Value Investing

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First, a section on allocation Notes from the Yale Endowment Report for Fiscal Year 2010 With an investment horizon measured in decades, if not centuries, a commitment to equities generates the long-term returns necessary to provide significant to support current scholars, while maintaining purchasing power for future generations. In addition, the universities our ability to inflation further directs the endowment away from fixed income and toward equity instruments. The big theme in both the endowment allocations and manager selection is the exploitation of market inefficiencies through active management. Yale had an overall 10 year return of 8.9% Pvt. equity: real estate: absolute return: timber oil and gas 6.2% 6.9% 11.1% 12.1% 24.7%

yield portfolio is structured using a combination of academic theory and informs market judgment. The theoretical framework relies on meeting-variance analysis, using statistical techniques to combine spec returns, variances, and cold variances of investment assets. However, the definition of an asset class is quite subjective, requiring precise distinctions were nonexistent. Also, quantitative measures have difficulty incorporating factors such as market liquidity for the influence of significant, low-probability events.

Target allocation Pvt. equity: real assets: absolute return: fixed income domestic equity foreign equity cash 33% 28% (includes real estate, timber, and oil and gas) 19% 4% 7% 9% 0%

the calculation was performed for Yale's spending disruption risk-defined as the likelihood of a real reduction of 10% and spending from the endowment over any five-year period-is 28% for this target portfolio. Impairment risk-defined as the likelihood of losing half of purchasing power over fifty-year horizon is 17%. (They think is much higher for other universities. The absolute return portfolio is broadly categorized as event-driven or value-driven. "Event driven strategies generally involve hedged investments is priced securities and depend on specific corporate events, such as mergers or bankruptcy settlements, to achieve targeted returns. Value-driven strategies also entail hedged investments in Ms. priced securities, but rely on changing company fundamentals increasing market awareness to drive prices toward fair value." Note: it's very curious use of the word hedged “here”; these strategies are well known arbitrage and value investment strategies; only merger arbitrage could be said to be a hedged strategy. Quote from a later interview: “The negative returns in the AR portfolios, if they are properly constructed, do not have to do with exposure to the equity markets, but a lot of the strategies you might employ, like merger arbitrage and distressed security investing, will end up with widening spreads in a financial crisis. … Even though it was painful to generate a negative return, these negative returns were far less than the returns we had with our direct equity exposure.” He claims that since June 1990 the absolute return portfolio had a monthly standard deviation of a remarkably low 5.3% annualized relative to 15.4% for the Wilshire 5000. He claims that the correlation of monthly returns with the Wilshire 5000 has been only 0.16, highlighting the significant diversifying effect of the asset class. He says that these event-driven strategies are expected to generate real returns of 5.5% in value-driven strategies are expected to generate real returns of 5%, both with the risk levels of 15%.

The claim to be opportunistic with respect to this class and two very allocations in response to changes in the investment environment, cooking and for example fluctuations in bankruptcy rates of merger activity, handed valuation levels. Note that it says that you prefers to hire managers to assess the depth and scope of experience in evaluating and investing in more than one strategy. With respect to domestic equity, he says that folio is typically by us small capitalization stocks that are achieved in relation to fundamental measures such as book value, earnings, or cash flow. He states that the stocks generally outperform the market long-term although with higher volatility of returns. He believes that larger capitalization stocks tend to be better followed and more efficiently priced. They don't like fixed income, but they use it to provide a clearly reserved support folio management activities. To ensure access to clean the they invest primarily in high quality instruments backed by the full faith and credit of the US government. He says that most active managers play a cynical game, consciously exposing client assets greater than benchmark risk claiming that the rental returns represent superior performance. He goes on to say that sensible investors focus on the superior diversifying characteristics of government bonds, holding only the amount necessary to provide sufficient liquidity for portfolio management activities.

He says that the foreign portfolio-expected correlation of 0.68 to domestic equity. Of their foreign portfolio, 4% is allocated to foreign developed equities; 2.5% to emerging market equities; and 2.5% to China and India. The portfolio is benchmark against a composite of 44% developed markets (MSCI Europe, Australasia, and Far East index; 28% MSCI emerging markets Index; and 28% blend of MSCI China, MSCI China A-shares and MSCI India. Yale recognizes the value of managers who specialize regionally. A regional mandate facilitate the execution of intensive company research, creating an edge over less focused global funds. Yale's long time horizon enables foreign equity managers to invest in companies that will compound value over several years.

