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Interviews - Value Investing Read No.

1 Interview With Value Investor Mohnish Pabrai Bookmark and Share It is my privilege to bring you the following interview I recently conducted wit h value investing superstar Mohnish Pabrai. Mohnish is my favorite investor who doesn't have the initials W.B. His stock selection style is similar to mine, exc ept that he's more successful at it. Much, much more successful. I'll let the numbers speak for themselves: A $100,000 investment in Pabrai Funds at inception (on July 1, 1999) was worth $722,200 on March 31, 2007. That works out to an annualized return of 29.1%, and that's after all fees and expenses. A ssets under management are over $500 million, up from $1 million at inception. A lthough a person probably can't get into the investing hall of fame with eight y ears of outperformance (even if they crush the indices), Pabrai is already menti oned in most articles about the search for the next Warren Buffett, and justifia bly so. Equally importantly, he genuinely wants to help others become better investors, and in that spirit has just published his second book, The Dhandho Investor. The book is both illuminating and easy to read, and it deserves to be on every inve stor's bookshelf next to Benjamin Graham's The Intelligent Investor. This is why I felt extremely fortunate when he recently agreed to answer some questions abo ut his investment strategy in this exclusive interview, conducted by email. I ho pe you find it useful, and I hope it inspires you to pick up a copy of his book if you haven't already. Happy Investing, Tom Murcko CEO, InvestorGuide.com InvestorGuide: You have compared Pabrai Funds to the original Buffett parternshi ps, and there are obvious similarities: investing only in companies within your circle of competence that have solid management and a competitive moat; knowing the intrinsic value now and having a confident estimate of it over the next few years, and being confident that both of these numbers are at least double the cu rrent price; and placing a very small number of very large bets where there is m inimal downside risk. Are there any ways in which your approach differs from tha t of the early Buffett partnerships (or Benjamin Graham's approach), either beca use you have found ways to improve upon that strategy or because the investing w orld has changed since then? Mohnish Pabrai: The similarity between Pabrai Funds and the Buffett Partnerships that I refer to is related to the structure of the partnerships. I copied Mr. B uffett's structure as much as I could since it made so much sense. The fact that it created a very enduring and deep moat wasn't bad either. These structural si milarities are the fees (no management fees and 1/4 of the returns over 6% annua lly with high water marks), the investor base (initially mostly close friends an d virtually no institutional participation), minimal discussion of portfolio hol dings, annual redemptions and the promotion of looking at long term results etc. Of course, there is similarity in investment style, but as Charlie Munger says, "All intelligent investing is value investing." My thoughts on this front are covered in more detail in Chapter 14 of The Dhandh o Investor. Regarding the investment style, Mr. Buffett is forced today to mostly be a buy a nd hold forever investor today due to size and corporate structure. Buying at 50

cents and selling at a dollar is likely to generate better returns than buy and hold forever. I believe both Mr. Munger and he would follow this modus operandi if they were working with a much smaller pool of capital. In his personal portf olio, even today, Mr. Buffett is not a buy and hold forever investor. In the early days Mr. Buffett (and Benjamin Graham) focused on buying a fair bus iness at a cheap price. Later, with Mr. Munger's influence, he changed to buying good businesses at a fair price. At Pabrai Funds, the ideal scenario is to buy a good business at a cheap price. That's very hard to always do. If we can't fin d enough of those, we go to buying fair businesses at cheap prices. So it has mo re similarity to the Buffett of the 1960s than the Buffett of 1990s. BTW, even t he present day Buffett buys fair businesses at cheap prices for his personal por tfolio. Value investing is pretty straight-forward - you try to get $1 worth of assets f or much less than $1. There is no way to improve on that basic truth. It's timel ess. InvestorGuide: Another possible difference between your style and Buffett's rela tes to the importance of moats. Your book does emphasize investing in companies that have strategic advantages which will enable them to achieve long-term profi tability in the face of competition. But are moats less important if you're only expecting to hold a position for a couple years? Can you see the future clearly enough that you can identify a company whose moat may be under attack in 5 or 1 0 years, but be confident that that "Mr. Market" will not perceive that threat w ithin the next few years? And how much do moats matter when you're investing in special situations? Would you pass on a special situation if it met all the othe r criteria on your checklist but didn't have a moat? Pabrai: Moats are critically important. They are usually critical to the ability to generate future cash flows. Even if one invests with a time horizon of 2-3 y ears, the moat is quite important. The value of the business after 2-3 years is a function of the future cash it is expected to generate beyond that point. All I'm trying to do is buy a business for 1/2 (or less) than its intrinsic value 23 years out. In some cases intrinsic value grows dramatically over time. That's ideal. But even if intrinsic value does not change much over time, if you buy at 50 cents and sell at 90 cents in 2-3 years, the return on invested capital is v ery acceptable. If you're buying and holding forever, you need very durable moats (American Expr ess, Coca Cola, Washington Post etc.). In that case you must have increasing int rinsic values over time. Regardless of your initial intrinsic value discount, ev entually your return will mirror the annualized increase/decrease in intrinsic v alue. At Pabrai Funds, I've focused on 50+% discounts to intrinsic value. If I can get this in an American Express type business, that is ideal and amazing. But even if I invest in businesses where the moat is not as durable (Tesoro Petroleum, Le vel 3, Universal Stainless), the results are very acceptable. The key in these c ases is large discounts to intrinsic value and not to think of them as buy and h old forever investments. InvestorGuide: For that part of our readership which isn't able to invest in Pab rai Funds due to the net worth and minimum investment requirements, to what exte nt could they utilize your investing strategy themselves? Your approach seems fe asible for retail investors, which is why I have been recommending your book to friends, colleagues, and random people I pass on the street. For example, your r esearch primarily relies on freely available information, you aren't meeting wit h the company's management, and you don't have a team of analysts crunching numb ers. To what extent do you think that a person with above-average intelligence w

ho is willing to devote the necessary time would be able to use your approach to outperform the market long-term? Pabrai: Investing is a peculiar business. The larger one gets, the worse one is likely to do. So this is a field where the individual investor has a huge leg up on the professionals and large investors. So, not only can The Dhandho Investor approach be applied by small investors, they are likely to get much better resu lts from its application than I can get or multi-billion dollar funds can get. T emperament and passion are the key. InvestorGuide: You founded, ran, and sold a very successful business prior to st arting Pabrai Funds. Has that experience contributed to your investment success? Since that company was in the tech sector but you rarely buy tech stocks (appar ently due to the rarity of moats in that sector), the benefits you may have deri ved seemingly aren't related to an expansion of your circle of competence. But h as learning what it takes to run one specific business helped you become a bette r investor in all kinds of businesses, and if so, how? And have you learned anyt hing as an investor that would make you a better CEO if you ever decide to start another company? Pabrai: Buffett has a quote that goes something like: "Can you really explain to a fish what it's like to walk on land? One day on land is worth a thousand year s of talking about it, and one day running a business has exactly the same kind of value." And of course he's said many times that he's a better investor becaus e he's a businessman and he's a better businessman because he is an investor. My experience as an entrepreneur has been very fundamental to being any good at in vesting. My dad was a quintessential entrepreneur. Over a 40-year period, he had started, grown, sold and liquidated a number of diverse businesses - everything from mak ing a motion picture, setting up a radio station, manufacturing high end speaker s, jewelry manufacturing, interior design, handyman services, real estate broker age, insurance agency, selling magic kits by mail - the list is endless. The com mon theme across all his ventures was that they were all started with virtually no capital. Some got up to over 100 employees. His downfall was that he was very aggressive with growth plans and the businesses were severely undercapitalized and over-leveraged. After my brother and I became teenagers, we served as his de facto board of dire ctors. I remember many a meeting with him where we'd try to figure out how to ju ggle the very tight cash to keep the business going. And once I was 16, I'd go o n sales calls with him or we'd run the business while he was traveling. I feel l ike I got my Harvard MBA even before I finished high school. I did not realize i t then, but the experience of watching these businesses with a front-row seat du ring my teen years was extremely educational. It gave me the confidence to start my first business. And if I have an ability to get to the essence of a subset o f businesses today, it is because of that experience. TransTech was an IT Services/System Integration business. We provided consulting services, but did not develop any products etc. So it wasn't a tech-heavy busin ess. While having a Computer Engineering degree and experience was useful, it wa sn't critical. TransTech taught me a lot about business and that experience is i nvaluable in running Pabrai Funds. Investing in technology is easy to pass on be cause it is a Buffett edict not to invest in rapidly changing industries. Change is the enemy of the investor. Being an investor is vastly easier than being a CEO. I've made the no-brainer de cision to take the easy road! I do run a business even today. There are operatin g business elements of running a fund that resemble running a small business. Bu t if I were to go back to running a business with dozens of employees, I think I

'd be better at it than I was before the investing experience. Both investing an d running a business are two sides of the same coin. They are joined at the hip and having experience doing both is fundamental to being a good investor. There are many successful investors who have never run a business before. My hat's off to them. - For me, without the business experiences as a teenager and the exper ience running TransTech, I think I'd have been a below average investor. I don't fully understand how they do it. InvestorGuide: Is your investment strategy the best one for you, or the best one for many/most/all investors? Who should or shouldn't consider using your approa ch, and what does that decision depend on (time commitment, natural talent, anal ytical ability, business savvy, personality, etc)? Pabrai: As I mentioned earlier, Charlie Munger says all intelligent investing is value investing. The term value investing is redundant. There is just one way t o invest - buy assets for less than they are worth and sell them at full price. It is not "my approach." I lifted it from Graham, Munger and Buffett. Beyond tha t, one should stick to one's circle competence, read a lot and be very patient. InvestorGuide: Some investment strategies stop working as soon as they become su fficiently popular. Do you think this would happen if everyone who reads The Dha ndho Investor starts following your strategy? As I've monitored successful value investors I have noticed the same stocks appearing in their various portfolios surprisingly often. (As just one example, you beat Buffett to the convertible bo nds of Level 3 Communications back in 2002, which I don't think was merely a coi ncidence.) If thousands of people start following your approach (using the same types of screens to identify promising candidates and then using the same types of filters to whittle down the list), might they end up with just slightly diffe rent subsets of the same couple dozen stocks? If so, that could quickly drive up the prices of those companies (especially on small caps, which seem to be your sweet spot) and eliminate the opportunities almost as soon as they arise. Looked at another way, your portfolio typically has about ten companies, which presuma bly you consider the ten best investments; if you weren't able to invest in thos e companies, are there another 10 (or 20, or 50) that you like almost as much? Pabrai: As long as humans vacillate between fear and greed, there will be mispri ced assets. Some will be priced too low and some will be priced too high. Mr. Bu ffett has been talking up the virtues of value investing for 50+ years and it ha s made very few folks adopt that approach. So if the #2 guy on the Forbes 400 ha s openly shared his secret sauce of how he got there for all these decades and h is approach is still the exception in the industry, I don't believe I'll have an y effect whatsoever. Take the example of Petrochina. The stock went up some 8% after Buffett's stake was disclosed. One could have easily bought boat loads of Petrochina stock at th at 8% premium to Buffett's last known buys. Well, since then Petrochina is up so me eight-fold - excluding some very significant dividends. The entire planet cou ld have done that trade. Yet very very few did. I read a study a few years back where some university professor had documented returns one would have made ownin g what Buffett did - buying and selling right after his trades were public knowl edge. One would have trounced the S&P 500 just doing that. I don't know of any i nvestors who religiously follow that compelling approach. So, I'm not too concerned about value investing suddenly becoming hard to practi ce because there is one more book on a subject where scores of excellent books h ave already been written. InvestorGuide: You have said that investors in Pabrai Funds shouldn't expect tha t your future performance will approach your past performance, and that it's mor e likely that you'll outperform the indices by a much smaller margin. Do you say

this out of humility and a desire to underpromise and overdeliver, or is it bas ed on market conditions (e.g. thinking that stocks in general are expensive now or that the market is more efficient now and there are fewer screaming bargains) ? To argue the other side, I can think of at least two factors that might give y our investors reason for optimism rather than pessimism: first, your growing cir cle of competence, which presumably is making you a better investor with each pa ssing year; and second, your growing network of CEOs and entrepreneurs who can q uickly give you firsthand information about the real state of a specific industr y. Pabrai: Future performance of Pabrai Funds is a function of future investments. I have no idea what these future investment ideas would be and thus one has to b e cognizant of this reality. It would be foolhardy to set expectations based on the past. We do need to set some benchmarks and goals to be measured against. If a fund beats the Dow, S&P and Nasdaq by a small percentage over the long-haul t hey are likely to be in the very top echelons of money managers. So, while they may appear modest relative to the past, they are not easy goals for active manag ers to achieve. The goals are independent of market conditions today versus the past. While circ le of competence and knowledge does (hopefully) grow over time, it is hard to qu antify that benefit in the context of our performance goals. InvestorGuide: Finally, what advice do you have for anyone just getting started in investing, who dreams of replicating your performance? What should be on thei r "to do" list? Pabrai: I started with studying Buffett. Then I added Munger, Templeton, Ruane, Whitman, Cates/Hawkins, Berkowitz etc. Best to study the philosophy of the vario us master value investors and their various specific investments. Then apply tha t approach with your own money and investment ideas and go from there. Read No. 2 Pabrai's Perspectives on Investing By Emil Lee | More Articles February 22, 2007 | Comments (0) Warren Buffett made billions buying shares of Coca-Cola (NYSE: KO ) , Wells Far go (NYSE: WFC ) , and Gillette (now a part of Procter & Gamble (NYSE: PG ) ) i n the 1980s and 1990s. But before that, he was actually posting better returns i nvesting in some companies you've never heard of, like Sanborn Maps, and some yo u have, like American Express (NYSE: AXP ) . In those early days, Buffett's investing strategies were geared more toward spec ial situations -- workouts, arbitrage, and liquidations. (Many people, based on comments Buffett has made, believe he makes more than 50% a year in his personal portfolio from special-situation investing.) From 1957 to 1968, Buffett's inves tment partnership posted 31.6% gross and 25.3% net annualized returns, respectiv ely, in comparison with the Dow's 9.1% annual return. Mohnish Pabrai, who was profiled in James Altucher's must-read Trade Like Warren Buffett, is an ardent Buffett follower, and his investment partnership likewise has a stellar track record. Pabrai's first book, Perspectives on Investing, was brilliant in its simplicity and ability to convey the principles of intelligent investing. Pabrai also has a new book, The Dhandho Investor, coming out soon. I thought Fools (myself included) would be very well-served to read up on some of Pabrai's thoughts, and the following is the first half of a two-part interview conducted with Pabrai via email.

Emil Lee: You've modeled your partnership after the Buffett Partnership -- do yo u mind providing any detail on how that's going? Are you on track in terms of pe rformance, assets under management, etc.? Mohnish Pabrai: It has gone far better than I would have forecasted. Mr. Buffett deserves all the credit. I am just a shameless cloner. A $100,000 investment in Pabrai Funds at inception (on July 1, 1999) was worth $659,700 on Dec. 31, 2006 . That's seven and a half years. The annualized return is 28.6% -- after my outr ageous fees and all expenses. Assets under management are over $400 million -- u p from $1 million at inception. On all fronts, Pabrai Funds has done vastly bett er than my best-case expectations. Going forward, I expect we'll continue to beat the major indices, but with just a small average annualized outperformance. Lee: You clearly believe in having a broad latticework of knowledge from differe nt educational disciplines from which to draw upon when judging investment ideas . Can you describe how you spend your day? Do you devote a general percentage of your time to reading "non-investment" material versus 10-Ks, etc.? Pabrai: My calendar is mostly empty. I try to have no more than one meeting a we ek. Beyond that, the way the day is spent is quite open. If I'm in the midst of drilling down on a stock, I might spend a few days just focused on reading docum ents related to that one business. Other times, I'm usually in the midst of some book, and part of the day goes to keeping up with correspondence -- mostly emai l. I take a nap nearly every afternoon. There is a separate room with a bed in our offices. And I usually stay up late. So some reading, etc., is at night. Lee: In Trade Like Warren Buffett, you mention that you let investment ideas com e to you by reading a lot, and also monitoring familiar names on the NYSE. Can y ou describe your process of generating investment ideas -- is it simply just rea ding a lot? Do you do anything else to actively seek out ideas? Pabrai: The No. 1 skill that a successful investor needs is patience. You need t o let the game come to you. My steady-state modus operandi is to assume that I'm just a gentleman of leisure, and that I'm not in the investment business. If so mething looks so compelling that it screams out at me, saying "Buy me!!," I then do a drill-down. Otherwise, I'm just reading for reading's sake. So, I scan a f ew sources and usually can find something scream out at me a few times a year. T hese sources (in no particular order) are: 1. 52-Week Lows on the NYSE (published daily in The Wall Street Journal and week ly in Barron's) 2. Value Line (look at their various "bottoms lists" weekly) 3. Outstanding Investor Digest (www.oid.com) 4. Value Investor Insight (www.valueinvestorinsight.com) 5. Portfolio Reports (from the folks who put out OID) 6. The Wall Street Journal 7. Financial Times 8. Barron's 9. Forbes 10. Fortune 11. BusinessWeek 12. The Sunday New York Times 13. The Value Investors' Club (www.valueinvestorsclub.com) 14. Magic Formula (www.magicformulainvesting.com) 15. Guru Focus (www.gurufocus.com)

Between all of the above, I have historically found at least three to four good ideas every year. Sometimes I make a mistake, and a good idea turns out to be no t so good. Lee: A big part of investing is knowing what to pay attention to and what not to [focus on]. How do you sift through the thousands of investment ideas? Often, b argains are bargains because they're unrecognizable -- how do you spot the needl es in the haystack, and how do you avoid the value traps? Pabrai: I wait to hear the scream. "Buy me!" It needs to be really loud, as I'm a bit hard of hearing. Lee: Would it be fair to say you are more balance sheet-oriented, versus income/ cash flow statement-oriented? If so, how do you get comfortable with the asset v alues (i.e., Frontline, death care)? Pabrai: John Burr Williams was the first to define intrinsic value in his The Th eory of Investment Value, published in 1938. Per Williams, the intrinsic value o f any business is determined by the cash inflows and outflows -- discounted at a n appropriate interest rate -- that can be expected to occur during the remainin g life of the business. The definition is painfully simple. So, cash can be gotten out of a business in a liquidation or by cash the busines s generates year after year. It is all a question of what is the likelihood of e ach. If future cash flows are easy to figure out and are high-probability events , then liquidation value can be set aside. On the other hand, sometimes the only thing that is a high probability of value is liquidation value. Both work. Depe nds on the situation. But you first need to hear a scream ... A worthy successor Pabrai's answers have provided a great look into the thoughts and habits of an e xcellent value investor. In fact, he's one of a handful alive who are generally acknowledged as worthy of following in Buffett's footsteps (Pabrai was nominated as a "Buffetteer" by Forbes magazine). Like Buffett, Pabrai gives credence to t he theory that activity shouldn't be confused with productivity, but instead ten ds to result in friction. Read No. 3 Rounding the Second Curve By Emil Lee | More Articles December 18, 2006 | Comments (1) Tom Brown is the founder of the $550 million hedge fund Second Curve Capital, wh ich specializes in financial-services companies. I once worked at one of America 's largest funds, and ever since, I've been obsessed with all things alternative . From my experience, Tom Brown may be the best financial services analyst on th e planet, and I doubt I'm alone in that opinion. About six months ago, I decided to read every article in the archive of the Seco nd Curve-run website bankstocks.com. It was almost like getting an MBA in financ e. I wanted the Fool's readers to learn about Second Curve's methodologies and s ome of the companies in which the fund is interested. I called Tom Brown up for a phone interview; the notes in italics are my own commentary. Question: I read some statistics on how you turned some initial capital from you r father into a large sum. Can you provide me with details? Tom Brown: My father got a lump sum contribution in 1984 of $130,000, which subs equently became $18 million by the early 2000s by investing only in financial st

ocks. Brown calculated the annual average rate of return at roughly 40%. Question: Why do you stick solely to financial-services companies? Tom Brown: Well, financial-services businesses are in my circle of competence. I can try to grow that circle, but I just don't know other industries as well. Question: Can you describe your due diligence process? Tom Brown: We look at 350 companies in our "universe." Then we use valuation too ls to identify where there's an attractive opportunity with our team of five ana lysts. Then we take a position and build upon our knowledge. We only own 15-20 s tocks in our portfolio, so we're focused in our investment activity. Question: How detailed do your valuation models get? Do you get into specific un it costs? Tom Brown: For the model, it really depends on the company. Sometimes they don't matter, sometimes they're critical. It could be a cash flow model, and sometime s it's an earnings model. We do 360-degree research; we go visit the company and talk to senior level management, but we also talk to mid-level management. That 's one of the benefits of bankstocks.com. We also talk to frontline employees an d customers. Question: How do you calculate free cash flow for financial services companies? Tom Brown: You can't. For our cash flow model, a company might securitize assets , which is accounted for with a gain on sale [taking the net present value of th e profit]. We're looking for the cash flow value of residuals. When a financial-services company securitizes assets, it usually sells a portfol io of loans to other investors. The investors are entitled to an annual interest rate payment, and the seller often retains the right to excess cash flow (the r esidual interest). Valuing this residual interest can be tricky, because it's ba sed on management estimates and can be used for accounting trickery. Second Curv e's intimate knowledge of management gives it a competitive advantage in estimat ing whether residual values are real or not. Question: So in general, you use an earnings-power model? Tom Brown: In most investments, that'd be the case. Question: What do you look for in insurers, banks, and other spread lenders? Tom Brown: Well, there's a list of what we like to see, and a list of what we us ually have to deal with. ... A big part of our job is our evaluation of the mana gement and constantly searching for new information that will lead you to suppor t or lead you to change that [view of management]. Management is critical. We tr y to find companies with a competitive advantage. Take a company like First Marb lehead (NYSE: FMD ) ; their advantage is in private student loans. First Marblehead provides outsourced underwriting services for private student l oans. Its stock took a dive when the market got scared that Marblehead's busines s model and cash flows were unsustainable, but Second Curve believed otherwise. Since bankstocks.com posted a bullish article on First Marblehead in 2005, the s tock is up 80%. Question: So how did you go about finding this investment idea? Did you already

know about the company before the stock dropped? Tom Brown: At beginning of 2005, I knew nothing about First Marblehead. We hired an individual who knew a lot about the company. The stock started to weaken in 2005, and the analyst who used to work here recommended it and we took a small p osition. We grew the position as the stock declined, and as we learned more abou t the story. At which point I thought to myself: Nice! In conclusion... I had heard the story before, but didn't realize how high the 40% rate of return that Tom earned for his father was. I was also surprised that Second Curve stic ks to a relatively small universe of 350 companies; that's truly a defined circl e of competence, and it explains why Second Curve was able to make the contraria n bet on First Marblehead. After reading the analysis on bankstocks.com it seeme d like Second Curve knew the company like the back of its hand. It's also noteworthy that Second Curve, because of its intimate knowledge and ha rd work in doing due diligence, had the conviction not only to stick with its Fi rst Marblehead position as the stock kept going down -- at the time, it seemed a s if everyone and their mother thought Marblehead was going to hell in a hand ba sket -- but also to buy more stock, a move which has since paid off in spades. I also noted that in doing due diligence, its important to get a holistic view b y talking to midlevel and frontline employees and customers. I think readers sho uld note that most due diligence methods are available to anyone who's willing t o pick up the phone and call a copy, or drive to its nearest location -- not jus t to employees of multimillion- dollar hedge funds. Second Curve employees often visit a bank's branch to get a firsthand sense from the customer's perspective, a trip that anyone can make. In fact, visiting stores in person helped keep me out of Cost PlusWorld Market (Nasdaq: CPWM ) and Pier 1 (NYSE: PIR ) , both of which are down 40% in the past year. Check back tomorrow for the second part of this interview, in which Tom Brown ta lks about some of his portfolio holdings, including RenaissanceRe (NYSE: RNR ) , Montpelier Re (NYSE: MRH ) , and a pick he describes in bankstocks.com as the single most attractive opportunity in the financial services sector. Emil Lee: Can you give me your bull case for Montpelier Re (NYSE: MRH ) ? Tom Brown: Montpelier Re is a reinsurance company with an above-average exposure in the areas with the greatest losses in 2004 and 2005. The market is overreact ing to these unusual years. Coming out of that, there were a number of changes - rating-agency changes -- which forced catastrophe-loss modelers to change. A l ot of companies are scared and have reduced exposures. Also, primary insurers ar e looking to increase reinsurance coverage. So it's a very good pricing environm ent [for reinsurance]. For example, coming out of the heavy hurricane season of 2005, let's [hypothetically] say pricing was up 20% on Jan. 1, [and] by July it was up 30%. The question is: Where is pricing going to be in 2007? It looks like it'll be down a little bit. Also, attachment points are up, so the risk of loss goes down. Attachment points are the point at which reinsurers are responsible for losses i n "excess of loss" contracts. The higher the attachment point, the less likely t he reinsurer will have to pay out claims. After huge hurricane-induced losses in 2005, reinsurance supply has gone down and demand has gone up, and that means r einsurers can demand higher attachment points. Emil Lee: It seems you are optimistic about the fact that Montpelier Re, as well

as RenaissanceRe (NYSE: RNR ) , is writing much more profitable excess-of-loss contracts [in which the reinsurer agrees to pay losses over a certain threshold ] versus quota reinsurance [in which the reinsurer shares a percentage of losses ]. This is essentially a bet against a high-catastrophe season [since excess of loss gets triggered only in high-catastrophe situations, and quota share pays lo sses from the start]. This paid off in 2006, thanks to a benign hurricane season , but is this wise in the long run? Tom Brown: The strategies of Montpelier and RenaissanceRe in 2005 were meaningfu lly different. Montpelier lost 70% of its book value. Now it needs to eliminate more of its downside risk, and to do that, it's willing to give up some of the u pside. In a year of no [major] catastrophes, you typically would've expected Mon tpelier to achieve a 30% return on equity, but it'll do mid-20s instead. RenRe d idn't get hit as much. [RenRe] thinks it still knows the business, so it took a different approach. If I had to choose, we own a little more of RenRe than Montpelier. Our earnings estimates for RenRe versus Wall Street's are wider than for Montpelier. The Stre et expects RenRe to earn $8.50 [in 2007]. We think it'll be north of $10 [per sh are]. Emil Lee: How do you get comfortable with a reinsurer's underwriting discipline? Tom Brown: They have to show the rating agencies. They tell us about their model , and they show the rating agencies [the specific policies]. We [don't get direc t access to their book of policies], but we have support from the rating agencie s. If the agencies are not comfortable with the downside loss, they'd downgrade [the reinsurer]. It's kind of like a bank. You talk to the company about its process, but when yo u talk to them, they all sound pretty good. So you look at the historic record. For reinsurers, you'd look for redundancies. Redundancies refer to instances when a reinsurer realizes that its past loss est imates were too conservative. In general, it's much more preferable to have a co nservative management that errs on the side of caution. Emil Lee: How much do you look for an insurer with a low loss ratio versus a low expense ratio versus an insurer that has skill investing its float? How importa nt is each aspect relative to the other, to you? Tom Brown: Well, it's kind of like a balloon -- you push on one side, and it goe s out the other. We have to look at all of these factors together and compare ou r view of the company to its valuation in the marketplace. Most of the time, we find the marketplace's valuation is pretty reasonable, which is why we have a co ncentrated portfolio. Emil Lee: How do you value float? Tom Brown: Every company is different. We look at the earnings potential. In the case of CompuCredit (Nasdaq: CCRT ) , which has excess liquidity, we ask, What 's the earnings impact of buying back stock or making an acquisition, and what's the range of earnings power? Emil Lee: Your modus operandi seems to be to buy a disciplined underwriter/opera tor in a beat-up sector when everyone else is scared. How do you identify these types of companies, and how do you avoid value traps? Tom Brown: To be honest, we've bought crappy companies, too. I made a lot of mon ey personally in the '90s, when banks had significant real estate loan problems.

