Issue Trial Fe 2013 Vii

ValueInvestor
February 28, 2013
The Leading Authority on Value Investing
INSIGHT
William Ackman
Pershing Square Capital Management
Perkins Investment Management

Jeff Kautz (l), Tom Perkins (r)
Stephen Goddard
The London Company
Control Premium
Reward vs. Risk
Working Capital
sk Bill Ackman why an activist investment strategy suits him and he has a ready answer: Its my personality to be a fixer, he says. I send my best friends to nutritionists and to the gym. I find them dates. Applying his taste for self-improvement to companies, Ackman has earned eyepopping returns for Pershing Square Capital investors. The flagship fund at the $12 billion (assets) firm has earned a net annualized 20.4% since the beginning of 2004, vs. 4.9% for the S&P 500. In addition to commenting on high-profile current investments, he took the time in a wide-ranging recent interview to discuss his general strategy, lessons learned from mistakes, and what he expects to be doing See page 2 20 years from now.
fter long stints at Kemper Financial and Alliance Capital, there was no grand plan in Tom Perkins joining his brother Bobs investment firm in 1998. Bob had done well in small caps, wanted to extend his franchise and needed another manager, says Tom. I availed myself of the opportunity. That opportunity turned out to be golden. The mid-cap strategy Tom founded for Perkins Investment Management now manages more than $13 billion in assets and has returned a net annualized 12.9%, vs. 9.2% for the Russell MidCap Index. Perkins and co-manager Jeff Kautz are finding opportunity today in such diverse areas as barge transportation, medical equipment, construction, mortgage REITs See page 7 and credit cards.
he career adage that competence attracts work certainly applies to The London Companys Stephen Goddard. From a one-person shop started to manage a life insurance companys tiny equity portfolio, Goddards Richmond, VA-based firm now manages $5.2 billion. Its large-cap strategy has outperformed the S&P 500 by 200 basis points per year since inception in 1994, while its smallcap effort has trounced the market since 1999, earning a net annualized 15.4%, vs. 7.2% for the Russell 2000. With a strategy geared as much toward avoiding big mistakes as it is to discovering out-of favor gems, Goddard today is finding upside in areas such as fuel additives, used-car sales, specialty retail, mattresses See page 14 and cigarettes.
INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS
Cabelas CarMax Discover Financial Herbalife Jacobs Engineering Kirby
Permanently Risk-Off
In excerpts from his new annual letter, Seth Klarman offers a dim view of todays macroeconomic environment, suggests a need for antifragile thinking, describes the high bar to clear before he commits capital, and reflects on lessons PAGE 22 learned in the 30 years since The Baupost Group was founded.
PAGE
19 18 13 5 10 9 20 17 11 12
Other companies in this issue:

Advent Software, Ameriprise Financial, Beam, Bill Barrett Corp., BlackRock, Burger King, Canadian Pacific Railway, General Growth Properties, Howard Hughes Corp., J.C. Penney, Microsoft, Nu Skin Enterprises, Procter & Gamble, Tejon Ranch, Tempur-Pedic, Vodafone
Lorillard NewMarket Stryker Two Harbors Investment
www.valueinvestorinsight.com
I N V E S T O R I N S I G H T : William Ackman
Investor Insight: William Ackman

Bill Ackman of Pershing Square Capital describes the company traits he looks for in both active and passive investments, why a high public profile is an important element of his strategy, whether his thesis on J.C. Penney has evolved, what lessons hes learned from a few prominent mistakes, and why his short conviction on Herbalife is as high as ever.
Starting at a basic level, how would you characterize your investing strategy? Bill Ackman: We rely on concentrated research to identify great businesses that are trading at highly discounted valuations because investors have overreacted to negative macro or company-specific events. Thats the time-arbitrage part of the strategy, taking advantage when the market reacts to short-term factors that have little impact on long-term intrinsic values. Our greatest competitive advantage, though, comes from using our stake in a company to intervene in the decision-making, strategy, management or structure of the business. We dont like waiting for the market to be a catalyst. Why is Warren Buffett willing to pay 20% above the highest price at which H.J. Heinz stock has ever traded, even after its had 20 quarters of great results? The answer is that control is very valuable. Not just for the bragging rights, but because you can change strategy, you can redo the cost structure, you can change the tax structure, you can sell off underperforming assets or hidden assets. The control premium is really telling you that the current management team and board are not optimizing the value of the business. For a financial buyer, which is essentially what Buffett is in this case, youre buying it because its a great business and because you believe you can make the price paid end up looking cheap. Thats very similar to what we try to do: Buy high-quality businesses at a price that is not reflective of the intrinsic value of the business as it is, and certainly not reflective of what the intrinsic value would be if it were run better. That allows us to capture a double discount. Thats a benefit we can have over private equity. They can buy a company and run it better to extract incremental value, but theyre typically paying the highest price in a competitive
February 28, 2013
auction, so they dont get that first discount. We dont get full control, but because we have a track record of making money for other investors, we can often exert enough control to make an impact. With Canadian Pacific Railway [CP], we won a proxy contest and with our 14% stake were able to appoint 8 of the 14 directors and recruited one of the best railroad executives of all time, Hunter Harrison, to be CEO. That has created a lot of value. How do you define a great business? BA: We like simple, predictable, free-cashflow generative, resilient and sustainable businesses with strong profit-growth opportunities and/or scarcity value. The type of business Warren Buffett would say has a moat around it. Weve done almost nothing in energy or other cyclical businesses. We avoid healthcare because of all the regulatory uncertainty. Weve done nothing active in financial services, except on the short side with MBIA. When youre putting 8%, 12% or 15% of your money in something, its not a day trade. You have to focus first and foremost on high-quality businesses that cant blow up and should grow in value over time. Like Procter & Gamble [PG]? BA: P&G is a perfect example. Its a global leader in many of the most-attractive consumer-goods categories, which have structurally high profit margins, strong customer loyalty, and excellent growth opportunities in emerging markets, where P&G has nearly 40% of its sales. Its brands, including Pampers, Tide, Gillette and Olay, are among the strongest in the world. Despite all that, in the second quarter of last year we were able to buy into the stock at a modest multiple on dewww.valueinvestorinsight.com
pressed earnings. The company had for three years underperformed its peers on many levels, innovation had been weak, and an already-high overhead cost structure had become even more bloated. With the stock at $60, we thought there was an extremely low probability wed lose money, and that with more effective leadership P&G could return to historically attractive levels of revenue and earnings growth and the stock would respond accordingly. So, a great business, at a cheap price, with an understanding of what can be done to make it more valuable. Thats a classic Pershing Square investment. Beam [BEAM] would be another example of quality. The spirits business is highly attractive, where brand leaders have significant pricing power, strong barriers to entry, high margins, and attractive growth both domestically and internationally. Beam is now the worlds only pure-play, publicly traded global spirits company that is not family controlled or influenced, making it a very scarce asset. We think in an industry that is very likely to see significant consolidation over the next several years, they have many interesting strategic alternatives available. What about something like Burger King [BKW]? Is that a great business? BA: This is a 60-year-old brand that for much of its recent history has been managed horribly, but it still exists, which is a good indicator of a good business. Its the worlds second-largest fast-food hamburger restaurant chain, with over 12,500 restaurants in 80 countries, and has made enormous progress on several strategic initiatives since it was bought in 2010 by 3G, the same group Warren Buffett is partnering with on Heinz. Theyre refranchising substantially all company-operated units, have overhauled the menu and marketing strategy, and have accelerated a lowValue Investor Insight 2
er-cost store-renovation program. All of that is paying off in significant and ongoing growth in free cash flow. That type of turnaround is usually only possible when the core business is a good one. Is it typical for you to delegate activism, as you seem to have done in this case? BA: Were generally averse to making investments in controlled companies, but we consider 3Gs controlling ownership of Burger King to be a positive. We 100% believe in it, the strategy and the management team. Someone else can be the catalyst from time to time. Describe how you construct your portfolio with both active and passive investments? BA: We think having 8 to 12 core positions at a time provides an adequate degree of diversification, while allowing us to concentrate in a handful of ideas that we know very well and believe have highly favorable risk/reward characteristics. If our capital base were permanent, wed probably only do active investments. But it isnt, so the fact that I dont ever want to be forced to sell an active investment in the course of an engagement means we also need to hold passive positions. Historically, around 55% of our portfolio has been in active investments, 15% or so has
been in cash, and the balance has been passive. What has tended to perform better, active or passive? BA: The 55% of our capital in activist investments has produced more than 90% of our returns. One primary reason were working hard to increase the amount of permanent capital we have is to devote as much of the portfolio as possible to active positions. Doing that should enable us to earn higher returns over time. Why maintain the 15% or so average holding in cash? BA: Thats just what its been on average, the level can be much higher or lower. We dont believe in leverage, so cash serves as liquidity for potential future opportunities, the size and availability of which can vary. We earn a high enough return on capital that we can afford the dilution of cash. Maintaining a high public profile appears to be important to the execution of your strategy. Why is that? BA: The press is a necessary element of the strategy. Look at something like Procter & Gamble. We havent run a proxy contest.
We havent made a public presentation. All we did is buy some stock. That became publicly known and immediately the press was all over the company and what they were or werent doing right. That saved us a lot of time and energy. On solid, highprofile boards of companies that are underperforming, sometimes the directors just need a little bit of a push. One of the best pushes is a reputational push, which a press spotlight can administer. That spotlight can be particularly important in our shorts. We dont short on valuation, but in situations where we believe a company is violating the law, or has misleading or inaccurate accounting, or has a potential regulatory problem. In these cases the attention really matters. If youre a regulator with any sort of oversight of Herbalife [HLF], how can you ignore it when a reputable investor who has spent 18 months researching it says it is a certainty that the company is a pyramid scheme? Imagine if Im right and theyve done nothing on a company thats in the paper everyday. In taking such public positions, do you risk being so committed that youre less apt to recognize evolving flaws in your thesis? BA: One of the keys to this business is having conviction based on your work that
Pershing Square Capital Top Holdings

Company
Canadian Pacific Railway Procter & Gamble General Growth Properties Beam J.C. Penney Burger King Howard Hughes Corp.
Bill Ackmans Pershing Square Capital Management held stakes worth at least $200 million in these stocks as of the end of last year. While almost all are firing on all cylinders, the negative outlier so far is J.C. Penney, off some 50% from its 52-week high set one year ago.
Price@ 2/27/13
121.70 76.75 19.32 61.07 21.16 18.78 76.97
Ticker
CP PG GGP BEAM JCP BKW HHC
Industry
Railroads Consumer Goods Real Estate Distilled Spirits Department Stores Restaurants Real Estate
52-Week Low
68.69 59.07 15.85 52.69 15.69 12.91 55.02
High
122.22 77.77 21.25 64.00 39.78 18.82 79.64
P/E (TTM)
42.8 17.4 n/a 25.6 n/a 56.9 n/a
Valuation P/E (Est.)

