Zeke Ashton

Centaur Capital Partners

Ten Rules of Value Investing

VALUE INVESTING FORUM – MAY 28, 2008
1. What is Value Investing?
† Value investing is the art of buying assets for significantly less than the
true “intrinsic” or business value to a rational purchaser.

“An investment operation is one which, upon thorough analysis, promises safety of principal
and an adequate return. Operations not meeting these requirements are speculative.”
- Benjamin Graham, Intelligent Investor

† Value investing requires significant research and analysis to calculate a

conservative value for any asset.
“What is investing if not the act of seeking value at least sufficiently to justify the amount
paid? Consciously paying more for a stock than its calculated value – in the hope that it can
be sold at a still higher price – should be labeled speculation (which is neither wrong,
immoral, nor in our view, financially fattening.)”
- Warren Buffett, 1992 Berkshire Hathaway letter

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Resist the Urge to Speculate
† Speculation is the purchase of securities without knowledge of or regard for value
in the hope other investors will soon pay an even higher price. Speculation
therefore relies on the predicted behavior of other investors.

† Speculation emphasizes what you can make and pays little attention to what you
can lose.

† Speculative urges (the desire to purchase assets for any reason other than
identifying an undervalued security based on sound and thorough analysis) are the
result of a desire for instant gratification and should be resisted.

“There are two times in a man’s life when he should not speculate: when he can’t afford it,
and when he can.” -- Mark Twain

† The good news: Many market participants are really speculators, and speculators
can create opportunities for patient value investors.

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Margin of Safety Is the Central Concept
“Confronted with the challenge to distill the secret of sound investment into
three words, we venture the motto, MARGIN OF SAFETY.”
-- Benjamin Graham, Intelligent Investor

Why is having a margin of safety important?

1) Valuation is an imprecise art

2) The future is unpredictable

3) Having a margin of safety provides protection against bad luck, bad

timing, or error in judgment.

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2. The Golden Rule: Don’t Lose Money
Great advice, but what does “don’t lose money” really mean?

• It is important to differentiate between short-term market fluctuations and

permanent capital loss.

• Avoid mistakes. The quantity of investment decisions is far less important

than the quality.

• Sell as soon as you realize that an error was made in the original
investment thesis, or when the investment is fully priced.

• Be patient. It can take time for the market to present a truly compelling
opportunity that coincides with your circle of competence. And it can take
time for a catalyst to emerge that allows you to realize the value you see
in the investment.
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3. Valuing Businesses is the Key
There are three steps to valuing a business:
“Business, People, Price” - Mason Hawkins, Longleaf Funds

Ask yourself these questions:

† Do you understand the company and its industry?

† Is it a good business? Does it have a sustainable competitive advantage? A strong
balance sheet? Can it grow over time?
† Does the management team have a track record of being capable, ethical, and
shareholder-oriented?
† Is the stock really cheap? Is there a margin of safety?

“There is nothing esoteric about value investing. It is simply the process of

determining the value underlying a security and then buying it at a considerable
discount from that value.”
- Seth Klarman, Margin of Safety

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Don’t Wait for a Catalyst
The Wild Card: Can you think of a number of potential
catalysts that could cause the market to recognize the value you see?
If you can think of a number of potential catalysts, don’t wait to find out
which one happens to purchase the stock.

“Waiting for the catalyst to appear before buying an undervalued stock will result in the
purchase of a fully valued stock.”
- Bob Olstein

There are any number of things that can unlock value in a security.
Acquisitions, spin-offs, restructurings, management changes, the sale of
assets, or simply good news!

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4. Build a Circle of Competence
† Nobody is born understanding businesses. Everybody’s circle of
competence starts out as a dot.

† To widen your circle, study and learn how various business models work.
Some of the more common business models we encounter are listed
below:

Retail Restaurants
Service Real Estate (Rental, Commercial, Lodging)
Software Manufacturing (Heavy, Light, Design)
Banking Asset Management
Brokerage Subscriber (Newspaper, Cable, Telecom)
Drug Development Intellectual Property (Patents, Brands)
Natural Resources Transportation & Logistics

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How to Widen Your Circle

† Each business model has its own profitability profile, accounting

conventions, and unique variables critical for investors to understand.
† Learning the nuances of each business model enables the right analytical
tools for each.
† Start with businesses that you are interested in or that you are already
knowledgeable about.
† If you read annual reports from the top ten companies in any industry, you
will have learned a lot about the industry, the competitors, the
opportunities, and the risks.
† If you find one industry or sector too difficult to understand or you don’t
like the economics of the industry, go on to another one.
† Over many years, your circle of competence should cover at least six to
eight different industries or business models.