I ended up owning the ones that had the worst underwriting but offered the most leverage to improvement. Emil Lee: Was this a NAV play? A net asset value, or NAV, play -- made famous by Ben Graham -- refers to a comp any selling below its net asset value, or liquidation value. Tom Brown: If you believed the banks would survive, and make a 15% return on equ ity and trade at 10-12 times earnings ... [you'd make a lot of money]. It was th at sort of upside analysis. Emil Lee: In the case of those troubled banks, what gave you the conviction that they'd survive? Tom Brown: You have to look at the capital reserves, the flow of NPA [non-perfor ming assets], and the inflows and outflows. Total NPAs will peak after the inflo w. It's helpful to monitor the inflow. Emil Lee: Can you tell us about the bull case for CompuCredit? On bankstocks.com, Tom Brown describes CompuCredit as the single most compelling investment opportunity in the financial-services sector. Tom Brown: CompuCredit's primary business is the issuance of subprime borrowings . [It has] two main products. One is a fee-based card with a $300 line of credit , where it makes more money off fees than the net interest income. The other is at the upper end of the subprime market, where CompuCredit makes more money off the balance with a $1,000 to $1,500 line of credit. That business has grown nice ly as a result of portfolio acquisitions, and primarily on the basis of organic growth. CompuCredit has emerging businesses -- such as payday lending, subprime auto fin ancing, and debt collection. Those businesses are growing wildly, and they're tu rning profitable. The real wild card is the $700 million of liquidity -- $100 mi llion of cash and $600 million they could draw down. What are they doing to do w ith that liquidity? If, in the next six months, they don't find anything, my pre diction is they'll buy back more stock. Management and the board own 60% [of the company]. Emil Lee: It seems CompuCredit might be underleveraged. Tom Brown: Tangible equity to assets is at about 33%; 20% is where they feel com fortable. The equity-to-asset ratio measures how leveraged a company is. In this case, tak e the inverse -- for a 33% equity-to-asset ratio, we take 1 divided by 0.33, whi ch equals 3. This implies that CompuCredit has $3 in assets for every $1 in tang ible equity, which excludes goodwill. A 20% E/A ratio implies $5 in assets for e very $1 in equity (1/0.2). In general, as long as it's prudent, leveraging up al lows a company to increase its profitability. You can buy this company at eight times 2008 [Second Curve's estimated] earnings -- plus the excess liquidity. CompuCredit has managed earnings and GAAP earning s. This year, the consensus earnings estimate is around 4 bucks; that's the GAAP estimate. The managed [earnings] estimate, which is what Bloomberg uses, is $3. 63 per share. My feeling is next year it'll do $4.50 to $5.00 per share. In general, the difference between GAAP and managed earnings is that the managed earnings acts as if securitizations stay on a company's books. This gives a mor

e holistic view of the company. Tom advises paying attention to managed earnings . Emil Lee: It seems as though CompuCredit has a built-in hedge -- when credit is tight, and advance rates on securitization and warehouse facilities dry up, that means favorable pricing for the debt-collection segment. What are your thoughts on this? Tom Brown: I must be careful what I wish for! [In those circumstances], it'll be the best time for CompuCredit to be making acquisitions, and for the debt-colle ction segment to be making credit card receivable acquisitions [in other words, buying up bad debt] -- but it'll be the worst time for CompuCredit's stock price . Emil Lee: Why don't other credit card lenders do this? Tom Brown: There's reputational risk. With two-year delinquent borrowers, you ha ve to get aggressive. That person may never pay you. Lousy collection practices affect the performing business because of word of mouth and media headlines. Ano ther issue is that large card issuers can book gains [from selling charged-off d ebt] right up front. It's a way of shoring up weak earnings. Emil Lee: Why is CompuCredit able to exploit the subprime segment better than it s competition? It seems that CompuCredit's 22% net interest margin would attract competition, so is there a long-term competitive advantage? Tom Brown: Right now, that's one of the thing I like about CompuCredit. To issue Visa and MasterCard (NYSE: MA ) cards, you have to be a member of the network. CompuCredit works with three different banks that house new credit card receiva bles. The banks that are issuers of the cards, such as JPMorgan (NYSE: JPM ) an d Bank of America (NYSE: BAC ) , are heavily regulated, and the regulators don' t like the subprime business -- that walls off competition. It's very difficult [for competitors] to serve CompuCredit's customers. Emil Lee: CompuCredit says its loans must make sense for the borrower. Is this w arranted, given the seemingly heavy fee structure and 22% net interest margins? Do you see CompuCredit's customers climbing the FICO ladder -- and does CompuCre dit retain the customers that are able to improve their credit scores? Tom Brown: CompuCredit is expending an increasing amount of its effort to retain those "moving up" customers. [CompuCredit] would really like to migrate custome rs from fee-based cards to balance-driven cards. It has specific rewards program s. For example, if a borrower makes timely payments, [CompuCredit] will increase the line of credit. The program works to increase timely payments. Emil Lee: CompuCredit has only a 10-year operating history. Is that enough credi t cycles to judge the company? Tom Brown: Senior management came from the collections business, so management h as a longer history of dealing with collections. When you're lending money to su bprime borrowers, underwriting is more important than the economy. Emil Lee: How do you judge whether a merger will create real synergies or not? Tom Brown: First, we have to understand the buyer. Does [the merger] make sense? What [is the buyer] trying to do, and does what the seller wants to do make sen se? I go in knowing historically that two-thirds to three-fourths [of acquisitio ns], from the acquirer's standpoint in banking in corporate America, destroy val ue. The burden of proof is on the acquirer. We know most [acquisitions] fail, so let's figure out why this is going to fail.

Emil Lee: How do you value the residual value a company retains in securitizatio ns? Tom Brown: We go through the assumptions -- there's enough information ust, such as prepayment [assumptions]. Sometimes, we need to know from t what their models are, the lumpiness with prepays -- [such as] right duation -- but there is data to track the actual performance of trusts e gain on sale calculation. in the tr managemen after gra versus th

Emil Lee: CompuCredit is expanding into other subprime segments, such as auto fi nancing and payday lending. How does this build the company's moat? Tom Brown: Well, that's what we'll see in 2007 -- which could cause CompuCredit to be a home run. It's testing in a Texas storefront location whether it can cro ss-sell these services. Emil Lee: It seems CompuCredit has recently had an uptick in charge-offs and del inquency. Is this a cause for concern? Do you think defaults will stay reasonabl e? Tom Brown: I think defaults will go up. The fastest-growing part of its portfoli o is the fee-based card, which has higher delinquencies but significantly higher revenue. The fee-based card is more profitable. Overall, it's a positive for pr ofitability. Emil Lee: In the end, it comes down to this: The stock market thinks CompuCredit is vulnerable to a credit crunch when an increasingly debt-laden borrower start s to default, spurred by things such as a possible housing downturn or a weakeni ng economy. What would your rebuttal be? Tom Brown: I would respond that underwriting is more important than the economy. CompuCredit is going to a higher level of earnings growth and profitability thr oughout the economic cycle. In conclusion Speaking with Tom was a tremendous and humbling learning opportunity. It was int eresting to hear how he has developed his contrarian view, how he looks at the u nlocked earnings potential in CompuCredit, and how he has thought through the di fferent angles of his investments. For readers who want to know more, check out bankstocks.com! Read No. 4 Richard is without question the best source of investment ideas for small UK bas ed companies on the internet. And best of all His ideas, portfolio and analysis is all completely free. This article is an exclusive interview with Richard Beddard where he explains hi s investment approach, his biggest investment mistake and life as an investment blogger. I trust you will gain as much from the interview as I have. You can find Richards blog here: http://blog.iii.co.uk/ His column in the Money Observer magazine can be found here: http://www.moneyob

server.com/category/author/richard-beddard How did you get started in investing? Richard Beddard: One of us had to work out what to do with our savings, and my w ife wasn t showing much interest so back in the mid nineties I subscribed to Succes sful Personal Investing , a correspondence course. It was on paper, and I believe it still is. Soon after, I set up an investment club at work with friends, and although we st opped investing together in the dot.com meltdown some of us still meet once a mo nth. We even talk about investing occasionally!

Can you talk about your investment approach and how it has developed over time? Richard Beddard: It s always been based on company fundamentals and financials as I don t really see how you can be an investor if you re not trying to understand bus inesses; how they make money, and what makes them go bust. I briefly dabbled in charting in the early days, but couldn t make any sense of it . I describe my method as screening plus .

I screen the UK market for companies that look cheap and financially strong and then investigate them further, mostly by reading their annual reports going back ten years. Different numbers tell different stories. The combination of a low valuation and high financial strength (improving profit ability and leverage ratios, for example) are signs a company is recovering. Sometimes I m looking for recovery, and sometimes consistent profitability and fin ancial strength, which I might be willing to pay more for. Looking back ten year s, I m trying to establish whether the story the numbers are telling me is true an d enduring, or just an artefact of creative accounting or the result of a partic ular, temporary, set of circumstances. I describe my approach in more detail here: rifty-30/ http://blog.iii.co.uk/about-the-th

How did you weather 2008 and the first part of 2009? Richard Beddard: Personally, about as badly as the market. It was a big shock to me. SCS Upholstery, a company I owned, went bust very quic kly, which demonstrated (painfully) that a company with no bank debt can go unde r. I didn t start the Thrifty 30, my public portfolio, until September 2009 but one o f the reasons it s so diversified (up to 30 companies) is that I lost a bit of con fidence in my stock picking abilities during the credit crunch (another reason i s that people would get pretty bored if I wrote about the same five stocks all t

he time).

How do you typically find ideas and what is your selection process before an ide a gets added to your portfolio? Richard Beddard: I screen the market using a database called Sharelockholmes. I update the screens monthly here: / http://blog.iii.co.uk/thrifty-30-candidates

How many positions do you typically have in your portfolio? Richard Beddard: A maximum of 30. I try to keep at least 10% of the portfolio in cash, so that if the market crash es I have the firepower to buy really excellent companies when they are cheap. The amount of cash may go over 10%, if I can t find enough good companies at cheap prices, and it may go to zero in a crash.

Describe some of your most notable investment mistakes and what did you learn fr om them? Richard Beddard: Well, SCS is the biggest. The shares had already fallen 99% when I bought a significant stake (in terms of the overall size of my portfolio). I remember somebody saying they couldn t belie ve I was buying the shares as trading at SCS had declined so rapidly. I even went to an SCS store, sat on the sofas, and experienced the desperation o f the salesman trying to flog me one before the end of the month. It was obvious the company was in trouble, but I felt reassured by its lack of d ebt. I didn t understand the doomsday mechanism that would undo the company. We all do now, because other high profile retailers like Woolworths died the same way. Although SCS had no bank debt it still had to pay rent. When people stopped buyi ng sofas, credit insurers stopped insuring its suppliers invoices. The suppliers, themselves probably not in too healthy financial condition, deman ded quicker payment and SCS couldn t pay suppliers and the rent. Recently, I got a couple of quid back from the administrator. Call it a salutary lesson. The lesson I learned is that all liabilities are important, not just interest be aring debt. Some liabilities, like non-cancellable operating leases, aren t even o n the balance sheet. Most retailers have these.

If you re a rubbernecker, you ll enjoy this post: -crunched/

http://blog.iii.co.uk/scs-and-me

So far there has not been a failure in the Thrifty 30. Armour, which makes car s tereos, home entertainment systems, and all manner of audio visual equipment for homes and vehicles has fallen about 50% since I added it to the portfolio, but my response has been to buy more shares, so we shall have to see how that goes. Armour: http://blog.iii.co.uk/armour-averaging-up/

What are your ideas concerning portfolio composition and the value of individual holdings in relation to the portfolio? Richard Beddard: I think there s a very simple rule. The more confident you are in your analysis, the fewer holdings you need, and the less diversified they need to be.

Do you follow any key risk-management guidelines in managing your portfolio? Richard Beddard: Yes. I m constantly seeking to make sure that individually, and a s a group, the companies are as undervalued by the market as possible, and their finances and businesses are as strong as possible. I m trying to guard against paying too much for shares, and suspect companies. Tha t s it.

What is the current geographic mix of your portfolio? Richard Beddard: Entirely UK, although even though they are smaller companies, s ome derive only a small proportion of their profit from the UK.

How do you manage currency exposures? Richard Beddard: No need.

How did you get involved in writing an investment blog? Richard Beddard: In 1999 I joined Interactive Investor, already one of the UK s bi ggest investment communities, as community editor. Previously I had managed a team of designers and editors for an internet publish er and part of the job was to design and implement online communities. That and my interest in investing probably got me the job. Then I became companies and markets editor. Mostly I commissioned and edited oth er financial writers and I started blogging as a channel for my own research int o companies and markets. As it s grown in popularity it s taken over more and more of my time. I write two columns for Money Observer magazine as well, one of which talks abou t companies in the Thrifty 30 portfolio.

What has been your most notable success while blogging and why? Richard Beddard: That I m still doing it nearly a year and a half into a five year project! The aim is to beat the market handsomely over five years using value investing t echniques, and it s gruelling. I m looking at companies that are dull, out of fashion, and often doing badly. Not only do I have to muster the enthusiasm to decide whether or not the compani es make good investments, but I have to write about them in a way that won t total ly depress my readers. In its first calendar year the Thrifty 30 rose 27%, against 9% for the market, w hich is an achievement, I think, because for much of the year I was adding compa nies to the portfolio, so the level of cash was higher than it will normally be. Anything can happen in a year, of course. The real test is over five years and l onger. You only really know if you ve succeed at investing when, on the day you ca sh everything in, you ve made a good return. Bearing that in mind, here s a review of the year: -30-review-a-good-year/ http://blog.iii.co.uk/thrifty

Back in the mists of time I remember writing a blog post that actually brought t he server down. I think it was The Great Crash of 2009 , written in May 2007. I got my timing wrong, but I it was a success of sorts. Here it is: g.iii.co.uk/the-great-crash-of-2009/ http://blo

What has been your most read blog posts and why? Richard Beddard: I don t know, maybe The Great Crash post I just mentioned. I concentrate on the posts, and not the stats. I mean that. I don t even know wher e the stats are, although people tell me how many unique users the blog has and I m aiming to grow that number as a measure of long-term success. I think the blog will be a success if the Thrifty 30 achieves its ambition to be at the market handsomely over five years. At worst, worrying about the popularity of individual blog posts would distract me into putting my effort into the sensational, and not the successful.

What company do you find interesting at the moment and why? Richard Beddard: I m reading a book called tury", which I highly recommend. Hidden Champions of the Twenty First Cen

These champions are the middle-sized specialist companies driving globalisation. Most of them are German; the only British one mentioned in the book so far is De

La Rue, the banknote printer that lost its lustre recently. But I think lift component manufacturer Dewhurst is a hidden champion and perhap s FW Thorpe, which manufactures lighting, too. You can read about them on the blog: Dewhurst: http://blog.iii.co.uk/dewhurst-a-hidden-champion/ FW Thorpe: http://blog.iii.co.uk/the-future-is-bright-at-fw-thorpe/ Read No. 5 Inquiring minds are reading a Guru Focus Interview with Investor Arnold Van Den Berg, a value investor. Guru Focus: You seem to believe that there will be high inflation risk in th e coming years. What is the best strategy in this inflationary environment? Van Den Berg: It is important to define what we mean by inflation. Inflation rates in the low single digits (1% to 3.5%) generally meet the definition of lo w and stable inflation. Inflation rates greater than 4% or lower than 0% have a high risk of destabilizing the economy. The primary risk of inflation stems from the potential for monetary policy errors. Monetary policy makers do well when t he underlying environment is relatively stable. But when conditions change sudde nly, there is a possibility for error. Thus, monetary policy errors can be eithe r deflationary or inflationary. The risk is especially high in unstable monetary environments, like we are experiencing today. Both inflation and deflation compress valuations. In the 1970s, stocks sank to single digit P/E ratios. We all know what happened to markets in the early 19 30s. Generally, economic instability is bad for valuations. We believe that we could go through a period of above-average inflation (on the order of 5%), but nothing like we saw in the 1970s. This period will be very poor for stocks. Since it is difficult to predict the timing of such episodes, we adjust for inflation (and deflation as well) by adjusting our valuations for lower price multiples. When we find bargains, we will buy them; when we cannot f ind bargains, we will hold cash. We expect that conditions in the economy and in the market will run counter to our investment philosophy for short periods of t ime, but we know that over the long run value investing outperforms. Guru Focus: There was a piece in OID approximately eight years ago where you discussed the post-bubble periods. It was transformative for me but I wonder wh ere you think we are at present. It seems the risks are greater than ever as our government tries to solve an over-consumption problem by issuing massive amount s of debt. Van Den Berg: A major characteristic of bear markets is that things that wou ld normally cause the market to explode like low interest rates have either mini mal or temporary effects. In bear markets, earnings could continue to grow, but multiples become compressed. This causes stock valuations to trade up one to two years, but then revert back to low levels and start the cycle over. Over the du ration of the bear market, the prices of stocks may not significantly appreciate . Stocks that may look cheap on a multiple basis may often get even cheaper. Thi s is exactly what we have been seeing since 2000. At the end of the bear market, multiples have compressed to very low levels. This sets the stage for the next bull market. How much longer will we be in this bear market? Bear markets typically last about sixteen years, so I would say that we have about five more years to go. Th is coincides with our earlier comments on how long we think it will take for the

real estate, unemployment, and fiscal problems to be reconciled. The way to inv est in this kind of environment is to stay focused on the valuations of individu al companies. You can still make money in this environment by buying stocks when they are cheap and selling when they are near fair value (remember that multipl es are compressing, so stocks won t go as high as one would expect in a normal env ironment). When bargains can t be found, hold cash. The Guru Focus interview is well worth a read in entirety. Are Stocks Cheap? Stocks look cheap now but they aren't because of three factors. 1. PE Compression 2. Earnings are mean-reverting 3. Record government stimulus globally Van Den Berg discussed point number one in detail. I covered points one and two in Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think. For a follow-up on those points, please see Anatomy of Bubbles; Negative Returns for a Decade Revisited; Is Gold in a Bubble? Earnings High From Record Global Stimulus Point number three should be obvious, but obviously it's not given pervasive bul lish sentiment nearly everywhere, including smack in the middle of article with bearish sounding titles. For example, please consider a few excerpts from Dow Ha s Its Longest Weekly Slump Since 2004 * Michael Shaoul, whose Marketfield Fund Ltd. beat 81 percent of competitors last year, said that while the payrolls report was disappointing, it may also b e a signal the slowdown in the economic data is near its peak. He noted that wea ker nonfarm payrolls reports in February and July 2004 failed to derail the last bull market, which peaked in October 2007. * The biggest decline in the S&P 500 since August is creating a buying oppor tunity for investors, according to Blackstone Group LP s Byron Wien. The price-toearnings ratio for the S&P 500 has fallen close to its lowest level in 2011, acc ording to Bloomberg data. The index currently trades at 14.8 times earnings, nea r this year s low of 14.7 when it fell in March after Japan s earthquake. * The economy is not as bad as it looks right now. Corporate profits will be good, very good. People are asking me, Do you still think the market can get to 1 ,500 by the end of the year? I do. In contrast, I think it is crystal clear much of the recovery is a mirage based on unsustainable government stimulus, that stimulus is fading, there is little c hance right now for more stimulus, and that corporate profits have peaked this c ycle in conjunction with a slowing global economy. I discussed the slowing global economy in a video: Mish on Yahoo Finance Daily T icker on Slowing Global Economy; U.S. Manufacturing ISM Plunge; Order Backlog an d New Orders Barely Above Contraction High Inflation Coming? Van Den Berg clearly has a different definition of inflation and deflation than

I do. I prefer to view inflation and deflation in terms of money supply and cred it. He looks at prices. He is calling for "high inflation" but high means 5%. Can we see a 5% CPI with falling demand for credit? Sure, why not? And if it pla ys out that way, there will be no hiding places at all. Treasuries and stocks bo th would be hammered. It is one of the reasons I do not like treasuries now. It is also a good reason why corporate bond rates at 2.33% for 10 years constitu te a bubble. , Bear in mind that a renewed credit crunch might send treasury yie lds lower but it will not be good for corporate bonds, especially junk bonds. Dissimilar Starting Points, Many Similar Conclusions Van Den Berg does not like gold. I do. I gave my reasons in a Yahoo Finance vide o last week. Please see Why I Continue to Like Gold for a discussion. There are other differences as well. However, we have both arrived at the similar conclusions regarding equity valuat ions in general even though we have very different starting points about what in flation is. Conclusions * The bear market is not over * Valuations are not cheap * When there is little value, then there is nothing wrong with cash Read No. 6 Interview With Value Investor Mark Feinberg Of Feinberg Capital Partners By Jacob Wolinsky on April 13, 2010 I am pleased to interview Mark Feinberg, General Partner of Feinberg Capital Par tners LP (www.feinbergcapital.com) a value oriented investment partnership. From 2006-2009 Feinberg served as portfolio manager for Feinberg Investment Group a group of separately managed accounts that using a true valuation orientation bea t the S&P during that time period by an estimated ~5% per year and in the twelve (12) months prior to shifting to a fund structure generated over 100% return an d beat the S&P by over 70%. Mark also held senior level strategy and consulting roles with Ernst & Young and the IBM Corporation and also started multiple comme rcial real estate firms (one of which was sold in 2009) and a software company i n the early part of the decade. I wrote in a previous article how hard it is to find a good fund. Most good fund s attract too many assets and are therefore are limited to only the largest cap stocks. Dodge and Cox is a good example of this they have spectacular managers b ut now manager over $40 billion. If they find a net net that has a market cap of $10 million they cannot waste their time investing in it as any investment woul d not move the proverbial return needle (as Buffett would say) plus they are lik ely to end up taking a controlling stake which doesn t necessarily have its advant ages. On the other hand there are certain smaller funds and/or newer funds with no track record. In your case its almost the best of both worlds as you have a t rack record and since you are transitioning your structure and starting a new fu nd your deployable assets are still manageable and you are not handcuffed to the larger dollar amount. How big of an advantage do you have over even the best va lue investors due to this? It s been studied and shown that investing in smaller cap companies over time lead s to greater returns Feinberg Capital s flexibility to invest in smaller cap compa nies is a huge advantage over many other funds. I try not to beat the Warren Buf fett drum over and over again but he often says things that crystallize a specif ic point. He said it best in his recent annual report. His having to invest larg

e dollars has and will continue to crimp returns. Feinberg Capital does not have this issue and at least for the very foreseeable future I don t expect to have th is issue as my plan isn t to grow so big where this becomes an issue. If this does happen I will be thinking long and hard as to how to handle this, but I stress this shouldn t be an issue any time soon. Take a company like Acme United Corporation (ACU) which is based in Massachusett s and has been in business since 1865 in one form or another. Its core products include school scissors, pencil sharpeners, compasses, protractors and other in classroom items as well as other cutting type tools. The company as far back as history will take you has had positive owners earning, free cash flow and has co nsistently grown revenues. The company also has very little debt and a generally pristine balance sheet. Their total market cap is just under $35M. The company sells for just around $10.50 yet based on a very conservative owners earnings ca sh flow analysis I feel the company is worth somewhere between $16-$19 per share . There is also about $2 per share in cash on the balance sheet and the company is paying about a 2% dividend which is rare for such a small company. Here is the issue for larger funds and money managers to come close to making an impact to their portfolio they would have to take a controlling stake in the co mpany and would come close to having to buy the entire company to truly move the return needle. Neither are attractive cases to a majority of the value funds ou t there. Feinberg Capital does not have this issue so this is a tremendous advan tage over the larger funds and money managers. Do you focus strictly on micro and nano caps? No I don t. Whereas there is nothing keeping me from fishing in the smallest of po nds there is also nothing that keeps me from fishing in the big ocean either. At the end of the day it comes down to being able to understand the company, being able to buy at a discount to what its worth and the intangibles. By intangibles I mean I need to trust the management and I need to feel comfortable they are d oing the right thing for shareholders. They need to have proven this over a long period of time. So if all these things add up and it happens to be a larger com pany then I would consider an investment in the company. I ve borrowed a bit from Buffett (post meeting Munger) in the fact if I see someth ing that is a good company at a fair price and not necessarily deeply discounted price then I will think long and hard about making an investment. Are you limited by fund rules by how much you can invest in micro-nano caps? No not at all. Our partners view this as a large advantage that Fienberg Capital has over larger funds. Many of the larger funds are handcuffed by fund limit ru les. Those who have invested with me in the past recognize that there are opport unities in many of the smaller cap names and so when I set up the fund I ensured maximum flexibility. Those that invest in Feinberg Capital understand that whil e there are at times additional risks with smaller cap names if you stick with c ompanies that are not speculative in nature and companies that have a proven lon g term business model and/or assets that justify a higher price than it s intrinsi c value, than having the added flexibility to buy these stocks are a huge advant age. I think it would be doing my partners an injustice if I limited what the fu nd can look at for no other reason than to fit a specific fund arrangement . The other key advantage along these lines is many of the small cap funds are lim ited to investing in only small cap funds. Feinberg Capital does not have this l imitation nor does the fund have to sell a quality small cap firm when it no lon ger classifies as a small cap or in another words once it has grown up to a poin t of not being a small cap any longer. Having this flexibility even though I may not encounter the situation that often, allows to the fund to hold something I

