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Graham & Doddsville

An investment newsletter from the students of Columbia Business School

Issue XXIX Winter 2017

Inside this issue:

G&D Breakfast P. 3
Kingstown Capital
Kingstown P. 5
Rupal Bhansali P. 15 Michael Blitzer and Guy Shanon are the
Managing Partners of Kingstown
Simeon Wallis P. 23 Capital, a value-oriented investment
Student Ideas P. 38 partnership that focuses on special
situation securities across the capital
Jared Friedberg P. 44 structure. The firm was founded in
2006 with strategic backing from
Studness P. 51 Gotham Capital and currently manages
Michael Guy $1.8B. Michael and Guy both hold
Blitzer 04 Shanon 99
(Continued on page 5)

Eric Laidlow, CFA Rupal Bhansali Simeon Wallis

MBA 2017 of Ariel of ValorBridge
Benjamin Ostrow Investments Partners
MBA 2017
John Pollock, CFA Rupal J. Bhansali is ValorBridge
MBA 2017 executive vice Partners, a private
president of Ariel holding company
Abheek Bhattacharya
Investments, a founded in 2004,
MBA 2018 money owns, operates or
Matthew Mann, CFA Rupal Bhansali management firm is an active investor Simeon Wallis
MBA 2018 headquartered in in several private
(Continued on page 15) companies; it is also a passive investor
Adam Schloss, CFA (Continued on page 23)
MBA 2018
Jared Studness Capital Management
Friedberg of
Visit us at: Rolf Heitmeyer Jared Friedberg is
the Founder &
Portfolio Manager
of the Mercator
Fund and the
Managing Partner
Jared of Sycale Advisors. Charles Roy
Jared was Studness PhD 63 Studness 06
Friedberg 99
previously Co-
Founder and Charles began his career teaching
(Continued on page 44)
(Continued on page 51)
Page 2

Welcome to Graham & Doddsville

We are pleased to bring you the vesting to international oppor- family of investors combine
29th edition of Graham & tunities. The CIO of Interna- their industry specializations to
Doddsville. This student-led in- tional & Global Equities applies invest opportunistically in these
vestment publication of Colum- the lessons of Warren Buffett two domains.
bia Business School (CBS) is co- as well as George Soros, whose
sponsored by the Heilbrunn concept of reflexivity is critical Lastly, we continue to bring
Center for Graham & Dodd for understanding financial cri- you pitches from current stu-
Investing and the Columbia Stu- ses. dents at CBS. CSIMAs Invest-
dent Investment Management ment Ideas Club provides CBS
Association (CSIMA). Simeon Wallis of Valor- students the opportunity to
Bridge Partners discusses the practice crafting and delivering
Meredith Trivedi, the Heil- In this issue, we were fortunate unique opportunity to redeploy investment pitches. In this is-
brunn Center Director. to speak with seven investors cash flows from the companys sue, we feature ideas from the
Meredith skillfully leads the from five firms who provide a primary portfolio company, 2017 Heilbrunn Center for
Center, cultivating strong range of perspectives and invest- ApolloMD, into public and Graham & Dodd Investing
relationships with some of ment approaches. All of these private investments. This flexi- Stock Challenge and the 2016
the worlds most experi- investors benefit from applying bility allows the organization to Darden @ Virginia Investing
enced value investors, and fundamental research to special- beneficially allocate capital to Challenge. Zach Rieger 17,
creating numerous learning ized investment areas that other the most attractive opportuni- Alexander Levy 17, Abheek
opportunities for students funds cannot explore. ties and to share valuable in- Bhattacharya 18, Harsh Jhaveri
interested in value invest- sights across asset classes. 18, and Ryan Kelly 18 share
ing. The classes sponsored Michael Blitzer 04 and Guy their ideas for Foot Locker
by the Heilbrunn Center Shanon 99 of Kingstown Capi- Jared Friedberg 99 of Mer- (FL), Axalta Coating System
are among the most heavily tal Management return to dis- cator shares how a family office (AXTA), and Cardtronics
demanded and highly rated cuss the benefit of longer time- can use its permanent capital to (CATM).
classes at Columbia Busi- horizons in special situation benefit from special situations
ness School. investing. The team discusses and long-term compounders. As always, we thank our inter-
the evolution of Kingtowns Additionally, the company can viewees for contributing their
strategy since our last interview creatively invest across the time and insights not only to
in 2010. Additionally, they share capital structure, to find value us, but to the investment com-
insights regarding complicated obscured by complexity. munity as a whole, and we
and overlooked situations, in- thank you for reading.
cluding international privatiza- Charles Studness and Roy
tions. Studness 06 of Studness - G&Dsville Editors
Capital Management demon-
Rupal Bhansali of Ariel Invest- strate the benefits of investing
ments shares her perspective on in negatively correlated indus-
applying fundamental value in- tries: utilities and banks. The
Professor Bruce Greenwald,
the Faculty Co-Director of
the Heilbrunn Center. The
Center sponsors the Value
Investing Program, a rigor-
ous academic curriculum for
particularly committed stu-
dents that is taught by some
of the industrys best practi-

Prem Watsa and Ajit Jain pose for a Regina Pitaro 82 with Professor Bruce
picture at the 26th Annual Graham & Greenwald enjoying the G&D Breakfast,
Dodd Breakfast held at The Pierre Hotel
Volume I, Issue 2 Page 3

26th Annual Graham & Dodd Breakfast

October 28, 2016 at The Pierre Hotel

Columbia Business School Dean Glenn Hubbard Professor Bruce Greenwald, Prem Watsa, and VJ
addresses the crowd Dowling share their views at the G&D Breakfast

Professors Tano Santos and Kent Daniel in discussion at Ajit Jain and Mario Gabelli 67 pose for a picture
the G&D Breakfast

The crowd listens to Professor Bruce Greenwald, Prem

Watsa, and VJ Dowling discuss this years theme: Finding
Value Through Specialization
Page 4

Save the date for the eighth annual

From Graham to Buffett

and Beyond Dinner

Friday, May 5, 2017

6 p.m. to 9 p.m.
The Omaha Hilton
1001 Cass Street Omaha, Nebraska

Tickets will go on sale in March at
Page 5

Kingstown Capital Management

(Continued from page 1)

MBAs from Columbia Most of these securities are in offs and distressed debt.
Business School where the $1B to $10B enterprise
they participated in the value range for both equities MB: Also, there's a big, timely
Value Investing Program and debt, though credit debate right now about active
and have taught Applied securities can be smaller. Being versus passive investing.
Value Investing as adjunct bigger also gives us research Passive has come into a lot of
faculty. Michael currently resources and access we just popularity. When we started
serves on the Executive didnt have when smaller, and twelve years ago, we
Advisory Board of the the structure of the industry is maintained the premise that
Heibrunn Center. making it harder for very small the markets are very efficient.
funds every year. Our strategy is to be
Graham & Doddsville exclusively focused on very
Guy (G&D): How did you both G&D: Why have you focused small pockets of inefficiency
Shanon 99 meet and how did the fund get on that particular size? within what is, generally, a very
started? efficient market. We have to
GS: I think one of the things have the flexibility to go after
Michael Blitzer (MB): Guy we learned is that it is not so companies that are smaller
and I have known each other easy to make money with than $10B or $20B
for a very long time. We both super small caps. You see a lot
went to CBS. I was '04, Guy of questionable management GS: And dont have twenty
was '99. We didn't know each teams and very low quality sell-side analysts covering
other while we were at businesses which have not them.
Columbia, but at that point become bigger for what are
AVI [Applied Value Investing] usually good reasons. Then of G&D: As the number of
was a very small network. course you have all of the special-situation funds grew,
extreme technical aspects, like how has this impacted
Guy Shanon (GS): So if liquidity dries up that makes Kingstown? Have you been
Michael everyone knew each other it even harder. Yes, there are able to maintain an advantage?
Blitzer 04 from different years. sometimes great opportunities,
and we look at small caps all MB: The longer we do this,
MB: Guy's class had six the time, but they arent giving duration of capital and time
people. They were the only six it away by any means, and horizon has actually become
people at Columbia who were focusing exclusively can be a more and more of a
interested in value investing tough way to make money competitive edge. We've
it was 1999. There was no over long periods of time. always defined the strategy as
AVI. The program really grew kind of having a medium-term
from there. We dont think of ourselves as time horizon, generally one to
a big fund, and we think we can three years. These securities
GS: Our initial investors and make the best risk-adjusted tend to have larger mispricings.
employees came from that returns in the size range we A typical example is a situation
network of students and currently target. The current that has a known or likely
professors. portfolio runs the gamut from catalyst but unknown timing
$300mm in market cap to you know it will happen
G&D: We last spoke with you $50B, so the range is wide and sometime in the next three
in 2010. How has the fund we look at everything. But the years, but it could be
changed since then and what sweet spot tends to be this tomorrow or it could be years
have you both learned? middle range which are small from now. Given the structure
enough to still experience the of the hedge fund industry and
GS: The fund has grown but technical factors that often the structure of capital, this
the strategy and portfolio lead to security mispricings but sort of patience becomes
structure are exactly the same. large enough to have quality of harder and harder over time
We still run a long-biased and business and management. This unless you align yourself with
concentrated portfolio of size also tends to have a larger long-term capital. So we're
special situation securities pipeline of the special situation clearly shorter-term focused
across the capital structure. categories we track like spin- than a private equity firm. But
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Harvey Sawikin
Kingstown Capital Management
there are very few investors in MB: In addition to size and approach. We've never had a
the public markets right now duration of time horizon, it's formal IR effort. You end up
who can take a one to two to also been concentration. We with a certain type of partner
three-year time horizon. Most run a fairly concentrated and by way of hiring a professional
can hardly take a month or a flexible mandate where we marketing person. We have
week. To take advantage of look across industry, personal relationships with all
most of the mispricing, geography, and capital of our partners. We spend a
particularly in the special structure. We think it is also a lot of time talking to them
situation space, you have to big advantage that we can about how they think about
have that kind of runway. Also evaluate the risk-reward investing. Not surprisingly,
there is a lot of capital coming across these different areas most of our partners have a
out of event-driven strategies, and pick our spots very value bias in their portfolios.
which overlap somewhat with precisely. Then obviously we But investment philosophy
what we do, this is very good combine all of this with what aside, a direct relationship with
for us. we like to think is a fairly deep partners creates more
research process. But you can transparency for them and
GS: In the past twelve years only do that level of research if keeps the alignment of
since we started, time horizons you're concentrated. When interests very close;
have become a lot shorter. As you group it together, these sometimes having a marketing
students at Columbia and with things differentiated the firm person between us inserts
the value-oriented internships initially and have been another agenda into the mix.
youve had, you might not fully consistent through the life of We think our approach is best
appreciate the low tolerance the business. for our partners returns over
for volatility. If you go to some the long run.
of these large multi-strat funds,
time and volatility are very
...risk and volatility are MB: It's just taken time and a
relevant because they're very different. A lot of lot of energy invested in
running massive amounts of getting to know our partners
capital. In fact, they've the returns that we've and how they think about
attracted so many assets investing. We've gone through
made have been either
because they manage volatility periods where, for many years,
so tightly. If you went to work averaging down or we didn't talk to anyone about
there as analysts and you drew new capital. We also learned
down a couple of percent in a buying things that were by watching what didn't work
month, you get stopped out. for other funds. But ultimately
But then what do you do with this has led to a small group of
that cash? You have to find partners who have stuck with
another trade tomorrow is G&D: How did you develop us over time. And with less
that better than staying with and cultivate an investor base time spent on marketing and
the business you owned the that allows for your strategy? investor relations, there is
day before? It just feeds the invariably more time spent on
volatility. I think the fact that GS: From the start, we've investing and the portfolio.
we only focus on very specific been very conscious of the
special situation categories also importance of having the right G&D: Going back to volatility,
makes us unique. We dont do partners. I think it mostly came how do you think about risk in
risk-arb for example. We are from some humility. We your investments and how do
just looking at certain areas understood that it is very hard you exit positions that are
where we know there are to beat the market and you going against you?
chronic mispricings. A lot of need help from your structure
fire directed into a small area. and partners. You have to MB: We mostly define risk as
That is what we do. And we match the duration of your permanent impairment, which I
have been doing it for a while capital with your investments. think is very different than
and it works, and we get Going back ten years, we've most people who view it in
better at it every year. turned down money from terms of volatility. We take the
people that didnt share this approach that risk and
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Harvey Sawikin
Kingstown Capital Management
volatility are very different. A but it's very hard to have three a great book. We've both read
lot of the returns that we've of the three because it's a it. I read it over and over and
made have been either mixture of a bunch of Im still learning, its not
averaging down or buying personality traits that are not exactly beach reading. But we
things that were down. On a often on the same gene. But don't have any formal
short-term basis, it's very you need all three. framework. Anyone who says
challenging to time tops and that they do, that's more of a
bottoms. I think a lot of people Part of temperament is being marketing gimmick. We're very
have failed doing that. One of able to be self-critical. Many aware of the behavioral stuff,
the approaches of having a people in this industry have its important. It is possible
longer-term strategy and been very successful all their that managing our own
longer-term capital is that you lives. They have always been at behavior effectively is the
can withstand those periods of the top 10% of everything they single most important thing we
volatility and take a view over have done. All of a sudden, a do as investors in public
a number of years. position is going against you markets at the end of the day.
and you have to really break it
Having said that, being very down and be honest with MB: Also the analysts here
patient and permanent yourself. Or you have to take a know that they're not going to
impairment often become the view that is vastly different do well unless they start with
same thing eventually. We take from what the smart people the risks and the downside.
the approach here that we are are saying, what your smart Before we figure out how
re-underwriting every single friends who are making money much we can make in an idea,
position every single day. If the this year are saying. A lot of we have to discuss what all the
facts change, we have to be people have never done that possible risks are that may or
intellectually honest and before. You have to be very may not happen. I am not sure
reevaluate that, otherwise you critical and skeptical all the if I would call that a pre-
are just hoping. It's a time, but also know when not mortem.
combination of research and to be. And how you go about
portfolio management. that has a big impact on GS: Pre-Mortem? We see that
performance over time. term a lot, its part of a
GS: Its easier said than done, checklist that people
but when something is going MB: You have to put up walls interviewing for jobs have
against you, you have to fight and blinders to eliminate decided they need to have in
off the urge to ignore bad behavioral biases when these anything they write, it has
news. As Mike said, be brutally things happen. Of course, become part of hedge fund
honest with yourself whether when something goes against analyst culture, like its some
or not what you thought was you in a meaningful way, the kind of innovation. But really
going to happen actually did market is usually not that its common senseif you are
happen or is happening. wrong. At the very least, it's going to put a substantial
down for a reason. Stepping amount of your net worth at
Over the years, a lot of our back and understanding what risk, wouldnt you think
former students have asked us that reason is. I think the only through how it could go
about starting funds and how way to do that is through a terribly wrong, and what the
we would evaluate somebody constant re-underwriting first signs of that would be?
who is starting a new fund. I process and a diligent research The answer is yes, and its
think there are three parts. process. probably a good idea to write
There's being a good analyst, it down.
and then there's being a good G&D: Do you have any
portfolio manager, which is formalized systems or MB: It's also a little nave.
actually a pretty different skill processes in place to eliminate When most people have lost
set. Then there's the third these biases when making money, us included, it is often
part, which is temperament. tough decisions, like a pre- not from any of the twenty
The big intangible. There are a mortem? possible risks you listed in
lot of people who have one of advance. When the bad
the three or two of the three, GS: Thinking, Fast and Slow is outcome happens, you'd be
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Harvey Sawikin
Kingstown Capital Management
shocked how often it was process of weighting factors. them, pulling the threads for a
related to something that Often we all have very similar thesis that might be missed by
wasn't on your original list. information, but the rub is, most others.
how do you weight it
For us, this is why it all comes differently in a decision to get If you just keep looking at
back to valuation. Being a good better outcomes, that is the these categories and you own
investor requires you not only Kahneman stuff too. You the good ones, unlevered and
to be wrong in ways you didn't should get better at that every at good valuations, and you can
anticipate and still not lose a year and as you live through be a little patient, you have a
lot of money. I think the only more things. But then again, good chance of outperforming
way to do that is to buy things you dont want to be over- in the market.
very, very cheaply. For most influenced by an unusually
investments that havent good or bad experience,
worked, we have been very because outcomes are more
...we want to be right
wrong on a number of things like the mean than the there on the front line. If
and still not taken a large exceptionagain, Kahneman.
impairment. one of our investments is
G&D: Would you mind
not working, we can be
GS: I think thats called walking us through an
margin of safety. The closest investment from the screening decisive and we can
thing we have to a formalized and search process to actually
process is our emphasis on putting capital to work? make a decision that we
written memos. For any
can live with.
position of a decent size, we GS: As we discussed earlier,
write very detailed memos. our view has always been that
We date them and we update the markets are very efficient. How does an idea go from
them, so that six months or They get more efficient every there to the portfolio? I think
eighteen months later we can year. There are lots of smart we are unique in that we
go back and see what we people out there working on screen for situation first, not
thought was going to happen. lots of names. We have to ask valuation. What you might find
From a psychological ourselves, Well, how are we is that a lot of value guys will
standpoint, you can play all going to make money in a just look at the new lows list.
kinds of games if your market that is generally There are reasons that's
investment ideas are all in your efficient? How are we going to dangerous, the biggest being
head, which is bad for do it consistently? Anybody value traps.
performance. could do it for a short period
of time. First, we look at the situation
MB: It also makes you refine and see if there is somebody
your thinking. By writing We have to look in places stampeding out of the stock or
something down you are where there is chronic bond. Do we understand why?
forced to focus your thoughts mispricing. You have to keep Yield breaks are good
in a way that verbally you looking in those places over examples. Every time a yield
cannot. and over again. You have to equity or credit is
keep the fund size small downgraded, there are
GS: Yes many times I have had because the bigger you get, the obviously structural reasons
this experience: I decide I like fewer places you can look. All why people have to sell. That
something, then I write down we do is look at a couple of will pique our interest.
the bull and bear cases for it, areas of special situations. We
go back to it a few times over look at every spin off. We look Then we'll start looking at
several days, adding things, and at every bankruptcy or valuation on an absolute basis,
then I think, you know what, I stressed credit. We look at to the enterprise. We dont
dont like this so much every rights offering. We look use relative valuation here. If
anymore. Writing things down at every privatization. Anyone the valuation on an absolute
brings more precision to your can get a list of these, but we basis is cheap, then we start
thinking and helps in the are really, really looking at doing fundamental research,
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Harvey Sawikin
Kingstown Capital Management
which includes a lot of primary Then they look to the analyst valuation to approximately 4x
research. And the primary and ask, Is the analyst good? to 5x earnings late in 2016.
research is something we have Then they start thinking about But, if you look at the
gotten better at over time, its the idea in the context of the company, there are many
something you only improve at analyst. How has the analyst competitive barriers to entry
by doing over and over and done recently? This actually in an industry dominated by
figuring out ways to gather but reduces to a kind of two main players and the
also prioritize information. momentum that analysts get business is actually more of a
inside funds, which influences high-return just-in-time
If it's a liquid equity, we're not investment decisions and is logistics provider and supplier
in a rush to buy it. We'll have a kind of crazy when you step than an old-line manufacturing
fully blown research process back and think about it. We company. The prior Vice
first. Weve met with are trying to reduce the Chairman of JCI is the new
management, interviewed a behavioral stuff between us CEO of ADNT. He has a very
large number of former and the idea, and want to be significant compensation
employees, done a lot of work right there on the front line. package that he converted
on business competitors. We'll We want to be fully informed from JCI that we think aligns
do that before we own it. and decisive. We dont have to well with future growth
wait for a committee meeting opportunities.
Credit is different because it's or consider the internal
such a choppy market. politics of an investment Incidentally, one of the biggest
Sometimes we'll own credit decision, because we have knocks against ADNT and a lot
when we're pretty sure it's neither of those. of the auto companies is the
good. We're 90% sure, but we disruption and potential change
have to take advantage of the G&D: Do you have an in the industry. But ADNT is a
liquidity at that moment and investment idea you want to big beneficiary of the move to
then we'll backfill our work. share? autonomous vehicles. Number
You also have more structural one, they have a position with
and legal protections here if MB: Our largest position right every single manufacturer. So,
you are wrong. Generally, now is Adient (ADNT). ADNT regardless of how market
we're fundamentally driven and is the largest manufacturer of share changes with
we know the investments very auto seating in the world and autonomous driving
well before we buy them. virtually every auto company is technology, they'rebad
a customer. Johnson Controls pungoing to have a seat at
G&D: Is a position fully sized (JCI) spun out the company in the table. ADNT and Lear
at this point in the process? October of last year. From an (LEA) control a majority of the
initial search process, it's an global market. As these
GS: A lot of times what we're example of something that vehicles become more
doing is averaging down struck our interest given the autonomous over time, one of
because we own something structure and nature of the the big differentiators is going
and it's the exact opposite of spin off. It was a much smaller to be the interior package, and
momentum. So we save room subsidiary, it was in a different seating is the biggest
to average down. industry, and it was an component of that.
underinvested business of the
I think we are also unique parent. We like the business a lot. In
because Mike and I work on an equity market that generally
the names with the analysts. It's also a very misunderstood is pretty fairly to over-valued,
The two of us are intimately business. Like many of its auto it's unusual to get an above
familiar with everything in the part competitors, it's viewed as average business for a third to
portfolio. I think that's a very low quality and cyclical a quarter of the S&P P/E
important because at a lot of business and thus not favored multiple. But I think it also fits
funds, if a name goes against by JCI investors. This bias in well to what Guy was saying
the portfolio manager and he along with a lot of forced about the search process: how
or she is reminded they just selling, because it is no longer the name was identified, what
dont know much about it. part of the S&P 500, pushed we like about it, why it was
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Harvey Sawikin
Kingstown Capital Management
mispriced, and how that flows They are also making real GS: The reason the
through the process. progress selling seats into non- opportunity exists is exactly
car markets, like trains and related to your question about
G&D: How concerned are planes. the cycle. If you went to your
you about the auto cycle and PM at most hedge funds until
where we sit today? MB: Units aside, the trend for very recently maybe, you
interiors is towards bigger cars would be told that you can't be
Elizabeth Gao 17, Maria GS: That's the bear argument, and higher value content. long auto because SAAR is
Muller 17, and Maryam but there are two parts to it. That's all to the benefit of peakish, in fact can you come
Badakhshi 17 celebrate at
the The Heilbrunn Center
First, the industry is cyclical in seating. If you look at back with some shorts here.
for Graham & Dodd Invest- general. Then there's the idea autonomous concept vehicles, Maybe we get some bad
ing Stock Challenge of a SAAR Wall. That is the the entire dash and driver numbers on SAAR over the
classic bear argument. We display is stripped out, and the next several quarters we
don't think SAAR is going to interior is basically four high- arent saying that wont
plummet. There are a lot of end seats like a living room. happen. But this is a business
people with short term trades Unless people start sleeping or that should grow sales over
based on where SAAR will standing in cars, ADNT will be the next five years. As a
move. We think SAAR levels a beneficiary of this change. private business that is how it
out at around 17 million in the Adient also has a pretty would be thought of, and we
United States, but quite significant opportunity to go try to think about it that way
possibly more. Regardless, into adjacent markets, whether within the practical limits of
ADNT can make a lot of it's train or aerospace or more being a public market investor.
money with SAAR just sitting industrial applications. They
where it is right now or if it historically have not been able We do have this moderately
falls somewhat. ADNT also to invest in these areas hedged because of Trump Risk.
makes a good amount of because of capital constraints We could start having issues
revenue outside of the U.S. while under the JCI umbrella. with Mexico or China where
The dynamics of production in the Chinese get mad at us and
Europe are different. There are On the unit volume issue, at try to penalize us with auto
reasons to think that least in North America, there somehow. And, as Mike was
production can grow in are cycles, but the growth saying before, it's always the
Europe. Also, even the skeptics over time is still up and to the thing that you didn't see
say that China is going to grow right. It is a function of cars on coming.
car sales for a long time, and the road and population. The
ADNT is generating a good common mistake is to look at G&D: Now that ADNT is
amount of its cash flow from units pre-financial crisis, which independent, how will this
China. was nearly ten years ago now, impact the business?
and to think that SAAR has to
go back to that number. But MB: We think ADNT is going
There is no investment there are so many more to generate $9 in earnings this
is without risk. But people and units required at year. Their margins are a lot
this point. If you look at it on a lower than Lears despite the
paying 4x earnings replacement cycle basis, it's fact that ADNT is significantly
unclear that even the current bigger and there are real
eliminates a lot risk. level of units can sustain that benefits of scale in this
demand. business which favors large
global platforms supplying very
The other interesting wrinkle Yes, it is certainly a risk. There large customers. These lower
is the growth in content per is certainly a cyclical margins just relate to under-
vehicle. In an extreme case, component. But the investment in the business
they can triple content per car geographic diversification and while controlled by the prior
in some markets over the next the significant tailwinds they parent. Management has a plan
five or so years. Even if unit have in content and technology over the next couple of years
volume decreases, its possible and where cars are moving are to at least match Lears
ADNT can actually grow sales. major pluses. margins, which at current
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Harvey Sawikin
Kingstown Capital Management
volumes would take them from the industry have changed so cost, which also discourages
$9 to $12 or $13 a share or its not clear that the future the OEM from trying to kill
more. This was a stock that will look just like the past if them on price and creates
got as low as $45 in unit volume goes down with some stickiness.
November and is still only $60 respect to profitability its
today. I think it's a unique quite possible return on capital MB: There is no investment
example of being able to prospectively is much better, that is without risk. But paying
purchase something with a which does wonders for a 4x earnings eliminates a lot
pretty attractive growth stock price. risk.
opportunity at a mid-single
digit earnings multiple. MB: Seating is one of the G&D: You mentioned hedging
better auto supply businesses this investment. Can you talk
G&D: Lear and Adient control to be in, but there have also specifically about this and also
most of this market. What not been stand-alone Kingstowns overall shorting
does the competition between businesses historically. Pre- strategy?
the two of them look like? financial crisis, these businesses
were grouped together with a GS: Our short exposure is
MB: It's been very rational. bunch of lower-quality, lower- generally zero to 25%. The
The good news is that they're return businesses like interiors majority of our hedging is
both big public companies. or metals or other where we think we can isolate
They both have margin targets. commodities. We are in a industry risk. We want to be
It's also a business where very unique situation where you very specific, we're not looking
few awards switch between have two seating-focused to hedge the volatility of a
the two of them. The companies and everyone particular name. We're looking
incumbent has such a assumes their performance is to tease out some exposure
significant advantage in this temporary and cyclical because that may worry us. Usually you
industry because winning these types of companies have can't do it, that's why we don't
business requires you to spend never been able to sustain do a lot of them.
a significant amount of capital returns for very long. But it
and build your plant within the has always been the other For ADNT, some of the things
physical confines of your businesses that have taken that we worry about will also
customer. When work is re- them down in past cycles. hammer Lear and some other
bid, the incumbent is always auto part suppliers, so we're
going to be at a cost advantage. GS: The other interesting short a couple of them. But we
thing is that this is a very low still have a very meaningful net
The only time you see gross margin business, which if exposure to ADNT.
platforms switch is if there's a you were a new value investor,
move in location or a massive you might say, "Oh, that sucks, G&D: Is there a component
re-engineering of the platform. it's a bad business." But its to your short book that is not
Traditionally, most of the actually pretty good because paired with your longs?
significant competition has the gross margin is mostly low
been on new platforms. Even because most of the costs are GS: We do some alpha shorts,
then, there has either been passed through to the but we don't do a lot. We
enough business to go around customer, yet it discourages don't have a formal process for
or the share has come out of other competitors from getting it. Sometimes in our work on
smaller players. Outside of into the business. With two longs we find something that is
North America, the majority companies that control a a screaming short. We've
of seating is still done in-house, majority of the business in a actually made a good amount
so there's still a big low gross margin industry, of money in absolute terms on
opportunity to outsource there is not a screaming siren our shorts over time. Because,
more to both Lear and Adient. saying "Come compete with unlike a long-short fund, where
us." The seat, in part because you're under constant
GS: Returns on capital for its so safety-centric, is a very pressure to maintain a certain
both companies are OK over a important part of the car and short exposure, we don't have
cycle, and these businesses and its also not a big part of the to keep loading the short book
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Harvey Sawikin
Kingstown Capital Management
with God knows what. If we than valuation. doesn't necessarily understand
think something is ridiculous the culture and, by the time
and we're trembling with G&D: Could we talk more you hear about something,
greed, we'll do it. Otherwise, about privatizations and some everybody in the country has
we'll just do nothing. That's of the unique features? Perhaps heard about it. The bar for us
kind of how we think about it. talking about specific ideas and to invest internationally is
case studies would be helpful. definitely higher.
G&D: You tend to look for
things that you feel have GS: Privatizations are MB: Sometimes you have
bottomed-out but youve also interesting for a couple of some interesting incentives. If I
mention that timing is reasons. First, they're usually take my tech company public, I
incredibly difficult. How do try state-owned enterprises, which want to get the highest
to manage these two means that they've been poorly valuation possible, because my
elements? run. So there are usually net worth goes up. When the
opportunities once you get a state owns the business, they
GS: We're not an algorithmic real corporate governance don't necessarily care that
strategy, so the answer is that structure and management much about the IPO valuation.
we just don't know and we just incentives. Then they can take They just want people to say
do our best. Sometimes we out a ton of costs or do things that the privatization worked
bought something all the way that should have been done out well and the stock price
down and we just have to stop. ten years earlier. That is not went up after the IPO. It
Sometimes we buy something always the case, but if you look doesn't really matter what the
and it goes up 50% and it was at ten privatizations, you're base point is.
small, because we never got going to find one or two like
the chance to make it big. Both that. Theyre similar to spin offs in
bad scenarios. After doing it that you often have a non-
for a while, we just assume it Second, they tend to be economic seller, a
all averages out. We're not unlevered because they were misunderstood situation, and a
going to own something unless owned by the government. We number of catalysts, that Guy
there's some reason to think hate financial leverage. We mentioned, for future
it's really misunderstood or have no leverage on the improvement.
really overlooked, and we are portfolio. We're usually
confident the market is wrong, carrying net cash and most of I don't think we want to talk
thats the bottom line. the companies in the portfolio about the specific name, but an
are not levered so that really investment we made recently
MB: You have to use valuation should help us in any kind of was in a railroad company in
as an anchor. That's not to downturn. Japan with a monopoly
mean something like ADNT, business in a certain part of the
trading at $60 and 5x earnings Third, these tend to be strong, country. The government
can't go to $45 and 4x. Things monopoly-type businesses. Its priced the IPO artificially low
can always get cheaper, but the railroad, it's the mail because the entire purpose
Joel Greenblatt used to say delivery system, it's the electric and mandate for this
that it's more binary. Things companies. privatization was to spur local
are either cheap or they are retail ownership in the stock
not. And if its cheap you G&D: The stock exchange? market which is currently very
should just buy it. If you can low. Their primary goal was
make a lot of money and you GS: Yeah, it's companies that not to raise the most money
have a significant hurdle that are incumbents because they possible. The primary goal was
you're reaching for, it should were originally funded by the to spur investment in the stock
be pretty clear. Back to Guy's state. The international aspect market by locals and to have a
point, that doesn't mean you is very tough. You have the successful track record so they
never can lose. currency issues. But more could do this again in the
importantly, you're always the future.
GS: When we say bottomed guy who knows the least.
out, we mean more sentiment You're the idiot foreigner who Then you take a business that
(Continued on page 13)
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Harvey Sawikin
Kingstown Capital Management
was being run for no profit good idea to listen more. Two, for interviews, we meet
historically, because the Analysts in this business, they hundreds of people who share
mandate was just to allow for get to a meeting with investment ideas and they all
cheap travel. Now, with a management and so much of it sound exactly the same. It's
profit maximizing management is about promoting themselves. very rare that somebody
and aligned incentives, it can comes into a meeting with
lead to a business with much some kind of actual insight.
...unlike most other
better economics in the future You get a unique insight
than existed in the past. But professions, there's no because you have been
some overlook this thinking about this information
opportunity and other specific experience differently or you found new
privatizations because all you required. My advice for information through primary
can see is the historical research. You visited 25
performance. MBAs is to appreciate stores, you met some
customers, you filed a FOIA
G&D: Outside of not finding how much you don't request, whatever. And it led
the right valuation, what are know... to some kind of insight. If you
examples of privatizations that can do that, you're going to
are not good investing have a lot more success than
opportunities? Lets face it, what are you most of the candidates will.
taught at Columbia or any
MB: There are big differences other business school? Youre Any monkey can generate
in the businesses that are taught to network and to EBITDA multiples and slap
privatized. Buying a monopoly promote yourself. Students them on slides with bullets.
railroad in a specific country and former students view More kids are going to
with no competition is very every interaction as a way to undergraduate business school
different than buying the state show how smart they are. than ever before. There are
owned oil company. Even People actually spend so much thousands and thousands of
though it may be the only oil of their energy in a meeting people who know Excel and
company in the country, it still talking but very little listening. have taken Finance. You are
operates in a globally I've had so many experiences not going to set yourself apart
competitive industry. where someone comes out of that way or be successful, and
a meeting and only absorbs even when you get the job,
It basically comes down to 20% of what was said, and it these are the kinds of things
how much control the should be closer to 80%. you have to keep doing and get
government has over it and Instead of thinking about your better and better at.
whether the market is local or next question or insightful
global. The last thing is related observation, just listen. MB: It's a weird industry
to the incentives of the because unlike most other
government and the new It may lead to something else professions, there's no specific
management team. In the past, that is useful even months experience required. My advice
there have been privatizations later, or stick in your head even for MBAs is to appreciate
that were vehicles for forever. These are simple how much you don't know and
governments to raise capital things but if you want to to find a place where you can
from foreigners, but still become a good analyst, you learn but also where you share
maintain most of the can benefit very much from a common investment
economics without doing it. It also helps in the philosophy. If you don't have a
shareholders benefiting. rest of your life. I tell myself common philosophy with the
there is going to be a test after fund and a real passion for
G&D: Do you have any advice every meeting and I need to investing, it's not going to
for students and other people retain like my life depends on work. You cant fake passion
entering the industry? it. It really works. Listen with and fit.
your ears, not with your
GS: I have two pieces of mouth! Also, given the popularity of
advice: One, I would say its a hedge funds over the past
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Harvey Sawikin
Kingstown Capital Management
decade, a lot of people have
come into this industry
because it's the next logical
step or the way to become
wealthy. Its what Investment
Banking was before that. So it
has attracted very high
performing individuals many of
whom have never experienced
a setback or disappointment.
But, this business humbles
people very quickly and how
you deal with these initial
setbacks will determine
success or failure. So we end
up focusing on and asking
about these disappointments
when we interview these high
performing candidates that go
from the Ivy League to bulge
bracket Wall Street firms then
to hedge funds. The setbacks
and how they have learned to
think about risk and reward
and their lives in general are
what differentiate people in
our experience.