16.1 17.6 16.0 20.9 70.5 20.6 n/a
EV/EBITDA
13.9 12.1 18.6 16.1 n/a 14.4 39.0
Sources: Pershing Square Capital Management SEC Form 13F filed as of 12/31/12; other publicly available information
February 28, 2013
Value Investor Insight 3
youre right and the rest of the world is wrong. If you dont have that confidence, youll never buy anything because theres always something that can go wrong. Everyone thought the idea of buying stock in General Growth Properties right before it went bankrupt in the middle of the financial crisis was the stupidest idea theyve ever heard of, and plenty of people said so. The stock was at 35 cents a share, down from $63, and we bought 25% of the company. You cant get much more contrarian than that. Theres obviously a balance to maintain between confidence and humility. You have to be humble enough to recognize when youre wrong. Im willing to look silly. With General Growth, we could have looked very silly. But even if things hadnt worked out, I still think it would have been a good investment. It was probabilistic, where we thought the upside was high enough and likely enough that we were willing to take the risk of the stock going to $0. Where are you today on the balance between confidence and humility with J.C. Penney [JCP]? BA: The complete transformation of a business can be a risky proposition. The basic strategy has been to wind down the traditional J.C. Penney business to build the company around new stores with bestin-class customer service and a unique store-within-a-store shopping experience representing top global brands. The results to-date of the new-shop strategy have been strong, while the results of the old J.C. Penney have been weak. Wall Street, not surprisingly, has reacted negatively to the overall sales decline and is ignoring the positive progress of the new J.C. Penney because its scale isnt yet material enough. The transformation isnt expected to be fully completed until 2015, which is forever relative to Wall Streets typical short-term orientation. At todays price, were sitting on about a 20% markto-market loss. [Editors Note: On the day of the interview, JCP shares closed at $19.80. The stock closed on February 28
February 28, 2013
at $17.57.] But if the new-shop sales and productivity continue at current levels, once the conversion is done we believe the company within the next five years could possibly approach $10 per share in earnings. Time will tell, but we still believe that the risk/reward here is solidly tipped in our favor. Before talking in more detail about Herbalife, explain in general why youre committed to shorting? BA: Both our shorting and activism have done a good job for us in tempering the
to Jim Chanos about Enron, or us about MBIA, or David Einhorn about Lehman Brothers, a lot of people could have saved a lot of money. What sparked your initial interest in Herbalife? BA: I got the idea from Christine Richard, who was a Bloomberg reporter before going into the independent research business focused on short ideas. She pitched me the idea in the summer of 2011 and we got really interested in December of that year when a Belgian court found Herbalife to be a pyramid scheme. After more than 18 months of research, we concluded the same thing. Since your initial Herbalife presentation in December, theres been plenty of public response, including from some high-profile investors who are long the stock. Has any of the response dented your conviction? BA: The bull case appears to be that the stock is cheap based on trailing earnings, that theyve been doing this for 32 years so why are regulators going to do anything now, and hey, even if they get shut down in the U.S., thats only 25% of the business. Thats about it. In terms of valuation, at the price we shorted at in the $50 range the stock traded at 12-13x trailing earnings. For this kind of business, thats not that cheap. It looks cheaper on consensus forward earnings, but our view is the estimates are too high. The spotlight on all the facts coming out about Herbalife make it more difficult to deceive people, which is going to make it more difficult to recruit distributors the vast majority of which are never going to make any money which is what the whole business is built on. That cant help but affect future earnings. As for the regulatory response, the risk in my opinion is whether regulators pay attention, not whether they look into it and conclude its not a pyramid scheme. We think weve already figured that out and whether its the SEC, the FTC, or some state Attorney General, were conValue Investor Insight 4
ON J.C. PENNEy: The transformation of a business can be a risky proposition. We still believe the risk/ reward is tipped in our favor.
downside. No one likes going through a crisis, but our shorts and some activist longs that moved independently of the market in 2008 kept us way ahead of the market and better able to respond to opportunities as they were created. On top of that, I think shorting is fun and interesting and plays a valuable role in the markets. Some would argue with that last point. Why is shorting valuable? BA: For one, I think it tempers volatility in both directions. Risk is created when things get overvalued and short sellers help keep that in line. Id argue that one reason housing got so overvalued is that until very late in the game everyone was on the same side of the trade, which created significant risk in the system. Short sellers also temper volatility on the downside theyre one of the earliest buyers when a stock crashes. Id also argue that the shorts who do good fundamental research play an important watchdog role. They have the resources to dig into something that a regulator might miss. Had people listened
fident they will too. Remember, they have subpoena power. I believe we can prove from public information that the company makes most of its money through sales to its own distributors. With inside information from the company, regulators can address that question directly. If the U.S. does determine this is a pyramid scheme, its unlikely the problem stays geographically contained. For one, the U.S. has a lot of influence internationally from a regulatory point of view. Also, the confidence of distributors in the companys model is critical if this is found by U.S. authorities to be a pyramid scheme,
INVESTMENT SNAPSHOT
every Herbalife distributor around the world is going to know. Can the company just change its policies? BA: We do not believe there is true retail demand for Herbalife products at the prices it needs to sell them in order for this not to be a pyramid scheme. These are not unique products you cant find anywhere else, theyre things like diet shakes and vitamins that are probably comparable to the competition, but have suggested retail prices, when you include shipping and handling and all the other charges, that
are 3.5x to 4x higher. To generate actual retail demand, that is demand from people outside the distributor system, theyd have to dramatically decrease prices, spend a lot of money on advertising and basically create a new business model. Thats never going to happen. Whats your downside here? BA: Critical to all our shorts is that there has to be a ceiling on valuation. In this case, the company generates a certain amount of earnings and cash flow, which has grown at some rate over time. I can put a multiple on those earnings, based on where comps trade. Say were wrong and the stock rises, its not going to infinity. Even the biggest bulls say the stock is worth maybe $70. At $70, given where I shorted it and the position size at cost, I lose 360 basis points gross, or 280 basis points net. Given what we do and the upside if regulators essentially turn out the lights on the company, Im absolutely comfortable with the risk/ reward here. What if Carl Icahn and Herbalife pursue strategic alternatives? BA: Again, theres a ceiling on valuation. Carl is not the kind of guy who wants to pay the highest price, so if he paid $35 or so for his Herbalife shares, if he bid $43 or $44 for the whole company that would be high. I still make money at that kind of price. I also think the ability to get financing for some sort of deal is an extremely lowprobability event. If you lend $3 billion on this and its a pyramid scheme, you lose $3 billion. If its not a pyramid scheme, you make LIBOR plus 400 basis points. Its a horrible loan. Talk about some mistakes youve made and the lessons learned. BA: We closed out a relatively short and unsuccessful holding in Citigroup last year. This was a passive investment, and while I think our thesis was mostly correct
Herbalife
Valuation Metrics
(@2/27/13):
(NYSE: HLF)
Business: Global seller through a broad network of individual sales representatives of nutritional-supplement, weight-loss, energy and personal-care products. Share Information
(@2/27/13):
P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

(@12/31/12):
HLF 9.2 6.9 5.5
S&P 500 17.9 13.7
Largest Institutional Owners
Price
52-Week Range Dividend Yield Market Cap
37.44
24.24 - 73.00 3.3% $3.86 billion $4.07 billion 16.2% 11.7%
Financials (TTM):
Revenue Operating Profit Margin Net Profit Margin
HLF PRICE HISTORY 80 80 70 70 60 60 50 50 40
40
Company Fidelity Mgmt & Research Morgan Stanley Vanguard Group Wellington Mgmt BNP Paribas Inv
Short Interest (as of 1/31/13):
% Owned 13.9% 7.6% 5.3% 4.0% 3.6% 34.8%

80 70 60 50 40 30 20
Shares Short/Float
30 30 20 20 10
10
2011
2012
2013
10
THE BOTTOM LINE
The companys reliance on sales to its own independent distributors rather than end retail customers would indicate it is a pyramid scheme, says Bill Ackman. Given the sharevalue downside if U.S. regulators agree, coupled with the probability he attaches to that happening, Im absolutely comfortable with the risk/reward here, he says.
Sources: Company reports, other publicly available information
February 28, 2013
on the fundamentals, we paid too much for the stock in light of the inherent uncertainty around a financial institution in todays environment. I hadnt owned a financial stock for 20 years, and in the end it just didnt pass the sleep-at-night test. JPMorgan Chase, one of the best-managed banks in the world, has a $6 billion loss in derivatives. If Jamie Dimon can miss something like that, what could go wrong at Citi? Its hard for as concentrated an investor as we are to own something like this. We took the tax loss and redirected the money into something we considered much more attractive long-term, P&G. Would your updated reasoning on Citi apply to a stock like AIG as well? BA: Its one of the great insurance franchises, trading at a discount to book value and the CEO seems to be doing a great job. But, yes, its just too hard for us to put 10-15% of our capital in something with that much leverage. I can do that with a railroad, or a beer company, or a consumer packaged-goods company. That doesnt mean AIG is a bad investment, its just not a good one for us in a 10-stock portfolio. Back to mistakes what about Borders? BA: The first mistake was buying it in the first place, because it didnt really meet our business-quality standards. It was a passive investment, and we thought new management would come in and fix the business. The second mistake was taking an active role at the companys request. Given the direction the industry was heading and how hard it was to make anything happen, it wasnt worth the time and energy. Paraphrasing Warren Buffett, when you find yourself in a sinking ship, sometimes the best thing to do is to switch boats rather than keep bailing. We sized it only as a 3% position, but even that was a mistake. If I only want to put 3% of our capital in something, I shouldnt invest in it unless its something like General Growth with truly outstanding potential
upside. Borders didnt have that. How about your long and ultimately frustrating engagement with Target? BA: We lost real money on Target in a coinvestment vehicle that owned options, which was not the thing to do before one of the biggest financial crises of all time
tivist thesis with the public sooner rather than later. Companies can stonewall you and you can lose some control of the agenda that you might have had otherwise. Do you expect to be doing this 20 years from now? BA: Absolutely I hope even 40 years from now. I find this job incredibly fun and interesting, and while Carl Icahn will accuse me of being sanctimonious, I think we do some good. Not only for our employees and our investors, but for the companies we invest in and the capital markets. Over time Id like to focus even more on opportunities like Canadian Pacific, where we get to help build a company and make it more valuable. Or like J.C. Penney, which if it works will be even more of a transformative event. One thing that will be different 20 years from now is that I expect my capital base to be permanent, either because its just my own or the structure allows it. Warren Buffett after shutting down his hedge fund rolled everything into a dying textile company, gave up his 25% promote for a $100,000 salary, and went about building a base of permanent capital. That turned out to be a pretty good trade. VII
ON MOTIVATION: I find this job incredibly fun, and while Carl Icahn will say Im being sanctimonious, I think we do some good.
hit. Wed had successes doing something similar in the past, but were not doing that kind of thing with options any more. In our main fund, we basically broke even on Target after four years, but we did learn something about how to approach activism. If youre going to run a proxy contest, it helps if theres been a long period of underperformance and theres a lot of frustration with management, which wasnt the case with Target. We also learned the importance of sharing our ac-
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February 28, 2013
I N V E S T O R I N S I G H T : Perkins Investment
Investor Insight: Perkins Investment