don t want to sell ifthe situation were to arise. Flexibility is the theme and a h uge advantage. You don t have any concentration limits either, isn t that correct? That is true. The fund typically holds on average 15-20 holdings at any given ti me. However, there is nothing in the fund rules that would keep the fund from ho lding less. There are certain situations where this could happen such as if I di dn t see enough investments meriting investment. Peter Lynch who used to have 1000 s of holdings recently came out in an interview in support of concentrated portf olios. I feel the same way as long as the homework is done on the few bets made. Are you at liberty to discuss your current holdings? I am a bit of a traditionalist when it comes to discussing holdings and except f or at times in quarterly and annual letters I tend not to get into specifics. Th is isn t an issue of me wanting to hide anything I just find it causes a lot of no ise and on some levels is a form of manipulation. Perhaps I m giving myself too mu ch credit by thinking anyone is paying attention but call me old fashioned. With that said I can say that at this time I am in a a lot of cash at the moment. So you think the market is fairly valued then? I am a stock picker so I try not to get to macro but at this point I am not seei ng a whole lot of the type of value that I tend to look for before I make a purc hase. We talked a bit about the huge advantages your fund has, I would like to discuss another point regarding your advantage as a fund manager. You have a great back ground in that in addition to managing money you ve started and run multiple compa nies, and you ve worked and consulted for many of the world s largest and most respe cted organizations (ie. IBM, Ernst & Young, Marriott, Spring and the list goes o n). It seems to me that your background could prove very advantageous as a fund manager. Would you agree? I would agree. It s not something I think about everyday as a lot of what I learne d is second nature at this point. Starting with having worked for many of the la rgest and most respected companies part of the question. As a former consultant my job was basically to parachute into a company and either figure out what was wrong and/or figure out how to do something better. The first part of this was t o figure out what they were doing the day I got there and identify areas of impr ovement and then rank the impact if they didn t improve. I think too many money managers focus so much on what the financials say that so metimes they lose sight of the fact there is a living, breathing company behind those financials. It s inherent in me to find out what part of the living, breathi ng company is about to stop breathing or in some cases already stopped. The fact that for me its 2nd nature to view a company like this gives me a huge advantag e over other managers plus I think having been inside a company I have a better feel for what really is going on vs. what one may think is going on from talking to people at the company or what a document happens to say. There are so many d ynamics many of which are intangible in nature that at unless you ve been on the i nside its hard to understand and make sense of all of the dynamics yet those dyn amics (good or bad) are often what determines whether a company is a good (or no t so good) investment. Shifting to the entrepreneurial part of the question. There are so many skills I v e learned as an entrepreneur but for the sake of the question I will focus on wh at I think is one of the bigger ones. Being an entrepreneur like with investing, capital allocation is paramount. As an entrepreneur financial resources are oft

en limited so how you spend and manage those resources is absolutely critical. Y ou learn when to spend and when not to spend and you are always looking for the biggest bang for your buck. You have to choose what to spend your money on as yo u don t have enough to spend on everything. Not that this wasn t the case at the lar ger companies but as an entrepreneur its life or death. So as a result of these experiences I tend to look at investing the same way and before I would even con sider making the investment I want to ensure I am getting a good deal but also t hat it is the wisest use of funds that will bring the biggest bang for the buck. I view every investment of a dollar as if its my last dollar and as an entrepre neur that s very often the case. It s a return on your investment equation but havin g had to do it under survival or no survival conditions it makes the process all the more focused. There are so many other skills developed from being an entrep reneur but I feel this is probably the most relevant for the discussion we are h aving today. There are different types of value investing so I am always curious to ask a val ue investor which Value Investor has had the greatest influence on your investme nt Style? Well I ll start with Benjamin Graham, Warren Buffett and Charlie Munger. Warren wa s influenced by Benjamin Graham, and then Charlie Munger and as a result his sty le changed over time. I also respect Walter Schloss a lot as any man who works f rom another company s conference room his whole life is someone I can respect. I a m a pretty frugal guy so I like that about Walter Schloss. I ve taken bits and pie ces from them and others as well. I don t like to think of myself as one vs. anoth er. Value investors and investors in general all have their own little quirks an d what I tend to do is if there is something that one does that works for me the n I adopt it or morph it into my own version. I ll continue to do that as well and don t expect that ten years from now my style today will be the same as it was. Where do you find your investment ideas and what is your investment process? I will answer the investment idea question first. It s multifaceted for me. I m fore ver looking for ideas in the house, when I go out to eat, when I drive down the street. Life is a breeding ground for investment ideas. For example I have a 15 month old son and inevitably products started making their way into my household . My thought is that if they made it into my household without me knowing about it first then that s a good sign that it s a product worth looking into, this is sim ilar to what Peter Lynch used to do. The first thing I would do is look at the l abel regardless of what the product was. I found a small cap company that provid es diaper linings to a large number of the larger diaper makers this way. That c ompany delivered close to 170% return for me yet wasn t followed by any analysts. In addition to what I call life research I read about 4-5 newspapers and/or magazi nes a day whether online or in print, peruse the 52 week low lists every day, ha ve screens set up looking for companies with solid balance sheets, large amounts of free cash flow and solid operating metrics and I listen and pay attention to what is going on around me. I try not to get too caught up in what everyone else is investing in although un like a lot of other fund managers who say they don t pay attention to what others are buying I do pay attention not as necessarily to follow their moves but as an other idea source. My view is not to rule out any stock, anyone s suggestion, and/ or any place for ideas. As long as you do additional due diligence and make your own decisions then the more ideas the better. With that said I can make a first pass decision on a company within a minute or two. I do think its important to be able to at least on first pass make a quick decision. To address the process question in particular. At any given time I typically tra ck about 250 companies that fit the criteria in which I look for when investing

in a company. These are all companies that generally have solid balance sheet, l arge amounts of free cash flow, and are in industries I understand, have solid m anagement teams, solid operating history and/or have other distinguishing value characteristics. From there it becomes a wait for the right time to strike exerc ise. I have a simple model that tracks these companies in three columns; in one colum n is what I think the company is worth, in another column is what I would pay fa ctoring in a significant margin of safety, and then in another column the actual trading price. When a company turns green then it s time to get even more serious about additional due diligence and I try to break our thesis about the company. What I mean by that is I start to really get serious about worst case. If the c ompany still looks cheap after this process, then and only then would I make an investment. If this sounds familiar its probably because Bruce Berkowitz comes a t this the same way. I think most value investors do, Bruce just has done a grea t job of talking about it. Along these lines how do you determine intrinsic value? At my core I am a DCF (Discounted Cash Flow) believer and more specifically owne rs earnings free cash flow. I also pay attention to a company s liquidation value and where as I don t put a lot of weight on earnings driven valuations due to the ability for earnings to be manipulated I do at least pay some attention to them. What I ve found is when a company is underpriced on a cash flow basis if the earn ings valuation is not also undervalued then there is less of a chance or it take s a lot longer for that company to reach its intrinsic cash flow basis valuation . That doesn t mean I don t invest its just something else I pay attention to. There are some value investors who meet with management and others who don t where do you fall in this? I don t go out of our way to meet with management. I do listen to what they have t o say in conference calls, quarterlies, annual reports, releases but I don t marry myself to their words. They are often there as salespeople for their company so one needs to be careful what you attach yourself to. With that said there is a lot you can pick up as far as tonality and for me I want to hear the truth and I want to hear the tone of complete frankness in their voice. Sugar coating is no t what I am looking for and I ll tend to stay away from the sugar coaters. Back to the fund structure, why did you decide to shift to a fund structure now vs. any other point? Well to be honest it was a twofold decision. The first reason is the structure t hat was in place as Feinberg Investment Group, while an easy structure to manage when limited to a handful of investors, when the demand started to outgrow the infrastructure that was in place it was time to change. I m better able to serve m y previous investor/partners but now I can also expand as well. The second part of the decision stems from seeing a void in the marketplace for a value oriented manager that has yet to be swayed by the need to be close to 10 0% invested most of the time. It seems the larger a fund grows the more pressure they have to deploy funds. I feel strongly that having a lot of cash on hand at the right times is the smartest move you can make. I know Seth Klarman feels th e same way but the more investors one has breathing on them I think this becomes harder and harder to stick to. Well that answers part of what my next question was going to be. What is your di fferentiation and competitive advantages over other funds that are out there? So the cash strategy and limiting to only those investments considered your best a re a couple, is there anything else you want to add?

Well being able to remain in cash is certainly a big one as is limiting investme nts to only the best ideas. If a partner isn t ok with this then Feinberg Capital is probably not the fund for them. This concentration and this focus has proven itself throughout history as one of the most successful ways to invest and being able to stay true to that is very important. I also think there are other advantages as well. Like Buffett in Omaha, me worki ng in Dunwoody Georgia I feel is a large advantage. I am not coerced by the nois e of Wall Street and I am able to stay true to the value investing thesis while not being influenced by others. People also like our fee structure as compared to other funds. So that is actually a good lead in to my next question. Can you talk a bit more about the structure of your fund and the types of investors that you are looking for? Sure. As alluded to, the fee structure is unique as compared to other funds in g eneral but for the value community it s a very recognizable structure. Whereas mos t funds charge an asset management fee and a performance fee I only charge a per formance fee with no asset management fee. In addition, I have to exceed a certa in performance threshold each year. If I don t meet that number then I don t get pai d. Frankly, I could not have done it any other way without feeling as though I w as taking advantage of someone. I was a bit tired of watching people turn over t heir money to other people to manage only to lose a portion but still the manage r was still making off with a solid payday. That model just never really made se nse to me for any business. I think without getting too theoretical that model h as created many of the issues we are seeing out there today as the compensation models are severely flawed and they lead to conflicting and non-fiduciary type o f behavior. So with my fee structure there is certainly risk that I may be eating Ramaan noo dles for awhile but I d rather eat Ramaan noodles then dine at some fancy restaura nt while my partners aren t making a dime. As far as the type of investors I am looking for. Very similar to other value in vestors and much in line with Warren Buffett s comments and trying not to just bea t the Buffett drum, I do believe that investors are and should be considered lon g term partners. I really want people who understand that investing is a long te rm proposition and whereas one could get rich in the short term that is often an accident and not often based on hard work and fundamentals. People do get lucky but that is not what Feinberg Capital is all about and the types of people who become our partners should know this going into it. In addition I want to really like the people who become partners. I ve run enough businesses and worked with enough people at this point that one bad apple can ma ke for a terrible apple pie. I am not going to risk my apple pie. I want people who are excited to be part of the fund. If you wake up every morning and either consciously or sub- consciously are asking yourself who you can take advantage o f that day by playing the market then you certainly aren t the right fit. However, if you wake up every day about how to move the ball forward, take care of someo ne, and ask what am I going to learn today then those are the types of people I am looking to attract. Your Fund structure sounds very similar to Warren Buffett s early partnership; can you elaborate more on this? Well with regards to the fee Feinberg Capital is different than the larger publi cally traded funds but similar to a handful of other private value funds in that

Feinberg Capital modeled it as other value investors do after Warren Buffett s ea rly 1950s partnerships. As mentioned there is no assets under management fee and only a performance fee. Most funds charge 2% just to hold an investor s assets an d to underperform index funds. In addition many mutual funds are charging in the mid 2s and fees are going up not down. This has been the case with almost every fund family lately including Vanguard. In many cases the investors do not even know their fees are going up. I cannot get into the specific details due to certain SEC guidelines but the bas ic premise is if the fund generates returns above a certain threshold then the g eneral partner gets paid. If the fund does not generate returns above the thresh old then the general partner does not get paid. Frankly it s the only way to struc ture fees that make sense to me. I say this as if you don t structure it this way there is a reward mechanism in place for volume vs. quality and focus on perform ance. Those who charge a fee would argue they get paid more when they have more of someone s money to manage so they are motivated to keep values up. However, man y funds are just looking for assets and they get paid a set fee even if their pe rformance is awful. My goal isn t simply to build up my asset level as that does m e no good. My fund fees are structured to make sure I try to perform really, rea lly hard otherwise I will be eating Ramaan noodles for dinner every night. How long have you been working to put the fund together and what has been the ha rdest part in establishing your fund? To address the first part of the question I truly feel that everything I have do ne to date and in my career has culminated in this. So on some levels this fund has been in the works my entire life. I ve been lucky in that I ve had the opportuni ty to work for and with many of the world s best companies such as Ernst & Young, Sprint, Coca-Cola, ING Insurance, Marriott, IBM Corporation so Ive had the chanc e to see from the inside and work with many of the great companies both from an operational standpoint as well as management standpoint. I ve also seen what the n ot so great companies look like so I have perspective on that as well. I ve also r un my own businesses and managed money so the combination of running businesses, serving as a consultant to others and being in strategic roles and managing mon ey has led me to this point. To address the specific question and perhaps the question you were asking is, I ve been working on the nuts and bolts of the fund for about 18 months. The hardest part without a doubt is finding the right team to support you. Every one is different and brings a certain style to the equation. There are a lot of good folks who are very good at what they do whether it be accounting, legal, fu nd administration, brokerage, marketing and everything in between. For me I wanted to surround myself with people who were good at what they did bu t also in addition to being good I wanted to be around genuinely good people who understood at its core what it meant to be ethical. Plus I am not one for a lot of noise (as alluded to) so I preferred people who valued their morals over peo ple who favored getting more clients. My investment thesis isn t as complicated as many of the other ones out there, nor do I or would I want it to ever get complicated. So I wanted the people around me to understand this that simple is very often the best approach. The team I have in place right now is amazing. They are ssionate about what they do and at their core are great excited about what I m doing as I am. For me that s an don t think the model works long term. So while it took very pleased. good at what they do; pa people. Plus they are as imperative otherwise I just 18 months to get here I am

Do you have a rate of return that you expect the fund to achieve? The goal of the fund is to beat the S&P each year. With that said since the fund wont be measuring long-term success by a year by year metric its possible and e ven probable that the fund would pace the index only to have a breakout year eve ry couple of years. Such is the case of my most recent 4 year performance where I paced the market for 2, missed one but then beat the market by over 70 percent . Sometimes it just takes a little time to unlock value so whereas I would like to beat the index year over year, I am not concerned if it doesn t happen. How will you measure success? I will know the fund is a success if those who become partners in the fund end u p becoming partners for life. That would tell me that we did what we said we wer e going to do and did it consistently. Well, I want to thank you very much for your time. Your welcome. I enjoyed it. Mark Feinberg is General Partner of Feinberg Capital Partners LP (www.feinbergca pital.com) a value oriented investment partnership modeled after Warren Buffett s 1950s partnerships. Feinberg also serves as Managing Member of Feinberg Capital Advisors LLC a registered investment advisory firm in the State of Georgia and m anager of the fund. He can be reached at mfeinberg@feinbergcapital.com. Read No. 7 October 13, 2009 Dear readers, I m proud to present our latest interview with value investor and author, Sham Gad . Among the topics discussed are his latest book, the financial crisis, how to examine stocks, and how to invest like Warren Buffett. Enjoy! Interview Questions Background: Q. When did you first become interested in allocating capital? A. When I was about 12 or 13 I think. I remember reading Lowenstein s biography on Buffett around that time and I was hooked. The ideas laid forth by Ben Graham r eally resonated with me. Q. You leveraged your passion for investing and landed a gig with the Motley Foo l. Tell us about this experience? A. I love to write and I enjoyed writing for TMF very much. Anytime you have a c hance to express your idea via the written word, it a great opportunity. I am lu cky in that writing about investing comes very naturally to me. Q. What motivated you to start Gad Capital? A. I didn t want to do anything else but invest money, but do it in the most fair and sensible way possible. I thought the Buffett Partnership structure was such a way you are in it 100% with your partners plus you re immensely rewarded if you do well, but you do so knowing you have enriched your partners equally. Q. Where does your upcoming book The Business of Value Investing ure, why did you write it, and who is the intended audience? fit into the pict

A. The book is really an extension of my love of writing about what I believe ma tters most in investing. I was introduced to some wonderful people at publishing house John Wiley by my friend Vitaliy Katsenelson, who at the time had just pub lished his own book. The folks at Wiley had seen some of my previous writings an d said that if I were ever interested in writing a book to send them a proposal. I had no problem writing 800 word articles, but a book was another matter. So I put the idea in the too hard pile. Three weeks later it occurred to me that there were six fundamental elements in value investing that the most successful value investors know and practice, but very few others do. These elements are well kn own, but they are often not applied effectively. It took me less than two hours to put the idea down on paper. Wiley loved it and here we are today. The book s audience is everyone, novice and professional alike. To the sophisticat ed value investor it s simply another refresher, but the wonderful thing about inv esting is that it s a never ending process. The books simplicity is what I hope ma kes so useful to even the practiced investor. But if you re new to value investing or want to know what its adherents focus on, then I hope this book does a decen t job. Let s Talk About Your Recently Released Book: Q. When is the release date, can we preorder the book on Amazon? A. The book should be out by October 15. It will be available on Amazon, Borders , and Barnes and Noble websites: Bn.com http://search.barnesandnoble.com/The-Business-of-Value-Investing/Sham-Gad/e/9780 470444481/?itm=1 borders.com http://www.borders.com/online/store/TitleDetail?sku=0470444487 http://www.amazon.com/Business-Value-Investing-Essential-Companies/dp/0470444487 /ref=sr_1_1?ie=UTF8&s=books&qid=1252437382&sr=8-1 Q. What challenges did you face in writing a primer on value investing? A. Honestly, none. I never try to force myself and write because that will produ ce sub-par results. I will say that I tried to structure the book somewhat diffe rently, so it s not just another boring read on concepts already laid forth by Gra ham, Buffett, and Klarman. Q. You write about the simplicity of investing? Give us a brief preview on keepi ng things simple in a field with a tendency for noise and complexity. A. The ultimate key is focus on the part that really matters: you are buying a p iece of a business. Everyone nods their head when you say invest in the business, buy the stock but if everyone really understood this they wouldn t have panicked s o much last year. Granted, as passive investors, you don t exert control over the company s affairs but still, I m assuming you ve done your homework on management. Q. What s your favorite part of the book? A. On a personal level, the acknowledgements section: nothing you do in this wor ld comes without the help of wonderful people. To be able to publicly express my thanks to those individuals really means a lot to me. However, I like the chapt

er where I examine actual investments that I made. It s silly to tell someone how to do something if you can t provide examples. Q. Unlike most investment books (which tend to be theory based) you share severa l of your best ideas and use them as case studies. What motivated you to do this ? A. If you can t back you what you say with examples, then you are really short-cha nging your audience. Q. Given the constraints, what additional material would you include if you coul d write 100 more pages? A. Nothing I wrote all I had to say. Q. Are you considering writing another book? A. Not at this time. Investment Questions: Q. Tells us about your approach to fundamental analysis-what is your focus/edge? A. I live in Athens, that s an awesome a few other things, ong term performance Georgia. No one has heard of me or cares about what I m doing advantage. I like to call Athens the next Omaha J. I could tell but I d rather not at this time. I hope they show up in the l of the Gad Partners Funds.

Q. How do you search for investment ideas? Where do most of these ideas come fro m? A. My ideas come from all over. I ve gotten some great ideas by piggy backing guys like Klarman, Berkowitz, and Pabrai. Other than that I just do a lot of reading and digging around. I read the annual report of a company three years that beca me an investment a few months ago, so you just always have to keep looking. Q. What s your definition of risk? A. What it really is losing money permanently. financial statements, what do you look for?

Q. As you navigate a business

A. To their detriment, many people place far too much initial emphasis on the in come statement. I first like to scrutinize the balance sheet and go from there. The balance sheet provides the first moat and then the income statement provides the second and equally important moat. But the balance sheet is the foundation. Q. Tell us about your experience with leaps and pair(s) trades. A. A decent experience with LEAP s, but nothing I would call spectacular. A much m ore pleasant experience with pair trades. I believe we made over 100% arbitragin g the Mueller Water A/B shares. We are having a very pleasant experience thus fa r with liquidations and workouts, although most decent ideas have now passed. Q. You recently wrote an article on the importance of taking macroeconomic persp ectives into consideration. How do you incorporate the macro in your decision maki ng process? A. Macro matters in the sense that you need to be aware of the world around you. I read five papers a day: FT, WSJ, NY Times, my local paper, and the Shanghai D

aily. For example, when you invest in an oil company, the two most important thi ngs are the production level of the company (both adding reserves to the company and selling oil to others) and the price of oil. The price of oil is to a certa in extent influenced by macro economic perspectives. I won t anchor my entire inve stment thesis on them, but to completely ignore them is not a good idea either. Q. Are you willing to share any of your macroeconomic perspectives with us? A. It s going to be a long time before consumption in this country approaches what it did a few years ago. That alone will have a profound effect on the rate of u nemployment, which will affect housing, and on and on. Such a view factors in my investment approach going forward. Also we have lost so many jobs in this country over the last year I believe over 700k per month. Who knows how long it will take before 50% of those jobs come b ack it could be several years before we even scratch 6% unemployment. Such a scena rio does not bode well for many sectors of the economy. I think about this possi bility a lot when looking at investments and a result, I can eliminate a lot of ideas very quickly. Q. What has the financial crisis taught you? How have you evolved as an investor ? A. It has reaffirmed my belief that markets are indeed inefficient, or put anoth er way, you are insane if you think markets are completely efficient. Personal Questions: Q. Your book promises to make us better investors. What other resources (books, blogs, etc) would you recommend reading? A. Graham s books, of course; Buffett s partnership letters, Benjamin Graham on Inve sting (new book); Albert Bartlett s video Arithmetic, Population, and Energy is a m ust, Bad Money by Kevin Phillips, and of course Simoleon Sense. Really, just rea d books on investing and outside investing by folks you admire. Q. We understand that you have an MBA. Has your MBA helped you value investment opportunities? If so, how? A. The MBA did not affect how I approach value investing; the MBA itself was a v alue investment I have gotten an astronomical return on my money and time invested over the course of my life in the two years since I left: I met my future wife there, I met Buffett, I met Mason Hawkins, and the list goes on and on. And who knows going forward. Q. Buffett has bridge, Charlie Munger has fishing, and Dan Loeb is a surfer hobbies do you have outside of value investing? .what

A. Aside from the partnership and my wife Maggie, I m really into golf. There are no short cuts to golf you have to work at it to excel. And by work at it, it mea ns you have to have an extremely patient and disciplined approach sound familiar? I started playing four years ago. After the first year I was a 24 handicap; afte r the second year I was 16; after the third year I was a 12, today I play to abo ut an 8 handicap. Like investing the learning curve shoots up in the beginning, but the real effort is required to truly excel and separate from the pack. My go al is to become a scratch golfer and if and when that happens, I will really hav e my work cut out for me. Q. In your opinion what separates the best investors from the mediocre?

A. The best are those who continue to fine tune their craft just when everybody else thinks they have reached the pinnacle. Buffett folded his partnership in th e mid 1960 s after amassing a record that he could have used to raise tons of mone y to invest, but he walked away. Tiger Woods decided to go back and change his g olf swing after the 2000 season in which he won 3 of 4 major championships. In b oth instances, most people would characterize that as insane. And look what s happ ened to both of them. I believe it was just last week that Forbes magazine anoin ted Woods as the first billion dollar athlete. In Closing: Q. What tips do you have for young investors interested in starting funds/partne rships? A. Be sure it s something you really want to do and would do it without any compen sation. So many people are enamored with the idea of having my own value partners hip but don t realize the extra effort involved. Make sure you would be willing to make it a lifetime commitment because good decent people are entrusting you with their hard earned money. But in the spirit of selflessness, I included a very s hort end chapter about starting a fund simply because so many wonderful people w ere very helpful to me in telling me what I needed to do to get started. Q. You re in your 20 s, have started a fund, written a book, and contributed numerou s times to financial periodicals. How would you like to see your life develop? A. I hope I am fortunate to grow old with my wife Maggie. Also, I want to use my resources monetary or otherwise to help society in some way. As Buffett would s ay I won the ovarian lottery having had the chance to be in the United States an d given the chance to do what I do. The least I can do is somehow enable other t o have the same opportunity as I have. Q. What message/advice would you give to readers of SimoleonSense? A. Keep reading, it s a wonderful effort. Read No. 8 Interview with Jeffrey Towson October 11, 2011 Today we re joined by Jeffrey Towson, who was Head of Direct Investments Middle Ea st/North Africa and Asia Pacific for HRH Prince Alwaleed Bin Talal Bin Abdulaziz Alsaud grandson of King Abdulaziz Alsaud, founder and first ruler of Saudi Arab ia. Prince Waleed is arguably the world s no.2 investor and nicknamed by Time magazine as the Arabian Warren Buffett . Prince Waleed s distinctions include: the world s 4th richest person (2004, Forbes), the largest foreign investor in the USA, the larg est shareholder of the world s largest bank (Citigroup, 2007), and the world s secon d largest media owner after Rupert Murdoch. Jeffrey Towson an introduction Jeff, a specialist in global and cross-border value investing, has developed ove r $15bn of investments across multiple geographies (US, China, and the Middle Ea st) and industries (real estate, hotels, banks / financial services, insurance, healthcare, retail, technology, petrochemicals, energy / infrastructure, etc.). Between 2000 and 2009, Jeffrey Towson was one of five core investment staff at P rince Waleed s Riyadh headquarters. A few of Jeff s major projects include the devel a global value investor

opment of the world s tallest skyscraper (maybe one mile in height), the turnaroun d of Saks Fifth Avenue stores, the development of a potential new mortgage compa ny in partnership with GE Money, the development of a potential new energy / inf rastructure company with GE Energy Financial Services. Jeffrey is currently Managing Partner of the Towson Group, an investment firm ba sed in New York, Dubai and Shanghai. He is a Fellow at Cambridge Judge Business School, University of Cambridge, and co-head of the Chinese Strategy and Investm ent courses at Beijing University Guanghua (Beijing) and CEIBS / Jiatong University (Shanghai). Best selling author of value investing books Jeff is a best-selling author focused on global value investing strategies. His first book on investment strategy was published in late 2010, called What Would Ben Graham Do Now?: A New Value Investing Playbook for a Global Age which we wil l review in due course. Jeff has a second value picking strategies that tegies Where the Little Jeffrey Towson a global investing book coming out next year. It s on global stock anyone can do (the working title is 10 Global Value Stra Guy Wins.) value investor

Jeffrey, how did you get started in investing? What attracted you to value inves ting? About how old were you? I was in my late 20 s when I really started investing. My training was in mathemat ics / physics (Stanford Linear Accelerator Center, graduate program in Stockholm , biophysics at Stanford Medical School) and then I eventually moved into invest ing. Even today, investing is still mostly just a math problem for me. Value investin g s focus on rational modelling of phenomena in the physical world is really simil ar to most scientific approaches. So I don t really see it as different discipline just a lot more profitable. I really formally jumped in when I joined Prince Waleed at Kingdom Holding Compa ny in Riyadh. He was on the Forbes list as the world s 4th richest person at that time and I was struck by how easily he walked between investing in the West and in emerging markets. A three month project turned into 8-9 years and I found position of both being very comfortable in the emerging strong at uncertainty analysis (which is the key skill places like China). So as the emerging markets began to ast 5 years, I found myself in a good situation. Investment philosophy What would you describe as your investment philosophy? How has it developed over time? Are you a long term investor? When do you buy? When do you hold? When do you sell? I am typically bucketed as a global value investor which in the West means someone who can also go into the emerging economies. However, in China, it means someon e who can also do distressed Western acquisitions. In Dubai, it just means inves myself in the fortunate markets and being pretty for value strategies in really take off in the l

ting (because everything is global when there are few local opportunities). I spend most of my time on the ground in China and the Middle East now. And my f ocus is 50% public equities / 50% private transactions with a strong preference for going long. Like most, the preference is to buy and hold great companies and then capture th e rising economic value per share over time. Buffett has pretty much shown that to be the most profitable approach over a career. However, how do you apply this to developing economies which are by their very d efinition uncertain (i.e., developing). Governments are active players. Competit ion is dynamic. Markets are emerging. Rule of law is limited. Regulations are ne bulous. And so on. All of these factors increase uncertainties and this is a dir ect challenge to the preferred buy and hold approach. In response to these perceived (and some real) uncertainties, most value folk sw itch to buy and sell (abandoning Buffett s approach), wait for a ridiculously low pr ice (which is impractical), or just stay away (very common). Global value invest ing is often mistakenly thought of as US value investing with a bunch of additio nal problems on top. I think that s a mistake. Because if you can crack the above problem (how to buy a nd hold on uncertain terrains) then there is an incredible pay-off. The very uncertainties that are the problem also make things wildly mispriced. R ecall, Buffett s first China investment (Petro China) which made him 8x his return s in 3-4 years? When was the last time a classic value investor bought the largest company in a market and made an 8x return? These markets are wildly mispriced. And there are thousands of companies popping up in them. So for me the holy grail of global value investing is re-adapting Buffett s at companies and hold strategy to uncertain emerging markets. Introducing Value Point buy gre

Within this overriding goal, I am actually transitioning my strategy at the mome nt. For the past 8 years, it has been Value Point (my own term). That s a re-appli cation of Graham s thinking to various emerging economy situations. It also incorp orates a lot of lessons learned working for Waleed (who is incredibly successful at emerging market value investing). But Value Point mostly targets value-added private transactions as that is where most of the emerging market action has been for the last 10-15 years (stocks ar e still a new and shallow phenomena in most places). Can you explain? I wrote a whole book on Value Point called What Would Ben Graham Do Now?: A New Value Investing Playbook for a Global Age which basically lays out a solution to the Buffett problem mentioned above. You structure surgical private transactions that solve your 5 main problems in e merging markets: * * * * limited access increased uncertainty in the current intrinsic value increased uncertainty in the long-term intrinsic value a weak or impractical claim on the asset

* various foreigner disadvantages The approach eliminates the uncertainties and lets you confidently buy and hold great companies almost anywhere in the world. In practice, this approach includes everything from designing the world s tallest skyscraper (an old project recently covered by the Wall Street Journal), to fixi ng distressed hospitals, to creating mortgage joint ventures between emerging ma rket and Western companies, and so on. It s ridiculously profitable. Since exiting Prince Waleed s company, I have shifted my approach to a mix of publ ic stocks and opportunistic private deals. That was a reflection of being on a s maller platform and the fact that there is now enough depth in the China market (and a few others) for straight stock picking. So we are now doing 50% buy and h old great stocks and 50% Value Point. In terms of stock picking, we focus on all the situations that make big Western investors nervous. We are based in Shanghai, not the US. We do on the ground res earch (anything that won t show up on a computer screen in New York). We like small er and medium companies in changing environments. We don t read anything that is p ublished in English. I generally think of it as how to beat Buffett and Russo in the emerging markets . It s a classic deep value approach. I have a second global value investing book co ming out on this next year. It s on global stock picking strategies that anyone ca n do (the working title is 10 Global Value Strategies Where the Little Guy Wins. ) Track record What is your track record? Ask me in a year. I can t really discuss past Kingdom Holding deals. What type of investment research do you undertake? How do you typically find ideas and what is your selection process before an ide a gets added to your portfolio? What types of questions are on your investing ch eck list? I think most of the big value opportunities in the emerging markets are still in value-added private transactions. It s the most logical and broad approach for de veloping economies. But I will answer for public stocks as it is probably more r elevant to your readers. There are the common global value stock approaches. Such as buying multi-nationals with emerging market exposure (say Tom Russo buying Diageo) and hunting for the big emerging market giants (Buffett buying Petro China or BYD). Both are good approaches and have a long successful track record but they are al so very limited. There are thousands of companies in China, India and Brazil. Li miting oneself to just a handful of multinationals is at best a short-term solut ion. You wouldn t go after American opportunities by looking only at French compan ies with a presence there. I see these as a way of avoiding most of the uncertai nty problems mentioned. For the first one (buying great multinationals with value in the emerging market s), we look for something being misunderstood in the inbound development process .

