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January 31, 2011
The Leading Authority on Value Investing
F E AT U R E S
The Other Side of Popular
It’s when one-time market gems are perceived to have lost their luster that Weitz Funds' Wally Weitz often steps in to do his most-profitable prospecting.
Inside this Issue
Investor Insight: Wally Weitz Finding value by zigging when the market zags in such companies as Iron Mountain, Liberty Interactive, PAGE 1 » Aon and Omnicare. Investor Insight: Eric Ende Seeking a select breed of long-term value compounders, today including Copart, Wabco Holdings, O'Reilly Automotive and Graco. PAGE 1 » A Fresh Look: Staples Buying a market leader when times are tough is typically smart, but the payoff can involve a wait. PAGE 18 »
e has been co-managing two Weitz Funds' equity portfolios with Brad Hinton since 2006, but Wally Weitz says that they are still learning to be co-managers. “If there's a weakness, it's that we're too deferential to each other,” he says. “Brad has trouble telling me when I sound crazy. We’re working on that.” Weitz has been crazy like a fox since the 1983 founding of Wallace R. Weitz & Co., which now manages $3.7 billion. His flagship Weitz Partners Value Fund has earned a net annualized 12.1% over the past 20 years, vs. 9.1% for the S&P 500. With current opportunities confined mostly to “80-cent dollars,” they are finding the most upside in such areas as document storage, drug distribution, TV shopping and insurance brokerage. See page 2
Brad Hinton (l), Wally Weitz (r) Wallace R. Weitz & Co. Investment Focus: Seek companies that a rational buyer, despite the latest or next quarter’s results, would pay significantly more to buy than the current market price.
Of Sound Mind It often makes sense to put off tough decisions, but delay isn’t always a PAGE 19 » neutral, or benign, act. Editors' Letter How value investing is like gravity; Parsing a management ploy to deflect PAGE 20 » unwanted attention.
INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS
Investing wisely in companies that themselves invest wisely has generated outsized returns for First Pacific Advisors’ Eric Ende and Steven Geist.
Eric Ende (l), Steven Geist (r) First Pacific Advisors Investment Focus: Seek companies in temporary disfavor but with the business models and management acumen to produce high returns on capital over time.
e proudly considers himself a value investor, but don't expect Eric Ende to go into great detail about his valuation methodology. “Only a small amount of our returns are from being clever on valuation when we buy,” he says. More important is the compound growth of high-return-on-capital businesses for which Ende has shown a knack in managing what is now $1.2 billion in fund assets for First Pacific Advisors. The FPA Perennial Fund he has run since 1995 has earned a net annualized 11.9% over the past 15 years, vs. 9.3% for the Russell 2500. Targeting small- and mid-cap U.S. companies, Ende and co-manager Steven Geist see opportunity today in such areas as auto supplies, truck equipment, car auctions and See page 10 fluid-handling devices.
PAGE 7 14 16 5 6 8 13 18 15
Graco Iron Mountain Liberty Interactive Omnicare O’Reilly Automotive Staples Wabco Holdings
Other companies in this issue:
Actuant, Apollo Group, Ascent Media, Baxter International, Charles River Labs, Dell, Grand Canyon Education, KAR Auction Services, Lincare, Microsoft, Noble, Office Depot, OfficeMax, Redwood Trust, Texas Instruments, VCA Antech
I N V E S T O R I N S I G H T : Weitz Funds
Investor Insight: Wally Weitz
Weitz Funds' Wally Weitz and Brad Hinton describe how experience served them well – and poorly – during the crisis, why their mood generally improves when the market goes down, why a “changing of the guard” among shareholders can create opportunity, and why they see unrecognized value in Iron Mountain, Liberty Interactive, Aon and Omnicare.