The only other thing that we

tell every person that we've
hired, no matter how old or
experienced he or she is, is
that you have to bring a
notebook to every single
meeting and you have to write
everything down. You'd be
shocked how few people do
that and how helpful it can be.
You'll never miss something
and if you do exactly what
your boss wants you to do, it'll
put you in the top 10% right
out of the gate.

GS: Are you guys writing this


G&D: Thank you for your

Page 15

Rupal Bhansali
(Continued from page 1)

Chicago, Illinois with CFA Institute, Morningstar accounting at age fourteen.

offices in New York and and Schwab. Looking back, one of my best
Sydney. The firm offers six decisions was to start working,
no-load mutual funds for Fluent in several Indian not only during summer breaks
individual investors and languages including Hindi, but also when school was in
defined contribution plans Rupal earned a Bachelor of session. I did a lot of
as well as separately Commerce in accounting apprenticeships in finance
managed accounts for and finance, as well as a whatever I could get my hands
institutions and high-net Master of Commerce in on. I worked on leasing,
worth individuals. As chief international finance and project finance, foreign
investment officer and banking from the exchange, investment banking,
portfolio manager of University of Mumbai. She stockbroking. Ironically, the
Rupal Bhansali Ariels multi-billion dollar later earned an MBA in one thing I could not get my
international and global finance from the hands on was investment
equity strategies, she University of Rochester, management. Entering this
oversees Ariels New York where she was a Rotary profession is a Catch 22. If
based global equities Foundation Scholar. you don't have the experience,
research team. you can't get in; of course, if
Graham & Doddsville you can't get in, you don't have
Rupal joined Ariel in 2011 (G&D): Rupal, thank you for the experience!
after spending 10 years joining us today. Would you
with MacKay Shields, mind starting with an overview I was fortunate to get my
where she was senior of your background and how break a few years after I
managing director, you became interested in finished my MBA. My
portfolio manager and investing and got into graduation coincided with a
head of international professional money nasty recession in 1992 so I
equities. Prior to that, she management? took any job I could just to
spent 5 years at stay afloat. Luckily my job
Oppenheimer Capital, Rupal Bhansali (RB): My involved covering emerging
where she managed background is unusual in that I markets on the sell-side and I
international and global have worked on both the sell- knew if I worked hard it could
equity portfolios and was side and the buy-side, in prove to be my launch pad to
promoted to co-head of investment banking and in the buy-side. At the time there
international equities. investment management, on was not much published
Additionally, she has held the long-only side and the long research on emerging markets
various roles at other -short side, on developed so I was a jack of all trades
financial services firms markets as well as those that researching ideas and writing
since she began her career are emerging. I have up notes at night and pitching
in 1989, including Soros researched scores of sectors ideas to clients by day. Soros
Fund Management. and thousands of companies Fund Management was one of
and covered close to 50 my clients and they liked my
In 2009, Forbes countries over the years. My work and asked if I wanted to
International Investment varied, hands-on experiences join themI obviously jumped
Report named her a over the past 25 years have at the opportunity. That's how
Global Guru, and in helped me understand the ins my career in investment
2015, Barrons recognized and outs of investing from a management started out.
her as a Global very deep and broad
Contrarian. Rupal is a perspective. G&D: What do you think has
frequent guest on premier allowed you to have a
shows such as Bloomberg, I got interested in investing successful investment career?
CNBC Squawk Box and because I grew up in a family of
Fox Business News. She is bankers and brokers. From a RB: In every job throughout
also a sought-after speaker young age, I knew I wanted to my career, I tried to have
at prestigious industry be in finance, and that gave me varied work experience and
conferences including the a head start. I studied ensured I learned something
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Rupal Bhansali
different. For example, in my from other people. Investment and learning are cumulative in
job working on leasing in management and equity nature. That foundational,
undergrad, I learned how to research are not things you formative experience is critical.
identify when an APR is being can teach; they have to be You dont want to end up in
manipulated by adjusting the learned. When you work the wrong place in your early
residual value. among smart, talented people, years. I've seen a lot of careers
you become smarter yourself. I end up in a dead end because
At Soros, I learned a lot about chose to work in some great people didn't choose well early
risk management and downside organizations where people on.
protection, because in the were so talented that it rubbed
hedge-fund world, there's just off on me. You rub off on G&D: You talked about crises
much more intensity and rigor other people and you become and how you were able to
around that compared to the a person who can make others benefit from past episodes
traditional long-only world. around you better. you've seen around the world.
Because I covered emerging Was there something in
markets for such a long time in I'm always surprised that particular that happened in the
my careerand grew up in students spend so much time past that allowed you to see
oneI learned a lot about figuring out which college to the financial crisis coming
dealing with crises. The one attend, but when it comes to before it occurred or was it
constant about emerging work, they don't do as much more about how you
markets is that there's always homework on their positioned yourself once you
something going wrong prospective employers and the were in the center of the
somewhere in the world. Your people who work there. It storm?
antennae go up for those becomes a passive exercise of
events. looking at what job postings RB: Oh, no! When it comes
are available as opposed to an to risk management and
Covering crises in emerging active exercise of finding out, protecting a portfolio, it has to
markets really helped my Where do I want to work be a preemptive strike. There's
clients in a year like 2008, and how do I get admission to not much you can do after the
when developed markets had my dream firm? Figure out fact. You always have to be on
their big financial crisis after a the kind of investment firm, the lookout for things that can
very long time. I had seen that philosophy and culture you go wrong before they actually
playbook before and we were want to be part of and then try go wrong. Frankly, we could
able to do very well by our to work yourself into it, as see things going wrong as early
clients and protect them opposed to waiting for it to as 2006 and we took proactive
during that crash. The markets happen to you. action in our client portfolios.
were down 43%; we were We sold off a lot of our
down 24%. I remember getting banking stocks well before
phone calls from our clients I'm always surprised people became aware of the
asking "are your performance mess in mortgages and the
numbers correcthave you that students spend so subprime housing loan crisis. I
guys made some calculation much time figuring out think that these things are a
error?" Turns out our confluence of many
performance was such an which college to attend, developments brewing over
outlier amongst what they timethey dont happen
were seeing, they thought our but...they don't do as overnight. The Lehman
stellar performance must have much homework on their bankruptcy may appear to be
been a typo! the catalyst but it was actually
prospective employers the culmination of a lot of
The other thing that was very things that happened prior.
helpful, and something that I
and the people who The Lehman downfall feels like
think all investors should find a work there. a shock catalyst because in that
way to harness, is the power one stark moment the
of osmosis in this profession. systemic risk became glaringly
You really learn on the job and Keep in mind that investing obvious to all. But the risk was
(Continued on page 17)
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Rupal Bhansali
there all along, and it was print, and lo and behold, they off-balance sheet leverage was
building over many, many were assuming very high exit even greater. Investors also fell
months, even years. You can multiples on the real estate for a recency bias and assumed
actually see it coming if you're they had acquired in the the ratio of non-performing
on the lookout for it. This terminal year of their forecast loans would remain low due to
allows you to prepare for it and that obviously worked out benign conditionsthis is a
instead of being blindsided. to a high IRR (internal rate of classic example of circular
return) on the investment. logic. Now most businesses
The challenge though is that They were touting this high can afford to make some
you pay the price for such IRR to unsophisticated retail mistakes and not have to pay
proactive risk management investors who did not know or too much for them. However,
with inferior performance, understand the difference in the world of banking and
until the risks you are worried between a forecasted IRR and insurance, you can't make a big
about actually manifest an actual one. I knew this was mistake because you have a lot
themselves. If the time gap is not a sustainable business of leverage on the balance
too wide, your clients can fire model and avoided the stock sheet. A small mistake is
you in the interim. You need despite its apparently high automatically multiplied and
courage to stay the course growth and ROE. The stock magnified into a big mistake
even if the very clients in was among the first to collapse through the power of leverage.
whose interests you are acting in the financial crisis as they And a big mistake becomes a
dont see it that way at the could no longer palm off the mega mistake. If your equity is
time. Being a contrarian is not expensive real estate they had very small, you're going to get
easy, but it is right. overpaid for at a profit and in wiped out. At that point,
fact had to book large losses. equity is nothing but a binary
G&D: What exactly did you By the way, this is the power option with a very, very high
see coming that others didnt? of fundamental researcha strike price because there are
quantitative model cannot a lot of claims ahead of you.
RB: My prior experience uncover these types of And that binary option may
working in various facets of questionable business expire worthless!
finance helped me smoke out practices.
potential rip-offs. Here is one
example. I remember talking to Additionally, we saw that too Investors [in banks] fell
a marquee financial institution many people in banking were
for a recency bias and
whose stock was a market focused on VAR, or value-at-
favorite because they were risk. Value-at-risk is a statistical assumed the ratio of non-
generating tremendous fee construct that always appears
income which investors loved very low when things are performing loans would
and put a high multiple on. On benign. So, if you don't
remain low due to benign
further investigation, I found understand the context, you
that a lot of those fees were will be misled. It's not that conditionsthis is a
generated by promoting closed regulators, rating agencies,
-end real-estate funds to investment banks, and even classic example of circular
investors. Knowing real estate investors, were not paying logic.
was overvalued and illiquid, I attention to risk. But they
was curious why anybody were being academic as
would want to buy a closed opposed to practical, and Risk assessment boils down to
end fund that itself was an single-dimensional instead of looking at the right things in
illiquid vehicle! Nonetheless multi-faceted, and that led the right way. We were relying
the company was clearly seeing them to looking at a single and on the power of good
a lot of demand and the facts wrong risk metricVAR. research. It's not about finding
didnt square with common the answers, it's about asking
sense. And that is the first clue We looked at other metrics the right questions. That's
to a scamsomething does and saw that leverage on what led us to understand that
not add up. So I read the balance sheets was increasing there was way more risk in the
prospectus to check the fine on an absolute basis, and the system and in individual banks
(Continued on page 18)
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Rupal Bhansali
than the market understood, grain. It also takes patience. In and applies everywhereso I
so we actually got out of our fact, in investing, stomach and applied his intrinsic value
positions and protected our stamina are more important investing approach to
clients. We didnt own a single than smarts or spunk. international markets. My
bank that went under, and investment track record is
that's from our first rule of Finally, it was not my fathers testament that it absolutely
investing: instead of focusing successes alone, but rather his works abroad as well.
on making money, first try not ups and downs that have also
to lose it. shaped my investment thinking. Other individuals that were
I'm a big believer that failure among my biggest influences
G&D: Who has made the teaches you more than and deserve my utmost
greatest impact on your success. Its what you get gratitude are all my former and
career? wrong, not just what you get current bosses. They were all
right that matters in investing. very demanding and expected
RB: My earliest influence was a lot of me, but frankly, I
my father who is now a retired With every company we would not have it any other
stock broker and investor. He way. If you're a high achiever,
unknowingly gave me my first look at, our attitude is: you want to make sure you
taste of equity markets have a boss that doesnt cut
because he used to work from You're not good enough you slack, but holds you to a
his home office which doubled for us. You are too risky. high standard and gets the best
up as my bedroom. I grew up out of you. Thats the
listening to stock stories and We are thinking about contrarian in me talkingmost
was exposed to contrarian people want the path of least
investing, because he was an all the things that can go resistance and prefer
independent thinker. He wrong. compliments to critique and
marches to his own tune in easy wins instead of tough
most things in life and investing challenges. But going for the
was no exception. The second influential person opposite will make you way
was George Soros. Before I better!
Remarkably, my father had the joined Soros Fund
foresight to know that if his Management, I had not G&D: If you were to look at
kids were going to be understood the role of your process and how you
independent minded, they had behavior and psychology and invest, what sets you apart
to be given independence. He the notion of reflexivity in from others in the profession?
made sure there was no markets. Markets are not just
helicopter parenting imposed made up of stocks, but of RB: I think the single biggest
on us. Making decisions, people. Their reflexive difference is in what we look
including and especially tough reactions can cause for. I feel that most long-only
investment decisions, comes movements in stocks and a managers think about what can
easy to me because I have had divorce from fundamentals. If go right and how much the
to make and be responsible for people have not read Soros' stock can go up. By contrast,
my decisions my whole life. book on reflexivity, The with our approach we first
Alchemy of Finance, it's not a think about what can go wrong
The things that I learned from bad idea to read it. Although I and how much can the stock
observing his investing career dont agree with everything go down. We pay more
is: a) how important it is to be a that he says in the book, it is attention to risk management
contrarian to make money in an interesting perspective. because risk is the permanent
markets, and b) how hard it is impairment of capital. That's
to be a contrarian. I saw the I know a lot of people talk what I think is really different
triumph of being a contrarian about Warren Buffett, so I about us, that we think about
but also, the tribulations. It's won't mention him being an risk before we think about
not for everyone because it influence because it's obvious. I returns.
requires a great deal of was convinced that Buffetts
fortitude to go against the way of investing is universal For most people, risk is an
(Continued on page 19)
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Rupal Bhansali
afterthought. For us, it's a think and what the market Frankly, I find a lot of
preemptive strike. We try to thinks, happens to be the same consumer staples around the
avoid risk and eliminate it from a.k.a., its a consensus view world to be very expensive.
the get-go because if you don't and already in the price. That Just because the quality of the
swim in shark infested waters, said, because we look at business is good and you are
the chances of you being bitten thousands of companies and not taking business risk, does
by a shark are very low. only need to own a handful, not mean you're allowed to
there are enough companies take valuation risk. Risk is risk.
If you think about the with low risk that have It doesn't matter in what form
motivation of a typical analyst compelling returns and growth it comesyou're still going to
at a traditional long-only profiles that are not well lose money if you're
shopit is to pitch an idea to understood by the markets. overpaying.
your portfolio manager to buy.
Obviously, your modus That's where we find our On the other hand, we found a
operandi is to look for things sweet spot and do a much number of technology
to like about that business deeper dive to understand companies that are great
because that's what you want what that risk and reward look companies but overlooked.
to tell your portfolio manager, like, and quantify it in an Microsoft comes to mind.
so that he or she puts it into investment write-up and Many people pooh-poohed us
the portfolio. This financial model. I want to when we bought the stock
conventional process underscore that we dont about five years ago and didn't
automatically creates a blind waste our intellectual buy Apple. Through our
spot in ones research because firepower on the obvious contrarian lens, we saw
instead of first thinking about high-quality businesses but use Microsoft as an enterprise staple
what can go wrong, you're it to identify the not so and knew it deserved the
now thinking about what can obvious quality businesses. multiple of a consumer staple.
go right. That creates a
confirmation bias. You're If you go to any enterprise,
Many people pooh-
looking for things to like and if you will find that people use
you find them, you're going to poohed us when we Outlook, Word, PowerPoint,
like it. Excel. I know a lot of college
bought Microsoft about students and non-professionals
In our process on the other five years ago and didn't like to use the Apple software
hand, we are actually looking and Apple gadgets, but in the
to reject, not to select. That buy Apple. Through our corporate world, Windows
means that with every and Office 365 rules. They
company we look at, our contrarian lens, we saw have the leading enterprise app
attitude is: "You're not good Microsoft as an ecosystem, so it's very sticky
enough for us. You are too and results in a recurring
risky. We are thinking about enterprise staple and revenue stream. In our book,
all the things that can go Microsoft was an enterprise
wrong. Generally speaking, knew it deserved the staple but the market viewed it
about two-thirds of the multiple of a consumer as a high risk and volatile
companies in our universe technology company that was
tend to get eliminated based staple. losing out to Apple and
on risk. Google. Both were false
notions as the latter only
With the third or so that Let me give you an example. A succeeded in the consumer
remain, we find that about half lot of people love to own market and made no inroads
of them are companies that we consumer staples. I mean, who into the enterprise market
judge to have low risk and doesn't? Warren Buffett of where Microsoft rules. As our
good returns, but so does the course, has talked about how thesis was borne out, we made
market. These companies are they are such great franchises. our clients a lot of returns and
unlikely to be a source of alpha They have moats. But all this is with low risk. That's the
generation because what you very obvious and well known. power of doing research in a
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Rupal Bhansali
different non-consensus way. industries are exposed to texting and we certainly
regulatory risk. weren't using video. Most of us
G&D: When you are Telecommunications is a great in the U.S. now have a
screening for risk, what types example. Even though it's a smartphone as opposed to a
of risk are most important? low-risk business with feature phone. Think about
subscription revenue and China as America eight years
RB: Risk is not statistical services in high demand, ago. The usage of data is
metrics such as beta or there's a great deal of risk extremely low today, but we
standard deviation or tracking from regulatory intervention. think it's going to go up a lot.
error. I know that's what's
taught in the CFA & MBA You can also have a lot of Monthly phone bills in the U.S.
programs but as a practitioner disruption risk and most are around $60. In China, the
I can tell you that is not the investors are vigilant about this equivalent bill would be closer
definition of risk. For an risk in, say, the technology to $10. The GDP per capita is
intrinsic value investor, risk is sector. Another industry that different in the two countries,
losing money permanently. was very exposed to this risk, but in China you don't have as
but not perceived by investors many fixed lines as in the U.S..
That said, the word, as such, lost investors a lot of For people in China, their cell
permanently, is very money when it materialized. phone is often their sole
important. You can always That industry is retailing. As access to the internet, to e-
have short-term volatilityi.e., we know, brick and mortar has commerce, to watching video,
you can lose money moved to e-commerce. That etc. You can see why we
temporarily, but not proved very disruptive to believe the monthly bill has
permanently. A lot of people retailers. By paying attention to significant headroom to grow.
confuse short-term volatility business risk, we avoided
and long-term risk. People are owning value traps and saved Despite these compelling
so afraid of volatility that a our clients money. When it prospects, the company's
contrarian investor can actually comes to risk management, a valuations are quite attractive.
take advantage of this dollar saved is a dollar earned. The market is implying a low
behavioral bias and still avoid single-digit growth rate in
risk. G&D: Would you mind earnings, but we are focusing
sharing some current on the double-digit growth
We think of risk in the investment ideas? rates in free cash flows.
underlying business. For Currently, the company is
example, if you're a RB: China Mobile (CHL) is a making large upfront
pharmaceutical company with a leading wireless carrier in investments in the network,
single product, even if that China. Think of it as a Verizon but in the future such capital
product is very successful, times four because they have expenditures will fall. It is
when the patent expires and over 750 million subscribers. similar to the cable TV
you have nothing to show for a China Mobile enjoys a companies in the U.S.they
successor, you're a very binary whopping 66% market share in are cash machines. The beauty
company. You could make the country, which obviously of China Mobile is almost one-
great profits today, covering makes it dominant. They have third of its market cap is sitting
your cost of capital, generating installed the 4G network well in cash, but they are looking to
lots of free cash flow; that is a ahead of their peers and are in increase their low dividend
low risk company, financially the early innings of Chinese payout ratio of about 45%.
speaking. But because it's single consumers migrating towards
product and it has no smartphones. The reason why we think the
successor drugs or pipeline, it's market doesnt agree with our
actually a highly binary and If you think about the playbook assessment is that historically,
risky business, so we would in the U.S., about a decade ago, some EM governmentsthe
eliminate it. we were still using feature Chinese government in
phones to mostly make voice particularhave had a history
Also, risk is very different in calls, and we were not using of intervening and preventing
different industries. Certain data plans. Data was really SMS the industry from earning
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Rupal Bhansali
super-normal returns. That's China so late. end and retreaded tires. The
something that the market is reason why those low-end
unduly concerned about, but in The government learned from tires don't end up hurting the
our opinion, even if they earn that mistake and they allowed high-end and mid-end tires is
normal returns, that's good China Mobile to develop a that a tire is very crucial to
enough for us. variant of the standard 4G achieve high fuel efficiency and
Finalists Zach Rieger 17, which is much more in line safety. The emission standards
Alexander Levy 17, Eric We love the fact that it holds with the global standards. As a and the fuel efficiency
Laidlow 17, and Marc net cash, which provides a result, the equipment and standards in the developed
Grow 17 celebrate with margin of safety in a world that handset costs came down and world keep increasing.
Geoffrey Hulme (middle) has gone on a debt binge. We made the service much more
after the The Heilbrunn love the fact that it's well affordable. You're absolutely There are a couple of ways to
Center for Graham & positioned from a network right, government intervention crack the code on improving
Dodd Investing Stock Chal-
perspective and from a was a risk, but once that risk is fuel efficiency. You can
consumer preference behind you, you don't want to obviously try to reduce the
perspective. They don't take double count it. weight of the car, you can
shortcuts in investing in the improve the engine efficiency
network at the expense of G&D: Thank you. Any other and clearly there's a lot of
generating free cash flows. ideas you would like to share? effort that goes into it. But
They do both and that's why physics has its limits. The
it's a high quality business. The RB: We are also positive on humble tire came to the
low valuation gives us a good Michelin. Many high-end cars rescue. If you have good air
upside-downside ratio. are fitted with Michelin tires or pressure in the tire, that alone
brands owned by them. One can make a remarkable
G&D: How do you think thing you will find about tires is difference in fuel efficiency.
about country risk in China? that they have pricing power.
China has this habit of rotating A pair of good tires can easily Michelin is not well
its preference among its state- cost you a couple of hundred understood as a company
owned enterprises. How do bucks. because for years, being a
you think about this problem French company, it was family-
where even though it's an owned, and managed in a
oligopoly and it is government We are also positive on patriarchal way. A couple of
controlled, we don't know years ago, the company
Michelin. Many high-end
which of the three mobile appointed professional
players the government may cars are fitted with leadership that has been trying
prefer on any given day? to improve manufacturing
Michelin tires or brands efficiency and addressing a
RB: Sometimes when owned by them. One bloated cost structure. The
government policies align with stock had sold off because the
what the company wants to thing you will find about street was very concerned
accomplish, it stops being a about an imminent downturn
risk; it's a source of return. tires is that they have in the auto industry. It is true
One of the drivers behind the pricing power. we are closer to the peak than
opportunity in China Mobile the trough and we admit that
developed precisely because of the auto industry is cyclical.
what you just referenced. The But what is misunderstood is
government forced China Tires appear to be a low-tech that tires are an after-market
Mobile to invest in a product. But if that is the case, product. It doesn't matter if
proprietary 3G network, and how are there only four new cars are not sold; as long
because they forced this, the players in the world making as you drive, you need to
country suffered because tires, when there are dozens replace your tires. It's a
nobody in the world made that can make cars? It suggests consumable. When investors
handsets which were that there's a high barrier to mistakenly threw this baby out
compatible with that network. entry. Indeed, the Chinese and with the bathwater, we picked
This is why the iPhone got to the Indians make a lot of low- it up.
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Rupal Bhansali
G&D: What advice would you prerequisite to success in this Also, I am very fortunate that I
give those interested in the profession. You should read a have a life partner who knows
investment management wide range of topics, not just that my career is very
profession and what specific finance. When you're important to me. I did not
advice do you have for women researching businesses, it's not have to make sacrifices that I
in the industry? just about numbers, it's about know many others might have
business and management to make if they don't have that
RB: First and foremost, strategy. Its about kind of support. For women, in
investment management is understanding change as particular, because this is a
learned on the job. You cannot opposed to the status quo. very demanding profession,
learn it from a textbook. You make sure that you set
cannot learn it from reading I hope this advice helps both expectations with your friends
Warren Buffetts annual genders but I think it applies and family and build a support
letters. If you tried selling your more to women. One of the system around you.
degree on eBay, nobody would things that I always did was to
pay you a dime for it. But if raise my hand. I never shirked G&D: Thank you so much, it
you apply what you have from taking on more has been a pleasure.
learned, then your employer responsibility, even though
and clients will pay you for it. there were times when I had
Knowledge is what you pay for, no idea how I would fulfill it.
application of knowledge is Raising your hand is a big deal.
what you get paid for. I remember in the late 1990s,
when I was working at
I think that too many people Oppenheimer Capital, we lost
think that just by getting a the person on our team
degree or reading a lot of the covering Japan. I raised my
literature they know investing. hand and was given the
But, it's about the rubber responsibility, knowing fully
meeting the road. This is like a well that it was one of the
sport. You don't learn hardest markets to cover.
swimming by reading about Mind you I never spoke
swimming. You don't learn Japanese and prior to that I
how to become better at had never covered Japan. As it
baseball by reading about it. turned out, we did
You actually have to do it. spectacularly well in Japan that
year, which I attribute to hard
So my biggest career advice for work as well some rookie
students is to start working. luck!
You are going to learn on the
job so make sure that you In a country like America, if
work in the right place. It you work hard and you work
should be a place that appeals smart, there is nothing that is
to your investment sensibility beyond you. Don't hold
and philosophy, because yourself back. Don't think you
without the right platform and can only cover something that
your peer group around you, it you know. Take on a challenge.
just doesn't happen. This is You may not know exactly
about osmosis. Start working how you're going to overcome
as soon as you can because that challenge, but if you don't
that's where your education give yourself the opportunity
and training really begins. It's to test yourself, you'll never
not in the classroom. know whether you could have
been successful or not. Raise
The other thing I would call your hand, is my most fervent
out is that a love of reading is a advice to women.
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Simeon Wallis
(Continued from page 1)