Why is Chivas doing well in China but Google never had a chance? Why are the exp enditures on marketing and distribution going to pay off in few years in one cas e but not the other? Recall, Danone went home from China after almost 10 years w ith nothing. Understanding that inbound developing process is an area where deep research can pay off. And if you can capture one of these great multinationals at the right price its pretty great asset for the portfolio. I think the much more interesting approach is when you start looking at medium a nd small emerging market companies. How do you buy a developing company (whose fundamentals are changing) in a devel oping economy (whose fundamentals are changing)? I think that is the heart of em erging market value investing. It s about understanding real changes in companies before others. This is somewhat similar to strategies in Joel Greenblatt s You Can be a Stock Mar ket Genius: Uncover the Secret Hiding Places of Stock Market Profits. We are looking at new economic events in a company we already understand. Not ju st a mispricing on its own. And in the emerging markets such new events are the norm, not the exception. This sort of emerging markets version of special situat ions investing is the deep well of opportunities. Do you invest wherever you see value? Do you use any specific metrics like ROE, P/B, ROC, other when evaluating equiti es? Which don t you use? Western investors typically like long historical earnings or cash flow that they can track (for reversion to the mean or current value strategies). And they typ ically use qualitative factors (competitive advantages, industry structures, dem ographic trends, etc.) for projecting forward beyond 2-3 years. We can t really do either in emerging markets. We usually have a short, and rapidl y changing, history. For example, BYD had all of 13 years of history when Buffet t bought in. During which time it went from 0 to 200,000 employees. So not a lot of reliable historical earnings there. And the future can be pretty unpredictable as well. Again, it s about uncertainty analysis. However, we do have strengths that developed economy investors do not have. Petr o China s government granted monopoly / duopoly is about as sustainable a competit ive advantage as you will find anywhere. Large consumer populations (i.e., 2 bil lion Chinese and Indians) tend to give you tremendous downside protection going forward. We are also big into balance sheet analysis with less focus on detailed earnings projections than in the West. Most emerging markets are not service economies t oday. They are more similar to the US in Ben Graham s time: lots of utilities, infrastru cture, real estate, etc. Lots of assets on the balance sheets. That is usually a good starting point for opportunities. It also gives us our most stable (least uncertain) point for understanding a company s current value. Typically, we want to see a mispricing of the current balance sheet that elimina tes the downside. And then we want a qualitatively attractive picture for the up side earnings.

Any sector preferences, currently? Do you invest in any particular sector? In theory, yes. We can invest in any geography and in any industry. But in pract ice we have fairly limited bandwidth. So we focus on companies with Chinese oper ations and a significant global component. Taiwan companies with manufacturing i n China and customers globally. Multinationals with significant presence in emer ging markets. These cross-border situations tend to be misunderstood both by the local investo rs (they don t get why BYD has 50% of the global cell phone battery market) and by foreign investors (such as reverse US listed Chinese small caps). Portfolio management How many positions do you typically have in your portfolio? 20 positions is the target (5% each) but we re not there yet. Who are your top investment heroes? Which value investors do you admire most and why? Which book(s) would you recomm end an aspiring value investor should read, and why? I tend to read a lot of Richard Feynman such as his Lectures on Physics. It s both simple and amazingly advanced modeling at the same time. I think he set the bar in terms of accurately modeling unclear aspects of the physical world. If you can master this book, you can model any investment, anywhere, anytime probably better than 99% of the investors out there. For me, this is the high water mark of mathematical modeling of the real world. A more popular read is . . . Joel Greenblatt s You Can be a Stock Market Genius: Uncover the Secret Hiding Plac es of Stock Market Profits is the closest thing I ve read to emerging market inves ting. The focus on good or great companies in special situations (not just mispr icings) is most of the emerging markets game going forward. I like the focus on special situations as opposed to company valuation. Micro-fu ndamental analysis is too often interpreted as company fundamental analysis. I s till think that the micro-fundamentals of special situations and complex combina tions of simple assets is the heart of value investing. For China focused investors . . Jonathan Woetzel s Capitalist China: Strategies for a Revolutionized Economy is a really good bottoms-up understanding of Chinese industries and how they are deve loping. Also includes interviews with leading multinational CEOs in which they s hare their personal experiences and insights on doing business in China. Not an investment book but a really deep detailed understanding from Dr Woetzel s 15 years with McKinsey on the ground in China. Final wise words? Assume everyone else is smarter than you. Not just as smart, but significantly s and

marter. And also that they work a lot harder than you. I find this posture forces me to build real, concrete advantages at the deal lev el. It s the only way I can win if others are smarter. A lot of the structure of o ur group (on the ground in emerging markets, deep research focused, long-term ca pital, etc.) follows from the need for such structural advantages. Thank you very much, Jeffrey. Jeffrey Towson is at Jeffreytowson.com Read No. 9 Interview with John Kingham August 19, 2011 We start our Talk Value interview session with John Kingham, a private value inv estor based in Kent. John is the editor and founder of UK Value Investor.com John is 39, married with a son. John e as an engineer, but he also worked d for the last 12 years or so, as an two reasons: first, I want to have I find it a fascinating subject . So, without further ado . . . How did you get started in investing? What attracted you to value investing? I got into investing in the 1990 s. I started saving about 500 each month and at th e time index investing was the thing to do, so that s what I did. I got into value investing through property, funnily enough. I d bought a flat in 1997 it was 42,000 for a 4 bed maisonette in London. Buying when property is chea p just made sense to me as it would to most people. By 2004 I felt that property was expensive and so I started looking to sell and lock in the six figure profits I d made. At the same time I d started to look beyond index investing for something better than just following the crowd and so my ex perience with property influenced the way I looked at shares. Eventually I found Benjamin Graham and The Intelligent Investor book. That s where I really started to put 2 and 2 together and started investing in shares in the same way that I d been successful with property. By then I was in my mid-30s. What is your investment philosophy? What would you describe as your investment philosophy? How has it developed over time? Are you a long term investor? When do you sell? My investment philosophy is to invest in companies that are very stable and like ly to grow over the next few years. I only buy them when they re cheap, typically when the dividend and earnings yields are high. Of course there s much more to it than that but that s the basics. s work life began with the Ministry of Defenc as a bailiff, bus driver, security guard an insurance software analyst. John invest for a comfortable retirement and second, because a private value investor

I started out as a Ben Graham net net investor, looking to buy companies for less than their current assets minus the value of all their liabilities. This is a pr etty small niche and was working well back in the crisis of 2008. Even French Co nnection fitted this bill for a while and I made a fair profit from owning them. This approach does tend to involve investing in a lot of quite weak companies wh ich I wasn t keen on, and that s why I moved to where I am now, to something like 50 % Ben Graham defensive investor and 50% Warren Buffett selective contrarian investor . I m a long term investor in that I invest based on a calculation of an investment s potential return over 5 years. My actual holding period is typically closer to 1 year though. I don t buy and hold. I don t see the point of holding a company if yo u don t think it s attractively valued anymore. Selling is one of the unique factors in the system I ve developed. Basically the m ethod borrows from the successful upgrading system used in American mutual fund ne wsletters like No Load Fund X. This has been a highly successful strategy for th em and I ve adapted it investing in individual shares. What is your track record? How did you weather 2008 and the first part of 2009? What has been one of your b iggest investing mistakes? When and what did you learn from it? I started tracking my investments with 100% accuracy back in mid-2008. For the s econd half of 2008 I beat my benchmark (the iShares FTSE 100 ETF) by 5%. In 2009 I beat the benchmark again by 10% and 10.6% in 2010. The crisis strengthened my belief that the crowd is typically wrong. Everyone th ought it was the end of the world in 2008 and the FTSE 100 reached about 3500. T hat was exactly the time to be getting in, rather than getting out like everyone else. My biggest mistake was in my personal portfolio at the end of 2010. I tried an e xperiment with a quantitative, multi-factor computerised system which I wrote. B y following this system for a short while I ended up buying some weak, speculati ve companies which has made me realise that I only like high quality companies! For example, I bought Yell, which may eventually turn out to be a good bet, but it s not an investment, it s a speculative gamble. What type of investment research do you undertake? How do you typically find ideas and what is your selection process before an ide a gets added to your portfolio? What types of questions are on your investing ch eck list? I start off with a paid screen that I ve set up to find growing companies that hav e good earnings and dividend yields. These results go into a spreadsheet where t hey are further analysed and ordered. The resulting list is what I call my level 1 Top list. I then further analyse the companies, removing those that aren t up to my standard s until I have a level 2 Top 10 list. After that I do further research into these companies and eventually pick a single best level 3 shares which goes into the por tfolio. For growth I m looking at sales, earnings, dividend and net asset value growth. Fo r value I m looking for earnings and dividend yields. For robustness I m looking at

interest cover and the general debt position. I also look at things like ROE, ROC, gross margin, industry, competitors, just a lot of different factors. Do you invest wherever you see value? Do you invest in any particular sector? Which company do you find interesting at the moment and why? I ll invest in any sector as long as my portfolio isn t too heavily invested in any one sector already. My top pick at the moment is Balfour Beatty since I ve just bought it. It s another globally diverse industry leader with a good growth track record. It s also availa ble with a dividend yield above 5%. Any diversification and portfolio management issues? How many positions do you typically have in your portfolio and what are your ide as concerning portfolio composition? Do you follow any key risk-management guide lines in managing your portfolio? My target is 20, but that s not set in stone. This enables me to be diversified bu t no overly so. I try to keep the portfolio widely diversified into many differe nt sectors. I do have ideas on asset allocation between stocks and bonds, but in my model po rtfolio its 100% shares all the time. For me that s the way to go for maximum retu rns. In terms of risk management, I basically control risk by mostly buying comp anies that are number 1 or 2 in their industry. I m not bothered by things like beta as a measure of risk. Basically risk to me is v olatility in income (since the portfolio is geared towards retiring on the divid ends) and risk of business failure. Both of those are controlled by buying big, stable, leading companies at good prices. Who are your top two investment heroes? Which value investors do you admire most and why? Which book(s) would you recomm end an aspiring value investor should read, and why? I am a Ben Graham and Warren Buffett man through and through. For further readin g, I d recommend: * The Intelligent Investor because Graham writes with such common sense; * The Guru Investor: How to Beat the Market Using History s Best Investment St rategies by John Reese because it breaks down the strategies of many great inves tors in an understandable way; and * Valuing Wall Street: Protecting Wealth in Turbulent Markets by Andrew Smit hers because it shows how easy it can be to see the market s irrationality if you look at it in the right way. Any final wise words? Investing in shares is for the long term, typically retirement or your children s education. No one can know what the value of your investments will be tomorrow, next month or next year. However, 20 years from now it s very likely the UK econom y will be much bigger than it is now and so if you can buy into the market or in

dividual, leading companies when they are going cheap, you might just do okay. Read No. 10 Paul D. Sonkin is the Portfolio Manager of The Hummingbird Value Fund and the Ta rsier Nanocap Value Fund. Paul is currently an adjunct professor at Columbia Uni versity Graduate School of Business, where he teaches courses on security analys is and value investing. He is a member of the board of several public companies including Meade Instruments Corp. He was previously a senior analyst at First Ma nhattan & Co., a firm that specializes in mid and large cap value investing. Bef ore that he was an analyst and portfolio manager at Royce & Associates, the inve stment advisor to the Royce Funds. Royce & Associates practice small and micro c ap value investing. Prior to receiving an MBA from Columbia University, he worke d at Goldman Sachs & Co. and at the U.S. Securities and Exchange Commission. He is a co-author of Value Investing: From Graham to Buffett and Beyond (Wiley Fina nce) Mr. Sonkin was nice enough to offer over an hour of his time for our interview. In fact he was prepared to offer even more time if I had more questions for him. It was a pleasure conducting the interview with Mr. Sonkin. Below is our conversation: Jacob Wolinsky: I always love asking this question to value investors. Value inv esting is contrary to human nature. Every value investor has a story how they go t started in value investing. What was your catalyst? Paul Sonkin: I was in the Columbia Business School and I knew I wanted to get in to money management. And there was this class by someone of the name of Bruce Gr eenwald and they only taught it for a year and it was called Value Investing. An d it must have been the first or second class where a Bruce Greenwald quoted a s tudy that had come in 1993 by Eugene Fama and Kenneth French that small cap outp erformed over time and value outperformed over time. And it was a really eppitha ny for me that if that is where the money is I should do small cap value. Jacob Wolinsky: I am just curious if Fama and French are strong believers in the efficient market theory and value stocks have lower beta and are therefore less risky how does this conform with their theory? Paul Sonkin: I don t remember exactly what is, but I think there is basically a li quidity premium and you are paid to take on that risk. Jacob Wolinsky: So basically they changed their definition of risk just to make it fit with their theory? Paul Sonkin: Exactly, and I don t remember if it was in that study I don t remember exactly what the specifics were. But that is really what got my start. There was an article in Barron s titled The Most Patient Man on Wall Street and Th e Second Most Patient Man on Wall Street and they interviewed someone from First Chicago. He did a lot of pink sheet investing. The second guy was a person by t he name of Ed Mcgoocklin who also did a lot of pink sheet investing. He spoke ab out a company called Park Lexington Corporation they owned about three buildings in New York City. I did an analysis on the company and it turned out it was che ap. I called up Ed Mcgoocklin and sent him my report and told him I had some que stions for management. He flew up to New York City to meet me. On Wednesday I went to listen to Mario Gabielli but I got the flu and I could ba rely walk out to get home. The meeting with Ed was on Friday and I had 104 fever but we had our meeting. He presented my report to the company and six months la ter the company went private at a pretty rich premium.

So I thought this is pretty cool. You can look at a company, talk to the managem ent pretty easily and have an influence on the outcome. I got a job working for Royce and Associates and I was on the microcap team and I was doing what I really loved doing. They were a lot smaller back then they ha d about $2 billion under management. Today they have something like $20 billion under management. Jacob Wolinsky: There are many different styles in value investing ranging from Benjamin Graham s net-nets to Warren Buffett s purchase of companies with wide moats ? What style do you must subscribe to? I assume you will have more of a Benjami n Graham style net-net approach due to the size of companies you invest in? Paul Sonkin: If you read the book Value Investing: From Benjamin Graham to Benja min Graham I talk about three different types of value investors: traditional va lue investors, value investors with a mixed approach and contemporary value inve stors. I consider myself to be much more of a traditional value investor lookin g at Benjamin Graham s net-nets and things of that nature. Jacob Wolinsky: So what else do you look for besides net-nets? Would that be you r ideal investment? Paul Sonkin: In the book Bruce Greenwald talks about the three traunches of valu e you have your asset value, your earnings value, and earnings power with growth . So we do the first two which is look at buying companies below their asset val ue, below book value, net-net value, working capital value etc. What your buying mostly is companies that is low priced to book stocks, companies that aren t earn ing a lot of money but have a lot of assets. So they are asset rich but earnings poor. What we do is find out what is wrong with the company and understanding w hy their earnings are done and if they might recover. The second company we buy is a company that is at a discount to its earnings pow er value. Those are the low P/E stocks. Those are companies that are trading at 5x, 7x or 10x earnings. These companies might be trading low because of a percep tion that their earnings will decline further in the future. What you are trying to do there is prove why the earnings will not decline in the future. Jacob Wolinsky: You invest in micro-cap stocks. Can you give me a number of the average market capitalization of a stock you invest in? Paul Sonkin: According to the classic definition micro cap stocks are stocks bel ow $500 million or $250 million. We operate our Hummingbird fund with an average market cap of $40 million and our Tarsier fund with an average market cap of li ke $8 million. Jacob Wolinsky: Can you clarify for the readers regarding the two funds you run? Paul Sonkin: We have two funds; the Hummingbird Value Fund and the Tarsier nanocap value fund. Jacob Wolinsky: I assume due to the tiny size of the companies you invest in you are forced to take a large stake in the company? Paul Sonkin: Yeah sometimes we own 5 to 10% of a company. In one case we own ove r 20% of shares outstanding and 65% of the float. Jacob Wolinsky: Are you forced to take an activist role due to this? We have taken an activist role in the past but it is something I shy away from. We focus on companies that are shareholder friendly. Being an activist investor

takes up an enormous amount of time. If you look at Bill Ackman and Michael Price who I both know and think are pheno menal investors what they do when they take an activist role is they will take a very large position. Like Bill Ackman had his Target Target fund, so they have much more concentrated portfolio. Jacob Wolinsky: And in general you have a more diversified portfolio? Paul Sonkin: Yes we have a diversified portfolio. Jacob Wolinsky: Is that due to the forces of circumstance or do you prefer havin g a diversified portfolio? Paul Sonkin: Its really both. By default I don t like positions more than 5% of th e portfolio. And in both funds around 10-20 positions will be about 50% of the p ortfolio while another 100 stocks will make up the remainder. But we have quite a few 5% positions. Jacob Wolinsky: You are a professor at Columbia University and you run a limited partnership. Do you see your future as more of a value investor or a value thin ker like Bruce Greenwald and Roger Lowenstein? Or both? Paul Sonkin: I would say both. What I really enjoy about teaching it gives me ti me to research on the research process. A lot of the materials I have start as l ecture. It is hard to know where the money manager starts and the teacher begins . I really try to integrate them both and I really try to bring a lot of live th eses into my class. Jacob Wolinsky: A lot of the current value investors are stepping back from thei r roles or will be in the future due to their age. Charlie Munger, Warren Buffet t, Martin Whitman and David Dreman are all getting older. Other than yourself, w ho do you see as the current rising stars of value investing to lead the next ge neration? Paul Sonkin: I see a lot of great money managers who all run small funds now. I don t think these investors will come from big organizations. I think it will be s mall guys you never heard of, and they will remain below the radar screen for a long time. So I don t know if that old guard is really going to be replaced. You do have people like Bill Ackman, Rich Rubin of Hawkeye, David Einhorn, maybe Dan Loeb. I don t really know. I think in doing what I do it is not going to make you rich and a lot of guys want to get rich. Because in the small cap world you can only get so big. There are very few people in the micro cap and small cap w orld making millions of dollars. So I don t know who the new guard will be. Paul Sonkin coauthored Value Investing: From Graham to Buffett and Beyond (Wiley Finance). In addition there is a chapter in the book that discusses Sonkin s inve stment style. Read more: http://www.valuewalk.com/2010/03/jacob-wolinsky-interviews-small-valu e-cap-guru-paul-sonkin/#ixzz1eS4Q0K7f Read No. 11 Whitney Tilson Whitney Tilson s bio from http://www.tilsonfunds.com

Whitney Tilson is the founder and Managing Partner of T2 Partners LLC and the Ti lson Mutual Funds. The former (http://www.T2PartnersLLC.com) manages three value -oriented private investment partnerships, T2 Accredited Fund, Tilson Offshore F und and T2 Qualified Fund, while the latter is comprised of two value-based mutu al funds, Tilson Focus Fund and Tilson Dividend Fund (www.tilsonmutualfunds.com) . Mr. Tilson is also the co-founder, Chairman and co-Editor-in-Chief of Value Inve stor Insight(www.valueinvestorinsight.com), an investment newsletter, and is the co-founder and Chairman of the Value Investing Congress (www.valueinvestingcong ress.com), a biannual investment conference in New York City and Los Angeles. Mr. Tilson writes a regular column on value investing for the Financial Times an d Kiplinger s, has written for the Motley Fool and TheStreet.com, was one of the a uthors of Poor Charlie s Almanack, the definitive book on Berkshire Hathaway Vice Chairman Charlie Munger, and teaches financial statement analysis and business v aluation for the Dickie Group. He was one of five investors included in SmartMon ey s Power 30, was named by Institutional Investor as one of 20 Rising Stars, has appeared many times on CNBC, Bloomberg TV, Fox Business Network, Lou Dobbs Money line and Wall $treet Week, was on the cover of the July 2007 Kiplinger s, has been profiled by the Wall Street Journal and the Washington Post, and has spoken wid ely on value investing and behavioral finance. He served on the Board of Directo rs of Cutter & Buck, a public company that designs and markets upscale sportswea r for two years until the company was sold in early 2007. Prior to launching his investment career in 1999, Mr. Tilson spent five years wo rking with Harvard Business School Professor Michael E. Porter studying the comp etitiveness of inner cities and inner-city-based companies nationwide. He and Pr ofessor Porter founded the Initiative for a Competitive Inner City, of which Mr. Tilson was Executive Director. Mr. Tilson also led the effort to create ICV Par tners, a national for-profit private equity fund focused on minority-owned and i nner-city businesses that has raised nearly $500 million. Before business school, Mr. Tilson was a founding member of Teach for America, t he national teacher corps, and then spent two years as a consultant at The Bosto n Consulting Group. Mr. Tilson received an MBA with High Distinction from the Harvard Business Schoo l, where he was elected a Baker Scholar (top 5% of class), and graduated magna c um laude from Harvard College, with a bachelor s degree in Government. Mr. Tilson s parents are both educators and he spent much of his childhood in Tanz ania and Nicaragua. Consequently, Mr. Tilson is involved with a number of charit ies focused on education reform and Africa. For his philanthropic work, he recei ved the 2008 John C. Whitehead Social Enterprise Award from the Harvard Business School Club of Greater New York. He is also a member of the Young Presidents Org anization. Mr. Tilson lives in Manhattan with his wife and three daughters. Whitney Tilson was kind enough to devote several hours of his time to let me int erview him. I asked him a variety of questions including value investment philosophy, specif ic stock holdings, and his opinion on the housing market and the economy. Our conversation is below (note that this is not an exact transcript, but rather my notes from our conversation): This is usually the first question I ask value investors. Value investing is con trary to human nature. Every value investor has a story how they got started in value investing. What was your catalyst?

I came late to investing. I was very interested in business and attended Harvard Business School. I would read the Wall Street Journal and immediately throw awa y the section on investing because I had no interest in it. After college I had no money and I was in debt and after that I went to business school and had business school debt. My parents are teachers and I didn t grow up with any money. Money is the necessity of invention so in 1995 I had my first $ 10,000 in my bank in my life. Bill Ackman who I went to business school with was still at his original hedge fund Gotham Partners, and he was the only guy I kne w in the investment business. He said there was only one thing I needed to do: r ead all of Warren Buffett s letters, and that was the best advice anyone has ever given to me. Intuitively it made a lot of sense; just buy a dollar bill for fift y cents. I read avidly all of Warren Buffett s letters, and all the books about him, and I read Peter Lynch s books, and other books about investing, especially value invest ing. I started practicing with my own tiny portfolio. In the late 90s I was a classic late 90s bull market genius: I bought high quality businesses like Microsoft, D ell, Home Depot, a little bit of Gap. These were business I thought I could buy and hold forever, I was very nave. It was fun and I thought I was God s gift to investing. In hindsight it was very n ave and I was clueless. After a few years I decided that I wanted to make a busin ess out of my hobby. I started on Jan 1st 1999, I had three investors: myself, my in-laws and my pare nts with about $1 million dollars. I managed it out of my bedroom. I had no cost s and my wife was a lawyer with a good paying job so she paid the bills and I wo rked very hard out of our apartment managing the world s smallest hedge fund. At t hat point I was still riding my Nifty fifty stocks that I had bought four years ea rlier, and I also owned some Berkshire Hathaway at the time. I head Warren Buffett predicting a bubble and I got nervous about it too. I got a job writing articles for the Motley Fool in late 1999 so I have a paper trail where you could read some articles where I talk about the bubble. I started writ ing there in September and I became a regular contributor in November 1999. I was preaching the gospel of Buffett, and telling people not to get fooled by t he bubble. I turned out to be right, though I mistakenly thought blue chips like MSFT were good buys. I was wrong in some ways but in the big picture I was right. I read a lot and learned very fast. I sold enough of the Nifty fifty stocks and bought enough of the value stocks to survive the crash from March 2000- October 2002. I do not recommend that to young people that they start as I did with virtually no experience in the business. I recommend to many people who write to me, don t d o as I did; instead, go work for someone and learn the business. I was lucky in hindsight, I had no business going into this business. You mention Bill Ackman as your original mentor. Do you subscribe to his philoso phy of investing? You mentioned Warren Buffett as your mentor also. There are ma ny different styles in value investing ranging from Benjamin Graham s net-nets to Warren Buffett s purchase of companies with wide moats? What style do you must sub scribe to?

