Chieftain Barrons Interviews 87/88

[CHIEFTAIN
CAPITAL BARRONS PROFILES] 1

Chieftain Capital Barrons Profiles

Part 1: 1987 to 1988
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Post-Crash Bargains --- Or, if You Liked It at 20, You'll Love It at 10
23 November 1987
Barron's
(Copyright (c) 1987, Dow Jones & Co., Inc.)

DESPITE their youthfulness, Glenn Greenberg and John Shapiro are seasoned veterans of the investment wars. They've
been in the Street for a dozen years, serving apprenticeships in the usual places (Glenn at Morgan Guaranty, John at Merrill
Lynch), then moving on to more venturesome ground -- running a large private portfolio -- and finally, several years ago,
launching their own firm, Chieftain Capital Management. In essence, they manage something like $150 million of capital
for individuals and their record shows they manage it exceedingly well. Since Chieftan was born in January 1984, its
performance has exceeded the S&P 500 by an average of 15 percentage points annually. Like the rest of the world, Glenn
and John were shocked by the October crash, but unlike much of the world they're not entirely convinced the bad days are
over. However, they also feel there are interesting values to be found, even in the worst of markets, and they talk about
some in the following Q & A.
BARRON'S: As we understand it, you're value investors. A value investor is someone who hadn't done very well this year
even before the crash.
Shapiro: That's a pretty good description. Although, most years, I wouldn't turn down our performance of the first nine
months and, of course, right now, I surely wouldn't.
Q: Tell us, though, how do you guys define a value investor?
Greenberg: I'll take a cut at it. I think all value investors look for a disparity between the current market price of shares and
the value of the franchise; at what price or liquidated. And so one beginning point for us is to look for companies that are
selling at half of what we think they're worth. And our valuation or appraisal tends to be on the low side.
The second thing we look at is to see whether these are good businesses. And that sort of falls into the Warren Buffett-type
idea that a good business is one that has predictable cash streams, throws off excess cash after capital expenditures, isn't
easy to attack by competition, is not highly volatile.
We look for these characteristics, and many of the companies we look at are what I refer to as geodes, stones that from the
outside to a casual observer look to be ordinary rock, but when you crack them open and look very carefully you see
beautiful crystals.
Shapiro: I would add another point. I think one of the big differences between the value investing we do and what other
people call value investing is patience. We have plenty of it.
Q: The merger and acquisition boom, of course, has made geniuses out of a lot of people who call themselves value
investors. Do you think every time you buy a stock that it's going to be taken over?
Shapiro: No. Definitely not. I think we've had maybe one takeover of a position we've owned in the almost four years since
we've set up our own shop. We look for the value to be realized because the business has a value, not because somebody's
going to come and pay more than you did.
Greenberg: A second way it gets realized is by management retiring a significant amount of shares outstanding. Because if
the business does generate cash, and if it's selling at a low absolute multiple, the best revenge on the stock being neglected is
for management to retire shares.
Q: How do you go about finding stocks? Do you use Wall Street research, for instance?
Shapiro: Certainly not.
Greenberg: That's one area we've never gotten an idea from since we've been in business. We give out commissions for
execution and not for ideas.
Q: Why do you suppose the Street, in your experience, has been so absent of ideas?
Greenberg: I think because Street research has become an extension of the sales arm and investment banking arm of
brokerage firms. They're out to get you to buy something or to sell something, and that's a very dangerous way to invest.
Q: Well, then, tell us how you do find likely-looking prospects.
Greenberg: I'd say we depend heavily on contacts we have with other so-called value investors who are looking for
companies with similar qualities to those we look for. We also rely very heavily on reading trade publications and
magazines and coming across something that catches our eye and causes us to take a closer look at the companies involved.
Q: What effect has the market crash had on you? Made you humble, we suppose.
Greenberg: We were humbled for the last 12 months before the crash, since our stocks were not performing terrifically.
Q: Can you quantify the impact of the crash on your performance?
Greenberg: We went from +18 to 3.
Q: Aside from making you poorer, has it made you wiser?
Shapiro: I am not sure if all of the lesson is over.
Q: What was most shocking to you?
Shapiro: We had not anticipated the total breakdown of the over-the-counter market.
Q: Who did!
Shapiro: In the period from August, when the market peaked, until right before the crash, our stocks held up very well,
despite the market coming down about 13%-14%. It was really after Black Monday, when the over-the-counter stocks and a
lot of the secondary-type stocks simply stopped trading, that we felt the pain.
Q: Has this affected your view of over-the-counter stocks? Or is that question too silly to even ask?
Shapiro: I think that we will have to be more cognizant, especially if we are taking large positions in terms of the amount of
float, whether a stock is traded over the counter. It was a rude awakening in that sense.
Q: The market makers didn't exactly present profiles in courage.
Shapiro: Not quite. One of the things that affected Gotaas Larsen Shipping quite negatively was the fact that a lot of people
in the market knew that George Soros had a large position in it.
Q: And still does.
Shapiro: Still does. And they came to the conclusion, with the type of reports that were appearing in the press about some
of his problems, that this would be a stock that he would dump. So the market makers all were short the stock.
Greenberg: A chart that interested me is in Value Line on the back of their white weekly report. It shows the relative
performance of the Value Line Index compared to the Dow Jones. And it shows what levels represent extreme disparity in
valuations: 1969 being an area of extreme overvaluation of smaller companies relative to larger ones; '74 and '75 being the
opposite. And then '83 being again the peak for small companies, relative to large ones.
Q: Right.
Greenberg: And today the decline has taken us about 80% of the way to the levels reached in '74-'75. What that suggests to
me is that we personally have done quite well to have had the kind of performance we have had.

Q: It also may suggest that there could be at least 20% more to go on the downside in the smaller-capitalization stocks.
Greenberg: It suggests that there is room to go, and also if '74-'75 is any indication, the first stocks people buy, no matter
how undervalued smaller companies are, the first ones they buy, once you turn the corner into a more positive market
environment, are the larger-cap companies. After that, when they get confidence, they become bargain hunters, and you
can make a tremendous amount of money in smaller companies.
Q: You had huge speculation in the large-capitalization companies. Is that cured?
Greenberg: To us, the most troubling element of the stock market today is that the S&P 500 is still selling at about 14 times
earnings, which strikes us as being absolutely high, and relatively high compared to bonds. Our portfolio might be five or
six times earnings, which strikes us as being absolutely low and relatively low. But if we have a readjustment of investors'
perceptions regarding the big companies, it looks like our portfolio won't be immune. As a result, today, although we
haven't sold all of any of our holdings, we have reduced our equity exposure to around 65%.
Q: Sounds like you're just a mite scared.
Greenberg: The standard forecast for this year on the S&P 500 earnings is about $17.50. And if next year is a recessionarytype year, and earnings are flat or down, and the market sold at 10 times those earnings (which is high, relative to other
bottoms), that would imply an S&P 500 price of $160-$175, vs. today's $240.
Q: So there would be a lot of room on the downside.
Greenberg: That would suggest that you might have as much as another 30% decline. And my guess is that some of the
smaller companies might go from five times earnings to 3 1/2 times earnings.
Shapiro: We reduced some of our positions, not because of a perception of fundamental change, but rather of being in a
higher risk environment, and new opportunities being created.
Greenberg: One of the things that we hope for is that, when people begin investing again, the fundamentals of our selections
will still be intact, and that investors will come back to them.
Q: Agreed that we might have more trouble ahead and it could be serious trouble. Still, the market has already taken down
stocks a tremendous amount, enough, certainly, to create some interesting values. After all, if you liked the stocks you own
before the crash, you've got to love them now. So why don't we talk about some of them?
Greenberg: Okay.
Q: Let's start with Gotaas Larsen. That stock has come down quite a bit. As you say, one of the reasons was the Soros
block; that is two million shares, we believe.
Shapiro: No, he has actually trimmed back. Originally, it was about 1.8 million, and now it is about one million. The stock,
I think, is down now about 25% from where it was.
Q: Gotaas Larsen is a shipping company?
Shapiro: That's right. There are three businesses. LNG Shipping, the cruise business, and the cargo business, and the cargo
business for them is predominantly oil tankers. Let me discuss each of these businesses. The LNG shipping is under longterm contracts, from which they get a guaranteed cash flow of approximately $80 million per year. The first of these
contracts ends in 1996, and the last contract ends in 2006. Their next major business is the cruise operation. They own onethird of Royal Caribbean Cruise Lines, which is a Norwegian cruise operation. They also own 51% of Admiral Lines. And
this has been the second-largest earnings component for them, and represents relatively stable but much higher growth
business for them than the LNG business, which doesn't really grow.
The third business is the cargo business, which consists of a variety of types of ships, but mainly oil tankers. And we are
extremely positive on the outlook for oil tankers.
Q: Why?
Shapiro: There are some very interesting things that have gone on in the tanker market. It's been such a disastrous market
that you've had a huge amount of scrapping over the past five years. Tankers, if they don't get used, get cut up. And not
only have you had scrapping of tankers, but you've had scrapping of shipyards. As a result, you now have a world-wide
fleet of tankers which is, No. 1, extremely old. Over 50% of the fleet is approaching age 15 or more, when you have to start
retiring some ships. And you have a fleet which is almost in equilibrium with today's oil demand. If OPEC is pumping 18
million barrels a day, these ships can be modestly profitable. If they get above 19 million barrels a day, rates tend to increase
at a multiple rather than a percentage factor.