Perkins Investment Managements Tom Perkins and Jeff Kautz describe the analytical effort theyre surprised so many people ignore, the virtues they see in a more-diversified portfolio, a tactic they use to keep their research team engaged, and why they believe Kirby, Jacobs Engineering, Stryker, Discover Financial and Two Harbors Investment are mispriced.
Given with whom we tend to associate, its not unusual to hear managers say, as you do, We focus first on the downside. Why is that a winning strategy over time? Tom Perkins: Its natural that early experience is the most defining. I was given my first portfolio to manage for a subsidiary of Kemper Insurance in the spring of 1974. I reported to an investment committee that outlined three basic principles for me: Preservation of capital is most important, investment income is a secondary interest, and if you get capital appreciation, thats good, but dont forget the first two. The emphasis was on strong balance sheets and sustainable cash flows that would support a company through a difficult time, which you may or may not remember was the case in 1974. The market was down 30% in my first six months. That has a way of locking in an aversion to risk. We believe in the power of compounding and the simple math is that you cant compound very well if you suffer too much on the downside. I dont understand why people who can go on at length about why this or that company will grow and prosper often spend little time on what can go wrong and the impact it could have on the share price. Its not as if defining the downside is more difficult its probably easier than estimating the upside. We also hear regularly about a focus on high-quality companies. What does that mean to you? Jeff Kautz: Nobody ever brags about buying low-quality stocks, do they? Weve actually looked closely at what quality means to Perkins. Underleveraged balance sheets. Not only the generation of free cash flow, but its stability as well. High and stable margins. Solid if not spectacular earnings growth. Tangible evidence of sustainable competitive advantage.
February 28, 2013
Our definition of quality probably isnt that much different than anyone elses, but the fact remains that over a longer period of time the stocks of companies with these types of quality characteristics, all else held equal, have outperformed the overall market with less volatility. How do you go about uncovering highquality, risk-averse ideas? TP: Our analysts have generally been following their industries for ten years or so and are constantly monitoring all the major players, across the market-cap range. As anomalies pop up usually in the form of low relative and absolute valuation ratios and stocks that have underperformed over the previous 6 to 18 months if the company fits our profile, well take a closer look at building the investment case. Stryker [SYK] is an example of a company that had always been expensive to us, but last year after a difficult quarter in which new management lowered expectations, the stock was trading at a pretty fair discount to the market and to peers. We knew the industry orthopedic implants and other medical technology having owned competitor Zimmer for years. Given Strykers product mix, growth prospects, free-cash-flow generation and impeccable balance sheet, it was unusual for it to be trading at a discount. Thats the type of thing well give a closer look. JK: A typical screen would be looking for underleveraged companies with good free cash flow, which are trading at material valuation discounts to their five-year averages. Thats often a result of an earnings miss, or just overall market volatility. But with a market over the last three or four years that has been up and to the right, a lot of the stocks that have lagged are lagging for good reasons, like secular headwinds and narrowing moats. You have to
be more diligent in this environment to sidestep the potential value traps. Are there other common reasons you find valuation anomalies crop up? TP: It can just be we believe the company has been misperceived. An example would be Ameriprise Financial [AMP], which seems to be treated by the market like any other life insurance company even though more of its business today comes from a stable and growing asset and wealth management division. If you assign a reasonable multiple to that part of the business, you come up with a value above where the stock is currently trading [$68]. JK: The misperception applies to the quality of the life-insurance business as well. This was the only life company that didnt have to come to market for financing in 2008. The balance sheet is strong, with more than $2 billion in excess statutory capital, half of which we expect to be used for stock buybacks and to boost the dividend. That will help drive the return on equity above 20%, versus 16% currently. The stock has done well, but its all been on earnings growth, without any of the multiple expansion we think is deserved. Is there any particular reason your strategy has worked so well with mid-cap stocks? TP: My brother Bob started the firm investing primarily in small caps, and the basic strategy has worked very well across the market-cap spectrum. Our mid-cap fund prospectus says we have to have 80% of our money in stocks represented in the Russell Midcap Value Index, which today has a cap range from $500 million all the way up to $25 billion. A lot of our own money is in the fund and we like to have as much flexibility as possible to pursue opportunities regardless of cap size.
I do believe mid caps to some extent offer the best of both worlds. Theyre usually not as well followed as large caps and by the rule of large numbers can have longer growth runways. At the same time, theyre broader-based and therefore less volatile than small caps, with better liquidity. I also think its been an advantage that the investing world seems more focused on small-cap or large-cap exposure, leaving mid-caps relatively neglected. Describe your valuation methodology. JK: As weve said, we start with the pessimistic case. After weve done our fundamental analysis and modeled out the financial statements, we stress test it all. Well model in a top-line contraction and margin compression, informed by how bad things have gotten back at least ten years. We look at how the balance sheet holds up when the income statement is stressed. On the valuation side, were looking over market cycles at whats happened both at the company and at peers, and apply, say, a trough multiple to trough earnings to arrive at a downside price target. For the upside price target, were typically looking at a normalized multiple on a normalized level of earnings. We dont want to rely on heroic assumptions, but more like things getting back to their longterm averages. We rarely count on the catalysts most people like to talk about; one, because you set yourself up for disappointment if they dont materialize, and two, you can get too caught up in a stocks story and be less driven by the numbers. If a stock has more than 25% absolute risk from todays price, were unlikely to be interested. Otherwise, were looking to buy or add to positions when the rewardto-risk ratio is 1.5-to-1 or better. You run a more diversified portfolio, with 135 positions today, than most investors we profile. Why? TP: Some of it has to do with the way we ease in and out of positions. When were buying, were often cognizant of the fact that one bad quarter is often followed by
February 28, 2013
another, or that well potentially benefit from the passage of time and from additional information in drawing firmer conclusions. Weve also learned to ease out of holdings that have worked well for us, which very often continue to run even when we consider them more fully priced. Generally doing things pretty gradually increases the overall number of positions. Our level of diversification is also just spreading the risk. It serves us well during downturns, which was certainly reinforced in 2008. I think it also makes us less emotionally attached to ideas and more willing to admit were wrong, which is important for any investor.
the money into broader-based, financially strong E&P companies. Jeff mentioned value traps earlier. Vodafone has been a value-investor favorite for two years now, but the stock has gone nowhere. What do you see in it today? JK: Theres no question the company in many of its markets is challenged cyclically and, in some cases, from a regulatory standpoint. But there are upsides we dont believe are reflected in the current valuation. We expect the wireless business in Europe to improve as the economy eventually mends, and we believe theres secular growth ahead from increased data usage that is still way below U.S. levels. The company is well-positioned in emerging markets. We also believe the special dividends paid on the ownership stake in Verizon Wireless are sustainable, which can support a dividend yield of as high a 8% on Vodafone stock [which now trades around $25]. That should protect us very well on the downside. Describe your investment case for barge company Kirby Corp. [KEX]. JK: Kirby is the 800-pound gorilla in inland barge transportation, with the newest fleet and a better-than 25% share of the market for hauling things like chemicals and petroleum products up and down the Mississippi River and the Gulf intracoastal waterway. In recent years it has extended its franchise into coastal marine transportation, where it has similar market share. These businesses together account for about two-thirds of total revenues and have what we consider a decent-sized moat, as size and scale allow for more flexible and efficient use of assets. One key driver for Kirby is growth in U.S. petrochemical production spurred by low natural-gas prices, which should particularly benefit inland-fleet utilization and pricing. That wont happen to the same extent if industry capacity gets ahead of itself, but we dont believe thats going to happen because roughly one-third of the barges currently in use are 35-40
ON dIVERSIFICATION: It help us in downturns, and makes us less emotionally attached to ideas and more willing to admit were wrong.
Your annual turnover tends to be in the 60-70% range. Is that partly a function of easing in and out of positions? JK: Were very price sensitive and constantly monitor those reward-risk ratios, which does translate into a fair amount of adding and trimming as those ratios move. Were not averse to holding a high-quality company with strong long-term prospects even when the ratio gets below 1:1, but well very likely be trimming it at that level. In general, the average name turnover in the portfolio has been closer to 50%. Can you cite a recent sale where you were moving more quickly than easing out? TP: As the intermediate-term pricing situation in natural gas became more stressful in the U.S., certain E&P companies we owned Bill Barrett Corp. [BBG] being a prominent example decided to double down on capital spending in natural gas. When what we considered less-than-rational capital allocation also unduly strained the balance sheet, we exited and redirected
years old, pushing the end of their useful lives. Even as new capacity comes on line to meet rising demand, a healthy portion of that will be offset by the scrappage rate. How do barges stack up against competitive modes of transportation? JK: Trucking and railroads generally move cargo faster, but barging is often more efficient and cost-effective for bulk commodities. A 15-barge tow has the capacity of 260 railroad tank cars or 825 tractortrailer tank trucks, and can transport one ton of bulk cargo 575 miles on one gallon
INVESTMENT SNAPSHOT
of fuel, compared with about 415 miles by rail or 155 miles by truck. Whats your outlook for the non-transport part of Kirbys business? JK: The Diesel Engine Services division manufactures and services diesel-engine power-generation and oilfield equipment. That business has come under cyclical pressure due to low gas prices causing drillers to reduce spending on new pressurepumping equipment. The maintenance side of the business is doing well, however, and we believe thats where Kirby wants
to focus going forward. That should reduce the cyclicality, while still positioning it well to benefit from long-term growth in shale-gas production. The stock has been on a bit of a tear. At $76.70, how are you looking at valuation? JK: By driving the consolidation of the barge market Kirby has increased operating margins, which we believe can hit 24% this year. That would result in earnings per share of around $5, on which were putting an 18x multiple to arrive at an upside share-price target of $90. Going forward, we expect free cash flow to be directed toward reducing debt, and also think the diesel-engine business can be much more profitable than it is today both of which could result in additional upside. Is Jacobs Engineering [JEC] another bet on the U.S.s energy-related renaissance? JK: Roughly 45% of the companys engineering and construction business is tied to chemicals and energy infrastructure spending, so to a certain extent, yes. Its book-to-build ratio has been greater than one for eight quarters in a row, in large part because of important new projects in this category. The remainder of the business is government-related buildings, roads and bridges or comes from nonprocess type industrial projects.
Kirby Corp.
(NYSE: KEX)
Valuation Metrics
(@2/27/13):
Business: Provider of inland and coastal U.S. marine-transportation services for the hauling of petrochemicals, agricultural chemicals and refined petroleum products. Share Information
(@2/27/13):

(@12/31/12):
KEX 20.6 16.1 10.0
S&P 500 17.9 13.7
Price
76.71
42.78 - 77.05 0.0% $4.29 billion $2.11 billion 17.3% 9.9%
Financials (TTM):
KEX PRICE HISTORY 80 80 70 70 60 60 50 50 40 40 30 30 2011
Company Select Equity Group Atlanta Capital Vanguard Group Bank of NY Mellon Perkins Inv
% Owned 7.5% 5.2% 4.9% 4.9% 4.4% 7.8%

80 70 60 50 40
Shares Short/Float
Adj Close
TP: The shares have lagged those of peers, which we attribute to Jacobs lack of the kinds of non-U.S. elephant projects that the market seems to favor. We actually prefer that the company focuses on smaller projects and deeper long-term relationships with large clients. They position themselves as a consultant advisor to clients and will sometimes recommend the client use another contractor for a piece of business for which theyre not best suited. That kind of relationship develops a great level of trust. We also like that the company primarily utilizes cost-plus contracts, which we think is more conservative. Over time the strategy and a consistent level of acquisitions theyve done 17
2012
2013
30
THE BOTTOM LINE
The companys strong market shares in both inland and coastal marine transportation position it well to benefit from growth in U.S. petrochemical production spurred by low natural-gas prices, says Jeff Kautz. At 18x his 2013 EPS estimate of $5, the shares would trade at $90 with added upside possible from an improving diesel-engine business.
February 28, 2013
deals totaling $1.5 billion in the past six years has produced an excellent record of stable and growing earnings. Over the past 20 years theyve had only one significant decline in earnings, a bit over 20% in 2010, and profits have grown on average at a mid-teens annual rate. If you put a blindfold on and looked at the record, youd say its a dynamic growth company. Is the government side of the business likely to be a drag? TP: Their government contracts are well diversified, mostly long term and involve
INVESTMENT SNAPSHOT
a high level of technical expertise, making them less susceptible to sequester-type cuts. The company does a fair amount of environmental-related work, which is one area where government budgets are healthy. So while government spending might be somewhat of a headwind, we expect the actual impact on Jacobs to be reasonably benign. From todays $48.60, what upside do you see for the shares? JK: The recent-year backlog growth hasnt really kicked in on the top line yet,
but we expect that to start changing and drive earnings of around $3.40 per share this year. With a 16x multiple and adding back $5.50 per share in net cash, that gives us a target price of nearly $60. Given the business that is pretty well locked in over the next few years, and the likelihood of a multi-year increase in infrastructure spending, we expect that to be a moving target as the top and bottom lines grow at a low- to mid-teens annual rate. Healthcare has been a favorite of yours. Why is device-maker Stryker [SYK] particularly interesting? TP: Our overweight in healthcare goes back to 2004, since the specter of healthcare reform started weighing on the sector. Weve been focused generally on equipment, device, tool and service providers that we believe are less susceptible to negative reforms and that have good earnings visibility, solid balance sheets, strong free cash flow generation and high-recurringrevenue models. Stryker is an excellent example. JK: The companys primary strength is in reconstructive implants, such as knees and hips. Both of those markets are roughly 75%-controlled by three major players Stryker, Zimmer and Johnson & Johnson with each holding roughly equal shares. While theres plenty of competition within the Adj Close like that the barriers to enmarket, we try are high and that the long-term growth prospects, driven by an aging and increasingly obese population and a greater insured population, are significant. Beyond implants, Stryker offers a diverse range of operating-room equipment, instrumentation, hospital beds and neurovascular products. International revenues account for about 35% of the total, which is well behind peers, but is an area of emphasis and expertise of the new CEO named last October, Kevin Lobo. Last month the company announced it was buying a spine-products manufacturer in China for $765 million, which greatly expands its foothold in the orthopedic market there.
Jacobs Engineering
(NYSE: JEC)
Valuation Metrics
(@2/27/13):
Business: Provider of engineering, construction, scientific, operations and maintenance services to industrial, commercial and government clients worldwide. Share Information
(@2/27/13):

