought it But permanent capital would stock picking in the last few might’ve been this past fall, but be a great thing for me years because it’s been the I was wrong. It is going to be because I would have a much place to be. But, generally, our ugly. longer term view of the world. holding period, unless it is distressed, is less than a year. G&D: How does that factor G&D: Would you consider Lately we’re about 70% short- into your and your investors’ creating your own family term, 30% long-term which is risk appetite? office? about as good as I can get. I’m at a point now in my life CE: One day that may end up G&D: Is there anything else where my investors are all risk happening. For instance, there you find challenging in this averse. None of them need to are bonds out in the distressed environment? get rich; their goal is to stay world that are literally rich. It’s a big difference. unbelievable, but I can’t buy CE: Before 2008, the risk-free Business school students can them because they were rate was 5%. That’s a fair risk- afford to be risky, do what I unbelievable a week and a half free rate and we were making did, play options, and live to ago and now they are three about 15% net. We were three make money. Once someone points lower. I don’t have the times risk-free net and I was turns 40 or 50, has kids, and a luxury of being down 6% in a considered a hero. What’s risk house, they need to make a month trying to make my -free rate now, you think? Call nice living and avoid going money next year. Firms like it 1%? If I make 8%, I'm eight backwards, and I did the wrong Oaktree and Apollo with times the risk-free rate, and thing going backwards this longer term money are buying I'm getting yelled at. What it year. hand over fist right now. means is that we are doing They’re all suffering near term things that are much riskier G&D: Have you considered losses because energy bonds now than it was before 2008 pursuing something similar to have gone down considerably, to get eight times. Investors Pershing Square, where you and continue reaching new don’t get that. Guys making establish a permanent capital lows, but they know that over 15% are either highly vehicle so you can have more time, over their investment leveraged, or crazy lucky and flexibility or take a longer term horizon, it’s going to be fine. good. view? My horizon is quarterly or yearly, so I don’t have that But sometimes you’ve got to CE: There are only a few Bill ability, I have to be more on accept the fact there’s no Ackmans out there. I cannot top of things and hope I can money out there. There are do that. Dan Loeb did it, Bill catch the bottom. That can be times to reap and sow. This is did it, and David Einhorn did it. difficult. not a reaping time; this is a Those are the three guys that crying time. We see the created permanent capital. G&D: Do you have the ability markets doing what they’re They deserved it. We don't to set up separate portfolios? doing now because of the deserve it. Bill is the smartest and Europe, guy I’ve ever met. There is CE: Some of our larger Japan, and taking on the nobody smarter in this world, investors have set up separate mantle of the US Fed. It’s very in my opinion, in what we do. accounts, and in those we’re scary. There is nobody more buying. The accounts are impressive to hear a story longer term, lower fee, but I’ll tell you what’s going on from. He's the best presenter there’s a two year lock-up, and here: asset inflation, whether I’ve ever met. He deserves in those we are buying. In it’s bonds, or real estate, even permanent capital because, those accounts we’re more so. Residential real over time, he will make a lot of interested in oil and Puerto estate is trading at one caps in money. David Einhorn is also Rico bonds. They have long New York. A one cap! The very impressive—different (Continued on page 15) Page 15 Craig Effron

tails to them, and we believe advantage to the new rigs? internally. They are running they are smart investments. It’s out of reserves to support great for all of us. That’s why I CE: Yes. That's exactly why themselves. Their currency is don’t really mind charging a we love them. We can buy begging to be de-pegged. They lower fee. There are things out these bonds knowing they're can't have that, so they've got there that are being worth at least double what to do something. misunderstood and being we’re buying them for today. thrown out with the bath We will probably see a bottom G&D: What do you think water. soon. Oil is probably near about Iran's supply coming on bottom too. It's trading at $37. now? G&D: Any examples you’d be Could it go to $30? Yes, but willing to share? remember last year, at this CE: Well, the market is time, it was $67. I thought that oversupplied by a million CE: A good example is was cheap, and then, before barrels right now. That'll be Vantage Drilling (VTDG). They that, it was $107. It's down another million, so it'll be two own the newest deep water 70%. That's a big move. All you million oversupplied. That’s fleet in the country. There are have to do is shut the spigots bad news. On the flip side, a hundred deep water drilling off, have production cuts, and Putin is now very involved in platforms in the world. They the Middle East, and he and own seven of them. They're Saudi Arabia are now allies. the seven newest and they “I think having a Putin’s country is going have a 30-year life. They were bankrupt because it is oil- built from 2012 – 2013 at a sounding board is an based. He is probably cost of $800 million each. The important thing. You negotiating with the Saudis, company is going through offering to go after ISIS if they bankruptcy and the bonds, have an opinion and elevate the price of oil. Saudi which we are buying now in Arabia holds the keys here. the high 20s to low 30s, are you start believing it, They can be the balancer, and valuing these drilling platforms that’s all it takes. Russia is at $180 million each. In the because it's your going out of business. It’s depths of the 2008 oil worse than Brazil. The whole depression, platforms traded at opinion. But, if you economy is oil, so I’m sure $300 million. These platforms have a good partner Putin is making a very hard are three years old. They are plea, hoping to get oil back to the most efficient, and they are who’s your friend, and the $50s. My suspicion is platforms people want to own you're going to see a surprise and lease. If you believe oil will loves you and tells OPEC meeting in February and not be $37 forever, which I they'll raise the price about tend to believe, at least in 27 you, "Hey, here's what $20. We're long oil now, years, this is not only money- actually, having bought it the good, but they’re also turning you're missing," and last few days. into equity, and could be a ten does so in a nice way, bagger. These bonds were 105 An oversupply of two million on April 1st this year; they’re it's a very good thing. barrels is not significant either now 30, going to be bankrupt, on 90 or 100 million barrels, and we're getting the equity. And you have to be with frackers stopping That's an example of what's production. By the second being given. We have bought a willing to do the same quarter, we can have it where position of about 4%. We we’re undersupplied by two cannot go any larger. We for him or her.” million—it wouldn’t be started buying at 44, they're surprising. That’s what we’re now 28, 27, and I can't buy you'll get a $20 rally overnight, thinking. anymore. and it’ll come soon enough because, I think, Saudi Arabia is G&D: We would love to get G&D: Is there a big cost starting to feel pressure (Continued on page 16) Page 16 Craig Effron

into your process for idea make it, how to express it, the was at $200. While I don't feel generation and also hear about time frame, and other details. that bad now, I felt bad at your process for deciding We start discussing whether it $250, but that was me getting when to put on a position. should be a pair trade against a out early. I had bought it at comp, options, bonds, CDS, or $140, and I made $60, which CE: Let me correct a any number of ways. looks good now. I never got misperception. Most funds back in, and I never shorted it don't author many of their I'm the risk manager; I put the either, but that was selling too own ideas, and we’re one of trades on. I can tell you every soon. them. We have an idea or two position we own, the number that we generate ourselves, of shares, and why we own it; Another adage to keep in mind especially in credit, but most but, I may not know the math is that you can’t like a stock as are in The Journal, behind it. I know the thesis. I much at $100 as you did at or they come up in discussions am the guy who does the sizing $20. I don’t care what it’s at dinner with friends of mine. and the risk, and I also know earning. It’s just the way it is. The idea that we’re sitting in a when positions start getting Look at Apple. Apple went room, and then are suddenly too big. I can sell at any time from $200 to $700 back to all like “I got it! Let's buy without consulting the analyst. $300. That’s just what XYZ.” That's not how it They know that I have one happens. I’m not saying to go works. Bill Ackman is a rule, don’t get mad at me if I to zero, in position and size, different guy. Bill does do that sell your idea one day, because but you can’t like it as much as and he's unique. John Griffin we may buy it back. you once did. Instead, an does that as well, especially in option may be to keep the Japan. Generally, though, we all There’s a very good amount of same position the same size. If talk to each other and share money to be made by trading, it's 3%, keep it 3% don't make ideas. Ideas are not generated what I call, around the edges. If it 12% because it’s rallied; out of thin air. They come to you're long a company at 5% that’s just dumb, and that’s me from Barron’s, The Wall and it rallies more quickly than how you go out of business. Street Journal, Financial Times, you thought it was going to You have to “feed the ducks idea dinners, brokers, etc. rally, if we sold 1% of that 5% when they're quacking,” and That's how they come. on a rally, hoping to buy it that's what I do because I back, it’s a win-win. If I’m know when I want to sell to The differences inside each wrong and it goes higher, them, they’re not going to be fund is how they take the that’s okay. If I’m right, I can there for me. You have to sell information, and we do it very buy it back, and create a little when you can, not when you simply. Before 2000, I was the alpha and nothing bad has have to. Some very smart, sole generator, with Curtis, of happened. large managers ended up every idea. I didn't use any of forced sellers of things they the analysts’ ideas. I was the I’ve taught my analysts that if love. Why? Because they guy who gave all the ideas and things happen quicker than we received redemptions and had they would generate the expect, take some money off to sell. What a horrible thing, numbers, but they were my the table and look to buy it selling things you love at the thoughts. back. Things don’t go in a bottom because you have to straight line. That’s been a sell. Now the division of labor is good lesson. There’s a probably one-third my ideas gentleman named Bernard G&D: Any other and two-thirds theirs. They’re Baruch, whom you may have recommendations? much better than I am now heard of, who famously and I’m not as good as I once responded to the question, CE: I recommend was. They’re smarter than I am “How’d you get so rich, partnerships, even though and a lot of ideas are theirs. Bernard? By selling too soon.” most managers like to be lone When they come to me and It’s a great line, and I am the managers. I think having a say, “I love this idea” we rank quintessential sell-too-soon sounding board is an important it one to ten, then we discuss. guy. I was long Valeant, and I thing. You have an opinion and My job is to decide how big to was selling the stock when it (Continued on page 17) Page 17 Craig Effron

you start believing it, because Amazon. People never get out teachers than I see hedge fund it’s your opinion. But, if you on the way up. They get out managers. Hedge fund have a good partner who’s when they have to and not managers have a habit of being your friend, and loves you and when they want to. very competitive. They’re all tells you, "Hey, here’s what alpha people. They would you’re missing," and does so in G&D: Do you think value will rather be flat and have their a nice way, it’s a very good have its day soon? competition down 10% than thing. And you have to be everybody be up 10%. It’s a willing to do the same for him CE: I hope so. I'm not an crazy world. or her. Amazon player. Value has it’s time but it’s always less than Don’t be like that. Understand Lastly, we are unusual. I am an what you think it's going to be. there's room for everybody to old school investor from the make money, number one, and ’80s, and there are only ten G&D: Has the crisis and its number two, when you make investors left doing this with aftermath changed your that money, don’t say, “I funds the same age as ours. perspective at all? should be happy, but I'm not.” There are only ten guys still It’s not a happiness factor. It around from the ’80s from the CE: I have this little program means you can do things. 300 people I started with, and every year for college That's all it means. You need the rest have all gone out of sophomores going to be to find happiness by loving business, because as I juniors, and my opening salvo what you’re doing, and a lot of mentioned, the average fund always says, “Do not confuse folks don't love what they’re folds every seven years. happiness with money.” I know doing. They hate competition. more unhappy than It’s a very stressful business. I G&D: Joel Greenblatt talks get yelled at a lot. This year I'm about how the stock market getting phone calls from an doubles and halves every seven “‘Do not confuse investor I’ve had for 20 years years, or thereabout. Is that yelling at me. I never get calls part of it, is it just part of that happiness with money when I'm doing well, that say cycle, when everyone goes out “Great going.” of business? […] You need to find If you get into this business— and I don't recommend it right CE: People start believing happiness by loving now—the government has they’re really good at it really made it difficult. Young because they have a good run. what you're doing, investors can't open a fund. They forget that a large part of and a lot of folks don't You have to go to a place and it is luck. We’re lucky to be in spend a lot of time learning this world, where people buy love what they're how to do it, and maybe you stocks for no reason. The get good at it and maybe with market is fragile. We’ve taken doing. ” that expertise, you can go and our book down dramatically. open a fund when you're in We are focusing on credit, your 30s. I did it when I was 28 which I think is more I can count on all my hands. because there was no barrier interesting, and that’s our bet. I Having money’s a great thing, to entry. You didn't have any can’t play a stock market that I and I would never not want to compliance officers; you didn't think is destined to be a have it—I’m not saying that— need to have big, heavy-duty debacle. The S&P might very but it does not make you accounting groups. Now, if you easily be overvalued by 25%. happy. It takes away one run $500 million dollars, day Energy is important, but retail, element of problems: how are one, you can't be in business. semiconductor, hospitals, I you going to eat, are you going Why? You can't get the right don’t know what’s keeping be able to go on vacation, or people. You can't have a them up. They are going to put your kids in private school? robust back office to make blow up, mark my words. It is your investors comfortable, going to be ugly when it starts It doesn’t create happiness. I and you can't get the to hit (FB) and see more happy kindergarten (Continued on page 18) Page 18 Craig Effron

compliance people you need.

They’ve made the business either get big or get out, and that's what we see happening. There’s nobody left in the hundreds of millions of AUM anymore. It’s sad, because there’s real value there. If you're running $500 million, it's much easier than running $5 billion.

G&D: Do you have any advice for Columbia students?

CE: I don't want to say you shouldn't enter the industry. I’m just saying have your eyes wide open. I would pursue at this point. Private equity is one place where they give you hope that you can still make money, and they can’t pull their money out. An investor can see three cycles in an eight year period. Over that eight year period, investors are going to have one chance to pull their money. For hedge funds you have eight months. If you start a hedge fund and lose 10% your first year, you’re out of business. In a private equity firm, if you lose 10% on paper your first year, you've got seven years to figure it out. I like that model better now. Long term assets are much better.

G&D: Thank you for your time, Mr. Effron

CE: I have enjoyed this immensely. I don't want to tell you not to be in this business. It's a great business, but I'm worried that it's not what I remember anymore. Maybe it'll become more normalized, but throughout there will be hurdles.

Page 19 Jeff Gramm (Continued from page 1) Chairman: Boardroom G&D: Was there a time in unstructured. Battles and the Rise of where you Shareholder Activism” realized that value investing, The analysts had a lot of published by that orientation, was right for leeway in what they looked at HarperBusiness. you? and what we got to do. Pretty It is a riveting history of quickly I got to do this activism that JG: I remember Greenblatt did campaign on Denny’s. We has garnered advance an in-class case study of were bond holders, then we praise from Arthur Levitt, Munsingwear and I remember bought the distressed equity Alan Greenspan, Fred getting it very quickly. I'm sure and I wrote a 13D protesting Smith, Charles Schwab that I didn’t know what the the company’s rumored plan and Tyler Cowen. The hell I was doing back then, but to equitize the debt. Then we book features an appendix the case clicked in a way that led a PIPE to recapitalize the with original, never-before- made me think I could be good company. It was a fun and Jeff Gramm ’03 published letters written at value investing. I wasn’t exciting time in the business. by Warren Buffett, especially confident in business , Ross school. I stuttered badly, I G&D: No new management Perot, Carl Icahn, and didn’t have any business though? Daniel Loeb. experience, I was very unpolished, and then along JG: No new management. The Graham & Doddsville comes this class where I felt I management at that time was (G&D): Could you provide really was getting it faster than good for a turnaround but had some background on your many of my classmates. That a hard time after the journey and how you came to was really important for me at turnaround. There have been investing? an important time in my life. several new CEOs since then.