What did you learn about your strategy during the financial crisis? Wally Weitz: We’ve made a good living over time taking the other side of the popular trade. Overall that strategy was confirmed – that if you're buying pieces of businesses, managed by people you trust, at the right prices, eventually you earn good returns. With financials it had almost gotten to be reflexive that if the sellers were scared, we could make a lot of money by stepping up to buy. We’d done that half a dozen times when the Fed was raising interest rates or there was some other externally driven restriction of credit. But this time around it wasn’t a Fed-induced credit crunch, it was a mortgage meltdown. While we’d been conceptually aware of the credit risk, we clearly underestimated what would happen when you got into a negative-feedback loop where the bad lenders with bad loans actually spilled over and wrecked the entire market, affecting what we thought were good loans from strong lenders. While I'm proud of the fact we admitted our mistakes and got out much earlier than we might have, four stocks, Countrywide Financial, Fannie Mae, Freddie Mac and AIG, caused some permanent losses. Brad Hinton: Beyond that I’d add that while we saw an economic slowdown coming, we were in retrospect too willing to look across the valley. Even though we felt good about them long-term, we were too early in betting heavily on economically sensitive companies like Martin Marietta Materials, Eagle Materials and Lowe’s. Given the depth and severity of the recession, we were too quick to go after what was most out of favor. WW: Once we were out of those four financial stocks that had kept me up at
January 31, 2011
night because I wasn’t sure we had modeled them right, I actually started to enjoy the collapse. Given my nature, my mood generally improves as markets go down. We took our cash level down from 20% or so in late 2007 to maybe 5% in March of 2009, which is the lowest it’s ever been. While we were early in some cases, I will give us credit for not being paralyzed by fear and for taking advantage of some terrific bargains. That paid off for us in 2009 and 2010. Having been through the valley, has anything changed in how you do things? BH: The overall methodology didn’t change, but one lesson from 2008 was that we were guilty of having a failure of imagination on the downside. We develop a base, high and low case for each business we analyze and one practical adjustment we’ve made is to make our low cases somewhat more draconian. That comes into play in what we’re willing to pay. We’re more reluctant to buy a stock that might look attractive relative to the base case if the downside from the low case is too great. That’s always been true – if the range of outcomes is wide, that probably means the cash flows aren’t as predictable as we’d like and we require a bigger discount – but it’s even more of a focus now. Is it possible your attachment to managements with which you've had great success – mortgage investor Redwood Trust [RWT] comes to mind – caused you at times to not see the forest from the trees in the business? WW: That’s a fair question. We’ve had a tremendous experience with Redwood Trust over the past 16 years and still strongly believe in it. It is possible, though, that our confidence in managewww.valueinvestorinsight.com
Brad Hinton, Wally Weitz
Through the Valley
In his first interview with Value Investor Insight (August 29, 2005), Wally Weitz was well aware of the froth creeping into asset prices: “[S]o much money has been available and cheap in recent years that speculative excesses exist in most asset classes, whether stocks, bonds, residential and vacation real estate, leveraged buyouts or certain hedge fund strategies. Human nature is such that these excesses are likely to continue to build until people start to feel some real financial pain.” Despite the prescience of those words, Weitz's equity funds were nonetheless hit hard in 2007 and 2008. “What's most embarrassing and annoying to me is that we foresaw many of the credit problems that came to pass,” he says, “but we failed to recognize the vulnerability of some of our companies to the liquidity crisis that occurred as the market had its emperor'snew-clothes moment.” After two strong comeback years, how does it feel to go from star, to has-been, and back again many times over a 40-year investing career? “It comes with the territory,” Weitz says. “Your perceived IQ is directly proportional to your latest 12 month's performance.”
Value Investor Insight 2
growing stream of free cash flow over time that it can use to enhance per-share value. it is still better than people think. Why? WW: The most obvious reason is that he’s made us a lot of money. where the market is disappointed in short-term results and our interpretation is that the long-term health and quality of the business remains intact. there's often a disagreement over how quickly the growth is slowing and whether the slowdown is permanent. for example. BH: We’ll speak in more detail about this later. [Note: BAX shares recently closed at $48. When you’re right that the market is overreacting to the challenges faced. The fact that Bill Gates was so skeptical initially was a clue maybe the company was misunderstood. You’ve been avid investor over time in companies controlled by cable-TV pioneer John Malone. but Iron Mountain [IRM] is a good example as well. attract your attention? WW: We actively seek out forums where we can meet company management and attended one last summer that included Texas Instruments.com to explain why they weren’t just an uninteresting commodity chip business. plasma. We’re taking the other side of that. People who were already worried about a move to a ON MICROSOFT: Buying it at 10x earnings is not like having to call whether Advanced Micro beats Intel in the next product cycle. They explained that the driver of the business was custom analog chips that go not only into all sorts of glamorous consumer electronics like iPhones. regardless of the business. Do you have favorite reasons for why targeted ideas have fallen out of favor? BH: One common reason is a difference in time horizon. but are also used to do things like retrofit motors to make them more energy efficient. The company has strong global franchises in hemophilia. Dell [ DELL ] is one example we own today. That’s a function of our having at least a five-year investment horizon. paperless society seem to have extrapolated what we judge to be cyclical challenges from the tough economy to be the start of an accelerated secular decline in the North American storage