Q: It would seem that the cruise business might be a logical casualty of the crash.
Shapiro: That is a question mark. To date, there has been no noticeable effect. But clearly, this could be an area that would
come under pressure. Although in prior recessions, the cruise business has tended to hold up pretty well. If you think about
it, a cruise vacation is a pretty good deal; for a couple of hundred dollars a day, you get your airfare, all your meals, your
entertainment, floor shows, and sports and recreation. You get everything paid for but your drinks. And you know exactly
how much your vacation is going to cost. In the past, in the 1981-82 recession period, Gotaas cruise earnings were down
less than 20%. I am not trivializing that, but it was certainly not a business that was a catastrophe.
Greenberg: A low dollar is very positive for the U.S. cruise industry, as it attracts foreigners, and also discourages vacations
in Europe. And a factor specific to Gotaas is that they are bringing on the most exciting and largest cruise ship in the world
in January 1988, which will add significally to their earnings. In addition, they are going to be changing labor agreements
for their vessels, which will save them about $3 million annually.
Q: What's the relative importance of the business?
Shapiro: The LNG business will generate close to $80 million in cash. The cruise business will probably generate
somewhere around $17 million. And the cargo business almost nothing in cash this year.
Q: But the cargo business should benefit from any break in the oil price, which would stimulate demand and, hence, tanker
use.
Shapiro: That's right. Charter rates on oil tankers have held up very well. They are quite strong today. The secondhand
prices on tankers are quite strong. And we think that the earnings and cash flow leverage in this area could be extremely
dramatic. And if you have a decline in oil prices, which encourages more shipments from OPEC, then that is going to be
very positive.
Q: What kind of earnings do you expect this year from the cargo business?
Greenberg: I expect it to be maybe a hair below breakeven. That is with a very depressed first half, when OPEC ran without
inventories.
Q: Overall, what do you expect Gotaas Larsen to earn this year?
Greenberg: Probably about $2.80.
Q: That would compare with $2.36 last year. And next year?
Greenberg: I'd say $4.20 is a good number.
Q: And how about cash flow?
Shapiro: Almost $7 a share in 1988. If OPEC production ran to 20 million barrels a day, your tankers would be extremely
profitable.
Q: How profitable?
Shapiro: They might chip in something like $4 a share.
Q: So at some optimum time, we could be looking at something on the order of between $7.50 and $8 a share in earnings
for Gotaas Larsen?
Greenberg: Yes.
Shapiro: I think to put this in perspective, it should be noted that the returns to the ship owners become exponential at a
certain point. If that happens, it will be very exciting. We are not counting on that happening. But it's not pie in the sky.
Q: What do you figure the company's break-up value is?
Shapiro: In the $45-plus range.
Q: And it's selling around $24. Or it was last week, which, of course, is no guarantee at all. Gotaas is not unknown among
what pass for sophisticated investors, although it's hardly a household name on the Street. On the other hand, most people

know another company you like, Ashland Oil. Now Ashland, of course, is a refiner, the largest independent refiner. If oil
prices decline, as certainly seems possible, what does that mean for Ashland?
Greenberg: The point that one should make immediately is that fiscal 1986 was the best year in refining that Ashland ever
had. and that fiscal '87, ended this September, was one of the worst. And yet the cash flow of the company declined less
than 10%.
Q: How do you explain that?
Greenberg: There are two common misperceptions about the company. First is that it is virtually totally dependent on
refining for its profits. And this ignores the fact that it has built up a very sizable chemical operation and has a very large
interest in coal production, which has remained very profitable over the last few years. And it is the largest road
construction company. And these diversified activities enabled the company to earn $4.27 last fiscal year, despite the fact
that its refinery operations were about break-even. It also has Valvoline Oil, which is the third leading branded of lubricant - which had an outstanding year in 1987.
Q: And the lubricant is used on cars, not people.
Greenberg: Used on cars -- not hair. The second factor that attracts us is that the non-cash charges of this company in 1987
ran about $350 million, which is approximately $12 a share. So if they don't make a dime, they would have $12 of cash
coming into the company. And in a very poor year, like fiscal '87, when they earned only $4, they had $16 per share of cash
flow. And this year, which we expect to be a significantly better year, should take them close to $20, after factoring in an
ongoing share-repurchase program.
Q: But obviously some of that cash flow must go to keep the corporate wheels turning.
Greenberg: Right. The important question is how much of this do they need to spend to sustain operations, because the
balance is what we call discretionary cash flow, and it is central to our whole investment philosophy. And, from what they
tell us, they need to spend about $150 million annually to keep their plants in good working order.
Q: So you have about . . .
Greenberg: $150 million, $5 a share. So that would imply that the company has, in a poor year, $10 a share of discretionary
cash flow. And, in a good year, $15. On a $53 stock price, I consider that we have quite a good value.
Q: With $10-$15 a share in free cash flow, what value do you place on the company?
Greenberg: Somewhere around $95 a share.
Q: And the crash hasn't affected your evaluation?
Greenberg: We have less reason to change our feeling about this company than any other we might have. The only
operation that I can see that would be hurt by a slowdown in business activity would be the chemical business. By the same
token, I would think that a slowdown might also be accompanied by lower oil prices, which would benefit their refinery
outfit.
Shapiro: You asked what the impact of falling oil prices might be. And I think that would be, very simply, very good for the
refining operation. Refining margins tend to expand during periods of falling oil prices. And given Ashland's exposure to
refining, you could see a significant swing.
Q: So, in other words, the trouble with earnings in fiscal '87 was that you had a sharp rebound in oil prices.
Shapiro: Oil prices nearly doubled, if you think about it, in a Sept. 30 to Sept. 30 timeframe; oil prices went from $12 to just
about $20.
Greenberg: Also, asphalt is one of the large purchases for road construction, and when oil prices are falling, asphalt prices
tend to be falling. So the road building subsidiary does better. It would also probably spill over into the chemicals
operations, as your feedstock costs might be falling.
Q: You noted in passing that the company has been buying back its own stock.
Greenberg: Very aggressively. They still have another three million shares that they are now authorized to buy.
Q: We seem to remember that they paid over $68 a share for large blocks.
Greenberg: That is right.

Q: So they are under water on their purchases.
Greenberg: They also bought their stock from the Belzbergs at $51.
Shapiro: And they bought one million shares during the month of October. And I would say that the bulk of that was
probably after the market crash. They have taken advantage of those opportunities.
Q: So like everyone else, Ashland has bought stock well and has bought stock badly.
Shapiro: If I could personally own Ashland with a five multiple, I would be getting a 20% cash return on my invested
dollar, which I would consider very attractive, considering that two-thirds of it won't vary with the business cycle -- that
being the non-cash charges part. As I say, they went from their best refining year to their worst refining year, and cash flow
went from $529 million to $489 million, which is a decline of 7 1/2%.
Q: So you have a stock now selling substantially below its high, although its fundamentals really haven't changed that
much, presumably.
Shapiro: I think also that this management is well aware of the fact that, when they buy in their stock, they are not just
buying their earnings -- they are buying their cash flow. And since their non-cash charges this past year are twice their
earnings, they are really buying cash very cheaply.
Q: Another name in your portfolio is U.S. Trust, which has come down a bit, too, since Oct. 19. As we recall, there was a
rumor around for while that someone was eager to take over this company.
Shapiro: We're not too well plugged into the rumor circuit.
Q: That makes you unique in Wall Street.
Shapiro: U.S. Trust has always been perceived as a bank.
Q: Right.
Shapiro: But, in fact, today I would argue -- and I think they would argue -- that's it's a financial service company with
banking capabilities. And to demonstrate that, let me give you a breakdown of their pretax earnings. Forty-two percent
comes from asset management fees, 37% from custody and processing fees, and 21% from banking. Now, that banking
figure is before they announced the recent sale of all of their commercial loans. They are essentially leaving the commercial
lending business.
Q: So, you're saying, they're really in the money-management business, or the asset-management business.
Shapiro: That's right. And custody and processing business. I think I would also throw software into that. Now, we feel the
company has tremendous earnings potential. They have been working to develop a software system which they can market
to bank trust departments. This year, they will expense -- and they've been expensing all of their development costs -approximately $2 per share, after tax, to complete this system. They expect to have the system completed by the end of this
year, or 99% completed by the end of this year. They currently have orders for 12 of these systems, even though they aren't
ready to start installing the systems. Each system sells for $3 million. That translates into 10 cents per share of earnings for
every system they sell. So for this particular software package, the outlook is for a significant decline in the development
expense. They will begin to sell some of these systems next year and obviously they'll be very profitable since they've
expensed all the costs.
Greenberg: Their development costs will not go to zero. John mentioned that the development costs were running, the last
year or two, $2 per share after taxes. They won't go to zero. But they might go down by as much as a dollar per share after
taxes over the next couple of years. If you combine that with, say, 60 cents per share of earnings from selling the systems
and installing the systems, it would be a $1.50 swing in earnings from a $3.25 base this year. Fairly significant.
Q: No argument.
Greenberg: That's one area where we think there's tremendous earnings potential. No. 2, they have a very large investment
management and trust business. I think a lot of people view them as having the prestige and image comparable to a Morgan
Guaranty. And yet Morgan Guaranty's trust fees are more than 30% higher than U.S. Trust's. When your major competitor
has fees significantly higher, it provides room for you to increase your own fees. And they have approximately $14 billion
of trust business.