We draw from every different style. Value investing is simply buying a stock at a significant discount to its intrinsic value. The closest classic value stock w e own which is almost a net net is a small retailer named Delias which is tradin g close to cash. We also own Berkshire Hathaway which has $186 billion market ca p which is more of a growth at a reasonable price. We also own General Growth Pr operties; the company is in bankruptcy which I would classify as a special situa tion. We try to find lots of different value opportunities and we try to keep an open mind. On a similar note Graham held stock short, so did Schloss. The biggest jump made by Buffett was really caring about the quality of the businesses he invests in. Benjamin Graham was mostly quantitative not qualitative. Phillip Fisher and Cha rlie Munger made Buffett see out in the future and what is called looking throug h the numbers. Have you adopted the same approach in you look through the number s? Benjamin Graham s core investment approach was buying statistically extremely chea p stocks. Walter Schloss and more recently Paul Sonkin of Hummingbird Capital ar e a good example of that fundamental approach. Buffett in his early career made his fortune buying extremely low-quality busine ss like Berkshire Hathaway, which was a dying textile business, at extremely low multiples of cash flow and/or discounts to liquidation value, so called net net s. Berkshire was in fact a net net when Buffett bought it. He once joked that in the 1950s or 1960s he would buy companies at 2x earnings and sell them at 3x ea rning and make a 50% profit. He would then find another business selling at 2x e arnings and buy it. Thanks slightly to Phillip Fischer but mostly to Charlie Munger and due to his o wn learning Buffett is a learning machine Buffett began to appreciate higher qua lity businesses and businesses that could grow value over time and how valuable those valuable could be. In my opinion, See s Candies is the first example of a bu siness in his career where he paid up for a high-quality business with a brand a nd moat and Charlie Munger helped him see that value and pay a higher price then he normally would have paid. The problem with being an investor in net net stocks is that they are very small and illiquid. Buffett knew that to grow his wealth he would have to cast a wide r net to put more capital to work. It sounds like you think that Warren Buffett changed his business style due to t he forces of circumstances. Do you think Warren Buffett would be a Net-net inves tor if he was much managing less cash? Yes, that is absolutely true. He has been asked this question many times and res ponded that if he were to be managing very little money he would be looking in t he nooks and crannies looking for extreme temporary mispricings. If you know whe re to look, you can sometimes find extreme temporarily mispriced stocks. However these stocks are usually small and it is hard to put much money into them. Not in a million years would Buffett own Kraft if he was managing $10 million. Considering that the world today is different from the time of Graham and Dodd w here more attention has to be focused on owner s earnings and cash flow, what do y ou suggest as the best resource for learning financial statement analysis includ ing proper statement adjustments from a value perspective? I do not have a good answer for this. I am self taught and have just done a lot of reading. There are a lot of good books. Thorton O Glove wrote Quality of Earnin gs on finding red flags in earnings. Howard Schilit wrote Financial Shenanigans.

Tim Koller wrote a book called Valuation. These books talk more about discovering red flags in earnings and do not discuss how to read a financial statement. Some people before they consider becoming in vestors should take some classes, or go to business school, or get a CFA so they have basic knowledge. Security Analysis of course is one of the original books. If you read these book s you will learn accounting. Value investing is just buying something for less than it is currently worth. Wh y is it so misunderstood? It seems simple to understand but most people don t get it , why? Most people can fairly quick understand the concepts. I think there are two main reasons people don t practice it. 1. Value investing requires patience it is get rich slowly investment philoso phy and most people want to get rich quickly. So the natural human inclination i s to try to find a stock that will beat earnings by a penny next week and theref ore the stock will jump 10%. People play short-term games trying to guess quarte rly earnings. 1. To be value investor you have to be able to estimate intrinsic value. It i s really hard to value businesses. You have to make predictions about the future and industry dynamics and that is very hard to do. I can tell you after getting a Harvard MBA and spending 11 years in the business it is still really hard to do. I cannot value most businesses because they are out of my circle of competence. Even Buffett says he can t value most businesses. I d guess that 90% of investors do not have skill or training or experience to value businesses. And if you can t va lue businesses you can t be a value investor by definition. Therefore you play the momentum game or short term game or some other game. You just mentioned that the average person cannot be a value investor. Studies h ave shown that if you buy a basket of value stocks low P/E, low P/B etc they wil l outperform over time. Why can t the average investor just buy a basket of value stocks? It is clearly better to be fishing in the pond of smaller stocks especially if y ou are a small investor, as well as statistically cheap stocks (low P/B, low P/E , low enterprise value etc.). Those are the ponds you want to be fishing in. Tha t said, there are the world s greatest PhD mathematicians, top quants like Jim Sim ons, who take statistically cheap approaches. I would emphatically advise indivi dual investors against trying to implement on their own a Dogs of Dow-like strat egy or any kind of mechanical or formulated strategy. I promise you that super-c omputers will beat you with that. First and foremost look at industries you know. But considering there 8,000 or s o publically traded companies you want to narrow that universe; look in those in dustries for you know something about. Then in those industries look for out of favor, statistically cheap, beaten down stocks. Then look for those that might b e able to fix themselves. I know a lot about the restaurant industry and have made a fortune over the year s investing in McDonalds, Denny s, Yum Brands, Jack in the Box, CKE Restaurants an d others. Today we are finding that the biggest blue chips like McDonalds are un dervalued. Though we don t own it, I would rather own McDonalds than the S&P 500 i

ndex fund for example. So sometimes the best risk-reward is sitting right in fro nt of your nose. Today an investor could do nicely though you will not double your money quickly, but you can double it over a period of five or six years owning a basket of blu e chip stocks like Berkshire Hathaway (one of our largest holdings), Microsoft a nd Pfizer. So there are a number of blue chips out there that you can own and do very nicely with. I don t want to comment on the company specifically. The only thing I will say is I have never been in a significant short position where there was not a credible long investor with a good track record on the other side. For example during the financial meltdown look at the value investors who were l ong MBIA, AIG, Fannie, Freddie, etc. So the fact that any investor is long any s tock that we are short or considering shorting is not relevant. We do our own wo rk and differing opinions are what makes markets. If you are ever going to short stocks you have to be comfortable with the fact that there will be some smart i nvestor with the other point of view. In your book released in mid 2009 you wrote a detailed analysis of WFC and MBIA, what is your opinion of those companies now? I wrote the book in a span of five weeks from February to mid March. You wrote the book in five weeks?!! Yes, we finished the book in mid-March as the market was bottoming. The publishe r turned it around and it was released in the first week of May. In the case of MBIA, our views haven t changed at all the exposure to toxic struct ured finance products is the same and we still think all their reserves will be wiped out. There was an article in Bloomberg News this past week about how the major bond i ssuers have over $1 trillion in exposure to municipal finance bonds. We didn t eve n look at that book when we analyzed our short of MBIA, but obviously states and cities across the country are facing major budget crises. The major muni insurers, MBIA, Assured Guaranty and Ambac, cumulatively have res erved only 4 basis points of reserves against their muni finance books! This is a whole area we didn t cover in the chapter on MBIA in our book. MBIA is trying to get rid of their toxic liabilities by trying to create a good bank/ bad bank structure. Many debt holders are suing MBIA to have a judge rule that this is a fraudulent conveyance. So far the lawsuits are proceeding in the debt holders favor. This is the only stock we were short that we wrote about in our book. Since it w as published, many financial stocks doubled but MBIA has not moved at all becaus e of its continuing terrible fundamentals. With Wells Fargo, the stock has more than doubled and that has dramatically chan ged the risk reward ratio. We own a very small residual position but we basicall y exited the position because we fear the losses to come. That said, Wells Fargo is clearly going to be able to earn its way out of troubl e. Their earnings have been even greater than we modeled in our book. There is n o question that this will be a $60 stock one day once the economy returns to nor mal. However the economy might not return to normal levels for many years it cou

ld be as long as five years. We think investors are rushing into financials thin king the worse is behind us and in two years we will be back to normal. However, we think it could be more than five years until we get through the whole housin g and commercial real estate mess. I would give us an A for the second half of our book where we discussed six inve stment opportunities those ideas have worked out well. Regarding the first half of the book, where we discussed the housing market, I w ould give us a B. Because of massive government subsidies, both constricting sup ply and stimulating demand, the housing market stabilized somewhat sooner and at a somewhat higher level than we anticipated. That said, the reason I would give us a B and not a C or D is because we said the aftermath of the housing bubble would be with us for years and there would be millions of foreclosures that woul d have to come through the pipeline to get to normal inventory levels. And all o f those things are proving to be correct. Today things are terrible out there but we are no longer in freefall. The patien t is stable but critical as opposed to crashing but critical. We think the signs of a turnaround that have gotten investors excited will prove to be temporary. Even in the past week things like existing home sales, new home sales, and inven tory data have been weak. Interest rates have nowhere to go but up not that I am predicting that any time soon so things are going to remain ugly for the next few years. However, we are not so bearish that we think there is going to be a major collapse. I think the government will do what is necessary to prevent that. And I am guessing you think there are more bank losses coming? Absolutely. The banking system is probably between 60-65% through in terms of to tal write-downs that will need to be taken. This still means a number of years m ore of write-downs. Sheila Bair (head of the FDIC) said this week that there will probably be more b ank failures this year than the 140 last year. Smaller banks, which tend to have larger exposure to commercial real estate, will be under the greatest stress. What is your outlook for the economy and does that effect your investment decisi ons or you completely a bottom up investor? The single biggest lesson for us of the collapse of the stock market is that it is not enough to be a completely bottoms-up investor. That is a mistake some val ue investors made and they paid a horrible price. We were in the Warren Buffett, Peter Lynch camp where if you spend more than 10 minutes a year focusing on mac ro concerns, that is ten wasted minutes. We discovered that the way you calculate intrinsic is usually a function of disc ounted cash flows and if the economy collapses, the cash flows forecasts can be thrown out the window and are worthless. Therefore having an opinion of some major economic shock and taking steps to pro tect yourself is a prudent thing. In fact it was our obsession with housing mark ets that saved us. If we had not figured out that the housing market was going t o collapse and taken steps to short a lot of financial stocks and protect oursel ves, I don t know if we would be around today. We have not become top-down investors, but I would say instead of being 98% bott oms-up and 2% top-down investors, today we are 75% bottoms-up and 25% top-down. Our net exposure is very much driven by whether we think we will have a V-shaped

recovery or a slower recovery. And I assume you do not predict a V-shaped recovery? My best guess is that there is a 20% chance of that. I think there is a 50% chan ce of a long, slow recovery (though not necessarily a recession) characterized b y the unemployment rate remaining stubbornly high for the next 3-5 years. Finall y, I think there is a 30% chance that things are worse than that. With such a wi de range of outcomes and valuations reflecting only be best-case scenario, we ar e investing cautiously. We aren t perma-bears however. If you think the world is going to go to hell, then you would own gold, cash and have a big short book, but we are not doing that. We have a big short book but our long book is larger. If you think the middle-case scenario I outlined above is going to happen (which I think is most likely), then you will invest cautiously on the long side and b uy stocks with very strong balance sheets like Berkshire Hathaway and Microsoft, and then you will have a big short book to cover the downside. If you believe there will be a V-shaped recovery you will buy speculative stocks , cyclical stocks and companies with lots of debt. We were buying those stocks 1 0 or 11 months ago because they were the most out-of-favor stocks, but now are t he most in-favor stocks. We are selling those stocks and in fact shorting them t o hedge our bets. Read No. 12 October 23rd, 2011 An Interview at Stockopedia on Becoming a Global Value Investor (October 11, 201 1) I did a related interview at Stockopedia which is run by Stephen Dotsch (he also has Dividend Income Investor). The interview link is here and text is re-pasted below.

Until 2009, Jeffrey Towson was Head of Direct Investments Middle East/North Afri ca and Asia Pacific for Prince Waleed arguably the world s no.2 investor and nickn amed by Time magazine as the Arabian Warren Buffett . While many investors are advi sed to have some emerging markets coverage in their stocks and share portfolios via various investment funds and ETF s, global value investor Jeffrey Towson inste ad suggest that successfully going global as a value investor requires successfu lly going direct. He believes going global as a value investor means exponentially increasing your p otential opportunities. However, experienced investors are finding themselves on rapidly changing and increasingly unfamiliar terrain.Issues like: when sitting in New York or London, can you really go long in China? Isn t getting accurate inf ormation a problem? Isn t the absence of rule-of-law in many places a problem? Wh at about the fact that there is often no real separation between commercial and government activities? Most private investors with global ambitions look at China, India, Brazil, Russi a and other places and are rightly cautious. Some investors decide to avoid the perceived risks by avoiding these markets altogether. Or they limit themselves t o short-term and liquid strategies. Or they try to invest in an indirect way, su ch as buying an international retailer such as Tesco s with significant exposure t o the emerging markets.

Going direct

five common

going global problems

Jeffrey Towson formulates five problems aspiring global value investors need to overcome when considering going global, including: Problem 1: Limited access to investments. Towson suggest following Buffett s most important lesson: that you accumulate weal th by targeting the most mispriced assets and going long. Market inefficiencies are your best targets while time is your best ally. Most of the really mis-priced assets in developing economies are private however . And these tend to be fairly tightly held often by conglomerates, state-owned-e nterprises and owner-managers. Even Warren Buffett was denied in his request to buy 25% of Shenzhen-based BYD (he ultimately got 10%). Getting access is a pri mary problem when going global. Problem 2: Increased uncertainty in the current intrinsic value Most developing economies are characterised by increased uncertainties and insta bilities. The markets and companies are developing quickly. Government actors ar e changing the rules or disappear overnight altogether. Information is limited a nd inaccurate. This all plays out in a greater uncertainty when calculating int rinsic value. Problem 3: Increased long-term uncertainty, including worries about instability The previous problem becomes even larger over the long-term. Five years in emerg ing countries is a very long time in terms of new regulations. It is hard to inv est long-term if the future intrinsic value of your investment can change signif icantly. Long-term uncertainties (including long-tail risk) are a big problem an d focusing on companies with a sustainable competitive advantage (i.e., Buffett s approach) is usually not enough. Problem 4: The availability of only weak or impractical claims against the targe t enterprise Board seats and contracts can mean little in many of today s rising markets. Minor ity shareholder rights even less. Keeping a strong claim to your asset over the long-term is a critical challenge. Problem 5: Foreigner disadvantages This is the catch-all for the various challenges you face when entering a market as a foreigner. You often have less information. The rules can be written again st you. There are language and cultural gaps. You are often far away. And so on. All these, and many more, manifest themselves as disadvantages when investing d irect in local companies. According to Towson, if you can overcome these problems you can start your hunt for value investments virtually anywhere. You will find, as Towson has, that mo st of the world outside the developed markets is wildly mispriced today. Alternatively, you can buy publicly-traded multinationals with extensive emergin g market operations. Buying an American or European company, in say retail or na tural resources, with operations in China or India takes care of problems 1 and 4. This approach also addresses problem 5 (foreigner disadvantages), which can be s

ignificant in many places (Russia and China being the most serious). A UK-based investor buying into an AIM-listed Chinese company is at the minimum going to ha ve some information disadvantages relative to local Chinese investors. But a UKbased investor buying a UK multinational has no such disadvantage. Read No. 13 License or reprint this article What We Value What exactly is "value investing" and why don't more people do it? By Whitney Tilson and John Heins From Kiplinger's Personal Finance magazine, July 2008 A walk down any supermarket aisle makes it clear we live in a world of increasin g product specialization. To break into a new market or grab more of an existing one, companies launch a dizz ying array of new products in ever-more-specific categories. Want your soda with more caffeine or less? You 've got it. More sugar? Less sugar? Six ounces, 10 ounces, 20 ounces? Whatever you like. This trend has not been lost on marketers of investments. Specialized mutual fun ds and exchange-traded funds cover almost every imaginable combination of manager style, geographic rea ch, capitalization size and sector expertise. If you're looking for a mid-cap growth fund focused on the socalled BRIC countries (Brazil, Russia, India and China), you'll surely find it. Dyed in the wool We understand the marketing reality of specialization, but we'd argue that the m ost important factor in judging an investor's prospective gains or losses is the person's underlying phi losophy. As you might guess from the name of this column, we're dyed-in-the-wool value investors, and we agr ee 100% with Berkshire Hathaway's vice-chairman, Charlie Munger, that "all sensible investing is value investing." What does that mean? After all, value investors pursue a wide variety of strateg ies: Some invest primarily in small companies, while others like large ones. Some go mostly overseas while oth ers stick to the U.S. Some run concentrated portfolios, and others don't. Some are activists; others aren't . But although specific strategies vary, the fundamental characteristics that unite value investors are many. We've come up with an even dozen: 1. We tend to buy what's out-of-favor rather than what's popular. 2. We focus on intrinsic company value -- what it's really worth -- and buy only when we're convinced we have a substantial margin of safety rather than try to guess where the herd will go next. 3. We understand and profit from reversion to the mean rather than project the i mmediate past indefinitely into the future. 4. We understand that beating the market requires a portfolio that looks quite d ifferent from the market, and we recognize that truly great investment ideas are rare. So we invest heavil y in our handful of best ideas rather than hide behind the safety of closet indexing. 5. We focus on avoiding permanent losses and on absolute returns rather than on outperforming a benchmark and on relative returns. 6. We typically invest with a multiyear time horizon rather than focus on the mo nth or quarter ahead.

http://www.kiplinger.com/printstory.php?pid=14080 1 of 3 6/11/2008 5:19 PM 7. We pride ourselves on conducting in-depth and proprietary analysis in search of what hedge-fund legend Michael Steinhardt calls "variant perceptions" rather than acting on tips or relying on Wall Street analysts. 8. We spend much of our time reading -- business publications, annual reports an d the like -- rather than staring at the ticker or watching television shows about the market. 9. We spend time analyzing and understanding "micro" factors, such as a company' s competitive advantages and growth prospects, instead of trying to predict the direction of i nterest rates, oil prices and the economy. 10. We cast a wide net, seeking mispriced securities across industries and acros s types and sizes of companies rather than accepting artificial style-box limitations on market capit alization and other criteria. 11. We make our own decisions and are willing to be held accountable for them ra ther than seek safety in whatever everyone else is buying or in decision-making by committee. 12. We admit our mistakes and seek to learn from them rather than take credit on ly for successes and attribute failures to bad luck. If that all sounds perfectly sensible, you might wonder, as we sometimes do, why everyone isn't a value investor. A simple explanation is that you must be able to estimate the value of a business, which requires a great deal of skill and experience to do with reasonable accuracy. There are oth er explanations as well. James Montier, equity strategist at France's Socit Gnrale, has studied the subject and fin ds the reasons are deeply rooted in human nature -- and, therefore, unlikely to ever change. The first reason he cites is aversion to loss. Research shows that people percei ve the pain of a loss about twice as strongly as the pleasure of a comparable gain. With its decidedly contr arian bent, value investing can sometimes fail to work for long periods of time, causing plenty of pain. To avoi d such an outcome, investors get drawn into a sucker's game of rapidly trading their portfolios rather than w aiting out the inevitable periods when they don't perform well. A second reason investors don't embrace value investing is that it's a get-richslowly approach. We are all hard-wired to pursue actions that offer immediate gratification. But stocks that are cheap often offer the greatest long-term rewards precisely because they have no short-term catalyst. A final reason for the dearth of value investors is the human desire to be part of the crowd. If you didn't own Internet stocks during the late 1990s, not only did you suffer lousy returns, bu t you also felt excluded. As Montier points out, "Contrarian strategies are the investment equivalent of seek ing out social pain." That's not easy to do. Value investors typically scour deeply out-of-favor sectors for opportunities, l ooking for the proverbial babies thrown out with the bath water. Last month, we wrote about two attractive opport unities, Target and Borders Group, in one of today's more reviled sectors -- retail. To that we'll add anoth

er: Barnes & Noble. Although it's in the same business as Borders, as an investment Barnes & Noble ( symbol BKS) has more in common with Target. Both are well-run, market-leading companies with strong bala nce sheets, trading at low multiples of earnings and buying back stock at a healthy rate. You might ask why own a stock like this -- or any retailer -- given the environm ent we're in. Why not wait until the consumer outlook shows sure signs of getting better? http://www.kiplinger.com/printstory.php?pid=14080 2 of 3 6/11/2008 5:19 PM The simple answer is share price. At $30, Barnes & Noble has a market capitaliza tion of $1.8 billion and -after deducting year-end cash of $361 million -- an enterprise value (minus cash and plus debt) of $1.5 billion. Last year, Barnes & Noble had earnings before interest, taxes, depreciation and amortization (EBITDA) of $380 million and free cash flow (after all capital expenditures) of $238 million . Thus, the stock is trading at 3.8 times EBITDA on an enterprise-value basis and 6.1 times free cash flow, for a cash-flow yield (the return shareholders would get if all free cash flow were paid out as dividends) of 16.3 %. When things start to get better, this current valuation will be long gone. A private buyer would likely pay double those multiples for such a high-quality business -- especially one with a respected, conservative, entrepreneurial management team led by Len Riggi o, who almost singlehandedly invented the book-superstore business. The biggest risk, of course, is continuing competitive pressure from big-box boo ksellers, such as Wal-Mart and Costco, and online alternatives, such as Amazon. But Barnes & Noble offers a n in-store experience that's attractive and sufficiently distinct from competing options to give the company an excellent chance of growing at a low- to mid-single-digit rate for many years. Given today's share p rice, such growth would be icing on the cake and not at all necessary for B&N to turn out to be a successfu l investment. Digging for insight There's one more reason that value investors probably aren't at risk of being ov errun by too many like-minded competitors: Value investing lacks drama. Poring over numbers and digging for de eper insight into a company or industry isn't exactly the adrenaline rush sought by the Jim Cramer, Mad Mone y crowd. To that, we'd suggest an alternative view of excitement: Sleeping well at night and compoundin g your money safely and at a decent clip over time seems like fun to us. Columnists Whitney Tilson and John Heins co-edit ValueInvestor Insight and Super Investor Insight. Read No. 14 Stocks Bear Market is Not Over, Interview with a Value Investor Stock-Markets / Stocks Bear Market Jun 05, 2011 - 05:29 PM By: Mike_Shedlock Stock-Markets

Best Financial Markets Analysis ArticleInquiring minds are reading a Guru Focus Interview with Investor Arnold Van Den Berg, a value investor. Guru Focus: You seem to believe that there will be high inflation risk i n the coming years. What is the best strategy in this inflationary environment? Van Den Berg: It is important to define what we mean by inflation. Inflation rat es in the low single digits (1% to 3.5%) generally meet the definition of low an d stable inflation. Inflation rates greater than 4% or lower than 0% have a high risk of destabilizing the economy. The primary risk of inflation stems from the potential for monetary policy errors. Monetary policy makers do well when the u nderlying environment is relatively stable. But when conditions change suddenly, there is a possibility for error. Thus, monetary policy errors can be either de flationary or inflationary. The risk is especially high in unstable monetary env ironments, like we are experiencing today. Both inflation and deflation compress valuations. In the 1970s, stocks sank to s ingle digit P/E ratios. We all know what happened to markets in the early 1930s. Generally, economic instability is bad for valuations. We believe that we could go through a period of above-average inflation (on the order of 5%), but nothing like we saw in the 1970s. This period will be very poo r for stocks. Since it is difficult to predict the timing of such episodes, we a djust for inflation (and deflation as well) by adjusting our valuations for lowe r price multiples. When we find bargains, we will buy them; when we cannot find bargains, we will hold cash. We expect that conditions in the economy and in the market will run counter to our investment philosophy for short periods of time, but we know that over the long run value investing outperforms. Guru Focus: There was a piece in OID approximately eight years ago where you dis cussed the post-bubble periods. It was transformative for me but I wonder where you think we are at present. It seems the risks are greater than ever as our gov ernment tries to solve an over-consumption problem by issuing massive amounts of debt. Van Den Berg: A major characteristic of bear markets is that things that would n ormally cause the market to explode -- like low interest rates -- have either mi nimal or temporary effects. In bear markets, earnings could continue to grow, bu t multiples become compressed. This causes stock valuations to trade up one to t wo years, but then revert back to low levels and start the cycle over. Over the duration of the bear market, the prices of stocks may not significantly apprecia te. Stocks that may look cheap on a multiple basis may often get even cheaper. T his is exactly what we have been seeing since 2000. At the end of the bear market, multiples have compressed to very low levels. Thi s sets the stage for the next bull market. How much longer will we be in this bear market? Bear markets typically last abou t sixteen years, so I would say that we have about five more years to go. This c oincides with our earlier comments on how long we think it will take for the rea l estate, unemployment, and fiscal problems to be reconciled. The way to invest in this kind of environment is to stay focused on the valuations of individual c ompanies. You can still make money in this environment by buying stocks when the y are cheap and selling when they are near fair value (remember that multiples a re compressing, so stocks won't go as high as one would expect in a normal envir onment). When bargains can't be found, hold cash. The Guru Focus interview is well worth a read in entirety. Are Stocks Cheap?

