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William C. Dunkelberg Owl Fund March 29, 2014 Michael Kollar: Lead Analyst Maxime Berin: Associate Analyst Shady Botros: Associate Analyst

Valero Energy Corporation

Exchange: NYSE Ticker: VLO Target Price: $73.68 Current Price: $52.86

Oil & Gas Refining & Marketing


VLO is the worlds largest independent petroleum refiner and marketer, supplying transportation fuels (Diesel, gasoline, jet fuel, ethanol) and petrochemical products (propane, sulfur, asphalts, etc.), with 16 refineries and 11 ethanol plants. VLO is based in San Antonio, Texas and its geographic portfolio includes the United States (73% of revenue), Canada (7%), United Kingdom (8%) and the Caribbean (12%). VLOs revenue is driven by refining (96%) and ethanol production and (3.57%). Its refineries have a collective throughput capacity of 3.1 million barrels per day (mmbdp), while its ethanol plants have a capacity of 1.2 billion gallons a year. VLO also owns and operates a 50 mega-watt wind farm.

Sector Outperform
Recommendation: BUY
Key Statistics
Price Projected Return Shares O/S (mm) Market Cap (mm) P/E $73.68 39% $ 533 $28,159 12 52 wk Low 52 wk High Yield EV (mm) Beta $33.00 $ 55.96 1.89% $30,917 2.49


VLO is undervalued as it currently trades at a 16% discount to its implied EV/EBITDA multiple (5.44x vs. 6.31x) relative to its peer group. In the past, Gulf Coast (GC) refiners such as VLO have been at a cost disadvantage due to purchasing expensive Brent crude international feed stock while midcontinent competitors possessed the ability to source cheaper WTI feed stocks. The cost advantage has begun to transition to the GC region as synergies are realized between the GCs geographic export capabilities and the low-cost feed stocks abundantly flowing from E&Ps in Canada, the Bakken, and other higher margin crude basins around North America. VLO is the largest independent refiner in the Gulf Coast region and will see margin expansion between its imported feed stocks and exported refined products. Along with margin expansion, VLO has numerous growth investments which will increase volumes, fueling EBITDA growth in FY2014 and FY2015. With margins supported by microenvironment forces such as the US ban on exporting crude and the imminent Keystone XL pipeline completion, efficient logistics systems, and growing international demand for highly refined distillate products, VLO is positioned to capture this value creation more so than any of its peers. We rate the company a strong Buy.

Earnings History
Date 1Q2013 2Q2013 3Q2013 4Q2013
$8.00 $7.00 $6.00 $5.00

$ $ $ $

EPS NI YOY NI Surp Price 1.18 251% 24.6% -3.8% 0.85 -44% -21.3% -2.1% 0.57 -54% 14.9% 3.0% 2.38 28% 74.5% 2.4%
Diluted EPS & Consensus

$3.00 $2.00 $1.00 $$(1.00) $(2.00)
1Q 2Q 3Q 4Q Year 2010 2011 2012 2013 E2014 E2015


Earnings Per Share ( $) for Fiscal Year Ending Dec.

Period 2010 2011 2012 2013 E2014 E2015 1Q $(0.20) $ 0.17 $(0.78) $ 1.18 $ 1.30 $ 1.55 2Q $ 1.03 $ 1.30 $ 1.50 $ 0.85 $ 1.65 $ 2.29 3Q $ 0.51 $ 2.11 $ 1.21 $ 0.57 $ 1.55 $ 1.76 4Q $(0.77) $ 0.08 $ 1.82 $ 2.38 $ 1.14 $ 1.32 Year $ 0.57 $ 3.69 $ 3.75 $ 4.97 $ 5.64 $ 6.92 All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl Fund does and seeks to do business with companies covered in its research reports.