Jeff Gramm (JG): I really G&D: Who besides Joel At HBV, I was lucky enough to learned about investing at Greenblatt would you say have a very good mentor. The Columbia. I went to the were major influences on you head of research, Greg Shrock, University of Chicago for and developing your style of had been an M&A lawyer with undergrad. I played music after investing? Wachtell Lipton for many college, so I was a career- years and then a bankruptcy transitioner when I got to JG: Definitely my boss Greg lawyer at Milbank. He and I left Columbia Business School. Shrock. He gave me all of the to launch a long/short That was before the whole Berkshire letters and the distressed fund called Arklow value investing program, so Munger speeches and that kind Capital where I was the junior Joel Greenblatt just taught a of stuff. Also, Bruce partner. We were seeded by regular Security Analysis Greenwald’s Economics of Protégé Partners in 2004. section. I was lucky enough Strategic Behavior class. It that his class was the one that really helped me understand I left Arklow to form Bandera fit my schedule and I just felt competitive advantages and in 2006 with my current like it clicked for me. Instantly, how to think about business partner Greg Bylinsky. It’s a the whole thing resonated with strategy. much more traditional value me and I got extremely fund: highly concentrated, long interested in investing. G&D: How did you decide to biased. I got away from long/ launch your fund? short diversified and distressed Before my first year core investing. classes, I had never really JG: My first job out of business known about accounting, I had school was at HBV Capital. It G&D: Why were those the barely even heard of Warren was a multi-strategy hedge right decisions for you? Buffett and so I came to the fund owned by Mellon Bank. I whole thing fresh. After Joel’s worked on their distressed JG: I was always interested in class, I just began to consume fund from 2002 to 2004. It was concentrating in my best ideas. everything I could. a billion dollar fund, but at the I’ve always thought that was same time it was pretty the best approach for getting (Continued on page 20) Page 20 Jeff Gramm

good returns. I didn’t enjoy have a dispositional fit for this them, so they added capital at being a part of a long/short business. I think I have a few the lowest points. That helped fund with a two man team. The areas of expertise, but us a lot. We also had a large short side is extremely labor ultimately, there are a lot of hands-on investor that was a intensive. Greg Shrock was people out there that are former bank owner who kept very keen on shorting the doing exactly what I do and us very honest when we subprime bubble. It ended up what Bandera does. looked at financial stocks. working out incredibly well for him, but having a short book When you go to the Berkshire Launching a fund is very was a lot of work and it didn’t Hathaway meeting, you meet difficult, and it’s easy to make leave a lot of time for doing dozens of other smart people mistakes right at the beginning what I wanted to do. that are doing exactly the same as you are trying to build a thing. It always gives you pause. portfolio. If the market is going I also didn’t love distressed It’s easy to talk about your up, as it was in 2007, there’s a investing, and especially during hedge fund’s process and your tremendous amount of those years, there weren’t a edge. But ultimately, I think a psychological pressure to get lot of actual workouts. There lot of that is overstated and your cash invested. weren’t that many distressed that value investing is mostly bonds even. Everyone was about keeping sane and using There were lots of investors looking at the same good judgment. with great reputations that opportunities. I’ve always were pounding the table and thought distressed investing is saying things like, “Fannie Mae an industry where there are “It’s easy to talk about (FNMA) or lots of economies of scale and (FMCC) is the best idea that I thought it was hard to be a your hedge fund’s I’ve ever seen in my entire little guy in the space. Big, career.” It’s hard to be a young established firms have lots of process and your edge. fund manager and hear Rich advantages in deal flow and But ultimately, I think Pzena and Bill Miller, or trading, that aren’t as prevalent industry experts like Tom in more classic value investing. a lot of that is Brown pound the table, and then watch Lampert pile into G&D: You say that Bandera is overstated and that Citigroup (C), and not follow. extremely long biased, that you’re concentrated. Do you value investing is G&D: Were you seeing have any sort of structural opportunities where stocks advantages that allow you to mostly about keeping were just selling off for do that, which maybe other sane and using good uneconomical reasons and you people don’t? were able to make the best of judgment.” that opportunity? JG: We are very lucky to have a good capital base of long- JG: Of course. It was an term investors that have been amazing period. I think my in the fund a long time and G&D: What was it like biggest mistake in that period have seen us in good years and launching in late 2006 right was passing on the extremely bad years. before the crash? good businesses we always knew we’d want to buy G&D: They’re all high net JG: I’m not going to lie, it was whenever the market tanked. worth individuals? exciting but also very scary. In We looked at Costco (COST) some senses the sky actually and Google and other great JG: Yes. They know what we was falling in 2008, but we had companies and we passed. are doing and how we think, two incredible strokes of good so to the extent that we have luck. A contingent of our G&D: You own Google now any kind of edge, I think it’s investors are high frequency though, correct? our investor base. I think I'm traders and that was an good at what I do. I think I extremely good period for JG: We do. We have owned (Continued on page 21) Page 21 Jeff Gramm

Google since 2011. But during other thing that I regret is not throw the financial crisis in the crisis we mostly bought establishing our back office there! cash-at-a-discount type stocks. operations. I think it was last We bought Hilltop Holdings year at the Columbia G&D: Can you talk a little bit (HTH) at a huge discount to conference where Seth more about your process? Idea cash. We bought the Hilltop Klarman talked about the generation, then the preferred which was a money- importance of getting good investment process, specifically good preferred at a huge operations people and a good having a co-portfolio manager discount. We bought into a CFO to be sure that you can model? Last year we company called Peerless concentrate on your investing. interviewed Jay Petschek and Systems (PRLS) at very big We definitely took the Steve Major at Corsair. We discount to cash. We joined opposite approach. We had a heard from them about their the board and pushed the processes as co-managers. company to return capital to shareholders. We viewed all of “[2008 and 2009] was JG: Idea generation is the least those as very low-risk an amazing period. I process-driven thing we do. investments with a lot of There are always ideas floating upside. We did buy a few think my biggest across your desk; I think the operating companies, including most important thing is having Popeyes (PLKI), which we had mistake in that period a good two-to-three minute been closely following and was internal filter to help you in the early stages of a was passing on the decide which ideas to dig turnaround. deeper into. As for our co- extremely good portfolio manager model, we G&D: You’re still involved businesses we always require written investment with most of the stuff you write-ups. We each have our were buying in 2008 and 2009? knew we’d want to buy own research process, and then we pitch our ideas to JG: Not all of them, but we whenever the market each other both in person and still hold many. Of our top five then with a written memo. It’s holdings today, we owned four tanked. We looked at harder to cut corners in of them, Star Gas, Tandy writing. Leather (TLF), Hilltop Holdings Costco and Google and and Popeyes, in 2009. The other great companies G&D: What do you look for financial crisis, for any fund in that process because there manager, was an incredible and we passed.” are a lot of good ideas that learning experience, but also a might not fit within your test of what you do when short-term lease and we ran a strategy? If someone pitched markets get scary. I think we bare bones operation. you Amazon, two years ago passed the test, but I certainly you probably wouldn’t have don’t think we got an ‘A.’ I think there are lots of been interested. sensible reasons to do that, G&D: You mentioned one of but I do wish that we had JG: I first try to understand if the lessons that you learned hired a CFO from the bat. We it’s a good business. Then, if I from starting your own fund ultimately over-complicated don’t understand the business, was don’t push to invest things for ourselves can I do the work to everything right away. Is there operationally. understand it? Those are the anything else you would key things that we think about recommend? The early years of a fund are first. If you can get there, even hard. Having business partners if the valuation looks not that JG: The big thing is to try to is hard. We’re a 50/50 business great, it might be worth a look. stay rational that first year, partnership. Learning how to because there is a tremendous manage a portfolio where It’s funny, in the class I teach at pressure to out-perform early there’s no boss is a real Columbia, we no longer teach in the life of the fund. The learning experience. Then you idea generation. I feel like one (Continued on page 22) Page 22 Jeff Gramm

of the goals of my class is to a year, a miserable sleepless companies. But since then improve your quick filter. I year. The initial idea for the share ownership has re- want the class to teach you book was to collect a bunch of concentrated into the hands of how to think about businesses “Dear Chairman” letters with fiduciary investors like pension and then how to value them. short explanatory funds. That’s really about it. introductions. This evolved into a more narrative book G&D: In the introduction to G&D: Switching topics to about the history of “Dear Chairman” you talk your upcoming book, “Dear shareholder activism. about how so many documents Chairman,” could you start have been lost. You had to with an overview of the book G&D: You did a great job of write to Buffett direct to get a and how you came up with the categorizing the shift in copy of that letter. Do you idea in the first place? attitudes and approaches of all think that’s beginning to these activist investors. What change with more SEC JG: When I teach I’ll always do you think are the main disclosure and the fact that all get a few students that ask me drivers of these changes? the SEC filings are online? for book recommendations. I’ll Where do you see it going tell them I like the Greenblatt from here? JG: I was surprised at how book. I’ll send them an email hard it is to find old business with a bunch of the Buffett JG: I think one of the most documents, like annual reports letters, the Buffett articles, the powerful forces in activism has from small companies. I think Munger speeches, Klarman been the change in the that will change not just letters, you know, just the shareholder bases of public because of EDGAR, but also classic value investing stuff that companies. Activist investors because people care more everyone passes around. And I are ultimately just a group of about business history. I credit always include a bunch of 13D economic actors out to make a Warren Buffett with that. Look letters. I’ve always enjoyed buck. It’s the evolution of at how popular Thorndike’s them. I came of age in the passive investors behind the “The Outsiders” CEO book is! industry at a time when there scenes that has changed the Many of the CEOs profiled in were a lot public 13D letters. attitudes and approaches of that book were completely We swapped them like bootleg activists. under the radar even at the tapes, so I still have a lot that I height of their powers. Now share with my students. At The book begins with Benjamin there are eager young students some point I thought, “there Graham in the 1920s, when, reading a book about them. must be a book that collects except for the big railroads, these things.” most public companies had G&D: Going back to the very concentrated ownership. 1950s and the “Proxyteers,” I looked for it and there wasn’t Ben Graham had to go directly we were struck by Robert one. I thought, “I can do that. to the Rockefeller Foundation, Young’s fight against New That will be pretty easy.” I had a 30% owner, to plead his case York Central and how that idea for a few years and at that Northern Pipeline needed involved both sides were in the some point, I decided to write to distribute its liquid assets to popular media. It seems really Buffett to ask for the letter he shareholders. By the 1950s interesting given the limited wrote to many concentrated public number of channels that were (AXP) in 1964. company owners had passed available at the time. Can you away, and their stakes had talk about the strategy for I got to work one day and it been sold off. Companies had choosing those channels and was in the mail and I said, very diffuse shareholder how they were able to get so “Holy cow! I should probably ownership which was much access when, today, do this book now.” It makes exploited by the “Proxyteers.” some important fights are you understand the power that They ran entertaining proxy rarely discussed in the media? Buffett has over all of his campaigns to win public CEOs. I felt this compulsion to support, and that allowed them JG: In 1954 the ownership of write the book and to do a to infiltrate the boardrooms of the New York Central was good job with it. It took about a lot of big, established extremely diffuse. There were (Continued on page 23) Page 23 Jeff Gramm

basically no large holders, so JG: They have a fiduciary duty quite hard to find a real both sides were forced to to shoot for the best financial disaster outside of BKF advertise in the newspaper to outcome. People have long Capital. The two most famous win proxies. You had to get been concerned that entities disasters are BKF and the votes of the “Aunt Janes,” like CalSTRS and CalPERS JCPenney (JCP), and I’d argue as Young called them. It was a could begin to operate in a that the intervention at JCP dynamic that you never see way that is pro-labor. Peter wasn’t as bad as people make today. If you’re trying to win a Drucker even wrote that the it out to be. It’s easy to point proxy fight now you’re usually is the first to the failure and blame courting 15 to 20 key socialist country because of Ackman, but he helped the shareholders and trying to get the control that the labor board lure one of the those votes. force has over industry industry’s biggest stars to be through pension funds. That’s the company’s CEO. That’s This difference in ownership always been a thing some what boards are supposed to structure also played out in the people are concerned about, do. campaigns’ messaging. Activists but it hasn’t really played out. used extremely populist The only case I remember was G&D: Potentially Target? rhetoric to collect votes. It when CalPERS ran a proxy was essentially a political fight against Safeway shortly JG: Not really. Target (TGT) campaign and that’s the reason after the company had a labor was a disaster just because the battles were so dispute and strike. The [Ackman] bought LEAPS, but entertaining. Back then, the PR CalPERS’ chairman was quickly the actual activism there didn’t representative was an removed because of fiduciary hurt the company. important person. You had to conflicts. get the best people to write When I started doing research, your copy, now your PR is G&D: Why did you choose to I thought that I would find usually an afterthought. include the Robert Young something really black and activist campaign against New white. Like an activist investor G&D: Young was also skilled York Central in “Dear calling for Apple (AAPL) to at getting organized labor on Chairman”? liquidate when the stock was his side. Is there a chance to at $8. I didn’t find too many do that going forward? JG: I picked Robert Young cases of blatantly misguided versus New York Central activism. Activism can fail long- JG: Could organized labor flex because it best depicted the term shareholders when its muscle? Well obviously the “Proxyteer” movement and companies are sold at the public pension funds have been Young was probably the most wrong time, but those cases very active investors. You famous of all the “Proxyteers.” don’t make for good drama could even argue that some of But there were lots of other like BKF or JCPenney. the largest public pensions interesting proxy fights that I funds are downright could have chosen. I talk about G&D: Michael Dell did say progressive as far as Ben Heineman in the book as that that's what he would have shareholder activism is well. There's also Louis done if he had been the CEO concerned. Wolfson who was extremely of Apple at that time, but he charismatic; he was a lot more didn’t go activist. G&D: Thinking about labor in colorful than Young was, but I general, let’s consider an ultimately felt that I had to go JG: Yes. I thought there would activist fight where a pension with the most important have been that kind of a plan for labor in an entirely battle. smoking gun from someone different industry is a major reputable and there really shareholder. They are G&D: In your research, did wasn’t. The majority of the unrelated, but is there any the activist campaigns mostly cases that I looked at did tend solidarity with labor that lead to positive results or to work out for the activist would get in the way of negative results? and shareholders, with a few activism? blunders here and there. In the JG: It was interesting, it was book, there's BKF Capital (Continued on page 24) Page 24 Jeff Gramm