James Stewart’s Common Sense Formula; When the market falls 10 percent from a previous high, it's an occasion to buy, as is every subsequent 10 percent decline. When the market rises 25 percent, it's an occasion to raise cash by selling.
Joel Greenblatt

From Forbes interview, July 2011 Greenblatt: Well, in the last book I wrote, I used EBIT – earnings before interest and taxes. For our new mutual funds, we actually go figure out what the real free cash flow is. EBIT was a proxy and it worked quite well in back testing. We actually do the work ourselves and figure out what real free cash flow is. So if we have pension liabilities, or tax assets, and tax liabilities, we just really pick it apart. Reading history books shouldn’t be able to make you money. Well, here we’re just using simple factors based on what’s already happened. And we can talk about in a second why that works. But we’re looking at trailing free cash flow to the price we’re paying. The all-in price we’re paying, including all the liabilities of a company. And the other thing we use in the mutual funds is really just our definition of return on tangible capital. And if you read through all of Warren Buffett’s letters, he really focuses very keenly on how good a business it is. And one of the factors that he looks at, most importantly, is a business that can earn high returns on tangible capital. In other words, why would we get a 15% earnings yield from one company and only 5% for another? Why is the market giving us this bargain? Generally the companies, if you look backwards, that earned a 15% earnings yield – most people don’t think that’ll continue in the future. At least the next year or two won’t be as good as their most recent past.

So they’re willing to sell it to you cheap, relative to its past earnings. They think the next one year or two will be down from where it is, so they allow you to buy it at a bargain, relative to past earnings. You’re buying out of favor companies. They earn high returns on capital, you’re getting a high earnings yield, but people are worried about the next year or two – that they won’t be as good. So they discount Forbes: So you’re not buying a company that’s going broke? Greenblatt: Exactly. You get high free cash flow now. You think the next year or two might not be as good, or there’s a lot of uncertainty. So you buy them with low expectations built in. And if they do a little better – or a lot better – you have the chance for asymmetric returns on the upside You don’t lose very much on the companies where the news doesn’t get a little better than expectations, and you make a lot on the companies where it’s a little better, or a lot better. On a surprise, you can end up making a lot of money. And it’s very systematic, and those factors have actually gotten stronger because of the institutional bias now in the market.

Successful investing goes hand in hand with productive worrying. Worried that a stock you hold might fall sharply? Reduce your holdings or buy some puts. Concerned that interest rates may rise or the dollar fall? Establish an appropriate hedge. Worried that the stock you bought on a tip might be a bad idea? Sell it and move on. Worry enough during the day and you can, in fact, sleep justifiably well at night. Seth Klarman To some extent, we were prepared this time. However, you can never be prepared enough. We had a lot of macro protection in terms of credit default protection on bonds where we were just betting that credit spreads would widen. That’s been incredibly helpful. But we’ve gotten really tired of buying market puts, or anything like that, because they inevitably are expensive and expire worthless. So as an investor, you have terrible trade-offs. Do you overpay for insurance— or do you go uninsured? That’s just one of those dilemmas for which there are really no perfect answers. Seth Klarman At Baupost, we are always on the lookout for such overreactions, whether due to the disappointing earnings of a failed growth stock, a ratings downgrade of a bond, the deletion of a stock from an index or its delisting from an exchange, or the forced sale resulting from a margin call. Usually, fearful overreaction equals opportunity. Seth Klarman More from Klarman: 1. Avoid short selling 2. Avoid debt of banks if it is subject to claims of depositors

From a Klarman speech with respect to bond puts:

if rates go to double digits, we can make

anywhere from 10 to 20 times over money, and if rates go to 20 or 30 percent, we can make 50 or 100 times our outlay. The puts are one kind of disaster insurance. I think the odds are low that such high infla- tion will happen in the near future, but looking ahead five years, it becomes more likely, although certainly not a 50/50 chance. With a very limited initial outlay, I think a hedge like ours is a reason- able protection.