(@12/31/12):
JEC 16.2 13.2 7.8
S&P 500 17.9 13.7
Price
48.57
33.61 - 50.48 0.0% $6.33 billion $11.02 billion 5.6% 3.5%
Financials (TTM):
JEC PRICE HISTORY 60 60
Company Fidelity Mgmt & Research Vanguard Group Artisan Partners State Street Lord Abbett
% Owned 6.5% 5.8% 5.4% 3.8% 3.7% 1.8%

60
Shares Short/Float
50 50
50
40 40
40
30 30
2011
2012
2013
30
THE BOTTOM LINE
Tom Perkins doesnt believe the company receives adequate credit for the diversity and stability of its infrastructure-related businesses or for its dynamic long-term growth, which he says can continue at a low- to mid-teens annual percentage rate. Putting a 16x multiple on his 2013 EPS estimate and adding back net cash, he values the shares at $60.
February 28, 2013
Our basic thesis is that volume growth, smart capital allocation and a tight rein on costs will more than offset pricing pressure that we dont expect to go away. Stryker typically targets double-digit earnings growth and we believe thats a reasonable and attainable goal at least over the intermediate term. How cheap are the shares, now at $63.70? JK: Driven by top-line growth and maybe 50 basis points of margin improvement from operating leverage, were estimating this years EPS at around $4.40. At a 16x
INVESTMENT SNAPSHOT
multiple, plus net cash expected on the balance sheet at year end, we believe the shares are worth in the high-$70s. TP: To our discussion earlier about quality, this has all the characteristics of the type of company we tend to favor. The companys businesses have excellent defensive characteristics and have generated stable increases in earnings and cash flow. In fact, theyve never had a down earnings year. The balance sheet is rock solid and the net cash provides them with considerable flexibility to return capital to shareholders, invest opportunistically in
growth, or ride out a difficult period if it comes to that. How did Two Harbors Investment [TWO] get on your radar screen? JK: There actually is somewhat of a story behind that. Management was coming through town on a road show and our financials analyst decided to take a meeting only to provide a comparison with Redwood Trust, which we own. He came away from the meeting very impressed and decided to dig in further. Two Harbors is structured as a hybrid mortgage REIT, investing in agency and non-agency mortgages. Its equity capital today is 53% in agency paper, 37% in non-agency paper, and 10% in an entity called Silver Bay, which is about to be spun off to shareholders. Silver Bay is a good example of how the company is opportunistic in allocating capital. They drill down on mortgages to the zip-code level to underwrite the credit quality and get to know the markets very well. In doing that, they concluded early on that actually buying big slugs of foreclosed homes in certain markets made sense. They set up Silver Bay to do that and have earned excellent returns. On the agency mortgage-backed securities side, theyve outperformed by investing in pools with very low loan balances. Theres less of an incentive to refinance a Adj Close low-balance loan versus a higher-balance loan, given the relatively fixed fees associated with refinancing. Therefore in this low rate environment prepayments have been lower than average, which has translated into above-market returns. On the non-agency side, Two Harbors is again starting to securitize its loans and sell them off to investors. That business which had been non-existent since the crisis is starting to recover, freeing up additional capital for management to reinvest on shareholders behalf. What happens if interest rates ever rise? JK: We believe the portfolio would benefit from a steepening yield curve. The
Stryker
Valuation Metrics
(@2/27/13):
(NYSE: SYK)
Business: Provider of a broad range of medical products, devices and equipment, including orthopedic implants, endoscopic technology and surgical navigation systems. Share Information
(@2/27/13):

(@12/31/12):
SYK 18.8 13.5 9.4
S&P 500 17.9 13.7
Price
63.66
49.43 - 64.46 1.7% $24.21 billion $8.66 billion 21.0% 15.0%
Financials (TTM):
SYK PRICE HISTORY 80 80 70 70 60 60 50 50 40 40
Company Greenleaf Trust Vanguard Group Capital Research State Street Yacktman Asset Mgmt
% Owned 8.4% 4.2% 3.8% 3.4% 3.2% 1.8%

80 70 60 50 40
Shares Short/Float
2011
2012
2013
THE BOTTOM LINE
Jeff Kautz argues that through global unit-volume growth, a tight rein on costs and smart capital allocation the company can achieve its intermediate-term goal of double-digit annual earnings growth. Applying a 16x multiple to his current-year EPS estimate and adding in expected net cash at the end of the year, he values the shares in the high-$70s.
February 28, 2013
spread income generated is basically the difference between the interest earned on the agency and non-agency paper less repurchase agreements against them. Think of it like a bank, where the repos are the equivalent of bank deposits. Two Harbors borrows short duration in the repo market and lends long by buying bonds. Just like a bank, they benefit from a steepening yield curve by earning a wider spread between their interest payments and their interest income. How are you thinking about valuation with the shares at a recent $12.50?
INVESTMENT SNAPSHOT
JK: We expect the company this year to earn $1.20 per share in spread income that will be available for distribution. At todays price, thats a 9.6% yield. If the yield curve steepens to a more normal trajectory, theres no reason income available for distribution couldnt get back to $1.60 per share. If the yield stays at 9.6%, youve got a share price of around $16.75. Thats not our near-term price target, but were quite content to hold and clip a nearly 10% coupon. In the meantime, we should benefit if management continues to increase book value at anywhere near the rate it has. Since the company came pub-
lic, book value has increased 50%, from around $7 per share in September 2009 to $11.50 at the end of last year. What interests you in off-the-radar creditcard company Discover Financial [DFS]? TP: We first got interested in the stock in 2010, post-crash, on the expectation that their reserving for losses had been so conservative that the true earnings power of the business had been obscured. We were buying shares in the mid-teens when we thought normalized earnings were around $2.50 per share. This is really a very basic credit-card business, which wed say is operated with a solid Midwestern approach. Customers tend to be in the middle part of the country, employed and with very good FICO scores. The company makes its money primarily on the spread on balances held by its cardholders, and has just consistently done an excellent job of underwriting and managing credit risk, keeping chargeoffs and delinquencies low. All of that translates into the financial results: Discovers operating margins are 60%, versus around 33% for Capital One and 25% for American Express. How would you characterize the companys growth prospects?
Two Harbors Investment Corp.

(NYSE: TWO)
Valuation Metrics
(@2/27/13):
Business: Real estate investment trust that invests primarily in U.S. residential mortgage-backed securities and residential mortgage loans. Share Information
(@2/27/13):

(@12/31/12):
TWO 10.4 n/a n/a
S&P 500 17.9 13.7
Price
12.52
9.85 - 12.84 17.9% $3.74 billion $296.0 billion 82.8% 98.6%
Financials (TTM):
TWO PRICE HISTORY 15 15
Company BlackRock Vanguard Group Perkins Inv Fred Alger Mgmt SAB Capital
% Owned 7.1% 4.2% 3.5% 3.1% 2.7% 4.6%

15
Shares Short/Float
12 12
12
99
66
2011
2012
2013
THE BOTTOM LINE
In a flat-yield-curve environment the companys opportunistic capital allocation in the residential mortgage-security market has the potential this year to generate $1.20 per share in distributable spread income, says Jeff Kautz. With a more normal yield curve, he says, that could be $1.60 even more attractive relative to todays $12.50 share price.
TP: Discover is pursuing prudent organic growth in its credit-card portfolio. We Close can see this in the uptick in its advertising spending, including sponsoring the NCAA football championship game this year and the roll-out of the new IT card. The credit-card industry had been very stagnant leading up to the crisis, but some competing products such as home equity loans will not be as prevalent in the future, which could lead to incremental growth for cards. Part of our confidence in their growth comes from an increasing acceptance of the Discover network, which is a closedloop payment network. The company is also making small tuck-in acquisitions of mortgage and student-loan origination platforms. Everything has been biteValue Investor Insight 12
February 28, 2013
sized and of sound credit quality, and has been weighed against returning capital to shareholders. At around $38.50, the shares trade at only 8.5x consensus earnings estimates for 2013. Why so cheap? TP: Part of it is that the earnings tailwind from releasing unneeded reserves is diminishing, but we also attribute the valuation level somewhat to neglect. Although the stock has more coverage now, it is still not as widely followed as its competitors and most people on Wall Street seem unaware
INVESTMENT SNAPSHOT
of why the company has performed as well as it has. Whats a more reasonable valuation? TP: Our upside target is around $47, which is less than 11x our 2013 earnings estimate of $4.30 per share. Were making no heroic assumptions on the multiple thats historically where the stock and the group have tended to trade. This is a case where we could imagine at one point this being a valued property for a potential acquirer, say for a multinational financial institution looking to
establish or expand its presence in the U.S. Whether thats in the cards or not, we do expect the company to continue aggressively buying in its own shares. It has $2.5 billion in excess regulatory capital today, and that number could hit $4 billion by the end of the year. We expect a good portion of that to make its way into shareholders hands. Tell us about the tracking portfolios all of your analysts manage. JK: Our research team is organized by sector and each analyst runs paper-based small-, mid- and large-cap tracking portfolios against customized benchmarks for the industries he or she follows. Everything is out in the open and everyone can see how each portfolio is performing. We find its a good way to hold both analysts and portfolio managers accountable for their decisions, and generates good-natured and productive competition in what we hope is a collegial atmosphere. Its become an important part of our culture. Tom, after 40+ years in the business, what keeps you as engaged as you are? TP: So many things impact the markets, from history, to politics, to popular culture, and those elements change day-today. The challenge of working through all that is consistently exciting and you can Close see your results on a real-time basis. I also get a lot of satisfaction in helping to provide clients with a product that has outperformed and is less volatile than the market, making it easier for them to stay with stocks through the ups and downs. As time frames get shorter and shorter and the speed at which information moves gets faster and faster, its probably easier to lose track of the longer-term context when making decisions. One benefit of experience is that you should be better able to keep things in perspective and not get caught in the weeds. Long-term results are truly what were after, so were very mindful of not getting caught up in short-term thinking. Thats more important today than ever. VII
discover Financial Services

(NYSE: DFS)
Valuation Metrics
(@2/27/13):
Business: Provider of credit-card, debitcard, ATM and electronic-transfer services worldwide under brand names such as Discover, Diners Club and PULSE. Share Information
(@2/27/13):

(@12/31/12):
DFS 8.6 8.5 n/a
S&P 500 17.9 13.7
Price
38.40
29.62 - 42.08 1.5% $19.10 billion $6.80 billion 59.9% 34.5%
Financials (TTM):
DFS PRICE HISTORY 50 50 40 40 30 30 20 20 10 10
Company Fidelity Mgmt & Research Vanguard Group State Street BlackRock CI Investments
% Owned 5.9% 4.8% 4.2% 2.8% 2.7% 0.5%