Spring 2014 POSITIVES

Widening WTI-Brent Differential: Currently, the spread is ~$8.00/barrel. The US Energy Information Administration forecasts that the differential between WTI and Brent crude prices and in its latest Short Term Energy Outlook report, the EIA stated, The economics of transporting and processing the growing production of light sweet crude oil in the U.S. and Canadian refineries will cause the differential to widen to $10/barrel over 2014 and $11/barrel over 2015. This is a key tailwind for VLO as it can continue to source cheaper, domestic feed stock and market higher yielding distillates abroad. Hydrocracking & Capacity Growth: VLO has growth investments underway at Port Arthur (+60mbpd, +17%) and Meraux (+20mbpd, +15%) refineries which will increase distillate yield by 1Q2015. Each of these refineries are located on the GC which will allow VLO to process more discounted sweet crude feed stock. Also, supplementing GC growth is a +25mbpd/+15% capacity expansion at VLOs McKee refinery, located in Texas. Keystone XL Pipeline Approval: The Keystone XL pipeline is the final 1,179-mile, 36-inch-diameter leg of the pipeline that will bisect the US. It will run from Canada to Nebraska, where it will link with existing pipelines and extend to the GC. After originally proposed by Transcanada in 2008, the project has been put on hold for environmental and political reasons. However, on January 31, 2014, the US State Department approved the Environmental Impact Statement (EIS) and confirmed the project is safe to continue. The project must be approved by the Obama Administration within 90 days of January 31. If approved, the Keystone XL will move 830,000 bpd of Canadian sour crude with wide margins. VLO has committed to taking 20% of XLs initial capacity. Rising International Distillate Demand: While worldwide demand for gasoline is expected to remain relatively flat, diesel consumption is expected to rise 2%. World product demand for diesel is expected to grow especially in Latin America and Europe, where supplies are low. Logistics: VLO will spend nearly half of its 2014 growth investments on its logistics segment, investing over $750 million in new rail cars. VLO had originally purchased 5,320 rail cars for $750 million, 2,000 of which have already arrived, while the remaining 3,320 are set to arrive by the second quarter of 2015. The newer rail cars will increase access to cost advantaged crudes and the capability to export products and crudes, regardless if the Keystone XL pipeline is approved.

Summary: VLO has a narrow but stable economic moat enforced by high barriers to entry. Location: VLO has refineries located on the Texas and Louisiana coast line close enough to large shale plays such as the Permian and Eagle Ford Basins affording VLO cheaper transportation costs on crude feed stock. See Location advantage. Scale: VLO benefits from being the largest independent refinery located on Gulf Coast. Integration: As a major gasoline producer, VLO is government mandated to blend ethanol in its products. VLO has aggressively invested in ethanol production, vertically integrating its supply chain. Diversification: VLO markets the ethanol it produces, supplementing revenue. VLO also maintains an ownership stake in Valero Energy Partners (VLP), a MLP that earns revenue by fees and tariffs for using its transportation & logistics infrastructure.

Commodity Price Volatility: VLOs margins are directly correlated with the prices of its feed stocks and its refined products. Economy: VLO is highly correlated with the health of the US and global economy. Consumption of refined products decreases in periods of economic weakness and when raw material prices fluctuate according to market supply & demand forces. Environment: VLOs refining operations, particularly in the Gulf, are at risk of disruption due to hurricanes. Regulations: Fines and sanctions from federal, state, and local environmental laws and regulations regarding discharge of materials, pollution prevention, waste management, and greenhouse gas emissions. Projects: VLO has multiple ongoing and newly beginning projects. There is potential that these may turn into drag factors if they fail to meet analyst and investor expectations as far as timing and returns.