Undervalued stocks are of interest when several or all of the following criteria are met: if the undervaluation is substantial; if there is a catalyst to assist in the realization of that value; if the business value is stable and growing, not eroding; and if the company's management is able and properly incentivized. We may further attempt to reduce risk for the portfolio through appropriate diversification by asset class, geography and security type, through market hedges such as out-of-the-money put options, and by our willingness to hold cash when we are unable to identify compelling opportunities. If the reason is that there are uninformed or emotional sellers, we become more comfortable. Situations analytically complex, or where there are forced, mechanical or panicked sellers, nicely fit this criterion. April 28, 2000 portfolio Our current portfolio is broadly diversified with a concentration in undervalued U.S. equities, many with a partial or full catalyst for value realization; A very high percentage of our equity positions trade at single digit p/e multiples, at a healthy discount to tangible book value, or both. Cash 4.6% U.S. Public Equities 61.9% Western Europe Public Equities 9.5% Arbitrage or Spread Trades 9.3% Other Public Equities 3.4% Private Equities and Partnerships 2.0% Performing and Non-Performing Debt 5.2% Securities in Liquidation 2.9% Market Hedges and Other 1.2% Total 100.0% At some unknowable future point, the undervaluation of small capitalization stocks lacking exciting growth characteristics will become so gaping that investors will once again be attracted. Margin debt (which we do not utilize) should be considered extremely dangerous; investors should never enable Mr. Market's mood swings to result in a margin call which could necessitate forced selling. Portfolio Allocation at October 31, 2000 Cash 15.7% U.S. Public Equities 46.7% Western Europe Public Equities 8.9% Arbitrage or Spread Trades 6.0% Other Public Equities 1.1%

Private Equities and Partnerships 2.1% Performing and Non-Performing Debt 16.2% Securities in Liquidation 2.8% Market Hedges and Other 0.5% Total 100.0% Wisdom of Bill Mitchell

2011 issues May 2011

Carveout companies are usually not directly interesting to value investors, because, as promoted offerings, they are less likely to offer a window of low price. Instead, they can create short-term opportunities in the parent companies. Since the parent typically retains the majority of the newly listed unit, it captures much of the market value of a new, promoted issue. Large repurchases. The common stocks of companies fitting the following profile will tend to be attractive:       Profitable financial firm that appears to have completed its panic-era write-down purge. Markers of financial stability, such as leverage ratio, credit rating and/or other objective bank rating. Selling at or below tangible book value. Rising assets and equity. Purchasing at least 10% of shares within a year or so. Outstanding shares declining (that is past repurchases were not recycled as management stock options).

Note that Mitchell in his main recommendations tries to deliver something large and liquid so that all sides investors can participate.

In recommending Lam Research, he notes that it's operating return on employed capital is about 115%, and its capital requirements are much lower than the average operating cash flow. It trades below 7.8 times earnings, or about 18% EBIT/EV net of cash. He likes free speculations. He thinks this one is because we are able to buy a well-financed, profitable (if cyclical) business, at a price that is low both on absolute and relative terms (to other companies in the industry), in an industry that appears to be consolidating. The catalyst was a belief that the company will do significant share repurchase. As a speculation, he recommended a small bet on out of the money puts for Netflix.

March 2011

In recommending CSP, he notes that it trades at 8 times trailing earnings, has no debt and trades at 15% below tangible book value. The latter two features go a long way to help the microcap investors sleep at night. In giving a favorable update on TTT, he notes that it trades at less than seven times earnings, less than tangible book value, and holds cash exceeding its liabilities. In discussing CPF, he says that he cannot in good conscience advise readers to buy options. However, later, he says that intrepid speculators might consider long dated out of the money puts on HII. The companies that he currently owns include Northrop Grumman, IDT, Western Digital, American built right, Dell, almost family, and TTT. In recommending Western Digital, he noted that we have a large Firm with ROIC of around 50%, low debt and nearly a decade of relatively smooth EPS growth (30% CAGR), a history he describes his stellar. Also, he notes that because of the Hitachi acquisition, it it will take almost 50% market share, and is available for a price of just eight times earnings. He also notes that in a given industry only one firm may have more than 50% share, and the first one to get their becomes unusually profitable and hard to unseat. February 2011 issue He describes what he calls the heterogeneity effect of spinoffs. Spinoff perform well in part because they allow for better portfolio optimization. One can consider a holding company to be in effect an inefficient portfolio, whose underlying assets are held at a fixed ratio that may be optimal for no one. The more different the component assets are from each other, the greater the potential inefficiency. Suppose the holding company earned $.10 a share, which is the sum of $.90 profit from a cash cow company, and $.80 loss from a speculative company. The holding company might be valued at some multiple of the combined earnings of the two units, and so be priced at only a $1.50 per share (15 times aggregate earnings). When the speculative company is spun off to shareholders, the parent now turns $.90 a share, and might be priced at $13.50. Meanwhile, as long as the spinoff is sufficiently capitalized to last another few years, it's price will not go immediately to zero. He only occasionally recommends buying spinoff before it occurs, because the best bargains can come from post spinoff selling pressure. In the case of Northrup Grumman, its scale and visibility make post spin mispricing of its subsidiary less likely, and it was cheap so he was not inclined to wait. He also noted that since NOC is a relatively cheap, stable, well financed large-cap, the consequences of error, over the short holding time were limited. He noted the spinoff would be servicing 40% of the combined companies' debt with only 8% of its EBIT. This is the sort of imbalance that makes for interesting spinoff opportunity. He recommended holding both companies through the filing of their first audited financial statements as independent companies. He noted favorably that the pre-spin parent generated just over 100% operating turn on employed capital, and