Management of U.S. Trust has been extremely astute at avoiding problems. They got out of the international lending
business in 1979. I would feel that their decision to get out of the commercial lending at this point in time will probably
prove to show tremendous foresight. They also authorized the repurchase of 10% of their shares outstanding, which in this
age of banks craving equity is quite an anomaly.
Q: It is, and, of course, U.S. Trust doesn't have that many shares oustanding.
Greenberg: That's right. They have 10.75 million shares outstanding, of which they've already probably purchased a couple
of hundred thousand, in fact, three to four hundred thousand shares.
Q: You say that they'll earn $3.25 in 1987, and you see, from what you've implied, a steady rise in the years ahead.
Shapiro: I don't want to be too optimistic, but you could certainly see over the next few years earnings growing a dollar plus
per share per year, as expenses run off and they start beginning to market these software packages.
Q: Pretty nice.
Shapiro: I might add that they've also developed some mutual fund software to compete with State Street. You ought to
begin to see some profits from that by 1989, and that could be a huge new market for them.
Q: What strikes us is, if their fees are based on the amount of assets they manage, the crash has probably shrunk the amount
of assets they manage and, inevitably, their fee total as well.
Greenberg: Well, there are several offsets to that, although basically the answer is, yes, their fee income could be reduced.
Q: Incidentally, can you give us a specific earnings estimate for next year?
Shapiro: Over $4 for 1988. And I can expand, if you like, on the fee situation.
Q: Yes.
Shapiro: On their managed assets, about 50% of them were in bonds, and 50% in stocks. So obviously you have a decline in
your stock side, but an appreciation on the bond side. The important thing is that there is a graduated fee structure. So even
as your assets decline you fall into a higher price category. Thus it offsets part of the decline. Taking everything into
consideration, the effect of the stock market crash might be to reduce fee income by around 30 cents a share after tax. But
that's probably a worst-case estimate.
Q: What are those software systems for bank trust departments that U.S. Trust has developed? Can you elaborate some on
them?
Shapiro: It is a very sophisticated accounting system for trust accounts for industrial portfolios, that can factor in all types of
financial instruments, taking into account dividends, interest payments. Really, compiling all the types of information that a
bank would need, both for its internal reporting and for reporting to clients.
Q: And you have high hopes for this, obviously.
Greenberg: They have 12 systems on order, as we said, at $3 million a copy. With all the development expenses already
written off, if they deliver six a year, at $1.5 million after taxes, they would take in $9 million -- which would be almost $1 a
share.
Shapiro: In addition, they get an ongoing maintenance fee that is on the order of $400,000 a year per system. And they feel
that there are probably 100 institutions that could be likely purchasers of the system.
Q: If U.S. Trust was supposed to be an attractive takeover candidate at 48 1/4, it should be even more so at 34.
Greenberg: One could certainly make a case that banks today are moving away from lending and moving toward fee-based
operations, trying to increase their fees, which are a predictable source of revenues. And over 80% of U.S. Trust revenues
and earnings are derived from fee-based businesses, where they have a leadership position -- whether it is managing money
for wealthy individuals, or acting as custodian, or acting as trustee for unit investment trusts or other kinds of data
processing. And their portfolio of loans to wealthy individuals, particularly those in the financial community, is still
perceived by some to be an attractive asset.
Q: We translate that to mean you think U.S. Trust is an attractive takeover candidate for another bank.
Greenberg: If a potential acquirer had a significant amount of custodian business, or data processing business, or
investment research, there could be tremendous synergies by combining the research departments or the data processing or
the software capabilities of the two concerns.
Q: Pre-crash, as we recall, you put a value of $70-$90 on the bank. That's 12 to 15 times possible earnings a couple of years
down the road. Does that still hold?
Shapiro: It's a buyer's market now, so any offer might be a bit lower than that.
Q: You guys have been humbled. Why don't we try Dynamics Corp. of America, which you also own and cherish. The
company's been around a while. It's gone through a couple of incarnations and last we looked was kind of an electronics
mini-conglomerate. What attracts you to this one?
Greenberg: Being as conservative as possible, we feel that the liquidation value of the company is $40, with no
consideration being given to surplus land, which the company last had appraised in 1984, and which was worth a
significant amount of money then.
Q: And the stock is selling at . . .
Greenberg: Around $15.
Q: Now we see what attracts you. Anything special about the business? It seems like quite a mishmash to us.
Greenberg: They have one outstanding business and that is Ellis & Watts. That operation makes the mobile vans which
house Magnetic Resonance Imaging machine -- MRIs they're called -- the newest generation of CAT scanners. Many
hospitals cannot afford a machine for themselves, so the equipment is installed in a mobile van and taken from hospital to
hospital and used that way.
Shapiro: Let me just jump in here. It's not simply a van for shipping purposes. It's a containment unit that has the proper
equipment.
Q: In other words, people go into this van to get their scan?
Greenberg: Exactly. And, in fact, many hospitals in older buildings, because of some of the shielding problems with the
machines, don't have the proper physical facilities, so they actually provide a containment unit, which would be a room that
you might install within a hospital, say within a hospital basement, to contain and operate the MRI machine.
Q: Dynamics doesn't make the device itself?
Greenberg: No. They just make this containment unit, which includes shielding, air-conditioning, special suspension.
Obviously, these are delicate machines and if you're taking them back and forth on roads, you have to have a tremendous
amount of protection.
Shapiro: They are half-a-million-dollar machines, so the vans are not exactly Fruehauf trailers.
Q: How long has Dynamics been in this business?
Shapiro: Well, the business has sort of evolved. Originally, they were making mobile vans to contain communications
equipment for the military. And using that type of technology, they developed these vans for CAT scanners.
Q: And is this now a significant part of the company?
Shapiro: Oh, this really is the main part of their earnings. Historically, Dynamics Corp. has earned about $13 million or $14
million operating profit per year, and $9 million or $10 million of that has come from the Ellis & Watts and Fermont
divisions. Fermont ships mostly the military vehicles and Ellis & Watts largely the medical. And these are the two main
operating units of the company.
Q: Dynamics also owns Waring Products.
Greenberg: Which has not been a big earner, but earns about $3 million or so, pretax.
Q: And they own a piece of CTS Corp.
Shapiro: 1.5 million shares of CTS. And three seats on the board.
Q: And they paid what?