50 40 30 20 10
Shares Short/Float
2011
2012
2013
THE BOTTOM LINE
In running a basic credit-card business with a solid Midwestern approach, Tom Perkins says, the company has built a highly profitable franchise that he wouldnt be surprised could one day attract a suitor. He attributes the shares lowly valuation at least somewhat to neglect at a more typical 11x his 2013 EPS estimate, the stock would trade at $47.
February 28, 2013
I N V E S T O R I N S I G H T : Stephen Goddard
Investor Insight: Stephen Goddard

Stephen Goddard of The London Company explains why he pays so much attention to a companys capital structure, what he looks for in insider buys and sells, why hes not big on regularly rebalancing positions, why he expects M&A activity to pick up sharply, and what he thinks the market is missing in NewMarket, CarMax, Cabelas and Lorillard.
If you were forced to pick one distinguishing characteristic of the companies that typically interest you as investments, what would it be? Stephen Goddard: Since my first job in the business as a sell-side analyst Ive always gravitated toward companies with high returns on capital. They typically throw off a lot of cash and tend to be more predictable. They also have far more flexibility to create value through capital allocation and the balance sheet. Wall Street tends to focus on short-term revenue and earnings growth, but Ive always believed sustainable margins, high returns on capital and smart capital allocation drive value more than anything else. How do you combine quality with price to identify potential ideas? SG: Our basic screening process weights three factors equally: return on tangible capital which we define as operating cash earnings over working capital plus net property, plant and equipment the multiple of EBIT to enterprise value, and free cash flow yield. We rank the universe weve defined on each factor individually from most attractive to least, and then combine the rankings and focus on the top 10%. Give an example of something that makes its way from that list, through your research process and into the portfolio. SG: Tempur-Pedic [TPX] is a good example. The stock got destroyed in the second quarter of last year when the company reported a disappointing quarter at the same time Serta and other competitors were taking market share with competing mattress products at the high end of the market. The stock went from $85 in April to $23 in June.
February 28, 2013
Mattresses are an extremely high-return business and Tempur-Pedic has a strong brand that has been dominant in its space. As we talked with a number of sources in the industry, we came away with a comfort level that despite some competitive headwinds, the outlook for Tempur-Pedic was far better than the market was assuming. It had new products and a new pricing structure in the works that were likely to blunt some of the competitive advance. In September, it announced it was buying Sealy, which would clearly strengthen its competitive position. We also pay a lot of attention to what insiders are doing, and in this case several were buying in the low- to mid-$20s, including some of the private-equity people on the board. It took us until the latter part of the year to start buying, but by then we were confident that a company with returns on capital as high as TPXs didnt deserve a single-digit multiple, and that the privatemarket value was significantly above the market price. Its done reasonably well so far [the stock now trades around $41], but we still believe the longer-term story is far better than the market seems to believe. Do you tend to gravitate towards certain industries over others? SG: Yes. Were usually overweight in consumer staples, where there are more stable, high-return-on-capital companies selling things like food, packaged goods, tobacco and liquor. Its not quite as consistent an overweight, but we also like financial-services companies. In our large-cap strategy we recently bought shares in BlackRock [BLK], which we dont think the market recognizes as the dominant power in ETFs that it is. I guess its partly If you cant beat em, join em, but we believe theyre very well positioned to take market share both from active managers and ETF comwww.valueinvestorinsight.com
petitors. From a return perspective, we appreciate the economics of a company with $3.8 trillion dollars under management where every 1% increase goes mostly to the bottom line. The stock has run up since we bought it [trading now at around $241], but we were able to get in less than six months ago at an 8x P/E, which I can assure you understates what the company is worth. Youve said information technology doesnt work particularly well for you in your small-cap strategy. Arent there plenty of high-return businesses there? SG: The problem is more that most smallcap tech companies have product cycles much shorter than our time horizon. We want to buy companies we can own for the long term, so the premium is on cash flows being stable 5 to 10 years out. For many smaller technology companies we cant make that assumption due to constant change and potential product obsolescence. In the rare case we find a candidate that meets our criteria, the valuation is often excessive. We noticed Advent Software [ADVS] made the cut, a name near if not dear to many money managers hearts. SG: It hasnt yet been a stellar performer for us, but we use their portfolio-management system and appreciate the high switching costs of their products the time and manpower necessary to convert your entire database to another system is very high. That speaks to the sustainability of the cash flow. We think Advent could make an attractive property for somebody to buy, but too much stock is in the hands of the company founder, Stephanie DiMarco, and longtime investor SPO Advisory for anything to happen without their active participation.
DiMarco has been slowly selling down her position, so well see what happens. Youve written that, The market is much less efficient at assessing risk than reward. How does that help you? SG: With investment horizons so short, the market can de-link stocks from the real world, so that the only thing that matters is the next week or month or quarter. When that happens, less attention gets paid to the assets a company has backstopping its value or the flexibility a strong balance sheet gives it to work through a problem. Because we pay so much attention to how were protected on the downside, we think that can help us uncover an opportunity when the market overlooks it. A good historical example of that is Alexander & Baldwin. Its two main assets were the Matson container-shipping business and a significant amount commercial, industrial and undeveloped real estate in Hawaii. Because the activity in real estate was at times slow, the market often ignored its true value, to the point where on our calculations you were getting the Matson business for free, or the implied value of 80,000 acres of prime real estate in Hawaii was laughably low. In the end, activists got involved and the company last year took one step toward realizing value by spinning off Matson. It all took a long time to play out, but thats a type of situation we find interesting. Anything similar in your portfolio that hasnt played out yet? SG: Weve for a long time owned Tejon Ranch [TRC], a former cattle-ranching company that owns 270,000 acres of land north of Los Angeles. Its close enough to the sprawl from L.A. that it has attractive properties to develop for both residential and commercial use, but the real estate crash and ongoing problems with state regulators and environmentalists have postponed the kind of value realization that we think ultimately exists. Weve had to be patient so far and dont see any immediate catalysts, but we know the value
February 28, 2013
is there. Once the development projects start moving again and you get a housing cycle going in the right direction, we expect our patience to be rewarded. Is insider buying and selling something you pay a lot of attention to? SG: We do, but we dont take it all at face value. Some people and some trades you pay a lot more attention to than others. When a founder CEO who has 100% of
ON M&A: With such a huge spread between the cost of equity and the cost of debt, why hasnt there been more activity?
his net worth in a stock buys another $10 million worth on the open market, thats interesting. When a director buys nearly $100 million of a companys stock, as happened last fall with BlackRock, thats interesting. When top management is exercising options that dont expire in 15 years, that makes us leery, especially when theyre publicly talking about how great everything is at the company. Sometimes we pay attention to what people are not doing. We decided to hold on to our shares in Nu Skin Enterprises [NUS] after the stock got hit when short sellers attacked Herbalife, a competing business model. But Im concerned that more insiders didnt buy on the weakness. If, in fact, I see they start selling, Ill very likely join them. Describe the balance-sheet optimization exercise you put all your most-interesting ideas through. SG: Its our term for debt recap. What can management do, fully under its control, with the capital structure to create value? Use Microsoft [MSFT] as an example. It has $60 billion of cash on hand, very little debt and throws off something like $30 billion in free cash flow per year.
The equity has been trading at 8x to 10x earnings and the company can issue debt at less than 3.5%, so theres a huge difference between the cost of debt and the cost of equity. As an exercise, what would happen if it went to a net $60 billion debt position? Given the free cash flow, thats still a modest capital structure. They take the $120 billion in cash proceeds and buy back a significant amount of their equity. With a lowered cost of capital and shares outstanding cut in half, if we run that through our cash-flow model assuming no growth we come up with a share value in the low- to mid-$40s, versus around $28 today. We look at this as our downside protection and also as a way to distinguish our analysis. Its difficult to out-predict the Street consistently on Microsofts growth over the next five years, but very few analysts focus on value creation through the capital structure, so it can provide us with a different perspective on how to value the stock. If you listen to Microsofts conference calls, everyone focuses on incomestatement model maintenance and outlook. But the elephant in the room is the value the company could create overnight with its under-leveraged capital structure. If Microsoft had allocated capital over the past 10 to 15 years closer to the way IBM has, its stock would be far higher than it is today. We frankly cant understand why, when theres such a huge spread between the cost of equity and the cost of debt, there hasnt been more M&A activity. Margins have peaked and overhead has been cut, so the next chapter should be taking advantage of equity-risk-premium arbitrage through buyouts, consolidations and accelerated repurchases. How generally do you look at valuation? SG: We use the balance-sheet optimization to help define the downside, while the upside is mostly based on transaction values in the marketplace. Theres always a good database of deals to look at in each industry, but as a check we confirm that prices paid arent out of line relative to the cashValue Investor Insight 15
flow and economics of the company. Normally for something to make it into the portfolio, we want to see at least a 40% discount to private market value. Why does the way you manage your portfolio result in fairly low annual turnover of around 20%? SG: One reason is just the fact that were making long-term decisions that we fully expect could take four, five or six years to play out. Its also a function of our general willingness to let our best performers appreciate. We typically at cost take at least a 3% to 5% position. Too often we end up underestimating a stocks upside by judging value on current EBITDA run rates and selling too early. Thats not to say we dont cut back when a stock gets too expensive or a position size gets too high our institutional clients often require it but we generally try to avoid frequent rebalancing.
Is that true when something goes against you as well? SG: We tend not to average down. I think this is a common mistake, when you dont realize theres something out there youre missing and you compound the problem. Weve instituted a soft stop-loss that is triggered whenever a position causes a 1% loss on the overall portfolio from cost, say a 5% initial position falls 20% from where we bought it. We dont automatically sell, but theres a high bar to keep something in the portfolio, let alone add to it. At the end of the day, markets are too efficient to totally ignore price action. If were going to be wrong, we usually know in the first year and can cut our losses. Better to admit it then rather than later. Any recent examples? SG: Luckily, no. Going back further, one we were absolutely wrong on was Capella
Education. New regulations around forprofit education changed the behavior of some weaker competitors and consequently destroyed Capellas business model. We were buying up to $60 and it ended up going below $30. It wasnt a pleasant experience, but we didnt add to the problems with the temptation to average down. Explain why you still consider long-time holding NewMarket [NEU] attractive. SG: This was one of the very first LBOs ever done, when a small paper manufacturer borrowed $200 million or so in the early 1960s to buy Ethyl Corp., whose main business was providing lead as a fuel additive for gasoline. Leaded gas was already on the way to being outlawed in the U.S., but the whole wind down of using lead in gas worldwide took a long time and the company generated plenty of cash flow to pay down debt and diversify into other businesses.
Keynote Speaker:
William Ackman Founder and Chief Executive Officer PERSHING SQUARE CAPITAL MANAGEMENT LP
Investment Idea Presenters Include:

The Childrens Investment Fund Corvex Management JANA Partners Marcato Capital Management Starboard Value Fund Value Act Capital
For more information, visit http://www.imn.org/activist13

