9th annual Spring value investing congress

April 3, 2014 • Las Vegas, NV
Finding Your Way Along The Many Paths of Value Lisa Rapuano, Lane Five Capital Management •

www.ValueInvestingCongress.com

Lisa O’Dell Rapuano, CFA Lane Five Capital Management

Finding Your Way Along the Many Paths of Value
Value Investing Congress April 3, 2014 Las Vegas

Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Finding Your Way

“The most important quality of an investor is temperament, “ - Warren Buffett

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Finding Your Way

“Ain’t only three things to gambling. Knowin’ the 60-40 end of a proposition, money management, and knowin’ yourself” - Puggy Pearson (HT Bill Miller)

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Finding Your Way

“I am not Warren Buffett and neither are you.” - Lisa Rapuano

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Finding YOUR Way
    

All approaches to value investing attempt to buy $1.00 for $0.50 We watch other investors’ ownership positions and reasoning Very few managers outperform over long periods of time A common trait of long term successful investors is commitment to personal process Important to consider:

• • •

At what do I excel? What mistakes am I prone to? What are my goals?

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Just because some very smart investor owns it, doesn’t mean you should Know yourself

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Lane Five Investment Approach: What is OUR Way?

Evaluate, research and invest in securities that are mispriced by the market


• •

Market prices diverge from long-term business values when short-term issues drive investor fear Exploit the psychology and behavior that create pricing anomalies Use depth of research and long-term, strategic thinking to identify areas where the market is over-weighting unlikely adverse outcomes

Use a probabilistic framework to constantly evaluate business value

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Our Way: Three Outcomes or Paths to Value

Compounders

• • • • • • • •

Great businesses at great prices due to short term problems Misunderstood: great businesses priced as average businesses Never significantly undervalued, but lower risk

Contrarian Investments
Out-of-favor, unloved, troubled, really cheap companies Behavioral finance influenced approach

Activist or Management Collaboration Candidates
Value trapped by managements, unlocked by shareholders Can be contrarian investments in need of a catalyst Cash-producing businesses that can become compounders with capital allocation discipline

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Compounders: What are they?

“Good” companies

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High return on capital Solid balance sheet Enduring competitive advantage Lower than average business volatility Opportunity to reinvest cash flow in the business at high returns

“Good” managements
Uses ROI to make business decisions History of proper capital allocation Repeatable business processes which reinforce competitive advantage

“Good” industries or markets

• •

Secular growth opportunity Competitive barriers to entry

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Considerations for Investing in Compounders
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Less frequently mispriced – everyone knows the “good ones” Sources of undervaluation

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• • • • •

Certainty of continued growth is high, but underappreciated Competitive advantage period is longer

Cautions
Great businesses are rare Distinguish between businesses in “sweet spot” and those with longevity Investments in growth can destroy value EVERYTHING is subject to technological change Selectivity is critical

Temperament Requirements

• • • • •

Patience Ability to withstand periodic “worry cycles” of sentiment and press coverage Ability to withstand long periods of no new information Long bouts of mediocre performance Often better in down markets than up markets

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Contrarian Investments: What Are They?
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Out-of favor stocks, clear potential for loss, price no longer reflects potential for improvement or hidden assets Higher expected returns

• •

But… a wider range of possible outcomes Drivers of return or loss are not market-, industry- or economy-specific, but rather company-specific or turnaround/execution related

Less correlated with market indices Human behavior is always searching for clarity and certainty: attractive contrarian investments are available in almost any market Best candidates often have

 

• •

• • •

Formerly good business model, formerly high valuation Signs of capitulation: shareholder turnover, disgust, management credibility in question No visibility; no catalyst Operating leverage magnifies upside scenarios Specious secular or competitive decline arguments

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Considerations for Contrarian Investing
Cautions  Determining consensus is difficult – often there isn’t one  Timing – each outcome follows a different story and timeline  Calibration – wide ranging outcomes = probabilities dominate valuation  Market switches positions frequently, and violently  Risk management/hedging

Temperament Requirements  Patience for the right entry price  Patience with the turnaround  Weirdness  Ability to handle criticism  Ability to stand alone  Comfortable with extreme volatility  Resourcefulness  Humility
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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Contrarian Patience and Timing Illustrated: COCO

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Contrarian Patience and Timing Illustrated: IL

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Activist/Engaged Investments: What Are They?
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Contrarian investments with an investor-created catalyst Opportunity to improve returns

• • • • • • • • •

Changing capital allocation Changing management incentives Changing strategy Changing governance
Limited restrictions on shareholder rights Consolidated shareholder base with limited exposure to passive funds Other contrarian investors on shareholder list Stable (enough) underlying business to withstand transition period Management or Board open to discussion

Best candidates often have:

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Considerations for Engaged Investing
Cautions  Expensive – lawyers are necessary, useful and expensive  Illiquid – requires standstill agreements and NDAs  Degree of Difficulty – you don’t get paid more for it. (The “OSM” – it is always worse than you think)  Time commitment is substantial

Temperament Requirements  Patience  Intensity – requires consistent pressure and engagement  Ability to withstand intense criticism – changing conventional management thinking is an arduous process. (Think “the B-word”…”Bad Guy”)  Requires financial analysis that exceeds financial statement analysis

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Why pursue several paths?