Shapiro: $43 a share, for a million shares.
Q: And where is CTS stock now?
Shapiro: $20.
Q: Not a smashing investment. We'd be tempted to say they overpaid just a trifle.
Shapiro: Significantly overpaid. And it is one of the reasons why Dynamics Corp. stock is so cheap today. The decision to
wage a proxy fight and buy a million more shares of CTS -- they already owned 500,000 shares -- reflects poorly on
management: It plainly misjudged the company that they were seeking control of so badly.
Q: Plainly. Does Dynamics Corp. control CTS?
Shapiro: They don't quite control it, but they have significant influence.
Q: And is CTS profitable?
Greenberg: CTS is earning at about a $2-a-share annual rate. And it has an excellent balance sheet and recently announced
that it would repurchase half a million shares, which is almost 10% of the total outstanding.
Q: What kind of earnings are you projecting for Dynamics Corp.?
Shapiro: The basic Dynamics business will do about $14 million or $15 million operating profit, which translates into $2 a
share, after taxes. And if CTS earnings get back to $3 next year, which I think is a reasonable assumption, that would add
another $1.25 of equity earnings, for a total of around $3.25.
Q: So the stock is selling at less than five times next year's earnings. How about cash?
Greenberg: If you include a patent award case they won from the U.S. government and make an assumption about interest
recovery on the award and some tax recovery on the loss on CTS' stock price, you get about $15 a share in cash. In other
words, Dynamics Corp. is selling for its cash.
Q: And you get the earnings and the business for free.
Greenberg: The operations are worth about $25. So I come up with a total value for the company -- the business and the
cash and CTS -- of $40.
Q: And that, we know you feel, is conservative. The company also has real estate. What's that worth?
Greenberg: We were once told by management that they thought they could get a mortgage of $40 million, which works
out to around $10 a share. We figure that you might realize a third of that figure if you liquidated it.
Shapiro: But, obviously, there is a lot of room in there to make money, even haircutting some of these values. It would be a
positive thing, if the management went out and bought in a significant amount of stock.
Q: Have they done that?
Shapiro: They have not done that. For two reasons. One: they are waiting to settle the government patent award interest
suit. Secondly, they may be giving consideration to buying additional CTS shares to bring their stake over 51%, and give
them effective control.
Q: You own a savings and loan, too, don't you?
Shapiro: Boston Bancorp, which was formerly known as South Boston Savings Bank until they became a holding company,
has been a large position for us. It's a Massachusetts savings bank, and has got a couple of key features. For one thing, their
expense ratio runs at about 1% of assets, which is less than half the industry average.
Q: Why is that?
Shapiro: Well, basically, I think there are two reasons. Well, actually, three reasons. They have only three branches and
they've developed a banking-by-mail program, which doesn't sound that sophisticated, but it has enabled them to attract
over $400 million per branch. It's a huge amount, and obviously they don't have the huge staffing costs. What's more,
management owns a lot of stock, and, as a result, I think there's a tendency to run the operation on the lean side. Their
individual net worths are very tied up in the price of the stock. And I think they just have a mentality of running cheap. In
fact, the first time I visited them, which was in January 1984, the president's office was almost a hallway into the chairman's
office, both of which sat off the bank floor. They have now moved upstairs, but, certainly, there's nothing opulent about the
operation.
So, the expense ratio is very low. They have also closely matched their assets and liabilities, thereby limiting their
vulnerability to interest rates.
Q: What is the match?
Shapiro: I think it's 92%-95% -- a very small gap. As a result, they can maintain decent growth, decent returns. They've been
able to generate returns on equity in excess of 20%, year in and year out.
They have a very disciplined management style, so that they are very careful about the types of loans they make. And also,
since January 1986 they have repurchased 20% of the stock outstanding.
Again, we like it when a management has a big vested interest, because then they tend to think as shareholders, not as nineto-five workers.
Greenberg: Let me just mention one other factor which is very unusual in the industry. Boston Bancorp is blessed with an
outstanding chief financial man in Bob Lee, who has given them the ability to walk away from the mortgage market and
make investments in any of the public markets, whether it's corporate bonds with a short maturity or bank stocks or
preferred stock. This gives them very important flexibility: They don't have to make loans when the spreads get too narrow.
Shapiro: What's important to note is that when you have a low expense ratio, you don't have to stretch to get the maximum
spread. You don't have to make more risky types of loans or more risky types of investments.
With a 1% expense ratio, Boston Bancorp can afford to take a loan that gives them a 2% spread, which doesn't require
taking any long maturity risk or taking any undue principal risk. They can afford to be prudent. And as real-estate prices
have gone up in Boston, as they have in New York, the bank has tightened their lending standards, rather than loosened
those standards.
Q: Boston and its suburbs have been in a big building boom. Booms lead to busts, sooner or later. Doesn't that bother you?
Shapiro: First of all, 53% of Boston Bancorp's are mortgages. What they have done is sold off mortgages they were
concerned about and, as Glenn mentioned, with the investment ability they have -- this is not necessarily just stock picking
but in terms of managing GNMA and FNMA portfolios and certain types of debt securities -- they have backed away from
situations where the loans don't look too attractive. They have increased the relationship of value to loan that they require
when they make a mortgage. They have increased the amount of income a person has to be earning in order to justify being
given a loan. In other words, they've tried to build in cushions.
Q: Still. . .
Shapiro: I mean, if you go into a collapse like in New York City in the mid-'Seventies or California in the early 'Eighties,
yes, they will be hurt somewhat. But if you were to talk to these people every day, you'd discover they sort of sit down and
try to think and worry about what could go wrong, and they've been acting that way since we first got into the stock. So
every year, they've become more alarmed and perhaps more conservative in their lending requirements and their
disciplines.
Greenberg: They are emphasizing investments over loan originations, because they see opportunities in preferred stocks,
corporate bonds and government bonds that will allow them to lock in a very attractive spread with a higher quality.
Shapiro: I think the real advantage they have in this type of period is that they have a very low-cost deposit gathering
mechanism. And that enables them to make money on investments that other people can't make money on. And, as I said,
what it really means is that they can take lower risks and have less exposure during periods when the world looks a little bit
more unclear, and still make an attractive spread.
Q: Are they buying more of their own stock?
Shapiro: Having completed a 10% share repurchase policy this year they have announced another repurchase plan to buy
an additional 5% of their common stock.
Greenberg: They are buying their stock at five times earnings. It has a very salutary effect on earnings and long-term
valuation.
Q: How about earnings?

Shapiro: We're looking for $3 a share in the fiscal year ending October 1988.
Q: How about the year just ended?
Greenberg: They probably earned $2.65, which, by the way, is about a 25% return on their book value, even though they
maintain a very strong equity position. These earnings have a high degree of predictability, and probably about 10% annual
growth through asset growth. That stream of earnings is growing about 10% a year, all cash, with no risk of obsolescence or
foreign competition or inventory write-downs. What's that worth in the world today?
The other possibility here -- and this management certainly is bright enough to possibly pull it off -- is that there are many
recently converted thrifts in New England. They're small. They're grossly overcapitalized and undermanaged. And expenses
are way out of sight. Many of these thrifts really shouldn't be public. And if these guys can convince the management of one
of those to join with them, which would be a brilliant move on the part of the acquired company, and if they could do a
cash merger, basically using the excess capital of the acquired thrift, they could bootstrap their earnings up, you know, 30%
or 40% in just one acquisition like that.
And certainly they're in a position to analyze the company they're buying because it probably would be a competitor and
neighbor of theirs.
Q: Do you guys ever go short?
Greenberg: Well, yes, occasionally. One we like on the short side is LL&E Royalty Trust. Remember, we're not specialists.
We're generalists, so we don't know everything there is to know about any industury that we invest in. We certainly don't
know that some of the operators of the field in which LL&E Royalty Trust has interests might not discover the world's
biggest oil reserve tomorrow, though it's highly unlikely. The units sell for around 7 3/4-8. The present value of proven and
probable reserves is around $2.50 a share.
And, in addition, the IRS has claimed that the operator of the trust field, Louisiana Land, owes $1.50, pertaining to the
spinoff of these properties to shareholders. It's called an IDC recapture tax.
Q: How does that relate to the trust?
Greenberg: Well, if Louisiana Land were found to owe this money to the IRS, it would mean that they would have to
withhold $1.50, present value, of the trust's future revenues. And since we think its present value is approximately $2.50
today, $1.50 withheld knocks that down to something like $1 per unit.
Since the units are trading at around 7 3/4-8, we think they're very overvalued in any event, but would be particularly
overvalued if Louisiana Land has to pay the IRS this money.
One indication that they're moving in that direction is that at the end of the second quarter, the trust pointed out that
Louisiana Land had begun withholding payments from one of the four properties that the trust derives revenues from, and
was going to finish a complete evaluation of all the trust properties and the status of the IDC recapture issue at the end of
the trust's September 1987 fiscal year. The results of the engineer studies ought to be known within a couple of months and
I would think at that point Louisiana Land will have to decide how much of the future funds to withhold against this
potential liability.
Shapiro: What we're doing here is really just the opposite of what we would do when we invest. If you sold all the shares of
LL&E Trust today, you'd take in nearly $160 million. But our view is that, with production declining very sharply from
these pretty mature fields, and even with some lift in oil prices, there's no way in the world these properties are going to
generate anything close to $160 million.
Q: So, in your deconstructionist mode, what would you say LL&E Trust was worth?
Greenberg: Between $1 and $2.50 in today's terms.
Q: That certainly gives you some room on the downside. Let's have a final company that you are keen on -- which one will
it be?
Greenberg: We have one other comany that's a major position for us. It's America General Corp. What attracts us to this
company is that they have some outstanding businesses, and it sells at a low multiple of earnings, less than eight times this
year's expected results and less than seven times next year's.
Q: It's an insurance company, we believe.
Greenberg: It's called a multi-line company, but unlike most of the other multi-lines, it doesn't derive an overwhelming
proportion of its earnings from property/casualty. This year, with property/casualty results doing very well, it'll get $150
million of earnings out of the company total of $650 million.
The biggest drag on earnings this year -- and they're going to have a modestly up year -- has been a higher tax rate. That's
the result of an anomaly in this year's tax bill which will drive rates up for life insurance companies, but then they'll come
down again next year. And also, American General's investment income is starting to fall for the first time in 40 years
because interest rates got so low over the last 12 months.
Q: Which doesn't sound like a plus, or are we missing something?
Greenberg: Well, I would not make a case that the property/casualty insurance business in general is a good business,
because I think it's highly competitive and a non-differentiable product is offered. Nor would I argue that, by and large, the
life insurance business is a great business. I think, again, it's highly competitive and mostly non-differentiable. In the case of
American General, three-quarters -- 80% -- of their life insurance earnings are from home service business. And I note with
interest that Warren Buffett is rumored to have made a significant investment in Torchmark, which is the other leading
home service life business.
Q: Home service means, literally, home service?
Greenberg: Right. The agent goes out and calls on the policy owner each week and collects the -- usually very -- low
premium, and it's a business which is basically not . . .
Q: It sounds like the way insurance was sold during the Depression.
Greenberg: That's right. It's not glamorous, but it generates a tremendous cash flow. Very slow growth, very good cash
flow, very secure business. American General's concept in the home service business was to buy other people's business and
then knock out the less productive agents. Combine the investment operations, combine the administrative operations, and
realize tremendous cost efficiencies. And I think, by and large, they've been successful at that.
Q: They've also diversified, haven't they?
Greenberg: They really have diversified. They bought CrediThrift Financial, which is a finance company, and they bought
it very cheap, and it's done very well. They've also got one other star performer, which is an annuity company called
VALIC, which has grown very rapidly and seems to offer a very attractive product. I think one of the reasons American
General's stock sells so cheap today is that they have expressed an interest many times in making another sizable
acquisition and people worry that they're going to pay 15 or 20 times earnings when their own stock is selling at a little
more than a third of that.
Q: That isn't your worry, though?
Greenberg: Well, it is our concern. And very much so. In fact, their balance sheet at the end of the year will show about
$500 million of debt and $4.5 billion of equity, which is a lot less leverage than Torchmark. And I think the reason why
people are attracted to Torchmark is because of its avowed desire and interest in repurchasing its shares so long as they're
cheap.
Shapiro: I'd like to jump in here for a second just to say, though, that this concern about an acquisition has been one that we
and others have held for some time. Yet management appears to have been pretty disciplined, because it's been several
years now since they've made an acquisition, and in fact they initiated a fairly sizable share repurchase policy earlier this
year. So I think they recognize that it doesn't make sense to go and pay 15 times earnings for somebody when your own
stock is selling at eight times and you probably have a better business.
Greenberg: I could argue that this company is not unlike General Foods was five or six years ago, in terms of having
relatively limited growth potential, but a great balance sheet and terrific undedicated cash flow. And insofar as they use that
cash flow intelligently, whether it's to make investments or buying in their own stock, this can be a very low-risk and
attractive return investment.
Q: Have they been buying in their own stock?
Greenberg: They started in April. And while they were blasting away at buying their own stock in the low 40s, now they
can blast away at buying it in the low 30s. And they've been buying -- although they're out of the market at the present time
because they're calling some convertible debentures, which requires them to step out of the market.
Shapiro: Their biggest problem and one of the reasons for their low return on equity is that they are way overcapitalized,
given the cash-generating nature of their businesses. And they really can afford to have more debt in their capital structure,
particularly when they can repurchase their shares at less than seven times year-ahead earnings.