February 28, 2013 www.valueinvestorinsight.com Value Investor Insight 16
NewMarket today is a holding company that makes a variety of additives that go into gasoline and other oil-based products. These are products that help improve the performance of engine oils or drive better emissions results for gasoline. Demand is primarily a function of vehicle miles driven, which over time have been growing consistently at a low single-digit rate per year. Ten years ago this was a more fragmented industry held hostage by a few irrational competitors. It has since transformed into an attractive, high-margin industry with four major, disciplined producers
INVESTMENT SNAPSHOT
including Lubrizol, which is owned by Berkshire Hathaway now controlling the global market. NewMarkets margins move around but are typically at least in the mid-teens. So while this isnt a high organicgrowth business, its stable, produces high returns, and NewMarkets management has been excellent in creating value for shareholders. The Gottwald family still owns a sizable stake and is active in the management of the company. What does your balance-sheet-optimization analysis tell you here?
SG: The company currently has about $300 million in net debt, while generating $300 million annually in cash flow. Capital expenditures run roughly $50 million per year. If we assume potential debt capacity up to 4x interest coverage, it could add $1 billion of additional debt to repurchase shares. With the new capital structure and assuming a normalized operating margin of just under 16% and revenue growth of 2% per year, our DCF model yields a pershare value of $330, 30% above the current price [of around $250.] How are you looking at the private-market value here? SG: We think Berkshire purchased Lubrizol for a surprisingly low price, less than 7.5x EBITDA. In the past many specialty chemical companies with less favorable economics have been acquired for 11-12x. A more reasonable valuation for a company with NewMarkets industry position, visibility and profitability would be closer to 12x EBITDA, which on our normalized numbers also comes to around $330 per share. We think there should be a real premium on businesses that have this level of control over prices and margins. Risks?
NewMarket
(NYSE: NEU)
Valuation Metrics
(@2/27/13):
Business: Global provider of a range of additives used by manufacturers and refiners of fuels and lubricants to improve product performance and functionality. Share Information
(@2/27/13):

(@12/31/12):
NEU 14.0 12.5 9.1
S&P 500 17.9 13.7
Price
249.87
172.50 - 291.10 1.2% $3.35 billion $2.22 billion 16.4% 10.8%
Financials (TTM):
NEU PRICE HISTORY 300 300 250 250 200 200 150 150 100 100 50 50 2011
Company The London Co Vanguard Group BlackRock Managed Account Adv Herndon Capital
% Owned 7.4% 4.8% 3.9% 3.7% 3.1% 12.6%

300 250 200 150 100
Shares Short/Float
SG: The biggest risk would be a competitor or new entrant adding significant proClose duction capacity. Plants take two to four years to come on line and theres nothing we see on the horizon, but something like that could certainly disrupt the balance in the industry. Describe your thesis for another Richmond-based holding, CarMax [KMX]. SG: CarMax is the largest retailer of used cars in the U.S., but the industry is still quite fragmented so it has only around 3% market share in its existing markets. It has successfully built the franchise by offering customers what we consider a superior value proposition and buying experience, which includes no-haggle pricing, broad selection, straight-forward financing and
2012
2013
50
THE BOTTOM LINE
The company continues to benefit from a changed industry structure now characterized by disciplined and more bottom-line-oriented competition, says Stephen Goddard. He believes a company with this level of control over prices and margins should earn a 12x EBITDA multiple, which on his normalized numbers would yield a $330 share price.
February 28, 2013
simple appraisal and trade-in processes. You may not get the absolute lowest price, but youll be treated professionally. This is a significant improvement over the traditional used-car-dealer experience. One-third of the companys profits are now derived from its rapidly growing wholesale business, where it auctions to licensed dealers the vehicles it acquires through trade-in and otherwise that dont meet its retail standards. With the weakness in new-car sales in recent years, used cars have been in shorter supply, increasing pricing particularly in the wholesale channel. If you look at where similar
INVESTMENT SNAPSHOT
publicly traded auction companies trade, this business alone is worth well over onethird of CarMaxs total market value. Is this basically a growth story? SG: Its a proven and profitable model returns on tangible capital have averaged 23% over the last three years in an extremely underpenetrated market. The balance sheet is reasonably leveraged and the company generates healthy cash flow to plow back into growth. Overall, we believe it has the potential to at least triple its current base of 117 stores.
How does a change in new-car demand impact used-car sales? SG: Used-car sales generally correlate well with new-car sales, an exception being the most recent recession when new-car sales dramatically declined relative to used-car sales. The short-term risk is that manufacturers of new cars get very aggressive on rebates and discounts, which would limit pricing flexibility for CarMax. Historically it has turned inventory over fast enough that it can sufficiently adjust the prices it pays to acquire cars, sustaining stable gross margins. With the shares trading at around $38.50, how are you looking at valuation?
CarMax
Valuation Metrics
(@2/27/13):
(NYSE: KMX)
Business: Largest retailer of used vehicles in the United States, primarily sold and financed through nearly 120 superstores located in 58 different markets. Share Information
(@2/27/13):

(@12/31/12):
KMX 21.2 18.7 17.5
S&P 500 17.9 13.7
Price
38.59
24.83 - 40.22 0.0% $8.81 billion $10.90 billion 6.5% 3.9%
Financials (TTM):
KMX PRICE HISTORY 50 50 40 40 30 30 20 20 10 10
Company T. Rowe Price Primecap Mgmt Vanguard Group Davis Advisors State Street
% Owned 11.5% 6.3% 5.9% 4.2% 3.8% 5.5%

50 40 30 20 10
SG: For a company that has grown earnings at better than 20% per year over the past ten years and still has a visible growth path ahead, we dont consider a 20x EPS multiple to be unreasonable. The stock has historically traded above that. On the $2.75 per share were expecting CarMax to earn in the fiscal year ending February 2014, that would give us a share price of $55. We know growth wont be linear, but the long-term potential is well worth some lumpiness along the way. Both NewMarket and CarMax are based in your hometown. Do you think that gives you an advantage?
Shares Short/Float
Close
SG: It can. You just can know more, about the people, the history, the culture, the character of management and how they behave. Sometimes we can almost anticipate what management is going to do next. I think that can give you a tremendous advantage. Moving out to the Midwest, describe the upside you see in Cabelas [CAB]. SG: This is a specialty retailer of hunting, fishing, camping and other related outdoor merchandise. It currently operates 33 stores in the U.S. and Canada and also has established strong direct-marketing channels online and through its popular catalog.
2011
2012
2013
THE BOTTOM LINE
With a unique, proven and profitable business model and an extremely underpenetrated market, the company has significant long-term growth potential that isnt being recognized by the market, says Stephen Goddard. At what he considers a reasonable 20x multiple on this fiscal years estimated EPS, the shares would trade at closer to $55.
February 28, 2013
The companys finance arm, which issues a branded Visa card and manages the related customer-loyalty rewards program, is highly profitable. Partly as a result of the credit card and reward program, the customer base has proven to be quite loyal and committed. There are two main parts to the thesis here. The first is that three years ago the Cabela brothers who founded the company went outside to name a new CEO, Tom Millner, who has been focused on improving margins and returns on tangible capital. Hes instituted a variety of new initiatives to increase the amount of CaINVESTMENT SNAPSHOT
belas-branded merchandise, better plan and manage inventories, and optimize the pricing and margin structure. The company is also rolling out a new, smaller store format with 60% less square footage than a traditional store, but with much higher sales per square foot and 40% higher margins. Total company returns on tangible capital averaged roughly 7% over the last three years, but in the latest quarter improved to nearly 16%. Like CarMax, we see this as another early-cycle retail company that is far from mature. Were expecting square-footage growth in the high single digits annually
and could envision Cabelas store base tripling to more than 100 over the next several years. The latest quarter had a particular boost from gun sales. Does the reliance on guns concern you? SG: After the tragic events in Newtown, there has been a large, unsustainable increase in gun sales. This category for Cabelas usually accounts for maybe 20% of revenues, almost exclusively from selling lower-margin hunting rifles and handguns. Over time, we dont expect guns to greatly influence the value-creation story one way or the other. Some bears argue the profits produced by the finance unit deserve a much lower multiple than the rest of the business. Is that a fair criticism? SG: Our view is that the company has done an excellent job of integrating the card business and rewards program, which have proven to be big drivers of sales and customer loyalty. To me its an integrated retail strategy that has worked theres no good reason to discount it from a valuation standpoint. The stock has done well over the past year. How cheap do you consider it at a recent $50.50?
Cabelas
Valuation Metrics
(@2/27/13):
(NYSE: CAB)
Business: Direct marketer and specialty retailer in the U.S. and Canada of hunting, fishing, boating, camping and other outdoor merchandise and related apparel. Share Information
(@2/27/13):

(@12/31/12):
CAB 20.8 14.1 15.3
S&P 500 17.9 13.7
Price
50.46
33.10 - 56.78 0.0% $3.54 billion $3.11 billion 9.5% 5.6%
Financials (TTM):
CAB PRICE HISTORY 60 60 50 50 40 40 30 30 20 20 10 10 2011
Company The London Co BlackRock Dimensional Fund Adv Vanguard Group McCarthy Capital
% Owned 5.5% 4.4% 4.2% 3.7% 2.9% 8.0%

60 50 40 30 20
Shares Short/Float
Close
SG: Specialty retailers typically go for 1216x EBITDA and wed put Cabelas at the high end of that range given its growth profile. On 2013 EBITDA estimates, that would put the shares in the low-$60s. But given the low- to mid-teens annual profit growth we expect the company to produce, that should be a moving target. Is there any insider buying or selling of note here? SG: There is one director we watch very closely, Reuben Mark, the former Chairman and CEO of Colgate-Palmolive. He bought stock in March 2011 in the mid$20s, more in May 2012 in the mid-$30s,
2012
2013
10
THE BOTTOM LINE
Following an operational overhaul under new management that has sharply improved returns on capital, Stephen Goddard believes the company is poised to take advantage of still-fertile expansion opportunities. His low-$60s estimate of current share value should be a moving target, he says, as profits grow at a low- to mid-teens annual rate.
February 28, 2013
and more again in November of last year in the mid-$40s. Following his lead has proven to be pretty smart so far. Your next idea, cigarette-maker Lorillard [LO], is certainly not without its share of controversy. SG: The company was founded in 1760 and is the third-largest manufacturer of cigarettes in the U.S. Its flagship brand is Newport, the leader in the menthol category, but other brands include Kent, True, Maverick and Old Gold. The international rights to its brands were sold decades ago, so its almost entirely U.S. This is one of the highest-return-ontangible-capital companies in our universe. The cigarette business has very high barriers to entry and Lorillards dominant share in menthol cigarettes by far the strongest relative segment of the market translates into significant pricing flexibility and operating margins in the 40% range. Returns on tangible capital have averaged more than 100% over the last three years. With all cigarette manufacturers, regulation and legal risk are nearly always present. The Food and Drug Administration has for years been reviewing menthol cigarettes, which have a smoother taste that critics say makes it easier to start smoking and attracts a younger and more urban audience. Our view is that nothing major on these fronts will materially hurt the business model. The FDA is unlikely to outlaw or ban menthol cigarettes too many consumers want the product and billions of dollars in tax revenues are associated with it. Banning menthol would just cause a black market to develop. But theres little question that the uncertainty with the case is an overhang for the stocks valuation. Youve spoken very highly of the companys CEO, Murray Kessler. What do you think hes doing right? SG: We had a very successful experience with him when he was CEO of smokelesstobacco manufacturer UST, which was
February 28, 2013
acquired by Altria in 2009. Hes basically following the same playbook here: focused on the core business, managing for margins and returns, and returning virtually all the available free cash to shareholders through aggressive dividend hikes and buybacks. Weve made a lot of money following the same successful jockeys around and think that will be the case here as well. Nothing is likely to happen until theres some resolution on the regulatory front, but Lorillard would make an excellent acquisition either for a foreign tobacco company wanting to expand in the U.S.
INVESTMENT SNAPSHOT
or an existing player who could take out significant costs and was looking to build its presence in menthol. Is there a balance-sheet optimization opportunity here? SG: With a stable business and ample free cash flow, we believe the company could maintain its current capital structure and buy back stock at a double-digit annual pace. Assuming the current EBIT margin and 2% growth per year, we value the stock at $50, nearly 30% above the current price [of just under $39].
Lorillard
Valuation Metrics
(@2/27/13):
(NYSE: LO)
Business: Manufacturer and seller of cigarettes, primarily through wholesale distributors in the U.S. Key brands include Newport, Kent, True and Old Gold. Share Information
(@2/27/13):

