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Ricky Sandler Eminence Capital ValueInvestorInsight-Issue 80

Ricky Sandler Eminence Capital ValueInvestorInsight-Issue 80

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Ricky Sandler's Eminence Capital featured in Value Investor Insight
Ricky Sandler's Eminence Capital featured in Value Investor Insight

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ValueInvestor

August 25, 2006

The Leading Authority on Value Investing

INSIGHT
Inside this Issue
F E AT U R E S

Quality Control
It’s rare for great businesses in structurally sound industries to get relatively cheap. When they do, Ricky Sandler is quick to take advantage.

W

ith a highly successful investor as a father, Ricky Sandler has often been tempted to join the family’s investment firm. “My dad has asked me something less than a 1,000 times, but more than a 100, to come work with him,” he says. “I've always wanted to do things on my own.” Sandler’s independent streak has paid off handsomely for his Eminence Capital investors since he started the firm in 1999. Now with $3.2 billion in assets, Eminence has returned 20% net to investors annually, vs. a 2% annual gain for the S&P 500. Sandler today sees particular opportunity in large-cap growth stocks. “When valuations are compressed and everything trades for 13-17x earnings, it's time to trade up for See page 2 quality and growth,” he says.

I NVE STOR I N S IG HT

Investor Insight: Ricky Sandler Seeing bright future prospects for Cisco, Applied Materials, Oracle and Arbitron, but clouds on the PAGE 1 » horizon for Lexmark. Investor Insight: Robert Robotti Finding eclectic mix of unrecognized value in shares of Atwood Oceanics, Drew Industries, Zenith National PAGE 1 » and Pre-Paid Legal. Special: SuperInvestor Insight Our new publication, tracking the activity of the world’s best investors:
I

Ricky Sandler Eminence Capital, LLC Investment Focus: Seeks companies earning high returns on capital which have “tripped” or are in secularly strong but currently out-of-favor industries.

I I I I

Up Front What They’re Buying What They’re Selling What They Own Stock Spotlight

PAGE 19 » PAGE 20 » PAGE 22 » PAGE 24 » PAGE 26 »

Not-So-Ugly Ducklings
There are plenty of prosaic companies in his portfolio, but Bob Robotti’s ability to unearth great values over the past 20 years is anything but dull.
I NVE STOR I N S IG HT

Editors’ Letter “Why wouldn’t you look at what other great investors have found?” Why, indeed. PAGE 28 »
INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS Applied Materials Arbitron Atwood Oceanics Cisco Sytems Drew Industries Lexmark Oracle Pre-Paid Legal Services Walter Industries Zenith National PAGE 6 9 14 5 15 10 8 17 26 16

A

Robert Robotti Robotti & Co. Investment Focus: Seeks ignored or temporarily struggling small-cap companies with the potential to at least double their share price within three years.

s CFO of the then 12-person Gabelli & Co. in the early 1980s, Bob Robotti got plenty of exposure to the investment process – if not much input into the actual decisions made. “Let’s just say Mario Gabelli didn’t need me to pick stocks,” he says. Since starting his own investment firm in 1983, Robotti’s record as a decision-maker has been superb. Focusing on unloved or unknown smaller-cap stocks, he’s returned an average 17.4% annually to investors over the past 20 years, vs. 10.3% per year for the Russell 2000. Great runs by the energy and small-cap companies on which he focuses haven't diminished his ability to find values, he says: “Volatility will likely be up, but we’re findSee page 12 ing plenty of things to buy.”

Other companies in this issue:
Acergy, Advanced Marketing Services, Apple Computer, CBS, Clear Channel, Comcast, First Data, Hewlett-Packard, McDonald's, Microsoft, NewMarket, News Corp., Ross Stores, Sears, Viacom, WalMart, Wendy's, Williams, Yum Brands

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Ricky Sandler

Investor Insight: Ricky Sandler
Ricky Sandler of New York’s Eminence Capital describes why he’s finally gotten interested in technology stocks, why a serious commitment to shorting makes him a better investor, what he thinks the market is missing in Cisco, Applied Materials, Oracle and Arbitron, and why he thinks Lexmark is a great short.
How has your investing philosophy evolved since you started your first firm, Fusion Partners, with Wayne Cooperman in 1994? Ricky Sandler: The philosophy is still very much the same. We called it then and I call it now “quality value.” Morris Mark, for whom both Wayne and I worked at Mark Asset Management, had a big influence because of his emphasis on research and on owning great businesses – great companies in secular growth businesses with excellent industry structures. Morris was more willing to buy a great business with less regard for price, but we believed you could pay too much for even the greatest business. We were also more open to the fact that there was a price at which a mediocre business could be attractive. So our focus was along the spectrum between “reasonable business at a great price” and “great business at a reasonable price”, with the rest being uninvestable. That’s still what I do today. One thing that has changed is my commitment to shorting. Wayne and I spent 80% of our time on the long side and 20% on the short side. Shorting was more of an afterthought, we didn’t dig in as much on the companies there. But when the markets tanked in 1998 – and in six months Fusion went from something like up 15% to down 15% – I realized it was very uncomfortable to want to buy more of what you own when you weren’t sure you were still going to be in business. We ultimately ended up flat on the year, but when I started Eminence, I committed to being aggressive short sellers and spending almost half our time on the short side. You’ve said you think actively shorting makes you a much better investor. Why? RS: I saw in 1998 that without having a commitment to the short side, it’s difficult
August 25, 2006

to be offensive when you should be. The highest-return opportunities are available when markets are in free fall, but if you’re getting shelled, you may not have the emotional conviction to be aggressively opportunistic and you may not even be able to do it, because of redemptions. Being able to be offensive when everybody else is defensive, in and of itself, can yield excess returns. A second element is that as true, committed short sellers, we have to be immensely skeptical, and skepticism is a terrific quality in a value investor. A key reason for our success is that we have a very high batting average on the long side. We’re better at avoiding mistakes because we’re very attuned to those situations where value gets destroyed, or where it isn’t really there in the first place, say, because of phony accounting. We employ gross leverage. Typical for us might be to be 120% long and 70% short. We could not be 120% long without also being 70% short – there’d be too much risk and volatility for our investor base. People say shorting is a waste of time and you never make money. I’d say just breaking even on my shorts allows me to be 120% long and still not have a lot of volatility. Shorting is and should be a profit center, but the benchmark people use to compare against is often wrong. The last element is that we believe the fundamental structure of a long/short portfolio minimizes the systematic risk you can’t control, say of a terrorist attack or a Russian debt crisis. If you employ the gross leverage we do, you’re then magnifying your stock-specific risk – exactly the risk we feel we should be taking. Do you tend to short specific companies or baskets of stocks? RS: We typically like to short individual stocks. Right now, though, we have a
www.valueinvestorinsight.com

Ricky Sandler

Not Far From the Tree
Ricky Sandler couldn't have asked for a more compatible partner when he and fellow Mark Asset Management analyst Wayne Cooperman started Fusion Partners in 1994. They were both in their mid-20s, shared a “quality value” orientation and were sons of Goldman, Sachs alumni who had started their own thriving investment firms: Harvey Sandler of Sandler Capital Management and Leon Cooperman of Omega Advisors. “We both thought we were ready to run our own portfolio,” says Sandler, “but there was some comfort in having a partner to do that with.” Within four years, Sandler and Cooperman built $28 million in start-up capital – $10 million from each of their families – into $350 million in assets. But their investment styles were evolving in different directions. “Wayne moved more to a deep-value emphasis, while I was increasingly focused on the quality of the business,” says Sandler. Since the partners went their separate ways in 1999, Sandler's Eminence Capital and Cooperman's Cobalt Capital have both thrived. Says Sandler: “It goes to show you there are a lot of ways to skin a cat in this business.”
Value Investor Insight 2

I N V E S T O R I N S I G H T : Ricky Sandler

bigger than average balance sheet on the long side – closer to 160% long – because we’re finding all these big companies we want to have 5% positions in. To support that, we’re now around 90% short, which is requiring us to use more indices than usual. The M&A environment makes us hesitant to significantly increase the number of company-specific shorts we have. We were short Albertson’s. We were short Sports Authority. These are structurally bad businesses that somebody came along and bought. We have to be aware of that and not add too much risk to the portfolio by adding a lot of new individual short positions. Back to the long side, what situations tend to result in your finding quality value? RS: One is the good company in an industry that’s out-of-favor, for whatever reason. Another is the good company that trips – the disappointment that hasn’t impaired the long-term value of the business, but the market overreacts in pricing it down. The third would be the good business that isn’t necessarily in plain sight – it’s obscured, say, by other business lines or special situations. Joel Greenblatt talking in your last issue [VII, July 28, 2006] about American Express is a good example. I’m probably more willing to pay up for quality than other value investors might be. Some of my investor friends often tell me my ideas are “too high-quality” for them. I would distinguish somewhat here from paying up for growth – I’ll pay more for a high-quality, slowgrowing business. I look for companies that will grow value, not necessarily revenue, at above-average rates. The higher the quality of the business, the lower discount to our estimated value we need. We’re happy to buy a great business at 75 cents on the dollar. Something would need to be at 50-60 cents on the dollar for us to buy a mediocre business. On average, I’d say our typical investment is 30-35% cheaper than we think it ought to be and we think it’s increasing value at 15-20% per year on top of that.
August 25, 2006

Describe how you come up with ideas? RS: Our best ideas tend to come from what I call “old research, new events”. That’s typically the good company you’ve studied carefully and would love to own at the right price, that gets marked down after it trips or its industry goes out of favor. A great example was Yum Brands a couple years ago. Comp sales at one of their restaurant chains, KFC, were way off one quarter and the stock crashed 35%. It instantly became an idea – I knew it was a good business and now it was on sale at a 35% discount. We also learn a lot from other investors. I go to idea dinners and regularly talk to a lot of people in the business. I’m not afraid of ideas owned by other people, but you obviously need to do your own work and make sure they fit what you do.

declines – kind of the opposite of what we look for on the long side. Wall Street tends not to fundamentally mark stocks down until bad news actually shows up in the numbers. We’ll ignore the supposed value today and focus on whether we think the “E” in a P/E is going to be materially less in three to five years. Once you’ve identified a potential idea, what do you do next? RS: We’ll put an analyst on it, who’s always paired on the idea with me or one of the two other principals in the firm. We’re leveraging the senior person’s time, but also want more than one pair of eyes looking at things. We’ll prepare a basic two-page writeup after ripping through the 10-Qs, 10-Ks and proxy filings and listening to conference calls. We want to get our arms around the business both quantitatively and qualitatively, so we summarize things like the company’s businesses, the competitive environment, recent financials, earnings quality, management, outstanding litigation and valuation. What jumps off the page for you? RS: I focus on return on capital and want to see EBIT compared to invested capital in the high-teens or better. We’ll look at it with and without goodwill, to try to separate out the impact of capital-allocation decisions versus operating decisions. We favor companies with some form of amortization, where we think cash flow is higher than reported earnings and that may be one reason why the stock is undervalued. We want to understand how net income plus depreciation and amortization is converted to cash flow from operations. Is anything getting lost in working capital or coming from other gains? We also focus on the relationship between capital expenditures and depreciation, to better understand how capital intensive the business is. If we still think the idea is interesting, we’ll set up calls with the company to better understand how they operate and think about things like capital allocation.
Value Investor Insight 3

ON SHORT OPPORTUNITIES: We’ll ignore the supposed value today and focus on whether the “E” in a P/E is going to be materially less in three to five years.
Many of our other ideas just come from having our eyes wide open. You read publications like yours. You talk to contacts you’ve developed in various industries. It’s often just about paying attention to what’s going on in the world. On the short side, what attracts your attention? RS: We primarily look for material disconnects between our view of economic earnings and the earnings that are reported and people are using to value the stock. It could be accounting related, so we pay careful attention to things like rising accounts receivable relative to total sales, cash from operations that is not keeping pace with net income and decreasing returns on capital. We also look for long-term structural
www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Ricky Sandler