Q: What kind of earnings are you looking for?
Greenberg: This year will be a disappointing year, at approximately $3.75. We look for the combination of lower tax rate,
lower number of shares outstanding, and somewhat of a recovery in their investment income to boost them to
approximately $4.50 next year.
Q: So what kind of value do we assign to American General?
Greenberg: It's hard, because these kinds of companies are so out of favor, you can't point to open market transactions, you
know.
Q: That's true.
Greenberg: Where you have insurance companies being taken over . . .
Q: Yes?
Greenberg: . . . they've tended to go at very, very high multiples, particularly when there's been interest on the part of
Europeans.
Shapiro: We might add that this company has some warrants, exercisable at 24 1/4. And they trade, I think, today around
9. So you're paying a couple of points premium to the common. That's actually the way that we've invested in the company,
because we think the stock's going up and the gains in the warrants should be approximately twice that of the stock.
Q: And the warrants? Are they listed, too?
Sharpiro: They're Big Board-listed. There are about 10 million warrants outstanding.
Greenberg: Another positive sign: This company had a large amount of friends in the analytical community two years ago,
and even one year ago. Virtually all of them, however, have decided that the stock is not attractive for investment.
Q: Well, we can think of no stronger recommendation. Thanks, both of you.
--- Greenberg's and Shapiro's Picks
Ticker Recent Company (Abbr.) Exchange Price
American AGC NYSE 29 3/4 General (AGnCp)
Ashland Oil ASH NYSE 50 1/2 (AshlOil)
Boston Bancorp SBOS Nasdaq 15 (BostBc) Nat. Mkt. Sys.
Dynamics Corp. DYA NYSE 15 1/8 (Dyncrp)
Gotaas Larsen GOTLF Nasdaq 21 1/2 (Gotaas)
U.S. Trust USTC Nasdaq 32 (US Tr)
Happy Days Are Here Again --- Two Astute Stockpickers Find an Array of Values
12 December 1988
Barron's
(Copyright (c) 1988, Dow Jones & Co., Inc.)
JUST about a year ago, Barron's talked to Glenn Greenberg and John Shapiro, two stockpickers noteworthy for their ability
to spot undervalued stocks and their patient, thorough and intelligent approach to analyzing those stocks. Glenn and John
run Chieftain Capital Management, which handles the accounts of well-heeled individuals. They've consistently
outperformed the market in the four years since striking out on their own (previously, they had put in stints as analysts and
portfolio managers in various parts of the Wall Street establishment). In the Q&A that follows, they focus on a handful of
what they view as exceptionally promising investments.
BARRON'S: It's been just about a year since we last talked and the world, of course, was still spinning from the Crash. The
market since then has made a grudging recovery. How have you done?
Greenberg: Our average account is up about 30% from the beginning of the year. And in addition to that, all accounts are
now approximately 12% above their highest point last year.
Q: Aside from the fact that you both got gray hair last year, did the Crash make any difference in the way you approach
stocks?
Shapiro: Right after the Crash, and in a period thereafter, we were more nervous, we retained higher cash positions just out
of concern. We feel the performance of our portfolios has validated the investment approach we follow that if you buy a
company that represents good value, in the end that value gets recognized.
Q: That's the orthodox view. Who can quarrel with it?
Shapiro: That doesn't mean that on Oct. 19 you are not going to lose money.
Q: We understand that. And so do your customers, we're sure. Looking over the stocks that you talked about last time
around, all are higher, except Boston Bancorp, which is more or less where it was.
Shapiro: American General didn't move either.
Q: You had one really spectacular winner in Gotaas Larsen. That stock was 21 1/2 and . . .
Shapiro: . . . there is a bid on the table at 48, which is expected to close in the next couple of weeks.
Q: You call yourselves value investors. You -- and, of course, the rest of the world -- are looking to buy the proverbial
dollar's worth of assets for 50 cents. But you're also looking for good businesses.
Greenberg: That's correct. I would emphasize that we are looking for good businesses where the fortunes of those
businesses don't turn on slight changes in GNP statistics, where there is substantial free cash generated and put into the
hands of extremely capable managements which will not go out and spend that money foolishly by overexpanding plant
capacity, or paying too much for an acquisition to get into somebody else's difficult business. And I think it has been
brought home to us in the last year that it really does make a huge difference that you have managements who are oriented
to creating shareholder value, as opposed to squandering corporate assets.
Q: Or opposed to lining their own pockets.

Shapiro: I think that the options available to managements today to significantly alter a company are so substantial that we
are focusing more effort than ever to try to assess the character of management.
Q: How do you do that? Management is kind of a metaphor. How can you judge a management except by how well the
company is doing? You obviously never see a manager literally manage.
Greenberg: First of all, we try to meet the top management team in every company where we take a substantial investment - if we can. And this is more difficult when we invest in larger companies. But we still try to do it. And we try to ask the
right questions. The second thing is that we really look carefully at what management's incentives are, and we would prefer
to invest in companies where management has substantial shareholdings themselves or substantial shareholdings through
options. Under the circumstances, they tend to put every decision into a perspective of what is going to help their own net
worth. And thirdly, we look for people who have a vision of building something, building their company into a great
business.
Q: Can you be more specific perhaps?
Shapiro: You can usually get some sense of how a person is oriented -- whether they are oriented towards getting
themselves more decoration in their office and a bigger corporate jet, or whether they are really out to build shareholder
value.
Q: The corporate jet vs. shareholder value really states it neatly.
Shapiro: Nothing is hard and fast. We try to evaluate the management, the business, the values, the stock price. And maybe
you can't check off, give an A-plus on every single point. So you make some compromises.
Q: It would appear that you guys have not been blown away on any particular company.
Shapiro: We have been blown away a couple of times. We were once shareholders in Fuqua because we loved the Snapper
lawnmower business. But Fuqua went out and bought an S&L in Georgia which it is in the process of selling, and we sold
the shares promptly after it did that.
Q: It could have bought an S&L in Texas.
Greenberg: We were fooled by the management of Dynamics Corp. of America, a stock we mentioned last year.
Management paid a very fancy price to try and take over a company which it had a substantial stake in, such a high price
that it could never justify it. The stock today is selling for half the price management paid in a million-share tender offer. So
we are sometimes wrong.
Q: Good to hear. Why don't we turn now to specific stocks? We notice the only repeat among the ones you'd like to talk
about is Boston Bancorp.
Shapiro: Actually, Boston Bancorp has gone nowhere in three years.
Q: Boston Bancorp, as we recall, is a thrift that used to be South Boston Savings, is that right?
Shapiro: It is the holding company for the South Boston Savings Bank.
Q: Let's take some general concerns here first. One, among anybody looking at a savings and loan these days, is that the
healthy ones will be penalized to keep the sick ones from going under. The second is that New England real estate seems to
be shaky. Loans therefore would also be dubious. Want to address those?
Shapiro: I will make two comments. First, Boston Bancorp is not FSLIC insured. So that FSLIC does not have a claim
against them.
Q: So this is an FDIC bank.
Shapiro: Which means they are not as susceptible to the problems as the FSLIC-insured banks are. In any case, Boston
Bancorp has one of the lowest expense ratios in the industry. Any increase in insurance is going to have to be constructed in
a way that it does not hurt thrifts that might be okay, but more marginal than, say, a South Boston.
Q: Well, we have a graduated income tax. Conceivably, were some sort of levy to be placed on S&Ls to bail out the
industry, it could be graduated as well.
Greenberg: I think that if anything, the plight of the weaker S&Ls could be an opportunity for the stronger thrifts. Those
that are well capitalized may increase their loans because the others will be in a position where they can't increase them.
Q: Let's go on to the effects of a softening in New England real estate.