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Overview Refinery revenue is dependent on domestic and international demand for their products, while profits are dependent on the Crack Spread, or the differential between the cost of crude to a refinery and the price it can charge for refined products after cracking the crude. While major integrated oil companies hedge themselves against market price movements naturally by controlling their supply chains, independent refiners use the futures markets to lock in future prices for fuels and other petroleum products depending on their optimal product mix. Futures prices are determined by the New York Mercantile Exchange (NYMEX) which was founded in 1882. Refineries run many types of crudes at various differentials, but as a proxy, their feed stocks prices follow West Texas Intermediate crude (WTI) while their refined products fetch prices closer to, and above Brent crude. The Year Ahead We believe that FY2014 will prove to be an excellent year for the refining industry, as robust investments in infrastructure solidify the Unites States position as a net energy exporter. Crude oil now flows from the mid-Continent US to refineries on the East, West and Gulf Coasts via interstate pipeline networks, railways, ships and river barges. It should be noted that there has not been a large refinery (>100,000bpd capacity) built in the US since 1976 ( See Appendices: Newest US Refineries). The lack of new refinery construction insulates Valero from losing market share going forward. Location Advantage The Gulf Coast (GC) is the largest refining center on the planet and companies with refineries in the region, such as VLO, have a large competitive advantage on feed stock costs and export capability compared to those who do not. Logistics infrastructure has been built out from the GC across the continent which affords refiners in this region with the lowest feed stock cost, currently $0 to $5 below the price of Brent, versus +$2 on the East Coast and +$1 to -$2 on the West Coast. VLO has over 50% of total refining capacity on the GC with a total operating capacity of 14.3 mmbpd, represented on the graph to the right, second only to XOM, the largest oil company in the United States. VLO towers above PSX and MPC, the only other refineries in VLOs peer group (other refiners are major integrated and private LLCs and LPs). VLO also benefits from being in the US as it pays about $4/mmbtu for its natural gas it uses for processing, compared to $16/mmbtu in Europe and $17/mmbtu in Asia. US Export Ban on Crude Not Lifting Anytime Soon A key tailwind to the refining industry and VLO is the US ban on crude exports. The ban will remain over the mediumterm as any change would require an act of Congress and the US Secretary of Energy has stated that those in favor of its lifting have failed to make a convincing argument. Further, requiring domestic crude to be refined prior to exportation effectively subsidizes gasoline prices for Americans because E&Ps cannot export their product directly to the international markets. If E&Ps could sell crude internationally, domestic prices would rise to equilibrium with international gasoline prices. Although there is immense lobbying done by the major integrated oil companies (such as XOM), Congress is unlikely to favor any legislation detrimental to American consumers and the overall economy.

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Effects of Ukraine & Russia Conflict Europe views the conflict in Ukraine as a potential threat to its economy because it imports 30% of its oil from Russia. Further, most of Europes natural gas travels through pipelines spanning Ukraine. Geopolitical unrest in the region creates volatility in the global energy markets, particularly the Brent crude index. While higher Brent prices historically amount to improved pricing for VLOs refined products, violence and war can inflate all crude indices, resulting in margin compression. WTI Brent Spread Crude oil in North America is priced as West Texas Intermediate (WTI) at a central hub in Cushing, Oklahoma. Without getting into explicit detail, WTI is sweeter than internationally benchmarked Brent crude because its lower sulfur content makes it easier to refine into diesel, gasoline, and other distillates. In theory, WTI would be priced at a premium to Brent because lower refining cost leads to higher margins, and price should reflect this cost advantage. However, structural difficulties in getting WTI to international market and rampant supply results in its discount to Brent. These structural difficulties include the United States ban on crude oil exports and government restrictions on pipeline development. This disconnect is more evident as the correlation between the benchmarks has also broken down since US production has increased since 2011. The U.S. Energy Information Association noted in its latest Short Term Energy Outlook report that it expects the spread between WTI and Brent to average $11.46 per barrel through 2014, and $11.34 per barrel through 2015higher than the current level of $7.50 per barrel. Supply The advent of hydraulic fracturing and horizontal drilling has made it economically sound to extract from the tight oil plays located in the Bakken (North Dakota), Permian (West Texas), and Eagle Ford (Texas) Basins. E&P production in North America has accelerated, and is forecasted to increase 1mmbpd by 2015. Combined with improved logistics, increasing supply will afford VLO cheaper feed stocks and facilitate the continued disconnect between WTI and Brent crude prices.