in a select few private He earned his MBA from business world and investing.
companies as well as The Wharton School of
opportunistically invests in the University of During my semester studying
publicly traded securities. Pennsylvania with a abroad in Australia, I walked
concentration in Finance into a bookstore and came
Atlanta, GA-based and his undergraduate across a book, which would
ApolloMD is ValorBridges degree in History, from shape my world view. That
Simeon Wallis original portfolio company. Duke University, cum book was Den of Thieves by
ApolloMD is a laude. James B. Stewart, a Wall Street
multispecialty physician Journal reporter at the time.
services company that Graham & Doddsville Den of Thieves recounted the
provides emergency (G&D): Thank you for joining great insider trading scandals
medicine, hospitalist, us Simeon. We really of the 1980s, and in doing so,
anesthesia and radiology appreciate your time. Could detailed the history of activism,
services to hospitals, you tell us about your the corporate raiders, the use
health centers and surgery background and how you of the highly leveraged finance,
centers across the United ended up at ValorBridge? Drexel Burnham Lambert, and
States. It is one of the Michael Milken. That really
most successful firms in Simeon Wallis (SW): I grew resonated with me. I believe
the physician services up in Manhattan. My father had part of the fascination was
outsourcing industry, as worked on Wall Street but had growing up in New York with
evidenced by its history of left by the time I was born. I those familiar names, but also
strong organic growth. always grew up with him the idea of mixing business and
investing on the side. We had a history, and understanding
Simeon Wallis currently family business, which was a how things came to be within
serves as Investment small chain of retail apparel the business world.
Director at ValorBridge stores, which, in retrospect,
Partners. At ValorBridge, was not a good business. I Afterwards, I immersed myself
he is responsible for our learned that entrepreneurship in different aspects of business
research process, is filled with highs and lows, history. Within my Markets &
investment origination and and our family finances Management program, my
due diligence. He is also a reflected that. My fathers thesis analyzed the leveraged
member of the portfolio investing was a huge benefit buyout phenomenon through
management team and that always stuck with me. the early 1990s, using KKRs
serves as a board member bid for RJR Nabisco as the
for several of ValorBridges Growing up I had exposure to lens; there was an outstanding
companies. Prior to investing with friends whose book, Barbarians at the Gate, by
ValorBridge, Simeon parents were on Wall Street. I Bryan Borroughs and John
advised value-oriented was one of those kids at 10 Helyar. My paper evaluated the
hedge funds and asset years old who enjoyed stock- market for corporate control,
managers with security picking contests. The first time basically activism in todays
analysis. He helped I started paying close attention vernacular. I was intrigued with
manage Lateef Investment to the market was at 13 years how business and history
Managements multi- old when I received shares in intersected, and how history
billion dollar concentrated Disney as a gift and followed could translate into future
portfolio in San Francisco Disney for the next decade. investments. I learned that the
and was an analyst with context behind events deeply
Cramer Rosenthal I went to Duke for undergrad matters.
McGlynn, Evercore Asset and majored in history. Duke
Management, and Gabelli is a liberal arts school, with no Coming out of Duke, I worked
& Co. in New York. undergraduate business school, in management consulting for
Simeon has been a guest but it had what was essentially nearly three years in Atlanta. I
lecturer at the Columbia a minor, called a certificate in then returned to New York to
Business School in its Markets & Management, that work on private-market
Value Investing program. provided exposure to the investments in earlier-stage
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Simeon Wallis
technology with a venture the business never really got management were about $3B
fund, named Dawntreader. It the legs underneath it, and at the time and rose to $4B. It
provided a very different eventually it was folded. It wasnt a good cultural fit. My
experience in terms of remains a lesson that wife and I moved back to New
analyzing smaller companies, randomness and luck, such as York, where I worked on
where managing cash flow was timing, can play a huge role not projects for several small cap
critical and management had a just in investing, but in careers. managersWynnefield
make or break impact. Capital, Candace King and
However, I realized that I was After Evercore, I moved to Amelia Weir at Paradigm
not exclusively a venture Cramer Rosenthal McGlynn, Capital Management, and Ken
investor at heart and chose to which is a more established Shubin Stein at Spencer
pursue my MBA at Wharton value manager. There were Capitalbefore connecting
before returning to the public about 20 analysts, and it was with ValorBridge, which was
side of investing. roughly $10B in assets under based in Atlanta. I joined in
management when I joined. May 2013 and I worked
After business school, I CRM was mostly long-only remotely in New York for
worked for Mario Gabelli 67 with a small long-short several years before relocating
covering autos, trucks, heavy product at the time, and to Atlanta last summer.
equipment manufacturers, and looked for businesses that
the whole value chain. The were undergoing change. That ValorBridge is a private holding
value chain encompassed the change would be difficult to company. It was started by
parts suppliers, the global model, or may not have been accomplished entrepreneurs
original equipment appreciated in sell-side models, and operators who built
manufacturers, aftermarket so these were neglected ideas. successful private healthcare
parts distributors, and auto Often these were value businesses. The operating
retailers. Autos and trucks opportunities, names that companies generate excess
were one of the first industries maybe didnt screen well, but cash that we use to make
that Mario followed. I was occasionally an analyst could either investments in private
literally 40 years behind him, find interesting angles to healthcare companies where
and essentially, was challenged gather insights. we feel we have some
to win any arguments about competitive advantage from
the subject with him. I was intrigued with our understanding of specific
customers and pockets of
From there, I joined Evercore how business and history opportunity, or we make long-
Asset Management, which was term investments that would
a start-up launched by four ex- intersected, and how diversify away from healthcare
Sanford Bernstein buy-side history could translate into businesses with
investors, who had received comfortable risk-reward
funding from Evercore into future investments. I profiles.
Partners to build an
institutional investment learned that the context We also invest in publicly
management business. It was a behind events deeply traded companies, depending
very intellectually and upon our projected return
analytically intense place in a matters. profile. We can move our
great way. It was very capital back and forth between
thorough research. If we were public and private markets
three years earlier or three After a few years at Cramer because its all internal capital.
years later, it would have been Rosenthal McGlynn, I received Were not a general partner to
a tremendous success, but an opportunity to work with a any outside investors, and
when we launched the small- friend at a 40-year old firm in there are only two situations
cap value and small- and mid- the Bay Area. This was a where we are a limited partner
cap value long-only products in concentrated fund, 15 to 20 in another fund. Over time, my
early 2006, the business timing names. There were three role has evolved from being
was completely wrong. investment professionals. I was pure public markets within
Because the timing was poor, the fourth, and assets under ValorBridge to straddling both,
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Simeon Wallis
and when need be, stepping business that had not been of Shareholder Activism.
into an operating role. We improved with all of the debt
believe our differentiation is issued. Its the worst of all Could you walk us through the
wearing several hats worlds. In good situations big lessons you learned
operators, public equity and there were manyan throughout your career and
investors, private market outside investor would come how you apply those to public
investorswhere we take our in and say, Youre essentially and private markets today?
knowledge in the private in four different businesses.
companies and apply it to Theres very little synergy SW: Mario had a pool of
public companies and vice between any of them. fifteen to twenty analysts who
versa. would sit around a table every
Its a reflection of the morning and he would
G&D: Thats a great overview. conglomeration movement of Socratically ask us about our
Could you talk more about the the 1960s and into the 1970s. coverage universe. I followed
academic work you did The company and its the automotive value chain, the
regarding activism and the stakeholders were generally heavy-truck manufacturers,
implications of that today? better off spinning off the such as PACCAR and Navistar.
assets or putting the assets I also covered heavy-
SW: A professor named into the hands of those who equipment manufacturers, such
Michael Jensen coined the would value it more highly via as Caterpillar, as well as
term the market of corporate divestitures, and use the cash agricultural equipment
control, which is an academic to find one or two businesses companies, such as John
way of saying the actions of to grow. Deere. What unites that
corporate raiders and activists. coverage universe was they
He believed in the efficient In situations when activists shared common parts
markets perspective that all came in with a mindset focused manufacturers. They had a
assets are properly valued in on capital allocation and long- common supply chain but
free markets, including term value creation, it was different distribution. What I
corporate assets. My incredibly beneficial. In learned was there were a
perspective was different in breaking up companies, the variety of business models
that I believed there were assets went to owners that within a specific industry. The
times when the market for either understood those business models had different
corporate control and activism businesses better, or youre margin profiles, different
were beneficial to most able to take capital and give it capital intensities, different
stakeholders involved; to those who can grow their growth opportunities, and
however, in the 1980s, there businesses in healthy ways. I therefore they needed to be
were points when I believed it dont believe one could valued differently. I started to
was detrimental. definitely say that activism on think more horizontally about
the whole was good or bad. the nuances of understanding a
An example when it was There were benefits and trade- different business model as
detrimental was when offs. I would argue that the opposed to the conventional
corporate raiders used good instances greatly wisdom of categorizing
greenmail. Carl Icahn was benefitted the U.S. economy companies by industries.
known as one of the leading over the long term.
protagonists; greenmail was Marios known for his acronym
when a raider would buy a G&D: Interestingly, theres an PMV, private market value,
stake in a company, threaten a adjunct professor at Columbia, which is a sum of the parts of a
hostile take-over, and Jeff Gramm 03, who wrote a business based upon what an
management would lever the book about a lot of these same intelligent buyer would pay to
company up in order to pay issues. acquire that business. In
the greenmailer off to go away, addition to thinking about the
all at a premium to other SW: Was that Dear Chairman? balance sheet, we looked for
stockholders. What the hidden assets or off-balance
remaining stockholders were G&D: Exactly, Dear Chairman: sheet liabilities, and put that all
left with was a highly levered Boardroom Battles and the Rise together to understand the
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Simeon Wallis
real value to the owner. To manufacturers. Wed compare G&D: Can you provide some
think about businesses that the fully loaded labor costs or comments from your
way was very valuable because healthcare benefits to retirees experience at Evercore?
having a differentiated per car that the consumer is
perspective is one of the few paying for, yet not receiving SW: At Evercore, I worked
ways to outperform peers and any value from. Thats a for Andrew Moloff, a portfolio
the market over time. competitive disadvantage manager who, better than
relative to another company anyone Ive known,
For example, John Deere had that spends that same amount persistently questioned his
manufacturing operations and a on what drives future value for analysts to help them
finance business, Deere the company, such as R&D. understand what the key
Finance, which provided drivers to an investment were.
dealers and end customers He was a teacher. Andrews
financing. Screening on I dont believe one approach was comparable to
Bloomberg or CapIQ, Deere could definitely say that what I would eventually learn
would show significant debt in studying Lean management
and appear levered; however, activism on the whole as the 5 Whys by going
diving into the SEC filings, an through ideas with the analysts
analyst would realize those are was good or bad...I through repeated questions to
two separate businesses. The would argue that the understand what the
finance arm could be valued as investment controversy was,
a finance company, such as at good instances greatly often better than management
book value or determine what understood it.
an intelligent buyer would pay benefitted the U.S.
for that portfolio of assets. economy over the long The methodology was very
similar to Rich Pzena or
Then one would evaluate the term. Andrew Wellington at Lyrical
capital structure of the where the analysis is driving
manufacturing business. Often toward deriving normalized
there would be net cash as At Gabelli, we invested time earnings in five years based
opposed to net debt, and an analyzing on a per-unit basis of upon the capital structure and
analyst could decide what is value creation or, alternatively, margin profile of the business.
the right multiple to pay on its we would determine what an The objective is to understand
mid-cycle operating earnings acquirer would pay for that whether the reason the stock
or EBITDA. So by valuing one unit of value. Mario found price is currently depressed is
part of Deere on book value industries that were based upon a temporary factor
and another on operating consolidating and determined or a structural change that
earnings plus the net cash, an how an acquirer would define would be difficult to fix. It was
investor could derive a value. For instance, in the cable a great lesson in understanding
valuation materially different industry, hed ask, Whats the the questions Whats the
relative to where the market enterprise value per subscriber right valuation? And What
was valuing it, especially if the thats in the subscriber are the right earnings to
market looked at it on a P/E network, and where should it assume in a normalization
ratio basis. Deconstructing be? He found huge disparities process?
businesses and valuing them between the current market
with the appropriate methods value of a subscriber and the G&D: Your team can invest in
based upon the attributes of takeover value on a per- the public market, in private
the underlying business models subscriber basis. If there was a market investments, and
proved tremendously valuable. large spread, that was really reinvest funds back into the
appealing. This EV and underlying business itself. How
The other big lesson from transaction value per do you decide where to
Mario was understanding the subscriber could be used to allocate capital?
unit economics of the business. value any subscription business
Lets say we were looking at model. SW: We do a back of the
one of the Big Three auto envelope IRR calculation,
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Simeon Wallis
thinking five years out. On the as earnings will probably revert incredibly appealing.
public side, our holding period back to a normal level.
might be three to five years. It In the private markets, theres
might be on the early side of G&D: Are there times when a deal process. Deals can take
that five-year IRR. Price will be youre comparing the public two or three months, at a
a component of the process. and private opportunities side- minimum. They can take six to
With the private investments, by-side? Is there a certain nine months with the due
we actually expect to hold amount of capital that you diligence and negotiations. Its
longer than five years; theres want to allocate to each part slower than public market
more opportunity to influence of the market? investing, and valuations can
the outcome because were still move during the process.
going to have more control. SW: We ask ourselves, We look at IRR based upon
Whats our opportunity cost? our opportunity set.
Additionally, we can invest Whats the risk-reward from
anywhere in the capital being in the public markets G&D: What does a typical
structure. We can provide versus private markets? What private market investment
capital as debt, mezzanine is our IRR in the public look like for ValorBridge?
securities, or common equity. markets and the private
We have a lot more flexibility markets? One of the SW: On the private side, Ill
in our ability to mitigate risk advantages of being in the break it into healthcare and
on the private side. The private markets is by definition non-healthcare. The two
tradeoff is, of course, that its theyre less efficient. Theyve founders of ValorBridge, Chris
not liquid. If were in the public become far more efficient and Beau Durham, have a
markets and we realize we because now 100 private background in healthcare. Both
made a mistake, you can just equity firms will look at the have law degrees and Beau also
sell. However, on the private same deal, but proprietary has an MBA, but they both
side, we have to invest deals still come through ended up going into healthcare
significant time to exert relationships. over time.
influence and affect change.
In the public markets, theres Within healthcare, we are far
For private investments, we nothing proprietary. Today it is more comfortable finding
concentrate on the harder to find compelling earlier-stage companies that
compounding of intrinsic value opportunities for us given are attacking a market niche
through owner earnings valuations. Whereas on the where we see a big
growth. Its more of a growth private side, we can find one- opportunity based upon our
perspective and operating off opportunities that might be knowledge of the healthcare
perspective, whereas on the more compelling. For example, industry. We can leverage our
public side, we are more of a there could be times when our existing relationships, such as
price-sensitive investor, where own portfolio companies can our relationships with hospital
were looking to double our make a tuck-in acquisition and systems, to accelerate the
money over three years. A pay 3x trailing twelve month growth of these smaller
bigger driver of that in our pretax earnings, adjusted for companies. In the last year, we
public investments is the amortization. Its hard to beat purchased a hospital out of
normalization of the earnings that. Thats inherently (with no bankruptcy, where we were
multiple, as opposed to growth growth) a 33% pretax return. already a service provider in
of earnings or cash flow. There Then add growth or cost that facility. We own a web-
are two levers to returnsthe reductions from synergies, and based scheduling company for
earnings or free cash flow and return on capital can rise to emergency rooms that
the multiple. On the private 80% or 100% quickly. Its functions similarly to
side we focus on growing cash difficult to find those OpenTable with a comparable
flows. On the public side, we opportunities in the public value proposition. A patient
tend to focus on situations markets, but if we were in gets hurt, knows that s/he
where we expect that the 2009-10, and we were to see should go to the ER, goes onto
multiple will rise to some level great valuations combined with the local hospitals website and
where it historically had been ample liquidity, then thats schedules a time to go into the
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Simeon Wallis
ER (assuming the injury isnt Were less willing to go with a Therefore, in sustainable
life or death), and can go home startup or a very young team growth businesses, profitable
to rest on his/her couch in in that type of situation. growth accrues more and
front of the TV as opposed to more to the shareholder.
sitting in the emergency room G&D: At what point do you
for 4-5 hours. We own the begin considering exit Look at John Malone and look
majority of a tele-health or opportunities? How do these at the team at TransDigm.
mobile health company. We factor into the IRR What they understand is that if
can leverage a network of consideration? an investor considers how
doctors with whom we already enterprise value compounds
have relationships. Due to SW: Our perspective going over time, with the
these capabilities, were willing into an investment is that we appropriate leverage structure,
to invest in earlier stage wouldnt invest in any business equity compounds even faster
healthcare companies. that we wouldnt be over time to the owner,
comfortable holding for a very assuming returns greater than
For our non-healthcare long term, at the very least, the cost of capital. Liberty and
investments, these are in more longer than the typical private Transdigm can run at higher
established businesses that equity funds investment cycle. levels of leverage because in
should grow free cash flow at We wont buy with a cable and in aftermarket
nice levels for owners based perspective of when or if to aerospace, the revenue growth
upon our research that the exit. That said, were all doesnt have to be fast. Modest
management team is far rational capitalists. Were organic revenue growth,
superior to its competitors. approached all the time about combined with operating
We directly own stakes in an acquisitions of a portfolio leverage works to have an
industrial distribution and company, and if we receive an extraordinary impact on the
service company for gas offer that is extraordinarily per-share growth of equity.
stations and fuel depots. We compelling, we have no
own a sizeable stake in a problem consummating that At the same time, in more
company that buys distressed transaction. But the bar is high. cyclical businesses, its pretty
consumer credit portfolios Very rarely do you find buyers foolish to employ even a
from issuing banks that are in who are willing to pay up for moderate amount of leverage.
charge-offs, where we can five years worth of free cash These cyclical businesses are
purchase them for pennies on flow growth and place a fair often asset-intensive and have
the dollar and manage the multiple on something five greater operating leverage.
collections process. I consider years from now. Whats helpful to me is to
this an investing business at its understand the reason for the
core. We own passive stakes G&D: How much leverage leverageis it to fund
in other companies, such as an does ValorBridge employ? operations of a capital-
industrial gas distribution intensive business or is it to
company and the largest SW: I believe private equity create a more efficient capital
manufacturer of wine bottle investors understand this structure for the equity
closures in the world. In our aspect well while a far smaller holder? Not appreciating this is
established company percentage of companies in the how an investor ends up in
investments, we focus on EBIT public markets truly appreciate trouble. We realized that with
somewhere between $1 this. Leverage should reflect our businesses, with the more
million and $10 million. We the cyclicality of the business cyclical ones, we will be
target companies with well-laid cash flows looking full cycle, overcapitalized with equity at
out growth opportunity, especially at the trough, not points in time. Given our
where theres nice organic just the most recent few years inability to accurately predict
growth and potential for tuck- or trailing twelve months changes in demand, were
in acquisitions. We seek EBITDA. Leverage magnifies comfortable with the
businesses run by highly skilled returnsgood and badto overcapitalization because its
owner-operators within their the equity holder. The more our capital thats on the line.
niche and who think about the stable the business, the more
world in a similar way to us. leverage it can carry. There are other businesses
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Simeon Wallis
where we can run at 3.5x financing and testing the management wanted to stay
EBITDA and feel pretty waters, do you determine that engaged in the business.
comfortable with the growth you dont want to invest the Theyre just looking for a
in that business, knowing the equity? different partner.
pipeline and competitive
positioning. Its dependent on SW: Very rarely. It might have We can install incentives that
taking a long-term view of the happened once in the four focus them on profitably
variability of unlevered free years that Ive been here. It growing the business over time
cash flow. reflects the due diligence so that the owners will see
process that we do with very good rates of return on
G&D: When you decide to management before making the their capital. We dont want to
invest in a business but have a mezzanine investment. We come in and buy 80% of a
variety of options of where to wont go into a situation to company and have
invest in the capital structure, provide mezzanine financing management take too much
how does your team make that where we dont like the skin out of the game.
decision? management team. There are
one or two situations where It speaks to one of the mental
SW: Mezzanine financing has weve done both mezzanine models that we use in both
been the initial way weve and equity at the same time, private and public markets. I
established a relationship to and the mezzanine ends up call it the 3 Ps. We think
help us understand whether protecting the equity if things about price, process, and
we like management and to go sideways for some period. people. The people part is tied
determine their ability to run a We protect the equity slice to incentives. The price is tied
business. Often we can provide with the mezzanine because to the IRR, or if its an
mezzanine capital at terms there are going to be acquisition or internal capital
below what the company could convertible features for project, whats our return on
receive from a traditional capturing equity if there is a investment. The process part
mezzanine lender. We might restructuring. is thinking about the
charge 200 or 300 basis points competitive advantage that we
below market; but to establish see. 3Ps is really IRR/ROIC,
that relationship, its still a We seek businesses run competitive advantage, and
good coupon for us. Were by highly skilled owner- incentives.
collateralized well. In the
capital structure were above operators within their G&D: How much do the
the CEO and the founders private and public investments
who own common equity so niche and who think influence one another in terms
that helps us to get insight into about the world in a of lessons learned or themes?
how they run the business.
similar way to us. SW: They influence each
Later, we would have other greatly. A mental model
additional discussions about we use, which we first
keeping the mezzanine piece, G&D: How do you and your employed on the private side,
but also investing in the equity team properly incent the is a deep understanding of the
to help facilitate growth, or do operators? drivers of value creation for
a swap. Its the crawl, walk, the equity holderthree of
run perspective of establishing SW: Our best situations have the four are operating drivers
a relationship. If we do like been when management has and the fourth relates to
each other, then were happy not taken very much capital capital allocation.
to help them grow by in the form of equityoff the
providing additional forms of table. Reducing equity stakes is On the private/operating side
capital, whether thats usually a yellow flag, if not a there are three drivers of
preferred or common equity. red flag, for us. More often profitable growththe first is
than not, management had a revenue growth, or gross
G&D: How often, when you different shareholder that profit dollar growth for certain
are providing mezzanine wanted to exit, and types of businesses. The
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Simeon Wallis