that over a third of employed capital, excluding cash, was tied up in the subsidiary, so the spinoff significantly improved the quality of the parent's business. 2010 issues In January 2010, in recommending KHD before its spinoff of the royalty trust, he described it thus: "reasonably attractive, cheap business: lots of cash, less than 5% debt to equity very high return on employed capital (between 15% and infinity, depending on one's judgment of its operating cash flow), and operating yields about 12% of total capitalization. He noted that if the company's present value of its mineral royalty assets is to be believed, then it trades at almost exactly adjusted tangible book value, limiting the risk of loss. In the same issue (when there was still lots of concern about the financial crisis, but the S&P was relatively high), he thought it was disconcerting to see value investors buy hedges, noting that they are instruments with no measurable book value or direct yield, and which hedge poorly against "Armageddon", depending upon financial counterparties that might fail. He suggested that one pass through the minefield, surer than cash under some scenarios, is a stable, unencumbered, yielding asset whose yield is dominated in utility, rather than currency. The requirements are: low debt, low capital requirements, stable demand, sustainable competitive advantage. He thought the tobacco stocks fit the bill. In the same issue, he noted that Weight Watchers international could be attractive, as it was a classic asset-light, astronomical ROI business, with repeated stock repurchases (reducing outstanding shares by 26% in the past four years, and trading at just 10 times earnings. (Note, this is no longer the case.) In the same issue, he recommended Prepaid Legal Services. He noted that this is an asset-like service business, with EBIT return on capital over 450%. He also noted that it traded at less than eight times earnings, and that the price to free cash flow ratio is also under eight. EBIT yield on total capital (debt plus market value of equity) is over 20%. February 2010 issue In analyzing a a holding company with consolidated subsidiaries, he noted that in analyzing the assets of the parent, all of the debt was in the consolidated subsidiaries, with no claim on the parent or its other holdings. He noted that three quarters of the debt resided with just two units, and if we simply wrote those off, net asset value would be twice the share price. In analyzing Altria, he noted that it had an unfortunate penchant for debt (three times equity, or over 30% of assets), but covers its interest 6 to 1. It traded at 13 times earnings, and now yields about 7%. It also noted that it had shares of SAB Miller worth about $11 billion. Net of that, and deducting SAB's dividends, the tobacco company alone is priced at just over 10 times earnings. He noted that tangible book value is less than zero; reasons as usual are debt and goodwill. He noted that the balance sheet is unattractive, but default risk is very low. In describing the repurchase plan of the company, he noted that it was about 30% of shares at that days price, to take place over three years. He noted that the company is his favorite sort of situation: a secure yielding investment with a free speculation on future growth.

In discussing KHD, he noted that cement is on an industrial bullwhip (also known as the Forrester Effect), in which changes in demand are amplified back through the value chain as suppliers adjust their forecasts under conditions of uncertainty. KHD is at the tail of that with. He noted that he was neither a commodity bull nor emerging-market bull.