VLO has two reporting revenue segments going into FY2014, refining and ethanol. The refining segment (5-Year CAGR: 16.8%) cracks crude oil into transportation fuels such as: conventional gasoline; reformulated gasoline; ultra-low sulfur gasoline; clean fuel additives; diesel; commercial, military, and defense standard jet fuel; and methanol. The remainder of crude is then processed into petrochemicals (See Appendices: VLO Major Products & Services). The ethanol segment (5-Year Revenue Segments $5,242 CAGR: 31.5%) continues to generate strong revenue for VLO, $5.2B $3,896 in FY2013. VLO acquired 11 ethanol plants which produce over 1.3 Refining: 93.5% billion gallons of ethanol per year, establishing VLO as the first Retail: 2.8% traditional refiner to enter the production of ethanol, under the subsidiary VLO Renewables. The Company produces more ethanol Ethanol: 3.7% than it can blend, selling the remainder on the market. VLO entered the ethanol market by purchasing the 7 plants in fire sales in 2Q2009, $131,940 acquiring the entire portfolio for 35% of estimated replacement cost, and earns a 40% cash IRR.

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The Company reported $138.1B in total revenue for FY2013, down from $139.3B in FY2012, despite seeing refining revenue grow $99mm (+<1%) and ethanol revenue grow $810mm (+18.3%). This decrease was a result of VLO spinning off its lower-yielding retail segment (accounting for +$12B revenue in FY2012) as a new publicly-traded company, CST Brands, Inc (NYSE: CST). After it was spun-off to shareholders on May 1, 2013, VLO held a minority interest until November. As this segment was discontinued, FY2013 retail segment only accounted for $3.9B in revenue. Going into FY2014, VLO is expected to see a further drop of 2.8% as there will no longer be retail revenue. *Bloomberg has expected revenue for FY2014 to be $121.7B, or -12% YoY growth. Upon further investigation, this forecast is the result of two outlier analyst expectations ($93B and $95B) pulling down the mean revenue estimate of a sample size of only six. These estimates imply that VLOs revenue would drop 31% in one year a highly unlikely scenario. Each analyst is unranked, one is from an undisclosed firm, and the other still maintains an Outperform rating on VLO with a TP of $63.00/share. After conducting our due diligence o n VLO, we believe the only factor attributable to such a large decrease in revenue would be the crude export ban being lifted which we feel is not feasible in the near-term. Excluding these two anomalies, the mean estimate reverts to a more realistic $135B in revenue, representing a modest -1.8% YoY growth, which is in-line with our expectations of flat-to-decreasing oil prices through FY2014 and absent retail revenue. EBITDA Due to the sometimes volatile nature of revenue, EBITDA is the best measure of a refiners performance. VLOs EBITDA in FY2013 was $5,185mm, down from $6,180mm in FY2012. This was a result of decreased margins on gasoline prices and the completion of VLOs retail segment spin-off to CST Brands, Inc. Despite this recent decrease, EBITDA has grown at a 5-Year CAGR of 28.7% from numerous growth investments in hydrocracking/distillate production and light crude capacity expansion. FY2014 EBITDA estimates are $6,702.3mm, +17.9% YoY. As VLO eliminated costly retail operating expenses and continues to add light crude capacity, distillate yields should appreciate further and drive EBITDA to these estimates or higher (See Appendices: Charges & Yields)

As the WTI-Brent spread expands, so too will VLOs margins. Also, it is highly likely that the passing of the Keystone XL pipeline will also boost margins for VLO in the short term. VLO invested more than $1.4B in its logistics projects and is forecasted to invest another $1.3B by 2015. By moving cost-advantaged WTI more efficiently, margins on this feed stock will expand. The increase in volume has also been a key driver in VLOs margins. They have increased their Gulf Coast refineries output by 139,000 barrels which now represents 57% of the total output. VLO currently has a margin of $12.25 per barrel, which is much higher than the previous quarters $7.88 per barrel. VLO has invested in distillates (Diesel, Kero, jet fuel) in 2013, which yielded a $16 per barrel margin, compared to a $12.25 per barrel margin for gasoline. Beneficially, global demand for diesel and jet fuels is growing 1.5x faster than the demand for gasoline.