which was an unmitigated chapter I wanted a classic G&D: Just because if it did go disaster. New York Central angry 13D letter, so I had to poorly, they had big positions was in trouble anyway, it’s not go with Dan Loeb. Star Gas is in their funds or do you mean like their problems were not the best case, but I think it the public nature of the caused by activism. is the best letter. It’s really campaigns? over-the-top, calling out the G&D: You can maybe even CEO’s mother and stuff like JG: No, I mean actual material say the GM one, because Ross that. In “Dear Chairman” the personal financial and career Perot didn’t really get what he original letters are all included risk. Look at Carl Icahn: he wanted. He got a lot of money, in the appendix. If I were leveraged up to do those early but he didn’t change the reading the book, I would start deals. He had fifteen deals in a company. by devouring the original row where each new deal used letters. a large portion of his capital. JG: You have to wonder what And they all worked out! It would have happened if he had G&D: How has researching was also interesting to learn actually been installed as the and writing “Dear Chairman” more about the hedge CEO. It’s a tantalizing thought. shaped you as an investor? fund era. It certainly drove Ross Perot’s letter to Roger home that the glory days were Smith is the best thing in the a little bit before my time. You book. “I was surprised at had guys like Carlo Cannell that had a billion dollar fund. Also, GM (GM) played a key how hard it is to find I’m not sure that would role because they basically old business docu- happen now. He deserves it. invented the modern pension He’s a great investor, but he’s fund. Then they proceeded to ments, like annual re- definitely an outsider. The run their company into the industry is much more ground for 35 years until the ports from small com- institutionalized and mature pension funds revolted. now. panies. I think that G&D: How did you end up I also found writing a book to deciding which cases to will change not just be an incredible exercise in include? because of EDGAR, learning to be more productive. I have a full-time JG: There were some that but also because peo- job, I was teaching, I have two were obvious, like Benjamin little kids. So to make time to Graham, Ross Perot, and ple care more about write a book and to have it Warren Buffett. There were come out well taught me a lot some where I had to depict business history. I about how much you can get movements like the done if you turn off your “Proxyteers,” the corporate credit Warren Buffett phone and your email. raiders, and modern hedge with that.” fund activists. G&D: We had Bill Ackman in an issue last year. He talked For the corporate raider era, I about his evolution and now picked Carl Icahn’s battle with What have you learned and for almost every position he Phillips Petroleum because I how has that affected your wants it to involve some thought that it had a lot of investments? elements of activism. It doesn’t important elements. It had a seem like you necessarily want very early poison pill. It had JG: It really drove home the all of your investments to be the first highly confident letter. big career risks that many of activist positions. Is that It had Icahn and Milken and these guys took. They all were correct? Boone Pickens, all in peak in comfortable positions, but form. proceeded to take massive JG: I think that’s a dispositional career risks. thing for me. I don’t enjoy For the hedge fund activism activism that much. I definitely (Continued on page 25) Page 25 Jeff Gramm

think it works. If you’re right can improve the operations or create a lot of value for that a stock is undervalued, the capital allocation, activism shareholders. If they’re paid activism is a great way to is very powerful. according to the value that improve your IRRs by having it I think activism is a good thing they create, it will be a scary play out more quickly. Ackman overall for passive looking number that’s hard for is good at activism. I think he shareholders, because a lot of the public to digest. On the enjoys it. these boards need to be other hand, a lot of CEOs are shaken up. It’s incredibly simply not that good and don’t I’m not that good at it and I frustrating to be invested in an deserve mammoth paychecks. don’t enjoy it that much. I undervalued, poorly-managed, It is a very hard thing to think I’m a decent investor, but and poorly-governed company reconcile. it takes a particular mindset to which allocates its capital be able to go onto a board and badly. To the extent activism, This is something that activism tell hardworking, usually or the threat of activism has not really solved. Activism honest people, who in some improves that dynamic, it is a sometimes rids companies of cases dedicate every waking great thing for investors. underperforming CEOs, but hour to the company, that Activism fails when it forces activists usually give the new they’re wrong. That’s just hard good companies to sell CEO a pretty good package. to do. I’ve had to do it when themselves at the wrong time. Remember, many of the my back was against the wall, And now, as activism has shareholders who become but it’s not pleasant at all. evolved, you are seeing arbiters in these situations are shareholders who are more overpaid as well. I’d love to G&D: How do you think and more focused on tinkering see more creative approaches activism plays out in general with operations. So we’ll to executive comp. One for shareholders in the long probably see a few more failed unfortunate side-effect of the term? Have you come across interventions in the coming Valeant debacle is that anything that convinced you years that look like JCPenney. Pearson’s comp package got a one way or the other that We should be willing to live lot of criticism. But I really activism is actually in the best with those if it improves liked how it was structured. I interest of shareholders for overall governance. liked that he had to risk his the long term as well? That money, and I like that the activism is not, as some people G&D: Talk about passive board installed an interesting, criticize the industry or the investing and indexing versus atypical compensation scheme. practice, just to chase short- pension funds and the shifts in term returns? shareholder bases. What Regarding the shift to indexing impact will that have for and ETFs, it is completely JG: If every company were governance and activism fascinating from a governance well-governed, and all activist broadly? Can you speak about standpoint. These votes campaigns did was to force a pay packages and say-on-pay matter, and you have to worry company sale to take votes? As companies get if the right incentives are in advantage of the disconnect bigger, it seems like place to make sure these big between the market valuation management teams get paid passive institutions vote wisely. and the valuation in the sale, more and they’re all getting then I think that you would paid the 75th percentile of all Vanguard is taking an active have to argue activism would their peers and pay keeps role in the governance debate be a negative, because escalating. and they are dedicating ultimately you are giving up meaningful resources into their your long-term value—or a JG: Those are two huge proxy voting. But you have to portion of it—to the buyer. topics—executive worry about how much power But the dirty truth is that compensation and the growth is accruing to these places. It’s governance is terrible, and in passive investing—that I do a little scary if you think too there’s a huge opportunity out not cover as much as I’d like to hard about it. there to shake up public in the book. They are tough company boards. If you’re issues. A great CEO is The industry tried to deal with correct on valuation and you incredibly valuable and can this problem by creating ISS. (Continued on page 26) Page 26 Jeff Gramm

But ISS has devolved into one case, then it is possible to an interview where he big best practices checklist. perform an aggressive suggested that there could be You need to have good takeover of a company that bad managers and bad boards, judgment and that’s the danger screws the shareholders. If the but that they’re not necessarily of the checklist. I wrote about pill is put in for the right bad people who are some classic examples in the reasons, and not to protect a deliberately negligent; rather book, including ISS’s bad management team, then it they could benefit from recommendation that Coca- can actually protect working with them. Have you Cola shareholders withhold shareholder value. taken a view as to the their vote from Buffett because evolution of activism and he owned . That You have to acknowledge that, where it might be going— is totally insane. If you’re an as a device, it’s not inherently perhaps to “shareholder actual shareholder of Coke, evil. Lipton obviously has a advocate” instead of “activist,” would you vote for Buffett on reputation as a defender of to work with management your board? Of course you corporations and he has a teams to make the companies would. business that is built around better and to keep these men that. So he always takes the and women in their jobs? G&D: Who is your primary anti-activism side, but I think audience for “Dear Marty’s a smart guy and if you JG: First of all, when I say “a Chairman”? bad CEO” or “a bad board,” “... The dirty truth is I’m not saying that they’re bad JG: I really wrote the book people. The power of that I would want to read. So I that governance is incentives are at play here. think the people that would terrible, and there’s a When your livelihood is on the get the most out of it are value line, it’s easy to convince investing fund managers, which huge opportunity out yourself of the rectitude of a is a pretty small target position that happens to audience. But ultimately, I there to shake up support your personal wrote the book for fun and employment and enrichment. because I wanted to. If you’re public company It’s not that all these people an investor, if you’re into value are bad. investing, if you’re interested in boards. If you’re governance, I think you will correct on valuation Could activism evolve into a enjoy it. Beyond that I don’t more constructive, positive know, it does get a bit nerdy in and you can improve engagement? I think that the parts. threat of activism, as pervasive the operations or the as it is now, is resulting in G&D: One other character companies beginning to be that’s really important to the capital allocation, more conscious of their weak development of activism is spots. They are forced to play Marty Lipton. Can you talk a activism is very defense before they’re even bit about his role and how powerful.” attacked, which is a good thing. your view of him has changed, Managers are being mindful of if at all? get him off the record he the areas where their obviously knows there are bad companies struggle, and they JG: I always understood the boards out there and bad communicate better with poison pill and I’ve always CEOs. shareholders about it. That’s a thought that in the right good development. circumstance, the poison pill Marty Lipton and Joseph Flom can be effective in protecting are very important figures in But in terms of constructive shareholder value. Ultimately, the development of corporate engagement, when the battle if you are a value investor, defenses so they’re key parts lines are drawn constructive then you understand that of the story. activism will only get you so markets can be very inefficient. far. Often, replacing the CEO So if you believe that to be the G&D: Carl Icahn recently did and changing the board is a lot (Continued on page 27) Page 27 JeffHarvey Gramm Sawikin

more effective than trying to activism. Yet the bigger public players compel them to do what you used a lot of leverage and want to do. When companies True long-term decision basically marketed themselves play defense, they usually do making is hard, both for to investors as utility-like, the bare minimum required to shareholders and for dividend paying companies. keep shareholders happy. It’s management teams. No one The original Star Gas was a better than nothing, but it wants to sit through two or financial roll-up run by an often doesn’t go far enough. three poor years for the investment banker named Irik promise of something better. Sevin, who’s in my book G&D: One of the themes in because of his battle with Dan investing is the G&D: Are there any Loeb. Sevin rolled up a bunch democratization of investment ideas that excite of heating oil dealers, information. People have more you and you want to share? accumulated a lot of debt, and access to information now, so tried to centralize the business that’s led markets to be more JG: We have an investment in as if it were a propane efficient. Given the threat of Star Gas Partners (SGU). It’s a distributor. But, heating oil activism and people finding heating oil distributor; they distribution is a service- information more easily, would deliver heating oil to 450,000 oriented business, Star Gas that drive managers to be households in the Northeast. pissed off their customers, and more short-term in nature just Heating oil distribution is a the company was to avoid an activist campaign? mature, declining yet overleveraged. When things surprisingly good business. It's got ugly, management began to JG: I’d question your premise true there are low costs of make some directional bets on that because of all this switching and it's easy to the price of oil that went information markets are change your dealer, but good against them. becoming more efficient. We heating oil companies have still have tremendous lapses in consistently generated quality A private equity fund, collective judgment. I’m not returns on capital. Every time I Yorktown Energy Partners sure that the extra information meet someone who runs a took control in 2006. helps. If markets have gotten small, private heating oil Yorktown founded a heating more efficient, it’s probably dealer, they are rich. oil company in 1981 that it ran because so many smart, very successfully until selling motivated people are At times, the market seems to out to Star Gas in 2000. They becoming professional misunderstand the quality of generated a fantastic return investors. the business, maybe because with Meenan by doing what the few public companies that Star Gas is doing now, But to the rest of your distribute heating oil have been allocating capital extremely question, everyone is paying disasters. This includes the old well into acquisitions and attention to shareholders now Star Gas, Heating Oil Partners, opportunistic share because they know the threats and Superior Plus, a Canadian repurchases. So here we have of activism. Companies are propane company that a deceptively good business going to try keep their overpaid for some US heating controlled by extremely good shareholders happy. If the oil assets several years ago. But capital allocators. The shareholders are short-term the truth is that heating oil company has bought back 25% oriented, does that lead to distribution can be a very good of the stock since Yorktown short-term decision making? It business if you operate well. took control in 2006 and it’s certainly can. It’s the job of still cheap at a very low shareholders and the board to G&D: Why have there been multiple of its normalized put management in a situation disasters if the underlying earnings power. The market where they can make the right business is so strong and there values Star Gas as if it is in a operational decisions, even if is quality return on capital? death spiral. Its enterprise it’s painful in the short-term. value is about $400 million, in This is always going to be a JG: It's a volatile business, a normal weather year the challenge for any management sometimes in the Northeast company should make about team in an era with or without we just don’t get a real winter. $100 million in pre-tax (Continued on page 28) Page 28 JeffHarvey Gramm Sawikin

operating income (backing out cetera. liquidation value because its amortization of acquired they’re not going to liquidate. customer lists). Earnings are And, the availability of If the industry goes away, then volatile. Last year Star Gas acquisitions is important. we’re hosed because there are made $160 million pre-tax; in When you talk about the no assets there aside from 2012, when there was basically valuation, Star Gas trades at 4x trucks. That’s actually why Star no winter, it made $66 million. the normalized pre-tax Gas is a good business; it is a But the stock is entirely too earnings power, but that's very low CapEx business. They cheap. Since we’ve owned misleading because it is a generate a lot of cash, but SGU, they’ve bought back $85 declining business if there is no there's no asset protection if million worth of shares and ability to make acquisitions. the business deteriorates. paid $130 million in dividends. Every so often some clown will waltz into the space and G&D: You mentioned short G&D: For Star Gas, can you overpay for heating oil dealers. selling is not a big part of talk about the corporate That really hurts us, because Bandera’s strategy, but it structure and shareholder Star Gas is the natural acquirer seems like the short of Famous rights? in the industry. Over the past Dave’s worked really well. five years, they’ve grown their Could you talk more about JG: SGU is a Master Limited customer base by 10% through that? Partnership, but it’s kind of a acquisitions. If you take their weird, vestigial MLP. All of the pre-tax operating income and JG: We will short assets of the business are held subtract the cost of the opportunistically, but it's quite at the C-corp level. If they acquisitions, they're generating rare. We usually only do it if could easily unwind the MLP $60 to $80 million a year. So it we know the company structure then they would, as really trades at 5x to 7x pre- exceptionally well. Famous it serves no purpose and has tax if you adjust for Dave’s (DAVE) was our only higher administrative costs. acquisitions. short position this year. We Plus, it’s a pain for investors. used to be the largest Regarding governance, the G&D: What does the balance shareholder in 2010 and 2011. investors could technically sheet looks like? We got to know the board replace the general partner if and management very well. they wanted to, but it's a very JG: They have a $100 million well run company, so that is term loan offset by about that A succession of activists not something that we would much in cash. investors rolled into Dave’s, like to see. and the market got extremely G&D: We were talking earlier excited about the future G&D: What are the big risks about doing some Graham and prospects of the business in a to the business? Are changes Dodd investing and buying cash way that we thought made no to interest rates or the price at a discount. How do you sense. We sold our position to of oil big drivers? think about the downside the activists on the way up. It here? is hard to short a company like JG: The big driver for them in that, where there's a lot of the long-term is the speed of JG: SGU is working capital- optimism, a lot of smart people conversion to natural gas for intensive business so you have involved, and they are heating. It's basically been 1% to normalize the working repurchasing a lot of shares. I to 2% for a long time, and that capital for seasonality. There have a very high opinion of could accelerate to a higher are times in the year where it Patrick Walsh, one of the first level. Over time, conversions seems like SGU has a mountain activists to get involved, but have been pretty stable, but of available cash, but it’s not the valuation just got too crazy various external forces could really freely available cash. and we shorted about 5% of change that, such as new Ultimately, Star Gas is going to the company. Even without regulations, government keep on doing acquisitions. obvious catalysts, you had a incentives to convert, changes They’re going to continue to struggling brand and a in the relative value of natural operate the business. It’s not shrinking company suffering gas versus heating oil, et that useful to look at the nine years in a row of declining (Continued on page 29) Page 29 JeffHarvey Gramm Sawikin

traffic. Yes, they are buying desk?” I tell students to write a Your judgment is important, back shares. Yes, there's cover letter that’s very short and if you do good work it will optimism about the future. But and include an investment get better. But at your first job the market’s valuation was write-up. Put it on fancy paper. in the industry, your boss totally disconnected with the Either drop it in the mail or really wants you to gather reality of the situation. We courier it to them. information and to work hard. knew the situation extremely well, having been the biggest If your research is on a I think a lot of the standard holder for several years. It was position in their portfolio, clichés about performing at a painful short for a while, but they’ll probably read it. If work, get there first, stuff like we knew that no one would you're looking at ten funds, it’s that, are true. You'd be buy the business at $35 a a lot of work to do a report surprised at how few people share. [Editor’s note: Famous on ten different companies, but actually do it. Dave’s has since fallen to under if that’s what it takes to get a $6 per share and Bandera filed a G&D: Jeff, thank you for your 13D disclosing a new position in time! the company in January.] “Most hedge funds I