March, 2010 issue He uses the traditional decision rules: low PE, EBIT/EV, high return on capital, strong balance sheet (either by debt-to-book or by solid interest coverage). By researching spinoff and other special situations, he simply applies this filter to data less accessible to other quantum value approaches. He noted that a Goldman Sachs presentation in June 2009 speculated that quantum value tactics might be flagging due to "quant crowding." Examples of data that is not universally available by feed are pro forma financial statements of the spinoff; implied pro forma financials of the parent, deduced by subtracting spinoff pro forma from parent's audited statements; binary (yes or no) management signals such as usually large insider share purchase. Note that he sold PPD because of sudden unexplained departures and share sales by knowledgeable insiders in the context of open investigation by the SEC, leaving him with "unknowable exposure," and hence no alternative but to advocate selling. He noted with favor a company trading at under 12 times earnings, 12% EBIT/EV yield, and extremely high return on capital (in fact, it employed negative capital). He noted with favor a company with normalized EBIT return on employed capital (including its cash pile) of over 100%. However, he noted that there was a value trap risk: sales and dividends have fallen over the past 10 years and earnings are unstable. He noted that in a declining business, a high current return on invested capital does not automatically imply a high present value of future cash flows. As a result, if earnings are in rapid decline then repurchases even at low PE, maybe a less effective allocation of capital than dividends. April 2010 issue He avoids merger arbitrage, as the expected unlevered returns are not what they were. He does not like Biglari (BH), formerly steak and shake. In discussing his stockpicking record, he notes that the disappointments have been disproportionately in financial sector value traps. While discussing River Valley Bancorp, he notes that it trades at a 30% discount to value, but seems to have good financials. He notes these factors: falling new provisions for loan losses, earnings up, assets that continued to rise through the crash, four-star Bauer rating (a proxy for various measures of financial strength), insider buying (although on a tiny scale), almost no construction loans, and operations in small-town Indiana and Kentucky, far from smoke craters in real estate. Also, it pays a 6% dividend and trades at 12 times trailing earnings, and eight times the quarterly run rate. Discussing KHD, he notes that in project engineering businesses, revenue is lumpy; revenue is at the tail of the supply chain; and construction bubbles are widely reported in developing countries, especially China. He is reluctant to invest in KHD alone as it appears unusually exposed to market, currency and reporting risk.

In discussing Genco, he noted that it is a low-return industry, with return on the capital of about 10% May 2010 issue He notes that Seth Klarman said that he fears a second "lost decade" with little or no market returns, and that his firm is considering a return of capital. He notes that Baupost has purchased long-term out of the money Treasury bond puts, as "cheap insurance" against a sovereign shock in United States. He expresses doubts about whether this is an effective tactic, because there was no protection against currency shock if the US is to devalue its currency instead. He disclosed he is the owner of VPHM even though it trades slightly above his upper limit of 13 times earnings. (Actually, if you take out the cash, it effectively trades at a much lower multiple.) He notes that VPHM has a very high return on invested capital (excluding its large cash pile). In discussing a liquidation recommendation, he discussed the appeal of these situations, specifically relatively little loss exposure. The company had announced the distribution, with a range of predicted amounts that appeared to limit potential losses to no more than a few percent. That estimate could be defended both by its balance sheet and by management's liability exposure, which would naturally lead them to estimate low. In recommending EDCI, he said he would buy and hold through liquidation.

In recommending Terra nova, he said that its royalty interest is held at historical value, which will be adjusted to fair value after January 2011. He said that TTT might be said to offer the currency hedging of a commodity, while still delivering an earnings yield. He said that shareholders will receive rights, can oversubscribe for unclaimed rights, Inc. and trade them on the market (encouraging some holders to sell rather than exercise). He noted in the July issue that the offering circular won't be sent to shareholders until a date that left a window of less than three weeks to exercise, probably much less for the vast majority that hold shares in street name. These features exactly describe the form of rights offering long used by savvy management to increase its own shareholdings at bargain prices; this likely will be a chance to align with insiders. He recommended the exercise of all rights, oversubscription for as many as make sense, within one's position limits. Watch the market price of the right, then consider buying more. June 2010 issue In recommending Vishay, he noted that despite the fact that the company had run aggregate losses for many years, it was pouring out a five-year average free cash flow of $134 million per year. He noted that in the previous year it was $237 million, but that was mainly due to falling inventory, so he used the average, suggesting a conservative free cash yield on employed capital of 9%. In short, the company is a mature, well capitalized, no growth business with reasonable return on capital. The company traded at less than 12 times its average free cash flow, less than five times the previous years, and about 1.1 times tangible book value. The subsidiary was not cheap, currently trading at 14 times his estimate of standalone EBITDA minus capex.