second is operating margin competitors. This leverages VSD framework.
expansion and the third is the concept of starting with
reducing the capital intensity of the end in mind. We put more faith in excellent
the business, often reflected in managers than many traditional
improvements in working The Strategy answers the investors, especially value
capital turns. For the public question How are we going investors. Management, in our
companies, we add a fourth to achieve our vision? belief, matters more the longer
driver: shareholder yield. Namely, it identifies what are a position is held. In our
the key operational items the opinion, the premium the
Shareholder yield is often company will need to execute market pays for outstanding
revealed in the Financing on, what are the key capital management relative to
section on the Statement of and operational investments average management is
Cash Flows. Is money flowing that will have to be made to frequently too narrow.
out of the business, and is it support the executing the
paying off debt and reducing priorities, how competitors On the public side, we typically
the share count? Or is money are likely to react and what are buy what we believe is the best
being brought into the the trade-offs that will have to management team in an out-of-
business, increasing debt, and be made, since everything has favor industry. We have
raising share count? Its an opportunity cost. deeper conviction that theyre
traditionally been owner- going to make owner-friendly
friendly when you reduce the Lastly, the Drivers are the decisions and less likely to
amount of capital in the critical activities that impair capital. Its also a belief
business. management will focus on and that management can make a
that can be measured in order difference in key situations.
We also use another mental to execute the strategy. As we That comes from operating
model that started with how developed this framework, we companies, allocating capital,
we work with our private saw how it is applicable to and serving on boards
companies, but has transferred evaluating publicly traded overseeing executives. The
to evaluating public companies companies, especially in difference can be dramatic
and their management teams. conversations with particularly the decisiveness
We uncreatively call it VSD: management. If a management and focus on the critical few
Vision-Strategy-Drivers. John team cant credibly and lucidly decisions and inputs that can
Wooden famously used a describe how they are have disproportionate impact
pyramid to explain his drivers allocating their key resources on profitability and
of success. We borrowed that. toward specific objectives that sustainability of the returns on
Vision would be at the top of they want to achieve over the capital.
the pyramid, Strategy would medium to long term, I believe
support the vision and the any investment thesis beyond G&D: How do you evaluate a
Drivers would be the base, reversion of the earnings management team when youre
supporting strategy. multiple is difficult to make. trying to look at so many
This is particularly true for different options in the public
For our established companies, compounders. space? What tools do you use?
we want them to have a ten-
year, high-level vision that The last few years Ive guest SW: I dont want to visit or
helps employees, key suppliers lectured at Columbia in the speak with management until
and customers, as well as the Value Investing Program in Ive thoroughly researched
board, have a good sense of Chris Beggs section of them and the investment
where our management team Security Analysis. I use 3Gs controversy. I want to avoid
is taking the company. It Ambev investment and Heico their influence in how I
motivates employees that they as case studiesfrom annual approach thinking about the
are part of a special company. reports, interviews, business. I want them to
It distinguishes us in our shareholder letters and address my critical questions
customers eyes because were articles, one could clearly see and I need to spend time to
seen as more aggressive in where management was taking determine what those are
addressing their needs than those companies using the beforehand.
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Simeon Wallis
A great executive can simplify advantage and focus the shares. Returns on capital. I
the business and her thought business resources in that believe that ultimately burned
processes in her area. A great example is many fundamental value
communications. She remains GEICO and Berkshire. Buffett investors because management
consistent in how she talks understood that the direct-to- lacked a true understanding for
about the business and what consumer model enabled the why the actions of The
she is focused on. She company to avoid higher cost Outsiders mattered. As Seth
communicates in easy-to- distribution than competitors. Klarman has said, you either
understand terms devoid of As a result, he could 1) invest get value investing or you
company and industry jargon. some of the savings in lower dont. This was the same
Decisive in actions, makes prices for customers and 2) thingit wasnt internalized.
difficult decisions quickly and is increase spending on customer An investor who sat down
candid about industry acquisition in the form of with management probably
conditions. She is honest and advertising that GEICO was a could have determined this if
transparent in better value proposition for they applied the 5 Whys line
communications. I determine consumers. of questioning to why this
this by reading ten to fifteen approach to capital
years worth of shareholder Our best situations deployment was correct.
letters, interviews, and
conference call transcripts. have been when After looking over longer
periods of communication to
management has not
I ask, Is the management team assess authenticity, I focus on
focused on the key drivers of taken very much the proxy filing to evaluate
the business? Do they incentives. Performance-based
understand what their relative capitalin the form of compensation tied to return
competitive advantage is? Its on invested capital and free-
equityoff the table.
source? Are they focused on cash flow growth are great.
the same metrics year after Reducing equity stakes is Ignoring the balance sheet or
year? This sense of what to capital base is a red flag.
do and why do it is usually a yellow flag, if Adjusted EBITDA is a negative
internalized. One lesson Ive not a red flag, for us. for that reason. Adjusted EPS
learned in operations is that is even worse.
its very difficult to manage and
influence employees. If he was thinking short-term, G&D: Can you talk a bit about
Simplifying and creating clarity GEICOs advertising budget the types of companies that
in terms of where a business is would have grown at a far youre looking at for the public
headed and what matters slower pace than it has. But portfolio?
enables organizations to take Buffett sees the tie between
actions more quickly and to be the competitive advantage and SW: On the public side, were
more responsive to changing the long-term value of an value investors. We focus on
dynamics. Great managers additional policy holder to buying companies that are at
understand a business creates GEICOs intrinsic value. modest valuations relative to
value satisfying customers or either their normalized
adapting to the marketplace, Im sure many value investors earnings or normalized free
not at the headquarters. The have been fooled when cash flow, three to five years
frontline people need to management teams say the out from now. Well place a
understand what management right things. After William modest multiple on that profit
is thinking because they reflect Thorndike published The or free cash flow, credit
managements thought process Outsiders, value and management for share
around what matters. Clear fundamental investors were repurchases if thats part of the
communications and incentives telling management teams, companys history and
are the best way to do that. You have to read this book. determine, given our
This is the way to do it. The expectations, whether we
Great managers understand management teams listened could double our money in
their relative competitive and spouted out, Buying back three years or quadruple it
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Simeon Wallis
over five years. G&D: It seems like a lot of comfortable quickly. Then
your analysis regarding were just seeking to
Since our capital is more management is comparative understand the idiosyncrasies.
permanent, we take a longer across companies within a
time horizon. We tend not to certain industry. Does that For example, on the public and
trade around our positions. require your team to focus on on the private side, weve
Geoff Hulme presents the We focus on industries that a certain number of industries invested in insurance
winner, Zach Rieger 17, dont have structural change, that you know better than companies. There are niche
and runner-up, Alexander where demand may be cyclical, others? Do you tend to aspects of insurance
Levy 17, of the The Heil- yet the product or service compare management across companies, and there are
brunn Center for Graham thats offered is a necessity. verticals? different types of insurers, but
& Dodd Investing Stock We seek returns on capital or at its core, an insurance
Challenge returns on equity over a cycle SW: We probably havent company has certain traits. Its
that are slightly above average. consciously compared about risk transfer. Its about
Were not trying to outsmart management teams across assessing how well a company
the market, just take advantage different industries. We focus has priced and managed risk.
of swings in the psychology of on business models. For Insurance companies are just a
others by being more patient. example, it is better to pool of capital. A policyholder
We look through what the compare the unit economics is giving capital upfront in
investment controversy is in and performance of the CEO return for the promise that it
order to determine whether it of AutoZone to the CEO of an will receive a payoff if an event
is temporary or structural. auto manufacturer or to the occurs. There are nuances, but
CEO of an industrial at its core an insurance
Were buying companies that distributor? Id argue it is the company and financial services
we believe have a competitive latter. If were looking at a firms are not inherently very
advantage, are the lowest cost management team thats in a different.
operator, and/or have the best distribution business, we
management team in their believe we understand what Some of the industrial
industry. We look at the the right incentives should be. businesses that weve been
margin profile and return on involved in, or even consumer
capital within the industry to Well use that information with packaged goods, often take a
see whos at the higher end. our private companies too. commodity, process that
Well look at the unit Well say, If I understand the commodity and sell the output
economics and productivity business model dynamics in in a brand. Commodity to
metrics, such as revenue per public companies and the two value-add. A skilled investor
employee or profit per or three things that matter, needs to understand the
employee to compare quality how can I apply that operating dynamics of that
of operators in an industry. knowledge to some of the type of business. Brands are
private companies, where Im about trust. So it is important
In some situations, all of these not confident that industry to understand how the brand
will align, where the management teams are is perceived by its customers
investment controversy is thinking that way? and potential users, not what
temporary and we can look the company says itself.
past it. Well buy the best Once we understand certain
manager and we are willing to industries or business models, Were willing to admit that
pay a turn or two more on these fall into our circle of theres a pretty large too-
earnings for the better competence. There are hard pile relative to the time
management team, as we complexities to the business, we want to spend. There is an
believe over the long-term, but the complexities in most opportunity cost for time and
theyll out-execute situations dont dictate the we want it to be high enough
competitors and the profitable outcome; the 80/20 rule so that only ideas that can
earnings growth will be there. usually applies. Once we meet our self-imposed return
The multiple premium may understand the core pieces of hurdles can make it through.
expand. information and levers in the There are certain businesses
business model, we get where if we cant get our head
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Simeon Wallis
around it relatively quickly, its Institutional investors typically sub-$100 million market cap
just not worth our time. want to see certain items, such companies and we passed on
as benchmark weightings. We both. Weve owned companies
If we give up some of the dont care about that because with $100B market caps
opportunity set, thats just a this is our capital. We want because we felt the concerns
tradeoff in how we do the best IRRs, and were willing were over short-term issues.
business. We want to try to to hold longer term and look
keep things relatively simple. like an ugly stepchild. G&D: You mentioned
We pick our spots. We would activism, which occurs on the
rather benefit from the fear private side often. How does
and greed psychology that is Great managers your internal team approach
reflected in the multiples that that regarding public
others will pay for quality, well understand a business investments? Do you look for
-managed businesses, than to creates value satisfying specific activist opportunities?
try to get complex situations
right. customers or adapting to SW: You mentioned private
equity, and there are many
G&D: How do you size the marketplace, not at cases where public equity
positions and how do you the headquarters. investors will say they take a
determine the composition of private equity approach to
the public portfolio overall? investing because they employ
a long-term holding period and
SW: In our public portfolio, in We try to use what we after significant fundamental
a steady state, wed have about perceive as disadvantages in research. I believe that
fifteen positions, of which the the system to our benefit. perspective is off the mark.
top five would be over 50%. Where we have a weakness, Value creation in the private
Because we are not we just try not to be there. equity business model comes
constrained by the We dont have 20 analysts, but from the willingness to engage
expectations of volatility or we can go after companies that at a board level and control
concentration risk, we can be the sell-side hasnt focused on two key things. First is having
more aggressive in allocating to much, or invest in significant influence over
positions where we think the opportunities that U.S. capital allocation decisions, and
risk-reward is more compelling investors may not consider. second is having significant
or let our winners run a little influence over the management
bit more. For example, we owned team, including picking the C-
Norbord, a Canadian-listed suite and the incentives that
One core practice at company that had a are implemented. In the public
ValorBridge is to determine disproportionate share of its markets, this only occurs if an
where we can align our operations and profits tied to investor joins the board for
relative strengths with what the housing rebound in the several years.
we see as institutional U.S.
weaknesses in different aspects The firms that I believe have
of investing. For example, G&D: Does this also allow executed this private equity in
private and public investors you to be more involved in the public markets model
almost never have a fluid flow small-cap companies? effectively are ValueAct in mid-
of information and to-large cap companies and in
communications between SW: Yes. At the low end, small caps, its Wynnefield
them. weve invested in market caps Capital. Wynnefield, which flies
between $150 million and below the radar, has been
How can we put ourselves in $300 million. We do want around for about 25 years with
the middle and use the some level of liquidity. phenomenal returns. Nelson
information from the private Obus and Max Batzer have
side with public companies, Twice we conducted due done a really tremendous job.
and vice versa? diligence with the thought of
becoming activist; those were To do this effectively, a firm
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Simeon Wallis
has to devote the resources to we know would be an ally to when FNFV traded below
be involved three to five years help us run the business. intrinsic value. He acquired
at a board level. Thats the Down the road, there might be previously spun-out technology
right mindset. We try to a real opportunity for us to businesses when valuations
determine how we can have an exert that type of influence. were depressed, and hes
impact on operating But given current multiples and spinning that out again as Black
improvements, incentives, and debt levels, its probably not Knight Financial Systems.
capital allocation decisions. At very fruitful now. Thats one of those structural
the same time, we have to be aspects that we try to take
willing to accept a lack of G&D: Would you like to talk advantage of. Many investors
liquidity because thats a trade- about some past public market are wedded to how financial
off for joining the board. investment ideas? models look in spreadsheets.
Yet our operating experience
We havent found the right SW: On the public ideas, one has taught us that business is
situation where weve been that ended up being very not linear and often value
able to partner with a fruitful for us and is creation doesnt model well.
management team where they representative of our approach
wanted to bring in a was the title insurance We bought FNF at 8x to 10x
concentrated investor to help company Fidelity National our estimates of normalized
build the business in the public Financial (FNF) in 2013. FNF earnings, and we received all of
markets. In one situation we operates in a relatively Foleys capital allocation
considered, it was an industry consolidated industry. It prowess for free. We held
executive that had followed provides a necessary service FNF for about two-and-a-half
the target company for years, unless there are legal changes years and when we started to
knew that the existing to eradicate title insurance, sell the publicly traded
management was ruining the which we didnt see on the portfolio, we exited FNF. With
business, and sought capital to horizon. Bill Foley ran the the spin-off of FNFV and other
help effectuate change. We company, and if you look at his maneuvers, FNF was a very
came close as the valuation track record, it is very similar good investment for us.
was incredibly compelling if we to John Malones at Liberty.
could change management, but Foley has deftly used the public Foley represents another
we passed due to our markets to buy and sell assets, aspect that we look for with
research. We realized that the timing the markets very well to managers, which is managers
business was inappropriately create significant value for his from outside of an industry,
levered, and the more work shareholders. Hes willing to who can apply what theyve
we did on the operations and run with some leverage and learned from outside that
capital structure, the more we make very difficult decisions industry to the new industry.
became uncomfortable with very quickly. He simplified his That allows the manager to do
existing managements ability business. He very much fit the things that are different from
to generate ample cash to profile of what we were the conventional wisdom.
service the debt. We didnt looking for. It was pattern Foleys background was in the
think our new management recognition. Hes created, I military. He has a law degree.
team would have the time and believe, close to $40B worth He eventually bought a title
balance sheet necessary to of enterprise value from deals insurer out of bankruptcy, and
realize the companys intrinsic and compounded returns for then proceeded to roll up the
value. shareholders at very high rates. industry. It was a very different
perspective from the
When we look at small caps, He built a company called traditional, slow-moving
were looking for good Fidelity National Information insurance company
managers who would be good Systems which he eventually competitors and the
partners, as opposed to an spun out. He has used a executives who grew up in the
antagonistic situation where tracking stock for his financial industry.
wed become activists. Its crisis-era investments, FNF
really special situations where Ventures (FNFV), to highlight G&D: Any current holdings or
we have someone in place that value and repurchased shares ideas?
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Simeon Wallis
SW: Currently we dont have at it, about 18 months ago, was not the right risk for us.
any investments in the public a double. The stock price was
market. One thing thats been around $65, and we thought it On the private side, valuations
on our radar is another could be worth upwards of are not great either, but
insurance company, Assurant $125 to $130, looking out occasionally we find ideas from
(AIZ). Assurant has been a several years. The process is proprietary deal flow or
quirky, niche insurer that has still going on. Assurant is about provide capital to our
consistently evolved the $95 a share now, and we operating companies for tuck-
products and services that its believe that theres still upside. in acquisitions at 3x pretax
insuring. Occasionally it We havent allocated much profit. As I mentioned before,
becomes very cheap when into the public markets thats hard to beat.
investors believe that a line of recently because weve had
business AIZ is in is about to some private opportunities G&D: That definitely sounds
fall off a cliff. Management has that are more compelling. compelling. Do you have any
been very good capital advice for students?
allocators, knowing to
repurchase shares when A second piece of SW: For students who want
investors price in Armageddon to get into this business, the
and to increase the dividend critical advice I have is business is changing
when investors are not the importance of significantly on the public side.
concerned. Over the last I see parallels between whats
decade, AIZ had been an removing ones ego. Ego occurring with the traditional
aggressive cannibal of its own retailers and the threats posed
shares, as share count has is the driving force to asset managers and hedge
declined greatly when AIZ behind most intelligent funds. Competition is emerging
traded below book value. from low-cost sources and
peoples mistakes. technology; for retailers, the
About two years ago, the chief threats are the Costcos, Dollar
of strategy, Alan Colberg, was Trees and Aldis of the world,
promoted to CEO. Colberg G&D: Is that more a and for investment firms, low-
came from outside the consideration of how good the cost passive vehicles such as
industry. He was an ex-Bain private deals are, or are you ETFs and index funds. Its also
partner who possessed a just not seeing adequate coming through technology-
materially different perspective returns in the public markets? driven interaction with the end
for growth, and quickly made user, whether its Amazon and
difficult decisions to exit legacy SW: Its the latter. Generally, the Internet-based direct-to-
businesses that were we havent seen compelling consumer business models in
structurally challenged; valuations. As I mentioned, in retail, or quants, factor-based
Assurant received good value the last year we purchased a investing, and robo-advisors
in exiting them. hospital we knew out of with computer-driven investing
bankruptcy. Several portfolio models for the traditional
An investor could follow companies had reinvestment investment firms.
Colbergs playbook, which was opportunities at rates well
taken out of one of Bains above what we could receive These competitive threats may
published books, Profit from the in the public markets. In the result in fewer analyst
Core. He focused on providing public markets, were looking opportunities; anyone who
additional services to existing to double our money every wants to join our industry
customers in highly profitable three years. We generally needs to be 100% committed
niches, where he could make dont like when theres a very to it, and eat, sleep, drink, and
tuck-in acquisitions and use levered balance sheet. Whats breathe investing, and
capital to grow in a relatively been cheap the last few years understand their own personal
low-risk way. When we is where theres been some points of differentiation for a
normalized for the different balance sheet concern in potential employer. Our
segments of the business, the addition to being in a industry attracts a
upside when we were looking commodity business. Thats concentration of type-A driven
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Simeon Wallis
people because of the financial active to passive settles down analytics. The value over time
rewards it traditionally offered. a bit? will come from the qualitative
The past may not reflect the insights that drive
future, so someone SW: I still dont know performance.
considering an analyst role has whether this is secular or
to be comfortable that salaries cyclical and I believe well learn For example, the ability to ask
may decline. I believe its just this when stock prices decline specific questions of
being cognizant that there has 30% or 50%. Traditional active management teams, of industry
to be a true love for investing. managers need to demonstrate consultants, of expert
their value through significant networks, that will have a lot
A second piece of critical outperformance to justify their more value going forward than
advice I have is the importance fees over the full cycle. If they the financial model. Active
of removing ones ego. Ego is can outperform in that managers need to focus on the
the driving force behind most environment, it will benefit the opportunities that wont score
intelligent peoples mistakes. industry. If theres not that well on factor models but
To quote Ryan Holiday, Ego is significant gap between what where theres a high
the enemy. Its a desire not to an index and what active probability of market-beating
look wrong in front of peers. management is able to returns.
Its uncommon that the simple generate during a downturn,
question thats in the back of then fee pressures will
others minds is asked publicly. continue. We want the best IRRs,
Nobody wants to look like
they didnt get an investment The cost structures of twenty and were willing to hold
absolutely right. The more that or more analysts, a full sales
a person can take ego out of team, and all the compliance is
longer term and look like
the decision-making, I believe just not realistic unless the firm an ugly stepchild.
the further a person will go in has hundreds of billions in
this business. AUM. I envision the industry
ending up with more boutique
Understanding as early as managers that have between G&D: You mentioned cultural
possible what the most three and seven investment mismatch earlier. Any thoughts
important question to ask that professionals, including PMs, on that subject for students?
identifies the critical few data who may have a little bit more
points or research topics that compensation at risk. Theyll SW: Culture is the most
your superiorPM or senior carry lower overhead and be important thing to understand
analystfocuses on will go a able to compete more on fees. about a company, and to
long way. Invariably, your boss, For investment management understand about ones self.
and to whom he or she firms the incremental dollar Everyone should understand
reports, are your customers that comes in really flows to his or her strengths and
and if you make your the bottom line. Theres weaknesses, and seek
customers happy, youll be significant operating leverage. environments that allow
successful. The better you can Assets have been trending strengths to thrive. Theres a
make them look, the better down for active managers. self-awareness component, and
youll look. Cost structures have to perhaps I didnt have enough
decline to mitigate the impact self-awareness earlier in my
The mistakes that Ive made and labor is a large percentage career.
have been not focusing my of the cost base.
attention around getting the Every organization is political
right information quickly so I dont know how valuable the and understanding the politics
that I could have a deeper and tenth or twentieth analyst on of people and personalities is
more productive conversation. the team, who covers a tiny critical. Coming back to the
slice of the market, really is, difficult situation that I placed
G&D: Do you have any especially when much of the myself in, the nature of that
thoughts on what the industry initial financial analysis can be organization was that there
looks like when the shift from done better with computer were strong egos. I tried to
(Continued on page 37)
Page 37

