Trojan Investing Newsletter

October 6, 2008 Issue 1 - Volume 2

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Inside This Issue
Investment Analysis
NCTY - Gaming China.......................... p.1

Learning Center
Understanding the Zero-Sum Game........ p.2 A Case in Optionality.............................. p.4

Market Performance Snapshot
2-Sep Dow Jones 11,516 S&P 500 1,277 NASDAQ 2,349 Russell 2000 738 10-Year T-Bill 3.746% 30-Sep 10,850 1,164 2,082 679 3.837% Return -5.78% -8.85% -11.39% -7.99% 2.43%

“This is a market of disparate opinions and therefore increasing opportunities for those who get it right. We hope Contributors: Joshua Inouye, Alexander Muhr, Matthew Riley to be one.” -Bill Gross

-Trojan Investing Newsletter Staff

Alexander Muhr Jordan Ohama

Disclaimer: Views expressed in this newsletter are not those of the University of Southern California or any of TIN’s affiliated groups, but the author’s own. Recommendations are made by students, not financial professionals. Readers should not rely on information from the following articles or the recommendations therein for trading or investing. The purpose of this newsletter is to facilitate discussion and broaden students’ awareness of current market issues. This newsletter may contain references or links to websites that are created and maintained by other organizations. TIN does not necessarily endorse the views expressed on these websites, nor does it guarantee the accuracy or completeness of any information presented therein.

The9 Limited - Gaming China
Increased Promotional Initiatives The9 stresses the acquisition of new users to achieve future Recommendation: Speculative Buy growth. Recently, the firm added a ground promotion division to its operations, which focuses on obtaining users in Snapshot smaller tier two and tier three cities. Personnel in this deCompany Name: The9 Limited partment work as promoters in Internet cafes in hundreds Ticker Symbol: NCTY of these smaller cities across China. The division has grown Closing Price (Oct. 2): $17.80 from 200 personnel in Q1 to over 300 at the end of Q2. Market Cap: $491 Million The company hopes to grow this team to 500 by year end. P/E (ttm) 10.59x As a greater number of users are attracted to The9’s games Source: through these promoters, increased revenues would be expected. Although this will potentially decrease profits int he The9 Limited is an online game operator in China. Its stock short-run, The9 is building a form of marketing infrastrucis traded on the Nasdaq as American Depository Shares ture that could be used for future releases. (ADSs)—each representing one ordinary share. The firm derives revenue from prepaid online game cards and virtual item purchases for games it licenses from game developers. A substantial portion of The9’s revenues come from Blizzard’s World of Warcraft, which has 12.6MM online accounts Source: in mainland China, a significant increase since its introduction there in July 2005. The company operates a variety of Future Prospects other online games as well, but World of Warcraft remains the To help drive continued revenue and margin expansion, The9 dominant player in revenue composition. has begun proprietary game development operations. The firm’s in-house Resesarch and Development department grew Impressive Recent Results from 40 personnel in 2007 to 190 at the end of Q2 2008. In its most recent quarter, Q2 ’08, The9 recorded $66.3MM This growth is expected to continue through the end of the in revenues, a 69% year-over-year1 increase. While the firm’s year, at which point The9 hopes there will be 250 personnel gross margin was 47% in Q2, or 5% higher than during the working on proprietary game development. The company same period a year prior, the company feels that this margin showcased its most recent in-house developed game, Warriors will increase with the release of games developed in-house. of Fate Online, at the 2008 ChinaJoy Expo and received upbeat The firm’s net income for the quarter of $16.9MM represents user feedback. It is also important to note that proprietary 129% growth on a year-over-year basis. This 25.5% profit game development will also help dilute revenue contribution, margin, coupled with a trend of increasing margins, shows lowering The9’s reliance on World of Warcraft. that the firm is effectively leveraging its business to maximize operating efficiency. With regards to the firm’s World of War- Valuation craft segment, Q2 was a record quarter with the largest num- With no debt and $300MM in cash, cash equivalents and ber of concurrent users in the game’s history. The concur- short-term investments, the company is well-positioned for rent users were measured at a high of 489,000, representing a future acquisitions as well as the operational improvements 3.8% quarter-over-quarter2 increase. Growth in this segment it intends to implement in the coming quarters. Additionis attributed to acquiring new customers mainly through the ally, the company’s Board of Directors recently approved recently released expansion pack Burning Crusade. a $50MM share buyback, a telling signal that the firm believes in its long-term performance. Significant cash reserves make measures such as these possible. An enterprise value of $143MM yields an EV/Revenue multiple of 0.6x, signifi1 Year-over-year OR YoY cantly lower than the Gaming Activities industry average of Compares the period to the corresponding quarter from the 1.8x. The9 is undervalued compared to its competition and previous year--ie Q2 2008 vs. Q2 2007 has very compelling future prospects. I am therefore recom2 Quarter-over-quarter Compares the current quarter to the one immediately before mending NCTY as a BUY.
i.e. Q2 2008 vs. Q1 2008