If that checks out, we’ll probably take a “R&D” position in the stock of 1-2%. Why not finish your research before you start buying? RS: We’ve already done a lot of work, so it’s not like we’re winging it. Action adds a sense of urgency to the work – there are so many things to look at in this business that things can fall through the cracks unless you force yourself to focus. Having capital on the books does that. We never stay at the R&D position size – it’s always then an up-or-out process. We spend another several weeks on field research, visiting management and speaking with as many people as possible who can give us insight into the company and industry. We tailor the field research to what we need to know. In Yum Brands’ case, we spoke to a lot of franchisees to really understand the health of their system. It’s not about how sales are going this month, it’s trying to understand from the people in the trenches things like how good the products are, why they have the market share they do, what’s happening to the market share and where the money is made in the system. When we find out the company’s a bad business partner, there are structural industry issues we didn’t know about or maybe there’s an earnings miss we decide isn’t a short-term event – then we’ll sell. But if every step of the way you get more excited by what you uncover, those are the companies that become 5%, 6%, 7% positions in the portfolio. Most investors try to get some sort of informational advantage. What does it take to be good at that? RS: lt certainly takes a lot of effort to call 40 Cisco distributors and get them to talk to you. It also takes a certain personality. People fundamentally like to talk about what they do, but they’ll only do that if you approach them the right way. You also have to listen very carefully. You may ask a distributor about price discounts and he’ll say, “That’s not much of an
August 25, 2006

issue, but trade-in values are going up.” That might be an interesting thing to pursue – you may have noticed inventories going up, but you didn’t really know why. How long do you tend to hold positions? RS: Our typical holding period is 18 months to two years. We don’t actively trade around positions, but we do manage position sizes around our updated analysis of intermediate-term risk/reward. As that changes, we’ll add or subtract to longer-term holdings. Volatility can be a friend of the value investor – it provides more situations where stocks significantly diverge from their intrinsic value and can allow us to turn our capital faster. Say something moves 50% in four months when we thought that might take two years. If it’s now 80-90% of what we think it’s worth, we’ll take money off the table and put it in something that maybe just got

sion was going to happen. We sold the other half because we saw a better opportunity. We’ve owned Ross Stores [ROST] off and on for years and when the stock got hit, we wanted to buy it without increasing our consumer discretionary exposure, which we think is the most stretched part of the economy. Why sell Wendy’s earlier this year? RS: We had bought in the low $40s, seeing unrecognized value in the Tim Hortons chain and in real estate assets. With the stock at almost $60, that thesis was played out. We sold because we thought the remaining upside – primarily from fixing the core Wendy’s business – wasn’t high enough and would take too long to be realized. When Viacom broke into two pieces, also earlier this year, you bought more of the Viacom piece and sold CBS. Why? RS: We like businesses that grow in value, and each of CBS’s businesses – broadcast TV, radio, local stations – is under secular pressure. I think it’s a classic cheap stock that is going to stay that way. They can do things with the balance sheet to maybe take the shares from $25 to the low $30s, but I think they’re hard pressed to fundamentally grow the value of the business. Viacom, on the other hand, has terrific secular growth prospects. If the multiple doesn’t change, we think they’ll grow their way into good returns. If the multiple does change to reflect that growth, the shares will really do well. We’ve been on the wrong side of this trade so far, but I stand by the thesis. We’re assuming selling your Apple Computer position in the third quarter of 2004 is one you’d like back. RS: We were early in seeing – and I still believe – that the digital online business is saving the music industry. We thought the iPod might be huge and that the trend to multimedia devices at home would play to Apple’s strengths. We bought shares,
Value Investor Insight 4

ON SELLING WENDY’S: We thought the remaining upside – from fixing the core business – wasn’t high enough and would take too long.
hit and now has higher intermediateterm potential. Do you have any strict rules for selling? RS: No, every situation is different. Let’s talk about some examples. Why did you sell Wal-Mart in the third quarter of last year? RS: We sold half our stake because we began to question our thesis. One of our reasons for buying Wal-Mart was that we saw material gross-margin opportunity through sourcing benefits and a reduction in import quotas. As the U.S. went back and forth on the quota issue, we started to question whether that margin expanwww.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Ricky Sandler

pre-split, at $25, when the company had something like $11 in cash. The shares went pretty quickly from $25 to about $38 [$19, post-split], which we felt pretty good about. Then we starting thinking, “The hardware guy never makes money, it’s going to get commoditized, so we should stick with the ‘software’ guys like EMI.” We couldn’t have been more wrong on that one. [Apple shares closed recently at around $68.] Do you focus on any particular industries or sectors? RS: It’s easier to describe what we don’t do: oil and gas, commodities, utilities and biotech. We fundamentally believe that energy and commodities have been valuedestroying businesses over time. At the same time, their value tends to be driven by the price of a commodity that we have no ability to predict. With utilities, they don’t tend to be businesses that can create excess value. They might be nice surrogates for bonds, but not much more. In biotech, we just have no illusions that we know how to analyze the business. Outside of these few areas, just about anything else is fair game. You own a lot of technology companies. Has that always been a strength? RS: Up until two years ago, I would have said we didn’t do much in technology – not by design, but because we rarely found companies that met our criteria. The great companies were valued ridiculously and the cheap ones were rarely good businesses and could be wiped off the face of the earth pretty quickly. That world has changed 180 degrees. It’s really been in the last six to nine months that we’ve significantly increased our holdings in technology. Some of the greatest businesses in the world – still growth companies in growth industries – are at significant discounts to small, lousy companies and to the market. It goes back to where we tend to find quality value. You find it when whole industries or sectors are out of favor, and both large-caps and technology are out of favor.
August 25, 2006

A perfect lead-in to talking about some specific stocks. Tell us about your interest in Cisco [CSCO]? RS: The company essentially makes switches and routers, which direct IP traffic within an internal network or between networks. The fundamental driver for demand of this type of equipment is the growth and complexity of data traffic. If you think about what’s happening with things like music, voiceover IP telephony and the transmission and downloading of video files, the growth tailwind behind this industry is quite interesting. This is a case where we probably did
INVESTMENT SNAPSHOT

more field work than usual, focusing very closely on Cisco’s competitive advantages. Why are they able to maintain 70% gross margins? Why do they have such incredibly high market shares? What we ultimately concluded was that Cisco’s service levels, combined with the critical nature of this infrastructure, made competitors a non-factor. No one is willing or able to work with customers the way Cisco does in training them and making sure everything is working. Given how important the functions being supported are, we kept hearing how it didn’t make any sense to go with somebody else to save 20-30%.

Cisco Systems
(Nasdaq: CSCO)

Valuation Metrics
(Current Price vs. TTM):

Business: Global manufacturer and marketer of routers, switches and other digital networking products that facilitate data, video and voice communications. Share Information
(@8/23/06)

P/E P/CF
(@6/30/06):

CSCO 23.8 17.8

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

21.05
16.83 – 22.00 0.0% $128.50 billion

Company Barclays Global Inv Capital Res & Mgmt State Street Corp Vanguard Group Wellington Mgmt
Short Interest (As of 7/10/06):

% Owned 5.0% 4.1% 3.0% 2.5% 2.0% 0.6%

Revenue Operating Profit Margin Net Profit Margin
CSCO PRICE HISTORY
30

$28.48 billion 25.0% 19.6%

Shares Short/Float

30

25

25

20

20

15

2004

2005

2006

15

THE BOTTOM LINE

Cisco’s unassailable competitive strength in a business ideally positioned to benefit as the volume and complexity of data traffic grows is not being adequately valued by the market, says Ricky Sandler. At a more appropriate valuation, he believes the shares are worth at least $25, with value compounding 20% annually on top of that.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 5

I N V E S T O R I N S I G H T : Ricky Sandler

So it’s almost game-over in the enterprise marketplace, where Cisco gets about 80% of its business. In the carrier marketplace, they still have great share, but not quite as strong a position. Carriers have more sophisticated engineers in-house, so Cisco’s service isn’t quite as important, and price is more important. Are growth prospects slowing? RS: We actually became convinced that this was an accelerating growth story, not just a growth story. In the last two quarters you’re starting to see that happen. First-quarter revenue growth was 11%, up from 9%. In the second quarter, sales rose over 12%. Do you consider management to be good capital allocators? RS: One of the most impressive things about Cisco has been the way they’ve integrated acquisitions. Most big companies have done dumb acquisitions and this is not one of them. They bring in a swat team and integrate the business quickly into their own infrastructure and sales force. So we’re very comfortable with their capital-allocation strategy, which is somewhat unusual for a technology company. The market didn’t like the Scientific Atlanta deal and I was a bit skeptical myself. [Note: Cisco’s $6.9 billion acquisition of the set-top box maker closed in February.] But if you start to think about how telco and cable networks are converging, how important video is becoming to Cisco’s business and the type of infrastructure Scientific Atlanta has, the deal begins to make more sense in helping Cisco provide solutions for video IP. Having rebounded recently to just over $21 per share, how are you thinking about valuation? RS: We started buying Cisco late last year when it was trading in the low- to mid-$17s. But even after the recent
August 25, 2006

move, the shares trade at only 15x both calendar 2007 earnings and after-tax cash flow, ex-cash. So we’re getting a 7% free-cash-flow yield in a company with a fortress balance sheet that is growing its top line at double-digits, without requiring capital. Assuming only modest increases in operating margins and continued share buybacks, we think they can easily grow earnings at 20% annually. At a more appropriate multiple, we think the shares should trade for at least $25 per share – with the value of the company growing by at least 20% annually on top of that.
INVESTMENT SNAPSHOT

Applied Materials [AMAT] is another technology leader you’re high on. Why? RS: The company is the largest and most dominant player in the semiconductor-equipment industry and operates across most of the industry’s verticals. Unlike Cisco – where I’d say the whole is greater than the sum of the parts – Applied’s strength comes primarily from its strength in the individual businesses they’re in, which often have different competitors and different industry dynamics. Their market shares range from 10% to 80%, with an average in the high-30s.

Applied Materials
(Nasdaq: AMAT)

Valuation Metrics
(Current Price vs. TTM):

Business: Manufactures, markets and services a broad range of fabrication equipment used by semiconductor manufacturers in North America, Asia and Europe. Share Information
(@8/23/06)

P/E P/CF
(@6/30/06):

AMAT 18.8 17.1

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

15.91
14.39 – 21.06 1.3% $24.88 billion

Company Capital Res & Mgmt Fidelity Mgmt & Res Barclays Global Inv State Street Corp Vanguard Group
Short Interest (As of 7/10/06):

% Owned 12.1% 4.0% 2.8% 2.6% 2.5% 1.6%

Revenue Operating Profit Margin Net Profit Margin
AMAT PRICE HISTORY
30

$14.10 billion 23.3% 15.7%

Shares Short/Float

30

25

25

20

20

15

15

10

2004

2005

2006

10

THE BOTTOM LINE

The prevailing wisdom that the semiconductor cycle is near its demand peak has made the company’s shares “incredibly cheap,” says Ricky Sandler. He believes the cycle has much further to run and that at the 16x multiple of next year’s estimated earnings he believes the company deserves, the shares are worth closer to $25.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 6

I N V E S T O R I N S I G H T : Ricky Sandler

There aren’t scale advantages? RS: Scale does help them with the outsourced foundries, like Taiwan Semiconductor, which are a growing part of the business and want a one-stop shop. It’s less of an advantage with Intel, which has its own engineers and is more than willing to buy etching equipment from one company and lithography equipment from another and put it all together. Scale also helps them in the backend, in investing in development of next-generation technology. It’s not the core of our thesis, but management here really gets how the technology is evolving and how to create value. They’re always doing interesting micro things at an operating level to diversify and expand their business. What is the core of your thesis? RS: There has been a massive underinvestment in capacity in the semiconductor industry since the bottom of the last cycle in 2003. This has been an atypical recovery, as the foundries and other manufacturers have been extraordinarily cautious in adding capacity, even as they operate near 100% capacity and even as we continue to have great growth drivers for semiconductors. This industry has grown at double-digit rates for the last 30 years and that will continue, as more and higher-value chips make their way into new digital cameras, iPods, cell phones and computers. We went back over time and compared overall semiconductor-industry revenue with industry capital spending. The relationship has been relatively stable, but two big things affect it over time. One is that as wafer sizes get bigger, capital spending per dollar of revenue actually drops, as customers get more chip for their money. Offsetting that, though, is that as the circuits on each chip get smaller and more complex, the capital spending versus revenue increases. The first effect, from bigger wafer sizes, is more of a one-time event with a
August 25, 2006