G&D: Do you have any advice know do not have a for students trying to start careers in investment system for hiring, so management? you need to be as JG: If you want to work at a hedge fund, you need to be creative about the creative about your job search. process as you would A lot of the funds that might possibly hire you don’t actually be in your investment know that they might hire you! Most hedge funds I know do research.” not have a system for hiring, so you need to be as creative about the process as you great job, you should try to do would be in your investment it. If I get a write-up on my research. desk about Star Gas, I've got to read it. I'll get these e-mails that read, “Dear fund manager. I want to You have to put yourself in a work at your fund.” You have position for people to pay to do better than that. You attention to you. It also helps if have to decide who you want your write-up includes actual to work for and then target research you have performed them. Most hedge fund rather than just opinions. It holdings are publicly available sounds harsh, but I find that and you can figure out which students often overvalue their funds invest in the type of own judgment. companies that interest you. It’s easy to find out who runs At your first job outside of the fund, but don’t just send a business school, even if you do generic email with a resume. great work and you're extremely smart, don't If you have identified the fund underestimate the fact that manager you want to work for, you're also there just to then think, “Okay, how can I perform work. Don't get my stuff onto his or her overvalue your own judgment. Page 30 Shane Parrish (Continued from page 1) decision making, strategy, practical way. The strong What appeals to you about and philosophy. Shane is a reception surprised me at first, investing? strategist for both but now the community has individuals and become very large, stimulating, SP: For Munger and Buffett organizations, and is and encouraging. I should point specifically, it's not necessarily dedicated to mastering the out that I don’t come up with that they're just investors, it is best of what other people anything original myself—I’m that they've modeled a path of have already figured out. just trying to master the best life that resonates with me. I of what other people like also appreciate the values that Shane Parrish Graham & Doddsville Buffett, Kaufman, Bevelin, and are associated with their (G&D): Can you discuss your Munger have already figured investment success. I think background and the origins of out. In fact, that’s our tagline. It what they've done is they've Farnam Street? reminds me of something taken other people's ideas, Munger said once when asked stood on the shoulders of Shane Parrish (SP): Farnam what he learned from Einstein, giants, so to speak, and applied Street started as a byproduct and he replied, only half- those ideas in better ways than of my MBA. As I was going jokingly, “Well he taught me the people who came up with through that program it relativity. I wasn’t smart the ideas. For example, with became evident that we were enough to figure that out on regards to psychological biases being taught to regurgitate my own.” That seems like a bit and Kahneman’s work, Munger material in a way that made of a wiseass remark, but and Buffett have found a way marking easier. We weren’t there’s some untapped wisdom to institutionalize this to a honing our critical thinking there. point where they can actually skills or integrating multiple avoid most of these biases. disciplines. We couldn’t G&D: What are your challenge anything. motivations for Farnam Street? Kahneman himself says Eventually, I got frustrated. I something along the lines of, didn't give up on the MBA, but SP: I want to embrace the "I've studied biases all my life, I did start using the time that I opportunity I have, which has but I'm not better." Yet, these was previously investing in been created largely through two guys from Omaha actually homework and started to luck, and I want to give readers figured out how to be better. focus on my own learning and and subscribers enormous development. At first it was value in three ways. It’s not just Kahneman and mostly academic. I started human biases. Munger and going back to the original First, I want to help them make Buffett have done it in a variety Kahneman and Tversky papers, better decisions. To do our of disciplines like Michael and other material that was best to figure out how the Porter’s work on Competitive journal based, because I figured world really works. Second, I Strategy. They separately I'd probably never have access want to help people discover derived the same basic ideas, to such a of journals new interests and connections except in a way that gives again outside of school. across disciplines. Finally, I them an enormous investing want to help people explore advantage. To my knowledge, So I started the website and it what it means to live a good Michael Porter has not done was really just for me, not for life and how we should live. I that. Of course, he may not anybody else. The original url hope by sharing my intellectual have been trying to do so. of the website was the zipcode and personal journey I can help Another great example is Ben for . I people better navigate theirs. Graham. He provided the didn’t think anyone would find bedrock that Warren Buffett it. It eventually grew into a G&D: It seems pretty clear built his brain on, but if you community of people that you have a profound really think about it, Buffett interested in continuous admiration for investors. was and is a much better learning, applying different Farnam Street is the street investor. And lastly, regarding models to certain problems, Berkshire Hathaway is located Munger, in my opinion his and developing ways to on, and you discuss Charlie method of organizing practical improve our minds in a Munger's views quite a bit. psychology is a lot better than (Continued on page 31) Page 31 Shane Parrish

the actual residents of that right now which will be G&D: Reading is something discipline, even the people who released next fall. you seem to know quite a lot “taught” him the ideas through about, but in a recent post, books. We are launching "How to you discussed that you are Read a Book" early in the year. purposefully reading fewer Returning to investing, the That course is aimed at books. What is your thinking field resonates with me adapting Mortimer Adler's around that decision? because investors have skin in theory of reading to the the game. Investors have clear modern age, and giving people SP: I fell into a trap with accountability and measurable a structured way of going reading. It almost became a performance. That contrasts about learning from books, as personal challenge that you can with many other types opposed to simply reading easily get wrapped up in. In organizations. For the most them. Seems simple, but most 2014, I was basically reading a part, investors are searching of us never really pick it up. book every few days. I think I for the truth and constantly ended the year with over 140 looking for ways they could be Today we are bombarded books read, but I must have wrong and that they could be constantly with information, started at least 300. I realized I fooling themselves. There’s a and we often read all types of was reading just to finish the pretty clear scoreboard. material in the same way. But book. That meant I wasn’t that’s pretty ineffective. We getting as much out of it as I G&D: Are you an investor don’t have to read everything should. I ended up wasting a yourself? the same way. Adapting your lot of time using that approach and it also impacted what I SP: Yes. I used to be involved read. You have these subtle with a small registered pressures to read smaller investment advisor based in “Adapting your reading books and to digest things in a . I still invest really quick way. I wasn’t personally and hope to return style to consider the spending enough time more of my focus to investing synthesizing material with what in the future. Right now I’m type of material you I already knew and honing my focused on Farnam Street, are reading and why understanding of an idea. which I see as the biggest opportunity ahead of me and you are reading it It's not about how many books the opportunity that I'm most you read but what you get out excited about. There’s a lot to makes you much more of the books you read. One do. great book, read thoroughly effective at skimming, and understood deeply, can G&D: Can you talk about have a more profound impact what you have planned for understanding, on your life than reading 300 Farnam Street? synthesizing, and books without really understanding the ideas in SP: I just hired somebody to connecting ideas.” depth and having them help out at Farnam Street for available for practical problem the first time. His name is Jeff solving. Annello. He’s amazing. It's become more of a reading style to consider the G&D: Can you discuss some sustainable business. We are type of material you are of your techniques for developing products. We have reading and why you are absorbing and synthesizing as two courses coming out next reading it makes you much much information as possible? year that we're incredibly more effective at skimming, excited about. I think we have understanding, synthesizing, SP: There is a lot that can be put over a year's effort into and connecting ideas. If you done after simply finishing a one of the products, and we're take the same approach to chapter. I like to summarize just starting the other one reading everything, you will the chapter in my own words. end up tired and frustrated. I also like to apply any (Continued on page 32) Page 32 Shane Parrish

learnings from the chapter to G&D: You also talk about the process of doing that shows my life, either by looking Feynman technique in some of you where your gaps are; this backward to see where your posts. is important feedback. If you concepts may have applied, or have a gap in your by looking forward to see if it SP: Yes, the Feynman understanding, you can circle might make sense to technique is essentially back to the book to better incorporate something into my explaining a concept or idea to understand that point. If you daily routine. I think the reason yourself, on a piece of paper, can't explain it to somebody to do that is twofold. One is to as if you were teaching it to else, then you probably don't give me a better understanding someone else with little understand it as well as you of that learning, and two is background knowledge. When think you do. It doesn't mean really a check and balance, and you're learning something new, you don't understand it, but a feedback loop. Have you it's all about going back and the inability to articulate it is ever watched TV and definitely a flag that it's somebody comes in on a something you need to circle commercial and says, “What “The Feynman back to, or pay more attention are you watching,” and you're to. like, “I have no idea,” but technique is essentially you've been sitting there 20 G&D: It seems like feedback minutes? Well, we can do that explaining a concept mechanisms are a key part of with books, too. You'll start or idea to yourself, on your approach. reading, and paragraphs will fly by, and then you'll have no idea a piece of paper, as if SP: I think at the heart of it, what you were reading. It's fine you want to be an active if you're reading for you were teaching it to reader. You want to selectively entertainment, you might be be an active reader, and not a able to catch up later, but if someone else with passive reader. These types of you're reading for activities make sure that you're understanding, that's little background reading actively. Writing notes something you want to avoid. knowledge. When in a book, for example, is really just a way to pound what Part of what I want to do is you're learning you’re reading into your brain. develop a feedback process to You need engagement. make sure that I'm not doing something new, it's all that. G&D: In a recent post, you about going back and brought up Peter Thiel's I try to make extensive use of concept of a “secret”. book covers for notes about making sure you Essentially, what important areas to revisit, potential understand it.” truth do very few people agree connections to other concepts, with you on? I'd be really and outlining the structure of curious if you have something the author's argument. After making sure you understand it. in mind that would fit this I've finished a book, I usually Can you explain it in simple, concept. put it on my desk for a week jargon free, language? Can you or two, let it sit, and then I explain it in a way that is SP: Ever since I came across come back to it. I reread all of complete and demonstrates this question I’ve been toying my margin notes, my understanding? Can you take with it over and over in my underlines, and highlights. Then an idea and apply it to a head. I’m not sure I have a I apply a different level of problem outside of the original decent answer, but I’ll offer filtering to it and make a domain? Take out a piece of one of the things that I run decision about what I want to paper and find out. into a lot but couldn’t really do with the information now. I think that being able to do describe until Peter Kaufman this at the end of a book is pointed me to a quote by Andy really important, especially if Benoit, who wrote a piece in it's a new subject for you. The Sports Illustrated a while back. (Continued on page 33) Page 33 Shane Parrish

Benoit said “Most geniuses— where the multidisciplinary loss of 50%, but which a wiser especially those who lead learning has been especially person never would have others—prosper not by powerful for you? Munger has purchased in the first place. deconstructing intricate a number of examples of him The sale looks smart, but the complexities but by exploiting arriving at a solution faster easier decision would have unrecognized simplicities.” I than an expert in a field as a been avoiding misery from the Student volunteers enjoy think he nailed it. This explains virtue of Munger using get-go. That kind of thing themselves at the Graham & Berkshire Hathaway, the New concepts from other fields. happens all over the place. Dodd Breakfast England Patriots, Costco, Glenair, and a host of amazing SP: If you were a carpenter Multidisciplinary thinking also organizations. I’ve long had a you wouldn’t want to show up helps with cognitive diversity. feeling about this but couldn’t for a job with an empty In our annual workshop on really pull it out of my toolbox or only a hammer. decision making, Re:Think subconscious into my No, you’d want to have as Decision Making, we talk about conscious mind before. Benoit many different tools at your the importance of looking at a gave me the words. I think we disposal as possible. problem in multiple dimensions generally believe that things to better understand reality need to be complicated but in Furthermore, you’d want to and identify the variables that essence there is great value know how to use them. You will govern the situation— into getting the simple things can’t build a house with only a whether its incentives, right and then sticking with hammer. And there is no point adaptation, or proximity them, and that takes discipline. in having a saw in your toolbox effects. But the only way As military folks know, great if you don’t know how to use you’re going to get to this level discipline can beat great it. In this sense we’re all of understanding is to hold up brainpower. carpenters. Only, our tools are the problem and look at it the big ideas from multiple through the lens of multiple I know of many companies that academic disciplines. If we have disciplines. These models invest millions of dollars into a lot of mental tools and the represent how the world really complicated leadership knowledge of how to wield works. Why wouldn’t you use development programs, but them properly, we can start to them? they fail to treat their people think rationally about the right so the return on this world. One important thing, for investment isn’t even positive example, we can learn from it’s negative, because it fosters These tools allow us to make ecology, is second order cynicism. Or consider better initial decisions, help us thinking—“and then what?” I companies that focus on better scramble out of bad think that a lot of people complicated incentive plans— situations, and think critically forget that there's a next phase they never work. It’s very about what other people are to your thinking, and there's a simple. If you relentlessly focus telling us. You can’t over- second and third order effect. on the basics and develop a estimate the value of making I’ve been in a lot of meetings good corporate culture—like good initial decisions. Nothing where decisions are made and the one Ken Iverson mentions sucks up your time like poor very few people think to the in his book Plain Talk—you decisions and yet, perversely, second level. They get an idea surpass people who focus on we often reward people for that sounds good and they the complex. Where I might solving the very problems they simply stop thinking. The brain disagree with Benoit a little is should have avoided in the first shuts down. For example, we that I don’t think these are place. It’s a little weird, but in change classification systems or unrecognized as much as some organizations you’re incentive systems in a way that under-appreciated. People better off screwing up and addresses the available think the catechism has to be fixing it then making a simple, problems, but we rarely more complicated. correct, decision the first time. anticipate the new problems Think about portfolio that will arise. It’s not easy. G&D: You discuss the power managers trumpeting how This is hard work. of multidisciplinary learning. they’ve “smartly sold” a stock Do you have any example at a loss of 20%, saving them a (Continued on page 34) Page 34 Shane Parrish

Another example is when a G&D: It makes sense that people running it to turn it salesman comes into a second-order and third-order into politics. I think we can all company and offers you some effects are underappreciated. agree those are not desired software program he claims is outcomes and yet that is how going to lower your operating SP: I think a lot of people get many incentive systems work. costs and increase your profits. incentives wrong and it has He’s got all these charts on disastrous implications on G&D: Do you have any how much more competitive corporate culture. Let’s look at thoughts on particularly you’ll be and how it will it from another angle – how powerful concepts or process improve everything. You think would you intentionally design implementations that can help this is great. You’re sold. Well an incentive system that investment organizations the second order thinking is to functioned horribly? You’d pursue investment excellence? ask, how much of those cost make it so complicated that savings are going to go to you few people understood it. SP: I think it’s important to and how much will be passed You’d make everyone focus on getting better at on to the customer? Well to a measured on individual and not making decisions over time. It large extent that depends on team success. You’d have is about making the process the business you’re in. different variables and clauses slightly better than it was last However, you can be damn and sub-clauses. No one would time. These improvements sure the salesmen is now understand how their work compound like money. You knocking on your competitors’ impacts someone else. To really have to flip it on its head. door and telling them you just make it even worse, you’d What’s likely to not work well? bought their product. We know thanks to people Generally speaking, analysts like Garrett Hardin, Howard “If you think you’re tend to have a focused view of Marks, and disciplines like the world and they stay in Ecology that there are second going to come up with their lane. Specialization and third order effects. This is good solutions to certainly helps develop specific how the world really works. knowledge, but it also makes it complicated problems hard to learn from the guy or Munger’s got a brain that I girl next to you who has don’t have. I have to deal with in 30 seconds and your knowledge in a different what I’ve got. I’m not trying to industry, so you're not come up with the fastest name is not Charlie improving your intuition as solution to a problem. It’s much as you’d probably want. great to have a 30 second Munger, I wish you It’s like chess. People once mind, but it’s not a race. Part luck. The rest of us thought great chess players of the issue I see over and were great thinkers, but over again is not that people should learn to say ‘I they’re not any better at don’t have the cognitive tools, general problem-solving than but rather they don’t have don’t know’ or ‘Let me the rest of us. They’re just time to actually think about a great chess players. Investment problem in a three dimensional think about it’ about analysis is often the same way, way. If you think you’re going especially if you’re siloed in to come up with good ten times more some industry analyst position. solutions to complicated frequently than we It’s probably not making you a problems in 30 seconds and great thinker, but you are your name is not Charlie do.” learning more about your Munger, I wish you luck. The industry. rest of us should learn to say “I offer infrequent and small don’t know” or “Let me think rewards. You’d offer a yearly In order to have the about it” about ten times more bonus of maybe 5% of salary or organization learn and get frequently than we do. something. And of course, better, we need to expose our you’d allow the people in it to decision making process to game the system and the others. One way to do this is (Continued on page 35) Page 35 Shane Parrish