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5. Wait for the Perfect Pitch
† Great ideas are scarce. When the market throws you a wonderful
opportunity, swing hard by investing an amount that will be meaningful.

† It is important to determine your comfort level with regard to

concentration, but finding more than one great idea per month is difficult.

† Every idea should be sized based on a thorough examination of the merits.

The inherent business risk, your level of conviction, the degree of
undervaluation, and factors contributing to a margin of safety should all
be considered.

† Most value investors practice focus investing. While the number of

holdings may vary, most successful value managers traditionally
concentrate their exposure in their top ten ideas. It is typical for the best
known value investors to hold 50% of their assets in their top ten ideas.
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Make the Market Your Servant
† Think for yourself, and learn to trust your own judgment.

“Don’t trust anyone over thirty. And don’t trust anyone thirty and under. Do your
own work.”
- Joel Greenblatt, How to Be a Stock Market Genius

† Think about investing as the purchase of businesses, rather than trading

stocks.
† Ignore the market other than to take advantage of its occasional
mistakes.
† Volatility does not equal risk. Volatility provides opportunity.
† Watch the business, not the stock.

“Be greedy when others are fearful, and be fearful when others are greedy.”
- Warren Buffett

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7. Be an Absolute Return Investor
† For rational investors, absolute returns are the only returns that matter.
“You cannot spend relative performance”.
† Absolute return investors buy stocks that are out of favor because they are
cheap. Relative return investors buy stocks that are popular, which means
they are usually already fully priced.
† Trying to keep pace in all environments promotes poor decisions and
increases the chances of making mistakes.
† Focus on the decisions, and let the outcomes take care of themselves.
† Value investors are likely to beat the market by protecting capital in down
markets and producing positive returns in up markets.
“Much of our out-performance has come in down markets. In up markets, we are
content just to keep pace.” -- Tweedy Browne Q1 2006 Letter

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8. When in Doubt, Hold Cash
† Relative performance oriented investors typically choose to be fully
invested regardless of value in order not to fall behind their benchmarks.

† Absolute return oriented investors have the discipline to hold cash in the
absence of obvious bargains, knowing that opportunities will come to the
patient investor sooner or later.

“Holding cash is a way of safely doing nothing until a compelling investment

opportunity arises. Cash offers the virtues of positive yield, complete safety of
principal, and full and instant liquidity.”
-- Seth Klarman

“While we don’t like having excess cash, we like doing dumb things even less.”
-- Warren Buffett

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9. Know When to Sell
Four reasons to sell:

† When the stock price reflects full value and there is no margin of safety
remaining against significant loss.
† When a demonstrably better idea becomes available.
† When it becomes clear that the original estimate of fair value was flawed.
† When the business fundamentals show signs of deterioration or new risk
factors emerge that substantially reduces the intrinsic value or threatens
the margin of safety.

Value investors generally don’t use automatic stop-losses to tell them to

sell. Rather, as long as the value is intact, value investors often average
down as a stock declines in price.

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10. Many Ways to Investor Heaven
Value comes in many forms. You can choose to specialize in certain
areas, or you can learn to recognize and take advantage of all types of
value opportunities.

Below are 18 different types of Value Ideas (from Value Investor Insight)

Out-of-favor blue chips Stubs

Out-of-favor cyclicals Net-Nets
Distressed industries Discounts to Cash
Turnarounds Declining Cash Cows
Overlooked Small Caps Oddball Companies
Fallen Growth Angels Sum-of-the-Parts
GARP (Growth At Reasonable Price) Activist Opportunities
Spin-offs Post-bankruptcies
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American Oriental Biotech (AOB)
† AOB is our favorite idea to play health care growth in China.
† Price as of May 22, 2008: $11.40
† Market Cap = $890 million; EV = $740 million
† AOB is a fast growing manufacturer and distributor of
pharmaceuticals and nutritional products in China.
† AOB is the ultimate arbitrage opportunity: access capital at
Western multiples, then buy undercapitalized and underperforming
Chinese companies with good assets at dirt cheap prices.
† AOB has a tremendous track record of acquiring businesses and
growing the value by 3-4 fold within two years of purchase, often
effectively paying 2X earnings two years out.