Stocks look cheap now but they aren't because of three factors. 1. PE Compression 2. Earnings are mean-reverting 3. Record government stimulus globally Van Den Berg discussed point number one in detail. I covered points one and two in Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It's Far More Likely Than You Think. For a follow-up on those points, please see Anatomy of Bubbles; Negative Returns for a Decade Revisited; Is Gold in a Bubble? Earnings High From Record Global Stimulus Point number three should be obvious, but obviously it's not given pervasive bul lish sentiment nearly everywhere, including smack in the middle of article with bearish sounding titles. For example, please consider a few excerpts from Dow Ha s Its Longest Weekly Slump Since 2004 * Michael Shaoul, whose Marketfield Fund Ltd. beat 81 percent of competitors last year, said that while the payrolls report was disappointing, it may also b e a signal the slowdown in the economic data is near its peak. He noted that wea ker nonfarm payrolls reports in February and July 2004 failed to derail the last bull market, which peaked in October 2007. * The biggest decline in the S&P 500 since August is creating a buying oppor tunity for investors, according to Blackstone Group LP's Byron Wien. The price-t o-earnings ratio for the S&P 500 has fallen close to its lowest level in 2011, a ccording to Bloomberg data. The index currently trades at 14.8 times earnings, n ear this year's low of 14.7 when it fell in March after Japan's earthquake. * The economy is not as bad as it looks right now. Corporate profits will be good, very good. People are asking me, 'Do you still think the market can get to 1,500 by the end of the year?' I do." In contrast, I think it is crystal clear much of the recovery is a mirage based on unsustainable government stimulus, that stimulus is fading, there is little c hance right now for more stimulus, and that corporate profits have peaked this c ycle in conjunction with a slowing global economy. I discussed the slowing global economy in a video: Mish on Yahoo Finance... High Inflation Coming? Van Den Berg clearly has a different definition of inflation and deflation than I do. I prefer to view inflation and deflation in terms of money supply and cred it. He looks at prices. He is calling for "high inflation" but high means 5%. Can we see a 5% CPI with falling demand for credit? Sure, why not? And if it pla ys out that way, there will be no hiding places at all. Treasuries and stocks bo th would be hammered. It is one of the reasons I do not like treasuries now. It is also a good reason why corporate bond rates at 2.33% for 10 years constitu te a bubble. , Bear in mind that a renewed credit crunch might send treasury yie lds lower but it will not be good for corporate bonds, especially junk bonds. Dissimilar Starting Points, Many Similar Conclusions Van Den Berg does not like gold. I do. I gave my reasons in a Yahoo Finance vide o last week. Please see Why I Continue to Like Gold for a discussion. There are other differences as well.

However, we have both arrived at the similar conclusions regarding equity valuat ions in general even though we have very different starting points about what in flation is. Conclusions * The bear market is not over * Valuations are not cheap * When there is little value, then there is nothing wrong with cash By Mike "Mish" Shedlock Read No. 15 Jacob Wolinsky Interviews Legendary Value Investor David Dreman Apr. 14, 2010 David Dreman is the founder, Chairman and Chief Investment Officer of Dreman Val ue Management, L.L.C., established in 1997. Mr. Dreman founded his first investm ent firm, Dreman Value Management, Inc., in 1977 and served as its President and Chairman until 1995, followed by a similar role at Dreman Value Advisors, Inc. from 1995 to 1997. Mr. Dreman s best selling book, Contrarian Investment Strategies The Next Generati on, was published in 1998 by Simon & Schuster. His previous widely acclaimed boo ks includePsychology and the Stock Market (1977), The New Contrarian Investment Strategy: the Psychology of Stock Market Success (1980), and The Contrarian Inve stment Strategy (1982). Articles discussing the success of Mr. Dreman s investment methodologies have appeared in national publications such as Forbes, Barron s, In stitutional Investor, The Wall Street Journal, The New York Times, Newsweek, Mon ey andFortune. A regular columnist for Forbes for over 29 years, he has presented before the Na tional Bureau of Economic Research, the Society of Quantitative Analysts, the Ha rvard Medical School, the Cambridge Center for Behavioral Studies, the Institute of Behavioral Finance, the Association for Investment Management and Research ( AIMR), the National Financial Analysts Seminar, as well as numerous other academ ic and professional groups. Mr. Dreman s research findings have also been publishe d in The Financial Analysts Journal, The Journal of Investing, and The Journal o f Behavioral Finance. Mr. Dreman is also co-editor of The Journal of Behavioral Finance, President of the Dreman Foundation, and a Director of the IFREE Foundation, whose founder Ver non Smith was awarded the Nobel Prize in Economics in 2002. Mr. Dreman was award ed a Doctor of Laws Degree from the University of Manitoba in 1999 and is a memb er of the Board of Trustees of the University of Manitoba. More from GuruFocus: David Dreman is the founder and Chairman of Dreman Value Ma nagement, LLC and also serves as the firms Chief Investment Officer. His Large C ap Value Fund has returned average 17% annually, and Small Cap Value Fund averag e 16.5% annually since inception in 1991. A regular columnist for Forbes for 25 years, Mr. Dremans recent best-selling book, Contrarian Investment Strategies The Next Generation was published in the spring of 1998. I f e n attended the Columbia Investment Management Conference several days ago. One o the main highlights of the Conference was a presentation by David Dreman on th financial crisis. After the presentation Mr. Dreman was kind enough to sit dow and answer a few questions.

(Mr. Dreman mentioned that he heard of GuruFocus, and in fact he read and enjoye d my recent interview with John Dorfman (John Dofrman had previously worked for David Dreman for several years).

Below is our conversation: Jacob Wolinsky: In light of the financial crisis where many value investors got burned, would you change your investment strategy at all? Specifically your appr oach that uses the lowest quintile of companies in terms of P/E, P/B, P/D, would you modify this approach at all? Would you focus more on balance sheets in the future, or do you view this as a once in a generation market crash and do you pl an not to change your investment approach? David Dreman: You always modify. In 2008 there was a crisis which you could not determine from the balance sheet. What the CDOs were priced at and what they cou ld be sold at were totally different. We changed our approaches in some ways. We should not look at companies and assu me if it is losing money that it as a one time earnings loss. If you get to a pe riod where earnings are indeterminate we should probably get out of those compan ies much more quickly. We have another fund it s a very small fund that I manage. It did not do well duri ng the crisis, but last year it was the number one fund in value it was up over 60%. In the three years it is down about 12% so it is about 10% ahead of the mar ket. I tend to fine tine more on earnings. If there are loses on earnings you have to move quickly and get to the bottom of the losses if you want to hold onto the c ompany. The rest we will keep as we have in the past. Jacob Wolinsky: Everyone nowadays is hyping gold and China. Being the original c ontrarian what do you think about these asset classes? David Dreman: There have been several studies done on gold. The best study done is by Jeremy Siegel in his book Stocks for the Long Run. Gold has done well over time much better than bonds. During inflation gold has done excellent. But if y ou take gold versus stocks have done much well especially since World War II. So my number one choice would be stocks. Everything people are cowering away from today I would prefer to invest in. If we have an inflationary environment value stocks should do well over the next 4-5 years. And can I say this dirt word? Real estate. Real Estate has been hit so hard if you have a holding period of 5 years with 20-25% leverage it is a 4-1 play on the upside. My view is once unemployment comes down and that will not happen overnight that will be a long many year process, I think we will have 10-12% inflation once une mployment comes down below 6% which could be another 4 years or so. There is no question there will be higher inflation in the future and housing with leverage will be an excellent investment. Stocks did well in Germany when the mark went down to one billionth of its value . German Stocks went up during the 20s in terms of real purchasing terms. In Bra zil the same thing. So stocks have been an inflation hedge. If you had $100,000 in 1945 in long term bonds inflation adjusted would be worth 40,000, but 100,000 in stocks would be worth today about 3.5 million. So most i nvestors who do not need the money today and have a 4-5 year time horizon should do very well in stocks. Jacob Wolinsky: Altria is a large position of yours. Is this a classic contraria n pick due to investor fear over lawsuits, higher cigarette taxes and more local

and Federal restrictions on Tobacco i.e. Banning smoking in certain places? David Dreman: I like the company. It has always been a high yielder and made us an awful lot of money over time. Tobacco companies are able to keep raising thei r prices. And they don t have as much legal liabilities because the Supreme Court has struck down a lot of these lawsuits. It has about a 6.5% yield right now and that is a very strong yield. I think tha t is a tock that will do very well, and it is a stock that is especially good fo r people who need income. Jacob Wolinsky: In General you tend to focus on larger cap stocks? David Dreman: We actually run a few funds large cap, mid caps, small caps. We ju st get the lowest price stocks wherever they are. Jacob Wolinsky: But in your book you write that you favor large cap stocks? David Dreman: Yes in general we do prefer large caps and over time they have don e very well. Some of the original statistics supporting the theory that small ca ps do well are based on flawed methodology. We won t mention the professor s name I think he is still angry at me for proving him wrong. The statistics were from the great depression. The best year for small cap stock s according to statisticians was 1932. I got curious about that because small ca p companies weren t around then. They were really large cap companies that had fal len so much in value that they were in the lower range of market capitalization. I detail all of this in my book. Jacob Wolinsky: You do not talk much about foreign investing in your books. With the emerging markets becoming a larger percentage of the world s GDP each year wo uld you recommend an investor have exposure to these countries? Are you concerne d about differing accounting factors, lack of investor protection and other conc erns in these countries? David Dreman: There are many factors to be concerned about. There is a liquidity factor also to be concerned about. The Russian market was down over 80% from it s peak. There are political factors to be concerned about. There are also legal factors and corporate law is not as strong. Compared to other countries US stocks did reasonably well in 2008. But there are other factors here. There is another factor which remains to be se en. I believe jobs are not coming back quickly and its possible 25% of jobs will never come back. I think we will look more carefully at free trade, and we will have more fair trade. There will be more political pressure to create jobs in t he United States. We can t have a nation without any manufacturing or an auto indu stry. All the higher paying jobs were being shipped out of America. You have a c omputer engineer making $8,000 or $9,000 a year versus $100,000 in the United St ates. And in one way it is very good because it makes companies very efficient b ut on the other hand it is putting people out of jobs. I think this will be a ma jor political factor in the next five years and probably even sooner. That being said I will invest in foreign stocks if I find cheap ones. However wo uld I be comfortable having 50% of my money in foreign stocks? No.

About the author: I am VP of Business Development for Sum Zero (http://sumzero.com), the largest c ommunity of buy-side analysts; consisting of over 5,900 hf and mf analysts, and over 3,600 extensive investment write-ups. I have prior experience in a value ba sed pe firm focused on PIPE transactions in micro-caps, and at a value based res earch firm, which focused on smid caps. In my personal portfolio I have outperfo rmed the market by a cumulative ~48% since 3/2008 (inception date). I can be con tacted at jacob(at)sumzero.com for sumzero related inquires. My website is http: //www.valuewalk.com/ Visit Jacob Wolinsky's Website Read No. 16 Pyrrhic Victory and Q&A with Kirk Report A Pyrrhic victory is so called after the Greek king Pyrrhus, who, after sufferin g heavy losses in defeating the Romans in 279 B.C., said to those sent to congra tulate him, Another such victory over the Romans and we are undone. Dictionary.com A quick thought on the debt-ceiling debacle. I believe that by August 2nd we ll s ee the debt ceiling increased, as the cost of not doing so is simply unknown and most likely too high. However, it will be a Pyrrhic victory for whatever side claims it, as the victory will undoubtedly undermine the world s trust in the US d ollar and its debt ($37.5 billion leaving money-market funds that invest in Trea suries in one week proves the latter point already). I analyzed Brown & Brown about a year ago (May 2010), and judging from the lates t quarter this analysis it is still very relevant today (here is a link). I was interviewed by Charles Kirk, the host of KirkReport.com. (Watercolor Mexican Shores is by my father Naum Katsenelson)

Q&A With Vitaliy Katsenelson A number of members have requested that I interview a value-focused investor wit h a longer-term time horizon. While there are many people I could choose, I thou ght it was about time I finally interviewed Vitaliy Katsenelson who fits that pr ofile. Many of you know Vitaliy from his website, Contrarian Edge, as well as hi s books on investing. While there are thousands of traders who read The Kirk Report daily, there are s till just as many who utilize longer-term approaches and who are focused on find ing value versus short-term momentum. No matter what your strategy or focus, we hope you find this interview helpful. Kirk: Hi, Vitaliy! It s great to have you here with us today. While I know many a re familiar with you and your background, please start out by telling us a littl e bit about yourself and how you began to learn about the markets and investing. Vitaliy: I was born in Murmansk, a city in northwest Russia, located above the Arctic Circle (think long winters with little daylight, intense cold and beautif ul white nights in the summer). Murmansk, on the Barents Sea, is the home of the only Russian shipping port that doesn t freeze in the wintertime. Russia had (and still has) a draft army. Though in the United States most look a t serving in the army as an honor, in Russia most parents dread the day their so ns turn 17. Not because of fear of dying in a war by the late 80s the Soviet Afgh an war was over but because serving in the army is looked upon as a prison sente nce, two or three years of lost youth. Draftees are usually sent away thousands miles away from their homes (the logic is that in case there is social unrest an

d the army brought in, soldiers more likely to use force against strangers than friends and relatives). Young soldiers are commonly abused by older ones, and th e pay afforded soldiers barely leaves them enough to buy postage stamps to write home to ask for more money. There were several ways to avoid the draft. You can fake sickness a very sane fr iend of mine spent two months in a mental institution, faking mental illness (he succeeded). Or you can run away. However, despite the enormous size of the coun try, the authorities will find you. Or you could keep constantly having kids unt il you turn 27 another friend of mine did just that. And finally and this is the most common method you can go to a college or university that has an exemption from the draft. By the time I was approaching the dreaded draft age, all universities in Murmans k had lost their draft exemption except one, Murmansk Marine College. It was a s omewhat unusual college: it accepted students after the 10th grade, and we were not usual students, we were cadets. The first three years we were required to li ve in an military-like dormitory. We wore navy uniforms, had commanding officers , walked to classes in ranks, and about twenty percent of our courses were milit ary. I hate following mindless orders till this day, and I hated every moment of bein g there. But, I was ten minutes away from my parents, and this was a much better alternative than going into the army. In other words, this was a milder version of hell. If I were to graduate I d become a mechanical engineer on a fishing or t ransport ship. I was looking ahead with horror to my graduation, because I was a bout to get into a profession that I could not stand. To say I was not motivated to study is an understatement; I barely passed every class, with the exception for one: microeconomics. I felt almost like a hidden gene was suddenly activated ; I had this intuitive understanding of the subject without opening a book. It w as the only subject that I aced. Luckily, I never had to face my worst fear of becoming a mechanical engineer bec ause, in 1991, a few months before graduation, my entire family, blessed by the genetic lottery by being Jewish, was accepted for immigration to the United Stat es (at the time, the Jackson-Vanik amendment forced Russia to allow Jews to immi grate to the US and Israel). My revelation with the economics class helped me to understand that I wanted to be a business major when we arrived here and I went to university, but it took m e a few more years to realize that I wanted to be an investor. In fact, I did no t even consider investing as a career track at first. Being an investor was not an option in the Soviet Russian culture there was no stock market! In fact, at f irst my understanding of investing was completely shaped by a Russian documentar y I watched in late 80s that showed videos of the NYSE, with people yelling and t hrowing papers around I remember that a man complained of going deaf from all th e noise. The impression I had was that the whole investing thing was like living in a really loud casino. While going to college in the US, the only employable skill I had (except my win ning smile) was my computer knowledge. To my great fortune, I landed a tech job at an investment firm. Now it sounds laughable, but the owner of the firm did no t want spend the money on a fax machine that had a multipage feeder. Yet the fir m needed to fax trade orders to multiple brokerage firms, so for the first few m onths I was the auto feeder for the fax machine. I spent several hours a day stand ing by the fax machine, feeding pages into it. The owner, who is now a good friend of mine, decided that my talents were better put to use doing something more creative, and he asked me to write a relational database. I got lucky. At the time (this is the mid 90s), Microsoft had unlimite

d technical support for its Microsoft Access product (that s not the case anymore) . I knew little about databases, but after spending three or four hours a day on the phone with Microsoft tech support (they were not in India at the time); I h ad learned Access inside and out. The database I wrote is still used to this day . While working for this investment firm I had the chance to learn what investing was truly all about (it was not about yelling and screaming, and you didn t need t o lose your hearing). Portfolio managers were happy to share their knowledge, an d I had unlimited access to a Bloomberg terminal. This is when I realized I want ed to become an investor. After that, nothing else mattered; I knew what I wante d to do. I changed my major for the sixth and final time to finance (that was th e closest thing to an investment degree at the University of Colorado at Denver) , and the rest is history. Kirk: Looking back, was there any key experience or person who was most instrum ental in your development? Vitaliy: There was frustration in the early 2000s. I started out as a GARP (Gro wth at Reasonable Price) investor. As a GARP investor you basically look for com panies that are growing earnings and trade at a fair value. This was the approac h my firm, IMA, used in the late 90s. It worked well, and we made a lot of money for our clients. However, in the early 2000s it stopped working. At first I thought this strategy had simply fallen out of favor, and then I real ized there was more to it. I was at a conference, and one of the speakers showed a chart of the Dow, going back 100-plus years. The speaker made the point that every time the Dow touched a 1 with a zero behind it the market stagnated. There was little explanation provided as to why it happened, but it sent me on a sear ch to discover the answer for myself. I did a lot of digging and realized that every prolonged (secular) bull market w as followed by a sideways market that usually lasted 15 years or so. This happen ed because stocks got overvalued at the end of secular bull markets, when their P/Es went too high they went to above-average levels, and it took time for the P /Es to contract to below average. I realized that the way we invested had to cha nge, because buying companies at fair P/Es was not going to work in this environme nt. We needed to own companies at unfairly low P/Es, the ones that traded at a d iscount to their fair value. This realization turned me in an instant into a val ue investor. I came up with the Active Value Investing approach, which spilled into my first book, Active Value Investing: Making Money in Range-Bound Markets which basicall y spells out how my firm manages money today. Last year my publisher, Wiley, ask ed me to rewrite Active Value Investing for a wider audience, and this how The L ittle Book of Sideways Markets came to life. On a personal note, as I get older I deepen my appreciation of the impact my par ents had on me. Last year I watched Man of La Mancha, a musical with Sophia Lore n and Peter O Toole, based on Miguel de Cervantes Don Quixote. I had read the book when I was a kid, but I don t think I understood its message until recently. Now I understand why this book is still read today, four hundred years later. Don Quixote, despite being delusional, saw in people more than they ever possess ed. He meets Aldonnza, a farm girl (a woman of the oldest profession ) and, either blinded by love or insanity (probably both), he sees only a lady in her, and sta rts treating her like one, calling her by another name, Ducinea. She knows that she doesn t deserve this treatment, but she starts believing him, and this belief transforms her into a different person she aspires to be the person Don Quixote sees in her. My parents were like Don Quixote: they always saw a much greater pe

rson in me, though I rarely deserved it (they really had a rich imagination); an d I tried to rise to become what they saw. Now that I m a father of two wonderful kids, I try to do the same for them. The little things we say to our kids really do matter! Kirk: That s a very inspiring story, Vitaliy. Thank you for taking the time to sh are it with us. How would you describe your current investment approach? Vitaliy: I am an active value investor. To my mind, a value investor is one who looks at stocks as businesses, not pieces of paper, and wants to own them at a discount to their fair value. Active value investing is the value investing proc ess that I created and modified for the sideways market we are in. Kirk: You ve been referred to as the next Ben Graham. Do you think that compariso n is true? Vitaliy: I almost fell off my chair when I read that praise from Forbes. It was not unlike our President receiving the Nobel Prize after being on the job for t wo weeks. Forbes comparison is very aspirational. No, I don t deserve it. Kirk: Tell us about your firm, Investment Management Associates. What do you do there what s your job at the firm? Vitaliy: IMA was started in 1979 by my partner, Michael Conn. Michael ran one o f the Founders mutual funds in the late 70s, so he started IMA as an alternative to faceless mutual funds. He figured that even though mutual funds are appropria te for people who don t have a lot of money to invest, the ones who had six figure s would benefit from custom-tailored portfolios. I joined as an employee in 1997 , later became a partner and CIO, and today the firm s investment process is the p rocess I described in the Active Value Investing book. Kirk: To your firm s credit, I really like the disclosed analytical process at th e site, which concisely lays out the quality, valuation, and growth test. Who de veloped this model and what was it based on originally? Vitaliy: I developed the QVG framework in the early 2000s. With this framework, the stock analytical process is broken up into three dimensions. The first two are Quality a company with a competitive advantage, a high return on capital, go od management, and a strong balance sheet and Growth a company that is growing e arnings and paying a dividend. If you think about it, a company that scores well in the Q and G dimensions is a good company, maybe a company you want to work f or; but only when it scores well in the third dimension, Valuation trades at a d iscount to its fair value (has a margin of safety) does it become a good stock. What is important about this framework is that it stresses the importance of int errelations between and within each dimension. In a perfect world you d love to ow n a company that aces each dimension, but the world is not perfect and it is ver y difficult to fill a portfolio with companies that meet all QVG criteria with f lying colors. So you need to compromise. For instance, if a company that is grow ing earnings at a slow rate and pays only a small dividend, there needs to a hig her margin of safety, because a larger portion of the return will come from the company s valuation reverting towards the mean. A company that has a volatile busi ness a fashion retailer, for instance needs to have a super-strong balance sheet , etc. Kirk: How do you find companies that are able to pass this QVG test? Do you uti lize any screening or filtering methods, or do other types of research?

Vitaliy: I try to use every tool possible. After all why limit yourself? I scre en for stocks. I have a watch list of several hundred companies that I ve looked a t and decided to pass on because of valuation. I set a target P/E and wait. Over the years I ve met a lot of value investors, and I was able to make a lot of friends. I talk to a few dozen of them on a semi-regular basis, and we share ide as (it goes both ways). I look at the portfolio holdings of investors I admire. I try to figure out why they bought or sold stocks. But I never buy a stock just because they bought it; I have to come to the buy conclusion through my own in-de pth research. I also read value investing letters, blogs, and mainstream media (though I find it less helpful in generating new ideas). The popularity of ETFs has created ano ther good source of ideas. I track a few dozen sector ETFs this way I can see wh at sectors are doing well or poorly. If I see a sector getting beat up, I start digging deeper in it looking for value. Amazingly, I find Twitter a good source of news/articles on investing. I strictl y use it for that purpose, and I share articles that I find interesting. You can follow me here. Kirk: As a teaching example, please go through the process you went through for a previously closed-out, successful investment. Start by telling us how you fou nd the investment, the decision-making process you went through to evaluate it, how long you held it, and finally what caused you to close out. Vitaliy: Early this year we bought Electronic Arts. I ve followed EA for a long t ime, but it suffered from the too successful company syndrome: it had a very large market share in the gaming industry and was very profitable. It lost focus, had too many titles, the quality of its games declined, costs ballooned, etc. The n ew CEO admitted to the problems a very important first step and then laid out an action plan: they killed a few titles, cut costs, improved quality etc. EA required a little bit of imagination. Statistically it did not look cheap, ma ybe it was fairly valued at best. But if you looked at its close competitor Acti vision (ATVI), whose sales were about the same as EA s, you saw that its profits w ere much higher (due to better margins). You could have said, well, if EA closes the margin gap, partially due to what management is doing, then EA is cheap. We bought EA under 16, it reported good numbers, improved margins, and the stock w ent up to the low end of our valuation target, so we sold it at about $24 in the second quarter. Kirk: Excellent. This shows the value not only in monitoring relative valuation , but also how important it is to compare companies with their direct competitor s. Please take us through one of your worst investments recently. Vitaliy: Nokia was by far the worst investment. We first bought in 2004, when N okia had missed the flip phone craze. We started buying it in the low teens, and then the company came out with good flip phones, earnings went up, and we sold it in late 2007 in the high $30s. In 2008 Nokia stock declined to the low $20s. We figured its earnings power was about $2 or $3. Its telecom equipment business was losing money, and we thought that if they shut it down or simply got it to breakeven, earnings would improve. So we jumped back in. The iPhone should have been a blessing for Nokia; it showed what phones of the f uture would look like. But Nokia was too successful and far removed from the US

to understand how important the iPhone product was. We gave the company the bene fit of the doubt at first they were the largest cell-phone company in the world, and they had missed product cycles in the past but the signs were there if you chose to see them: They grossly overpaid for Navteq. They came out with a music phone, which was basically a semi-dumb phone with a music service. Then they wer e desperately trying to take Symbian, an operating system that did a marvelous j ob running Nokia s dumb phone, and make it into something it could not be, a smart -phone operating system. We were already thinking of throwing in the towel on Nokia, but then it announce d a partnership with Intel to develop a brand-new, Linux-based operating system, MeeGo. It made perfect sense; MeeGo would not be burdened by the code that had been written for dumb phones. We decided to wait and see. The old CEO was fired, and Stephen Elop, a Microsoft executive, was brought in a s CEO. It seemed that things were getting brighter. However, knowing what I know now, I truly believe that Mr. Elop was the worst thing that ever happened to No kia and one of the best things that had happened to Microsoft for a long time. E lop announced that Nokia would abandon both Symbian and MeeGo and start making c ell phones to run exclusively under the Microsoft Windows OS. With this move, No kia went from being an Apple-like business that could differentiate itself from competitors because it controlled software and hardware and commanding low-teen profit margins (Apple s margins are actually pushing the low 20s now), to a Dell-l ike company with net margins of 5% in a good year. Though the Windows decision may have benefited Nokia in the short run, in the lo ng run it reminded me what IBM did with Microsoft in the 80s: it saw little value in the software and went after the hardware business. Cell-phone hardware will become ubiquitous in a few years and Nokia will be competing on price and manufa cturing efficiency with its rivals. Microsoft on the other hand will get Windows installed on a huge number of phones, and it will benefit from Nokia s enormous d istribution system. And it only cost Microsoft a billion or two. When this annou ncement was made the market rightfully punished Nokia stock, and we got out at a round $8. Mr. Elop s actions have the smell of being a double-agent for Microsoft. He said t hat neither Symbian nor MeeGo were ready for primetime; by the time they d be read y the party would be over, and it would be too late for Nokia to have a relevant product. When I heard that I thought, well, he must be right; after all, he is the CEO; he gets to see Symbian and MeeGo firsthand. However, a few weeks ago No kia came out with the N9, its newest MeeGo phone. What is shocking is that it is an incredible, iPhone-worthy phone. After seeing this phone, Elop s decision to k ill MeeGo-based phones makes no sense. I try to learn as much as I can from my mistakes, so they don t go to waste. In th is case, I let our success with Nokia the first time around cloud my judgment. Kirk: I think we ve all been there at one time or the other. The key, as you say, is to learn from your mistakes. What would you say is your average hold time for individual stock positions? Vitaliy: We look for about a 50% upside when we buy a stock. If it takes a week for that to happen, then so be it, we ll sell it (it never happened to me yet, an d if it did it would be sheer luck). We hold stocks for months and years. Kirk: Looking back over the first half of 2011, what have been your best perfor mers to date? Vitaliy: Electronic Arts and United Health.