In discussing whether the company could be a value trap, he said if so, it is a mild form trap in the sense that there is a stable yield (undistributed) but no growth. The strong form value trap is a company which always looks cheap on a trailing basis, but whose earnings or book value keep falling. He notes that compared to his early years he has delivered far fewer losers, which might be attributable to better discipline about price ratios and credit quality.

July 2010 The simple crucibles of low price ratio and high return on capital go a long way toward avoiding mistakes. The author purchased eBay at 9 times earnings late 2008 in part to gain a cheap entry to PayPal, and intends to hold the shares for a long time. In commenting favorably on a REIT, he noted that it treated just below tangible book value, estimated that it would yield over 8%, and noted long-term debt is about 60% equity. In recommending Dulux group, he said that as manufacturing businesses go, it is a winner: over 60% EBIT yield on employed capital. Revenue and EBIT growth have been relatively smooth and stable. It was trading at 12 times trailing earnings, and EBIT/EV is 11%. He noted that this is not only a reasonable price on an absolute basis, but also 30% below that of the other pure play paint makers. He said the company offers a feature he loves: a free speculation, in the form of merger prospects.

Recommended holding it one year, but selling if the pe ratio exceeded 20 stable earnings, or on a significant decline in credit rating. In describing the risk of the debt, he said that long-term debt/equity is about 7. What interest coverage 6 to 1, about 60% of the total must be rolled over when the company's primary revolving line terminates on April 30, 2013. He described the company as an archetypal spinoff. He said that it is a high-quality, if overly indebted, business, slow but stable growth over a long period. Until recently it has been from from an investment perspective hidden within an unrelated, pricier, in much larger business. As result, we have the happy combination of a long operating history, but usually low visibility.

August 2010 Business wish list for riding out macro uncertainty:   Low debt, so that yield is immune to shocks in the cost of capital. Low capital requirements, so the yield is immune to shocks in the price of plant and equipment.

 

Stable demand, so that yield is immune to shocks in general economic activity. Sustainable competitive advantage, so costs can be passed on to buyers, rendering yield immune to wild swings in input prices.

With these features can be had at fair prices, they make the long-term holdings that bring a good is one sleep. Firms lacking these qualities may still make sense-if cheap-but more likely as short-term holdings. In recommending LyondellBasell, he pointed to the fact that the company trades only on the pink sheets, but would be listed on the NYSE.

When the company went bankrupt, it was $24 billion in debt teetering atop $700 million EBIT. He noted that he avoids industrial commodities, but to this recommendation anyway, for its unusual combination of low price, much improved balance sheet, low visibility (no analysts, no audited financials, almost no SEC filings), lack of promotion, and for catalyst in the form of imminent increase visibility,NYSE listing and regular reporting. He noted that in the long run, commodity companies lacking a moat, tend to have nothing to offer but blood, toil, tears and sweat. As a result, he presented this as a is to short-term holding. The one exception is when not everyone the same costs of production. So scale advantage is sufficiently meaningful.

September 2010

In discussing Mass Financial, he noted favorably that long-term debt is less than 25% off tangible equity. He said he is not a fan of EBITDA, absent a coherent argument as to why depreciation and amortization should not count. Depreciation is not a precise measure of carrying cost of fixed plant, but it beats the alternative. One might use EBITDA in conjunction with an argument that equipment will somehow last far longer than his depreciation schedule. He noted a company that had shed debt, this doesn't help EBIT, which is not affected by capital structure. Discussing five-year warrants to buy a company at $58.80, he noted that the price amounted to over $18 per warrant, $3.80 out of the money. While he thinks long-term warrants can be an underappreciated kicker, that one didn't look spectacularly cheap. He describes the prerequisites for liquidation: an asset sale and a resolution to dissolve.