By Matthew Riley

A Case in Optionality
By Alexander Muhr
In a market as volatile and unpredictable as it is these days, the difficulty of finding potential investment opportunities is limited at best. The best way to maximize your return, in my opinion, is by using a concept called optionality. You can use actual options, but the idea is more about limited downside risk for a particular bet. For instance, earlier this year the yield curve was flat, and there might have been a great reason for that, but due to economic woes, it was more likely to steepen than invert itself again. The small probability of it inverting again would give you limited downside risk on your play that the yield curve would steepen again, in essence creating optionality. Needless to say, on August 12th, CVS made a bid for the company at $71.50 per share in a tender offer. This is where things get really interesting. The tender offer agreement is unique for the fact that it’s open for a whole year – meaning that CVS can buy shares from shareholders at the offer price for one year. They need to reach a share count of 2/3 of the outstanding shares in order to complete the buy-out. While this is going on, the company would still be paying its normal dividend, which pays for owners to wait.

August 14th – LDG is already trading above the buy-out price and closed at $71.55. When this happens the market is indicating that a higher bid is likely to occur, because normally shares trade slightly lower due to risk of the bid fallRecently there has been a great example to illustrate option- ing through, and that’s where merger/buy-out arbitrage hapality. A famous face during the past year or so has been Bill pens. Ackman of Pershing Square Capital, a hedge fund. He correctly predicted problems in the bond insurance companies (MBIA and Ambac, which he was short) and continues to express concern for the economy and the way the situation is being handled by the government. Some might believe that he is a perma-bear, but if you looked more closely at his portfolio (which anyone can do quarterly by looking online at the SEC website for a 13-HF’s), he is more long stocks than he’s short. On August 4th, Pershing Square filed a SC-13D (which is mandatory once any entity or individual gains a stake of 5% or more in a public company) in a company named Longs Drug Stores (NYSE:LDG) for 8.8% of shares outstanding. The filing was for an action completed on July 23rd so we can assume most of the stock was bought at a price below $46.50.


This had piqued my interest because I subscribe to the RSS feed of Pershing Square, but did not look into it more.


After a few days news began to trickle out as to what was really going on. Mr. Ackman began to publicize concerns that CVS and LDG management were undervaluing Longs’ real estate. The firm owns about 200 of its 500+ stores, all of which are in California and Hawaii – some of the highest priced real estate in the country even with the recent market troubles. It was disclosed by CVS that they had put a “conservative” value of $1 billion on the stores, 3 distribution centers, and 3 office buildings. CVS also planned on making money by either selling the assets or generating cash through a sale-leaseback transaction. In an interview on CNBC, Mr. Ackman talked about LDG and that CVS was grossly underestimating the value of the real estate. He believed that the real estate was closer to the value of the buy-out offer, and in a sense you were getting their prescription benefit management business (RxAmerica) for free. In that interview he saw the real value closer to $90 to $95 per share or higher. The premise is valid and the trade turns out to be a phenomenal opportunity. With shares hovering just above $71.50, anyone had the ability to buy shares for a price slightly above the buy-out offer. For instance, I paid $71.60 per share, which is 10 cents above the buy-out price, giving me a 10 cent option on a higher bid and have really smart people working for my money. The most I could lose was 10 cents – although if the buy-out did not go through then I could lose money, but I gave the chances of that happening virtually zero because based on what I had learned, there would be other bidders. On September 11th, Pershing Square sent a letter to the board of Longs. There it is revealed that they have a total exposure of 12.3 million shares (9.2 of which are through private transactions), which equals about 34% of the shares. That amount in effect blocks the buy-out because CVS could never buy the 2/3 it needs in order for completion. In the letter, they also state that they have identified “four potential buyers including two separate strategic buyers, a REIT and a real estate private equity investor.” September 13th – Walgreens (NYSE:WAG) sends in a bid to the board of Longs for $75 per share, including the $100 million break-up fee from the CVS agreement. LDG closed at $75.70, indicating again that there would be a higher bid for the company. It’s not really worth going into much more now, but Walgreens, Longs and CVS have been sending each other letters, which you can read on EDGAR. There is also another fund, Advisory Research that owns about 10% of the company and also believes there is a better offer out there. CVS also re-

ported how many shares had been tendered in about a month of the bid being open; only 4% of shares were tendered. The idea of optionality is great to think about during tough times. All you need to do is enough research in order to understand the situation so you can place odds on the trade. If the odds are in your favor, then be confident and back up the truck. Hey, Longs might even still have some legs left in it.