Simeon Wallis
overcome other peoples egos its a great opportunity, its
by arguing my perspective with probably not the right
objective, quantitative data; opportunity.
that wasnt how arguments
were won in that organization. G&D: Thats excellent. Thank
I should have done a better job you so much again for your
of finding former employees time.
who had worked there to get
a better sense of how
decisions were made, and the
relationship between senior
management and others in the
organization. There wasnt an
investment style difference, but
there was a research
difference, whereas at
Evercore, I believed there was
an emphasis placed on very
deep-dive research, which
tended to be very quantitative
and analytical. Why is this
number volatile? Why is that
changing? Lets go back four
annual reports, make all the
adjustments, normalize it, and
understand what was going on
in the spreadsheet, and let that
analysis drive qualitative

The San Francisco situation

was a very small team. Theres
a dichotomy in how
organizations will handle
differences of opinionsome
say, Culturally, we want to
have a diversity of thought and

While others will take the

other side. We want to make
sure everybody is exactly on
the same page when thinking
about this. I misread the
situation. I thought it was the
former, and it was more the
latter. My strengths did not
align with what they wanted
for how their team was
constructed. It comes down to
culture and how much
research you can do on your
own strengths and weaknesses
that tie into that culture. If
theres not a good fit, even if
Page 38

Foot Locker (NYSE: FL)Short

2017 The Heilbrunn Center for Investing Stock Challenge1st Place Finish
Zach Rieger

Recommendation Current Capitalization

Recommend a short on Foot Locker Share Price 1/20/17 $69.14
(FL) with a price target of $55, offering DSO 134.0
20%+ downside from todays price of Market Capitalization $9,265
Zach Rieger 17 $69. Plus: Debt 128
Less: Cash (865)
Zach is a second-year MBA Business Description Enterprise Value $8,528
student at Columbia Busi- Foot Locker (FL or the Company) is
ness School. He spent his the largest specialty retailer for athletic
Trading Statistics
summer internship at Owl footwear in North America and has
Creek Asset Management. 52 Week Low - High $50.90 - $79.43
benefited from secular trends towards
Prior to CBS, Zach worked Avg. Daily Volume ($ in mms) $79
more casual footwear and healthy life-
in private equity at Short Interest as % of Float 6.4%
PineBridge Investments
style. The Company has 3,401 stores
Dividend Yield 1.7%
after spending two years in globally with ~13mm square footage and
Net Debt / 2016E EBITDA (0.6x)
BAMLs technology invest- FY 2015 revenue of $7.4Bn. FL operates
ment banking group. He a number of different concepts including
Summary Valuation
holds a BA from the Uni- Foot Locker, Champs Sports, Lady Foot
2016E 2017E 2018E
versity of Pennsylvania. Locker, Eastbay, Six:02, and Runners
Base Case
Point. Each concept has a different tar-
get customer and slightly different inven- EV / EBITDA 7.5x 7.9x 8.0x
tory mix but footwear represents 82% Price / Earnings 14.8x 15.3x 15.2x
of revenue. FL also has a very concen- FCF Yield 5.8% 5.8% 5.8%
trated supply base with Nike represent- Consensus
ing 73% of revenue and the rest primari- EV / EBITDA 7.3x 6.8x 6.5x
ly coming from Adidas, Under Armour Price / Earnings 14.5x 13.2x 12.0x
Price / Earnings (ex. Cash) 13.0x 11.8x 10.8x
and a few other players.
vs. Consensus
2016E2017E 2018E
Investment Thesis
1) Key Suppliers Such as Nike and Revenue - ZDR $7,690$7,806 $7,923
Under Armor Want to Grow Revenue - Consensus $7,778$8,147 $8,531
Their Direct to Consumer % Difference from Consensus (1.1%)(4.2%) (7.1%)
(DTC) Business
Foot Lockers largest supplier is Nike, EBITDA - ZDR $1,143 $1,085 $1,066
with 73% of sales. Nike is increasingly EBITDA - Consensus $1,168 $1,251 $1,319
trying to grow their direct to consumer % Difference from Consensus (2.1%) (13.3%) (19.2%)
business due to the higher margins,
which puts it in direct conflict with Foot EPS - ZDR $4.67 $4.53 $4.55
Locker. Foot Lockers key advantage vs. EPS - Consensus $4.76 $5.24 $5.74
e-commerce is the exclusive inventory % Difference from Consensus (1.9%) (13.5%) (20.8%)
they have, which may slowly be evapo-
rated away as Nike attempts to use that inventory for their DTC business. In order to reach their $16Bn
DTC goal by 2020, NKE needs to grow 20% per year, implying that there will be a lot of pressure to enhance
and grow this business from management.

2) Average Sale Prices (ASPs) are plateauing / declining for Nike Basketball Shoes
Basketball shoes have seen a major increase since 2010, which has generated much of the success at Nike and
Foot Locker. The trend towards basketball shoes as a fashion item helped to increase the ASP at Foot Locker
as basketball shoes are ~14% premium to casual sneakers and 38% premium to running sneakers sold at Foot
Locker. The key driver of this basketball trend has been the growth and popularity of Jordan Brand sneakers.
Nike also has a number of other superstars in its stable including LeBron James, Kobe Bryant and Kevin Du-
rant. However, over the past year the sneakers for these stars have not been as popular and other brands
have taken some market share, driving down ASPs.
On top of the issue with basketball sneakers declining in popularity, Nike has lost market share with
the resurgence of Adidas and Puma and emergence of Under Armor in the sneaker space. Nike has started to
see a deceleration in both unit growth and ASPs over the last four quarters. The ASP growth is largely ex-
plained by lackluster performance in basketball shoes, as a few of the marquee shoes (LeBrons, KD9, etc.)
were not as successful as anticipated. The decline in unit growth is likely explained by market share losses as
Page 39

Foot Locker (FL)Short (Continued from previous page)

Adidas and Under Armour have taken share in Nike Futures Growth Gross Profit Decline from Nike Shift and ASP Declines
the space. Both of these have important im- 14.0% 0.0% 57.0% 62.0%
Nike as % of Total
67.0% 72.0% 77.0%

pacts to FLs P&L: 12.0% (10.0%) (14.4%) (14.1%) (13.8%) (13.6%) (13.3%)
(5.0%) (8.7%) (7.9%) (7.1%) (6.3%) (5.5%)
Nike ASPs are ~32% higher than Adidas 8.0%
Nike ASP 0.0% (2.6%) (1.3%) 0.0% 1.3% 2.6%
5.0% 3.7% 5.6% 7.5% 9.3% 11.2%
10.0% 10.4% 12.8% 15.3% 17.8% 20.2%

and other shoes (calculated by taking the 6.0%4.0%

top sellers on and averag- 2.0%
Every 5% ASP decline at Nike is ~7% decline
ing for both Nike and Adidas) so the de- 0.0% Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 in gross profit, while Nike share shifts are
cline in Nike share hurts Foot Lockers '13 '13 '14 '14 '14 '14 '15 '15 '15 '15 '16 '16 '16 '16 '17
only ~1% -2% declines. With operating
gross margin dollars ~1.3% for every 5% Unit Growth ASP Growth leverage, the EPS hit is even larger
Nike loses.
More importantly, a decline in ASPs (due to mix shift) in Nike more directly hurts Foot Locker, and every 5% ASP decline is ~7% in
gross profit dollars.
FLs cost structure is largely fixed, so these declines fall almost entirely to the bottom line.

3) Foot Locker Store Base is Mature

Square Footage Growth 2020 Financial Objectives (2015 Investor Day)
and Efficiently Run, Leaving Little
Room for Growth Upside
Foot Lockers revenue growth has largely
come from ASP increases as they have 14,500
14,120 2020 Goal 2015A
shrunk the store base. Foot Locker is also 14,000
13,501 Gross Margin 33.5%-34% 33.8%
a mall-based retailer, facing general indus- 13,500
12,955 12,918 EBIT Margin 12.5% 12.7%
try headwinds on mall traffic. While the 13,000 12,635
12,705 12,734
Net Income % 8.5% 8.1%
Company has been able to succeed despite 12,500

these headwinds, and remains a destination 12,000

for many shoppers, there is only so much 11,500

Foot Lockers 2020 Financial Objectives Were
FL can do to maintain traffic and volume 11,000
2007 2008 2009 2010 2011 2012 2013 2014 2015
Largely Achieved in One Year

momentum going forward.

I think it will be hard for them to grow at the same rate as they have been after 6 years of topline gains. They are run pretty efficiently, when the
economy was in rough shape we managed a lot of the costs and got very efficientbut I think mid-single digit growth is going to be really hard, low
single digit is more likely. Former President and CEO of Foot Locker

4.) Border Adjustment Tax Could Provide Meaningful Downside and Erode Foot Lockers Profitability
Nike is responsible for 73% of Foot Lockers sales and manufactures a 2017E EPS
majority of their footwear overseas. Under proposed new tax reform, Border Tax Adjustment Increase to COGS
imported goods would not be deducted from COGS, materially in- $4.53 0.0% 5.0% 10.0% 15.0% 20.0%
creasing Nikes overall COGS. Given their dominance in the relation- 15.0% $5.93 $4.48 $3.03 $1.58 $0.13
ship, this would likely be passed on entirely to Foot Locker, who Corporate 20.0% $5.58 $4.22 $2.85 $1.49 $0.12
would then have to pass on to the customer or eat the cost increase. Tax 25.0% $5.23 $3.95 $2.67 $1.40 $0.12
This provides meaningful downside, as certain scenarios would erode Rate 30.0% $4.88 $3.69 $2.50 $1.30 $0.11
35.0% $4.53 $3.42 $2.32 $1.21 $0.10
most of FLs profits.