12-to-15 year cycle. The second effect, from increasing complexity, is more consistent and steady over time. The result is that the curve plotting capital spending against revenue slopes upward to the right, with one-time step reductions every 12 to 15 years. The industry went through a wafersize increase from 2001 to 2003 and we won’t see another one until maybe 2014. So the key driver going forward, putting upward pressure on cap-spending requirements, will be ongoing increases in chip complexity. The combination of that dynamic and the fact that companies have been so cautious about spending makes us believe that we’re below

back 6-8% of the company per year and that’s likely to go up. Moving to another technology titan, what do you think the market is missing on Oracle [ORCL]? RS: Oracle, of course, is one of the largest software companies in the world, with a roughly 35% market share in database software, 17% of the application-sever market and a growing application-software business. About 65% of their total revenue is maintenance and services, which is extremely stable and sustainable. One of the appeals here is that this is a maturing, big company that really understands how to use its balance sheet. In 2004, they started buying bestof-breed application-software companies, which, financially, has been a very good use of capital. Oracle runs at 40% operating margins and can go into a PeopleSoft, say, and take them from 15% margins to 40% or higher by integrating them well. In each of the big acquisitions – PeopleSoft, Retek and Siebel Systems – the prevailing concern has been that Oracle would abandon the acquired products in order to shove their own products down customers’ throats. Customers wouldn’t like it and, as a result, license sales in applications would drop. If you look at Wall Street’s sell-side models for the company, combined applications revenue over the next couple of years is estimated at maybe 20% below what the separate companies generated in 2003. What you find when you go out in the field, though, is that customers have been surprised at how well Oracle has supported, upgraded and maintained these newly acquired applications. By integrating what they’ve bought and making each of the individual pieces stronger, they’re starting to regain market share from competitors like SAP. The bottom line is that we believe there’s meaningful upside to the market’s expectations on how Oracle is executing on these acquisitions.
Value Investor Insight 7

ON CHIP CYCLES: We believe we’re below midcycle in semiconductor capital spending. That is not, however, the prevailing wisdom.
mid-cycle in semiconductor capital spending. That is not the prevailing wisdom, however, which says we’re much more near the peak of the cycle. If the market thinks the cycle is peaking, how cheap has that made AMAT shares, now at $15.90? RS: The shares trade at only 11x October 2006 free cash flow, ex-cash. That’s incredibly cheap – at below midcycle earnings – for a dominant company in a growth industry. If the company grows just at the rate of the industry – 10-11% per year – I see no reason why this shouldn’t trade at a midto high-teens multiple of mid-cycle earnings. At 16x times next year’s earnings – which we think will to be closer to midcycle – this is a $25 stock, with doubledigit annual growth in value beyond that. The company also thinks the shares are cheap. They have $3.40 per share in net cash and have been aggressively buying back shares. They’ve been buying
www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Ricky Sandler

Is the growth potential here as high as it is at Cisco or Applied Materials? RS: It’s a bit less, in the high single-digits, but the inherent stability is higher. The core database business has very high retention rates, a large recurring maintenance revenue stream, very low capital requirements and it generates tremendous cash flow. We don’t believe the market fully recognizes the sustainability of that business. If you look at the analysts’ models, they don’t have interest income building up or the share count coming down – as if all the cash they’re generating just disappears into thin air.
INVESTMENT SNAPSHOT

How does Larry Ellison’s stewardship fit into your thesis? RS: He’s obviously a visionary who has built one of the country’s outstanding companies. We’ve spent more time with the co-Presidents, Chuck Phillips and Safra Catz, and think they’re very disciplined operators who really get where the company is in its lifecycle. We think it’s a nice balance – a visionary at the top, combined with people who really understand financial management. At a recent $15.30, what upside do you see for the shares?

RS: Our estimate for calendar 2007 free cash flow is $1.15 per share, higher than the $1 consensus estimate that we think misjudges how well the company is executing. That’s a 13.5x multiple for a company with a great franchise, great margins and growing at a stable rate in the high single-digits. We also see this as worthy of a mid- to high-teens multiple, worth $21-22 per share, with growth beyond that. We’re guessing Arbitron’s [ARB] ties to the radio business aren’t doing the stock any favors. RS: Therein lies the opportunity. Arbitron supplies ratings to the radio industry, which are then used to sell advertising. We’re going into a digital world where radio audiences are becoming more fragmented and, while that might concern radio broadcasters, it’s actually a big positive for Arbitron. Arbitron’s ratings business is one of the all-time great businesses. Its data is the certified currency advertisers use to buy radio advertising. They’re a monopoly supplier – in a business where it makes sense to have only one supplier – to an industry that can’t survive without its product. In 2004, CBS balked at Artbitron’s contract terms and tried to play hardball with them. Arbitron stock took a hit, but a month later, CBS signed up. They really had no choice. What’s particularly interesting now about Arbitron is that they have two significant projects – the rollout of the “portable people meter” and what they call Project Apollo – that are penalizing earnings. You see sell-side analyst reports saying nothing is going to happen with the stock because the earnings are down, but the earnings are down because investments are going up for good reason. What’s a portable people meter? RS: It’s a small pager you clip on that picks up an inaudible code that each radio station sends out, automatically tracking what you’re listening to. It
Value Investor Insight 8

Oracle
(Nasdaq: ORCL)

Valuation Metrics
(Current Price vs. TTM):

Business: Develops, markets and services database, middleware and application software products for large enterprise customers worldwide. Share Information
(@8/23/06)

P/E P/CF
(@6/30/06):

ORCL 24.3 19.4

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

15.32
11.75 – 15.95 0.0% $80.25 billion

Company Capital Res and Mgmt Barclays Global Inv State Street Corp Fidelity Mgmt & Res Vanguard Group
Short Interest (As of 7/10/06):

% Owned 9.9% 2.4% 2.1% 2.0% 1.9% 1.1%

Revenue Operating Profit Margin Net Profit Margin
ORCL PRICE HISTORY
20

$14.38 billion 34.5% 23.5%

Shares Short/Float

20

15

15

10

10

5

2004

2005

2006

5

THE BOTTOM LINE

Ricky Sandler says the market isn’t fully recognizing the sustainability of the company’s database business and how well it is executing against its recent application-software acquisitions. If Oracle delivers the growth in profits he expects, he believes the shares will be worth 40-45% more than their current price of $15.32.
Sources: Company reports, other publicly available information

August 25, 2006

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Ricky Sandler

knows if you switch stations, if there’s radio on in the background at the store you’re in, or if you’re listening over the Internet. The meter data will be much more precise and accurate – and therefore valuable – than information from the paper-and-pencil diaries that are currently used. Is the technology ready for primetime? RS: The technology hasn’t yet gotten MRC [Media Ratings Council] accreditation, but it’s close. We don’t think there’s a risk they won’t get accredited, it’s just a question of time.
INVESTMENT SNAPSHOT

A lot goes into the accreditation process. For example, the people meter can miss a signal if a horn is honking or there’s some other noise interruption. There has to be a specific policy laid out for how a situation like that is to be recognized and the results recorded in the final data. Arbitron is already one year into the give-and-take of the accreditation process. The next-closest company is just starting a friends-and-family sort of test on whether their technology actually works. This technology transition was actually the one opportunity someone might have had to attack Arbitron’s

franchise, and everyone’s at least three years behind. What is the pricing difference for the people-meter ratings? RS: It will be 30-50% higher. Part of that will be justified by Arbitron’s own increased costs in getting the information this way. But they’re also providing much more information that is of better quality and more targeted. It scares some people in the industry and nobody loves a big price increase, but I think it’s ultimately going to benefit the industry overall – both in helping them sell and in programming, as they better understand people’s habits. Most of the big radio players have signed on, but Clear Channel is trying to play hardball and see if they can find an alternative. Because nothing else is close to being ready, I think what will happen is the MRC accreditation will come through, Arbitron will start turning on markets with the people meter, and the local Clear Channel stations aren’t going to be able to sell. They’ll ultimately come around. What is Project Apollo? RS: This is a joint venture with Nielsen – with Procter & Gamble also actively involved – that will marry people-meter data across different media with actual purchase behavior. I call it the “holy grail” for advertisers and the potential is enormous. This is long-term optionality, though – you’re not paying at all for this in the stock price. The shares, at around $35.50, don’t look particularly cheap.

Arbitron
(NYSE: ARB)

Valuation Metrics
(Current Price vs. TTM):

Business: Media and marketing research firm focused on the measurement and composition of local and national radio audiences in the U.S. and Mexico. Share Information
(@8/23/06)

P/E P/CF
(@6/30/06):

ARB 19.3 16.0

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

35.41
32.68 – 42.78 1.1% $1.04 billion

Company Eminence Capital Neuberger Berman Schupf & Co Capital Res & Mgmt Pamet Capital Mgmt
Short Interest (As of 7/10/06):

% Owned 11.4% 10.9% 9.2% 6.8% 6.2% 6.2%

Revenue Operating Profit Margin Net Profit Margin
ARB PRICE HISTORY
50

$320.2 million 26.0% 18.0%

Shares Short/Float

50

40

40

30

2004

2005

2006

30

THE BOTTOM LINE

Excluding the investment spending on projects that Ricky Sandler expects will pay off handsomely, the company’s shares trade for only around 14x estimated 2006 net income. That’s too cheap for the ongoing franchise, he says, let alone for the growth from new products he thinks can make the shares a “major, major homerun.”
Sources: Company reports, other publicly available information

RS: With the investment spending included, Arbitron is expected to earn $1.75 per share this year, so people see 20x earnings and think that’s expensive for a company supplying a troubled industry. If you exclude the people-meter and Apollo expenses, though, the stock trades for only 9.5x 2006 EBIT and
Value Investor Insight 9

August 25, 2006

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Ricky Sandler

around 14x net income. That’s cheap just for the ongoing radio franchise with 5-6% annual top-line growth and a monopoly business. But we expect the people-meter rollout for radio to ultimately result in a roughly 40% lift to revenues and profits. On top of that you’ve got optionality from the people meter doing other things – it can also track TV usage and outdoor advertising, for example – and from the eventual rollout of Project Apollo. We started buying this within the last six months and now own more than 10% of the company. We think it could be a major, major homerun. Tell us about one of your short ideas, Lexmark [LXK]? RS: This is a case where we think the market is giving the company the benefit of the doubt as they try to fix some operating mistakes, primarily because people believe the printer business is a great business. Hewlett-Packard and Lexmark used to own the business – with Lexmark at the low end – selling hardware at little or no margin and making a ton of money on ink and supplies. That’s all considerably changed, to the point that we believe the printer business is no longer a great business. Epson, Canon, Samsung, Xerox and other competitors have expanded in the business and the standard now is to lose 20 to 40 points of gross margin on hardware. It’s still theoretically a razor/razor blade model, except it costs you a lot more money to give the razors away. As printers have become so cheap, the replacement cycle has increased fairly quickly. With a two-year replacement cycle, how valuable is the “blade” business in a hotly competitive market when you can lose market share almost overnight? That’s a particular problem for Lexmark, which never had that great a brand and was primarily just the cheap alternative. It’s early yet, but the growth in private-label replacement ink is also going to be a negative for the whole printer
August 25, 2006

industry. If your business model is reliant on very high ink prices, heavier price competition in that area won’t be good news. Is Lexmark’s manufacturing of Dellbranded printers a positive or negative for the company? RS: I think the relationship has hurt Lexmark because Dell beats them up on price and then basically gives the printers away with their computers. By definition, then, the person getting the printer may not actually want it and may never use it. So the add-on consumables
INVESTMENT SNAPSHOT

business Lexmark needs just doesn’t materialize. Won’t positive secular growth trends in printing, such as increased photo printing and use of color, benefit Lexmark? RS: We think their product line is very poorly positioned and that they haven’t invested enough in R&D to change that. They’ve historically been heavily skewed to black-and-white, inkjet printers, while the world is going to color and to laser. So even if the overall printer business grows, we don’t see Lexmark taking much advantage.