to highlight the variables we thousands of pages of material because you’ll be tossing a lot think are relevant. Start making to read.” of ideas out very quickly. clear why we made our decisions and the range of Clearly Berkshire Hathaway G&D: It seems like you would outcomes we thought were has done a really good job with prefer the Buffett and Munger possible. It needs to be done in this, with basically two guys model over the approach of advance. A lot of people do doing all of the information the average hedge fund with this through a decision journal. processing—two really smart specialists? Some accomplish this through guys, but only two. a discussion that flushes out SP: If my job is being a which variables you think will How do they do that? Well, neurosurgeon, I need to keep dominate the outcome and part of the reason is that up-to-date with all the latest most importantly, why. Not Buffett and Munger are neurosurgery papers, academic only does that facilitate an continuously learning about articles, books, and talks environment where others can companies that do not change because I'm very specialized in challenge your thought rapidly. They're learning about that one particular area and it's process, but over time it companies that change slowly. relevant to my job and relevant enables them to get a good That in and of itself is a major to my livelihood. feel for what you think are the advantage. They also are key variables in that particular operating in industries in which If you look at investing industry. That helps me expand they know the key variables of holistically you can't do that my circle of competence. You determining an organization’s for every company in every don’t want an organization success or failure, and more industry. In my understanding, where the automobile analyst importantly, ignoring the part of the reasons Buffett and knows nothing about banking industries where they don’t. Munger have accumulated so and the chemicals guy knows It’s a huge step to be able say much knowledge is that they little about consumer to yourself “Look, I’m going to focus on learning things that products, and then a portfolio miss some enormous winners change slowly. That makes it manager with a little surface that were incredibly hard to easier to identify potential knowledge of everything is see ahead of time. I’m OK with outcomes and determine the pulling the trigger. I have never that.” Buffett and Munger can relevant variables. seen that work, but I’ve seen a do it, but most struggle. So lot of people try. The they stretch and invest in David Foster Wallace had this “everyone’s a generalist” things where they really cannot great quote, “Bees have to approach has its own accurately predict the odds of move fast to stay very still.” limitations, like a crippling lack success or failure, all forces And that’s what most of us do. of specialized knowledge. considered. Probabilities being We move a lot to stay in the what they are, if you same place. Buffett and Munger So, obviously, any investment consistently invest in things are getting further ahead each organization has to find a with middling odds, you’ll have day. middle ground. How could it middling results. Again, how be otherwise? You must start could it be otherwise? The key Unless physics changes, for with this basic and obvious is knowing the difference example, it’s unlikely that we’ll truth to solve the problem. between an obviously see the development of more attractive situation and a efficient way to move bulk Another challenge in the difficult-to-predict one and freight. It doesn’t seem subject investment world is dealing being able to act on the former to technological disruption, but with the sheer volume of the and sit on the latter. Of instead will likely be aided by information. I get questions course, I’m over-simplifying a technology. Technology helps from portfolio managers all the bit, but you can’t get around improve the management of time about how best to keep the fact that reality is reality. your rail network, but it’s not up with the information flow. You have to find a way. And going to replace the entire They say “I get 500 emails a this will help you solve your network anytime soon. day. I have researchers’ work information flow problem, I think that Berkshire is come to me at all hours. I have actually moving away from (Continued on page 36) Page 36 Shane Parrish

uncertainty by pursuing Berkshire Hathaway. As I does it work at Google? Is it companies like this. If you understood it, they are trying because of how it fits in the don't know the range of to add value to the overall culture? The problem I outcomes, you will have a hard entrepreneurs. Also, they’ve see is that people are taking time assessing probabilities. moved away from a business one piece of a large puzzle and One of the things that decision or idea based sourcing process thinking that it’s going to solve journals help identify is to one that is almost their problem. It might help. It outcomes outside of what we exclusively focused on the might not. It’s just a tool. It expected. That's a very entrepreneur. That directly reminds me of the group of humbling experience. After contradicts some of Buffett’s blind people touching the identifying possible outcomes thoughts on the relative different parts of the elephant. and applying confidence levels, importance of a management Also, some of these innovation its humbling to get it so wrong. team versus the underlying projects get done for the business. wrong reasons, and with the G&D: You have also studied wrong incentives. If my boss an investment firm that's It makes sense that they would asks me for ideas to help the probably as different from have different approaches. I company innovate and I give Berkshire Hathaway as think it's important to him an idea that sounds good, possible with your most recent understand that there are one that subconsciously podcast with Chris Dixon of things that we want to have in reminds him of an article he Andreessen Horowitz. What our mental tool box. But part read in Fortune about are your thoughts on good of being an effective craftsman innovation, isn’t that basically decision making as applied in is knowing when they work good enough for me as an the venture capital world and and when they don’t. You can’t employee? Does it even matter how is it different than just pull our random tools and if it works? In most Berkshire Hathaway? expect them to work. organizations, am I really going to be held responsible for the SP: Chris was an excellent In 2013, I did some consulting success or failure of my guest to have on The work on improving innovation innovation prescription? The Knowledge Project. He in organizations and the most organization might suffer, but operates in Venture Capital—a common thing that people will I suffer personally? world I don’t get much were doing at the time to Probably not. My lack of ability exposure to. He has insight on solve the innovation problem to think the problem through things I know very little about: was copying Google’s 20% of will probably be forgotten in venture funding, how to time spent on independent time if the idea sounded good structure a venture capital firm innovative ideas. and relevant at the time. If it so that you are adding value, was defensible via Powerpoint. etc. And they’ve been very I found this interesting for a This is one reason hiring successful. number of reasons. It consultants rarely works as surprised me that every well as hoped. I think we're largely operating executive had it on the tip of in unprecedented territory their tongue, but there's no So, we copy Google's twenty given the magnitude of private large sample size for a percent innovation time. valuations. In past decades, successful innovation like this They’re an innovative companies IPO’d at much 20% idea. Google and, I think, company; they're hip; they're lower valuations so public 3M are the two most cool; we’re going to copy market investors could more prominent examples. Google, them. Okay, well, we can do easily participate in their at the time, I think they had that. It’s a good story. success. I don't know how this only been around for15 years. What gets lost is a potentially plays out, but talking to Chris That’s a pretty small sample useful discussion like, “Maybe was fascinating. size for continuous innovation. we should remove the things Also, you need to understand in our environment that take Andreessen Horowitz has a how that fits with the company away from natural innovation, very different operational culture, and why it works even like all these meetings.” That’s approach as compared to if you're seeing it work. Why a much tougher conversation, (Continued on page 37) Page 37 Shane Parrish

but just like taking away sugar What could be better than I don't come up with almost works better than adding constantly learning new things anything that's original. I broccoli to your diet, taking and discovering that you're still aggregate and synthesize other things out of the corporate curious? Most of us forget people's thoughts and put it culture is often a better what it's like to be six years into context for people. I think solution than adding new stuff. old and asking "why?" all the that those are things that I like Munger has us paying attention time and trying to understand to focus on, I have a passion to incentives because they why things operate the way for doing that. I'm doing it really are driving the train. You they do. It’s hard to still do anyway because I get a lot of have to get it right. that, but you can still carry that value out of reading, learning, wonder with you into life and and exploring the world, and I G&D: One big theme for you try to understand why things share that with people. is the concept of life-long are happening and why success learning. What is your or failure happens. G&D: With regard to Mental motivation to pursue it? Models, you spend a lot of Munger has called it a moral time discussing their duty. Do you have similar “Avoiding stupidity is importance, but you also feelings? highlight their shortcomings. better than seeking Can you discuss your view of SP: I wish I were as eloquent the value of mental models? as him. I've always had to work brilliance. But that by harder. You just have to keep SP: It's important to getting better everyday. You itself is suboptimal. understand how we are likely have to keep learning. If you're You also want to copy to fool ourselves. Aside from going to accomplish what you the psychological factors, want to accomplish, it's models of success. We which Munger and Bevelin talk probably not through going about extensively, there are home and watching Netflix don't necessarily have other ways. every night, right? You have to learn how the world works. to come up with all of For example, we run We have a huge statistical organizations based on sample size of things aren't this stuff ourselves. dashboards and metrics and changing. There is an excellent We can see a better we make decisions based on letter by Chris Begg at East these numbers. Investors look Coast Asset Management that model and adopt it, or at financial reports to make discusses Peter Kaufman’s investment decisions. thoughts on this. Physics, math, the parts of it that will and biology are things that We think that those numbers change very, very slowly, if at help us along.” tell a story and, to some all. Learning things in those extent, they do. However, disciplines is good. It’s they don’t tell the full story. practical, because that's how Avoiding stupidity is better They are limited. For example, the world works. Those are than seeking brilliance. But that a strike-out can be a good things that don't change over by itself is suboptimal. You also thing in baseball. Players who time. want to copy models of suck statistically in one system success. We don't necessarily can thrive as a part of another I think that, for me, it's just have to come up with all of – the whole “Moneyball” idea become "How can I pass this stuff ourselves. We can lives here, and the Patriots people that are smarter than see a better model and adopt have been extremely successful me?" I think if I can get it or, the parts of it that will with a wide variety of talent. incrementally better every day, help us along. Giving up on In business, reported compounding will kick in and holding on to our own ideas is depreciation can be widely off. over a long enough time, I'm really important. The accounting could be going to achieve the things that gamed. A tailwind could be I want in life. (Continued on page 38) Page 38 Shane Parrish

benefitting a business G&D: Essentially, they can be about See’s Candy. What did temporarily, soon to dissipate. powerful if used correctly, but his summary table show every Many companies look their we can also over apply them in year? Pounds of candy sold, absolute best, on historical some ways? stores open, total revenue, figures, just before the big total profits. The key variables. denouement. SP: They work sometimes and Then he explained in clear not other times. You need to language why See’s was a good There is a great quote by be aware of limitations. The business and what had George Box who said “All point here is just to be occurred in the most recent models are false but some are cautious—the map is not the period, and if possible, what he useful.” Practically speaking, we terrain. It doesn’t tell the full foresaw in general for the have to work with story. following year. That’s what we reductions—like maps. A map need more of: give investors with a scale of one foot to one G&D: Do you have any other an updated report of the major foot wouldn’t be useful, would investors or companies outside drivers and then tell us what it? Knowing that we’re of Berkshire Hathaway that happened. Leave out the fluff. working with reductions of really have some profound You don’t need to write essays reality, not reality itself, should thinking or you really love like Buffett. Just help us give us pause. We recently reading their shareholder understand the business and wrote a piece on Farnam letters or you've learned a lot what’s going on. Street called “The Map is Not from? Anything like that that the Territory,” which is a we can talk about? G&D: This has been great, more in-depth exploration of Shane. Thanks so much for the nuances behind this. SP: Berkshire has an incredibly your time. unique model of writing to Knowing how to dig in and shareholders, and frankly no understand these maps and one else is as good. One that’s their limitations is important. A slightly off the beaten path, lot of models are core – they although it’s become a lot don’t change very much. Social better known over the past proof is real. Incentives do few years, is a Canadian drive human behavior, financial company called Constellation and otherwise. The margin of Software (CSU). The CEO safety approach from there is truly doing God’s engineering works across work as far as how he reports many, many practical areas of to shareholders. Very clear life. Those are the types of presentation of the financial huge, important models you performance of the business, want to focus on as a part of and a lucid and honest becoming a generally wise discussion of what’s going on. person. You need to learn them and learn how to There are two key synthesize with them. components to reporting to From there, you layer in the shareholders well, as I see it. models that are specific to One is presenting, in as clear a your job or your area of way as possible, the results in desired expertise. If you’re a the prior periods. Presented bank investor, you’re going to consistently and honestly over look to attain a deep fluency in time. The second is being bank accounting that a extremely forthcoming about neurosurgeon wouldn’t need. why these figures came out the But both the analyst and the way they did; good or bad, surgeon can understand and warts and all. When Blue Chip use the margin of safety idea Stamps was still a reporting practically and profitably. company, Munger would write Page 39 Jon Salinas (Continued from page 1) Jonathan earned an MBA professors were passionate behavioral aspects of investing from Columbia Business about are really important for School. While at investing, helpful, and thinking about investing on Columbia, he completed thoughtful. They were really both sides, but they are the Value Investing inspiring early mentors that particularly important on the Program administered by motivated me to stay involved short side. the Heilbrunn Center for in the program. Graham & Dodd Investing. After business school I went to He received a BA with a The seminal experiences I had work at Festina Lente for Jon Salinas ’08 degree in Political Science were studying under Bruce David Berkowitz, who had run from Rutgers College, Greenwald as well as a seminar Gotham Partners with Bill where he graduated with at Blue Ridge Capital taught by Ackman. It was a very high honors and was John Griffin and David concentrated long-only fund elected to Phi Kappa. Greenspan. In Bruce that had about six investments Jonathan is currently an Greenwald’s classes, I learned in total. They focused on very adjunct professor at the “economics of strategic high quality, durable businesses Columbia Business School behavior” and how to truly with great management teams where he teaches Applied analyze competitive dynamics and capital allocation Security Analysis and has of a business. strategies. This experience previously taught Distress taught me how to think about Investing. concentration, and what does “The seminal and doesn't work. It was also Graham & Doddsville experiences I had 2008, so I got to see the (G&D): Could you start off by financial markets collapse. telling us about your were studying under Being in a concentrated long- background? only fund during that period Bruce Greenwald as was definitely a learning Jon Salinas (JS): I started off experience in terms of how in a rotational capital markets well as a seminar at you think about the impact of program at UBS where I got a market de-leveraging. broad-based background in Blue Ridge Capital equity, credit, and derivatives, taught by John Griffin From there I went to work at which has influenced the way I Ziff Brothers where I worked invest in that it allows me to and David with Yen Liow. Yen’s a very look for investments across thoughtful investor who is very the . I also met Greenspan.” focused on framework- a lot of people who had oriented investing. This different approaches to involves thinking through investing, both modern and old In the Blue Ridge seminar, it certain qualitative processes -school, and learned the hard was the first time I was and pattern recognition and soft skills of investing. exposed to a really associated with great After UBS, I attended phenomenal process for investments, both long and Columbia Business School and conducting primary research as short. I spent some of my time was a part of the Value well as investing in a really there focusing on energy which Investing Program. I met a differentiated way. We also was helpful to get a base number of incredible learned about short selling as understanding of how all influencers there including well as the behavioral aspects companies are impacted by Professors Bruce Greenwald, of investing. I studied commodities. I realized it was Joel Greenblatt, and the other philosophy, political science, an area where you had to be adjuncts. David Rabinowitz and economics, and psychology in specialized so we avoid Eddie Ramsden taught my college, so the behavioral investing in energy. As a Applied Value Investing aspects of investing and generalist, I think it's important section. They were markets dynamics have always to understand which areas concentrated, special situation intrigued me. It was nice to see require some real expertise. oriented investors. Both that overlay. I think the (Continued on page 40) Page 40 Jon Salinas