Kirk: Without disclosing your entire book, can you take us through a few compan ies that match what you look for and that you think offer excellent upside poten tial? Vitaliy: Computer Sciences and Xerox look very interesting. Both are not high g rowers (especially Xerox), but this is the case when an insanely low valuation ( free cash-flow yield is greater than 13%), a stable and slightly growing top lin e, combined with management willing to buy a lot of stock, creates enormous shar eholder value. Both companies generate huge free cash flows. Xerox announced the y ll start buying stock back in September, and Computer Sciences as soon as they f ile financials with the SEC (they were delayed in filing due to a $50 million ac counting irregularity in one of their subsidiaries, but this is a company that h as $16 billion in revenues). Kirk: On a sector basis where is the most value to be found in this market? Vitaliy: High-quality, noncyclical, or slightly cyclical large companies are th e most attractive asset class. Think J&J, Medtronic, Microsoft, Cisco etc. Inter estingly, these companies are labeled as value traps. I believe they should be c alled growth traps instead. The distinction is very important. Their stocks have g one nowhere in a decade or so, so they were a trap, but not because their earnin gs have stagnated or declined. Earnings in most cases tripled for each company, but their valuations (i.e., P/E s) declined from unreasonably high levels in the late 90s to current insanely low levels. Their earnings growth going forward will be lower than it was over the last decade they are much larger companies today but they ll still have growth. Cu rrent valuation is factoring in declines, but that is an unlikely scenario. Kirk: Where do you think there are real value traps to avoid in this market? Vitaliy: Most value traps I see today are in the highly cyclical companies whos e revenues are driven by rises in demand for industrial commodities. I ve written a lot about it, but to sum up in a few sentences, I believe China is in the mids t of an over-investment bubble of enormous proportions that will make our real e state bubble look like child s play. Once it bursts, demand for industrial commodi ties and heavy equipment will drop off substantially. Companies that benefited t remendously from the bubble will become its casualties. Take Caterpillar, for instance. It is trading at 15 times earnings, but if you l ook at projections of CAT s earnings for 2014-2015, it trades at more like at 8x t imes. Cheap, right? The problem is that CAT s revenue is expected to double from t he height of the 2007 bubble, and its margins that are hitting all-time highs to day are expected to rise further. China is responsible for all incremental deman d for industrial commodities; and as the Chinese economy stops growing and likel y starts contracting, CAT will experience what the new normal means for the glob al economy. Its revenues will decline and profit margins will come back to earth . Suddenly investors will discover that CAT earnings power is $2 or $3 a share, not $6 or $12, and at over $100 CAT will be a value trap. The spillover effect of the Chinese bubble is huge. Think of countries that are heavily dependent on commodity exports, like Australia, Brazil, Canada, and many others that are currently primary beneficiaries of what is transpiring in China . They will suffer as well. For instance, 25% of Australian exports go to China today, up from 5% a decade ago. CAT is just one illustrative example, but if you think about the primary and secondary beneficiaries of unsustainable Chinese de mand for commodities, the large list of stocks that were rocking and rolling ove r the last few years suddenly doesn t look very appealing.

I ve written a lot on China for those interested in learning more. Kirk: That s very interesting. I m curious do you currently see the U.S. market as undervalued, fairly valued, or overvalued, and why? Vitaliy: Well, statistically, if you look at forward earnings the market is che ap, but only statistically. Corporate profit margins are hitting all-time highs. Historically, profit margins have been mean-reverting creatures: they have neve r stayed at above-average levels for long. The reason is simple: when a company starts making excess profits, competition waltzes in and starts offering a produ ct at a lower price, driving profit margins down. To assess true cheapness of th e stock market, one should look at price divided by ten-year trailing earnings. This ratio normalizes data for cyclicality (volatility) of profit margins and te lls a much different story: stocks are not cheap at all, and in fact trade at ov er 40% above average valuations. This article explains this point in greater det ail. Kirk: How does the performance of the overall market impact your analysis or de cision-making process? Vitaliy: So far, believe it or not, the market is performing by the sideways/ran ge-bound market playbook. A secular sideways market is full of cyclical (short-te rm) bull and bear markets the last, 1966-1982 sideways market had a half a dozen of each. Since 2000, that is when the current sideways market commenced, we had a cyclical bear, a bull, a bear, and a bull again; but we are still not far fro m where we started, and valuations are still high. However, the Great Recession may have increased the duration of this sideways ma rket. Let me explain. Sideways markets are really a drama of two opposing forces : growing earnings and declining P/Es. It is really the earnings growth that get s us out of sideways markets. Stock prices in general, though volatile, remain t he same but earnings growth compresses P/Es from above- to below-average. GDP growth for the first two-thirds of past decade was supersized by increased c onsumer leverage: people spent money they did not have to buy things. Now it s pay back time. It is not unreasonable to expect that consumer deleveraging will slow down econo mic growth. At some point in the not-so-distant future, our government will have to join the deleveraging party, which will further slowdown economic growth. In addition, high government indebtness should lead to higher taxation and/or high er interest rates both are detrimental to economic growth. So if you assume economic growth going forward will be a few points below that o f the past, then this sideways market will likely last longer. In the long run, GDP growth equals earnings growth. I know we d like to think that the economy s earn ings can grow at a faster rate than the economy (this would require always-risin g profit margins), but historically that has not been the case. From our decision-making process, we are presently very defensive in our stock s election. Kirk: I can understand why, given those keen observations. In my experience, many value-focused investors have an exceptionally tough time knowing when they are wrong in a position or have been caught in a so-called val ue trap. How do you manage risk when you re wrong? Vitaliy: You bring up an excellent point. A value trap is the value investor s ve rsion of hell. A value trap is when you buy something that is seemingly (usually

statistically) cheap, but earnings/cash flow collapses, and suddenly it is not cheap anymore. There is only one way to avoid a value trap through analysis. There is no magic to it. Borders looked cheap until the last day of its existence. Also, you need to be willing to walk away from a stock and say, I don t know, I don t understand. let s be realistic: an occasional visit to that hell is unavoidable; you just wan t to minimize the damage it inflicts on your portfolio. Kirk: What is the best way to spot a value trap? Vitaliy: I ve been thinking about value traps a lot since our VALUEx Vail confere nce. The easiest one is where you see a tectonic shift for example, the Internet s impact on book and music stores and the newspaper industry. It is extremely dif ficult for a company to adapt to this type of transformation, as it requires und ercutting its current, very profitable business for a future though yet unprofit able one. We know the obvious examples of value traps, but there have also been a few successes: Amazon did a terrific job with Kindle and Netflix with its vide o streaming. Best Buy stock now has the smell of a value trap. Consumers today are equipped w ith smart phones that allow them to scan the barcode of a large-screen TV and ge t comparative prices from on- and offline retailers in a second. Online retailer s offer better selection and often better prices. So to some degree Best Buy is becoming a free showroom for Amazon and the likes. Unless Best Buy s management is thinking how they ll drastically transform their business, it may turn into a val ue trap. Kirk: Would you say that value-focused investing is more challenging to learn t han other approaches? Why or why not? Vitaliy: In theory value investing is easy you buy stocks when they are cheap a nd sell when they are loved. It is not difficult to learn how to value stocks. H owever, the difficult part is the psychology. You are usually buying stocks that everyone hates, so you need to have the confidence to stick with your convictio ns when the crowd disagrees with you, and have the humility to change your mind when you are wrong. My mistake with Nokia was a psychological one, not a valuati on one. Kirk: Is it realistic to suggest that individual investors have what it takes t o do the type of homework you and other professionals do, without a CFA? Vitaliy: In short the answer is YES.

But

I am a Chartered Financial Analyst, and I learned a lot from going through the C FA program (as well as from getting two finance degrees); but the problem with t he CFA program is that half your time is wasted on useless concepts, and since t here is an exam, the program also requires you to be a good test taker (I was ne ver good at that). It is probably still the most relevant program if you want to be an investor; bu t in all honesty, you can take the CFA curriculum, pick relevant subjects, e.g. economics, accounting, valuation (excluding Modern Portfolio Theory), statistics , behavioral finance, and derivatives, and study them on your own and just not w orry about taking the exam. You ll learn a lot, won t waste your time on irrelevant academic and politically correct topics like ethics (all you need to know is to always put clients interests first, and err on the side of the perception of wron g doing vs. legality. When people trust you with their life savings, you never w ant them to question your true motives).

But that would be just a start. Then you d want to read a lot on value investing ( books, blogs, newsletters/interviews, presentations, etc.) and finally, take as much money as you could afford to lose and start investing. Paraphrasing Charlie Munger, learning about investing only from books is like le arning about sex from romantic novels. Kirk: The same can be said about trading. LOL! So, if the average individual investor with some experience desired to learn how to quickly ascertain the fair value of any stock, what method would you recommend they learn first? Vitaliy: To value a stock you first really need to understand the business; you need to understand what makes the business tick. The valuation is the easy part . Any model is as good as the inputs that go into it, so if you don t understand t he business you may come up with a precise value that is precisely wrong. I try to come up with a range of values, using different tools. Some valuations tools are more appropriate to one industry vs. another. For inst ance, book value is an appropriate and useful tool when you value insurance stoc ks, but it s worthless when you value software companies. My favorite tool is disc ounted cash-flow analysis. It s a very crude, extremely imprecise tool, which will spit out a precise number. But I like to use it, the process of building a discounted cash-flow model help s me to understand the company better; it directs me to what variables have the largest impact on the company s value, etc. It is usually very helpful at the extr emes, when a company is extremely undervalued or ridiculously overvalued. It wou ld have kept you away from CSCO in the late 90s, and probably give you the confid ence to own CSCO today. Kirk: How do you go about ascertaining a company s earnings quality? Do you have a quick trick to share in this regard? Vitaliy: The best way to assess a company s earnings quality is to look at its ca sh flows. For every company in our portfolio, we come up with a cash earnings po wer, which is really normalized free cash flows (cash flows will always be more volatile than earnings, since earnings use a lot of accounting accruals that ten d to smooth them). Cash flows are lumpier but tell a more accurate story of a co mpany s true earnings power. You want to adjust cash flows for benefits from issui ng stock options; they actually increase operating cash flows. Also, a lot of co mpanies now have underfunded pension liabilities; you want to nick their cash fl ow for that liability. Also, a company that has a high recurrence of revenues will usually be less vola tile and have more stable earnings/cash flows. Kirk: Do you have books, websites, etc. to recommend to those who wish to learn value-focused investing? Vitaliy: Here is my recommended book list. Gurufocus.com is probably one of the better websites on value investing. It has a lot of articles on value investing and also shows you the holdings of gurus. Val ue Investing Letter is also another good source of articles on value investing. I also like Whale Wisdom to look at positions of other value investors I respect who may not be followed by Gurufocus. Kirk: In The Little Book of Sideways Markets you offer the view that we are tra

pped in a sideways market. First off, what would change your view in this regard ? Vitaliy: After I wrote Active Value Investing I realized that I had inadvertent ly created a market cycle framework in which you could plug in your own assumpti ons and draw your own conclusions about the future long-term direction of the US stock market. Both secular sideways and secular bear markets took place after s ecular bull markets. However, the wild card that determined if it was a bear or a sideways market was the economy. Nominal earnings grew during sideways markets and declined during bear markets. If nominal earnings/economic growth over the next decade are negative, then our current sideways markets will spill into a be ar market. The chances of a secular bull market arising out of our current very high (if your normalize margins) valuations are extremely low. Kirk: Thanks so much, Vitaliy! Your perspectives offer a lot to consider and we appreciate your willingness to share them. Good luck with the rest of 2011! Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Managemen t Associates in Denver, Colo. He is the author of The Little Book of Sideways M arkets (Wiley, December 2010). To receive Vitaliy s future articles by email, cli ck here or read his articles here. Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private inves tors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson s Active Value Investing (Wiley, 2007) book. Copyright Vitaliy N. Katsenelson 2011. This article may be republished only in its entirety and without modifications. Read No. 17 Contrarian Investor Forbes: Thank you for being with us, Robert. Robert Kleinschmidt: Nice to be here. Move up Move down Video: Expert Investors On Saving For Retirement Video: William Rhodes, Banker To The World Video: Protect Your Portfolio From The 3-D Hurricane Forbes: You re called a contrarian investor. Is that any different from a value i nvestor? How do you define your discipline for the market? Kleinschmidt: Well, I think it is a little bit different than a value investor. We certainly have a value orientation and we look for value when we re investigat ing stocks. But as a contrarian, we re looking to be away from the consensus poin t of view. In our case, certainly in my case, that also fits my personality. So it s not only what I believe from an investment point of view Forbes: Are you a troublemaker? Kleinschmidt: I was an authority-resistant troublemaker, exactly. But I rather firmly believe that the consensus, more or less, gets priced into the market. S o it s very hard to make money if you re in the consensus; that s basically what the p rices in the market are reflecting. And the consensus very often is correct; it s not that it s always wrong. But it s very hard to make money from that point of vie w.

So what we try to do is we try to take a point of view that s contrary to the cons ensus and then build a value case behind it that is convincing to us, so that we can believe that the consensus over time will change and come around to our poi nt of view. In that way, we think we re eliminating most of the risk to equity investing, or a t least a great deal of it. And we re positioning ourselves to make some money if the consensus goes our way. It s not so much the contrarian as it is that we want to be opposite or away from where the consensus view is.Distinction Metrics Forbes: So what screens or metrics do you use? How do you find these securities ? You make the distinction between large stocks and small-cap, mid-cap stocks. Kleinschmidt: Right. Forbes: Define the metrics for both of them. Kleinschmidt: Well, the larger-cap stock are easier to find. It s not hard to det ermine what the consensus point of view is on larger-cap stocks. So we normally have a lot more large-cap names in our portfolio than we have smaller-caps and mid-caps, where it isn t so immediately apparent. In the case of the smaller names, it s not so much as being out of favor as it is being ignored or investor ennui that we re playing against. With the large-cap na mes you only have to open up the newspaper or turn on the television set to know what is currently not in favor and where the consensus point of view is negativ e. And so that s the way I do it. We have analysts that use screens the new low list is a pretty good screen that I tend to look at. And there are any number of re al techniques. But I think that the ideas for real investment managers come out of the ether. They re floating around and you can find them. Forbes: How dare you say that. Kleinschmidt: Yeah. It s true though, it s true. I used to do screens. I used to d o them in the early days. And I found that what appeared on the screens were ex actly the names that I expected were going to appear on the screens once I laid out the criteria. Once you start laying out the criteria, you can pretty much predetermine what s go ing to end up on other side of that process. So I don t use them, but I know our analysts do and I know that some of the work that they do comes as a result of s creening. Forbes: How many issues would you have? You personally manage plus in the fund $2 billion, $2.5 billion? with $12 billion

Kleinschmidt: Yes. The group that I oversee manages about $2 billion, $2.5 billi on. Probably closer to $2 billion today, closer to $2.5 billion a couple of week s ago. We will have about 50 names in the portfolio. And the largest names wil l be in the 3%, 3.5% range. And we ll have the smaller name might go as low as a .5%. Forbes: Now, you make it a discipline that nothing can get bigger than, say, 4% or 5%? Kleinschmidt: Yes. And the reason for that is really risk. I have seen too man y good companies, good stocks, fall out of bed as a result of something that cam e in out of left field that nobody expected. The one example I like to use is w

hen Merck announced that they were pulling Vioxx off the market. Merck is a $55 stock, and then you woke up and it was a $30 stock. There was no way of predicting that that was going to happen. Wall Street didn t have any not ion that that was going to happen. But if you owned, as a couple of my nondiscr etionary clients did at that time, a disproportionately large position in Merck, you re going to get hurt. So I m willing to give up some of the upside that can occur when you have an outsi zed position in order to buy more risk prevention in the event that something th at you own has a hiccup that you couldn t possibly foresee. And you want that to have as minor an impact on the portfolio as possible. So 3%, 3.5%, up to 4%, I think, is about the limit that we use. Forbes: Now, some of measurements you use free cash flow yields. How do you come up with that number? What s the big number? Kleinschmidt: These days it s specific to specific situations, right? You re willin g to have a lower free cash flow yield for certain types of companies companies that are growing more rapidly or companies that are actually spending money in t he right way to grow their business. But these days, in a zero interest rate world, if you can see free cash flow yie lds of 7%, 8%, 9%, 10%, that s pretty attractive, I think. And so we do look at t hat, and that falls out of models that the analysts compile for the investment c ommittee. The Market Has Become A Paper Game Forbes: Now, one of the points you make on that is that Wall Street has too much of a short-term orientation. And that you feel that investors should look at t hese companies as you do, as if they were private. Don t get hung up in the price, because there s good value there that you d want if it was a private company. Kleinschmidt: Well, I think that s what investing is, really. It became, over the last many years, sort of a paper game or a casino game where people thought mor e about stocks than they thought about the underlying companies. But I think if you re were an entrepreneur or a private individual and owned, say, a hotel compa ny and a paper company and an oil well and a movie company, just to pick, you wo uldn t necessarily sell those companies just because the next six months didn t look so good for that industry, right? If they were good companies, you d hunker down and you d do something to get through that period. And if they were good, long-term investments, you d want to hold th em. Well, it seems to me that the Wall Street focus is really on the next three to six months or so. And the recommendations are based on the near-term outloo k for companies. And as an investor, as a private investor, the near-term outlook for companies i s only instructive if it is an indication of what the long-term outlook for comp anies are. And if it s just the near-term outlook, what do you care? So we try t o use those situations as buying opportunities in stocks that we like. Enterprise Value and EBITDA Forbes: Now, another metric you have is enterprise value and EBITDA. Kleinschmidt: Right. Forbes: Could you describe that?

Kleinschmidt: I will. But first I m going to make a wild claim, which is that I t hink I invented this approach. Because back when I first started out in Wall St reet in the 70s Forbes: Have you patented it? Kleinschmidt: No. But nobody was using this. In 1970s, people never talked abou t enterprise value versus EBITDA or versus earnings or versus any other metric. It was always Price/Earnings ratios. And it seemed to me that you had to add i n the debt and you had to take a look at the whole capital structure when you we re comparing two companies. What enterprise value is, is we take the market value of the equity, and we also take the market value of the debt securities and the other things in the capita l structure. And that gives you what the market collectively is valuing the com pany at. Then we divide that by pretax earnings and we also divide that by pretax cash fl ow, which includes depreciation, to get a sense of how the market is valuing the company. And it is one of a number of metrics that we use looking at names. I t s not dispositive, but it s very helpful. Missing Momentum Forbes: Now, in terms of patience or finding these things. Some say, Well, the di scipline should be momentum. When something is riding you, you ride with it and go with it. Do you feel you obviously you don t but explain how you don t miss a lo t of opportunities. Kleinschmidt: Well, I do miss a lot of opportunities, don t get me wrong. And on both sides. And we probably miss more by selling too early than we do on the bu y-side. But look, momentum there are guys who know how to do it, I presume. An d people have made fortunes doing it. It s not what we know how to do. Momentum is much more a function of looking at stocks, rather than looking at underlying companies. When you re buying momentum or selling momentum, you re not doing it on the basis of the underlying fundamentals of a business. It s more of a trading strategy than it is an investment strategy. And we re investors. Forbes: So, Microsoft. You still have Microsoft? Kleinschmidt: I do have Microsoft. Forbes: You put it in when you were born. Kleinschmidt: No, I wasn t smart enough to do that. But I did buy it several year s ago, probably in the mid-2000s, when it was already down considerably from whe re it was. This is an interesting story, because the way we looked at that comp any, and the way we came up with the value for that company, is we sat around th e room and said, What if we owned it? What if this wasn t a public company? What if we owned it? What would we do? Or, What if we managed it and it was a closely held company? What would we do? Thi s was about the time that Disney had floated a 100-year bond and somebody else h ad floated a 100-year bond. And we said, You know what? We would borrow $100 bil lion on a 100-year bond and pay it out to the shareholders. And we d do a leverag ed recap with this company, because it generates a tremendous amount of cash. A nd debt is cheap. It was cheap

Forbes: Would you do the same thing to Apple? Kleinschmidt: Yeah, I might do the same thing to Apple today. But the only diff erence is that the debt is cheaper today than it was. Had I done it then, I d wish I would ve waited. But the point is that looked at from the point of view of a p rivate owner or an entrepreneur, it looked and we didn t expect Microsoft to do thi s. But it was a way of getting a notion of what s the underlying value here. If you really could do what you wanted to do, how much money could you make? And I thi nk that s still true with Microsoft. They still generate a lot of cash. They sti ll have very high returns. They still have a dominant market share. Things are changing, but they re not exactly sitting on their hands. They know th at things are changing as well. And its stock trades at less than ten times ear nings, and probably closer to eight times earnings if you subtract out the cash. If you can buy a company like that privately for eight times earnings that s gene rating 20% ROEs and generating cash, you d do it in a second. You would never think to ask twice about what the stock price was. You d just wan t to own that company. So that is, I think, the better way to look at long-term investment. And it leads you to companies like Microsoft, which can be out of favor. Microsoft s been out of favor for a long time. Keeping Emotions Out Forbes: How do you keep emotions out? Kleinschmidt: I think that s probably the key question, Steve. I think that when people hire a money manager, they may think that they re hiring them for performan ce. But what they re really doing is they re hiring them to put a barrier between t he market and their own emotions, right? Because people do make emotionally inc orrect decisions during particularly big swings in the market. And what you want a money manager for, I think, is to keep you from making those wrong decisions of buying at the top and selling at the bottom. We re human. But keeping emotions out of the investment decision is the single most important th ing. And probably the best way to do it is to look at individual companies rath er than looking at the market as a whole. Because the market as a whole is real ly subject to these emotional swings. But individual companies there, their num bers Forbes: You still believe that the market fluctuations day to day have absolutel y nothing to do with underlying fundamentals? Kleinschmidt: They might not. They might, but who s smart enough to know that? B ut what you can know is you can look at a company, you can look at their market share, you can look at their returns, you can look at their balance sheet, you c an look at their cash flow, and you make pretty unemotional decisions about that . It s much easier to make an unemotional decision about that than it is to make about big swings in the market like we re having today. Forbes: Now, talking about human nature. It s human nature to hire managers who ar e on a good streak and to avoid those who may have a rough patch but a disciplin e that holds up in the long-term. How do you deal with clients on that? Kleinschmidt: Well, that s more of an institutional thing. And we do have an inst itutional business. And I think the institutions are under a lot of pressure as well. The guys that generally are making the decisions for the institutions ar

e not the guys who intend to stay in that position very long. They hope to go o n to become the chief financial officer, maybe even the CEO. So their pension p lans, for example Forbes: A ticket to be punched. Kleinschmidt: Well, it is. Their pension, it s exactly a ticket to be punched. T hose pension plans can be a negative for these guys, but it s really rare that the y can actually be a positive, right? They re not going to get credit. If the mar ket goes up and their pension plan goes up, the guy that s overseeing that isn t goi ng to get a lot of credit. But he will surely get a lot of blame if the business goes the other way. So it is tough to deal with those guys. I d much prefer the high net worth business to the institutional business. But on the other hand, the institutional business is a big part of our firm. We just tell our story, and they either get it or the y don t. And if they don t, then they would be better off with somebody else, I thi nk. Most of our relationships are very long-term, even on the institutional sid es. Are You Going To Spend This Money? Forbes: Now, you have a great question you asked. I guess you can do with indivi duals if somebody wants to take money out and you think it s emotional. Are you g oing to spend this money? Kleinschmidt: Right. Forbes: Explain. Kleinschmidt: Well, that s the in the first place, to invest investable funds? Or is this o, three, four years? Because first question I ask when they bring it to the firm the money. I ask them, Are these really long-term something you intend to spend in the next one, tw if you do, you re just gambling.

Nobody can tell you what the market s going to be like over a two, three, four yea r period. And similarly, when people say they want to sell because they re worrie d about the market, you ask the question, Well, what are you going to do with the money? Are you going to spend it? If you re going to spend it, fine. It s too ba d that you didn t sell it earlier, but if you re going to spend it, fine. If you re taking it out because you think that you re going to be smart enough to pu t it back in when it s the right time, then you re really fooling yourself. Because then you ve got to be right twice and then emotions do come in because you ll be af raid to put the money back in because you ll be worried about the market and the m arket will come up and you ll still be worried. And then you ll think that you miss ed it. And finally when you reached the point where you were confident enough to put th e money back in again, you ve already missed a great deal of the move. And you ma y be putting it back in at the top. So don t try to outguess the general directio n of the market. The amount of money that you should have invested is in money that you firmly believe is your patrimony. It s your long-term investible funds. It s not there for a short period of time or a relatively short period of time so that you can then buy an apartment, or then buy a car, then buy a boat. If that s the case, keep it out in the first place. Lessons From 2008

Forbes: Now, what lessons did you learn in 2008, 2009? When the things that loo ked contrary and cheap Fannie Mae, Freddie Mac? Kleinschmidt: Yeah, those are two good examples. Fannie Mae, particularly and t o a lesser extent, AIG, which are the two that we got hurt in. For me, that s a v ery sensitive issue. Because I think that there was something of a sea change i n my perception of the relationship between myself as a citizen and as an invest or and the United States government. I remember the Friday that Paulson, after the market closed, announced the natio nalization of Fannie and Freddie. And what I remember about that day very disti nctly is that Fannie was selling at $9 a share, Freddie was selling at $9 a shar e, Lehman Brothers was selling at $25, $26 a share, and AIG was at $32 a share. That s the Friday before r the market closed that to be nationalized. The e following Tuesday, AIG any announcement was made. An announcement was made afte Fannie was going to be nationalized, Freddie was going following Friday, Lehman Brothers was bankrupt. And th needed to be bailed out.

So what I learned is that the power of bad government policy to do great damage to asset values is something that I had historically underestimated. And that I had to pay more attention to what was going on politically not on a case by cas e, stock by stock basis, but just in terms of the general, overall investor perc eption or investor environment. And I think that was a very painful lesson to l earn. But it s a lesson that we need to pay attention to today. P/E Ratios Forbes: Being we get to that, you think that PE ratios are adequately priced tod ay, so to speak? Kleinschmidt: I think stocks are reasonably cheap today. I think that, all othe r things being equal, there is probably a reason that they re cheap. But I see lo ts of values in the marketplace. Our top five positions are also in at ten time s or less earnings. Now, it s a low interest rate environment and the interest rates could go higher. But ten times earnings or eight times earnings or nine times earnings when the risk free rate is less than 50 basis points is pretty attractive. Are We Living In Argentina? Forbes: Talking briefly about the environment we re in, which sometimes seems like Argentina rather than the United States of America Kleinschmidt: Argentina circa 1907. Forbes: Yes. Or even 1927. How do you see things going now, looking at the broad er environment? Kleinschmidt: I think that the ust the United States, but let not at the point where it can o think that the measures that ian and will be difficult. physical situation in the United States and not j s stay with the United States for the time being it s t be fixed. I do think it can be fixed. But I als are going to be required to fix it will be dracon

And it signals to me and this is, I think, true with Europe as well we re really s eeing sort of the logical end of the welfare state. The welfare state, as we kn ow it, has to change, if for no other reason than for demographic reasons. You had this big ball going through the snake, and that big ball was paying for the

relatively little amount of people that were over here. And all of a sudden that big ball, the baby boomers, are going from being the pa yers of the welfare state to the consumers of the welfare state. And there s just not another big ball on this side to pay for them. That s true all over the deve loped world, but it s really true here. So regardless of how you feel about these programs, whether you think they re good or bad or whatever, they re not going to b e affordable. They re just not. And so politicians and leaders are going to have to deal with i t. And they can either deal with it poorly or well. And under any set of circu mstances, even if they do everything right, if we have an increase in interest r ates to more normal levels, the savings that we might get by dealing with these problems is going to get eaten up by their at the cost of servicing the debt. So there are real problems. I m not at all bullish on sovereign debt, and haven t be en for some period of time. And for that matter, on paper currencies. Gold, Gold, Gold Forbes: Well that gets to the stocks that you like right now. Newmont Mining sti ll? Kleinschmidt: Newmont Mining is probably the largest position in house. It s not necessarily the best-run gold company, but it s one of the biggest and it s getting better. And we think that their management s getting much more cautious about the way they deploy their cash. That s a very good way it s good proxy for the entire i ndustry. But it s a very good way to protect yourself against the fiat currencies. And so that is, I think, the largest position in house for the firm. And it s lagged beh ind the price of gold as all the big miners have, by the way. Forbes: Why is that? Kleinschmidt: Well, I used to be an oil analyst. And what would happen with the oil stocks is that they would lag behind oil price increases as well, because t he general market would feel that oil prices Forbes: Can t last? Kleinschmidt: Yeah, can t last. And they re going to come down. And I think that s wh at s going on with the gold names now. If gold stays at these levels for any leng th of time though, I think you could see a big catch-up in the gold miners. Onc e people begin to believe that it s for real. And recently and I wouldn t necessarily say that this is a long-term trend but rec ently you ve had the gold price going up with oil prices going down. And oil pric es are a pretty good proxy for miners costs. Because during a lot of this bull m arket run in gold, the cost of mining has gone up almost at the same pace as the cost of gold. So they re making more money, but their margins haven t gotten a lot better. If we stay for any length of time with high gold prices and lower oil prices, the miners are going to begin coining money. So that s a good name, I thi nk, to own. Forbes: Does that mean gold s a bubble? Because usually oil and gold, just over t ime, are closely related. Kleinschmidt: Well, I don t think it s a bubble, because I think that gold is a logi cal alternative to people who were worried about the government s ability to manag e their finances. And if you look at some of the major currencies the yen and t

he euro and the dollar

they re all in serious trouble.