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AOB Historical Milestones & Events
Dec’01 AOB goes public via reverse merger
Feb ’03 AOB acquires a soybean peptide biotech project & manufacturing
plant previously established by AOB founder and Harbin Medical
University. Assets appraised for $40M; AOB paid $3M.
Sep ’04 AOB acquired HSPL, a Chinese state-owned company with a 50 year
history and a well-known branded product, for $11 million. Price was
~90% of book value, and 3X times sales. By year-end 2006, AOB
increased HSPL product sales to $27.5M with 30% net profit, and
sales and profits grew by another 20% in 2007. AOB ultimately paid
about 1X the earnings produced by HSPL two years following the
deal.
July ’05 AOB lists on AMEX. Company raises $60M in equity offerings in
late 2005 and early 2006 to do additional acquisitions.
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AOB Historical Milestones & Events
Apr ’06 AOB acquires GLP, a profitable Chinese pharmaceutical company
with a leading brand for $23 million, or 1X book value and 2.5X
2005 sales of $10M. By year-end 2007, GLP products accounted for
~$40M in sales with 30% profit margins. By year end 2008, GLP
products will likely produce $60 million in sales, such that AOB will
have paid only 1.5X earnings two years following the deal.
Dec ’06 AOB moves from the AMEX to the NYSE
July ’07 AOB raises $75 million in a secondary offering at $8.50 per share
Sep ’07 AOB acquired CCXA, a small private pharmaceutical company with
2006 sales of $9 million. CCXA has about 25 marketed products and
operates primarily in rural China. AOB paid $28 million, or 3X sales.
CCXA contributed Q1 ’08 sales of $4.3 million.
Oct ’07 AOB acquires Boke, an OTC pharmaceutical firm with a strong
branded franchise of products for nasal congestion and sinus pain.
Boke had 2006 sales of $12M. AOB paid $40M, or 3.3X sales. Boke
contributed $5.7 Q1 ’08 sales of $5.7 million.
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AOB Most Recent News
Apr ’08 AOB enters into strategic alliance with China Aoxing (CAXG).
CAXG has the largest licensed manufacturing facility and pipeline of
narcotic pain drugs in China. AOB will market and distribute CAXG
products. As part of the agreement, AOB bought 30 million shares of
CAXG for $0.60 per share ($18 million). CAXG trades at about
$1.50 per share now, such that the deal has already created significant
value for AOB shareholders.

May’08 AOB announces record Q1 revenue and earnings, and projects 2008
sales of at least $245 million not including new acquisitions.
AOB also announces that it has made $16 million in deposit
payments towards multiple acquisitions to be closed later in 2008,
which are expected to be accretive.

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AOB Financials and Valuation
YEAR SALES NET INC OP CASH FCF
2003 $ 20.9 $ 4.6 $ 2.5 $ 2.4
2004 $ 32.0 $ 7.8 $ 8.4 $ 6.4
2005 $ 54.7 $ 13.4 $ 11.6 $ 5.8
2006 $ 110.2 $ 29.2 $ 29.1 $ 24.8
2007 $ 160.5 $ 43.3 $ 45.1 $ 41.1
*Net income does NOT include FX benefit, which added ~$10M in 2007.
† We expect 2008 revenue of at least $240-250 million, net income of $60-
65 million, and FCF of $55-60 million without additional acquisitions.
† AOB should be able to grow sales and net income at 15-20% for years.
† At a market cap of $890M and EV of ~ $740M, AOB trades at ~15X ’08
earnings, but on an EV basis, the multiple is closer to ~13X.
† We believe AOB is worth at least $15-17, which is still conservative.
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American Oriental Bio - Risk Factors
† “China Risk”: Political, regulatory, economic, currency, etc. We believe
that China’s policies are actually promoting the interests of high quality
consolidators like AOB and we are happy to take the currency exposure.
But you never know…..
† High Short Interest: As of April 22, 2008, there were nearly 11 million
shares short on a float of 44.6 million shares. Do the shorts know
something we don’t know? (We don’t see the short thesis, and we think
you’d have to be crazy to short a stock like this).
† Negative article in Barron’s on June 25, 2007 questioning the claims
made for two AOB products as well as associations with some unsavory
promotional firms prior to 2004.
† Execution risk – can they continue to be successful with their acquisition
strategy?
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 Zeke Ashton
Centaur Capital Partners

QUESTIONS?
Ten Rules of Value Investing
VALUE INVESTING FORUM – MAY 28, 2008
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