After spending some time at really how I tend to filter the been very upfront with our Ziff Brothers, I joined Marble world. investors about concentration Arch, which was a Tiger- and the by-product of oriented fund seeded by Julian G&D: Can you walk us volatility, which I think helps Robertson. The two founders through your decision to filter for an investor base were from launch Plymouth Lane? comfortable with volatility, and Hound Partners. I joined understanding that it is often a Marble Arch in 2009 as a JS: I launched Plymouth Lane byproduct of differentiated, generalist when it was a young in May 2013. I had always high absolute returns over organization, about a year and wanted to try and express my time. It's very hard for an a half into its life. It was a small style and my voice. I thought I investment manager to reduce team, and we had a really great could have success investing in volatility and still get abnormal run in the four years that I a concentrated manner, both returns. I'd say having those spent there, and we were able long and short, focusing on types of conversations with to grow the organization. They very high quality businesses investors have been very were very opportunistic, that would compound for helpful. investing both long and short, many years, and evaluating with the ability to look at special situations that could We've also tried to spend a lot distressed credit when it offer attractive risk-adjusted of time helping investors learn offered more attractive risk- returns whether it was about us, our team, and our adjusted returns. They were through distressed credit, spin- process. We think that type of very dedicated to absolute offs, or some other subset of transparency has given our returns on the short side. It special situation investing. I investors comfort along the was where I was able to really was really driven to achieve way. We also try to align expand my skillset as a short high returns on a standalone interest. For example, in seller. basis, to try to build a high return for a multi-year quality team, and to commitment, we earn our The generalist approach is one qualitatively embrace certain incentive fee over a multi-year that I gravitated toward things like volatility and period. If we're not generating because I enjoy being able to concentration that most returns over the long term, always look at new investors don't typically we're not getting paid, which I opportunities. Now, I'd say embrace. think is a little bit different most generalists end up than how most tend to specializing in some way. For G&D: What have you done structure their business in the me, I specialize to some degree for your capital structure to industry. within TMT and consumer, but enable you to embrace I’m also willing to look at volatility? We felt like we were building a financials and industrials. I’m business for the partners. Our willing to look at any business JS: One lesson I learned along structuring was very partner in which I can truly break the way from investors was friendly. The underlying down the business, assess the that if one is going to invest in thought I have is that duration durability of the moat, and the a concentrated manner, you of capital is very helpful for quality of the business. I’m also have to build the business investing and outperforming open to evaluating special structure to allow for volatility. over time. We try to be situations where it's easy to As a result, we primarily focus thoughtful in structuring our analyze the assets and on partnering with very long- capital base as long duration as liabilities. In some cases, there term oriented investors, those possible. It makes the job of might be complexities that think about investing out generating returns easier if you associated with the situation, over multiple year time have a longer time horizon to which is leading to the horizons. The majority of our invest. inefficiency. The ability to capital is under multi-year break down the inefficiency commitments, which lets us G&D: One of your big and understand it while also think about the long-term, and investments that allowed you thinking through the margin of not necessarily focus on short to break into the industry was safety and the intrinsic value is term volatility. We've also a credit investment, but not (Continued on page 41) Page 41 Jon Salinas

many long/short managers (GGP), one of the largest business and began to spend that much time on regional mall REITs that understand that regional malls credit. Why do you think existed at the time. It had been tend to be pretty high quality credit is interesting and what funded using short term debt businesses. Regional malls own are you seeing today? to reduce its overall interest some of the premier Class A expense. That was a positive commercial real estate across JS: When I was entering while the debt markets the United States. It's very business school, I wanted to remained open but created a hard to construct a regional understand the bankruptcy problem when debt markets mall. There are real “NIMBY” process, which is a critical area seized after Lehman collapsed factors in that malls tend to be of traditional value investing. and they could not rollover massive structures, so it's very Some of the best investments their short maturity debt. difficult in a town or a city to have tended to result from a GGP was in a strange limbo for add a new mall. Therefore, if bankruptcy process. I also like a few months after it had you own a regional mall, you that it creates a catalyst for defaulted on its debt but not have a bit of a regional value realization, and there is a yet filed for bankruptcy. It was monopoly. certain amount of complexity about a four or five month involved. Because of my period where no one was G&D: In 2008, ecommerce background in the social willing to foreclose or force a penetration was much lower sciences, I had an interest in bankruptcy on the company. than it is today, right? understanding the law in the overlapping business JS: It was low and it was implications. I started learning “[GGP] had three starting to increase slightly, but under Harvey Miller at what was interesting was GGP Columbia Law School. At CBS, companies that had had an incredibly diversified I studied under Dan Krueger portfolio, so no tenant ’02 and worked at Schultze been combined in a accounted for more than 2% of Asset Management, which is revenue. They were incredibly run by another Columbia REIT structure, with diversified with very high alumnus. an incredibly complex occupancy rates, and remained very stable after 2008, so you I met Mark Kronfield, one of capital and corporate saw really no degradation in my partners at Plymouth Lane, occupancy at all for the while he was a Senior Analyst structure. It had over business. The operating and I was an intern at Schultze performance never really Asset Management. He taught 100 different deteriorated. me a lot about distressed investing. Distressed investing properties, each with What was interesting was their is a great way to invest in its own debt and complex corporate structure. special situations, like complex GGP had acquired Rouse Co. litigations. For example, some profitability. I think about a decade prior to the of the energy investments we bankruptcy. Before that, Rouse are invested in now are that complexity had acquired the Howard situations where we are Hughes Corporation, which thinking about how cash will created an was another commercial real be distributed and the estate and mall operator. You inefficiencies that may exist. opportunity.” had three companies that had been combined in a REIT Distressed investing is also a structure, with an incredibly way to invest in really high There was a lot of preparation complex capital and corporate quality businesses during that was done ahead of time by structure. It had over 100 periods of financial distress. Weil, Gotshal & Manges, run different properties, each with The investment I think you by Harvey Miller, who was its own debt and profitability. I alluded to in your question is representing the debtor. I think that complexity created General Growth Properties started doing an analysis of the an opportunity. The value- (Continued on page 42) Page 42 Jon Salinas

added research task was sitting purchased it. JS: Historically we entered down and taking every media investments with an property and trying to G&D: Was that a situation assumption that cord cutting estimate what the profitability where you had an appetite for was exaggerated or not of each property was and distressed credit but you necessarily evidenced. I'd say thinking through its private hadn't spent a lot of time in that's still the case in that market value. commercial real estate and as a aggregated cord cutting generalist you were able to numbers are not accelerating Using very conservative recognize the mental model as dramatically. That being said, multiples on the profitability of a situation you'd seen before, we think cord cutting is a each property and then and then figure out the reality that impacts the subtracting the debt you could business model? economics of the business in get a sense of the equity value. that it gives content providers The sum of the positive equity JS: Exactly. I think that's a less leverage than they've had in the properties was what perfect example how you historically. GGP was worth. You had to attack this and how you think overlay the corporate about value. The big Our favorite investment in the structure in the appropriate inefficiency was everyone was media content space at the way. Doing that analysis took a thinking about the moment is DHX Media lot of work. It was very consolidated profitability and (DHXM). It's a really tedious but it allowed me to slapping a cap rate on that to interesting investment get comfortable under value the enterprise, and then opportunity. DHXM is a $700 conservative assumptions that I subtracting the debt to arrive million market cap in the U.S. could walk away with a 50-60 at the equity. With that and about a billion in Canada. cent recovery with the portion method, the selection of the It's Canadian and U.S. dual- of the debt I was focused on. cap rate impacted how listed but primarily trades in The exchangeable notes were recoveries flowed through the Canada. As a Canadian-listed trading at 10-20 cents on the debt structure, which is the and domiciled entity it has a dollar at the time, suggesting a wrong way to think about it structural advantage. Canada 3x to 5x return in conservative because in a bankruptcy you has significant dedicated media scenarios. If things worked out tear apart the corporate funds and tax incentives for reasonably well, it was very structure and you really build production and creation of easy to envision a recovery to the value from the bottom up. content within its borders. It's par, which would be 5x to10x You don’t think about very important culturally for return, which is what consolidated profitability Canadians to remain leaders in happened and happened very unless it's deemed that that's producing video content and quickly. necessary. That was one risk it's a real niche they've carved to try and evaluate because out. For players like DHX, I felt even if you liquidated the this was different businesses these subsidies allow them to company under very, very that had been pieced together. produce new content while conservative cap rates in the I felt like it was highly unlikely taking less risk than they would low teens, you could walk they would do that unless it outside of Canada. Often they away with a multi-bagger was to the benefit of the entire can have 75-100% of content outcome. I was using low teen entity, which likely implied a cost covered from government cap rates even though pretty robust recovery. funding or some private historically they had never dedicated media funds, which gone that high. What G&D: You've had a long bias allows DHX to put less capital ultimately happened was towards media and content at risk when starting a project. shortly into the bankruptcy over the years. Are there any process, liquidity began to businesses that are ownable in They've also been very smart improve for commercial real your mind given the hard-to- in that they've focused on estate. Then Simon and answer questions around cord doing only one thing and trying Brookfield got into a bidding cutting and changes in the to do that one thing very well, war for the asset, and industry landscape? and that’s producing content Brookfield ultimately for children. If you study the (Continued on page 43) Page 43 Jon Salinas

world and the way things are Also, interestingly, they the revenue. They own their changing, as we move from pursued vertical integration in own production studio in linear television to an over-the Canada. They cheaply Canada so they produce all -top format for video purchased the Family Channel their own events and they also distribution, kids’ content is which is the number one kids do third party production very much subjected to and family-oriented linear which helps them utilize their disruption because kids prefer television channel in Canada. capacity better. on demand viewing. Children Historically it had been the like repetitive viewing, and in Canada. G&D: It sounds like you like they don't really care about They actually let the contract the business units. What the freshness of content so with Disney expire and they makes it especially interesting you could potentially pushed their own library to you today? repurpose older content. This content while also licensing would be very disruptive for content from Hit JS: John Malone has been very legacy players with scale Entertainment, which is owned vocal about the importance of economics like Nickelodeon, by Mattel and DreamWorks. content to serve as a Disney, and others. differentiating factor for distributors on a go-forward DHX has been a low cost “From my perspective, basis. He’s demonstrated this disrupter. They built up a very thesis with his movement to cheap library of kids’ content. the DHX Media thesis invest in Lions Gate. From my They figured out early on what perspective, the DHX Media translated well in an over-the- is very similar to the thesis is very similar to the top video environment. They Lions Gate thesis but may can license this content to Lions Gate thesis, but represent a better way to Netflix, Hulu, Amazon, and express the theme. others very cheaply and may represent a better generate attractive returns on way to express the With DHX, you avoid the the library content that they concentration and cliff risk of acquired, which is very theme.” the Hunger Games franchise. disruptive for other players. You have a clean business Content in their library model focused only on kids’ includes Caillou, Yo Gabba!, content, which is incredibly Teletubbies, and Degrassi. So essentially they rebuilt this important in an over-the-top They have no real ties to the linear television channel in a world. Most of our diligence traditional linear television cheap way, passed on some of suggests that 30% of SVOD ecosystem. Most of the the cost savings to distributors viewing is kids’ content, if not distribution is monetized over- to keep DHX in a really strong more. Any SVOD operator the-top, positioning them really position, and they get an that I’ve talked to continually well for how the industry additional benefit in that they highlights the importance of landscape is changing. They're can monetize new content that kids’ content. I also think there growing that business line they produce first via Canadian is greater optionality on a organically at approximately 20 linear television before takeout. If you think about this -30%. distributing it over-the-top in business, it is so small relative other regions. to the value it can offer to a They're also a very large player distributor, we think it is the in Advertising Video On They also have a type of thing that can easily be Demand (AVOD), which merchandising and licensing purchased at some point. universally is primarily business. Merchandising and YouTube. About 10% of their licensing is a great business. Lions Gate tends to trade at distribution revenue actually They basically take the kids 2x the valuation multiple of comes from YouTube which is content and partner with a toy DHX Media despite DHX one of the larger distributor and toy having higher organic growth. concentrations of any player manufacturer. When toys are We think high organic growth that I know. sold, they receive a share of can persist as well. DHX just (Continued on page 44) Page 44 Jon Salinas

signed a deal with signs are very positive. It's G&D: You mentioned a DreamWorks to co-produce taken about two-thirds share concentrated portfolio, and 130 new episodes of kids- of the 0-3 age demographic on this seems like a very oriented animation over the CBeebies, which is BBC kids, compelling idea. How big next five years. They’ve and it's taken about a one-third would something like this be? partnered with all the main share of the 3-6 age SVOD players globally without demographic. It's going to JS: Our larger positions tend having too much revenue launch in Canada in January to be about 10-15% of capital. concentration to any single and then in the US. This is one of our larger SVOD player. positions so it is in that range. At its peak in the late ’90s On our numbers, it trades at Teletubbies had the largest G&D: Could you tell us about 10-12x earnings on a 12 month annual sales of all kids-oriented how you think about portfolio forward basis and a high single merchandise. It sold almost $2 construction? Do you have digit multiple of EBITDA. We billion in retail merchandise in exposure targets? How do you tend to focus on EPS or cash the late ’90s in a single year, think about shorting? EPS, so I think it's really not over a multi-year period. If attractive to own this business you adjust that for today's JS: We try to do exactly that. at a high single digit to low dollars and you assume even a Our net exposure tends to be teens yield when it's growing fraction of that success, it will between 40-60% and that organically 15-20% with a ton be very significant. DHX on a flows from the bottom up. We of optionality on a takeout or standalone basis in Canadian cap our largest shorts at about Teletubbies growth. dollars is a 100-120 million 3-4% of capital. We focus on a CAD EBITDA company. It's few different buckets on the It’s underfollowed as it is only very easy to envision a short side. covered by Credit Suisse and a scenario where Teletubbies few Canadian banks. I think it's can increase EBITDA by 25%- We look for really challenged really interesting. 100%. businesses where there may be really negative competitive G&D: Can you describe the G&D: Do you have thoughts dynamics. Competition short is option value on Teletubbies? on management? the typical name for that framework. It's the classic JS: DHX purchased JS: Michael Donovan and Steve Greenwald-style analysis Teletubbies very cheaply and DeNure are the two founders. where the company may have they've just relaunched it. They are chairman and COO, a first mover advantage that is Teletubbies is preschool respectively, and they unsustainable and the research content with no real spoken effectively run the company. process involves understanding words, so it translates really They've both been involved in how new competitors are well internationally. This is a kids’ content, and content going to attack the business, benefit I learned about with production overall, for many undercut pricing, and capture Discovery. When content can years. They basically were in a market share. Reduced be easily re-dubbed and strong position a few years ago profitability is a key focus area distributed globally, you can to slowly build the company, for us. Also, we focus on earn really high returns on and build the company for frauds, fads, or businesses that content investment. today's environment, so they we think are overearning and Teletubbies is even distributed have no legacy economics unsustainable. Separately we in China, which is pretty big they’ve needed to sustain. look for credit bubbles—for because China is pretty businesses that have restrictive in terms of Western DHX has been a pretty smart experienced some type of content that they're willing to acquirer of content. They've enormous debt-driven growth distribute domestically. In purchased library content where leverage will be reduced November, DHX partnered typically at about 5x EBITDA or impaired in some ways. In with the BBC to re-launch the and they've historically traded these situations, you can have series. BBC was the original at a multiple that is twice as a real asymmetric downside in producer and distributor. Early high, creating value. the equity. (Continued on page 45) Page 45 Jon Salinas