business. It all came together and we bought a lot of stock in the $23-24 range. how they’d bought a huge amount of manufacturing capacity at 10 to 15 cents on the dollar in the depths of the recession – giving them a cost advantage going forward – and how they were devoting almost all free cash flow to share buybacks and increasing dividends. is more of a marketing. but management did an excellent job of describing how the business had evolved. as investors were disappointed with the 2011 outlook. where we basically believe there's a good long-term trade in assuming that while the company isn't as good as it used to be. high-value items that they can sell millions and millions of and that are designed into product platforms that can last 10. not surprisingly. there’s often a significant amount of complexity in his companies that. assembly and distribution business – it only incidentally makes products people label as technology. There's a changing of the guard among the shareholder base and as that happens. 2011 view versus the market about the sustainability of its moat. has done a mediocre to poor job in the past of reinvesting its profits to develop new products. Value Investor Insight 3 . vaccines and renal care. While there are some cyclical headwinds in the plasma business and the margin outlook is somewhat threatened over the medium term due to pricing and reimbursement concerns. It’s in the business of storing boxes filled with paper. It so happened that Bill Gates of Microsoft was there and challenged them www. More generally. and while it doesn’t get much duller than that. I am certainly not a semiconductor expert.] WW: In many cases we’re getting involved when a rapidly growing company is slowing down or maturing. we bought shares in medical-products company Baxter International [BAX] when the share price fell into the lower $40s last fall. the investment result can be quite positive.I N V E S T O R I N S I G H T : Weitz Funds ment contributed to our holding more of it than we should have in the past couple of years. These are low-ticket. To your point that it’s not our typical holding. the technology companies we typically own aren’t those characterized by rapid-cycle change. How did something like Texas Instruments [TXN]. They were saying all the things we like to hear. We expect Baxter to generate a healthy. rather than trying to trade on any given earnings report. the company was a growth-stock darling for much of the past decade as they reinvested cash flow in building out a big physical network that is very difficult for competitors to replicate. Dell. 20 or 30 years. but we’re still happy to hold at this price.valueinvestorinsight. where we have a variant January 31. Buying it at 10x earnings is not like having to make a call on whether Advanced Micro Devices has an advantage over Intel in the next product cycle. We find those situations can be a fertile area for opportunity. we believe those negatives have been excessively priced into the stock. Microsoft [MSFT]. and seeing them change his mind made me want to dig into the story. The market seems to have caught on [the shares now trade around $34]. For example. not what we’d consider your typical kind of holding. scares investors. which we also own. The stock fell to $20 or so last September. but because of nearmonopoly market positions it is a supertanker of cash generation.60. as long as we’re able to build management relationships that engender trust and provide us with a direct source for gaining understanding of the underlying businesses.
access or destroy documents. that's $6 of annual growth in per-share business value in an asset-light. so true free cash flow. I can imagine a day when that original $40 per share in cash becomes $40 per share of equity value in an expanded securitymonitoring business. The quality of the opportunity set can impact that – we’ll be quicker to sell the 80-cent dollar. for $1. The document-management industry is fragValue Investor Insight 4 ON IRON MOUNTAIN: We very much like physicalnetwork businesses because of the competitive moats that are built around them. we have less confidence in our projections of future free cash flows than we would like. but in this case.valueinvestorinsight. the share price would almost certainly be significantly higher than today's level [of just over $38]. more After worries over a changing regulatory environment caused for-profit-education stocks to crack last summer. with the stock in the upper $50s. Apollo Group [APOL]. WW: In light of the current political uncertainties. you doubled down on one holding. So despite the potential upside in many of the stocks. the company has an experienced and highly capable team led by Brian Mueller. leaving it with an empty canvas and $40 per share in cash. a security monitoring business. making the affordability of its programs – a key bone of contention with regulators – relatively better. but only 50% for another. Given all that. we might be willing to pay 70% of our appraised value for one business. Some people might use different discount rates to reflect those variables – we use the same discount rate. two in-demand fields where it has a long history of successfully preparing students for careers. Finally. who was one of the key players behind Apollo’s growth over the past 20 years. and there are additional service fees any time you want to move. BH: The company helps its customers store. BH: We think Grand Canyon has several distinguishing characteristics: Its student mix is tilted to graduate and bachelor’sdegree students with previous college experience. we have chosen to focus on Grand Canyon because of its particular advantages. I can't show you a blueprint for how Monitronics will perform over the next ten years. Lucky or good? WW: We’ve gotten out way too early plenty of times. free-cashgenerating business. informed buyer would pay for the whole business. With the stock off 27% in one day two weeks ago. Its program mix is anchored by nursing and education. It charges a per-box monthly fee for storage. BH: We’ll typically start selling lightly as the price-to-value gets above 80%. including contracts. We got interested when John Malone joined the board as chairman last Spring and said he had some ideas on what to do with the business. www.com . and dumped another. 