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Operating Expenses
VLOs overall operating margin decreased by 7.5% in 2013 after the spin-off of its retail and convenience store, CST Brands in May 2013. This decreased the VLO retail segments operating expenses by $267mm, or 67%. The refining segments operating expenses increased by $36M mainly due to an increase in natural gas prices. Finally, there were higher operating expenses in the ethanol segment, amounting to $55mm, due higher corn commodity prices driven by droughts in the Mid-Western US. VLO production rose during this period which demanded increased chemicals, which also increased operating expenses.

VLO reported 4Q2013 EPS of $2.38 v. $1.50 estimates. These earnings were above analysts estimates by 58.35%. This compared to $1.82 EPS in 4Q2012. This large beat included a nontaxable gain of $0.60 per share from the disposition of VLOs retained interest in its retail segment to CST Brands, Inc. Excluding this unusual item, adjusted EPS was $1.78 which still beat estimates by 13.2%. Although earnings are affected by the seasonality of the business, VLO has beaten estimates 9 of the last 12 quarters. A key catalyst for future earnings growth is VLOs MLP , VLP, which currently houses three of VLOs logistic assets (See Appendices: VLP MLP). VLP is a traditional MLP and generates cash flow from tariffs and fees for transporting crude and does not source earnings from the commodity itself. The first drop down to VLP is expected to be in 3Q2014 and is forecasted to increase distributions 20% annually for the next three years.


VLOs board of directors recently announced an 11.1% increase to its quarterly dividend, raising it from $0.22 to $0.25 per common share. This represents 65% dividend growth rate in the last three years, and a dividend yield of 1.89%. In FY2103 VLO distributed $1.4 billion to shareholders through dividends and share buybacks, doubling that of FY2012. Valero is strongly committed to shareholder return and consistently increasing the dividend.

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Total Debt: $6.56 Billion Debt to Equity: 32.9% Interest Coverage Ratio: 12.0

After $1.2 billion in debt was issued between FY2008 and FY2010 to fund aggressive capital expenditures to expand refining capacity, VLO has been reducing its leverage. Debt has been decreased each year since by an average of 6%. VLOs debt to capital ratio at the end of 2013 was 24.8%, compared to 28% in FY2012 and 32% in FY2011. Currently, VLO holds total outstanding debt of $6.56 billion. Despite this burden, VLO is more than capable of meeting its short term obligations, with an interest coverage ratio of 12.0, as well as a current ratio of 1.50. VLO is solvent as evidenced by a debt-to-equity ratio of 32.9%. VLO is scheduled to pay off $200 million notes in April 2014 and maintains an investment grade debt rating by S&P.

Free Cash Flow

VLO FCF has a 5-year CAGR of 26.9% with $3.44B reported in FY2013 and $2.04B in FY2012. Management has given FY2014 CAPEX guidance of ~$3.0B. They anticipate 50% of this to fund growth projects while 50% will be allocated to maintenance. Refineries are operational 24/7/365 and due to the intense pressure, heat, and mechanisms involved in the refining process, regular maintenance is crucial to ensure continued operations without outages.


The target price was calculated using an implied EV/EBITDA multiple. Once VLOs catalysts are realized, the company will trade more in-line with its peer group, represented by a target multiple, of 6.31X.


This peer group includes the other members of the S&P 500 Oil & Gas Refining & Marketing index, as well as other US refiners. Tesoro Corporation (NYSE:TSO) Marathon Petroleum Corporation (NYSE:MPC) Phillips 66 (NYSE:PSX) Delek US holdings (NYSE: DK) Holly Frontier Corporation (NYSE: HFC)

Peer Analysis Target Price = $73.68

Target Multiple EV/EBITDA = 6.31x NTM Consensus EBITDA = $6,659 Projected Return: 39%