G&D: You mentioned earlier Martha Stewart can be thought Also, it was under the radar that you also invest in of as a combination of a good with a sub $200 million market derivatives. Can you share how business and a bad business. It cap, almost $50 million of cash you think about using has a publishing business with and no debt at the time, which derivatives? premier titles like Martha was also interesting. The Stewart Living, which is one of licensing business did almost JS: On the long side, options the preeminent female $40 million in EBITDA and can be an interesting way to publications, and Martha most of that was offset by use non-recourse leverage to Stewart Weddings. The publishing and corporate protect capital at risk but publishing business is overhead. We felt if you could augment returns. It's basically challenging because it is facing just move publishing to break non-recourse leverage that macro headwinds. In addition even you could unlock $20-25 you can use. On the short side, to publishing, MSO owned a million in operating profit from we focus on terminal shorts— licensing business which is the licensing business for a businesses that we think could incredibly strong and highly business that had about $150 be worth zero. In the later profitable. I am attracted to million enterprise value at the stages of a terminal short, licensing businesses because time. volatility and squeeze risk they are high margin, capital become quite high, so we may light, and tend to be strong Martha Stewart branded use puts to protect our capital consumer businesses overall. products are the number one at risk while still being able to selling item in Macy's for their participate in the downside if Corporate overhead was high wedding registries, and Macy’s there is a terminal outcome. because it was a founder- has the largest wedding The last thing we use options owned company. Martha registry business in the US. for is to hedge volatility or Stewart had gone through a Martha Stewart historically has squeeze risk in some of our number of CEOs over a very been one of their top selling later stage terminal shorts. In short period of time but failed products. MSO has a number these positions, we may short to effectuate a turnaround. of other licensing deals: a deal the equity and buy a small Then in late 2013, a for Martha Stewart Pet amount of short duration call restructuring executive, Dan Products with PetSmart, a deal options that protect us from Dienst, was brought in. He had with JC Penney, a deal with upside risk. This lets us previously restructured a scrap Home Depot for Martha augment positions at higher metal business. We thought Stewart Furniture, and there's prices and use squeezes to our the fact that Martha Stewart now Martha Stewart Office advantage. had brought in a scrap metal Products licensed with Staples. restructuring advisor to run We thought there were G&D: Any other ideas you'd her business was a really opportunities to expand like to talk about, long or interesting development and licensing. Interestingly there short? that she was serious about the are no food products, so turnaround. there’s an opportunity to JS: An interesting special develop Martha Stewart brand situation right now is Martha Stewart owned 25% of food items. International was Sequential Brands Group the business and a little more also a whole new opportunity (SQBG). We came to SQBG than 50% of the voting control. as nothing was being done through our special situation There was a founder share internationally. investment in Martha Stewart class with super voting rights. Living Omnimedia (MSO), as In our view we thought it was The first move to trim SQBG recently closed on MSO really interesting because we corporate overhead and a few weeks ago. MSO was a assumed she likely wanted to reduce losses in the publishing classic special situation where turn around the business, business was successful. They consolidated profitability did improve profitability, and cut a deal with Meredith not appropriately reflect the ultimately sell the business. She Corporation where Meredith true economic value. is in her early 70s so we effectively took over the thought it was reasonable to publishing business and then think about a sale as a catalyst. turned it into a revenue share (Continued on page 46) Page 46 Jon Salinas

agreement. This reduced most remain the chief creative G&D: Do you have any advice of the losses associated with officer for the business. We for students looking to get into publishing and started to think since Martha Stewart had the industry? unlock the profitability of really no research coverage licensing and merchandising. and no following, that it's very JS: I think it's a great industry, Then what ultimately happened under the radar. People don't but a challenging industry, and I was there was a bidding war realize how profitable that think you have to really enjoy for the asset and SQBG won licensing business was, how the job of analyzing businesses the bidding war and just closed powerful the international and thinking about what makes the transactions a couple of opportunity can be, and all of a great business and a bad weeks ago. that will unfold within SQGB. business. If you enjoy doing that, then I think it will be a SQGB is run by Bill Sweedler, really great career. My advice who has been involved in would be to spend as much licensing businesses for many “I think [investment time as you can studying years. Bill Sweedler originally management] is a different types of businesses, sold Joe Boxer to Iconix and analyzing different ideas, and has been involved in a bunch of great industry, but a doing different case studies. other brands. At SQGB, they You should be trying to own a portfolio of licenses: challenging industry, understand why certain longs Avia; And 1; Ellen Tracy, which or shorts have worked well as is pretty prominent female and I think you have well as understanding how brand; Jessica Simpson’s great management teams have business; and William Rast, to really enjoy the job acted and created value over which they bought from Justin of analyzing businesses time. Pay attention to Timberlake. Greenwald’s teachings on what and thinking about are the characteristics of a They're one of the largest great businesses. Seek out as distributors for Walmart. what makes a great many mentors as possible, try What’s interesting to and learn as much as you can understand is their athletics business and a bad from other investors and from business in Walmart with Avia people who are willing to just and And 1. Most street- business.” spend some time chatting with oriented shoe companies students. That's my advice. won't sell in Walmart because On our math, it's very they don't want to cannibalize conservative to estimate, on G&D: Great, and take your pricing in other channels. This pro forma basis, that SQBG class, right? puts Avia and And 1 in an could earn $0.80-$1 per share. enviable position because they The stock trades under $8, so JS: Yes, definitely. Take my have brand cachet but can sell you can buy SQBG at 8-10x class, and spend some time on lower priced products that earnings with upside short selling. they replicate from more optionality from a pretty expensive sneaker providers durable licensing business. It G&D: This has been really like NIKE, Reebok, and Adidas. has about 4x net leverage, but great. Thank you. will de-lever quite quickly. It's They can be a low cost Carlyle and Blackstone-backed provider within Walmart. so they have real investor Obviously, this gives them a backing. SQBG has a $500 huge base to sell and distribute million dollar market cap and to. They'll partner with a $1 billion enterprise value, so manufacturer and collect a they have little bit more licensing fee. With the Martha research coverage, but it is still Stewart acquisition, they will an underfollowed situation. have a whole new homes and lifestyle vertical. She's going to Page 47

Dexcom, Inc. (NYSE: DXCM) - Short 2015 Darden at Virginia Investing Competition - First Prize

Marc Grow, CFA Benjamin Ostrow Evan Zehnal [email protected] [email protected] [email protected]

Executive Summary  Wall Street darling with misunderstood competitive dynamics provides skewed 4.1x upside to downside ratio Marc Grow ’17  Primary research supports thesis that perceived patient benefit is higher than actual  Overestimation of total addressable market Marc is a first-year MBA  Insiders have been selling the entire way up – last purchase was in Q1 2013 around $15 per share student in Columbia Busi- ness School. Prior to CBS,  Short interest of 2.5% with 50bps cost of borrow Marc worked as the CFO of a after spending two years as an equity analyst at a value- oriented hedge fund. He holds a BA in Accounting from Whitworth Universi- ty.

Benjamin Ostrow ’17 Benjamin is a first-year MBA student at Columbia Business School. Prior to CBS, Ben worked as an Investment Thesis Investment Analyst at Dexcom is a short today for three reasons. The market is underestimating the competitive dynamics within the industry Stadium Capital Manage- along with overestimating the patient benefit associated with using the product. These aggressive assumptions have translat- ment for four years. He ed into the perception that CGM devices will have widespread adoption among the entire diabetes population, which dra- holds a BS in Commerce matically overvalues the TAM for this product. This combination has materialized into an extremely aggressive valuation. from the University of Competition is moving towards an integrated device and longer life sensors, which means market share and pricing pressure Virginia McIntire School of for pure-play CGM provider Dexcom. Commerce. Company Overview Dexcom designs and develops continuous glucose monitoring systems for patients with diabetes. Currently 29m people in the US are affected by diabetes but CGMs are primarily used for patients with Type 1 or Juvenile Diabetes, which only represents approximately 5% of the diabetic population. CGM systems are made up of three Evan Zehnal ’17 components: sensors, transmitters, Evan is a current first year and a display device. The sensor is student at Columbia Busi- inserted into the skin and remits ness School. Prior to CBS, glucose data back to the display Evan worked within the device. Patients use this data along opportunistic credit invest- with data from finger pricks in ment team at Canada Pen- order to dose their insulin therapy. sion Plan Investment Board This is a razor/razorblade model as and in investment banking the hardware lasts for years but at TD. Evan graduated the sensors have an FDA approved life of 7 days. Each sensor costs approximately $70. It’s important to note that the utili- from McMaster University zation of sensors is actually much longer. Primary research suggests the average life of current sensors is actually double the with a Bachelor of Com- FDA recommendation. The sensors get smarter the longer you wear them; patient feedback indicates the most accurate merce. days were 5 through 14. Page 48

Dexcom, Inc. (DXCM) - Short (Continued from previous page)

Market View Variant View Type 2 diabetes market represents larger and Primary research suggests this is largely overdone. A very small percentage of T2 patients even faster growing opportunity monitor their glucose levels like T1. There could be some initial benefit to monitoring in early stage of T2 diagnosis but the revenue/customer profile would be a fraction of T1. Historical market share gains translates into Given Medtronic’s market share in pumps and their salesforce size, an integrated device that future market share success combines CGM & pump technology with a single insertion site is likely to become the industry standard. Revenue growth is the key value driver Q3 was the first quarter in three years where SG&A growth outpaced year-over-year revenue growth, suggesting the cost to acquire new customers is accelerating and the low-hanging fruit has been picked.

Valuation & Scenario Analysis The model was constructed with a top-down approach. The total addressable market was developed and then market share assumptions were made along with pricing in order to construct a revenue profile. The base case assumes: market adoption of CGM technology of 51%, DXCM achieves 50% of the mar- ket, and revenue/customer remains flat at $2,500. High gross margins were sustained but industry operating margins of 25% were assumed as DXCM ma- tures. A discount rate of 8% and terminal growth of 3% achieves a price target of $20.00.

Catalysts: Innovation: There is a tremendous amount of innovation in the product pipeline with regards to therapy for patients with diabetes. Specifically, Med- tronic’s integrated device that combines CGM technology along with pump therapy with a single insertion site along with companies like Senseonics that have an implantable sensor with a 90-day life spell trouble for pure-play CGM player DXCM. Revenue Miss: Management has kept their revenue targets consistently low but acceleration in SG&A spend suggests customer acquisition cost is acceler- ating. Next generation sensors coming out in 2016 also extend sensor life by 3 days; fewer sensors = less revenue/customer. The market is clearly not valuing this business on earnings or cash flow but rather market opportunity, so we see this as the key catalyst.

Risks: DXCM realizes price increases over time: It’s more likely that Dexcom could maintain current prices on sensors but sensor life continues to improve; further reducing annual spend per customer. Management commentary suggests pricing pressure over time, especially if they want to increase adoption. Greater adoption of CGM technology: Base case assumes 51% adoption which is greater than current adoption of insulin pumps. Primary research sug- gests meaningful price concessions would need to be made in order to achieve more significant adoption. DXCM gets bought out: Likely player would be a larger pump company. But Medtronic has 65% market share in pumps. DXCM has been public since 2005 so there has been plenty of opportunity for a takeout. Major competitors are developing their own technology.

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Quest Diagnostics (NYSE: DGX) - Short 2015 CSIMA Stock Pitch Challenge (Columbia Business School) - First Prize

Nielsen Fields Joanna Vu Adam Xiao [email protected] [email protected] [email protected]

Recommendation Quest Diagnostics represents an opportunity to Capitalization Other Metrics short the independent diagnostic testing lab Current Share Price $67.42 Short Interest 5.16% NielsenJoanna Fields Vu ’17 ’17 market which we believe is facing secular pres- Shares Outstanding 143.35 52-Week Low/High $60.07 / $89.00 Nielsen is a first-year MBA sure due to commoditization of service, unfavor- Market Cap $9,682 able regulation, and increased buyer bargaining student at Columbia Busi- EV/FY'15 EBITDA 8.8x power resulting in persistent pricing and volume ness School. Prior to CBS, Less: Cash $123 EV/FY'16 EBITDA 8.5x Nielsen was a Co-Portfolio pressure. Quest Diagnostics, in addition, has experienced cost inflation in it’s high labor- Plus: Debt $3,731 Price/FY'15 Earnings 14.2x Manager and Senior Ana- Enterprise Value $13,290 Price/FY'16 Earnings 13.3x lyst at Summit Global Man- intensive and fixed-cost structure, which the agement, a long biased company has failed to fully offset through it’s “Invigorate Cost Savings Program”. Quest has been disguising the revenue and hedge fund. cost pressures by making $1.5B of acquisitions, which have only served to offset the profit decline and should be considered a form of maintenance capital expenditure. After adjusting free cash flow, we believe a truer picture of free cash flow is significantly below consensus expectations and arrive at value using a DCF methodology of $35 per share, which represents ~50% downside from DGX’s current price.

Business Description Quest Diagnostics provides diagnostic testing services such as routine testing, esoteric testing, and drug testing through it’s national infrastructure of approximately 2,200 patient testing centers, 3,000 courier vehicles and 20 aircrafts that collectively make tens of thousands of stops daily. The company serves one in three adult Americans and about half of the physicians and hospitals in the United States. Consensus view is that Quest operates in a duopoly structure with competitor LabCorp, both of which have built moats of national scale in a highly fragmented industry that has seen steady consolidation of smaller independent regional labs. However this duopoly represents just 25% of the total diagnostic testing industry if hospitals are considered as part of the market. Joanna Vu ’17 Joanna Vu is a first-year Investment Thesis MBA student at Columbia 1) Pricing & Volume Pressure 2017E 2018E 2019E 2020E Business School. Prior to Visiting hospitals and via conversations with hospital Maximum PAMA Cuts 10% 10% 10% 15% CBS Joanna was an associ- staff, we found there was little differentiation independ- Out Estimated PAMA Cuts 5.0% 5.0% 5.0% 7.5% ent labs offered in routine testing. The only dimension ate at Colony American DGX Resulting Rev Decline 0.71% 0.71% 0.71% 1.07% Finance. that labs truly compete on is price. Based on our re- search, we foresee pricing, which has already been a significant headwind, as a greater issue in the future. As more baby boomers enter retirement, Medicare's bargaining power as a customer increases. The Protecting Access to Medicare Act (PAMA) takes effect in 2017 and will lower reimbursement of diagnostic tests by enforcing market-based pricing – potential- ly leading to pricing cuts of up to 10% per annum – and potentially much more after 2019.

In addition to this, non-Medicare insurers who decide which lab vendors to reimburse have been consolidating over recent years with 2015 being a banner year as the big five providers will become the big three – covering nearly 60% of the US population. We believe regional players covering the remaining popu- lation will likely continue to merge to remain competitive under the Affordable Care Act (ACA). As private insurers become larger, their bargaining power with service providers increases which limits Quest’s ability to raise prices. Adam Xiao ’17 Adam Xiao is a first-year Quest does recognize that price will continue be a headwind and in 2012 MBA student at Columbia launched a new strategy to grow esoteric test revenue which commands a Business School. Prior to higher margin. Since that time however we have seen no evidence of growth in CBS, Adam was an equity esoteric revenue. In fact, esoteric revenue decreased by 11% and increased by research associate at just 1% in 2013 and 2014 respectively. In general we believe the strategy to Dodge & Cox. grow esoteric revenue to be flawed as growth is driven by external factors out of Quest’s control such as testing equipment capabilities and the physicians’ decisions to order these uncommon tests.

In addition to pricing pressures, Quest has been and will continue to face vol- ume pressure. Just as ACA has decreased profitability for insurance providers, physicians and hospitals are experiencing the same effect. Several physicians explained to us that because of ACA they find it difficult to remain profitable independently and are joining hospitals. In addition to hospitals gaining diagnos- tic testing volume through the acquisition of private practices, hospitals are merging thereby gaining regional scale and will have enough testing volume to profitably insource testing rather than outsource to Quest.