Top: Walgreens Logo, Source: Middle: CVS Pharmacy Logo, Source: Bottom: Longs Drugs Logo, Source:

Understanding The Zero-Sum Game
By Joshua Inouye
ing (either new or old), it may help to consider a quote from Michael Lewis’ Liar’s Poker: “Those who say don’t know, and The zero-sum game is an extremely important concept that those who know don’t say.” can cause many investors to lose money in the stock market, or at least not produce returns that equal those of the overall Luck. This is an extremely important factor in successful inmarket. In stocks, every person that outperforms the market vesting. It is what makes it so difficult to determine whether an does so because someone else underperforms the market. If investor actually has a real chance at outperforming the maryour object is to outperform the market, you should certainly ket. In fact, it is so difficult to statistically prove that someone be thinking about who will be losing to you. Two good ex- is skillful rather than lucky, that it is almost futile to do for any amples of people that might be willing to lose to you are but a very few extremely successful traders. In Hedge Hunthedgers, who in essence pay a premium for financial insur- ers by Katherine Burton, one of the interviewees estimated ance, and speculators, who seek an unusually high return by that even a great speculator like George Soros is only correct about 60% of the time. If you don’t know who will lose to taking on significant risk. you or why you would The semibe good s t r o n g in outperefficientforming the market hymarket, and pothesis, you do anywhile disways, luck puted by is probably some, states the reason. that it is impossible Edge. In to predict The Alshort-term chemy of stock price Finance, movements George Sowithout ros reveals inside inwhat his for maedge was: tion. This his unique means that theoretical all the inframework for mation embodied available is Source: in the concept of reflexivity between percepalready priced into the stock. For individual intions and facts. Soros’ theory stood traditional vestors, this is a very important concept to consider, because it is foolish to think that you can outperform economics on its head and espoused the idea that prices were the market today by trading on yesterday’s news. The institu- always wrong. In his book Getting Started in Technical Analtional and professional investors out there who are better and ysis, Jack Schwager states, “If you’re wondering what your more quickly informed make money in the zero-sum game edge is, you probably don’t have one.” by trading with people who trade on old information. Former SEC Chief Economist Larry Harris, in his book Trading Let us consider mutual fund managers. They are supposed and Exchanges, calls these losing people pseudo-informed to be very informed and one would imagine that they have a traders. They think they are well informed and can trade prof- certain informational advantage over the individual investor. itably, when in reality, they are trading on old information. But it is well known that mutual funds are extremely inept in When you think about the information that you are receiv- outperforming the market for any length of time. Although

some hedge funds routinely seem to beat the market, there are many that fail, and if a mutual fund manager or a hedge fund manager does not know why they have an edge and a good reason to believe that someone else will lose to them in the zero-sum game, the success is probably largely attributable to luck. With enough individuals and fund managers out there, some have to beat the market according to the laws of probability. Consider the classic example of 1,000,000 people flipping a coin 10 times in a row. 1000 of them will get heads 10 times in a row! 30 of them will get heads 15 times in a row! If you compare this to investing, 15 years of outperforming the market will get you a lot of acclaim and wealth. And with so many people doing it, some are bound to get rich, but not necessarily because of their skill.

provides so much information about value, there is virtually no barrier to entry, and product homogeneity—this is a situation approaching perfect competition! The stock market is one of the purest forms of perfect competition in existence. Enough said. Now, somewhat isolated markets in stocks do exist, and the big guys don’t even pay attention to them or send analysts to investigate them. There are almost 10,000 stocks out there and only analysts on about 1,000 of them. They are typically micro-cap and small-cap stocks that any big institutional investor could make a great percentage return on, but only with a small amount of money, the kind that individual investors have. However, keep in mind that someone still has to underperform the market for you to be able to outperform.

When you think about your edge, don’t compare a certain Don’t know what your edge is? All hope is not lost. The stock skill you have such as your understanding of business or eco- market still has a fantastic record of great long-term returns, nomics or accounting or mathematics to the general popula- and for those who may decide not to bother with active intion. That will lead you to a wrong perception of an edge you vesting, passively managed index funds or ETFs are a great don’t have. The general population doesn’t invest, or certainly way to virtually eliminate transaction costs and management not that much when compared to institutional investors. You fees. Personally, at the present time, this is the only kind of must be able to identify an edge that you have over the people investing I am comfortable with. you are competing with. For example, let us compare this to playing poker. It is not enough to be able to beat your friends In the film Rounders, Matt Damon dishes out a poker tip that and neighbors, even if you can do it consistently. To make embodies the concept of the zero-sum game and that can money in the stock market, you have to have an edge over be used wisely by enterprising investors: “If you can’t spot the big guys, because you are competing against them all: the the sucker in the first half hour at the table, then you are the world poker champions and such. You cannot isolate your- sucker.” self to compete with only those that you have a certain edge over. This is better done in secluded markets such as car or real estate sales, even craigslist. The stock market can be accessed by anyone and the competition is stiff and the information plentiful. Has anyone besides me gotten frustrated with bidding at Ebay auctions in the past few years and decided the local craigslist market is easier and cheapSource: er to deal with (at least for some things)? Ebay can be compared to the stock market in this way: the internet

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