And with little prospect of fixing themselves quickly. There are things that ca n be done, but it s going to be tough. So gold represents a pretty decent store o f value it seems to me, compared to those currencies. And I m not in any hurry to sell my gold just because it s reached $1,800 an ounce. Forbes: Boy. Kleinschmidt: The example I love to give is that back in the 1980s, early 1980s, when gold reached $800 an ounce, there was maybe this much gold above ground. And gold adds about 1%-1.5% a year to its stock. So over the last 30 or 40 year s or so, 1.5% will double I guess, the rule of 70 it ll take about 50 years or so for it to double. So 50 years later, the pile of gold is this much higher, it s tw ice as high as it was. Meanwhile, the pile of paper money into which gold is priced is whatever it was in 1980, where is it now? It s above the Empire State Building. So there s no rati onal price that you can come up for gold and say, Well, at $1,800 it s overvalued. Based on just the relationship between gold and the amount of paper currency in circulation in the last 40 years or so, it could be any price. It could be $15, 000 an ounce. So it s really a function of what people think this big pile of pap er currency is worth. Hot Stocks Forbes: What other stocks are you buying? Kleinschmidt: Well, I just bought this won t sound very adventuresome but I just b ought Exxon in the market break, the last week or so, under $70 a share. I thin k Exxon is a terrific company and very well run and very intelligent users of ca pital. And I don t think that people will stop using the oil and/or particularly natural gas any time in the near future. Move up Move down Video: Expert Investors On Saving For Retirement Video: William Rhodes, Banker To The World Video: Protect Your Portfolio From The 3-D Hurricane I bought Ford Motor Company in the recent break, under $10 a share. Ford is the one auto company that didn t require government assistance, a company that s done v ery well over the past two or three years or so, in what can only be characteriz ed as a very lackluster economy and a very lackluster auto market. They certainly would be a beneficiary of a weaker dollar compared to the yen or the euro, as an example. So I thought that was a well-run company and at a good price. We own, as I mentioned, Microsoft is a large position for us. I own a company called NextEra Energy, which is the old Florida Power and Light. And I like that a lot because I think that one way or another, baby boomers are going to find their way into Florida. Forbes: If only because they don t have state income tax. Kleinschmidt: That s right. That s exactly right. And I think that if you re going t o invest in the utility industry and it s an area that intrigues me but if you re go ing to invest in it, you want to be invested in areas where you re going to see ra te base growth. Because that s the only way they can really make any money. And I think you ll see rate base growth in Florida, because I think you ll see the b

aby boomers figuring out a way to get down there all the more so now because hou sing is affordable in Florida. So that s an example. Those two or three are the t op names that we have in the portfolio. Natural Gas Forbes: Natural gas, do you like natural gas? Kleinschmidt: I love natural gas. I don t think necessarily that natural gas price s are going to be very high in the future Forbes: So how do you make money? Is this like airlines, where they carry a lot of passengers but never seem to make money for very long? Kleinschmidt: No. I ve never owned an airline. But you can make money in the hori zontal drillers the people that produce it. You can make money, I think, in uti lities that use natural gas. And you can make money in companies that one of t he names that we are using in this area is CARBO Ceramics which makes the proppa nts that are used in fracking. So there are ways to make money. I ve been very bearish about the government and this and that. But if you want to look at one thing that I think could be very bullish for the U.S. economy is the fact that natural gas has the ability to ret urn us to the pre-1973 era of cheap energy. That s really there. That possibility is there. And that would be very beneficia l for American business and very beneficial for American foreign policy and very beneficial for America. There are a whole number of things that cheap gas, chea p and plentiful gas could do for the United States. And so I m very bullish on it . And I think that we should make every effort to get it developed. Forbes: That s not good news for Russia. Kleinschmidt: No, it s not good news for Russia, and not good news for a lot of ou r friends in the Middle East, either. Do Investors Need To Look Overseas? Forbes: Final thing, do you feel you need to look overseas for contrarian stocks ? Or do you find enough here at home? Kleinschmidt: Well, the answer is that we don t look overseas just for the sake of being investors in overseas markets. But if we identify a name that happens no t to be located in the United States but meets all of our other criteria, I thin k you ve got to own it. Most of the names that we own that are domiciled in the U nited States do far more than half of their business overseas anyway. Microsoft, with 75% of its business overseas is that a domestic company or a for eign company? So no, we will look overseas. I prefer it if they re listed here. And I prefer ADRs because I think it s more transparent and you can understand th e financials better. But I think you ve got to be a global investor in today s mark ets. Forbes: Robert, thank you. Read No. 18 Interview: Top Indian Value Investor Chetan Parikh Outlines His Fundamental Appr oach by: Miguel Barbosa November 13, 2009 I m exceptionally proud and honored to present an interview with one of the top va

lue investors of India, Mr. Chetan Parikh. This interview with Mr. Parikh repres ents one of the highlights of my career. Mr. Parikh is a man whom I admire and w ho has extensively contributed to the value investing community (via Capital Ide as Online and his numerous writings). I hope you enjoy the interview. Mr. Chetan Parikh s Background Chetan Parikh is a Director of Jeetay Investments Private Limited, an asset mana gement firm registered with SEBI. He holds an MBA in Finance from the Wharton Sc hool of Business and a BSc in Statistics & Economics from the University of Bomb ay. He has been investing in the Indian capital markets through proprietary inve stment companies and family trusts. Chetan was rated amongst India s best investors by Business India magazine. He is also the co-promoter of capitalideasonline.com, a well regarded investment websi te. His writings have been published in Business Standard, Business World, The E conomic Times, and Business India. He is a visiting faculty member at Jamnalal B ajaj Institute of Management Studies (University of Bombay) for the MBA course. Opening Questions Q. There are many different approaches to investing. What led you to choose the value approach? A. Value investing is a logical, safe and disciplined approach to investing. It requires a lot of patience which fits in with my temperament. Q. Which investors do you admire? Besides these investors who else has influence d you? A. Any value investor can learn a lot from the Masters. In India I ve listened to and learnt from Prof. Rusi Jal Taraporevala and Mr. Chandrakant Sampat. Q. What s your opinion of the efficient markets hypothesis and practitioners of te chnical analysis? A. I believe that the efficient market hypothesis in the various avatars (strong , semi-strong and weak) is not correct. Sometimes prices deviate far away from i ntrinsic values and it is possible to earn high risk adjusted returns. In fact, the lower the downside risk, the higher can be the upside reward. I do not know anything about technical analysis. Q. Tell us about your approach to fundamental analysis-what is your focus? How d o you search for your investment ideas? Where do most of these ideas come from? Describe your evaluation process (both quantitative & qualitative)? How long do you hold on to your positions? A. My firm, Jeetay, principally invests in publicly traded Indian securities and seeks to maximize investors capital by buying securities trading at values mater ially lower than their true business value. Jeetay aims to achieve high absolute rates of return while minimizing risk of ca pital loss. Jeetay combines the analytical vigor of determining the fair value o f a security with a deep understanding of the Indian markets. Jeetay will invest in securities where it can ascertain the reasons for the market s mispricing and the likelihood of the mispricing being corrected. Jeetay follows the value investment philosophy, which means that the objective i s to buy a security trading at a significant discount to its intrinsic value. Si nce the focus is on discovering undervalued stocks, the fund doesn t base its inve

stments on macro-economic factors like GDP growth. Jeetay determines intrinsic value as the present value of the future cash flows of a company discounted at a rate that properly reflects the time value of the m oney and the risks associated with the cash flows. In other cases Jeetay invests in Special Situations which involve the following: * * * * * Repositioning assets to higher uses Mergers and acquisitions / open offers Restructuring troubled companies Spin-offs Buybacks

The fund invests in a company if the market price is quoting at a discount of at least 60% to the intrinsic value. It sells when the market value approaches int rinsic value or it finds a security trading at a steeper discount to intrinsic v alue. Jeetay believes that while in the long term, a company is valued by its fundamen tals, short term mispricing occurs due to investor psychology, liquidity and mac roeconomic factors. This provides opportunities for the diligent and patient inv estor to make outstanding risk-adjusted returns. The time horizon of Jeetay is 3-5 years. It believes that short-term market move ments can be volatile and the market may recognize mispricing only in the medium to long term. Hence the emphasis is on understanding the corporate strategy and the resultant cash flows for a 3-5 year period. The probability of the markets recognizing the mispricing becomes high over the medium to long-term period. The firm does not limit its investments to certain asset classes or sectors. The fund evaluates any sector or asset class where a conservative estimate of intri nsic value is determinable with a reasonably high probability and invests if the security is available at a reasonable margin of safety. The firm does extensive research to arrive at estimates of expected cash flows, asset values and earnings. Jeetay culls information from public databases, quart erly and annual filings, annual reports, meetings with management, competitors, vendors, customers and other industry participants, industry experts, trade jour nals and bankers. Jeetay has extensive networks in India to get data and informa tion for superior analysis. Jeetay believes that a disciplined private equity ap proach to investing that stresses on buying at a discount to intrinsic value wil l deliver consistent absolute above average investment returns and safeguard cap ital irrespective of the state of the markets. Jeetay believes that the following steps are essential to its process: 1. Opportunity Identification. Jeetay identifies opportunities through a multitu de of ways. Jeetay has numerous financial models and screens that are used to fi lter investment opportunities within the framework of the investment philosophy. Jeetay has many contacts and professional relationships. This gives it many opp ortunities consistent with the investment philosophy. 2. Analysis. Jeetay does intensive financial and qualitative analysis on compani es once an opportunity is identified. The analysis is mainly to arrive at whethe r a disparity exists or not between the traded value of the security and its int rinsic value. Jeetay has substantial experience in determining the intrinsic val ue of a company across sectors. Multiple valuation metrics including discounted cash flow analysis, price to earnings, dividend discount model, price to sales, price to book, comparative analysis is used to arrive at the valuation of a comp any.

Other than financial analysis, Jeetay extensively meets every possible associate of the company to understand the opportunity better. These include vendors, cus tomers, middle management, bankers, competitors, large stakeholders and senior m anagement. This helps Jeetay arrive at a closer intrinsic value and also exit an investment if unfavourable events arise or the team s original calculation of int rinsic value was wrong. The analysis would focus on the 3B s, lance sheet and looking for bargains. Take each in turn: 1. Business: What is the nature of the business and its competitive strengths and weaknesses? What is the competitive ecological niche that it occupies and h ow protected are its profits from predators there? What are the nature of the en try barriers or moats - intangible assets, switching costs, network effects, cost advantages? How wide and deep are the moats? Does the business cover its cost of capital? A qualitative assessment of the business should be made to understand whether it is a superior or inferior business. Evidence of pricing power or the ability to lower cost of production and distribution should be searched for. 1. Balance Sheet: In order of importance is the balance sheet, the cash flow statement and the profit and loss account. 1. Bargains: One need not to be able to determine value exactly to know wheth er a stock is cheap or not. As Ben Graham wrote, To use a homely smile, it is qui te possible to decide by inspection that a woman is old enough to vote without k nowing her age, or that a man is heavier than he should be without knowing his w eight. A discount to value, a margin of safety is paramount, without which an inves tor is relying on the whims of Mr. Market for his investment return. Q. As a follow up question, how do you determine intrinsic value? A. The textbook definition of Intrinsic Value is the present value of the future cash flows discounted at a rate that realistically reflects the time value of m oney, risk and volatility of the cash flows. The problem is that it is difficult to: 1. determine the future free cash flows 2. determine the discount rate 3. determine the terminal value There are very few companies, i.e. those that are franchises earning well over t heir cost of capital and growing whose intrinsic value can be calculated using t he Dcf approach. Ben Graham s method of bargain identification is useful in other cases. You don t have to calculate intrinsic value with precision (especially where it is not possible) to know whether a stock is cheap in seldom to its value or not. Q. Do you invest in foreign companies? If so, do you evaluate foreign companies different than those based in India and how do you hedge currency exposure(s)? A. I have not invested in foreign companies as of yet. Sitting in India, I would have to invest in the large cap stocks in foreign markets, and have not as yet found large caps in USA to be cheap in relation to my investing universe in Indi Understanding the business, analyzing the ba

a. Whilst markets may change, valuation principles are universal-they are the sa me whether it s the USA or India. Q. How many stocks do you typically hold in your portfolio? A. In my family portfolio, given the time horizon and tax considerations, there is a heavy concentration on a few stocks that have franchise value and entry bar riers. There are smaller positions, but the bulk of the portfolio is in a handfu l of stocks. In the managed accounts, price in relation to value is of paramount importance a nd many of the businesses are clearly not franchises. The portfolio thus in the managed accounts tends to be more diversified with roughly around 18-25 position s. Cash is carried at all times in the managed portfolios, the level directly co rrelated with the valuation of the broad market. Q. Do you invest in any fixed income? If so, tell us about the role of fixed inc ome investments in your portfolio. A. I do not normally invest in fixed income securities. Cash is usually a defaul t position and varies directly with the level of the market. The cash is usually kept in the bank or in money market funds. I do not like to take a credit risk with money that I know will eventually be opportunistically deployed in the stoc k markets. The key is to be able to sit on your low-yielding cash without losing your patience. Q. . How do you judge a company s management? A. There are three ways of looking at management: 1. their integrity 2. their competence both operational and in capital allocation

3. their corporate governance In the end you want to deal with people who do not make your stomach churn. Inte grity and competence are both necessary in top management. Finally there is the factor of the passion to improve the game by never becoming complacent. Sometimes a good price can cover a multitude of sins, including poor management. But if I had to hold a non-franchise investment for any length of time, managem ent would certainly be an important factor. In many cases, it is the jockey, not the horse that one should bet on. Q. What makes you sell an investment? A. I sell when: 1. My original thesis was wrong 2. Price is reached 3. A better option comes along Ben Graham s criteria should be kept in mind. Switch for: 1. Increased security 2. Larger yield 3. Greater chance for profit

4. Better marketability Q. How do you look at risk? A. Risk is very subjective. Academic theory has one definition of risk namely st andard deviation which is wrong. Actually, if one had to use statistical distrib utions to measure risk, then there are three dimensions, Variance, Skewness & Ku rtosis. I do not think however that risk can only be captured by statistical measures. T o me, risk is simply the chance of permanent loss of capital and an investors job is to eliminate that risk. He may not be able to do so for individual securitie s, even with a margin of safety, but he has to do it in a portfolio context. Q. What s your take on leverage? A. Leverage is one of the two things that can cause a permanent loss of capital to a value investor. Avoid it, unless you are willing to take a risk of a perman ent loss to your capital. The other thing that can cause a permanent loss of cap ital is holding on to overvalued stocks, but I assume that a value investor woul d not do that. I always carry cash for optionality, rather than borrow against my holdings shou ld the opportunity arise. Q. Do you invest in commodities, gold, real estate, etc? If so what has been you r experience with these classes? A. I have legacy investments in real estate. I view it as an inflation hedge and a different asset class in the portfolio. Currently I have investments in gold as a hedge against a highly likely decline in the value of the dollar and a meltdown in financial assets. The economic prob lems in US are severe and the wrong treatment is being given. When fiscal and mo netary insanity prevails, gold always reigns supreme. I m not making a directional bet on gold prices it is only a hedge against my financial investments. Q. Tell us a little more about your involvement with special situations? A. It depends on the definition of special situations . If special situations means a value stock with identifiable catalysts like change in management, operationa l and financing restructuring, buybacks, mergers and acquisitions etc, then we c ertainly do invest in special situations. We have investments in spin offs and i n open offers as a result of takeovers. Q. Have you ever taken the role as an activist investor, would you ever do so? A. I ve never wanted to take a confrontational attitude with management although s ometimes I m forced to. If I m not happy with their policies, I sell - but my aim is to influence management through logic and rationality, not through financial bl ackmail. There is a grey area however. I ve been connected with the press through my column s in various newspapers and magazines and I ve written about instances of corporat e misgovernance there. But I ve never threatened management. I do not have the temperament to fight management or for that matter, anybody. I believe in exiting relationships where there is no mutual respect, rather than slugging it out for dominance.

Q. We understand that you are very focused on bottom up value investing-what has the financial crisis taught you? A. I wrote this piece awhile ago and it would be related to the question above. It may be interesting to use a cross-disciplinary approach to the problems and m istakes made by banks in the sub-prime market. The power of rewards that leads to repeated actions and the flawed compensation structure that led to misaligned incentives could be one mental model. As Raghur am Rajan pointed out in Financial Times (Jan 9, 2008), the compensation practice s in the financial sector are deeply flawed. The compensation is based on the so -called alpha that a manager of financial asset generates. There are three sources of alpha : 1) Truly special abilities in identifying undervalued assets (eg. Warren Buffett ) 2) Activism using financial resources to create, or obtain control over, real as sets and to use the control to change the payout obtained on the financial inves tment. 3) Financial engineering financial innovation or creating securities that appeal to particular investors. Many managers create fake alpha i.e. they appear to create excess returns but are taking on tail risks which produce a steady return most of the time as compensatio n for the very rare, very negative returns ( black swans ). The AAA rated CDOs gener ated higher returns than similar AAA rated bonds. The tail risk , so evident in hin dsight, of the CDO defaulting was not as small as perceived and so the excess re turn was compensation for that. The credit rating agencies that rated these securities as AAA because of their in sured status were themselves wrongly incentivized (compensated by the issuers of the securities). Furthermore once their peers started issuing AAA ratings, social proof came into play and the ratings war as to who assigned the highest ratings for junk became a classic Prisoners Dilemma.. This is proving to be a game of chicken between the regulators and the players ( banks and monoline insurers). In a classic game of chicken, two cars drive towar ds each other. The first driver who turns loses. Of course, if neither car swerv es then there is a crash. The best outcome for each player results when he goes straight whilst his opponent turns. Insane players have a massive edge in a game of chicken. At this point of time, the jury is out given the level of insanity in the system. Q. How have you evolved as an investor? A. I guess the process but efficient markets I ll never leap out of so my ability to widen of evolution is never over. I started out knowing nothing and so the leap to value investing was a big one. I know value investing, but the nuances may undergo changes, as al and deepen my circle of competence.

Q. What is the most interesting part of your job? A. It is searching for investment ideas, working out the odds and reading from a wide variety of sources. Q. Which books would you recommend?

A. Here are a few, but they are by no means exhaustive. 1. 2. 3. 4. 5. 6. 7. Everything by Jared Diamond Everything by Garett Hardin The Road to Serfdom - Friedrich Hayek The Prophet of Innovation More than your know - Michael Mauboussin The Robot s Rebellion The mind of the market - Michael Shermer

Try to read all of Mr. Munger s book recommendations and also the books in Mr. Pet er Bevelin s Bibliography in Seeking Wisdom: From Darwin to Munger . I do not think t hat I ll be able to read all the books that have been recommended in my life time but I m going to give it a shot. Q. What is the biggest mistake keeping investors from reaching their goals? How have you guarded yourself against this folly? A. Greed, fear, sloth and envy are the four emotions that are positively inimica l to becoming a better investor. Meditation, detachment from results, but attachment to efforts, yoga, discipline in living and thinking are some of the ways for self-improvement in investing. One must also have an open mind to new ideas and try to become in the words of M r. Munger a learning machine. Q. What should investors understand before investing in India? A. Indian markets are very volatile, so be very careful on entry prices. Growth is a seductive term and stories woven about growth even more seductive, but be ver y careful of paying too much for it. Homework matters. Liquidity can dry up, so be clear whether you can live with relatively illiquid positions. Closing Questions Q. If you could do anything besides allocating capital what would you do? A. I would teach and write more often than I do. Q. What message/advice would you give to readers of SimoleonSense? A. Read a lot, be disciplined, be humble about your knowledge and stay within yo ur circle of competence. Q. What does the future hold for you, your funds, and website? Are you going to do this forever? A. As long as I can, mentally and physically. Miguel Barbosa: Mr. Parikh thank you for taking the time to interview with us. Read No. 19 E-mail | Print | Comments | Request Reprints | E-Mail Newsletters | My Yahoo! | RSS Adviser Q&A Outsourcing For Outsized Profits

Whitney Tilson and John Heins, Value Investor Insight 12.20.05, 12:00 PM ET When John W. Rogers Jr. started Ariel Capital in 1983, there were plenty of mana gers pursuing "value" strategies and many invested in small, fast-growing compan ies--but few were trying to do both at the same time. "We were fairly early in c ombining a contrarian, value approach to smaller companies," he says. Having stayed true to Rogers' original philosophy, Ariel today manages more than $21 billion. The flagship $4.8 billion Ariel Fund has returned 14.9% annually o ver the past ten years versus 11.6% per year for the Russell 2500 index of small er companies. In this excerpt from a recent Value Investor Insight interview, available exclus ively at Forbes.com, Rogers and his vice chairman, Charles Bobinskoy, describe w hy they re betting on the general theme of outsourcing as well as on the specific ability of Pitney Bowes (nyse: PBI - news - people ) to capitalize on it. Where do your best ideas come from? John Rogers: We ve had good success in finding niche areas, like in office product s or restaurant equipment, where we can have an edge from being experts, and whe re we believe in the secular trends driving growth. We believed in the trend tha t more people were going to eat out, for example, so we spent a lot of time gett ing to know the restaurant-equipment industry. The nice thing about the equipmen t business is that it didn t really matter which restaurants you were betting on, they all needed to buy things like ice cream machines. It has been similar with office products. The big trend is more and more people working in offices, so we v e looked for companies for which this is good news, companies like Sanford, for example, which makes markers and pens and was sold to Newell Rubbermaid. In 2001, John Buckingham bought ValueClick at $1.85. Today, it trades for nearly $19, more than a 925% gain. Click here for all of Prudent Speculator's current buys. Any other themes you're currently pursuing? John Rogers: We re making a very big bet right now on outsourcing. What s nice about outsourcing from an investment perspective is that it goes through up-and-down cycles of market interest. Now people have generally soured on the idea, and man y companies are trading at discounts to their private-market values. But we don t think that view accurately reflects the powerful secular growth we re going to see as companies and individuals outsource more of their day-to-day activities. Special Offer: George Putnam told his subscribers to buy Apple Computer at a spl it-adjusted $7.82 per share in November 2002. Apple now trades at $72--nearly a ten-bagger in 36 months. Click here for Putnam's December turnaround picks in th e Turnaround Letter. This is a broad theme that has many potential applications. We love Jones Lang L aSalle and their international opportunities in real estate outsourcing. We own ServiceMaster, which is a leader in landscaping, pest control and a variety of o ther home services. We re also bullish on Aramark, which provides food services fo r everything from stadiums to jails to schools. Let's talk about Pitney Bowes, one of your big investments under the outsourcing theme. John Rogers: Pitney Bowes is the dominant manufacturer and lessor of postal mete rs and has been for a very long time. We love the sort of quasi-monopoly they ha ve in the industry. We believe we have some distinctive competence in understanding what has and wil l go on in the modern office. Pitney Bowes strategy of adding more and more servi

ces to take over management of a company s mailstream --creating more and more recurr ing revenue--just makes sense to us. Charles Bobrinskoy: This is a case where our hands-on experience with the compan y has been a big plus. They ve worked with us in our own mailroom and keep taking on more and more responsibility, not just for mail but for presentations and put ting together and otherwise managing documents. They ve made niche, tuck-in acquis itions that have added a particular competency that fits with what they do, whic h is what we like to see--as opposed to making big acquisitions that go outside of their core business. John Rogers: We also believe that the outsourcing of functions like this is a wo rldwide phenomenon. The Pitney Bowes brand name and experience will allow them t o grow very effectively in rapidly developing economies like India and China. It hasn t been and won t be easy to break through traditional ways of doing things or government bureaucracies, but international expansion has tremendous potential f or them over the next three to five years. Isn't part of what's weighing on the stock a belief that traditional mail in the Internet age is not going to be what it was? Charles Bobrinskoy: The Internet has been around for quite a while now, and trad itional mail not only is not disappearing, it s growing. You re right, though, peopl e are very nervous about this macro trend, and what it means to Pitney Bowes. We look at it as a possible risk, but see it as one that s overblown. John Rogers: The increasing options for moving information may unity. They are the absolute pros of the mailroom, and they re ying to help companies transform and send information from one around the world. They re positioning themselves as delivering eople decide to get information from place to place. also be an opport in the middle of tr place to another solutions however p

Margins in add-on businesses are rarely as good as in the core business of a com pany like this. Is that a problem? Charles Bobrinskoy: The first year of outsourcing contracts often reduce margins as the companies have to hire new people and add new equipment. The beauty of t hese contracts, though, is that they lock in the customer over a long period, an d in the remaining years you don t have those first-year costs. This dynamic is an other thing we think the market is missing. The market is overly focused on the short-term impact of some new outsourcing contracts and not giving Pitney Bowes credit for the second, third and fourth years of those contracts. Currently at around $42, the stock has been mostly dead money for the past two y ears. How are you looking at valuation? Charles Bobrinskoy: Two key metrics we look at are the discount to our private-m arket value and the price-to-earnings to forward earnings. For Pitney Bowes, we believe the private-market value per share is just under $58. We also think it w ill earn $2.94 next year, which gives a below-market multiple of about 14 times earnings. JR: This is a good example of a larger-cap company not getting its due. While we r e in this hot market for small-cap value stocks, you have this extraordinary lar ger mid-cap stock that s selling for only 14 times next year s earnings. This excerpt is from an original interview published in the Nov. 30, 2005 issue of Value Investor Insight newsletter. Read No. 20