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Relative Valuation
Valero Energy Corporation (VLO) Comparable Analysis
($ in millions except per share) Capitalization Stock Equity Enterprise Price Market Market Value Value Company Current
MPC HFC (MLP) PSX DK TSO Median Mean VLO $52.86 $28,159 $30,917 $87.67 $47.45 $76.65 $28.43 $50.50 $25,675 $9,441 $43,476 $1,712 $6,616 $27,191 $9,385 $44,673 $1,908 $9,390

Valuation Multiples P/E Multiple LTM

12.92 12.65 13.74 14.60 17.58 13.74 14.30 11.76

Margins Gross EBITDA LTM

5.3 6.8 5.3 4.0 8.0 5.3 5.9 3.6

Profitability Net LTM

2.2 3.6 2.4 1.3 1.1 2.2 2.1 2.0

5.97 6.06 12.78 5.83 7.40 6.06 7.61 5.44

19.2 12.6 16.2 12.8 9.3 12.8 14.0 13.1

7.6 7.2 7.6 4.3 3.4 7.2 6.0 5.9

8.17 10.11 9.72 10.05 7.81 9.72 9.17 8.35

4.17 4.75 5.74 4.18 4.15 4.18 4.60 4.37

4.8 7.7 2.3 3.7 3.3 3.7 4.4 4.1

Liquidity Leverage Current Interest Debt/ Debt/ Dividend ROC Ratio Coverage Equity Capital Yield Ratio NTM LTM LTM MRQ LTM LTM
14.9 10.4 13.9 10.8 7.5 10.8 11.5 11.5 1.30 2.33 1.49 1.31 1.56 1.49 1.60 1.47 16.09 18.31 9.27 6.31 5.16 9.27 11.03 10.86 31.1 16.7 28.0 43.9 65.8 31.1 37.1 33.7 23.1 13.1 21.6 26.8 34.0 23.1 23.7 24.8 1.76 6.74 1.73 3.34 1.78 1.78 3.07 1.61


On a 3-year EV/EBITDA basis, VLO has deviated below where it normally trades, relative to its peer group. With industry tailwinds of decreasing oil prices, increasing distillate international demand, and continued discounted crude feed stocks, we believe VLO is currently undervalued at its current multiple of 5.44X. Given our bullish outlook for VLO over the next twelve months, we expect 16% multiple expansion from 5.44X to the implied multiple of 6.31X.

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Spring 2014 APPENDICES

VLO Capacity Dominance VLO is the dominant independent refinery in its peer group, as well as in the GC region

Charges & Yields (2013, 2012, 2011) VLO has been increasing the amount of sweet crude it has processed in the last 3 years by almost 10%. This has resulting in higher yields. Our focus is on VLOs refineries in the GC, as they have reduced sour charges since 2011 and doubled the amount of sweet crude charges, improving yields in both gasoline and distillates as a result.

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WTI BRENT Historical Spread over 10 year period

VLO EV/EBITDA to S&P 500 Oil Refiner Index EV/EBITDA over 10 year period

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VLO Major Products & Services
Reformulated gasoline blend stock for oxygenate blending (RBOB) Conventional gasoline Premium grades of reformulated and conventional gasoline California Air Resources Board (CARB) Phase III gasoline Customized cleanburning gasoline blends Clean-burning oxygenates Low-sulfur gasoline Low-sulfur diesel Jet fuel Aviation gasoline Kerosene Home heating oil and stove oil Asphalt Lube oils Crude mineral spirits Bunker oils Propane Octane Alkylate Naphtha Raffinate Reformate Anhydrous ammonia Ammonium thiosulfate Benzene Iso-octanes Mixed xylene Methyl tertiary butyl ether (MTBE) Petroleum coke Petroleum coke gasifier slag Spent metal catalyst Spent sulfidic caustic Spent sulfuric acid Sulfur Toluene Ethanol

VLO 3-Year Historical EV/EBITDA Benchmarked to S&P 500 Oil&Gas Refiner Index

VLO 5-Year Historical EV/EBITDA

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DISCLAIMER This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward looking statements contained within are simply the authors opinions. The writer does not own any Valero Energy Corporation stock. TUIA STATEMENT Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in real -world principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Funds goals ar e threefold: Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.

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