Periodically, it will seem only one way of investing works

• • •

If you can time it correctly, you should, (but you can’t) Compounders always seem lower risk, until you’re wrong about one

You will be wrong about one

• From 2004-2007 Contrarians worked best Portfolio diversity manages risk and creates upside

For example, currently compounders massively outperforming contrarians because of falling interest rates, low risk tolerance and large cap market bias


Higher range of outcomes in contrarian investments means more upside if you do it right Lower absolute undervaluation in compounders makes mistakes difficult to make up for
Compounders more market correlated Contrarian Investments’ value-drivers are more company specific

Market valuation/correlation different in each group

• •

Activism/Engagement can create catalysts

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Two Ideas

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Markel (MKL $595.00)
April 2009-Present

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Markel: A Compounding Machine
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Time from premium receipts to claims payouts creates float, which is invested in financial assets Markel makes underwriting profits, so has enough cash from premiums to pay claims Therefore, all income from investments (value) accrues to shareholders AND future underwriting profits add to shareholders’ capital base Excess capital is reinvested in insurance (when favorable), or equities and ventures for higher returns
MKL vs. Industry Combined Ratios Markel cash income vs. net claims paid:

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Markel: Culture Drives Track Record of Value Creation
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Must visit Markel to understand its culture (and read the proxy) Sticks to niche insurance segments, never prices for share Reserves cautiously, and allocates capital sensibly All united by single shared goal: Entire management teams’ bonuses are paid on 5-year trailing book value CAGR. Book Value CAGR < 11% = no bonus CAGR since 1995
Book Value: 15.8%

MKL Stock: 14.1%

S&P 1500: 7.6% S&P 1500 P&C Insurers: 6.8%

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Markel: The Market Doesn’t Get It

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Best in class property casualty (P&C) insurer outperforms peers and the stock market… …with MUCH lower volatility (Beta = 0.6) Yet stock follows the run-off value (book adjusted for timing and reserve redundancies) So all future underwriting profits, investment and ventures growth is free Don’t expect the market to understand, given belief that “you can’t value an insurer with a DCF”
MKL Stock: $593 (1.25x book) Run-Off: $596 Plus Future UW Profit: $125 Conservative Value: $721 (+22%) Net Investments per Share: $992 Plus Future UW Profit: $125 $1,117 per share (1.9x book)

DCF: $1090+, depending on future interest rates

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Markel: Get Rich Slowly
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Market values Markel like all P&Cs, on book value, so stock will grow roughly with book value Acquisition of Alterra increased net investments per share to $992. Plus current insurance cycle creating capital inflows (profits) from underwriting – lots of new capital to invest in equities and ventures Ventures and equities rarely sold, so MKL is a tax-deferred savings account Oh… and it’s a PM’s dream:
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No tricky sell decisions Equity+ returns, bond volatility
Ticker: Price: Market Cap: Book Value: Book CAGR: MKL $593 $8,307m $477 12-15%

Beta:

0.6

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Bed, Bath & Beyond (BBBY $68.43)
April 2012-Present

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Bed, Bath and Beyond: Not a Declining Retailer
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Established merchant with a “see-it-before-you-buy-it” assortment Five unique concepts Significant valuation discrepancy with home-goods peers Stable profitability and cash flow enabling reinvestment in mobile, e-commerce Thoughtful, well-timed share repurchase creates a significant cash yield Price strategy and nature of goods allows time for omni-channel transformation PWV of $105 implying 54% return from here

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

BBBY: Valuation Discrepancy
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BBBY is down 15% year-to-date – only Pier One has performed worse BBBY trades at a 15% to 25% discount to home related retail peers depending on one’s preferred valuation metric

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

BBBY: Stable Profitability and Cash Flow
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BBBY has consistently produced higher profit margins and returns on equity versus peers If the stock were to simply trade in line with HD, a company producing a similar average return on equity, BBBY would be a $90 stock ULFCF has remained just under $1 billion for the past five years and the management team has committed to continuous share repurchase…
Last year EBITDA Margin 13.8% 10.7% 13.8% 13.7% -2.7% 9.9% 16.8% 5-yr Avg ROE 22.8% 12.3% 16.7% 13.3% N/A 16.3% 21.1%

HD LOW WSM PIR RH Average BBBY

FY End February 2010 2011 2012 2013 2014

ULFCF ($mln) $754.5 $806.7 $982.6 $878.7 $870.2

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

BBBY: Using Capital Wisely
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40 new stores a year across five concepts Remaining share repurchase authorization $2.5 billion, expires 2015 To complete the program, which we believe is the goal, share repurchase should meaningfully accelerate The depressed stock price provides an opportunity for management to increase value through share repurchase, which they have been apt to do in the past

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Lane Five Capital Management

Finding Your Way Along the Many Paths to Value

Thank You!

Lisa O’Dell Rapuano, CFA lisa@lanefivecapital.com

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