2011 about the industry. how we feel about management and how we feel January 31. how do you arrive at a stock’s fair value? WW: We try to figure out what a rational. when the market lumped Grand Canyon’s prospects in with competitors that we expect it to outperform.2 billion. and we should be gone when it gets to 100%. predictability of cash flow. we saw that as an opportunity to buy more. but in this case we would need to see a higher discount before coming back. We use a standard 12% discount rate as the hurdle rate that buyer would want to earn. it was near our estimate of fair value and we were well aware that any sign of slowing growth could result in a period of big disappointment on the part of the momentum guys who had bid the stock up. Describe your selling discipline. We’d expect that kind of buyer to base the price on how much cash the business would generate over the next 15 to 20 years in excess of what’s needed to run the business. If that happens. Its tuition levels are lower than most peers. Walk us through in more detail your thesis on Iron Mountain [IRM].and 60-cent dollars out there. but the economics of the security-monitoring business are similar to those of cable television – a business Malone knows better than anyone. recurring-revenue. when we’re finding a lot of 50. If it can earn a 15% return on equity. for example. financial records and human-resources-related materials. but just require a higher margin of safety when we think it’s appropriate. protect and destroy mostly physical documents. heavily as it moves above 90%. is it now one of those changein-shareholder-constituency ideas you described earlier? BH: We love to return to old favorites. We very much like physical-network businesses because of the competitive moats that are built around them. The company then agreed to sell off nearly all its existing operating businesses for more than $15 per share. Grand Canyon Education [LOPE]. Ascent has since announced it will use roughly half its cash hoard (and leverage) to buy Monitronics. You appear to have gotten out of Coinstar [CSTR] before the latest earnings warning slammed the stock. in an industry in which good management is at a premium. In more traditional cases. Depending on the quality of the business. Explain why. which has led to better-quality outcomes.I N V E S T O R I N S I G H T : Weitz Funds Was your purchase last year of Ascent Media [ASCMA] almost a blind-faith bet on Malone? WW: Ascent was spun off by Discovery Communications and its assets a year ago consisted of some fairly prosaic video processing businesses and a lot of cash.
The tug and pull on the stock revolves primarily around the speed and extent to which increasingly digital document management impacts the business. economic component to the business. The company has invested heavily in building out digital-document and e-mail imaging and storage services.4x. and fewer shares outstanding – as a result of aggressive share buybacks – we would expect to see midteens growth in free cash flow per share over the next few years.0% 40 35 30 25 20 15 Revenue Operating Profit Margin Net Profit Margin IRM PRICE HISTORY 40 35 30 25 20 15 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE Wally Weitz believes the market is misjudging cyclical weakness in the company's document-handling business as the start of a secular decline. we value the business today in the low $30s. so the shares currently trade at a multiple on that of around 13. (@9/30/10): IRM n/a 20. It also has established international businesses in the U. as less paper tends to be created as business activity declines. 2011 www. Management has been slow to increase prices as the company built out its network and captured share.. how are you looking at valuation? BH: Now that they’ve slowed capital spending.K.valueinvestorinsight. Counteracting that somewhat have been increasing regulatory and legal requireINVESTMENT SNAPSHOT ments around what must be retained and for how long. other publicly available information January 31. flat interest expense.2% 5. Through price increases. Share Information (@1/28/11): Trailing P/E Forward P/E Est. we’re expecting revenue growth in the mid-single-digit range. There is a cyclical. Certainly in the mutual fund business what we’re required to retain has gone up significantly. international growth.1 billion. free cash flow is substantially higher than reported earnings.7% 4. which now account for about $230 million in revenue on an annual base of $3. he expects mid-teens annual growth in free cash flow per share.95 billion $3. As the company navigates this digital transition. protection and destruction of documents. and discounting that all back.0% $4. Now that this is a free-cash-flow story.8%) Company Davis Selected Adv Goldman Sachs Vanguard Group Schooner Capital Capital World Inv Short Interest (as of 12/31/10): % Owned 20.12 billion 19. what assumptions are you making about growth? BH: All in. which should help margins expand. His appraised share value: in the low $30s. growing at a doubledigit rate over our planning horizon.6% 3.1% (-0. Our estimate for 2011 free cash flow per share is $1.49 3. All that results in high operating margins – EBIT margins are just under 20% – and a strong and stable recurring-revenue stream. accounting for the cash flow earned between then and now. business is 25% of sales today.2 13. The biggest competition is do-it-yourself storage. vs. but Iron Mountain is the largest player with around 20% of the physicalstorage market in North America. but Iron Mountain has the potential to grow here through share gains and price increases. How mature is the traditional business? BH: The overall North American physical-storage market isn’t expanding. but once a customer has decided to outsource this type of thing.85. Value Investor Insight 5 Iron Mountain (NYSE: IRM) Valuation Metrics (@1/28/11): Business: Provider of records-management services. With 9-10% annual EBIT growth.S. including the storage. Australia and New Zealand and is investing in faster-growing regions of Latin America and in Europe. to commercial and governmental customers. but has now stated that pricing will be a focus in North America. Using a 13x multiple on our 2015 estimate of free cash flow. Sources: Company reports. We’re counting on EBIT margins increasing from 19% currently to about 22% by 2015.93 – 28.3% 4. we expect healthy per-share growth rates combined with smart capital allocation to generate considerable shareholder value.70.6 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 24. The non-U.I N V E S T O R I N S I G H T : Weitz Funds mented. margin expansion and share buybacks. With the shares trading around $24. it’s rare that they cancel and ask for all the boxes in storage to be returned.4% 7.1 S&P 500 18. It’s a lowermargin but still decent business.com . 40% on the physical side. with EBITDA margins of around 25%.72 19.