(@12/31/12):
LO 13.8 11.5 7.7
S&P 500 17.9 13.7
Price
38.84
36.70 - 47.02 5.5% $14.73 billion $4.64 billion 44.1% 23.7%
Financials (TTM):
LO PRICE HISTORY 50 50
Company Capital Research BlackRock Fidelity Mgmt & Research Vanguard Group Massachusetts Fin Serv
% Owned 10.5% 6.9% 5.8% 4.5% 4.2% 4.9%

50
Shares Short/Float
Ad
40 40
40
30 30
30
20 20
2011
2012
2013
20
THE BOTTOM LINE
While the market is understandably concerned by the threat to the companys business of future FDA action on menthol cigarettes, Stephen Goddard doesnt believe new regulation will materially hurt its business model. At the 15x EBITDA multiple he believes the company would fetch in an acquisition, the stock would trade at around $50 per share.
What might an acquirer pay? SG: Given the strategic and/or synergistic value to another cigarette manufacturer, we could see the company going for 15x EBITDA on an enterprise-value basis, which on our 2013 numbers would also be around $50 per share. On top of that, managements goal going forward is at least a 10% annual return to shareholders from the dividend the current yield is 5.5% and share buybacks. If theyre able to resolve the FDA issue and continue to increase prices and margins as theyve done in the past absent M&A or any change in the multiple wed expect total annual returns on the stock in the 15%20% range. Tell us about the very highly concentrated portfolios you run for some clients. SG: Some of the consultants have come to us and said they want to put together a number of very concentrated best-ideas
portfolios that are perfectly well diversified as a package. In our concentrated portfolio well have 10 to 15 positions, but often with 50% or more of the total capital in the top three or four. I think this portfolio is likely to outperform our other more-diversified port-
are the biggest enemies of long-term outperformance. Can you single out one biggest worry in todays investing environment? SG: Uncertainty in Washington probably worries me the most at some point we have to start addressing the major debt issues rather than keep putting them off. I would say that we dont put much energy and effort into worrying about macroeconomic issues in our bottom-up process. Whatever we know on the macro front is likely already discounted, so we dont think we can add value there. A former colleague used to say, Its the things people arent worried about that you need to worry about, which I think is often true. What hits us often comes out of left field and we dont anticipate. Thats why we spend most of our time focusing on individual companies and known facts, versus speculating on macro issues that may or may not happen. VII
ON RISK: Investors dont focus enough on avoiding downside risk and major mistakes, the enemies of out-performance.
folios over time, largely because it focuses us even more on making sure were not wrong rather than on where we can be most right. It also allows our winning positions to have far more impact on the overall portfolio. I dont think investors pay enough attention to avoiding downside risk and major mistakes, which to me
February 28, 2013
S T R A T E G y : Seth Klarman
Permanently Risk-Off
Legendary investor Seth Klarman in these excerpts from his latest annual letter takes a less-than-sanguine view of the global macroeconomic environment, praises anti-fragility, describes the high bar to be cleared before he makes an investment, and reflects on lessons learned in the 30 years since The Baupost Group was founded.
Market Forces at Bay The success of an investment firm is necessarily dependent on the actions of others. The collective behavior of the entire community of investors determines market prices, and price fluctuations, in turn, drive investment opportunity. In other words, determined effort, deep analysis, strong processes, and good judgment are necessary but not sufficient for investment success. When buyers are numerous and sellers scarce, opportunity is bound to be limited. But when sellers are plentiful and highly motivated while potential buyers are reticent, great investment opportunities tend to surface. The actions of two powerful figures, Ben Bernanke and Mario Draghi, impacted us and other investors profoundly last year. Throughout 2012, the Federal Reserve chairman and his counterpart at the European Central Bank (ECB) were maestros whose monetary symphonies beguiled most investors. Their seductive melodies, consisting of the same flat notes of lenient policy actions and endlessly offbeat repetitions, had the effect of intensifying competition for investments by luring many investors into paying up for risky assets while dampening any urgency sellers may have had. Bernankes plan for quantitative easing (QE3), announced in September 2012, involved the Feds purchase of $40 billion of agency mortgagebacked securities (MBS) a month. Then, only three months later, he effectively doubled down with a plan to augment the MBS activity with monthly buybacks of $45 billion of long-term U.S. Treasury securities. Bernankes ongoing financial experiment (now in its fifth year and counting) is a real-world test of his Ph.D. thesis on the proper response to a looming depression. In reaction to his efforts, investors belted out a resounding chorus of risk on for much of the year.
February 28, 2013
While economic conditions in the U.S. have moderated from crisis levels, Eurozone economies continue to struggle. Greece remains mired in economic depression; its GDP today is 19% below its level of four years earlier. Reported Spanish unemployment hit 25% recently, the highest since 1976. Mario Draghis midyear announcement to undertake Outright Monetary Transactions (OMTs), in which
THE RISK OF RISK ON: When market forces reassert themselves, those who grabbed for return and bore excessive risk will encounter substantial declines.
the ECB buys back shorter-term maturities between one and three years of peripheral European countries sovereign debt, calmed markets while provoking risk taking. Spain, Italy, and other countries have temporarily benefited from issuing debt at interest rates well below what the market would have otherwise demanded, while European banks purchase debt of their own sovereigns through collateralized borrowings in a new form of carry trade. Meanwhile, according to the International Monetary Fund (IMF), the underlying sovereign debt-to-GDP ratios of Portugal, Ireland, and Spain all continue to grow. According to the IMF, Germany and France Europes core now have debt-to-GDP ratios of 83% and 90%, respectively, a level considered dangerous for any countrys long-term fiscal soundness. The sovereign debt crisis and Eurozone fiscal imbalances remain grievous threats to the global economy, with Draghi effectively declaring a three-year truce between debtors and creditors at
great expense to the healthier European economies. His actions are keeping market forces temporarily at bay, but when they re-emerge another day of reckoning will be at hand. Thanks to Bernankes and Draghis interventionist policies and the markets belief that they will continue indefinitely interest rates have plummeted. In the U.S., the ten-year Treasury bond yield bottomed at 1.43%, while the yield on thirty-year Treasuries hit an astonishingly low 2.46%. Triple-A-rated Microsoft recently issued five-year paper at less than one percent, while the five-year Treasury bond yielded as little as 0.56%. Similarly in Europe, rates in most countries fell significantly while bond prices surged. Vanishing interest rates have combined with the pressures wrought by short-term, relative investment performance measurement to drive investors into riskier investments (i.e., risk on). Desperate for yield, investors poured money into high-yield bond funds; 2012 inflows into such funds more than doubled the previous yearly high set four years ago. As a result, junk-bond investors have posted huge gains as yields plummeted to all-time record lows in late 2012 and again in early 2013. Similarly, yields on commercial mortgage-backed securities hit their lowest level since the inception of the Barclays Capital U.S. CMBS Investment Grade Index in 1997, while leveraged loan issuance hit a fiveyear high. As perceived risk dropped and bond yields plummeted, most global equity markets surged in 2012 in an equally frenetic reach for return. Both the Russell Midcap Index and the Russell 2000 Index of small-cap stocks hit an all-time high just yesterday. When todays aggressive policies finally end and market forces reassert themselves, those who grabbed desperately for return and bore excessive risk to do so will encounter substantial market value declines.
Ticking Time Bomb Turning our attention homeward, our nations ever-mounting burden of on- and off-balance-sheet liabilities is a ticking time bomb. The U.S. now owes $16.4 trillion to creditors, up from $10.6 trillion only four years ago, an increase of over $50,000 per household over those four years. Assuming a continuation of current tax and spending policies, public debt, only 38% of GDP in 1965, is projected by the Congressional Budget Office to hit an ominous 90% of GDP within ten years and by JPMorgan to hit an absurd 247% of GDP within thirty years. The government is on the hook for about another $55 trillion, in addition to public and intragovernmental debt, to meet other federal commitments and unfunded entitlement programs such as Social Security and Medicare. The cost of such entitlement programs, well under one-third of the federal governments total outlays in 1960, amounted to two-thirds of federal spending by 2010. On its current path, commentator Fareed Zakaria recently warned in Foreign Affairs, the U.S. federal government is turning into, in the journalist Ezra Kleins memorable image, an insurance company with an army.1 In 2011, the federal government took in approximately $2.3 trillion of revenue and spent roughly $3.6 trillion, running up a deficit of over 8% of GDP. Even the most aggressive remedies balanced between revenue increases and spending cuts, such as those proposed by the Simpson-Bowles deficit-reduction plan, are unlikely to halve the deficit over the next decade and the national debt would continue to mount. These deficits mean that we are spending borrowed money to fund current priorities, while leaving future generations on the hook for the debt we incur. Indeed, the U.S. government currently spends four dollars on citizens over age 65 for every dollar it spends on those under 18.2 Fewer and fewer Americans pay federal income taxes (though most, of course, still pay FICA withholding, local sales, and real estate taxes), while increasing numbers receive payments from the
February 28, 2013
government. Tackling the federal deficit would weaken an already soft economy, while failing to act would push us closer to unsustainable debt levels. To meet the annual cost of all its unfunded obligations, the U.S. government would, by some estimates, need to take in an additional $7 trillion a year. Yet all federal taxable income individual plus corporate, in its peak year of 2006 totaled only about $6.7 trillion, meaning that these entitlements are completely unaffordable and can never be paid.
RAMIFICATIONS OF dEBT: Its like driving with a faulty navigation system along a steep mountain road at night while wearing a blindfold.
The fiscal cliff deal to raise tax rates for the wealthy may matter symbolically, but the recently voted increases only scratch the surface of the deficit problem. Meanwhile, the absence of any agreement on spending cuts augurs ominously for the future. The sooner we acknowledge the full reality of our predicament and amend benefits and eligibility for these programs, the better the chance of limiting the uncertainty and potential social upheaval when the promised benefits fail to appear. Worse still, todays debt-service costs are artificially low because interest rates have been pushed down by QE, masking the mounting danger. One prominent economist bizarrely argues (twice weekly) that todays deficits pose no danger because interest rates remain historically low, as if QE were not artificially driving down rates and as if markets are not both fickle and often wrong. Government debt maturities, which, in a rational world, should have been extended during a time of low rates, have, in fact, been shortened. Total interest expense on the federal debt is roughly unchanged from 2007 levels, even though the debt is about 80% greater. The shorter debt duration also means that the U.S. government must tap
the capital markets to the tune of about $4 trillion annually, including amounts needed to fund the deficit and refinance debt maturities. It is dangerous to need constant access to the capital markets for such staggering amounts of financing. An unknowable tipping point looms over the horizon. When we reach it, outsiders and U.S. citizens alike will become suspicious of our creditworthiness, causing interest rates to rise and the dollar to plummet. Holders of greenbacks will rush to spend their money while it still has some value, causing the prices of goods and stores of value (like gold) to surge. No one knows precisely how much debt is too much, or at what moment the tipping point will be reached. Its like driving a car with a faulty navigation system along a steep mountain road at night while wearing a blindfold. Sooner or later, youre going to plummet over the edge. By the time we reach that point, it will likely be too late. Astonishingly, we seem to lack the political will to act in advance, dooming us to the vicissitudes of volatile markets and the unpredictable hand of fate. As we enter 2013, our nation is on a dangerously flawed trajectory of unprecedented money printing, unchecked government spending, massive federal deficits, government subsidies, artificially low interest rates, and speculative behavior. According to the Pew Research Center for the People and the Press, close to 50% of Americans aged 18 to 29 view capitalism negatively. We arent teaching young people about the virtues of the free-market system, though they do seem aware of its inevitable shortcomings. Meanwhile, even though we are all in this together, the government continues to ask nothing difficult from the majority of its citizens. We talk of everyone paying his or her fair share, but no one discusses the obligation we as citizens have in a democracy to do our fair share. Instead, we are encouraged to follow the feckless path of living beyond our means, making life more comfortable in the near term while the nations crumbling infrastructure, faltering education system, and declining international competitiveness put us further and further behind all
the while piling up a crushing debt burden for future generations. As investors have become accustomed to sputtering economies and massive government intervention, episodic risk-on and risk-off behaviors drive the capital markets. Unexpected bad news means risk off. A stopgap solution to the crisis du jour is offered i.e., a bailout, a rescue, a Band-Aid deal, QE(n) and risk-on resumes. We have been on a roller-coaster ride for the last four years and counting, with no meaningful recovery, no feasible solutions, and ineffectual leadership. Investors conditioned to the short-term trading mentality are increasingly ill prepared for policy changes. What will happen when the Fed declares, as it someday must, that the era of low interest rates is at an end? What if governments holding trillions of dollars of sovereign debt and other securities stop buying and begin to sell? Or if another serious crisis economic, political, international materializes and governments have insufficient ammunition to intervene? The content, though not the timing, of the next chapter in market history is quite predictable. Few will say they saw it coming, though, in fact, everyone could have seen it if they had only chosen to look. Antifragile One of the investment challenges arising from the current environment is that while the U.S. stock market may appear to be quite volatile, posting as much as oneand even two-percent swings on some days, overall market volatility has been low to average over recent months and years. In mid-January, the VIX Volatility Index hit a five-year low. This dampened volatility, accompanied by higher securities prices, is a challenge for Baupost. Big market swings can benefit us. Extremely high prices, for example, are useful for taking profits. Were the markets to rise dramatically from todays levels, we would undoubtedly take advantage by selling into strength. Conversely, if the markets were to drop significantly, we would redeploy cash on hand to thoughtfully scoop
February 28, 2013
up the bargains uncovered by the receding tide. Unfortunately, the Federal Reserves relentless interventions and manipulations (the Bernanke put) have truncated market declines, leaving relatively little worth acquiring at least for now. Nassim Taleb, author of the new book, Antifragile, praises volatility and criticizes those who would artificially damp it at great unseen cost. He is concerned about the rigidities inherent in our system. Taleb writes: Stifling natural fluctuations masks real problems, causing the explosions to be both delayed and more
ON ANTI-FRAGILITy: This is exactly what we strive to do: Embrace elements that benefit from volatility, variability, stress and disorder.
intense when they do take place. As with the flammable material accumulating on the forest floor in the absence of forest fires, problems hide in the absence of stressors, and the resulting cumulative harm can take on tragic proportions. And yet our economic policy makers have often aimed for maximum stability, even for eradicating the business cycle. [In contrast,] Mervyn King, Governor of the Bank of England, has advocated the idea that central banks should intervene only when an economy is truly sick and should otherwise defer action.3 Accepting that we cannot predict the future i.e., that there will always be unexpected and highly consequential events is the first step in becoming less fragile and more adaptable. People should be highly skeptical of anyones, including their own, ability to predict the future, and instead pursue strategies that can survive whatever may occur. Taleb advises us to be anti-fragile i.e., to embrace those elements that benefit from volatility, variability, stress and disorder. This is exactly what we strive to do at Baupost, and Taleb has coined a name for it. The world will always deliver surprises coming from left field, things that have never
happened before or, at least, that no one can remember having happened. As Nobel Laureate Daniel Kahneman notes, people tend to underestimate the odds of extreme events that havent occurred recently. Its a tendency known as availability bias. This tendency is crucial to effectively position ourselves to survive and even thrive regardless of an uncertain future. How do we do that? By eschewing portfolio leverage, keeping ample cash balances ready for rapid deployment, pursuing a mostly generalist and flexible approach while avoiding narrow silos, seeking bargainpriced investments where possible adverse developments are already priced in, holding numerous investments with uncorrelated catalysts to drive outcomes irrespective of market levels, maintaining prudent diversification, demanding high intellectual honesty while consistently striving to improve, and having clients whose longterm orientation matches our own. High Bar We clear a high bar before making an investment, and we resist the many pressures that other investors surely feel to lower that bar. The prospective return must always be generous relative to the risk incurred. For riskier investments, the upside potential must be many multiples of any potential loss. We believe there is room for a few of these potential five and ten baggers in a diversified, low-risk portfolio. A bargain price is necessary but not sufficient for making an investment, because sometimes securities that seem superficially inexpensive really arent. Value traps are cheap for a reason perhaps an inept and entrenched management, a poor history of capital allocation, or assets whose value is in inexorable decline. A catalyst for the realization of underlying value is something we seek, but we will also make investments without a catalyst when the price is sufficiently compelling. It is easy to find middling opportunities but rare to find exceptional ones. We conduct an expansive search for opportunity across industries, asset classes, and geographies, and when we find compelling barValue Investor Insight 24
gains we drill deep to verify the validity of our assumptions. Only then do we buy. As for what we own, we continually assess and reassess to incorporate new fundamental information about an investment in the context of market price fluctuations. When bargains are lacking, we are comfortable holding cash. This approach has been rewarding as one would hope with a philosophy that is painstaking, extremely disciplined, and highly opportunistic. Fundamental Lessons We opened our investment partnerships for business in early 1983, a fledgling firm with an investment philosophy adopted straight from Graham and Dodd. Weve refined that approach a bit over the years, pursuing some new asset classes (commercial real estate) and covering some new geographies (weve become more global), but we have stuck to the bedrock principles of value investing and are far better off for it. We seek absolute returns, not relative ones, and resist being benchmarked against market indices for that reason. We have always had a traditional, seat-of-the-pants view of risk, and we steer clear of the foolhardy academic definition of risk as volatility, recognizing, instead, that volatility is a welcome creator of opportunity. Weve maintained a commonsensical, albeit increasingly unconventional, approach to investing in that we strive to maintain a long-term perspective in a world of short-term actors, and we patiently hold cash in the absence of compelling opportunity, refusing to pull the trigger until the target is clear and compelling. Oddly, few others seem willing or able to follow suit. We put our money where our mouths are, always
aligning interests as much as possible by investing the vast majority of our personal net worths in our partnerships directly alongside client capital. We pursue opportunity largely off the beaten path, sifting through the debris of financial wreckage, out-of-favor securities and asset classes in which there is limited competition. We specialize in the highly complex while mostly avoiding plain vanilla, which is typically more fully priced. We happily incur illiquidity but only when
ON STRATEGy: We sift through the debris of financial wreckage, out-of-favor securities and asset classes with little competition.
we get paid well for it, which is usually when others rapidly seek liquidity and rush to sell. We make no heroic assumptions in our analysis, hoping, instead, that by compounding multiple conservative assumptions, we will create such a substantial margin of safety that a lot can go wrong without impairing our capital much or even at all. We never invest just to invest and dont bet blindly on mean reversion or on historical relationships holding up. Our settings are permanently turned to risk off. For thirty years, weve been more focused on risk than on return, which perhaps counterintuitively has actually served us well in achieving strong returns with very limited likelihood of permanent capital impairment. Weve suffered marketvalue declines in only two years out of
thirty. We always work hard, really hard, to find compelling opportunity. But we are cognizant of the risk in trying overly hard to make money, because in investing one can definitely try too hard, which usually involves overpaying, excessive risk tolerance, and an increasingly compressed time horizon that often leads to lower rather than higher returns. Pressuring yourself or your team for results is, more often than not, counterproductive. Rather, we strive to avoid loss, which actually works as intended. In 2012, as in every year prior, we incurred only very limited risk, assiduously searched for opportunity and found some, and achieved many successes with relatively few mistakes, while earning decent risk-adjusted returns. Some twenty-one years ago, Margin of Safety was published, which spelled out why financial markets werent, and never would be, efficiently priced and what we intended to do about it. I endeavored to make the book timeless more about how to think about investing than about what one should buy or sell at any given moment. Some of the categories of opportunity I wrote about hardly exist today (e.g., thrift conversions), while others that have emerged in recent years couldnt have been specifically contemplated two decades earlier (e.g., distressed structured products). But while the categories and the specific opportunities may have changed, the fundamental lessons remain. VII Footnotes: (1) Fareed Zakaria, Can America Be Fixed? Foreign Affairs, January/ February 2013; (2) Fareed Zakaria, Can America Be Fixed? Foreign Affairs, January/February 2013; (3) Nassim Nicholas Taleb, Learning to Love Volatility, The Wall Street Journal, November 16, 2012.
2013 The Baupost Group, L.L.C. Reprinted with permission for sole use by Value Investor Insight, Issue No. 97. Further copying, redistribution or resale by anyone other than Value Investor Insight is prohibited, whether electronically or in paper form. Baupost and The Baupost Group are registered service marks of The Baupost Group, L.L.C.
February 28, 2013
General Publication Information and Terms of Use
Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the Site) by Value Investor Media, Inc. Use of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse. For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use. No Investment Advice This newsletter is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This newsletter is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financ ial situations, or needs of individual investors. The price and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this newsletter may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Disclaimers There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this newsletter. Value Investor Media will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this newsletter, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this newsletter. Related Persons Value Investor Medias officers, directors, employees and/or principals (collectively Related Persons) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter. Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, a registered investment adviser. T2Partners Management, LP may purchase or sell securities and financial instruments discussed in this newsletter on behalf of certain accounts it manages. It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of this newsletter before purchases or sales are made of any securities or financial instruments discussed herein as Investment Snapshots. Compensation Value Investor Media, Inc. receives compensation in connection with the publication of this newsletter only in the form of subscription fees charged to subscribers and reproduction or re-dissemination fees charged to subscribers or others interested in the newsletter content.
February 28, 2013