Lexmark
(NYSE: LXK)

Valuation Metrics
(Current Price vs. TTM):

Business: Manufacturer of inkjet, laser and dot-matrix printers – as well as associated ink and supplies – for both home and commercial use. Share Information
(@8/23/06)

P/E P/CF
(@6/30/06):

LXK 19.1 10.5

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

54.71
39.33 – 65.19 0.0% $5.49 billion

Company Maverick Capital Franklin Resources State Street Corp Brandes Inv Partners Barclays Global Inv
Short Interest (As of 7/10/06):

% Owned 7.1% 7.0% 5.1% 4.4% 4.3% 5.7%

Revenue Operating Profit Margin Net Profit Margin
LXK PRICE HISTORY
100

$5.09 billion 10.3% 6.2%

Shares Short/Float

100

80

80

60

60

40

40

20

2004

2005

2006

20

THE BOTTOM LINE

The computer-printer business is no longer the great business it once was and Lexmark’s product line and undistinguished brand name make it particularly vulnerable to competition, says Ricky Sandler. “We view this as a long-term short – their market share is going down and we don’t think that’s going to change,” he says.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 10

I N V E S T O R I N S I G H T : Ricky Sandler

The stock, close to $100 two years ago, now trades around $55. How much worse can it get? RS: The shares are both well off their high and well off their low. When quarterly earnings fell off a cliff late last year, the stock crashed down to the low $40s. Since then, they’ve actually beaten earnings estimates handily in the last three quarters. They’ve been pulling out of lines of business where they were losing even more money than usual on printer sales. Optically, earnings go up when you stop selling negative-margin hardware and you cut a lot of costs. But by later this year, when you start to anniversary when they started to lose hardware share, we think you’ll start seeing a negative impact on consumables sales from the lower installed base. The stock trades about 14x this year’s cash earnings and, we think, at 16x next year’s. So Lexmark trades at a premium to all the great growth businesses we spoke about earlier and we think its business is disintegrating. We view this

as a long-term short – their market share is going down and we don’t think that’s going to change. I would go so far as to say I think this company could go away in the next five years. Are there any general short themes you’re focused on now? RS: One is our view on the relative valuations of large-caps versus small-caps. Most of our shorts are in small-caps. On the index side, we’re short the Russell 2000 – it trades at a 20% premium to large-caps, but it has much worse prospects and is much more levered to the domestic economy. The last five years have been really great for small-caps and, like everything else, it tends to go on longer than it really should. I think that’s been exacerbated by the growth of hedge funds. Most hedge-fund managers don’t look at a Cisco because it’s too big and too wellfollowed and they don’t know what their edge is going to be. They like to find – and their investors want them to find –

the obscure little things. My feeling on that is that investors pay us to find value and value is in the Ciscos of the world right now. What do you like most about investing? RS: You mean besides the incredibly attractive financial characteristics? [Laughing] Yes, we’ll take that as a given. RS: I love learning about businesses and the intellectual challenge of investing. I’m also intensely competitive about generating great returns. I love that you get a scorecard at the end of the day and I love to win. Winning to me is looking back after 30 years and saying, “Wow, look at that track record – these guys did it well and they did it right.” That’s not to say I’m particularly fond of those days when you feel like an idiot and your numbers make you look like an idiot. But as a competitive person, I wouldn’t have it any other way. VII

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August 25, 2006

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Value Investor Insight 11

I N V E S T O R I N S I G H T : Robert Robotti

Investor Insight: Robert Robotti
Robert Robotti of New York’s Robotti & Co. explains which special situations most attract him, the parts of the energy sector he thinks have the brightest prospects, why tougher audits create opportunity and where he sees unrecognized value in Atwood Oceanics, Drew Industries, Zenith National and Pre-Paid Legal Services.
Your portfolio is a hodgepodge of lessthan-glamorous stocks. Is there a common theme to your investing? Bob Robotti: The first security I ever bought, which worked out very well, was a defaulted New York City Housing Authority bond at 36 cents on the dollar. When I set up my own firm in the early 1980s, we focused at the beginning mostly on pink-sheet, trade-by-appointment type stocks. So I’ve always been a bit attracted to distressed or messier situations. Our general focus is on companies that attract little attention from Wall Street and/or are beaten up and out of favor. We usually invest in small- and micro-caps, where I still think there are more opportunities to find things that are truly inefficiently priced. I want to believe going in that things we buy can double in price within the next two or three years. You’re a big proponent of special-situations investing. What kinds of situations attract your attention? BR: We’ve been successful with a variety of special situations, such as spin-offs, bankruptcies and rights offerings. With rights offerings, for example, these are usually done by companies under some stress and we’re looking to see insiders step up as standby purchasers in the offering. You’re basically looking for an insider trade, where people in a position to know the business better than the market might be telling you something. One of our biggest wins ever was with Stolt Offshore, a deep-sea, oil-and-gas drilling contractor which is now called Acergy. It trades on the Oslo exchange and on Nasdaq [ACGY]. In May of 2004, the company did a rights offering as one of the final events in a long restructuring. The Oslo exchange has a rule that if you do a
August 25, 2006

private placement of shares, you have to offer the same terms to public shareholders, which turned out to be an offering price of $2.20 per share. The $2.20 share price valued the company at around $400 million. That was for a company with $1.5 billion in revenue, no net debt and fixed assets with replacement values far in excess of $400 million. New management had restructured the business and industry consolidation was improving contract terms and pricing. We bought 1.25 million shares in the offering, increasing our position by four to five times. We didn’t need energy prices to go up to do well on this, but when they did, demand for Stolt’s services took off. Almost every piece of equipment they have is contracted out for the next two or three years. Today, the stock trades around $18. Have you taken money off the table? BR: We’ve sold very little. They now have $300 million in cash, no debt, around $2 billion in revenue and will earn $1.40 per share this year. The number of deep-water provinces where you can find and produce oil and gas is going to double over the next five years, as provinces open up in Australia, Malaysia, China and elsewhere. That’s where people are looking now and that’s going to be very good for Acergy’s business. I think this can ultimately be a 25x-multiple stock when people recognize the strength of their business and how well positioned they are. Do you pay attention to share buybacks? BR: We often look at cases in which a company with significant insider ownership is aggressively buying back shares, but the insiders don’t participate in the buyback. Again, that indicates that someone who may know more about the business
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Robert Robotti

By the Books
Bob Robotti was “bitten by the investment bug” while serving on the audit team poring over the books of Tweedy, Browne Co. in the late 1970s. “It became quite clear to me that investing was far more interesting than the ‘ticking and footing’ of the auditing process,” he says. Robotti, however, has not turned his back on his accounting roots. “Bob is without peer in drawing insight about a company and its business from its financials,” says Mario Cibelli (VII, June 30, 2006), who once worked for Robotti and now manages his own investment partnership. In fact, Robotti lets the numbers do much of the talking when analyzing a company. “I find that subjective judgments about management and the industry are tough to make until you’ve actually owned the shares for a while,” he says, “We focus first on an objective look at the reported numbers.” The post-Enron shift toward tougher audits and board scrutiny of financial reporting has created new opportunity for sleuths like Robotti. One of his most fertile areas for ideas today? “Companies delinquent in filing their financial statements,” he says. “It’s a real growth area.”
Value Investor Insight 12

I N V E S T O R I N S I G H T : Robert Robotti

wants to own more at a particular price. An example of that – which took a long time to play out – is the old Ethyl Corp., which does chemical additives for petroleum products and is now called NewMarket [NEU]. In the late 1990s, the controlling Gottwald family bought back 25% of the outstanding stock at $46.25 – adjusted for a 1-for-5 reverse split – and we began buying about a year later when it traded down to $35. Unfortunately, the business deteriorated and the stock a few years ago got down to about $4, which was 1x trailing 12-month cash flow. We liked that the company was generating cash and paying down debt, and we thought the industry dynamics were finally changing for the better, so we bought a lot more. The business turned around beautifully and it’s still a big position for us. [NewMarket shares closed recently around $61.] We see that like any good value investor, you’re not afraid of doubling down when something goes against you. BR: You have to be willing to do that when you invest in the types of companies we invest in, where things often get worse well before they get better. I don’t want to leave you with the impression, however, that it always works. In the late 1990s I had about a 12% portfolio position in Superior National, a big player in California workers’ compensation insurance. I increased my position in a rights offering and it got to as much as 20% of my portfolio. When the workers’ comp business in California fell apart, the company turned out to be too leveraged and the shares went from $22 to zero. Ouch. BR: The lesson wasn’t to not be aggressive, but to not be overweighted in anything that’s so leveraged that it really has the risk of going to zero. Acergy is now about 13% of my portfolio, but it has no debt and $300 million in cash. The earnings might slow down, but there’s no issue with the viability of the company.
August 25, 2006

Are there relatively new special situations you’re seeing more of? BR: One newer area is companies that are delinquent in filing financial statements. Up until 2002-2003, corporate audits were really commodity items and there was little value added. The value added, such as it was, was in distorting the economic reality to fit accounting rules and regulations. The world today is very different and auditors have come to rule the world. With

ON OIL-SERVICE COMPANIES:

from blue-chip clients and the inventory was mostly books returnable to the publishers for full refund. The company was and is losing money, but it has in the past earned around $1 per share, which we believe should be achievable again. Unfortunately, rather than get in compliance and resume their listing, the company now says they plan to de-register their shares. It will still trade in the pink sheets, but we’re concerned about the information we’re going to get going forward. The stock now trades around $3, and while the risk has increased, we still think there’s value here. You’re a long-time investor in the energy business. Where do you stand on the question of whether things are “different this time” with respect to prices? BR: Our portfolio is currently about 30% in energy, so it’s the biggest industry exposure we have. Having invested in the business as long as I have, the one thing I know about energy prices is that whatever the consensus is about future price movements will be wrong. It always is. The big increase in energy prices has added a lot more commodity risk to investing in the sector today. It’s harder to be totally agnostic about the prevailing price levels. I do believe the energy market has fundamentally changed and there will be a new long-term, market-clearing price for energy that is higher than it has been. How much higher, I have no idea. The excess supply in the global industry actually started to be used up by the mid-1990s. Because this is a long lead-time, capitalintensive business that has gone through 20 years of underinvestment, it will take many years for responses on the supply and demand side to work their way through the system. As that happens, what areas of the energy business do you consider most attractive? BR: In general, I believe the service companies are more attractive than producers in the current environment. Whether oil is $40 per barrel or $70 per barrel, I’d argue it’s not going to have that much
Value Investor Insight 13

Whether oil is $40 or $70 per barrel, I’d argue it’s not going to have that much impact on demand for services.

long, drawn-out audits and conflicts over reporting, you see more and more companies fall behind in filing, getting de-listed or even choosing to de-register their shares to avoid filing requirements. Those things usually cause a dramatic repricing of the shares and may provide opportunity. Can you give a current example? BR: We own Advanced Marketing Services [MKTS.PK], which trades in the pink sheets. The company distributes books, mainly to major wholesale-club retailers like Sam’s Club, Costco and BJ’s. In 2004, they discovered that the head of marketing was defrauding customers. They had to hire forensic accountants and lawyers to track the extent of the fraud and determine the restitution to customers, so they became delinquent in their filings with the SEC. As a result, they got kicked off the New York Stock Exchange in April of last year and the stock went from $7 to about $3.50, which is when we got interested. There was enough information available that we thought the stock was trading for less than our $5-per-share estimate of what the restated, tangible book value would be. The balance sheet was mainly receivables and inventory – the receivables
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I N V E S T O R I N S I G H T : Robert Robotti

impact on demand for services. Many of the big oil companies have declining reserves and will be desperate to add reserves. To do that, they’ve got to spend on finding and developing new production or getting more production out of what they already have. Well-positioned service companies will benefit from that trend for a long time. As I mentioned earlier with Acergy, service companies involved in deep-water exploration should be particularly strong. Exploration success as the number of provinces expands will only breed more activity. At the same time, because of the expense and lead times on the capacity side, there’s much less risk of oversupply than with land-based drilling. Tell us about another of your favorite oilservice holdings, Atwood Oceanics [ATW]. BR: Atwood is a contractor of large offshore drilling rigs. Four of their rigs are semi-submersibles, which can drill in 3,000 to 5,000 feet of water, for which the leasing rate is now about $400,000 per day. The other rigs they own, which drill in shallower water, go for closer to $200,000 per day. There’s huge operating leverage at current rates: operating costs are $45,000 per day on the semisubmersibles and $30,000 per day on the shallower-water “jack-ups.” From investing in energy for a long time, you develop an appreciation for smart managements that know how to operate in a cyclical business. They don’t spend money on capacity when everyone else is and they add it on the cheap when no one else wants to. From 1982 to 1991, Atwood didn’t spend a penny on equipment because they thought the business was going to be oversupplied for years. Then in 1991 they bought an interest in three rigs for $6 million. They spent $10 million to refurbish the equipment and then in 1995 bought the remaining interest for another $16 million. So for $32 million, they owned equipment that had been built in the early 1980s for $240 million. They’re very good capital allocators and understand how to build value.
August 25, 2006

Isn’t the concern here that many in the industry won’t be so prudent and too much capacity will be added? BR: Exactly. There are currently around 200 deep-water rigs on the market – semisubmersibles and drill ships – and another 35 are under construction. Most of those rigs are not being built by the traditional industry players, but by speculators who are betting on day rates staying high. Is that too much new capacity? As I said, I’m convinced demand for deepwater drilling is going to explode. So much so that I don’t think the market will be able to meet the demand, even with the new
INVESTMENT SNAPSHOT

capacity. The world just needs the production from these deep-water provinces. How does this view play out in your earnings estimates for Atwood? BR: Their full fleet is contracted out for next year and almost all contracted the following year. Based on contracted rates, the company should earn $5 per share next fiscal year and more like $9 in fiscal 2008. Given that some contracted rates are well below current rates and that they have a new rig coming on in 2008, we think sustainable earnings – at current market conditions – are more like $11-12 per share.