Greenberg: To begin with, there's a huge amount of mortgage-backed securities which can be purchased. So you always
have the option of purchasing mortgage loans as opposed to originating them. Since South Boston never booked substantial
loan-origination fees through their income statement, they are not going to suffer in that regard if their loan production
declines, as it has this year. Also, I think we mentioned last time that they have a really first-rate chief investment officer
who has done extremely well investing in preferreds and common stocks. And I think they have always looked to him
when the mortgage market is soft to deploy assets in an intelligent and low-risk fashion, and earn high returns.
Q: Why has the stock been so dull?
Greenberg: First of all, we have been in a rising interest rate environment. Secondly, there have been examples of
tremendous loan losses in the S&L business, which inevitably affects investor psychology. Then, too, profitability among
the industrial companies has been rising very rapidly, and except in unusual circumstances, financial institutions usually
don't show rapid earnings growth. So investors have been drawn to those companies showing rapid earnings gains over the
last couple of years.
Shapiro: One more point. Boston Bancorp has always traded at a premium to book. They have, if anything, an understated
book. And they earn a very high return on it. The simplistic rule of thumb that a lot of savings-bank investors use is that a
thrift must sell at a discount to book. Boston Bancorp may earn over 20% on book, and some of these other thrifts are
earning 5% on book. Yet people would rather buy the thrifts trading at the big discount, that aren't earning very much.
Q: Now, what is book value for Boston Bancorp?
Shapiro: It is about $12.50 a share.
Q: And what are earnings?
Shapiro: This year just ended were $2.27.
Q: And that compares with what?
Shapiro: $2.57.
Q: So they have had lower earnings.
Shapiro: They have had lower earnings, but significantly, they had lower gains on sale of securities.
Q: What are operating earnings?
Shapiro: $2.30.
Q: And how about this current year, the new year that started November?
Greenberg: The new year should be somewhat better from the standpoint of core earnings. We are not anticipating either a
dramatic run-up in interest rates or a dramatic decline. But in either event Boston Bancorp is not terribly vulnerable to
interest rates because of the way they structured themselves.
Q: The stock is selling at . . .
Greenberg: Six times coming year's earnings.
Q: What kind of price do you think this should command, using your criteria?
Greenberg: Some people look at the market and ask whether a business is worse than average, or better than average
business. And therefore decide whether it should have a multiple higher than the market or lower than the market. I would
argue that this company is a better-than-average company. That the way they are structured, it is a better-than-average
business. This has been a difficult year in terms of interest rates, in terms of a deposit war in Massachusetts, in terms of real
estate declining. Notwithstanding that, their core earnings are just about as good as last year, adjusting for the fact that they
did buy in one million shares. Since they are now applying for a Federal Home Loan Bank charter -- which they should
have shortly -- I would expect that they will be buying in a lot more stock in the next 12 months.
Q: Boston Bancorp should have a market multiple, you're saying. That would make it $25 or so.
Greenberg: That's true. The other thing that we didn't mention is that Boston Bancorp has approximately 400,000 split

shares of Freddie Mac at about $20 a share. And those shares today are trading at $48. So it has perhaps a $10 million gain
on this holding as of right now. Which, if we are right, could turn into a $20 million or $30 million gain over the next few
years.
Q: And how many shares does Boston Bancorp have outstanding?
Greenberg: A little bit under eight million shares. As their book value grows, it allows them to buy in more stock. So as
long as the stock stays at a low multiple, they have a very obvious way of investing their money at 15%-18%, after tax
return. Most businesses don't have that option. Boston Bancorp is a little unusual in having strength in its capital ratios,
excellent investment acumen, and the intelligence to take their capital and use it to retire shares at a low multiple.
Q: We've got a natural transition here. You mentioned Freddie Mac, which you also own. What does it do?
Greenberg: It basically has two businesses. Their main business it to buy packages of mortgage loans that meet their
guidelines for creditworthiness and convert those into securities, which are then tradeable. Those securities can be held by
the bank or thrift that originated the loans. Or they can be sold off to provide liquidity for the bank or thrift. Freddie Mac
also has a modest portfolio -- $15 billion of mortgages that it owns for its own account. It really makes money in three ways;
it has three sources of revenues. First are the management, or guarantee, fees on the so-called "sold portfolio." That is the
securitized portfolio. It gets about 22 basis points on $220 billion of securitized loans. Second, it collects interest and pays it
out, but holds on to money for approximately 30 days. So it gets interest on the float, which is a very substantial float -- $2
billion. And third, it gets a spread on the $15 billion portfolio that it holds for itself on its own books. The business of
guaranteeing mortgage loans is a duapoly.
Q: It and Fannie Mae.
Greenberg: They are the only two in the business.
Q: What's the difference between the two?
Greenberg: The major difference is that Fannie Mae has roughly a $100 billion portfolio of mortgages, which it finances
through issuing debt instruments. Which means it has a greater exposure to fluctuations in interest rates. Its earnings have a
greater fluctuation.
Shapiro: They both in the aggregate have pretty much the same asset pool. In the case of Fannie Mae, however, 40% of
those assets they own and carry the interest rate risk on, whereas Freddie Mac only has $15 billion, or about 6% of assets,
on which they have an interest-rate risk. So given our orientation to try to find the less risky investment, we are more
attracted to Freddie Mac.
Q: This is a brand-new security, for all intents and purposes.
Shapiro: It is trading on a when-issued basis now. You can buy it on the New York Stock Exchange. If you buy it today
you don't have to pay for it until probably the second of January, when it starts trading the regular way.
Q: How did it come to go public?
Shapiro: One reason it came to be public is the Federal Home Loan Bank Board, which governs it, decided that since the
ownership had been restricted to the thrift industry, it would be a convenient way, with the stock so undervalued, to
increase the capital of the thrifts that held all the stock. For example, the stock was selling at the equivalent of $11 a share
earlier this year. It traded basically on a yield basis.
Q: Strictly between and among thrifts?
Shapiro: Between and among thrifts. When it was announced in July that Freddie Mac would be freed up for public
trading, the stock basically quadrupled, to where it is selling for approximately seven times next year's estimated earnings of
around $7 a share.
Greenberg: Actually, the ownership deserves a little explanation as it is somewhat perverse. There is $100 million face
amount of redeemable common stock held by the Federal Home Loan banks. That is important to remember -- that the
common is redeemable and entitled to about 10% of the earnings and dividends. Okay, now let's turn to the participating
preferred stock held by the thrifts; a conversion process enabled them to contribute $7, plus each preferred share, for four
new preferred shares. There are 60 million participating preferred shares outstanding after the 4-for-1 split.
Shapiro: To make this confusing, the preferred is more equivalent to common. And what they call common is more
equivalent to a preferred.
Greenberg: The importance of that is that the earnings per participating preferred share are now basically approximately
90% of the overall earnings of the company. Ten percent of Freddie Mac's earnings is attributable to the common held by
the Federal Home Loan banks. That amounts to some $35 million. Clearly, one of the first steps that management must
take within the first year or so of public ownership to prove that they intend to be a fully public company, run for the benefit
of their shareholders, is to redeem this common. If they borrow the funds, the interest would cost perhaps $6 million-$7
million after taxes. Thus, you'd have nearly $30 million of additional earnings thrown into the pockets of the participating
preferred holders. That's about 50 cents a share.
Q: The common might be redeemed . . .
Greenberg: We make the assumption that this will be done within the next 12-18 months and our estimate for next year is
based on what happens.
Q: Can you give a brief history of Freddie Mac here?
Greenberg: It was established by Congress in 1970 to enhance the liquidity of the secondary mortgage market. But the real
growth in the business has taken place since 1980. In 1980, there were almost no home mortgages that were securitized. At
the end of 1987, approximately $400 billion in mortgages of the $1.5 trillion of non-government-insured mortgages were
securitized. So approximately 30% of all home mortgages are now securitized by Freddie Mac or Fannie Mae. And there
are reasons to think, and this is really part of the excitement of the ownership of Freddie Mac, that the percentage of
mortgages in the country being securitized will be increasing dramatically over the next three or four years as the Federal
Reserve and the Federal Home Loan Bank Board implement the new risk-based capital requirements of the banking
industry.
Q: And, of course, any increase automatically rebounds to Freddie Mac's benefit.
Greenberg: I think Fannie Mae and Freddie Mac will split whatever business there is.
Q: Are these true competitors, then?
Greenberg: Yes.
Q: And you do not own Fannie Mae?
Greenberg: No, but as I say, it is more because we don't know where interest rates are going to go. And we would prefer to
have the steady stream of earnings generated by a Freddie Mac rather than the potentially greater volatility in a Fannie
Mae. Clearly, both stand to benefit by the greater trend towards securitization.
Q: You suggest that Freddie Mac has only a nominal interest-rate risk. What is the risk, then?
Greenberg: There are two risks. One risk is that there are people who believe that we are going to have a massive deflation
in housing values across the country. And this could lead to higher default rates and to credit losses for Freddie Mac and
Fannie Mae. Although I would point out that in real terms housing inflation peaked in 1980 and that the national rate of
housing inflation has been less than the overall inflation rate since then.
Shapiro: We have had, obviously, significant deflation in home prices in the Southwest. So you have some basis for gauging
their underwriting standards. And the fact of the matter is that their default rates have been extremely low. And so it would
seem to give some credence to the feeling that they have been prudent and conservative in the standards they have used.
They will not simply securitize any mortgage. It has to meet certain requirements.
Q: You mentioned a second risk.
Greenberg: The second risk is more the perception that there are only three directors, that it is going to be used as a tool for
some sort of government aims and goals, as opposed to a fully public company run for the benefit of shareholders.
Q: How do you address that?
Greenberg: We do have the example of Fannie and Sallie Mae, which have been extremely successful companies, and
which also were initially founded by Congress.
Q: You don't obviously consider either risk serious enough to prevent you from buying Freddie Mac.
Greenberg: I don't believe that we are going to have a depression in this country. In fact, if anything, I think our political
will to withstand slow growth or negative growth will prove to be very low.