Base Case Return Potential: FY 17 EPS of $4.53 at 12x EPS is $55 (20% downside)
Bear Case Return Potential: FY 17 EPS of $4.33 at 10x EPS is $43 (37% downside) KEY ASSUMPTIONS
Bull Case Return Potential: FY 17 EPS of $5.93 at 15x EPS is $89 (30% upside) Bear Case Base Case Bull Case
There is additional downside from the border adjustment tax, but that is not baked into the
Revenue operating
CAGR 15-18 assumptions
5.1% at this9.0%
point as it10.2%
is not
clear what tax reform will look like. This is a key part of the on-going thesis. EBITDA Margin 2018 8.0% 8.5% 9.1%
FCF per share 2018 2.38 2.95 3.48
Key Risks P/FCF 10.0x 11.0x 12.0x
Secularly Growing Industry: Foot Locker benefits from the trend towards casual footwear
Price as consumers purchase
Target 2017 23.80 more and more
32.50 41.76
sneakers. As the largest specialty retailer, they have and will continue to benefit from this(Downside)
Upside trend. -13.7% 17.8% 51.4%
Clean Balance Sheet + Capital Return: FL has a net cash position and low Net Debt / EBITDAR which allows free cash flow to go
towards share buybacks and dividends
International Growth Opportunity: Foot Locker has an opportunity to expand through new stores internationally which should en-
hance the growth profile vs. a relatively mature store front in the U.S.
Page 40

Axalta Coating Systems Ltd. (NYSE: AXTA)Long

2017 The Heilbrunn Center for Investing Stock Challenge2nd Place
Alexander Levy, CFA
Executive Summary
Axalta is an undervalued, misunderstood coatings company with durable competi-
tive advantages that also generates prolific FCF. The market perceives a cyclical
Alexander Levy 17 chemical company that sells into the economically sensitive auto end market, par-
ticularly in the U.S.. On the contrary, only ~32% of sales are to auto OEMS and
Alexander is a second year
MBA student in the Value
only ~10-15% of sales are to auto plants in N. America. Axaltas core business
Investing Program at Co- (~50% of EBITDA) caters to the more stable auto refinishing market (repair work
lumbia Business School. He driven by collisions), where the companys customer base is fragmented and less
spent last summer at Arbi- price sensitive given the importance of flawless refinish work. Axalta occupies a
ter Partners, a New York leading position in most of its markets, which are also highly consolidated. Given
based hedge fund. Prior to pricing power, EM exposure, and current end market outlooks, investors can expect GDP+ (3-5%) sales
CBS, Alexander spent four
years at Morgan Stanley in
equity research covering Ongoing cost cutting initiatives are expected to add ~$200M of EBITDA (~30% of 2013 starting EBITDA) by
coal, steel, and iron ore. year-end 2017 following the companys 2013 divestiture by DuPont. Management is streamlining operations in
He graduated from Duke what was formerly a small business lost in a corporate behemoth. Axalta has dramatically improved its lever-
University with a degree in age profile, with debt almost at target levels of 2.5-3.0x EBITDA and no maturities until 2020. Purchase ac-
political science and is a counting obscures the companys true economic earnings power by inflating depreciation and amortization and
CFA charterholder. depressing GAAP ROIC due to the re-marking of assets after the companys sale. Investors are currently able
to buy a stake in a durable franchise with a tangible ROIC of ~20%+ at an attractive 8%+ levered free cash
flow yield. My $35 price target implies ~20% upside and assumes a 6.5% 2018e FCFE yield or ~11.5x EBITDA.
Company Description
Axalta is a global manufacturer of coating products used to paint or refinish autos. Axalta was formed by The
Carlyle Group to acquire DuPonts Performance Coatings business in 2013 and completed its IPO in 2014.
Carlyle has since exited its investment, but Berkshire Hathaway currently owns a 9.8% interest. The Perfor-
mance Coatings segment sells coating solutions to auto refinishing (42% of sales) and industrial (16%) custom-
ers. The Transportation Coatings segment sells coatings to OEMs of light (32%) and commercial (10%) vehi-
Investment Case: Long
Favorable Market Structure
Axalta holds a leading 25% global market share in its core auto refinish end market and a 2nd place 19% share
in the auto OEM market. As a result, Axalta has the global reach and scale to serve large global OEMs. The
markets in which Axalta operates are also highly consolidated, with 67% of the refinish market and 74% of the
OEM market served by the top four players. Increased market concentration reduces competition and in-
creases pricing power. In the OEM market, carmakers looking to retain multiple coating suppliers distribute
business broadly to the leading players, reducing internal industry rivalry and price competition.
Refinishing Business is a Durable Franchise with Barriers to Entry and Low Cyclicality
Axaltas core refinishing business constitutes ~42% of sales and ~50%+ of EBITDA. The refinishing business
has more favorable characteristics than direct to OEM. First, refinishing is less cyclical. Collisions occur re-
gardless of the state of the economy and continue to require repair. Accordingly, refinishing revenue tends to
have more recurring or maintenance-like characteristics. Second, the refinishing customer base is extremely
fragmented. Axalta sells to ~80k auto body shops that have very little pricing power over a consolidated stable
of coating suppliers. While there is a trend toward multi-shop operators (MSOs), it is unlikely to lead to major
changes in market dynamics given the long runway for consolidation. In addition, as a market leader, Axalta is
well positioned with MSOs, meaning the company will likely pick up market share.
Third, coating refinishing makes up only ~5-10% of the total cost of an auto repair. Accordingly, Axalta has
flexibility to implement price increases and pass through raw material costs without dramatically affecting end
customer costs. Furthermore, refinishing is one of the most critical parts of an auto repair, since the exterior
is the most visible part of the car. Any flaws in paint or color matching are generally unacceptable, making
quality more important than price. Fourth, through its refinishing business Axalta offers body shop customers
not only the actual coating product used but also a range of services. The company provides technical support
and training to customers as well as color matching equipment and software. The company has an extensive
library of 4m color variations. As mentioned above, successful color matching is imperative. These services
deepen relationships and make switching more difficult, risky, and time consuming for customers.
OEM Business Has Healthy Competitive Dynamics
While more competitive than refinishing given the smaller customer base, there are several factors that help
Page 41

Axalta Coating Systems Ltd. (AXTA)Long (Continued from previous page)

protect returns in Axaltas OEM business. First, the high level of market concentration (see above) helps with pricing power. Second,
coatings are only ~1% of the total cost of a car, meaning OEMs are not able to win big savings by pressuring coating suppliers. Axalta has
been successful in passing through raw material costs. Third, value-added relationships and on-site placement of technical staff at OEMs
increase customer stickiness. Some relationships with automakers date back 90 years.
Exposure to OEM Auto Sales is Geographically Diversified
~32% of total sales are to auto OEMs, but only ~10-15% of sales are to N. American auto plants. As a result, while certainly important,
U.S. auto sales are not the dominant earnings driver. The companys OEM portfolio is well diversified, reducing the risks posed by any one
region: ~9% of sales are to automakers in EMEA (flat to modestly positive sales outlook), ~5% of sales are into the LatAm OEM market
(likely near trough after steep declines in 2014-2016), and ~5% of sales are to Asia Pacific OEMs (~4% expected annual sales growth). In
all, ~31% of Axaltas sales are to emerging markets, which are seeing increasing auto penetration, providing a long growth runway.
Cost Cutting Initiatives Provide Self-Help Route to Higher Earnings; Costs are Highly Variable and Capex Intensity Low
Under DuPont, Axalta was not optimally run. Post-LBO, Axalta has two ongoing cost cutting initiatives that have already yielded results
but also have more runway. Fit-for-Growth and Axalta Way are expected to yield ~$200m in cost cuts by YE 2017, ~$150m of which
should be in place by YE 2016. The results are already tangible, as EBITDA margins have improved to 21.3% YTD vs. 20.3% in 2015, 19.0%
in 2014, and 17.5% in 2013. Margins could reach ~22.5% by 2017/2018. In addition, raw materials (~70% oil and gas linked) represent
~50% of cost of sales, meaning half of costs are variable and fluctuate with production levels. As a result, Axalta has some ability to adjust
its cost structure with changing demand. Capex intensity is low, with maintenance capex estimated at ~$60m/year or ~1.5% of sales.
Recent Currency Headwinds Unlikely to Persist Over Medium to Long Term
A strong USD has been an earnings headwinds for Axalta given ~66% of sales are outside N. America, but these issues should prove tran-
sient. The DXY index is near five year highs, meaning Axaltas foreign earnings translate into fewer dollars. 2015 sales fell 6% while actual-
ly rising 5% ex-FX. In 2016, the company expects flat sales compared to a 4.5% increase ex-FX. The economic impact of currency fluctua-
tions will be smoothed out over time as FX rates normalize, removing the negative optics of falling or flat headline USD sales.
Purchase Accounting Obscures Attractive Returns & Robust Free Cash Flow
When Axalta completed its LBO, its assets were re-marked to fair value. While the physical assets remained the same, their book value
increased, lowering accounting returns. As a result, GAAP ROIC stands at a mediocre ~9% in 2016e, but removing goodwill and intangi-
bles yields an attractive ~19%/21% ROIC in 2016e/2017e. LBO purchase accounting also inflated D&A, which totaled ~$320m in 2016e vs.
capex of ~$160m (including only ~$60m maintenance capex). As a result, FCF runs well in excess of net income, making Axalta appear
expensive on a P/E basis. The company trades at 21x 2017e EPS (~5% earnings yield) compared to a more attractive ~7% FCFE yield.
End of Deleveraging Bodes Well for Capital Deployment & Cleaned Up Balance Sheet Reduces Cyclical Risks
Since the LBO in 2013, Axalta has been working to reduce its leverage to a more prudent level. Starting from an initial 5.6x net debt/
EBITDA, the company has reduced leverage to 3.3x TTM EBITDA. Management is targeting net leverage of 2.5-3.0x EBITDA, which will
likely be achieved by early to mid-2017. Once this goal is met, management has publicly stated that the company will consider capital re-
turns (dividends or buybacks). In addition, the next debt maturity is not until 2020 and the revolver was extended from 2018 to 2021.
Axalta was able to lower its average cost of debt from 4.7% to 4.0%, and interest
coverage is healthy at 4.3x EBITDA/interest in 2015, 4.9x in 2016e, and 5.9x in 2017e.
Room for Continued Accretive Tuck-In M&A
Axalta will likely continue to allocate to tuck-in M&A given the long time horizon of
shareholders like Berkshire. The company has spent ~$104m on acquisitions YTD in
2016 at an implied multiple of ~1x sales and ~5x EBITDA (given acquisition margins
roughly in-line with company margins). As a result, M&A can be very accretive
given that Axalta trades at ~11x 2016e EBITDA. The company focuses on targets
that produce specialized products or offer geographic diversification.
My $35 price target implies ~20% upside to intrinsic value and is derived from a
relative valuation based on FCF and EBITDA checked against a DCF. I apply a
6.5% yield to my estimate of 2018e FCFE, which implies an ~11.5x EBITDA mul-
tiple. Peers trade at an average 2018 EBITDA multiple of ~10.5x and 2018 FCFE
yield of ~5.5%, including diversified competitors, but coating focused peers (PPG,
RPM, Sherwin-Williams, Valspar) trade at 10-12x. In fact, Sherwin-Williams is
buying Valspar for 15x 2016e EBITDA or 10.9x post-synergies. I believe that
Axalta can also compound intrinsic value over time at 10-12%+ annually given
6.5% FCFE yield, 3-5% sales growth (GDP plus share pick ups in the MSO refinish
market, EM growth, and depressed starting points in LatAm, commercial, and
energy exposed end markets), and 0-2% earnings growth from M&A and cost
Upside Catalysts
1) Feb 22 analyst day; 2) Cost execution; 3) Hitting leverage target; 4) FX nor-
malization; 5) Commercial vehicle rebound
Page 42

Cardtronics (NASDAQ: CATM)Short

2016 Darden @ Virginia Investing ChallengeFinalist
Abheek Bhattacharya Harsh Jhaveri Ryan Kelly

Market Metrics
Cardtronics is the worlds largest non-bank ATM operator, with over
225,000 ATMs across the U.S., Europe and Australia. The Company
typically owns or manages ATMs placed in retail outlets (CVS,
Abheek Bhattacharya 18
Walgreens, etc.) and off-site ATMs for banks. While Cardtronics pri-
Abheek is a first-year MBA mary revenue streams are surcharge fees from customers and inter-
student at Columbia Busi- change fees from banks, it also earns revenue from bank branding on
ness School. Prior to CBS, ATMs and management fees. The short thesis for Cardtronics is based
he wrote for the Wall on declining cash usage, limited organic and inorganic growth opportu-
Street Journal in Hong nities and the loss of its largest customer (18% of revenue), which will
Kong, most recently for its also lead to increased competition in this space. Cardtronics is current-
flagship Heard on the ly trading close to its 52-week high and is valued at 25x FY16E earn-
Street investment column.
He studied philosophy at ings.
Yale University.
Investment Thesis
1) Cash usage is on a decline globally, both as consumers switch to
debit cards and as digital payments rise. ATM cash withdrawals in the
U.S. declined nearly 1% from 2009-2012, based on the latest Federal
Reserve data available as of November. According to Accenture, North Americans using cash for transactions
will decline from 66% in 2016 to 54% in 2020. Other reports by Euromonitor and McKinsey also highlight
similar trends.
Cardtronics performance has mirrored the trend in declining cash usage, with same-store cash with-
drawal transactions going from 4-8% growth in FY11 to negative growth.
ATM unit economics have also significantly deteriorated with revenue per ATM decreasing from $14,335
in FY11 to $7,534 in FY15, as CATM expands with machines were it only manages the services (and col-
Harsh Jhaveri 18
lects a management fee). These have grown from 10% of total ATMs in FY12 to 60% of all ATMs in 9M
Harsh is a first-year MBA FY16 and earn ~5% the level of the average Cardtronics ATM.
student at Columbia Busi-
ness School. Before that, 2) Cardtronics will lose its largest customer in mid-2017, which paves the way for increased competition
he worked with Fidelitys Cardtronics largest customer 7-Eleven, which contrib-
venture capital and growth uted 18% of revenue, has decided to terminate its
private-equity fund, and
Financial Snapshot
contract in July 2017. It will switch to FCTI, a company
Barclays investment bank-
ing team in India. Harsh owned by Japan-based Seven Bank, whose biggest
1500 10%
shareholder is 7-Elevens holding company. While the
received a B.S. in Electrical 1,200 1,260
Engineering from Yale revenue impact from the loss of this contract is 1200 8%
1,055 7%
University. known, its impact on profitability is even higher. The 7-
Eleven contract likely earns higher margins given 7- 876 6%
900 6%
Elevens receive higher foot traffic than Cardtronics
other retail locations and that the ATMs in 7-Eleven 600 4%
included a $50M bank branding fee with Citi.
Cardtronics remaining top four retail customers (19% 300 2%
of revenue) have contracts due for renewal in an aver-
age of three years. They potentially now have more 0 0%
bargaining power with Cardtronics post the loss of 7- FY13 FY14 FY15 FY16E
Eleven and can threaten to defect to FCTI.
Reven ue ($ M) Net income margin

Ryan Kelly 18
3) Cardtronics has masked its inability to grow organically
by acquiring 14 companies since 2011. But acquisition opportunities will be limited in the future:
Ryan is a first-year MBA In its most recent deal, Cardtronics agreed to acquire one its largest rivals DirectCash (expected closing
student at Columbia Busi- in January 2017). The $460M transaction, which included $205M debt from DirectCash, was funded pri-
ness School. Prior to this, marily by cash and additional debt from Cardtronics existing lenders. Cardtronics proforma net debt /
he worked as a consultant EBITDA will be 2.6x, close to triggering the 3x covenant on its revolver. Further, Moodys undertook a
at Deloitte, most recently
in Philadelphia. Ryan holds
review of Cardtronics rating for a downgrade after this transaction announcement. This will prevent
a B.S. in Finance from Cardtronics from exploring any significant acquisitions in the future.
Villanova University. Cardtronics own M&A binge has reduced acquisition opportunities in the future.
Page 43

Cardtronics (CATM)Short (Continued from previous page)

4) Cardtronics managements interests are misaligned with shareholder interests:
Management advertises adjusted EBITDA and adjusted net income in all its interactions with shareholders. From the proxy state-
ments, it is evident that their compensation is also linked to these adjusted profitability metrics, allowing them to ignore actual GAAP
profitability. Revenue breakup
The CEO currently owns just 0.6% (1% including unvested shares) and the ex-CFO owns 0.2%
(0.3% including unvested shares). The ex-CFO retired and has recently been replaced.
The CEO has sold 51,714 shares (~18% of his ownership) worth $1.7M in the last two years

Based on CATMs 2-year average forward P/E of 21x, we ascribe a 21x multiple to FY19 EPS
This results in a price target of $30.3, a 36% downside.
Exit multiple
19x 20x 21x 22x 23x
Price 27.4 28.9 30.3 31.7 33.2
Downside (42%) (39%) (36%) (33%) (30%)

The impact of the loss of the 7-Eleven contract on profits will only be understood in the 2nd half of 2017
The remaining 4 of Cardtronics top 5 customers, which comprised 19% of revenue, will renewon averagein the next three
years. These contracts will be under competitive pressure since FCTI has entered the fray.

Cardtronics may announce another large acquisition.
Mitigant: Given that Cardtronics credit rating was recently reviewed by Moodys for a downgrade and its pro forma net debt / EBITDA
position is 2.6x, which is very close to its 3x revolver covenant, it seems unlikely that they will make any major acquisitions in the near
future. Further, given that Cardtronics has acquired 14 companies since 2011, there are practically no large acquisition targets remaining.
Cardtronics may partner with a big bank
Mitigant: Partnering with a bank would help Cardtronics earn managed services revenue or a bank-branding fee, but revenue per managed
services ATMs is only 5% of the revenue earned from the average Cardtronics ATM. It is also questionable whether banks value a long-
term bank-branding
relationship with
Cardtronics given
that Cardtronics is
both a competitor
and a partner. An
example of this is
when Chase can-
celled its partner-
ship with Card-
tronics to manage
its off-premise
ATMs in 2014.
expands into
emerging mar-
Mitigant: Regula-
tions regarding
ATMs in emerging
markets are more
stringent, probably
the reason why
most independent
operators have
focused on devel-
oped markets so
Page 44

Jared Friedberg
(Continued from page 1)

Partner of Compass Global hundreds of businesses, and to fortune to be sitting on a lot of