Atwood Oceanics
(NYSE: ATW)

Valuation Metrics
(Current Price vs. TTM):

Business: Houston-based contractor of large-scale offshore rigs used in the drilling of exploratory and developmental oil and gas wells around the world. Share Information
(@ 8/23/06):

P/E P/CF
(@6/30/06):

ATW 19.1 13.8

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

41.18
32.55 – 58.44 0.0% $1.28 billion

Company Columbia Wanger Asset Mgmt Trafelet & Co. Barclays Global Inv Mackenzie Financial Mellon Financial
Short Interest (@ 7/10/06):

% Owned 7.2% 4.6% 4.1% 4.0% 3.6% 9.6%

Revenue Operating Profit Margin Net Profit Margin
ATW PRICE HISTORY 60 50 40 30 20 10

$240.6 million 30.9% 28.9%

Shares Short/Float

60 50 40 30 20 10

2004

2005

2006

THE BOTTOM LINE

Oil companies desperate to add energy reserves will fuel a long-lived explosion in demand for the deep-water drilling equipment the company provides, says Bob Robotti. Based on contracted day rates and the addition of new capacity, he believes the company’s sustainable earnings are $11-12 per share, less than 4x today’s share price.
Sources: Company reports, other publicly available information

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Value Investor Insight 14

I N V E S T O R I N S I G H T : Robert Robotti

Given our view on supply and demand, we believe that’s sustainable for some time. With the stock recently around $41, the market seems to disagree. BR: Yes, given that the shares trade at less than 4x what we think the company is going to earn in three years, the sustainability of earnings is clearly where our view differs from the market. The company will have no debt by the middle of next year, so their net earnings will be mostly cash earnings. So within three years, then, not only will they be earning at a very high level, but they will have accumulated $20 or so per share of cash. If that happens, it doesn’t take very sophisticated math to arrive at a share price significantly above where it is today. What if oil prices go down? BR: Exploration to find a deep-water field costs $5-7 per barrel. Producing it then costs another $3-5 per barrel. So whether oil is at $75 or $40 won’t make that much difference on demand. What attracted you to your next pick, Drew Industries [DW]? BR: This is a relatively straightforward story. Drew sells component parts – like windows, doors, chassis and axles – to manufacturers of recreational vehicles and manufactured homes. They do business with almost all manufacturers and probably have 50% market share in both businesses. The revenue mix is two-thirds RVs, one-third manufactured housing. There are two main things that attracted us here. First, we’re convinced they have an excellent model for growth. They’ve been very good at identifying products that will have broad appeal and then making small acquisitions to fill out their product line and leverage their relationships and sales infrastructure. We’re also big believers in the turnaround potential of the manufacturedhousing industry – where Drew operates at maybe 50% of capacity and where they have historically earned higher margins.
August 25, 2006

Why do you think the manufactured housing business is set to improve? BR: The industry has been beaten up for some time. In the late 1990s, the industry was selling 370,000 new homes per year, driven by very aggressive financing offers. Many of those loans blew up, dumping a lot of inventory on the market. At the same time, falling interest rates made stick-built homes a more affordable option for many people. As a result, sales of new manufactured homes fell to 130,000 per year and have stayed around that level. We now think higher interest rates will refocus many low-end buyers’ attention on
INVESTMENT SNAPSHOT

the relative affordability of manufactured housing. Lending to the industry is now much stronger and default rates are way down. In fact, terms have gotten so rigid that legitimate potential buyers – who generally have lower FICO scores – can’t get loans. We expect that all to adjust as time goes on. Clayton Homes is the biggest player in the industry and you can imagine one reason Berkshire Hathaway bought it was for the opportunity to lend money to help finance the industry’s rebuilding. Getting back to even 200,000 new manufactured homes sold per year, which is fully achievable, would result in tremendous upside for Drew. We think

Drew Industries
(NYSE: DW)

Valuation Metrics
(Current Price vs. TTM):

Business: Supplier of windows, doors, chassis and other components used in the manufacture of recreational vehicles and manufactured homes in the U.S. Share Information
(@ 8/23/06):

P/E P/CF
(@6/30/06):

DW 14.0 9.9

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

24.95
20.95 – 38.90 0.0% $537.2 million

Company Fidelity Mgmt & Res Royce & Assoc Munder Capital Columbia Wanger Asset Mgmt Mellon Financial
Short Interest (@ 7/10/06):

% Owned 8.6% 8.1% 5.6% 4.9% 3.9% 8.8%

Revenue Operating Profit Margin Net Profit Margin
DW PRICE HISTORY 40 35 30 25 20 15 10 0 2004

$762.0 million 8.6% 5.2%

Shares Short/Float

40 35 30 25 20 15 10 2005 2006 0

THE BOTTOM LINE

Earnings should increase at double-digit annual rates as the company capitalizes on add-on acquisitions and an expected turn in its business supplying the manufacturedhousing industry, says Bob Robotti. He expects significant multiple expansion – of at least 50% from today’s 12x forward earnings – to accompany that growth.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 15

I N V E S T O R I N S I G H T : Robert Robotti

that business can double for them in the next few years. With the stock currently trading just under $25, how are the shares valued? BR: The stock currently trades at around 11-12x our estimate of next year’s earnings. As they continue to add new products and the manufactured-housing business turns, we think earnings will increase at double-digit annual rates. With that kind of growth and the high-teens multiple we believe the business will then deserve within three years, you’ve got a lot of upside from today’s price. After your Superior National experience, we’re surprised you still own a workers’ comp company, Zenith National [ZNT]. BR: The California workers’ comp market – where Zenith does about two-thirds of its business – is very large, very volatile and, as I learned firsthand, has historically destroyed a lot of capital. It’s important to give some history here about the market. In the early 1990s, the economy in California turned down and people were losing their jobs. When that happens, you see a big increase in workers’ comp claims, because the benefits are generally much better than those provided by unemployment insurance. This was all facilitated by a significant number of lessthan-ethical doctors and lawyers, who saw this as a great way to make a buck. That led to regulatory reforms in 19931994 that were meant to address the increase in the number of claims and the resulting increase in the price of workers’ comp insurance. They changed things like increasing how much of one’s stress had to be related to their job to qualify for a claim. They also cracked down on doctor and lawyer mills generating bogus claims. Wall Street then came into the picture and started to pour capital into workers’ comp insurers in California. This too ended badly, because the companies were overly leveraged and thought they were transferring a lot of risk to undisciplined reinsurance companies who didn’t know what they were doing. The result was that
August 25, 2006

the market got very undisciplined and started to crack in the late 1990s. Fremont Insurance was seized by the state insurance department. Superior went bust. Where was Zenith during all this? BR: Stanley Zax, who has run Zenith for 30 years, is a very disciplined operator who has been through all the ups and downs of the business. He kept Zenith on track and relatively well reserved, so the company came out of the turmoil of the late 90s in a stronger position, as many of the dumb competitors went away. Fast forward to today and you have a
INVESTMENT SNAPSHOT

much healthier industry. The major players in the business are much better-run and new regulations, such as requiring a medical-review process for claims, have been instituted. That all plays particularly to Zenith’s hand, because their focus and expertise is on smart underwriting and claims management. What does the current rate environment look like in California? BR: Rates are coming down, but that’s because losses have come down. Given that, I don’t think Zenith’s margin of profitability comes down all that much over

Zenith National
(NYSE: ZNT)

Valuation Metrics
(Current Price vs. TTM):

Business: Insurance holding company primarily focused on the underwriting of workers’ compensation insurance in California and Florida. Share Information
(@ 8/23/06)):

P/E P/CF
(@6/30/06):

ZNT 7.7 7.7

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

37.19
36.14 – 55.30 2.9% $1.38 billion

Company Gilder, Gagnon, Howe & Co Fidelity Mgmt & Res Barclays Global Inv American Century Vanguard Group
Short Interest (@ 7/10/06):

% Owned 14.6% 6.1% 5.5% 4.5% 3.8%

Revenue Operating Profit Margin Net Profit Margin
ZNT PRICE HISTORY 60 50 40 30 20 10

$1.19 billion 23.9% 15.4%

Shares Short/Float

4.3%
60 50 40 30 20 10

2004

2005

2006

THE BOTTOM LINE

Fears over the capital-destroying tendencies of the California workers’ compensation insurance market are outdated, says Bob Robotti, and the healthier dynamics of the industry bode well for disciplined competitors like Zenith. At a more appropriate 10x multiple on normalized earnings, he believes that shares are worth $55-60 per share.
Sources: Company reports, other publicly available information

Value Investor Insight 16

I N V E S T O R I N S I G H T : Robert Robotti

the next couple of years. I also think they’ll be able to offset any rate decreases with both increases in investment income and adjustments from excess reserves they’ve put on the books in recent years. Is there a growth story here? BR: If there’s a negative, it’s that growth prospects – at least the way Stanley Zax runs the company – are limited. He sticks to what he knows and executes well, but he shows little aspiration for growing his policy count. Over time, then, the business will grow as payrolls in their markets grow. What upside do you see for the shares, recently trading just about $37? BR: Last year Zenith earned $4.25 per share, including a loss of about $1.30 per share from a reinsurance business they’ve since exited. So the stock is trading at only 6.8x the current earnings run rate of $5.50 or so per share. The stock is so cheap because everybody still assumes workers’ comp in California is a horrible business. We think if the market recognized the improved dynamics of the industry and gave Zenith full credit for running a disciplined, conservative business, a 10x multiple on normal earnings of $5.50 to $6 per share would be more reasonable. We’re curious, is Berkshire Hathaway getting more involved in the market? BR: They actually bought a company recently, Applied Underwriters, which is a player in the workers’ comp business. These are pretty smart capital allocators, so we obviously see that as a positive comment on the business. It hasn’t happened so it probably never will, but we’ve actually thought Berkshire would be a logical acquirer of Zenith one day. There no dearth of controversy around your last idea, Pre-Paid Legal Services [PPD]. BR: Our interest is primarily based on our conviction that they have a great product. For a monthly payment of around $25,
August 25, 2006

you get access to certain legal services for free and to others at deeply discounted rates. We think that’s an interesting product offer for $300 a year, with applicability to even more people in the U.S. than for the tax-prep services of H&R Block. The model is actually similar to H&R Block – providing a level of service most people need on a more cost-effective basis. Describe how the service works. BR: You’re assigned a local law firm as your point of contact, which improves customer service. The first time I tried to use it was when I bought my co-op. The probINVESTMENT SNAPSHOT

lem was they wouldn’t get involved until I already had the co-op picked out, but in New York you have to have your attorney involved earlier in the search process to get access to certain information. So it didn’t work there. Where it did work for us: we bought a $700 TV from Best Buy and it broke a month or two later and they wouldn’t take it back. For no additional cost, the Pre-Paid lawyer wrote a letter for us and we received a refund shortly after. A friend of mine, who also owns the stock, bought his house in Westchester County and used a Pre-Paid lawyer for his closing, paying less than half what every other lawyer wanted. He’s even used one

Pre-Paid Legal Services
(NYSE: PPD)

Valuation Metrics
(Current Price vs. TTM):

Business: Provider of legal services to roughly 1.5 million U.S. families who purchase plan memberships carrying monthly fees of approximately $25. Share Information
(@ 8/23/06):

P/E P/CF
(@6/30/06):

PPD 12.5 10.0

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

36.77
32.15 – 48.40 3.3% $533.7 million

Company Thomas W. Smith Steadfast Capital Mgmt Goldman Sachs Wellington Mgmt Co Barclays Global Inv
Short Interest (@ 7/10/06):

% Owned 20.8% 5.6% 5.0% 4.3% 3.9% 54.3%

Revenue Operating Profit Margin Net Profit Margin
PPD PRICE HISTORY 60

$438.0 million 18.3% 10.3%

Shares Short/Float

60

50

50

40

40

30

30

20

2004

2005

2006

20

THE BOTTOM LINE

More-traditional marketing of the company’s proven and unique legal-services plan to a broader audience, combined with a heightened focus on customer retention, can unleash tremendous untapped revenue and earnings potential, says Bob Robotti. Success on both fronts, he says, would result in a “multiple” of today’s share price.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 17