He said one might view a certain company as a currency hedge, as it produces a commodity with industrial applications. He says however natural diamonds are not priced purely as an industrial commodity, but are instead affected both by a distribution cartel and by luxury gemstone demand. In recommending Almost Family, he said that excluding its recently assembled cash pile, return on employed capital is on the order of 12 to 1. He noted that the company has grown faster than its rivals and more consistently, with EPS up about 50% annualized for the past nine years. He also noted that cash flow tracks closely to net income, implying the smoothness is not merely accounting legerdemain. The company was trading at nine times earnings (closer to eight times earnings excluding cash), a mature business price for a company that has grown earnings per share by a factor of 36 to 1. Growth numbers like this serve to illustrate the danger of applying discounted cash flow. We dare not extrapolate, because the present value is so sensitive any error in estimating growth rate. Then again we need not extrapolate, because AFAM is pricing in no growth at all. As always, we strongly prefer situations in which growth is a "speculative kicker", included at no extra cost. He noted that Questar (STR), the stub parent of QEP Resources, saw ex-spin revenue rise 7% in the year ended June 30, 2010, while transported gas volume increased 11% year-over-year in the quarter ended June 30. STR remains outside our price range at 17 times earnings. November 2010 He noted the recent, global trend in public floats of metals mining companies. Commodity bulls might ask themselves why so many knowledgeable insiders suddenly want to sell. Carveouts are defined as being spinoffs by public offering. He says IPO proceeds usually go mostly or entirely to the parent. It is interesting to examine how overpriced IPOs create wealth transfer from punters to parent. Benefits can be more than just cash, and are thus not necessarily reflected immediately in the share price: eliminating a business at a premium also improves the balance sheet, which improves credit rating, cuts cost of capital and, if the elimination is chosen carefully, increases return on employed capital, all at the same time. He notes one in which the parent received almost 4 dollars in cash for every dollar of book value given up. He notes that promoted issues are often expensive. He notes the wildly successful Fairholme fund (FAIRX) continues to load up on AIG. In examining a rights offering, noted the size of the offering is insufficient to pay off debt due in six months, which means the company short-term survival depends upon either a sudden turnaround or a second capital raise. He notes that EDCI going dark allowed the firm to release $1.3 million in reserves, resulting in an extra $.19 per share in liquidation.

He says that eBay remains one of his favorite hold forever stock selections in recent years. It still trades below 15 times earnings, has no debt, and enjoys over 100% return on employed capital. It is growing steadily and will achieve the transition from auction house to electronic payments company. PayPal is the only global, mass-market instant payment system (credit cards are not a direct substitute because they're not instant, not peer-to-peer, cannot maintain positive balances, cannot easily clear in multiple currencies). It is difficult to construct a scenario in which 10 years from now PayPal and eBay will not both remain the runaway market leaders in their respective areas. In discussing an REIT he notes that it is not cheap, trading at a 20% premium to adjusted tangible book value (based on company estimates of its property value), and with an earnings yield under 4%.

He says to consider Sun Life healthcare (SUNH), which is now asset-light, management debt, trading at under 11x2009 EPS (under 7x pro forma numbers). In recommending real estate developer Howard Hughes Corporation, he noted that it trades at over 40% below tangible book value, and has enough cash to last four years at its current burn rate. It's the only company he's ever recommended that runs negative cash flow and is the speculative. He liked the nature of the management incentives, and very substantial insider purchases. He noted that HHC avoided "fresh start" accounting that would require marking up undervalued assets; therefore, there are possibly hidden assets. He noted the singularly opaque circumstances of a simultaneous spinoff, emergence from bankruptcy, private equity investment, and warrant issue. 2009 issues December 31, 2009 issue He speaks favorably of a stock whose shares traded nine times earnings, noting that return on employed capital is over 100%. He speaks favorably of ARO, noting that it trades at 11 times earnings, and that trailing EBIT is over 120% of employed capital. He spoke unfavorably of a company whose EBIT yield on total capitalization (debt and equity) is only 9%, and which trades at several times tangible book value. He makes an interesting distinction between plans and strategies. Strategies are better, they seek to gain lasting competitive benefit even when rivals execute well, typically by exploiting rivals' inflexibilities. Exchange offers can be signals of sorts. The example was a parent that wants to exchange subsidiary stock for parent stock at a discount: a dollar of the subsidiary for $.90 of the parent. Management actively chose an exchange over its spinoff or cash sale. Assuming that management seeks to maximize the value of the parent, the most logical explanation for the offer is that they consider a dollar of the parent far more valuable than a dollar of the subsidiary.