In addition to losing volume to hospitals, Quest has lost testing volume to their biggest competitor, Labcorp. Although or- ganic growth in revenue has declined for both companies, organic growth in volume has increased for LabCorp and declined Page 50

Quest Diagnostics (DGX) - Short (Continued from previous page) for Quest, which suggests that Quest has lost vol- ume to LabCorp. Through personal interviews, physicians indicated that they prefer sending tests to LabCorp because pick up times are better, test results are provided within 24 hours, and are easier to view online.

2) Failed Cost Savings Beyond Quest experiencing downward pressure on revenue the company is also experiencing rising cost pressure. In 2012 Quest initiated a cost savings program with a target of $1.3 billion in run rate savings by 2017 and claims to have hit $700M run-rate cost savings thus far. However upon closer inspection, we find that after accounting for acquired costs, there is a cost gap of $343. The gap implies there is cost inflation and that the savings program is simply a way to keep operations at steady state. This is a classic case of the “Red Queen” syndrome as Quest has to run as fast as they can to stay where they are. To run faster, Quest continues to acquire and invest in a troubled diagnostic industry, an industry that LabCorp is diversifying away from with the $5.6b acquisition of Covance, a company which operates as a contract research organiza- tion.

3) Overstated Free Cash Flow Over the past 5 years Quest has spent over $1.5b in net acquisitions (including sales of nearly $800m), how- ever both sales and NOPAT have changed very little over that timeframe. We believe acquisitions have been used to fill the hole created by a declining core routine testing business. Capital IQ’s stated unlevered FCF fails to exclude $250m in stock based compensation expense, which we consider a real expense, and over $400m in restructuring and acquisition integration charges, items we also consider to be ongoing as Quest will continually have to restructure operations to offset ongoing cost inflation and acquire new volumes through lab acquisitions to offset price and volume declines in its core business.

This is an important point regarding Quest’s need to pursue acquisitions. Quest buys smaller regional labs for the book of lab testing business, not the fixed assets. The majority of the purchase price, some 85%, is booked as either goodwill or intangible assets and therefore rarely hits the income statement as D&A. These maintenance acquisitions can be thought of as customer acquisition costs incurred in order to main- tain current levels of revenue and NOPAT. These costs are essentially capitalized on the balance sheet but never depreciated over time — we make the correction of subtracting the acquisition costs from free cash flow. These acquisitions come with diminishing levels of potency which is evidenced by the declining return on net operating assets over the period, falling from nearly 12% to ~8.5%, driven by a growing asset base yet a stagnant level of NOPAT.

Valuation Present Value of Cash Flows 2016E 2017E 2018E 2019E 2020E We believe the appropriate methodology to value Quest is Unlevered Free Cash Flow $682 $722 $779 $681 $588 by discounting our adjusted free cash flows. Our base case Discount Rate 8.25% 8.25% 8.25% 8.25% 8.25% valuation of $35 assumes flat revenue over the ensuing five year period driven by half the allowable PAMA cuts to Discount Factor 1.08 1.17 1.27 1.37 1.48 Medicare and Medicaid reimbursement rates. We do not PV of Future Unlevered Free Cash Flow $631 $617 $615 $497 $5,920 model pricing pressure from private health insurers despite evidence that suggests otherwise. We believe we are being Enterprise Value $8,281 conservative in these estimations. We estimate lost volume similar to the prior five year period in which Quest faced Less: Net Debt ($3,170) similar pricing pressure that was offset by acquisitions to Market Value $5,110 Terminal Growth Rate 1.00% keep revenue flat over the period. We assume that similar Shares Outstanding 144 Enterprise WACC 8.25% cost inflation of 1.4% experienced in the prior five years is Intrinsic Value Effective Terminal Multiple 13.79x more than offset by savings from Quest’s Invigorate pro- $36 gram which peak in 2018. At a nearly a 14x unlevered FCF multiple, which incorporates an 8.25% WACC and 1% terminal growth rate, and is in line with the average multiple Terminal Growth Rate DGX traded at over the prior 5 year period, we arrive at a value of $35 per share. 31 0.00% 0.50% 1.00% 1.50% 2.00% 9.50% $24 $26 $28 $30 $32 Key Risks Risks to our valuation & thesis are PAMA cuts being less significant than outlined driven 8.88% $27 $29 $31 $34 $37 by hospital inclusion into sample pricing. Quest follows LabCorp by diversifying away WACC 8.25% $31 $33 $36 $39 $42 from its declining core diagnostics business. Hospitals sell their lab business to Quest or 7.63% $35 $38 $41 $45 $49 LabCorp in order to focus on their core business of patient care. Quest is purchased by $40 $43 $47 $52 $57 private equity, or less likely, a strategic purchaser. In fact it was rumored this summer 7.00% that Quest had received an offer, however nothing materialized. Page 51

XPO Logistics (NYSE: XPO) - Long 2015 Alpha Challenge @ UNC Kenan-Flagler - Second Place

Justin Hong Zachary Rieger Cristóbal Silva [email protected] [email protected] [email protected]

Recommendation Key Trading Statistics XPO is strong BUY with a target price of $48 per share (~115% upside). XPO has a phenomenal CEO (Bradly Jacobs), a performance-driven culture, sticky relationship Share Price (01/11/2016) $22.58 with customers, growth opportunities (organic and inorganically), a cash generative 52W High $50.96 Justin Hong ’17 core business overlooked by the market and attractive valuations (10.9% and 15.7% 52W Low $21.33 Justin is a first-year MBA FCFE yield 2017 and 2018 respectively). Avg. 3-Mo Daily Volume ($MM) $29.92 student at Columbia Busi- ness School. Prior to CBS, Business Description Short Interest (% of DSO) 24.2% Justin worked in the High XPO Logistics (“XPO” or “the Company”) is a top ten global provider of supply Shares Out (MM) 132.91 Yield Bonds group at chain solutions. XPO enables customers to operate their supply chain more effi- Market Cap ($MM) $3,001 Oaktree Capital Manage- ciently and at lower cost. Net debt 2015E ($MM) $5,800 ment. This summer he will Adj. Min. Interest ($MM) $836 be interning at Carlson Bradley Jacobs consolidation the fragmented logistics market started in 2011, with Capital. the purchase of Express-1, a express carrier that operated an asset-light model with EV ($MM) $9,637 almost $200 million in revenue. Today, XPO has more than $15 billion of revenue Revenue 2016E ($MM) $15,758 and $1.1 billion of pro forma 2015E EBITDA. Its integrated network includes appro- Adj. EBITDA 2016E ($MM) $1,198 ximately 84,000 employees at 1,469 locations in 32 countries serving over 50,000 EV/EBITDA 2016 8.04x customers.

XPO Logistics

Freight (27.0%) Transportation (36.5%) Contract Logistics (36.5%) Asset-heavy (Acquired from Con-way) Asset-light (Freight brokerage) Non-Asset (New Breed, Norbert and Menlo) (%) % Consolidated Revenue 2015E Pro forma Zachary Rieger ’17 Investment Thesis Zach is a first-year MBA 1) CEO with a phenomenal track record of consolidating industries, management team with substantial indus- student at Columbia Busi- try experience, incredible alignment of incentives with shareholders, and significant insider ownership ness School. Prior to CBS, Jacobs founded and led four highly successful companies, including two public corporations that he grew through successfully Zach worked in private consolidating historically fragmented industries: equity at PineBridge Invest- i.) United Rentals (1997 – 2007): Built world´s largest equipment rental company. United Rental stock outperformed S&P ments after spending two 500 by 2.2x during his tenure. years in BAML’s technology ii.) United Waste Systems (1992 – 1997): Created 5th largest solid waste business in North America. United Waste investment banking group. stock outperformed S&P 500 by 5.6x from 1992 to 1997. He holds a BA from the iii.) Hamilton Resources (1984 – 1988): Grew global oil trading company to $1 billion. University of Pennsylvania. iv.) Amerex Oil Associates (1979 – 1983): Built one of the world´s largest oil brokerage firms.

Management compensation includes elements that are heavily weighted to variable compensation. The performance-based equity grants to XPO NEOs are subject to the achievement of two performance goals: i.) Stock price must trade at or above $60 for 20 consecutive trading days prior to April 2, 2018. ii.) The company´s fiscal year 2017 adjusted cash earnings per share being at least $2.50.

Jacobs and the rest of the management team own 14.5% and 1.5% of XPO, respectively.

2) XPO is uniquely leveraged to powerful secular trends in the 3PL industry. XPO’s scalable technology plat- form and management’s history of successful integration make it an ideal consolidator of an industry that is highly fragmented There are more than 12,000 3PL providers. Many are smaller local providers that mostly offer one unsophisticated service, Cristóbal Silva ’17 truckload brokerage. Through 17 acquisitions, XPO is now a true one-stop 3PL shop. The company multimodal capabilities help solve shippers’ increasingly complicated supply chain problems interacting with just one counterparty. This generates Cristóbal is a first-year sticky relationships with customers as they share strategic data with XPO and XPO co-locates workers and assets at customer MBA student at Columbia sites (retention over 90%). Business School. Prior to CBS, Cristóbal worked in The infrastructure that XPO put in place in 2011, 2012, 2013, building the company like a tank in the back-office, is what sepa- Bancard (family office of rates XPO from roll-ups that have failed. XPO overinvested in its technology platform upfront with the vision and capability of Mr. Sebastián Piñera) co- taking on future acquisitions and quickly integrating them without disruptions. In fact, customer satisfaction has improved after managing a $1B portfolio of acquisitions. equities, fixed income securities (High Yield and 3) Two transformative deals in the past six month have raised concerns in the investment community around Distress) and derivatives Mr. Jacobs´ strategic view and XPO´s leverage. This triggered the sell-off, which we believe is a buy opportuni- invested in Latin America. ty. On April, 2015 XPO announced the acquisition of European Logistics Provider Norbert Dentressangle. The price paid (including debt) was $3,530 million (EV/EBITDA pre-synergies of 9.1x). The market reaction was “Jacobs went too far too Page 52

XPO Logistics (XPO) - Long (Continued from previous page) quickly. It would be difficult to increase profitability”. In our opinion, the deal made economic and strategic sense. XPO became the leading transatlantic logistic provider. Cross-selling opportunities raised immediately (XPO signed a contract with Zara to execute their e-fulfillment in North America within 22 days after closing). Within the first 6 month, XPO applied its proprietary technology platform, changed the compensation plan and shut-down unprofitable business. Results speak for themselves, European transportation and logistics EBITDA increased by 26% and 17% respectively in the 3Q 2015.

Then, on September, XPO announced the acquisition of Con-way for $3 billion. When the acquisition was announced, the reaction of the street was: “This acquisition does not make sense. This is a departure from asset-light strategy”. We believe the acquisition is a response to what is changing in the industry: i.) Shippers are increasingly looking to 3PL not only to help them design supply chain solutions but also to execute. ii.) Increased complexity in execution with the need for same-day and next-day delivery. iii.) Tight LTL capacity due to regulatory constraints and to spill over demand from tight Parcel capacity.

Regarding cost savings, our primary research confirms Con-way was not run efficiently. As a matter of fact, Con-way consistently obtained EBITDA mar- gin below its competitors (by 200-400bps) in the last three years. We estimate XPO will achieve $200 million on cost saving within the next 24 month (management range is $170 - $210 million). Incorporating this, the effective multiple paid was 4.2x EBITDA which is below the 6x peers market multiple.

4) One-time costs associated with acquisitions mask a profitable and attractive core business In fact, organic revenue growth has stabilized at 10%. Post integration, free cash flow conversion approaches to 70% and return on invested capital (ROIC) to 16%.

XPO is now entering an “integration phase” in which organic revenue growth will translate into free cash flow generation and ROIC expansion. This wIll trigger a multiple re-rating and serve as a catalyst for the stock price.

Valuation Valuation Method Base Case No Margin Expansion Bear Case Our $48 target price is based on the average of a DCF (WACC 10% and Exit DCF $52.44 $29.48 $23.70 multiple of 8.0x in 2022) and sum-of-the parts exercise (XPO´s EBITDA 2017 Sum-of-the-parts $45.32 $32.72 $23.92 for each business line @ listed peers´ EV to fwd EBITDA multiple). Price Target $48.88 $31.10 $23.81 Upside 116.5% 37.7% 5.4% Our projections assume negative 5% and 0% revenue growth for Con-way in Multiples (@ Market Price $22.58) 2016 and 2017 respectively (economy is cooling down and new management EV to EBITDA 2016 8.04x 8.51x 8.51x EV to EBITDA 2017 6.82x 7.95x 7.95x would shut down unprofitable business). We also assume an one-time ex- EV to EBITDA 2018 5.67x 6.93x 6.93x pense of $150 million in cash on 2016 related to Con-way integration. Multiples (@ Price Target) EV to EBITDA 2016 10.96x 9.51x 8.66x The company´s low-base scenario is 200 bps EBITDA margin expansion over EV to EBITDA 2017 9.29x 8.89x 8.09x the next three years. Although XPO has delivered on every financial target it EV to EBITDA 2018 7.73x 7.74x 7.04x has set for itself, the market is not giving credit for this new target. 3PL Providers LTL Carriers TL Carriers Peers EV to fwd EBITDA multiple 10.72x 5.85x 5.77x Based on XPO’s core business quality and meaningful growth opportunities, Weighted Average Multiple* 9.78x We believe XPO should trade at least in line with its peers (9.8x EV to fwd Note: EBITDA 2016 does not include one-time expense of $150 million related to the integration of EBITDA). At market price, XPO trades at 10.9% and 15.7% FCFE yield 2017 Con-Way. However, this expense is considered in the valuation. and 2018 respectively, which in our opinion is a compelling valuation for a *Weighted by segment EBITDA contribution to XPO´s total EBITDA company with double digit EBITDA growth (19% CAGR 2016-2018).

Our bear case valuation (it assumes no margin expansion and 10% discount on peers multiple for the sum-of-the-parts valuation method and 10% discount on exit multiple for DCF valuation method) is $23.85/share (~5.4% upside). This represents an attractive margin of safety in case the turnaround of Con- way turns out more challenging than expected.

Key risk to thesis and mitigants (-) XPO is running at 5.0x net debt to EBITDA 2015E and the Company just added cyclicality to its results with Con-way´s acquisition when the economic outlook is deteriorating. Mitigant: Asset-light business accounts for 77% of free cash flow. Highly cash-generative business allows deleverage to 3.8x in two years. Debt has no hard-covenants. In the case of a recession, margin in freight brokerage and contract logistics increases (evidenced in 2009) and capex at the LTL business can be cut to almost zero (2009).

(-) A shortage in available drivers could limit XPO Freight´s to fully utilize the company´s fleet and pressure margins through wage increases. Mitigant: Real driver´s problem is in the truckload business, not in LTL. TL driver turnover is 95% versus 12% in LTL. Annual driver compensation in the LTL industry is $64,000 versus $50,000 in TL. In addition, Con-way´s LTL drivers turnover is 7.5%, way below industry average (12%).

(-) Startups aim to leverage drivers´ smartphones to quickly connect them with nearby companies looking to ship goods. If successful, it would disinterme- diate third-party brokers (CH Robinson, XPO, ECHO Logistics, etc). Mitigant: XPO spent $115 million and $400 million in technology in 2014 and 2015E, respectively. Our primary research confirms XPO´s superior IT capabilities. “Mario Harik, the CIO, is a terribly talented guy. He is literality a genius IQ” – Former XPO employee. “We are likely to be the disrupter rather than the disrupted” – Bradley Jacobs

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

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

Scott DeBenedett ’16

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

Anthony Philipp ’16

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