I N V E S T O R I N S I G H T : Robert Robotti

of their lawyers for routine securities work, at one-fifth the cost I pay for the same work at my regular law firm. Who is the target audience? BR: The company says it’s not the top 10% or bottom 10%, but the 80% in between. The reality is they reach mostly middle- to lower-income people, which I think is more a result of how they sell than of who might benefit from the product. A dreaded multi-tiered marketing system? BR: Yes, they use a system just like Amway’s, which is one reason Wall Street hates the company. We agree that how it’s sold is a limitation, but not based on any elitist view of what’s appropriate. The first problem is that by selling to people you know, who sell to people they know, they don’t reach large parts of the population – namely higher income levels. The current system also isn’t adequately educating people on how to use the product and what a great value it is. The more people use and take advantage of the services, the longer they remain customers. We think there’s great untapped potential in promoting to a broader population base through advertising and more traditional marketing. They also should enhance customer-service efforts to connect more often with paying customers. The growth upside from doing both of these is tremendous – they win from dramatically increasing the customer base and from higher retention of the customers they already have. The founder, Harland Stonecipher, still runs the business. What makes you think things will change? BR: Management has been open to suggestions of certain long-time shareholders. Tom Smith, the managing partner of Prescott Investors, has been on Pre-Paid’s board since 2004. I’m sure he’s introduceing ideas that will continue to impact how they look at the business. We see it already in how they’ve started new programs to try to increase usage, in how they’re looking
August 25, 2006

more carefully at the lifetime value of a customer. They have more than enough resources to invest in better marketing, and we think they will. We’re also optimistic about the identity-theft product they launched in 2003 in a joint venture with Kroll. It’s a relatively unique service that doesn’t just monitor for problems with identity theft, but also has a restitution part if something goes wrong. Kroll is a part of Marsh & McLennan and the entire company is quite sophisticated in how they sell their products. I believe this relationship can open new doors to Pre-Paid.

There were accounting concerns, primarily over the company amortizing over three years commissions on new customer sales. Now those commissions are expensed immediately. Today, cash earnings slightly exceed reported EPS. With all this, we come back to the fact that we believe in the product – that it’s a proven, cost-effective service for consumers that has been around for 30 years. The “noise” has calmed down quite a bit, but sometimes a high short interest takes on a life of its own. As long as you’re comfortable with your work, you just can’t worry about that. The stock has been stuck near its current level, around $37, since the beginning of 2005. Where do you think it can go? BR: The shares currently trade for around 11x trailing earnings, if you adjust for the fact that the identity-theft earnings are temporarily lower because the start-up selling expenses are being expensed immediately. There’s no capital spending, so the earnings translate to free cash flow. Protecting the downside is that they have no debt and they’re using free cash flow to buy back stock. The company has gone from over 24 million shares outstanding to less than 15 million today, which has had a significant effect on EPS growth. I can’t give you a specific target number for the stock price. But if they can really get at the untapped potential I think this product has, the share price will be a multiple of what it is today. You’ve been in the investment business for over 25 years. How would you say the business has changed? BR: You know, the particulars might change from time to time, but people drive the environment and human nature is pretty constant. A year ago, NewMarket shares were at $15 and nobody wanted them and today it’s at $61 and everybody wants to own it. Fundamentally, it was positioned a year ago to earn what it’s earning today. Things like that are as likely to happen today as they were 25 years ago. VII
Value Investor Insight 18

ON CHANGING TIMES: The particulars might change from time to time, but people drive the environment and human nature is pretty constant.
Is the competitive environment agreeable? BR: The other main players – the Hyatt Legal Plans division of MetLife and a former Montgomery Ward business that’s now owned by General Electric – operate mostly in the corporate market, offering plans as employee benefits. Pre-Paid is by far the market leader with consumers. The short interest, nearly 55%, is about as high as it gets. Why do so many investors loathe the stock? BR: There have been lawsuits against the company alleging various damages, usually amounting to no more than a few hundred dollars each. One case, in Mississippi, resulted in a punitive-damage award of $9.9 million, which is now on appeal. Many business people would not consider an early negative verdict from a Mississippi jury as great cause for concern, and we agree. The Connecticut Attorney General also announced he was looking into the company’s sales practices, but nothing’s come of that since it was announced with great fanfare a year ago.
www.valueinvestorinsight.com

SuperInvestor
August 25, 2006

From the Editors of Value Investor Insight

INSIGHT
IN THIS ISSUE
What They’re Buying Industry turmoil, as in healthcare today, typically creates value opportunities that attract smart investors’ attention. Page 20 Table: Heart and Home Table: Biggest New Bets What They're Selling Consumer and financial stocks, light on buy lists in the second quarter, are well represented among popular sells. Page 22 Table: Consumer Isn’t King Table: Up (or Down) and Out What They Own Media and technology may be out of favor on Wall Street, but you wouldn’t know it from the portfolios of star investors. Page 24 Table: Core Holdings Table: Below the Radar Stock Spotlight Unfocused businesses tend to attract the attention of investors expecting change – witness the case of Walter Industries. Page 26

UP FRONT

Distinction With a Difference
he eclectic nature of value investors is on full display in analyzing the portfolios of the best of the breed. Homebuilders like D.R. Horton and Centex share space in portfolios with media companies such as Time Warner and News Corp. Energy firms Transocean and Williams stand alongside Microsoft and Oracle. At the same time Greyhound-bus parent Laidlaw International attracts attention, so do biotech firm Nuvelo and controversial videogame maker Take-Two Interactive. We’re coming to believe that the traditional distinctions between “value” and “growth” investors are increasingly artificial and irrelevant. As Charlie Munger once said, “All intelligent investing is value investing,” meaning all smart investors are trying to buy a stake in a company for as little as possible relative to its intrinsic value. But there’s great leeway in how one ascribes value to any given stake, from a focus on hard current assets to more weight given to higher future profits. The best investors are comfortable with assigning value from along that continuum, as is clearly evidenced by the breadth of businesses in their portfolios. This is not to say there aren’t core principles that set apart the SuperInvestors we track. They tend to buy what’s out of favor rather than what’s popular. They invest heavily in their best ideas rather than hide behind the “safety” of closet indexing. They focus on generating high absolute

T

returns rather than on relative returns or outperforming a benchmark. They typically invest with a multi-year time horizon rather than focusing on the month or quarter ahead. They focus on the difference between a company’s current share price and their estimate of its true worth, rather than trying to guess where the herd is going to go next. Another trait we believe most SuperInvestors share: an ability to learn from experience. Knowledge is cumulative, and savvy investors realize that there’s no capacity limit on what one can learn and apply toward becoming a better investor. Our hope with SuperInvestor Insight is that it can be an additional and regular contributor to your own store of investing knowledge – with the help of the best “teachers” in the business. SII

The SuperInvestors
SuperInvestor Insight tracks the activity of an elite group of value-oriented hedge-fund managers (plus Berkshire Hathaway), based on their holdings as filed in Forms 13F with the SEC. While certain activity of specific investors will be highlighted, the focus is on drawing collective insight from this group of 2530 of the world’s best investors, which currently includes William Ackman, David Einhorn, Joel Greenblatt, Carl Icahn, Seth Klarman, Edward Lampert, Warren Lichtenstein, Stephen Mandel, Larry Robbins, Jeffrey Ubben and many more.
SuperInvestor Insight 19

John Heins Co-Editor-in-Chief

Whitney Tilson Co-Editor-in-Chief

WHAT THEY’RE BUYING

Healthy Expectations
Dynamic change, such as that currently roiling the healthcare industry, tends to create the types of value opportunities that attract smart investors.
It’s not surprising that the giant U.S. healthcare industry produced several of the most prevalent buying opportunities for SuperInvestors in this year’s second quarter. Shifting legal and regulatory winds buffeting the industry, combined with hotly-competitive and high-growth markets, create the type of turmoil that attracts against-the-grain investors. Market skepticism about mergers-andacquisitions activity appears to have played a role in two healthcare buys. Stent-maker Boston Scientific completed its $27.5 billion purchase of Guidant during the quarter, but the stock remains plagued by concerns that Boston Scientific overpaid for damaged goods. Guidant’s sales of implantable defibrillator devices have fallen due to concerns over the product’s safety and Boston Scientific announced earlier this year that it faced some 550 individual and classaction lawsuits related to problems with Guidant’s heart devices. BSX shares, at a recent $16.78, remain barely above their second-quarter low. While less controversial, Thermo Electron’s announcement during the quarter that it was merging with fellow lab-equipment supplier Fisher Scientific raised integration concerns about the $10.6 billion deal. Only recently upbeat earnings news from Thermo have returned the shares to their mergerannouncement level of around $39.25. Sentiment appears particularly divided on one of the quarter’s biggest bets, the new $280 million position reported by Larry Robbins’ Glenview Capital in Omnicare, which provides pharmaceutical services to nursing homes. Omnicare shares are off more than 30% from their March high as concerns over its Medicaid billing practices have resulted in a recent fraud charge by the Michigan attorney general. While Glenview was buying, however, three other SuperInvestors closed out their Omnicare positions dur-

What They’re Buying: Heart and Home
Company
Microsoft Walter Industries NTL Williams Companies Dell UnitedHealth Comcast D.R. Horton Mirant Boston Scientific Caremark Rx Centex Smurfit-Stone Container Thermo Electron

Healthcare-related and home-builder shares attracted particular buying attention from superstar investors in the second quarter. Below are stocks in which at least three SuperInvestors established new positions or increased their existing share positions by more than 15% during the quarter.
Price@ 8/23/06
25.67 51.70 26.46 24.61 21.64 49.64 34.86 21.02 28.66 16.78 56.40 48.59 11.17 39.21

Ticker
MSFT WLT NTLI WMB DELL UNH CMCSA DHI MIR BSX CMX CTX SSCC TMO

Industry
Computer Software/Services Diversified Industry/Construction Cable TV Oil & Gas Computers Health Insurance Cable TV Residential Construction Power Generation Medical Devices Specialized Health Services Residential Construction Paper Products Medical Equipment

Q2 2006 Low
21.46 44.60 22.40 20.01 23.53 41.44 26.18 22.55 23.36 16.47 42.40 44.13 10.21 33.85

High
27.94 71.45 31.00 23.59 30.25 56.60 33.55 35.27 26.86 23.58 50.66 64.62 15.15 41.85

# of New or Inc. Positions
6 5 4 4 4 4 3 3 3 3 3 3 3 3

% Change In Total Shares Held
170.1% 220.8% 43.2% 3626.4% 49.1% 903.4% 109.6% All new positions 148.0% 1200.1% 101.6% 165.5% 145.1% All new positions

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006

www.valueinvestorinsight.com

SuperInvestor Insight 20

WHAT THEY’RE BUYING

ing the quarter (see table, p. 22). Volatility in two previously booming sectors, energy and housing, also resulted in significant buying activity. Four investors increased their positions in Williams, the natural-gas and power-generation company which hit its 52-week low in March, as energy prices took a short-lived dip. Mitch Julis of Canyon Capital argued in a recent Value Investor Insight (March 31, 2006) that Williams shares traded at a significant discount to the sum of its parts, weighed down by a complex business structure and the taint of past miscues in telecommunications and energy trading. Evidenced by their purchase of WMB shares, many of his peers seem to agree. The implosion of homebuilder shares attracted multiple buyers to two companies in the industry – D.R. Horton and Centex. As perceived-to-be-cyclical companies tend to do at the end of cycles, both trade at miniscule trailing P/E multiples – Horton at 4.4x and Centex at 5.2x – and are at least 40% off their 52week highs.

While shares bought on non-U.S. markets need not be disclosed in 13F filings with the SEC, those in holdings of foreign companies with shares trading on U.S. exchanges are. The sole such company appearing in this quarter’s buying activity

ON DELL:

SuperInvestors are betting against Dell shares becoming the computer industry’s latest dead-money champion.
was Swiss-based food giant Nestlé, in which Ricky Sandler’s Eminence Capital disclosed a new $157 million holding at the end of June. While we didn’t speak with Sandler about Nestlé in this month’s interview (see p. 1), the company was a featured pick by Gardner Russo & Gardner’s Thomas Russo when we interviewed him in June (VII, June 30, 2006). Russo sees Nestlé as one of the world’s

best-positioned companies to benefit from increasing prosperity in developing countries such as China and India. Microsoft, in which six SuperInvestors significantly increased their holdings in the second quarter, will certainly not be a new idea to readers of Value Investor Insight. Co-Editor Whitney Tilson laid out his thesis for the shares in detail a year ago (VII, July 29, 2005), focusing on the software behemoth’s peerless brand franchise, stellar economics and still-vital growth prospects. The change in the shares over the past year: $0. He now has plenty of elite company in expecting the company’s shares to prosper. Will Dell shares replace Microsoft’s as the computer industry’s latest deadmoney champion? The shares, at a recent $21.64, trade below their second-quarter low. The SuperInvestors apparently see potential, though, as four of them increased their holdings during the quarter. We wouldn’t bet against them. SII
Funds managed by Co-Editor Whitney Tilson own Crosstex Energy, Dell and Microsoft.