Shapiro: I would like to just emphasize that what I think is very important in the next few years for Freddie Mac and for
Fannie Mae is the greater capital requirements for banks. The banking industry can very quickly increase its capital simply
by taking mortgages which it currently holds on the books and securitizing them.
Q: An obvious question: Has there been any time in the past eight years in which their earnings were lower?
Greenberg: No. There hasn't been. The business of securitizing mortgage loans, as we said, really started taking off in 1980
and then ballooned in the mid-'Eighties.
Q: You did have a recession of some severity in '82.
Greenberg: But the business was so immature at that time. In any case, you have to remember that they will not insure a
mortgage which is over 80% of the value of the property. So they start out with 20% cushion. Let's take a mortgage that is
three years old. If there has been 3% or 5% inflation in home prices, the value of the home has gone from 100 to 115.
Meanwhile, the mortgage is being amortized at 2% per year in the early years. So their cushion builds up. Your greatest risk
is in the first year.
Q: Can you sum up the earnings outlook for us?
Greenberg: Over the next three or four years, with the sharp rise in securitized mortgages, Freddie Mac's earnings could
grow 20%-25% a year. Later on, that will moderate to around 12% a year.
Q: Why don't we go on to some other situations you like, like Burlington Resources?
Shapiro: Burlington Resources is being spun out from Burlington Northern.
Q: The actual spin-off will take place at the end of this year.
Shapiro: Yes. There are currently 20 million shares which they took public in July and the balance, 130 million shares, will
be spun out as of the end of this year.
Q: Okay.
Shapiro: Burlington Resources is primarily a natural-gas company. It also owns El Paso Natural Gas Co. It has large realestate holdings, large timber holdings, and large mineral holdings, including coal, gold and some lesser types of minerals.
Q: Why did Burlington Northern decide to spin it off?
Shapiro: I think two reasons. First of all, management felt that the value of Burlington Resources could never be truly
recognized as part of Burlington Northern. Railroad analysts don't know much about gas. Gas analysts don't know much
about railroads.
Q: And analysts don't know much about anything.
Shapiro: I think that was the primary reason. In addition, I think this is a point worth noting -- the management of
Burlington Resources has authorized 10 million shares under option, of which they have granted themselves 4.5 million
shares so far at $25.50. And they also have authorized a million stock-appreciation units. Basically, I think what the
management has said is that this is an underappreciated asset, as part of Burlington Northern, so we are going to spin it out,
and we are going to give ourselves a significant equity interest at the same time, and thereby create a stock which,
hopefully, eventually will get the recognition it deserves. And at the same time, if that occurs we will be able to make a lot
of money.
Q: Now tell us what you like about it.
Shapiro: We feel positive about natural gas. You did a big article recently about the industry, and I don't need to rehash
that. But I would just say that we started from the premise that natural-gas prices have either bottomed or are close to the
bottom and the next major move -- I am not saying it is going to come tomorrow -- will be up. Then we have done our
break-up-value analysis on the company.
Q: We'd like to hear that.
Shapiro: Amoco bought some directly comparable reserves from Tenneco recently in the San Juan area where essentially all
of Burlington's gas reserves are located. Amoco appeared to pay $1.10 per MCF for proven reserves based on stated proven
reserves. Using that figure, and putting some other numbers on some of the other divisions of the company, we come up
with a break-up value for Burlington Resources of $54 a share.
Q: And the stock is a bit over $30.

Shapiro: But Burlington Resources has significant holdings in the Fruitland fields. Interestingly, most of the analysts have
either ignored it or have never tried to attempt an evaluation of what these Fruitland gas reserves might be. Management, if
you talk to them, will acknowledge a certain level of reserves that they expect to find. But we have talked to other people
who have holdings in the Fruitland fields. We have talked to several independent geologists who have studied this area
extensively. And we have found some articles that have been published by some independent geologists. And we have
come to the conclusion that those reserves are quite significant for this company. Basically the Fruitland field appears to
hold. . . . I will throw a lot of numbers at you.
Q: Be our guest.
Shapiro: The gas resources in Fruitland are estimated to be 50 TCF. Burlington owns about 20% of that. So that would
mean about 10 TCF of potential gas resources. In talking to the numerous geologists and some of the other people who
have had some greater drilling experience -- Amoco being one of the major parties in this same field --we have come up
with recovery estimates of 30%-70%. So that would suggest reserves ranging from three TCF to seven TCF. In addition,
there are tax credits, some very significant tax credits associated with drilling in these fields. The tax credits are based on
production starting in 1990 and going on for 10 years. And they escalate from 90 cents per MCF to $1.34 per MCF.
Q: What does that mean in terms of operating results?
Shapiro: What happens is that for any well the company drills between now and 1990, they get these tax credits. For each
MCF they produce they are going to get 90 cents of tax credit that they can use against other taxes. And the finding costs
are estimated to be 30 cents per MCF.
Greenberg: Given these incentives, the company is completing a well about every 24 hours.
Shapiro: If you take all of these numbers, factor in the potential recovery rates, the tax credits, less the cost of drilling,
without making any assumption about gas prices going up, we think that the Fruitland reserves alone could easily add
anywhere from $18 to $40 a share of incremental value to Burlington Resources above that $54 value.
Greenberg: Let me just add that management has already announced that they plan to sell their Plum Creek Timber
operation, which should bring in approximately $450 million-$500 million after taxes. And the parent company's balance
sheet now has about $500 million of working capital. All the debt, the $500 million debt they carry, is all El Paso Natural
Gas debt, which they are required to have by regulators. So basically we are looking at a company which will essentially be
debt free, with $1 billion in cash and generating a cash flow higher than its capital requirements, even with the frenetic
drilling program in the San Juan Basin.
Shapiro: The management team is splitting up somewhat. Some will stay with Burlington Northern. The chairman will be
chairman of both. The CEO of Burlington Resources will be a guy named Tom O'Leary, whom we have met and been very
impressed with. And as management has been quick to point out, given the 4.5 million shares they have already been
granted, they are significant shareholders.
Q: There are some 150 million shares outstanding. In terms of anyone taking it over, it's a fair-sized swallow.
Shapiro: That's right. Whether this is taken over or not is something for speculators. From our perspective, we see a $30
stock. We see a stock that probably has somewhere between $75 and $90 a share of value. We see a debt-free balance sheet,
and a management that seems to be oriented toward improving shareholder value. You have that mix. We feel that with
patience, we are going to make very good money here. And the one point that I haven't emphasized is that a lot of people
feel that, looking out over the next five years, gas prices could go up. And if you use the low-end estimate on what
Fruitland could contain, you basically have over 40 MCF underlying each share of Burlington Resources stock.
Greenberg: So if gas reserves were worth someday $2 instead of $1, you would be talking about $80 of value just for the gas
reserves.
Q: Why don't we switch to another company you like and consider undervalued, Newhall Land & Farming? You guys
were quite exercised by management.
Shapiro: Newhall Land is a real-estate company in California. Their primary and most attractive holding is an area called
Valencia, which is in the Santa Clarita Valley. It is 58 square miles, which is about twice the size of Manhattan. And it is 35
miles north of downtown L.A. If you look at a map of it, or go out to the area and drive around, it is sort of the last big area
that can be developed within reach of L.A.
Shapiro: And, in fact, there is a lot of pressure to slow down growth within L.A., which appears to be forcing both business
and housing development to these outlying areas. As a result, business out there today has been unbelievably brisk. Just