Finally, he recommended a company that traded at about 10 times free cash flow, or about 14.5 times net earnings. He noted that the price would not be a screaming bargain for a mature company, but the recommended company was a well capitalized firm in a fast growing market. 2008 issues In making a recommendation, he notes that tangible equity is negative, so that the common stock will tank if the company flirts with debt default. In discussing additional data he is providing, he says that he will approximate the parent company's ex-spinoff financial statements by subtracting them from the spinoff's pro forma financials. That can be useful to compare the ROIC of the two companies. This can reveal if the reason for separation was to free a high ROI business from a low one. Since the parent does not is one public ex-spin financial statements until several weeks after the breakup, this permits easier exploitation of opportunity in the parent companies in particular. It is also useful to reveal whether the spinoff was effected to deleverage one entity from the other. Historical statements are derived from the parent company's internal accounting pre-spin off, and thus will tend to underestimate the true general and administration cost load of the independent spinoff. Historical statements should, however, accurately display the growth and stability of revenue and earnings. Thomas Russo, general partner of Semper Vic partners and partner at Gardner Russo & Gardner. In speaking about buying a dollar for price of $.50, "I think you do not really care about the dollar bill very much if you're like me, since as a long-term investor what you really want to do is find a $.50 dollar bill that will grow over the years. Buying dollar bills have $.50 provides a measure of safety. Finding strong companies capable of investing grow that dollar bill for future returns. The government only gives you one break as an investor, namely non-taxation of unrealized gains, which means you want to buy and hold for a very long time. Nestlé (NSRGY) is their largest position ("almost no company is better situated"; nearly 11% of funds), followed closely by Philip Morris International, Richemont, Heineken, SAB Miller, Pernod Ricard, companies that increasingly exploit their goodwill in growing parts of the world because of the rise of consumerism. We have had the privilege of global brands to invest behind by management with the courage to make thoughtful owner-minded investments by the fact that the company's founding family are still involved to a most unusual extent. The market doesn't pay enough for the value that comes from a company that is properly managed where the family is looking out for the long term. We cannot shy away from making investments because the burdens on income statements. ( "Really the hidden value in Nestlé is the capacity to reinvest.") One of the beauties of these companies is that they can decide where to put their investments for the best returns. For example, Richemont decided it was putting no more money into Japan because of its declining growth; it's great because the company has a multinational, global franchise that can invest money where it has its highest prospective returns. If I invest in Chinese-only companies I don't think they can reach globally, and I'm focused on companies that have global reach.

I have exposed us in our business to substantial population growth in the developing and emerging markets. "Right now" 70% of his clients money is invested in Western European companies. Berkshire Hathaway is one of the largest holdings. He discusses the equity index put options that Buffett purchased at a $5.3 billion premium because almost no one else had the capital sufficient to assure that they would be able to make good money on it a $37 billion insurance policy if the world equity markets went zero. No collateral posting requirements. And Buffett has the capacity to suffer through reported profit losses. He thinks that owner-minded management are more often found abroad. He dismisses concerns about commodity costs for the euro. "The very existence of that consumer's insatiable demand is expressed in commodity cost." 30% of Nestlé's profits come from emerging markets and will increase to over 50% in the next 15 years. It has compounded almost 15% a year total return since 1987, and maybe more attractively priced today than then. He is not afraid of private label competition. He thinks that his companies can address that. He is focused on a handful of industries, food, beverage, tobacco and media. He invests in a large number of spirits companies. The most desired quality in hiring a person is the capacity to suffer. That is a really incredibly powerful theme. In order to succeed people have to feel pain. In the 1980s Gillette had years of seemingly dull performance that were really decent performance in the core business masked by the investment spending that occurred to develop their projects. It's rare that companies are willing and able to step up and make the full investment. He tells the example of Schulz at Starbucks who told a young analyst, "If you want us to dominate China, then let us not show profits for a long time." One of the things that almost all American companies had done by 2008 is they took high interest rate long-term money they took it down to overnight money . They take risks with their future, then they overstate their short-term results. North American rule of law: something that protects us and secures our business interest, is also the source of enormous entitlement and enormous amounts of money that gets spent in nonproductive ways. Likes Richemont more than LVMH because of its better treatment of outside shareholders.

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