What They’re Buying: Biggest New Bets
Company
Omnicare Crosstex Energy Comcast SPCL Microsoft Boston Scientific Nestlé Valeant Pharmaceuticals Walter Industries Cigna Williams Companies

A willingness to make significant bets on their best ideas is a hallmark of superior investors. Below are the ten largest brand-new positions taken by individual SuperInvestors in this year’s second quarter.
Price@ 8/23/06
43.30 91.28 34.73 25.67 16.78 84.30 18.62 51.70 109.49 24.61

Q2 2006 Investor Low
41.00 71.50 25.99 21.46 16.47 71.85 15.75 44.60 88.05 20.01

Ticker
OCR XTXI CMCSK MSFT BSX NSRGY VRX WLT CI WMB

Industry
Specialized Health Services Oil & Gas Cable TV Computer Software/Services Medical Devices Food Consumer Products Pharmaceuticals Diversified Industry/Construction Insurance Oil & Gas

High
58.02 96.00 33.40 27.94 23.58 78.45 18.44 71.45 133.13 23.59 Glenview Chieftain Lone Pine Greenlight Highfields Eminence ValueAct JANA Icahn Omega

Value @ 6/30 ($mil)
$280.4 $243.0 $231.1 $207.4 $206.6 $156.9 $139.8 $119.1 $104.4 $82.1

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006

www.valueinvestorinsight.com

SuperInvestor Insight 21

WHAT THEY’RE SELLING

Consumption Patterns
Consumer and financial stocks, light on SuperInvestors’ buy lists in the second quarter, are quite well represented among the most popular sells.
The U.S. consumer’s voracious appetite to spend has clearly been a significant contributor to the economy’s and the market’s relative health in recent years – fattening corporate profits along the way for those positioned to benefit. That the consumer spend-fest would end has been much anticipated, if not much observed. From their portfolio activity in the second quarter, it would appear that many SuperInvestors are positioning themselves more for a slowdown in consumer spending than the contrary. Money was taken off the table in traditional consumer stalwarts such as retail and restaurants. Consumer-media positions were reduced, as were those in financial firms tied closely to the consumer. Each individual story, of course, is different. Four SuperInvestors each decreased their holdings in McDonald's and Wendy’s following sharp turnarounds in each company’s share price since bottoming in early 2003. Having lost its way early in the decade, McDonald’s has turned itself around through wholesale menu and operational changes and the shares have responded, nearly tripling from their February 2003 low to a recent $35.60. Wendy’s shares, recently around $63.50, have nearly doubled in the past two years, partly through the efforts of activist investor Bill Ackman of Pershing Square Capital to force management's hand to spinoff its Tim Hortons doughnut-shop empire and unlock hidden real estate value. That some investors in both of these stocks have realized profits isn’t terribly surprising. That four investors decreased their holdings in Sears is somewhat surprising. The old-line retailer’s shares have performed remarkably well since investor Edward Lampert – whose fund is included in the roster of SuperInvestors – took control of the company. While Lampert’s reputation as a value creator remains

What They’re Selling: Consumer Isn’t King
Company
News Corp. McDonald's NRG Energy Oracle Sears Wendy's Advanced Medical Optics American Express CBS Int'l Game Technology Kohl's Morgan Stanley Omnicare Sprint Nextel Talisman Energy TXU

Shares in retail, restaurant and entertainment companies came in for some selling by SuperInvestors in the second quarter. Below are companies for which threee or more superstar investors reduced their positons by 15% or more in the quarter.
Price@ 8/23/06
19.45 35.59 50.16 15.32 142.40 63.46 48.15 53.00 28.34 37.47 60.89 68.05 43.30 16.42 18.10 65.24

Ticker
NWS MCD NRG ORCL SHLD WEN EYE AXP CBS IGT KSS MS OCR S TLM TXU

Industry
Entertainment/Media Restaurants Power Generation Computer Software Retail Stores Restaurants Medical Devices Financial/Travel-Related Services Media Gaming Equipment Retail Stores Investment Banking Specialized Health Services Telecommunications Oil & Gas Power Generation

Q2 2006 Low
17.61 31.73 42.44 13.07 130.38 56.25 43.94 50.92 24.05 34.71 51.51 54.52 41.00 19.33 14.93 44.10

High
20.57 35.99 52.61 15.21 167.95 63.65 50.87 54.91 27.24 39.39 59.73 66.00 58.02 26.89 20.33 59.93

# of Decreased or Closed Positions
6 4 4 4 4 4 3 3 3 3 3 3 3 3 3 3

% Change In Total Shares Held
(-49.9%) (-94.5%) (-34.5%) (-48.3%) (-80.3%) (-69.6%) (-31.2%) (-100.0%) (-59.7%) (-100.0%) (-44.3%) (-41.2%) (-100.0%) (-51.4%) (-95.8%) (-54.3%)

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006

www.valueinvestorinsight.com

SuperInvestor Insight 22

WHAT THEY’RE SELLING

undimmed, the heavy Sears’ share sales would indicate some smart investors feel the easy money has already been made. While strong share performance likely explains many of the quarter’s prevalent sales – in International Game Technology, Procter & Gamble and energy companies Talisman, Suncor and Chevron, for example – other sales bear the whiff of capitulation. Warren Buffett’s Berkshire Hathaway appears to have closed its position in Gap, whose shares trade at the same level they did in 1998. Freddie Mac shares, unloaded in volume by Chieftain Capital, haven’t moved since 2001. Even worse is the performance of wireless provider Sprint Nextel, sold by three SuperInvestors, whose shares are off nearly 40% in the past year. That smart investors are bailing on Sprint Nextel highlights the fact that even the best investors can arrive at diametrically opposed positions on a given investment. Legg Mason’s Bill Miller, for example, remains strongly bullish on Sprint’s prospects, as he recently explained to Value Investor Insight (June 30, 2006).

Similarly, Gotham Capital’s Joel Greenblatt sees great opportunity in American Express shares – also explained recently in VII (July 28, 2006) – but three SuperInvestors sold their positions entirely in the latest quarter. Messages are similarly mixed on News

ON CHANGING OPINIONS:

As Mirant’s bid for competitor NRG Energy died, so, apparently, did enthusiasm for NRG’s shares.

Corp. While a total of six investors decreased their holdings in Rupert Murdoch’s global media empire, four retain holdings of greater than $50 million each. Less ambiguous was the reaction to broadcast media’s CBS, which Viacom spun off earlier this year. As the shares started to trade separately, three investors collectively sold 60% of their CBS shares.

While SuperInvestors generally invest for the long-term, their opinions on a given company can change rapidly. Independent power generator NRG Energy was a popular pick in this year’s first quarter, held in five portfolios. The company was expected to participate in consolidation in the power-generation business, and, in fact, received a bid in May from competitor Mirant Corp. The bid died, as, apparently, has enthusiasm for NRG’s shares. Interestingly, Mirant is currently on the popular buy list (see table, p. 20). Its response to the failed merger attempt has been to restructure itself, selling off assets and aggressively buying back shares. It's inevitable that some sales appear to have been premature. Shares of wholesale power company TXU, which peaked in the second quarter just under $60, now trade at around $65.25. That’s not at all a criticism – it’s just nice to see that selling too early happens to even the best investors, as well as to the rest of us. SII
Funds managed by Co-Editor Whitney Tilson own McDonald’s and Wendy’s.

What They’re Selling: Up (or Down) and Out
Company
Freddie Mac Suncor Energy Applied Biosystems Teva Pharmaceutical Sears Gap Procter & Gamble American Express PNC Financial Chevron

Whether after great runs (Suncor Energy, Chevron, PNC), or not-so-great (Freddie Mac, Gap), big steps were taken out of these stocks in the second quarter. Below are the ten largest positions that individual SuperInvestors eliminated during the quarter.
Price@ 8/23/06
61.80 80.25 30.84 34.30 142.40 16.52 60.92 53.00 70.52 65.68

Q2 2006 Investor Low
56.50 67.36 26.38 29.83 130.38 16.83 52.75 50.92 65.30 55.41

Ticker
FRE SU ABI TEVA SHLD GPS PG AXP PNC CVX

Industry
Mortgage Loans Oil & Gas Medical Instruments Pharmaceuticals Retail Stores Retail Stores Consumer Products Financial/Travel-Related Services Banking Oil & Gas

High
63.99 89.88 33.00 43.90 167.95 19.10 58.73 54.91 72.00 63.65 Chieftain Lone Pine ValueAct Glenview Pershing Square Berkshire Hathaway Blue Ridge JANA Third Point Highfields

Value @ 3/31 ($mil)
$403.3 $348.4 $280.2 $240.7 $206.4 $186.8 $140.0 $128.0 $114.4 $103.2

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006

www.valueinvestorinsight.com

SuperInvestor Insight 23

WHAT THEY OWN

High and Low Concept
While media and technology stocks have generally been out of favor on Wall Street, they're not out of favor in the portfolios of superstar investors.
It’s a safe bet that a similar list in early 2000 of the most prominent large holdings of superstar value investors would have looked absolutely nothing like the list below. Cisco? Microsoft? Oracle? No way. Time Warner? News Corp.? Sprint? Highly unlikely. Such are Wall Street’s changing moods that so many once-untouchable shares have found their way into value-investor portfolios. As Eminence Capital’s Ricky Sandler puts it in his interview in this issue (see p. 1): “Some of the greatest businesses in the world – still growth companies in growth industries – are at significant discounts to small, lousy companies and to the market.” He describes in the interview his thesis for two such companies, Cisco and Oracle, that were also held in volume by other SuperInvestors at the end of the second quarter. Not all of the popular technology-related holdings are large-cap icons. Agere Systems, spun off from Lucent in 2002 and currently sporting a $2.6 billion market cap, has struggled to find its footing in hotly competitive markets for hard-diskdrive and communication-product semiconductors, but is starting to deliver improved financial results. Take-Two Interactive Software, publisher of the controversial Grand Theft Auto series of videogames, has been buffeted by hard times in the videogame business – due to transitioning game platforms – many questions about its accounting and legal problems over hidden sex scenes in some of its games. Take-Two shares, at a recent $12.67, are half their 52-week high. Even biotech company Nuvelo, with an active pipeline of cardiovascular and cancer drugs in development, was owned by three SuperInvestors at quarter’s end. With a market cap of just over $1 billion, Nuvelo reported $1 million in revenues in its latest quarter. Media, both content and distribution, is well represented on the widely-held lists.