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ValueInvestor

February 28, 2013

The Leading Authority on Value Investing

Perkins Investment Management

Reward vs. Risk

Other companies in this issue:

Lorillard NewMarket Stryker Two Harbors Investment

Investor Insight: William Ackman

Pershing Square Capital Top Holdings

Valuation P/E (Est.)

February 28, 2013

Value Investor Insight 3

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

HLF 9.2 6.9 5.5

S&P 500 17.9 13.7

Largest Institutional Owners

% Owned 13.9% 7.6% 5.3% 4.0% 3.6% 34.8%

THE BOTTOM LINE

February 28, 2013

Always on the lookout for better investment ideas?

Or call toll-free: 866-988-9060

Want to learn more? Please visit www.valueinvestorinsight.com

February 28, 2013

Value Investor Insight 6

Investor Insight: Perkins Investment

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

KEX 20.6 16.1 10.0

S&P 500 17.9 13.7

Largest Institutional Owners

% Owned 7.5% 5.2% 4.9% 4.9% 4.4% 7.8%

THE BOTTOM LINE

February 28, 2013

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

JEC 16.2 13.2 7.8

S&P 500 17.9 13.7

Largest Institutional Owners

% Owned 6.5% 5.8% 5.4% 3.8% 3.7% 1.8%

THE BOTTOM LINE

February 28, 2013

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

SYK 18.8 13.5 9.4

S&P 500 17.9 13.7

Largest Institutional Owners

% Owned 8.4% 4.2% 3.8% 3.4% 3.2% 1.8%

THE BOTTOM LINE

February 28, 2013

Value Investor Insight 11

Two Harbors Investment Corp.

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

TWO 10.4 n/a n/a

S&P 500 17.9 13.7

Largest Institutional Owners

% Owned 7.1% 4.2% 3.5% 3.1% 2.7% 4.6%

THE BOTTOM LINE

February 28, 2013

discover Financial Services

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)

DFS 8.6 8.5 n/a

S&P 500 17.9 13.7

Largest Institutional Owners

% Owned 5.9% 4.8% 4.2% 2.8% 2.7% 0.5%

THE BOTTOM LINE

February 28, 2013

Investor Insight: Stephen Goddard