Investments LLC, a single- own businesses and be forced cash. We started to consider
family investment to live with those investment where to deploy that capital in
company based in New decisions; a valuable such a distressed environment.
York. Prior to Compass, experience in seeing patterns And when we considered the
Jared was a Principal at in investing. You tend to think risk positioning of certain
Cortec Group, a U.S. about risk and the potential for managers that we were
Jared Friedberg 99 middle-market leveraged capital impairment differently invested inboth into the
buyout fund where he was when you're buying something crisis and then their business
involved in a myriad of and putting a lot of debt on it. stability and psychology when
industries including opportunities presented
healthcare, retail, and What happened afterward was themselves during the crisis
value-added an interesting life event. In we found ourselves less than
manufacturing. Jared has 2006, my father-in-law and my satisfied.
also held positions in the wife started the process of
M&A group at Salomon setting up a single-family office. G&D: How so?
Brothers and in equity My father-in-law was a Latin
research at Brown American industrialist and, JF: Certain managers were
Brothers Harriman & Co. starting as early as the 1980s, reaching for risk too much on
Jared earned his MBA had been investing in the way into the crisis, and not
from Columbia Business alternative assets. They were reaching for it enough on the
School and graduated essentially taking their holdings way out. Of course, you don't
magna cum laude from the and putting them under one always know whether that is
University of Pennsylvania roof. Throughout the course purely psychology or whether
with a B.A. in Diplomatic of that year, as they were that is driven by a lack of
History. putting the pieces together, I stable capital, or both.
became interested in the family
Graham & Doddsville office as a platform for G&D: So is this when the
(G&D): Could you tell us investing. I liked the intellectual Mercator Fund came about?
about your background? What honesty that you could bring
brought you to investment to bear using that platform and JF: Yes, a family office provides
management? What was the the focus on capital a great stable capital base for
origin of the Mercator Fund? preservation that investing taking advantage of mispriced
your own capital requires. opportunities with an
Jared Friedberg (JF): I uncertain time horizon. So we
graduated from Columbia At the end of 2006, I left set up a series of managed
Business School in 1999. I was Cortec to help set up the accounts for the family, with
very interested in learning how family office. I liked the the mandate of taking my
to analyze businesses using a prospect of having a seat private equity and debt
value investing philosophy. I where you are looking at other experience, and applying that
focused on finding work in investment managers, both on to public market opportunities.
private equity, on the the private equity and public
leveraged buyout side. My logic sides. You get to see what From the outset, we wanted to
was to see many kinds of they're doing well, what you be able to invest across the
businesses in tremendous think they're doing incorrectly, capital structure. It was clear
detail. Coming out of business where your philosophy jibes that the opportunities weren't
school, I got a job at Cortec with theirs, etc. It was very only in equities. We were
Group, a middle-market interesting for me to go from witnessing some incredible
leveraged buyout fund. It was a my previous micro-level fixed income opportunities at
hands-on, operationally analysis of companies to that time. By going higher in
focused firm. thinking more broadly about the capital structure, we could
capital allocation. get access to returns that were
Over the course of my seven very attractive, so we were
years there, I had the As the financial crisis hit in initially more heavily weighted
opportunity to analyze 2008, the family had the good to fixed income, with the
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Jared Friedberg
rationale being, why take more realized that when an asset is rational. If we identify a
risk if we don't have to? The for sale in the way that private company that is becoming
other factor central to the companies are today, there are more dominant or growing
strategy relates to my private typically many middle-market faster than the industry,
equity days. If you think about buyout funds that are looking especially with pricing power,
private equity dynamics, a at a given opportunity. we continue our work. And if
private equity fund raises a Proprietary sourcing of deal the dynamics we described are
pool of capital and they have a flow is challenging. resulting from a sustainable
time limit to put that to work. competitive advantage that we
You put that money to work In private equity, you're can identify, thats where we
or you're out of business as creating this environment of really get excited.
you wont be able to raise the perfect competition when
next fund. The incentives are youre looking at an asset. I In private equity, youre
not ideal. We don't have those realized quickly that in the
incentives. We felt that part of public market, the competition creating this environment
being intellectually honest had is sometimes less perfect than I
to be that we didn't have to be would have expected and of perfect competition
fully invested. If we weren't sometimes things are out of when youre looking at
finding compelling favor in ways that are
opportunities, our strategy irrational. You can take an asset.
was, and is, that we dont have advantage of this dynamic in a
to invest the capital. very fluid way, which you
rarely can in private equity. Now, within that dynamic, you
G&D: So youve been around do not often find those
for eight years and have a solid G&D: What is the Mercator opportunities undervalued. But
track record, yet you seem to Funds investment approach? we don't approach sourcing
be quite under the radar. compounders from a value
JF: We operate in three asset perspective, we come at it
JF: Yes, until very recently we classesequities, fixed income, from a quality perspective. We
primarily managed capital for and cash. It is important to us are doing work on
the family and some business that there be no preset opportunities irrespective of
partners with similar allocation among the three. the value today. The idea is to
philosophies to ours. And in Within equities, we're really create a backlog of businesses
2013, we converted the trying to do two things: we're that you dream of owning
managed accounts into a fund seeking underappreciated when they are temporarily
and spun out of the family compounders, which means misunderstood or out of favor.
office. The family remains our something specific to us, and
largest investor, but now we special situations. Special situation equities are
also have some high net-worth more amorphous. We're
individuals, other family offices, In terms of compounders, generally looking for situations
and a couple endowments as were always looking out for where value is obscured by
investors as well. We are systemically important complexity. That can come in a
seeking to grow the capital in a businesses whose existence is lot of forms; there are
gradual, disciplined manner. critical to their industries. Our scenarios we see repeatedly to
markets are developed help us identify such situations.
G&D: How did your markets with good legal Let me provide a few
background in private equity regimes like the U.S., Canada, examples.
inform your worldview and and Western Europe, which
your investment process for provides us with multitudes of First, liquidations. We recently
public securities? industries and thousands of identified REITs that we
publically traded companies to thought would be prone to
JF: When I graduated business explore. We pay attention to liquidation and got involved
school, I had the idea that industries, even niche with them, owning them into a
private equity was a less industries, that are growing potential liquidation, and then
trafficked area. Then I quickly and where competition is throughout the process. This
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Jared Friedberg
allowed us to buy groups of and 2012, there was a lot of down, the points at which
quality assets at significant investor fear. The bonds of were making it larger are also
discounts to intrinsic value very stable businesses were predetermined. The strategy is
where that value is realized in trading at attractive yields with executed unless the thesis has
an idiosyncratic way. So the what we believed was minimal changed.
correlation to other assets and risk of capital impairment.
the markets is limited. We have gravitated to this
Another area we source such price discipline because we
Another area of opportunity is opportunities is the publicly have also found that it helps us
businesses that have assets in traded debt of private manage our psychology. We
one country but are publicly companies. We have found the use the same discipline when
traded in another. For debt of private companies can deciding when to trim or exit.
example, we own a U.S. be particularly interesting as When other people are
cinema operator with information is not readily freaking out and an asset is on
operating and real estate assets available. Just having to get sale, that's when we want to
in Australia and New Zealand. approval from the CFO of the have the psychological
The complexity makes these company to get the wherewithal to step up and
assets difficult to own, which information removes a lot of buy it. And the converse,
has led to a dislocation in the competition of people were reinforcing our
value. looking at such opportunities. psychological wherewithal to
sell when others are too
We also look to identify We rarely make an sanguine.
hidden assets that do not
appear on the balance sheet of investment decision that G&D: For your stressed
a company. For example, we credit investments, how do
were recently involved with a does not have a 12 to 36 you think about where you
publicly traded restaurant month timeline. want to be in the capital
franchisee, where the market structure?
did not appreciate that the
company had a right of first G&D: Across all categories, JF: We look across the capital
refusal to buy other how do you think about entry structure of an enterprise.
franchisees in their network. points? And how about Take the special situation
This right has tremendous catalysts and timing? restaurant equity I mentioned
value but is not recognized on before that had a right of first
the balance sheet. JF: We rarely make an refusal to buy other
investment decision that does franchisees. We felt that the
G&D: And what is your not have a 12 to 36 month equity was undervalued and we
approach on the fixed income timeline. Our stable capital would be able to own it for a
side? base gives us the flexibility to multi-year period. That
not be pressured on timing. company also came to the
JF: On the fixed income side, Even in those situations where market to refinance its debt in
we explore distressed there may be a catalyst, we feel March 2015. At the time, there
opportunities, but our main like that catalyst being a year was momentary fear affecting
focus has been on what we call or two away often gives us an credit markets and the
stressed credit, a situation advantage. company had to settle for a
where we feel the bonds are higher interest rate than they
pricing in real risk where we In terms of entry points, we expected. We already knew
believe the risk is limited. We are disciplined about the price the business and the
are looking for areas of stress, levels where we get involved management, and with minimal
and this can come in a lot of with any investment. We risk we could earn an 8.5%
forms. It can be idiosyncratic document where we would return. In a sense, we looked
to the company, or our buy the security at such an at that and realized that 8.5% is
sourcing can also be more attractive discount that were actually more attractive than
macro. For example, during comfortable making it a the double-digit return we're
the European crisis in 2011 predetermined size. If it trades going to get in the equity.
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Jared Friedberg
G&D: Regarding your quality in the risk of capital That said, we're obviously not
compounders, how do you impairment were taking inflexible, but you can't cheat
determine when they are too relative to the return we yourself. Thats why we write a
expensive? If its a truly expect. So by definition, every memo with the thesis, risks,
dominant company, wouldnt a idea is always being compared signposts, etc., explaining why
ten-year or longer discounted to the others. This dynamic is we believe the asset is
Zach Rieger 17 presents his cash flow (DCF) analysis with also what primarily defines our mispriced. If we are shifting
winning investment idea at reasonable scenarios still show position sizing decisions. our approach, we have to
The Heilbrunn Center for upside? Something with a low risk of clearly explain why the thesis
Graham & Dodd Investing capital impairment and with an has changedit may be that
Challenge JF: We always conduct a DCF attractive return is apt to be growth is accelerating or the
on compounders, because it sized larger than something company has a new
forces you to think through where both the risk and return development.
assumptions and about the are higher.
growth trajectory and drivers I woke up one morning last
of that business. We use a When we cant find week to see that one of our
more conservative discount opportunities that meet our European compounders had
rate to be on the safe side. It criteria, our allocation to cash announced a transformative
boils down to whether we is going to be larger. This merger with a complementary
think the compound annual approach has been heavily business. We went through
rate of return that we're influenced by the family office the process of thinking about
getting, relative to the emphasis on capital what it meant to put the
uncertainty of all of those preservation and has allowed businesses together and what
assumptions that we just made, us to generate equity-like value would be created. The
is worth the risk. returns while taking less-than- thesis had changed and we
typical equity risk. couldn't, with a high level of
It's more art than science, but I confidence, get to a place
can tell you if I'm making an G&D: What is your decision where we were nearly as
assumption on something process in buying and selling? excited about the deal as the
that's five, six, or seven years Do you have a process to market. The intellectually
out and I'm only getting a mid- guard against thesis drift? honest thing to do was to sell
to-high single-digit compound the position and re-evaluate
annual return, thats not JF: We make decisions whether the combined entity
attractive enough for me. We collectively. We've tried to met our standards as a
can probably find ways to create an intellectually honest compounder.
generate those kinds of environment. It is not about
returns, taking less risk, being the smartest person in G&D: Can you talk a little bit
elsewhere. We always ask the room; we simply want to about how you get a research
ourselves whether we can get get to the right answer. Ideally, edge?
those rates of return we protect each other from
elsewhere with greater our own biases. JF: I think that MBAs often
certainty and less risk. assume that most professional
Before we invest in anything, investors conduct a lot of
G&D: When you are looking weve determined the price primary research to gain real
at a special situation or a levels at which we're buying insights into a business and an
compounder, do you stack and selling. There's only one industry. But we find its not
those up against each other or real question when the price always the case. For example,
do you have more absolute hits our target, which is: has one great way to get an edge is
metrics to judge by? the thesis changed? If the to get off the island: to go to
answer is no, we are selling. industry conferences and
JF: We dont have any high- This is about forcing yourself engage with industry
level preset allocation among to be disciplined. It is not participants. The reality is that
our asset classes. Our capital always easy but it is important many investors dont go that
flows to investments where we to have a plan in black and extra mile. Let me give you a
have a high level of confidence white in front of you. specific case. We have been
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Jared Friedberg
following the deathcare space year. requirements, and zoning
since 2014. The industry is restrictions. Funeral homes
primarily made up of funeral G&D: Can you discuss the and cemeteries also have high
home and cemetery operators, investment in depth? fixed costs. Now, if you
which may be the least sexy imagine the incremental
businesses to be talking about. JF: Sure. As I mentioned, we volume that's going to be
The industry only has a few find the underlying coming through these homes
public companies and doesnt fundamentals of the industry to with Baby Boomer deaths, it
fit into typical sell-side be quite attractive, such as the will be at high incremental
coverage so few analysts expected demographic margins because these are
follow it. We attended the tailwind. The average life under-utilized assets. So you
largest industry conference and expectancy for a person in the have businesses with pricing
it was pretty clear there was U.S. right now is about 80 power, high incremental
nobody from Wall Street in years, so the average person margins, and demographic
attendance. The attendees dying today was born in 1937, tailwinds that are hard to
were all funeral home which is right in the middle of escape.
directors and they are usually the Silent Generation, before
thrilled to talk to an industry the Baby Boomer generation. In addition to organic growth,
outsider interested in their Even though this isn't a cyclical this is a consolidating industry
work. That's where you can business in the traditional where 80% of the market is
begin to develop a research sense, you can imagine the still owned by independent
edge, by understanding the demographic trough we're in families, mom-and-pop shops.
dynamics of an industry. right now and the massive Carriage Services (CSV) is the
upturn Baby Boomer deaths name we currently find most
There are also analytical will bring over the next attractive. The Company owns
insights from publicly available decade. 170 funeral homes in 28 states
information. The CDC, for and 32 cemeteries in 11 states,
example, reports death We saw other investors so about 200 properties.
statistics weekly and you can They're about one-tenth the
learn a lot from tracking such extrapolate the results market cap of the largest
data. Last year was the player in the space, Service
weakest flu season in five years and over-react to what Corporation (SCI), which
and, because there is a high we viewed as temporary manages 2,000 properties.
correlation between flu
severity and number of deaths, and extraordinary What makes Carriage special
funeral homes reported in the deathcare space is both
disappointing results. We circumstances. the management team and the
expected this to happen. We business model. The
saw other investors We spent a lot of time looking management team is really
extrapolate the results and at funeral homes and focused on buying best-in-class
over-react to what we viewed cemeteries to understand the assets. They do not acquire
as temporary and economics of the businesses businesses for the sake of
extraordinary circumstances. and how they make money, consolidation; they only look
and found that they can be for great local businesses with
This was our chance to own a very high-quality businesses pricing power and attractive
target in our backlog at our with significant barriers to local demographics, and great
predetermined price. The entry. A quality funeral home entrepreneurs to run those
industry has very attractive in a local town can almost be a businesses. Their model is
underlying fundamentals, is in monopoly with customer completely decentralized,
the middle of major stickiness going back many meaning they're buying these
consolidation, and has a couple generations. You're not going businesses and letting them
of high quality companies. We to see new funeral homes run on their own. One of the
were very excited to initiate an come and take its business. things that attracts these
investment when the stock Even fewer cemeteries pop up entrepreneurs to sell to
price became dislocated last because of the land and capital Carriage is that they allow the
Page 49

Jared Friedberg
homes to maintain their local, assets at a reasonable price. 42,000 potential members. We
family business feel. SCI, on the like the stable, recurring
other hand, is highly We have actually increased revenue nature of the business.
centralized, with a corporate our investment in Carriage, The low churn and growing
top-down approach. In many despite buying at a higher price member and waitlist numbers
ways, SCI has its own than when we initiated, as we reflect the high value that the
compounding capability, but have become more club provides to its members.
we found Carriages comfortable with the business,
management team to really the industry, and the We think we have a variant
understand their advantage and management team. We believe view from many fixed income
utilize it to attract the best Carriage is a better business investors who look at trailing
assets. than the market perceives. financials that reflect a business
that is approximately 7x
To return to the question The great investors are levered. The company is
about developing a research performing very well and in a
edge, our research on Carriage the ones who have the major growth phase, having
focused first on understanding recently opened a number of
the core business and ability to be new houses, so the growth-
management team, and second, independent in their related expenses understate
on understanding the M&A the companys true earnings
opportunity and how much thought. power. We believe on
value that could create. It took normalized earnings, the
us a lot of time to do the company is actually levered
diligence and get comfortable Carriage trades at a price that under 4x, and the current yield
around both of these points. does not reflect its solid core of approximately 8% is
business and strong industry attractive given the short
The CEO of Carriage is tailwinds. This, coupled with its duration and high quality of the
unconventional in a way that excellent management team, business. As I mentioned,
could put some investors off, unique decentralized weve found that the public
so understanding his mindset consolidation strategy, and debt of private companies is a
was very important. He disciplined approach to capital good source of opportunities
founded the company in 1991 allocation, provides us as they can often trade at
and owns 10% of the conviction we will compound more attractive yields since
Company, which is a majority our capital for years to come. their financials are not as easily
of his wealth, so we feel well- accessible to all investors.
aligned as shareholders. As we G&D: Is there a fixed income
spent considerable time doing idea you could briefly share G&D: Any advice for students
diligence on the CEO, we with us? interested in getting involved in
concluded that he is investment management?
misunderstood and is in fact an JF: Sure. One of our
excellent CEO. He has a great investments that we believe JF: I would start off with
vision, he is a strong leader, offers a compelling risk- something necessary for a
and he is a disciplined capital adjusted return is the senior newcomers personal
allocator. secured 2018 bonds of Soho development. The amount of
House, a private British group thinkthe influence that
On the M&A side, after company that operates people have on each others
spending a lot of time talking member clubs across the beliefsin this industry is quite
to people in the industry, you world primarily for people in surprising to me. I have been
start to understand what it creative industries. Members disappointed by the lack of
means to have a quality funeral pay a monthly fee and pay to independent thought. It's noisy
home versus an average one. use the clubs amenities and you've got to find ways to
You start to understand the restaurants, bars, and meeting block out that noise.
reputation Carriage has, why it rooms. The clubs have
attracts quality assets, and why approximately 66,000 To a newcomer, I would say
they're able to buy quality members and a waitlist of that you should do whatever it
(Continued on page 50)
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Jared Friedberg
takes to develop your own
personal philosophy. It should
be something you really can
underwrite to and have a high
level of confidence with. It
should be a philosophy that is
evolved enough to block out
noise that doesn't make sense
to you, but let in things that
are helpful to you. The great
investors are the ones who
have the psychological ability
to be independent in their
thought. We believe many
MBA students underappreciate

Related to my private equity

background, I believe it is
beneficial to have the
opportunity to analyze
hundreds of businesses and
watch how those situations
play out. It is central to
building your own authentic
ideas on how to make money
and compound capital over
time. I would not be put off by
going to a smaller asset
management firm where it's an
intellectually honest
environment and you're going
to have the opportunity to
wear multiple hats and take on
more responsibility.

One of my business school

professors told me culture
really, really matters, a culture
of mutual respect and
intellectually honesty. These
are the sorts of things you
don't necessarily think about.
You may be more focused on
the analytics, but you want to
work with decent people who
you respect and who respect
you. I think there is greater
opportunity to flourish in an
environment like that.

G&D: Thank you very much.

Page 51

Studness Capital Management

(Continued from page 1)

economics and finance at a portfolio because they generalist but tended to work
Baruch College. He then respond in opposite in a couple of different
worked at the Federal directions to changes in industries, including
Reserve in New York long-term interest rates. community banks and utilities.
before working at several Moreover, stocks of Over the years, I'd talked often
Wall Street brokerage companies in each industry about investments with my
firms as an equity research tend to do well in different dad, who has a deep
Roy Studness 06 analyst covering airlines economic environments, background in the utility
and utilities. In 1979, he so between the two world.
founded Studness industries there are usually
Research, conducting attractive areas for Charles Studness (CS):
research on the electric investment. The bank and After receiving my PhD in
utility industry. In 1984, utility stocks they target economics from Columbia I
Charles began managing are evaluated on a worked for the Federal
portfolios invested commingled basis that is Reserve and then began work
exclusively in the electric grounded in a five-year as an equity research analyst
utility industry and since forecast for all of the for several brokerage firms
then compiled an annual companies. Their fund, covering utilities. Eventually I
total return of 16.7% per Studness Capital decided to set up Studness
year through 2015 Management, generated a Research which provided
(compared to the S&P 500 return of 65.7% in 2016. research on the electric utility
Charles Studness at 11.1% and the utility industry to institutional
PhD 63 index at 10.7% during the Graham & Doddsville investors and managed money
same period). Charles (G&D): Thank you for taking for clients exclusively in utility
received BA and MA the time to speak with us stocks.
degrees from the today. Could you tell us a little
University of Minnesota bit about yourselves and what G&D: What came from the
and a PhD in economics brought you to investing? conversations between the
from Columbia University. two of you?
Roy Studness (RS): I
Roy began his investment graduated from Columbia RS: We realized how well
career at First Manhattan Business School in 2006 and banks and utilities actually fit
Co. after graduating from was a member of the Value together in an integrated
Columbia Business School Investing Program. Before portfolio. A lot of it is driven
in 2006. Roy analyzed a business school, I spent a by how the two industries
variety of industries, couple of years as a respond differently to changes
including banks and bankruptcy lawyer. Practicing in interest rates.
utilities, during his time at law, I found myself more
the firm. Roy received his interested in the investment There is a very high negative
BA from Wesleyan side of the cases I was working correlation between the
University, JD from on. Also, growing up with my changes in bank and utility
Vanderbilt University, and dad in the investment business stock prices in response to the
MBA from Columbia certainly added to my interest 30-year treasury yield. Often,
University. in investing. So, I decided to when one industry is
pursue my interest in investing attractive, the other tends not
In 2016, Roy joined and Columbia seemed like a to be. If you go into a period
Charles, adding his great place to do that. After of low interest rates, where
expertise in the banking graduating in 2006, I went to net interest margins for banks
industry to Charless long work at First Manhattan are compressed, bank
track record of successfully Company, a long-only profitability is reduced and
managing money in the investment management firm in valuations suffer. At the same
electric utility industry, New York. They primarily time, with low interest rates,
and banks were added to cater to high-net-worth people seek out yield and they
the portfolios. The two individuals with a long-term treat utilities as a bond proxy.
industries work together in investment horizon. I was a They're not necessarily
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Studness Capital Management