What They Own: Core Holdings
Company
Comcast First Data Microsoft American Tower News Corp. Time Warner Transocean Tyco Cisco Systems Dade Behring Freescale Semiconductor NTL Oracle Sprint Nextel Williams Companies

Media and technology stocks are well represented among those companies with multiple superstar owners. Below are stocks in which three or more SuperInvestors held positions of more than $50 million at the end of the second quarter.
Industry Price@ 8/23/06
34.86 41.28 25.67 35.49 19.45 16.54 67.04 26.19 21.05 38.68 28.80 26.46 15.32 16.42 24.61

Ticker
CMCSA FDC MSFT AMT NWS TWX RIG TYC CSCO DADE FSL NTLI ORCL S WMB Cable TV

52-Week Low
25.35 38.60 21.46 22.73 14.76 15.70 52.34 24.65 16.83 32.90 20.87 19.99 11.75 15.92 19.35

High
35.31 48.88 28.38 36.05 20.57 19.00 90.16 31.28 22.00 43.11 33.04 31.00 15.95 26.89 25.72

Portfolios with $50+million position
5 5 5 4 4 4 4 4 3 3 3 3 3 3 3

% Change In Total Shares Held
14.6% 15.1% 158.8% 0.1% (-20.5%) 0.0% 20.8% 13.3% (-3.6%) 2.6% 2.2% 42.2% (-6.9%) (-24.6%) 135.3%

Payment Systems Computer Software/Services Communications Infrastructure Entertainment/Media Entertainment/Media Offshore Oil & Gas Drilling Diversified Industry Networking/Communcations Medical Testing Semiconductors Cable TV Computer Software Telecommunications Oil & Gas

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006

www.valueinvestorinsight.com

SuperInvestor Insight 24

WHAT THEY OWN

Five investors hold positions in excess of $50 million in Comcast, the bluest of blue chips in an industry beset by concerns over the cost of competing with phone and satellite companies. Also attracting attention have been shares of NTL, the dominant market leader in the U.K. cable market, whose shares trade in the U.S. Four portfolios each held big stakes in media titans News Corp. and Time Warner. News Corp. is generally credited as being the most international and nimbly run media company, but its shares have done little for the past five years. Time Warner, blessed with remarkable media brands, is still reeling more than five years after its disastrous merger with AOL – its shares, after a steep plunge early in the decade, have flat-lined for more than four years and trade today around $16.50. It’s not all glitz and glamour, of course. Retailer Advance Auto Parts, automotive supplier Lear and vehicle-salvage firm Copart were all owned by three or more SuperInvestors at quarter’s end. While Advance Auto and Lear are off 35% and 50% respectively from their 52-week

highs, Copart’s business of auctioning cars from insurance companies for salvage value is growing nicely, and the company had a debt-free balance sheet and

ON BKF CAPITAL:

Even the best investors have their Waterloos. BKF shares, above $35 a year ago, now trade at around $4.
over $250 million in cash at the end of its fiscal second quarter. Offshore contract driller Transocean was the SuperInvestors most widely held energy bet, with large positions owned by four investors. Bob Robotti of Robotti & Co. (see p. 12) – who doesn’t currently own Transocean – makes the case in his interview in this issue that offshore drillers are particularly well positioned to prosper, as he expects deep-water drilling to significantly increase as oil companies

seek to replenish depleting reserves. The investment case for paymentsprocessor First Data, owned in five portfolios at quarter’s end, was made by Glenview Capital’s Larry Robbins in Value Investor Insight last fall (October 28, 2005). Western Union, the company’s money-transfer gem which Robbins felt the market wasn’t fully valuing, is now slated to be spun-off. One remaining risk: that Wal-Mart pulls its credit-card processing business from First Data if it ultimately receives the bank charter it seeks. Even the best investors have their Waterloos, which appears to be the case for three SuperInvestors in investment manager BKF Capital. Activist investors were successful in gaining control of the company, but assets under management have since fallen off a cliff, leaving the company a shadow of its former self. The shares, above $35 a year ago and still at nearly $20 earlier this year, now trade around $4. SII
Funds managed by Co-Editor Whitney Tilson own Microsoft and Tyco.

What They Own: Below the Radar
Company
BKF Capital Take-Two Interactive Nuvelo Lear Copart Laidlaw Agere Systems Advance Auto Parts Pioneer Natural Resources DaVita

It isn’t only high-profile large-caps that attract the attention of great investors. Below are ten companies with market capitalizations below $6 billion that were owned by at least three SuperInvestors at the end of the second quarter.
Industry
Investment Management Videogames Biotechnology Automotive Parts Vehicle Salvage Bus Transportation Integrated Circuits Retail Automotive Stores Oil & Gas Dialysis Services

Ticker
BKF TTWO NUVO LEA CPRT LI AGR AAP PXD DVA

Price@ 8/23/06
4.00 12.67 19.41 19.41 27.30 25.81 15.16 29.60 41.78 56.79

52-Week Low
3.80 9.06 7.53 15.60 21.14 21.09 8.81 27.65 36.43 43.99

High
35.10 25.07 19.89 39.73 28.19 29.40 17.18 45.50 56.35 60.70

Market Value @8/23/06 (mm)
$32.9 $919.2 $1,010.0 $1,310.0 $2,470.0 $2,520.0 $2,570.0 $3,110.0 $5,210.0 $5,880.0

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006

www.valueinvestorinsight.com

SuperInvestor Insight 25

STOCK SPOTLIGHT: WALTER INDUSTRIES

Out of Focus
Few companies have as unlikely a mix of business units as Walter Industries – which explains its attraction to so many SuperInvestors last quarter.
Investors’ appetite for conglomerates rises and falls over time, but the emphasis today is clearly that focus is a virtue. Focused businesses are considered more nimble and responsive to changing competitive environments. From an investment perspective, the more uncluttered a given business is – the thinking goes – the more likely it is to be accorded full value by the market. That’s a big reason behind the steady stream of high-profile completed or contemplated corporate restructurings of late: Viacom’s breakup, American Express’ spin-off of financialadvisory subsidiary Ameriprise, Tyco’s prospective breakup, First Data’s plans to spin-off Western Union … the list goes on. This backdrop may help explain why conglomerate Walter Industries was one of the most hotly pursued stocks by SuperInvestors last quarter. No fewer than five investors increased their positions by more than 15% in the quarter – and four of those were newly-established positions. Walter, based in Tampa, Florida, has three quite disparate lines of business, producing approximately $3.1 billion in annual revenue: Mueller Water Products is a leading maker of piping, flow-control systems and end-of-line water transmission products like fire hydrants. Jim Walter Resources is a leading producer of high-quality metallurgical coal, used by steelmakers to make the coke that fuels blast furnaces and by utilities in producing steam. Jim Walter Homebuilding, the company’s original business, builds and finances low-end single-family homes throughout the southeastern U.S. Walter’s motley crew of businesses last year attracted the attention of activist-investor Pirate Capital, which filed a 13D with the SEC calling for the breakup of the company to better realize shareholder value. Walter has subseAugust 25, 2006

quently been responsive, agreeing to spin off 25.1% of Mueller Water in an initial public offering in June and committing to dispose of the rest in a tax-free spinoff before the end of the year. Walter shares – at $15 only two years ago – traded as high at $71.45 earlier this year before falling off sharply after the Mueller IPO. They’ve recovered someINVESTMENT SNAPSHOT

what from their second-quarter low of $44.60 and recently traded at $51.70. The ongoing investment thesis for Walter is relatively straightforward, says Gary Claar of SuperInvestor JANA Partners. “It’s just what we look for – value, plus a catalyst,” he says. “Business by business, each piece of Walter deserves a more robust valuation

Walter Industries
(NYSE: WLT)

Valuation Metrics
(Current Price vs. TTM):

Business: Conglomerate operating in three discrete business segments: coal and natural gas, home building and watersystem infrastructure. Share Information
(@ 8/23/06):

P/E P/CF
(@6/30/06):

WLT 46.1 62.6

S&P 500 19.3 13.7

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

51.70
39.45 – 71.45 0.3% $2.25 billion

Company Pirate Capital JPMorgan Chase Steel Partners JANA Partners Stephen A. Feinberg
Short Interest (@7/10/06):

% Owned 8.5% 7.9% 5.2% 4.7% 4.6% 7.4%

Revenue Operating Profit Margin Net Profit Margin
WLT PRICE HISTORY 80 70 60 50 40 30 20 10 0 2004

$2.80 billion 18.7% 1.6%

Shares Short/Float

80 70 60 50 40 30 20 10 2005 2006 0

THE BOTTOM LINE

The company is in the middle of the process of rationalizing its disparate businesses, which should result in each being more highly valued by the market, says JANA Partners’ Gary Claar. JANA’s purchases of WLT shares during the second quarter were at an up to 50% discount to the estimated value of the sum of its parts, he says.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

SuperInvestor Insight 26

STOCK SPOTLIGHT: WALTER INDUSTRIES

than it’s getting as part of a conglomerate, and they’re in the process of rationalizing that structure.” Mueller Water’s vertically integrated line of products is well positioned to take advantage of the heavy infrastructure spending necessary to upgrade and replace aging water systems throughout the country, says Claar. He believes the growth and sustainability of the business warrants at least a 10x multiple of earnings before interest, taxes, depreciation and amortization – 25% higher than the 8x multiple it currently sports – which is likely only after Mueller shares are fully spun out later this year. The natural-resources business is also a much better business than it currently gets credit for, says Claar, and might eventually make an excellent acquisition target for a large, diversified coal company. High-quality metallurgic coal sells for a solid premium to lesser-quality coal and the location of Walter’s mines near steel mills in the southern U.S. gives the

company a cost advantage over many competitors. The business is tied to steelindustry cyclicality, but steel is in a relatively strong part of what many consider to be a long-lived cycle. In addition, coal’s central role in

ON THE COAL BUSINESS:

Less susceptible to naturalgas competition in power generation, coal should be a lot less cyclical going forward.

power generation, now less susceptible to competition from higher-priced natural gas, “makes coal companies a lot less cyclical going forward than looking back,” Claar says. He believes Walter’s coal business should trade for a premium 6x EBITDA multiple, up from less

than his estimate of 3.5x today. Even Walter’s homebuilding business – which Claar calls “lousy” – has potential upside. The company’s focus is primarily on homes priced between $50,000 to $150,000, which should better position it for a tough housing market. Just as low interest rates and easy financing allowed many low-income buyers to trade up from Walter’s typical offering during the boom, more difficult times should increase demand for its homes. Claar values the business at roughly $5 per share and expects it ultimately to be sold to a competitor or in a management buyout. All in, Claar says JANA bought into Walter at a 30-50% discount to the estimated value of the sum of its parts. “We typically look for a very dynamic period of a company’s public life when it undergoes a lot of change and gets revalued by the market,” he says. “We think we’re right in the middle of that period now with Walter.” SII

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August 25, 2006

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SuperInvestor Insight 27

E D ITOR S’ LETTE R

High-Level Networking
When we launched Value Investor Insight eighteen months ago, we deliberately ignored the typical formula for investment newsletters. We made no promises to regularly unearth the next Microsoft, or to double your money in two weeks, or to let you in on our SECRET!, PROPRIETARY! system for market-beating returns. What we set out to do was present intelligent interviews and commentary on investing, drawing insight and wisdom from the best value investors in the business. The goal was – and is – to provide both actionable investing ideas and ongoing learning on how to become a better investor. Our aspiration is to help readers invest more successfully tomorrow, next year … and ten years from now. Like fingerprints, no two investing strategies are exactly alike. We very much believe there are central principles upon which sound investments are made, but any investor's given performance is a function of hundreds of individual decisions over time about what, how much and when to buy and sell. In this issue, Ricky Sandler explains why he's never touched energy stocks and Bob Robotti describes
Value Investor Insight™ is published monthly at www.valueinvestorinsight.com (the “Site”), by Value Investor Media, Inc. Chairman and Co-Editor-in-Chief, Whitney Tilson; President and Co-Editor-in-Chief, John Heins. Annual subscription price: $349.
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why energy makes up the largest share of his portfolio. Neither is “right” – and both have consistently produced remarkable returns. So if investing is the individualistic affair we believe it is, why are we launching a new quarterly newsletter – the first issue of which is included herein – to track the latest portfolio activity of superstar value investors? The reason is that while winning investors clearly make their own decisions, they also have an insatiable appetite for good ideas. That's the thesis behind SuperInvestor Insight. Learning that five of the best investors in the world bought shares of Walter Industries last quarter doesn't mean you should buy it, but our hope is that such knowledge may spark a line of inquiry worth pursuing. What you do with it is up to you. In fact, great investors freely admit to relying on their “grapevine” of peers for good ideas. “We learn a lot from other investors,” Ricky Sandler tells us in this issue's interview. “I'm not afraid of ideas owned by other people, but you obviously need to do your own work and make sure the ideas fit what you do.” Fairholme Fund's Bruce Berkowitz said

much the same thing to us earlier this year (VII, April 28, 2006): “Why wouldn't you look at what other great investors have found?” We couldn't agree more. Each quarter, SuperInvestor Insight will analyze the collective portfolio activity of 25 to 30 of the best value-oriented hedge-fund managers. The list will evolve over time, but will always include the investors we most respect, such as Bill Ackman, David Einhorn, Joel Greenblatt, Seth Klarman, Stephen Mandel, Larry Robbins, Jeffrey Ubben and many more. The one nonhedge-fund manager included: Warren Buffett’s Berkshire Hathaway. A trial subscriber to VII called us early on to say he wouldn’t subscribe unless the format evolved. “I basically want you to tell me what to do,” he said. No, we won’t do that. But we’ll keep doing everything we can to help you better figure it out for yourself. VII

John Heins Co-Editor-in-Chief

Whitney Tilson Co-Editor-in-Chief

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Value Investor Insight 28

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 Media’s 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, an investment adviser registered with the U.S. Securities and Exchange Commission. T2 Partners 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 of any securities or financial instruments discussed herein are made. 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.

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