anecdotally, they opened up a particular area where they were going to build 100 houses. They had 10,000 people show up.
The people are drawing out of a lottery to see who is going to be allowed to buy the houses.
Greenberg: But fortunately they are planning to build 10,000 houses in this one area -- eventually.
Shapiro: The company has been involved in litigation as a result of some anti-takeover provisions that they put in. And the
value of the litigation from our standpoint is that there has been a lot of information that has seen the light of day. Including
the fact that in early 1987, Morgan Stanley completed a valuation, which put a value on the assets of $70-$92 per unit.
Since that time, according to some of management's own comments, the appraised value of the properties has increased at a
30% annual rate. Which suggests that at this point in time, the value per unit of the real estate is probably north of $100 per
share. In other words, we have a stock selling at $49, with a value perhaps as high as $100 a share.
Greenberg: And we don't believe that the Newhall ranch property, over time, is going to decrease in value, given the
dynamics of the L.A. building environment.
Shapiro: Also, you have a balance sheet where unlike most real-estate companies, cash significantly exceeds debt. And most
of the debt is convertible debentures, which are in the money. So in a sense you really have a debt-free company with about
$4 a share of cash.
Q: We had a wonderful piece by Ben Stein on the litigation.
Shapiro: Management has come under a lot of criticism because of the anti-takeover provisions. And I support that
criticism. At the same time, from an operating standpoint, management has really been doing a good job lately. They have
significantly speeded up the pace of development.
The litigation has gone through several stages. They put in this shark repellent. There was a proxy vote on it. People
questioned whether the proxy had provided adequate disclosure. Management probably was successful in getting a positive
vote because it had withheld certain information. The court worked out a settlement between the company and certain
lawyers who claimed to be representing the shareholders on a class-action basis. From our perspective, it was only a form of
greenmail on the part of the class action lawyers. However, the settlement was approved a few weeks ago. But several
shareholders, most noteworthy being the State of Wisconsin Investment Board and the Templeton Fund, dissented. And
what that means is that they have 60 days in which to appeal the settlement. I don't know what they are going to do.
Q: Does it matter to you if the settlement stands?
Shapiro: Some gratification might have to be forgone. Basically, all this litigation and the publicity that they got, I think,
has put a lot of pressure on management. As part of the proposed settlement they have agreed to repurchase one to two
million shares. I think they are under tremendous pressure to take steps to keep the unit holders happy. And what that
really requires is narrowing the gap between the stock price and the value of the company. And I think management is very
aware of that. And assuming that this litigation dies, I think they will continue to take steps both by operating the company
well, and by beginning some share repurchases to increase value.
Q: In any case, you are not going to be moved out of this stock.
Shapiro: No.
Q: Shall we move on to Erbamont?
Shapiro: Erbamont is really a first-class pharmaceutical company which specializes in anti-cancer drugs. Their largest
product is something called Adriamycin. They are 72% owned by Montedison, the leading Italian pharmaceutical house.
The company has a significant outpost here in the form of Erbamont N.A., which operates out of Stamford, Conn.
Adriamycin is one of the pre-eminent chemotherapies. Erbamont has a problem which is the reverse of most
pharmaceutical companies. Their problem is that they have a huge amount of new drugs in the pipeline that are expected to
be approved in the next few years. But they lack the infrastructure, the selling and marketing force, to fully exploit these
drugs. But the point is that unlike a lot of companies which have very few new drugs coming along, this company has a
dramatic array of new drugs.
Q: Can we touch on some of them?
Shapiro: The one that we consider most significant is something called ADR-529. This is a drug which protects the heart
from the toxic effects of chemotherapy. As you may be aware, with chemotherapy you are trying to kill the cancer cells at a
faster rate than you kill the patient. And the area which is most hurt is the heart. They hope to have this drug on the market
by the end of 1989. And this drug will be very beneficial. First of all, there will be a ready market for it. Secondly, it will
allow people to tolerate higher levels of Adriamycin; so it could in fact stimulate the sales of Adriamycin. In addition, they
have a drug which they introduced in Japan called Sermion, which has been going very successfully there. It helps to
eliminate some of the memory loss associated with senility or Alzheimers' disease.
Q: What do earnings look like?
Shapiro: For 1988, the company should report about $2.40. And in 1989 we are estimating about $2.80. The lack of
infrastructure and the costs associated with building that are penalizing the earnings, and are penalizing the P/E. Once you
start getting these new drugs coming on in late 1989 and '90, those sales will be pushed through this infrastructure.
Q: What do you see becoming earning power at that time?
Shapiro: I think that you could be looking out a couple of years and seeing a $4 earnings number. Why shouldn't this
command a 15-times multiple, which would be more commensurate with the quality company it is?
Q: Erbamont is listed on the Big Board.
Shapiro: Right. And this gets to the next point, which is the ownership by Montedison, which owns about 72% of the
shares. Montedison itself is now controlled by a Mr. Gardini, who is almost a raider.
Q: A neo-raider, we will call him.
Shapiro: Although I don't know if he would consider himself that. He has a privately controlled company which is involved
in heavy chemicals and agriculture and trading. He bought about 40% of Montedison about a year ago, and tossed out the
mangement. And since then has been shuffling around the assets. As a result, there has been periodic speculation that
Erbamont might be sold.
Q: You think there's something to those rumors?
Shapiro: Strategically, without ever knowing what might be in the mind of a person who controls a company -- in this case,
Mr. Gardini -- one could make an argument that it might be better for Erbamont to be owned by somebody else or to have a
partner who could bring management talents and infrastructure elements to the picture.
Greenberg: This comment should have been made back when John was discussing the tremendous investment they are
making in building up their pipeline and in the R&D required to bring these many new products to market. But looking
back to 1985, the company was spending 9% of sales on R&D. And today they are spending over 15%. And in 1985 they
were spending 34% of sales on SG&A, whereas today they are spending about 40%. But they have had about a 10percentage-point decline in their margins as a result of this spending required to bring these new products to market, and to
be sure that the marketing pipeline is in place.
Q: The company doesn't get much attention in Wall Street, at any rate.
Greenberg: It is 72% controlled by its parent, and has a reasonably small float. And since its accounts are stated in Italian
with translation in English, some analysts feel that it is a daunting task.
Q: Shall we wind up with Foremost Corp. of America? This is an insurance company.
Greenberg: In our search for niche businesses that are hidden away in basically pretty bad businesses, we came across
Foremost Corp. of America, at a time which proved pivotal for the company, because a management change took place in
1986. And the current management was installed with a mission to pare the company back from the many businesses it had
gotten into, using the excess cash generated by its core business, which is property insurance on mobile homes and
recreational vehicles. And it is by far the leader in insuring mobile homes against property damage. The characteristics of
this business that we like are 1) they write one-year policies, and they can reprice every year; 2) they are insuring against a
specific amount of damage. So there are no long tail lines or liability, or chances for them to have unanticipated losses other
than from hurricanes, which occur from time to time.
Shapiro: You are talking about property damage. The values are not going up on these things -- they are going down. It is
not like an asbestos loss where you don't have any idea what the ultimate cost could be. You know from Day One, when
you price it, what your cost is going to be.
Q: How sensitive are they to the level of RV and mobile-home sales?
Shapiro: They are sensitive to new shipments of mobile homes, since they get about 72% of the insurance business that is
originated by mobile-home dealers. This is one of their key sources of new business -- mobile-home dealers. So when new
shipments are off they are affected.
In the state of Texas, mobile-home shipments have declined from approximately 50,000 units per year to less than 10,000 as

a result of repossessions and outmigration of oil workers. So the mobile-home market has been really devastated by the oil
collapse over the last couple of years. Foremost has managed to come through this very nicely in its basic business. And it
would benefit substantially if the mobile-home business comes back.
Q: It also obviously is sensitive to interest rates -- that is, the mobile-home business is sensitive to interest rates.
Shapiro: The argument is that the higher interest rates are better for mobile homes.
Q: We've heard that one before.
Shapiro: Because people get priced out of the single-family detached housing market. And actually, the gap continues to
widen between the cost of the single family home, or price per square foot on detached housing, vs. manufactured housing.
But except for retired people or people who can't afford detached homes, most people would prefer not to live in a mobile
home. I don't think we have any illusions about this being a great growth business. Or it going back to the shipment levels
of the 1970s. And in fact, it is probably better for Foremost that it not be a glamour business, because by being a dull, slowgrowth business, it doesn't attract competitors.
Q: We notice an estate has about 19% of the stock.
Shapiro: Actually, it is 35% in trust. Mr. Frey, who passed away earlier this year, personally owned 19%, but a trust
controls 35%. And our understanding is that his estate has no tax problem until his wife passes away. They might have to
sell stock to pay state taxes. Mr. Frey was a restraining influence on the company. One way he restrained them was that he
had lived through the Depression, and really only wanted short-term, extremely high-quality, investment grade paper. As a
result, the after-tax yield on Foremost's portfolio was about 6%, which was, as you know, approximately 2% lower than the
industry norm. If they were able over the next few years to raise their yields by two percentage points, this would add
approximately $1 per share to their earnings.
Q: What are the prospects for earnings?
Shapiro: We're looking for increases of 15%-20% a year over the next few years.
Q: When they sold their mortgage-insurance operations in mid-year, they declared a special dividend of $6.50 a share. Not
too many companies even consider passing along a windfall of sorts to shareholders.
Shapiro: This is a case where the company really has a management with its head screwed on properly. It wants to reduce
the amount of excess capital that it has. And it has done so by declaring the special dividend, and also by retiring shares.
Mr. Frey did not believe in retiring shares. But he was persuaded to do it in a modest way prior to his death. And now the
management has a much freer hand in managing their capital base. On a $16 book value, Foremost will earn about $3.35
this year. And we would expect the return on equity to range between 20% and 25%.
Q: Thanks very much, both of you.

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[CHIEFTAIN

CAPITAL BARRONS PROFILES] 1

Chieftain Capital Barrons Profiles

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at a multiple rather than a percentage factor.

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Greenberg: That is right.

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Q: Let's go on to the effects of a softening in New England real estate.

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Q: And the stock is a bit over $30.

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