investing based on the What we've done is put the money center banks like J.P.
fundamentals of the utilities at two industries together. You Morgan and Citigroup. We
that time; they're more trading can value them on similar look for mid-sized banks that
on yield. In the more recent metrics, so we have built a have high returns and are
period before the recent lengthy database for both growing.
rally banks were trading at industries. We went back a
low levels and utilities were at number of years to get a sense We create a five-year forecast
their highest valuation in 50 of what the trends are. We for all of the stocks in our
years. built models and ultimately got universe and we then run
to a point where we are valuations screens, including
We said to ourselves, "Hey, valuing banks and utilities on an P/E, total return, dividend
this is a real opportunity. integrated basis. We put the discount model, etc. for the
These two industries work two industries together in forecast period. This results in
really well together." My dad January 2016 and produced a a ranking of our stock universe
was investing in utilities and total return of approximately for each metric. We then
had a very good track record, 65% in 2016. We are using the combine these individual
but at the same time, the same methodology that metric rankings into a
volatility was increasing due to produced a 13.4% total annual composite ranking based on all
the persistently low interest return from 1991-2015 which of the metrics used. Now that
rate environment. You could compares to the S&P at 9.6% we have the stocks ranked in
outperform the S&P one year and the utility index at 8.9% order of attractiveness, that
and underperform the during that period. tells you where you want to be
following. If you're only in that focusing your attention.
one industry, you don't have
anywhere else to go when We realized how well The rankings arent fully risk-
things get unattractive without adjusted so you can start with
shorting or going to cash. If banks and utilities number one and say, "Okay, is
you have another area to actually fit together in there a risk here? Are there
invest with a high negative aspects to this company that
correlation to interest rates, an integrated portfolio. mean you don't want to own it
that could provide an for some reason? Is the loan
opportunity for better returns. A lot of it is driven by portfolio too risky or are they
It reduces the risk in the how the two industries doing other things that you're
portfolio as well. not comfortable with? If so,
respond differently to then you could cross that
Both banks and utilities are name off and move on to your
highly regulated industries in changes in interest
next one.
which there is a large amount rates.
of publicly available data. Both Ultimately this leads to a
provide very critical services. portfolio of about twelve to
Power and financial systems thirteen stocks which results in
are necessary for businesses to G&D: How do you select the concentrated positions. We
operate properly. These arent best opportunities within these don't want to be an index and
discretionary businesses. two industries? we want to make sure we're
Utilities are regulated outperforming. In the utility
monopolies, so that's a unique RS: Essentially, we view our space, if there's only 30 names
dynamic. It's a rate case universe as about 100 stocks. and you own seventeen of
mechanism that sets returns. There are about 30 electric them, you're going to be that
By contrast, competition is utilities the industry has industry index anyway and it's
what determines bank consolidated over the years, so going to be hard to
outcomes. Banks are regulated, there are not so many of them outperform. That's why we
but competition determines left. The other 70 are banks, stay more concentrated.
winners and losers in that and we focus on those that
industry. have a track record of high G&D: How do you manage
performance. We exclude the the mix of these two industries
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in the portfolio? not as strong in those years may own a brokerage firm and
but still negative. Obviously, are very complicated. The
RS: We believe in focusing on that's a rather unique period of ones that we want are single-
your most attractive time. If you went back further, service and much simpler in
opportunities where we have youll see another strong that regard.
the most conviction. We correlation before the financial
invest in whichever stocks are crisis. In general, there is a high RS: As far as the banking
the most attractive at a negative correlation over the universe, we're looking at 70
particular point in time. If longer period. of them. There are over 5,000
numbers one through 30 are banks in the United States.
all banks, then our portfolio is Many of them are small and
going to be all banks. The same Investing in the two private. Liquidity is an issue for
goes for utilities. If we're at a industries can provide a some of them. It's a
point where it's a mix, then the consolidating industry. If you
portfolio would reflect that. natural hedge on interest went back to the early 2000s,
The construction of the there were over 8,000 banks.
portfolio is really driven by the rate changes. The consolidation will continue
forecasts for all of the stocks and there's going to be fewer
and the valuation screens. banks five to ten years from
G&D: You mentioned you're now than there are today. The
Interest rates are important not looking to make calls on government has to grant you a
because they can create rates, but a lot of the charter to form a bank.
movement in the stocks we economics for a bank are Normally, there would be this
own. We're not trying to driven by rates. How do you consolidation but there would
forecast interest rates because address this? also be new banks being
we think that's not something formed. A management team
one can do. We're not making RS: At the base level, you could sell to a large regional
any direct forecasts of interest want to start with the industry bank at a big multiple and then
rates, we dont say "interest fundamentals and understand they could go across the street
rates are going to go up 50 the dynamics there. Once you and set up their own bank.
basis points next year." We have a sense of where the They'd attract clients back and
have our forecast for all of the industry is and what the do it all over again. But that
companies in our universe. fundamentals are, then you hasn't really been happening
There can be an indirect proceed to the most attractive over the last nine years
forecast of interest rates stocks within that industry. because only a handful of new
within those forecasts but charters have been granted.
we're not trying to make a big We are focused on traditional The result has been
macro call on the interest banks, where the primary accelerated consolidation since
rates. Investing in the two driver is net interest income. the financial crisis.
industries can provide a natural There are banks out there,
hedge on interest rate changes. especially the money center G&D: How does the ongoing
banks, where they have an trend of consolidation affect
G&D: Are there periods of investment bank or trading your investing outlook? Do
time where the relationship arm and there's lots of other you view M&A as a beneficial
did not hold? Were there moving parts. It's a little hard driver for banks?
abnormalities where that to understand what's going on
benefit of negative correlation or what the real drivers are. RS: It's a consolidating
did not exist? We try to focus on banks that industry so there's been lots of
derive most of their earnings M&A and there's going to be
RS: It stands up over time but from net interest income. more M&A. One might rather
the strength of the negative own the seller than the buyer
correlation can change. It's CS: These are largely single- because the premium would
been strong for the last five service companies, much like accrue to the seller. The banks
years. If you went back before the utilities. Once you get into that we're looking at are
that, to the financial crisis, it is the money center banks, they performing at the high end of
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the industry so they tend not commodities? something that inherently has
to be the target or receive a changed about the business
shareholder activist letter RS: For the banks, that might prevent this? Banks
requesting a bank be sold. competition determines that have high returns and
Some of them are better off on returns and profitability, and grow are usually not going to
their own because they're ultimately the winners and be the cheapest banksbut
going to generate a better losers. We're trying to focus this can vary with size and
return over several years than on those that have a track liquidity of a bank stock as
if someone gives them an record of high performance. well.
immediate premium. Up until Since it's a competitive
recently, a lot of people didn't landscape, loans and deposits Usually, an abnormal event
have the resources to provide are really just commodities. makes a bank suddenly move
an adequate premium for the We could get some capital, we up toward the top of our
higher performing banks. could attract some deposits, rankings sheet. Maybe a bank
and then make some loans. has a very good track record
For banks we target, M&A can That by itself is not that hard. of performing and growing;
also be a part of their strategy. Those that have the ability to but, for whatever reason, the
If they have the capital and a consistently generate double- market is focusing on a short-
sufficient stock currency, they digit ROEsover 1% ROAs term issue and this is impacting
can make the transactions there's usually something the stock price. Then you have
accretive. But you want to unique about the business, to determine if what the
look at what's happening to theres often a niche there. market is focused on is
tangible book value per share. There's something about their transitory. Is this something
Are we still compounding that? business that makes the that is leading to a
Is that still going up? There are returns durable, that makes it disappointing quarter but is
banks out there who do these so those returns aren't easily not necessarily impacting the
transactions and they become competed away by the long-term model? Over the
bigger, but the tangible book thousands of other banks that next year or two, is everything
value over three or four years are out there. going to rectify itself and
is exactly the same. It hasn't return the bank to high
gone anywhere. You just look performance? Or is the issue
Management is critical
around and ask, Are we any an impairment of the business?
better off?" in the banking industry
G&D: How do you consider
You want to look at who is because over time the and judge the quality of
acquiring effectively. That's the industry hasnt had large management? Specifically for
appeal of looking at those banks, where does that skill
banks that are compounding barriers to entry. If manifest itself?
book value. Maybe M&A is not
a primary strategy but it can be youve got some capital, RS: Management is critical in
something that a strong bank you can get some loans the banking industry because
considers to accentuate the over time the industry hasn't
growth opportunities. For and deposits. That by had large barriers to entry. If
every management decision, I you've got some capital, you
would ask, "If I really just boil it itself isnt going to lead can get some loans and
down to one share, is my one to good returns. deposits. That by itself isn't
share more profitable after going to lead to great returns.
they do that? Are we
compounding that per share Part of the process is trying to The niches are really important
value or not?" I would look at understand: do I have and they can really vary. Part
M&A within that prism as well. confidence that the factors of it is based on the market on
that led to the returns over which you focus. There are
G&D: How do you find these the past six to seven years are some banks that focus on an
high quality banks when most likely to persist for the next ethnic market. It could also be
banking services seem to be four to five years? Is there a focus on a particular end-
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market. A large bank called intensive business and the that regulators want solved.
Silicon Valley Bank has a niche utility needs access to the Increasingly, regulators are
catered towards the venture capital markets to be able to viewing the utilities as a part of
capital and private equity fund ongoing capital the solution, which is different
markets. If we were just expenditures needed to than in prior eras in which the
putting together our bank and maintain the infrastructure to relationships were more
making loans and deposits, have a reliable power grid. adversarial in nature. Utilities
those are areas that are a little have a lot of capex projects to
harder to penetrate. We Over time that is going to address this issue and
couldn't just go out and get result in certain valuations for customers can really see the
into those markets. That utilities based on access to the benefits, as opposed to prior
requires expertise. capital markets. If a utility's capex projects, such as
trading around book value, installing a scrubber on a coal
Part of a niche can also be they don't have very good plant, in which the project is
product-driven. For example, access to the capital markets. If large but at the same time it is
some banks focus on making they're trading at 1.8-1.9x harder for the customer to
commercial real estate loans tangible book value, then they feel or see the benefit. The
and can do it better than other clearly do have good access to projects now tend to be
banks. So you've got this capital markets. That might smaller, more granular, so
expertise that you develop that cause some issues, such as a there is lower regulatory risk.
is very hard to replicate. Some rate decision that might not be Together you've got a
banks are more responsive. as favorable. That's a dynamic backdrop of positive
Other deliver on execution. that's at play that's unique to a fundamentals. Obviously,
Some players provide deal regulated monopoly. prices are high for utility
certainty that others cannot. stocks at the moment which
has been driven by low
There are different ways that a Regulation is becoming interest rates, but the
bank can establish a niche. You fundamentals for the industry
look at it over time and it more of a partnership as
are good.
proves itself out through the climate change is a
durability of the returns. At For banks, the fundamentals
the end of the day, common problem that have been challenged for
management is going to be several years since the financial
critical in identifying,
regulators want solved. crisis. The challenge that they
cultivating, maintaining, face is persistently low interest
broadening, and protecting rates and compressed margins.
those niches. G&D: How do you view the Since the financial crisis, Dodd-
current fundamentals of each Frank was passed and thats led
G&D: What would you say is industry? to more regulation, which has
the biggest difference between added a lot of additional costs
utilities and banks, from an RS: The fundamentals for to the industry. On top of that,
investors point-of-view? utilities are very strong. That's the recovery, while it's been
separate from the stock price lengthy, has been rather slow.
RS: Utilities are different in valuations, but just the Banks can do well in a growing
the sense that they are business fundamentals are very economy as the growth fuels
regulated businesses; they are positive. They're state- more loan demand.
monopolies. The returns are regulated businesses and a lot
not determined by competition of states are dealing with We'll see what happens in
with other utilities they are climate change. A lot of them 2017, but the market seems to
largely determined through a are setting renewable be anticipating change. Some of
regulatory process. This is an standards, and that is having an those headwinds may dissipate
essential service so regulators impact on the business. or you may see tailwinds. With
want to make sure that Regulation is becoming more the election, there's been a
electric power stays on for the of a partnership as climate sharp rally in bank stocks with
customers. It is a capital- change is a common problem people expecting some
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regulatory reform or that really need rather than new at?
burdens will be reduced in projects. That could lead to a
some way. There's been talk of better rate case as they file the G&D: Utility rates are driven
fiscal stimulus, so perhaps you next one, leading to better by the government and they
would have a more robust returns and an improvement in can ignore economic reality for
economy. If that picks up, that valuation from 1.0x book value periods of time before they
Nicholas Turchetta 17, would be something that could to maybe 1.5x book value. In have to come back to the
William Hinman 17, and be a positive on the this type of a case, I don't think underlying fundamentals. How
Charles Wu 17 celebrate fundamentals for the banks as you're necessarily making an do you handle this dynamic?
the end of the semester at well. With interest rates, there explicit forecast or prediction.
the Value Investing Holiday was the increase by the Fed in It's more your reaction to CS: We look mainly at
Party December 2016 and we'll see opportunities that are coming regulation. When regulators
if that leads to continued about based on rate cases and make rate decisions that are
action. Some of the past how the market responds to very unfavorable, this sets off a
challenges may disappear or be them. chain of events: pressure on
reduced going forward. the utility and pressure on the
CS: As Roy noted, the stock price. We look at that
G&D: With both industries regulation of the utility is and how far the regulations
being driven by regulation, primarily at the state level. You can go, which can be more
how do you try to assess have a different set of forces telling than how far the
industry prospects? How does and dynamics than you have company can go. At a certain
heavy regulation influence your with bank regulations at the point, the regulator's going to
process? federal level. In California, they have to come to terms with
have their own renewable economic reality. It's not the
RS: We're not making a bet program. As far as the change utilities coming to terms with
on whether reform is going to in federal rules, the movement that but more on the
happen. Partly because at this away from coal burning is not regulatory side.
point, it's hard to really know. driven by regulation, it's driven
Taking the utility side first, by the market. Gas is cheaper G&D: Would you like to talk
you've got rate cases and its a than coal to generate power. through a couple of recent
process, so you see how it Bank regulation is a different investments you've made or
plays out over time. Access to animal and is dominated at the ideas that you find compelling?
the capital markets is federal level.
important as that's going to RS: We've been invested
influence those rate cases RS: For the banks, we're not exclusively in banks since
going forward. It can create making any type of prediction February 2016. The most
opportunity if a utility has a on what type of reform is attractive stocks between the
bad rate decision, leading to a going to happen. You want to two industries were clearly
decline in the stock price. All understand the industry on the banks in our rankings. When
of a sudden, it may be trading macro level, but the drivers for they sold off in the beginning of
at a value that one would stock selection are the 2016, the banks were just too
question what type of access forecasts for the all of the cheap. That was the starting
to the capital markets they individual stocks in the point. You have the headwinds
have. That's a situation where universe. That's where you we talked about and banks
you're going to see a good really focus on the micro were not very popular. Now
investment opportunity if it is rather than trying to make after the election, there's been
managed properly. broader interest rate or a lot of anticipation or
reform calls. We break it discussion of how some of
You say to yourself, "Oh, they down for each specific these headwinds might go
can't go out and raise equity to company and ask, what's the away.
do the various projects and company-specific outlook?
maybe they need to cut back How does that outlook and I think people all of a sudden
on the capex." So what does valuation compare with the forgot how profitable the
that do? Maybe they're only outlook for the other ones in industry was before the
going to do the minimum they the universe that we're looking financial crisis, before the
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regulation changed, and with market and this differentiates it issues. One, there was concern
higher interest rates. If you from other banks. The bank on the Chinese economy and
went back in time to 2003 to can provide a level of service how that was going to grow.
2006, for a group of these competitors cannot or do not Two, EWBC had a regulatory
midsize, high-quality banks, provide. It does not only help issue with Bank Secrecy Act
you're looking at ROEs of 15%. them get business directly (BSA) compliance. Regulators
People have forgotten that was related to China or Chinese examined the bank and said,
really achievable. Dodd-Frank companies entering the U.S., it "We don't think your
came and people thought also helps them get non- procedures to monitor Bank
"We're not going to go back to related business because some Secrecy Act compliance are
that world. might want the option to sufficient enough and we're
access this expertise at some going to require you to beef
I think the election may have point, even if it is not needed that up."
caused some people to re- immediately. I think that's
examine that assumption. something that can help them This was the first time they'd
ROEs don't necessarily have to elsewhere outside of that gotten any type of regulatory
get back to 15%, but if that targeted Chinese-U.S. business. order in their history. The
15% went to 9% from 2007- CEO has been at the helm for
2011 that's a big drop. All of a In addition, while EWBC has a over twenty years and it's been
sudden it goes during 2012- strong record of financial the same management for
2015 up to 10.5%; that's a little performance, the mix of its some time. Those two issues
better but you're not back to loans and deposits has changed made the stock sell off and
15%. It frames the issue as far over the past ten years to become quite attractive. Our
as where we were and where make the bank more attractive. analysis was: first, was the
we are. Specifically, EWBC used to be stock attractively valued? Since
a bank focused on commercial the valuation was attractive,
Back to the micro level, banks real estate loans that were we moved on to a second
that we like are the high- funded by high-cost CDs step: are the issues causing this
quality ones that have a track both of which are transactional high-quality bank to become
record of growing. One I can in nature rather than based on attractively valued transitory?
think of off-hand is the largest a relationship. This mix has Is there an impairment of the
Chinese-American bank, East shifted as EWBC has business going forward?
West Bank (EWBC). The bank diversified its loan portfolio to
has a very good track record. also include more home On the BSA issue, we got
A lot of these high-quality mortgages and commercial confidence that this was
banks we view as business loans while isolated. This isn't a bank that's
compounders. You look at significantly reducing its perpetually in and out of
tangible book value, they just percentage of deposits regulatory problems, and they
have good compound growth comprised of CDs and had a clear plan to deal with it.
year in and year out. They're increasing its core deposits. So, They laid out the parameters
putting up double-digit ROEs these have made the bank and the course of action.
and the bank is growing. more of a relationship bank Throughout 2016, one could
rather than a transactional track and see how that was
For EWBC, their niche is their bank which, all else equal, going. We got comfortable
expertise in facilitating business makes the bank more valuable. that this was not an
between Chinese and In addition, EWBC is a very impairment of the business.
American businesses. EWBC asset-sensitive bank with lots There are implications if you
brands itself as a bridge of variable rate loans which have an order like that. It does
between the two markets and position the bank well for have some restrictions on
they can help facilitate higher interest rates. management and capital
relationships in either allocation, but those are
direction. There are other Why is it attractive? EWBC primarily related to M&A and
Chinese-American banks out became very attractive opening new branches. It can
there but it is the largest. towards the end of 2015 and it take a bank a year or eighteen
EWBC has expertise in that remains so. EWBC faced two months to get out of this type
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of order. That didn't seem mainland China, but they have current idea in the utilities
overly onerous to us and the presence there and that's space?
wouldnt change the thesis or solidifying the expertise they
the quality of the opportunity. have. RS: Since we do not own any
We got comfortable that these utilities at the moment, a past
were transitory issues. In Those are things that gave us utility investment may be
addition, EWBC has spent the comfort that the shorter worth discussing. Ameren
significantly on non-recurring term issues aren't impairments (AEE) exemplified some of the
consulting costs to improve its of the business model. This issues that we've talked about
BSA systems and these costs bank has a long track record of and is a great case study.
should reduce significantly high returns and good quality They're a utility in Missouri
(around $15 million) in 2017 assets and one can reasonably and Illinois. They have a history
which can provide an expect that to continue over of good returns. They're
additional benefit to earnings. the next few years. When we primarily a regulated utility but
look at our five year forecast they also had some merchant
G&D: Dont the remaining and the valuation screens we power plants in Illinois, which
concerns regarding the health run on that, even now it still were deregulated. AEE
of the Chinese economy looks very attractive to us. operated them very well and
represent a substantial and had good performance. Then
possibly unknowable risk for G&D: Does the company get power prices went down and
this investment? an advantage in attracting and the returns in the merchant
retaining low-cost deposits business went down.
RS: We're not experts on the with its focus on China and
Chinese economy and cant Chinese-Americans? When the financial crisis hit,
provide any unique insight on they decided to cut their
it, but we're not looking to RS: They're not unique in the dividend. When a utility cuts
trade for a particular quarter. sense that they're a Chinese- its dividend, it can have a very
We're trying to take a longer American bank. There are out-sized negative impact on
term view and make an numerous others as well. I the stock because that's why a
investment that is going to don't want to create the lot of people own the stock.
work out over the longer impression that they're unique Maybe management thought
term. We think that the in that sense. Where their other utilities were going to
interconnectedness of the uniqueness comes from is cut their dividends as well. But
worlds two largest economies higher up the food chain. It is only one other utility did so
will continue to increase over in the expertise and the during the crisis, so AEE stood
time and that there will be a sophistication that they can out even more. The stock sold
growing need for expertise for provide. On the sophistication off sharply. It began trading a
facilitating business between level, these other Chinese- little bit below tangible book
these economies. The increase American banks can provide value. There was a change in
may not be linear but the access to or knowledge of the management and a bad rate
direction is up. Chinese market, but they're case decision as well. The issue
small and do not have the was "How are we going to deal
If you looked at Chinese expertise or product offerings with this? What is the plan to
investment in the U.S. over the of EWBC. In addition, they bring the returns up?"
last several years, it's been don't have the balance sheet to
steadily increasing. In fact, the access certain parts of the RS: The new managements
Chinese direct investment in market. For those larger banks, plan after they got the bad rate
the U.S. surged in 2016 Chase is going to have a desk decision was that it would only
to about $50B up from a few to deal with China or Korea. undertake absolutely essential
billion five years ago. China is a They're going to have those capex. That would result in
very large market, and we people that are dedicated fewer jobs, so the unions all of
think the expertise of EWBC is towards that market, but they a sudden joined the side of the
hard to replicate. EWBC has don't provide the service. utility because they don't want
ten offices in China. They're to see the job cuts. That sent a
not making many loans in G&D: How about a past or clear message to the regulator
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to get a better rate decision value. The cloud hanging over another one later on. It can
because clearly the company this company represented only help you get a feel for how
doesnt have access to the 10% to 15% of the earnings different each industry can be
capital markets at that low and it should not have been and what the drivers are. I just
valuation. part of the story. think about banks and utilities.
A lot of people wouldn't
CS: New management was Eventually AEE sold the initially think that they would
actually a promotion from merchant business, which go together. The person who's
within, so it was not a new made it a much cleaner story. covering the banks is generally
executive from outside. They became a pure regulated not covering utilities. I don't
utility focused on the right think they are paired together
RS: It showed a lot of issues, notably the rate cases. at all in that sense. Initially they
discipline. If they'd just kept Over time, it's worked out seem very different but as you
going with the plans as if very well, beginning around see, over time, the drivers of
nothing had happened and 2010. From 2010-2014, one industry can drive another
were still going to spend Ameren produced a very good industry, and reactions can be
money on capex, then that's annual return of approximately very different. That can create
on the shareholder. The 14% with low risk. unique opportunities in
shareholder's subsidizing unexpected areas.
everything and they're the G&D: Did they have any
ones taking the hit. In that problems servicing their debt Five years ago, I wouldn't have
case, the customers and during the crisis? thought that these two
regulators aren't taking a hit industries together would have
for the poor rate decision. It RS: They cut the dividend but this great fit. Being open-
was important to see how the they didn't need to cut it. We minded about those things and
utility management was going thought they were being overly looking at relationships that
to handle the situation. cautious by cutting. In our aren't presented by Wall
view, they were doing Street is valuable. Remain open
I would recommend something that they didn't -minded about investing.
need to do. Obviously it
initially getting as much created a significant CS: Being open-minded is not
opportunity as a result. a matter of finding glamorous
exposure as you can in industries. Utilities are usually
many industries. I think CS: They absolutely didn't thought of as a rather dull
need to cut the dividend. It industry, but I think you can
that can help you even if was important in that it led to see from what we've done that
the management change. There you can make very good
you focus on another were some other things returns in an industry like this.
one later on. happening at that time that The important thing is not to
showed a lack of leadership in start excluding anything. As
management and that got Roy said, be very open.
The other thing in the changed.
background was the merchant RS: Sometimes investors have
power business, which was a RS: The merchant business preconceived notions on what
small part of the business, but had some debt as well, but is possible from certain
it started to dominate the they had that ring-fenced. industries. Sometimes you'll
story. The merchant power want to look at the facts and
business was only 10% to 15% G&D: Do you have any advice the numbers, and not
of earnings, but people really for current students? necessarily listen to people's
focused on it all of a sudden. preconceived notions. That
This shouldn't have been a big RS: I would recommend can lead to more
negative. You could back out initially getting as much opportunities.
the value of the rest of the exposure as you can in many
business and the merchant industries. I think that can help G&D: On that point, do you
business had a negative implied you even if you focus on have any particular view
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regarding specialization versus
remaining a generalist?

RS: I've narrowed over time

on what I've focused on. It's
worthwhile to have the
broader experience to provide
more context then maybe
focus on particular industries.
At a Graham & Dodd
Breakfast, Bruce Greenwald
was talking about specialization
and how he was a proponent
of it, suggesting that this was
one feature that could lead to
high performance. We would
probably agree with part of
that. The problem is, to us it's
not just knowing the stock
it's knowing the industry. It's
knowing what drives
economics for that industry.
It's harder to gain that
expertise in a short period of
time and be actionable on a
stock. Not that it can't be
done, but from our point of
view, it seems a little more
challenging. That's how I would
think about specialization, but
there's not a wrong way.

G&D: Thank you again for the

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Contact Us: Graham & Doddsville Editors 2016-2017 Eric Laidlow, CFA 17
Eric is a second-year MBA student and member of the Heilbrunn Centers Value Investing
Program. During the summer, Eric worked for Franklin Templeton Investments. Prior to
Columbia, he was an equity research analyst at Autonomous Research and a senior port-
folio analyst at Fannie Mae. Eric graduated from James Madison University with BBAs in
Finance and Financial Economics. He is also a CFA Charterholder. He can be reached at

Benjamin Ostrow 17
Ben is a second-year MBA student and a member of the Heilbrunn Centers Value Invest-
ing Program. During the summer, Ben worked for Owl Creek Asset Management. Prior to
Columbia, he worked as an investment analyst at Stadium Capital Management. Ben gradu-
ated from the University of Virginia with a BS in Commerce (Finance & Marketing). He can
be reached at

John Pollock, CFA 17

John is a second-year MBA student. During the summer, John worked for Spear Street
Capital. Prior to Columbia, he worked at HarbourVest Partners and Cambridge Associ-
ates. John graduated from Boston College with a BS in Finance and Accounting. He is also
a CFA Charterholder. He can be reached at