more-affluent-than-you’d-expect women.8 16.com. in a not-so-healthy environment. selling a wide variety of discretionary household and personal items to a loyal target audience primarily of middle-aged. Its primary business is the QVC home shopping network. and without the capital requirements of bricks and mortar retailers it generates nice free cash flow. now trading at $15. We’re well aware of the risks from someone like Amazon. The business held up quite well through the recession. as well as some small private online retail properties like Backcountry. Adjusted EBITDA fell less than 10% from 2007 to 2008. reaching 195 million cable households worldwide. as Liberty Interactive is scheduled to become an independent company later this year. (@9/30/10): LINTA 14. describe the upside you see in Liberty Interactive [LINTA].7% 11.com.8 billion.1% 9.com and Bodybuilding. business last year. says Brad Hinton. 2011 ing the product mix and can adjust it on the fly based on what’s selling at that moment.4 Nasdaq 12. The complicated structure is going to be simplified.7% 7. Rowe Price Southeastern Asset Mgmt Dodge & Cox Harris Assoc Vanguard Group Short Interest (as of 12/31/10): % Owned 11. also includes minority stakes in such firms as Expedia. Interval Leisure and Tree. Using a low double-digit multiple on our 2015 free cash flow estimate – reasonable given that capital reinvestment demands are fairly low – and discounting back at 12%. We expect that to increase to about $2 by 2015. Liberty Interactive (Nasdaq: LINTA) Valuation Metrics (@1/28/11): Business: Liberty Media tracking stock representing primarily the QVC shopping network. they actually have a more robust selling proposition online because of all the raw material they can plug in from the TV side. QVC accounts for nearly 90% of Liberty Interactive’s total revenues. Sources: Company reports. driven mostly by top-line growth internationally and a recovering consumer retail environment in the U.valueinvestorinsight.1 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 15.08 – 16. Share Information (@1/28/11): Trailing P/E Forward P/E Est.com Value Investor Insight 6 .S.80 0. HSN and Tree. QVC's revenues were roughly flat from 2007 to 2009.65 billion for 2010. but it also includes LIberty’s public ownership stakes in Expedia. for example.76 billion 12.4% 20 15 10 5 0 Revenue Operating Profit Margin Net Profit Margin LINTA PRICE HISTORY 20 15 10 5 0 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE Uncertainty over the timing and final terms of its formal spinoff from Liberty Media is causing investors to underestimate the resilience and competitive strength of the company’s QVC shopping network. He pegs the current value of QVC and other marketable securities the company owns at $21-23 per share.0% $9.2 21. HSN.2% 1.9% 3. INVESTMENT SNAPSHOT How are you valuing the stock. The sales mechanism is quite sophisticated – a chef selling her cookware on QVC.com. has the producers whispering in her ear and suggesting she point to the purple pot because call volume picks up whenever she does that. It broadcasts 24 hours a day. with the rest in Europe and Japan. roughly 100 million of which are in the U. BH: They’ve also been very good at incorporating the Web into their own business model – online sales accounted for roughly one-third of QVC’s U. other publicly available information www. and we estimate that they grew by 6% in 2010 to a new high of $7.6% Company T. To what extent do you consider online competitors like Amazon a threat? WW: The TV network offers an entertainment element that sets it somewhat apart and has proven to have legs against Internet competition.. and is expected to be back at 2007’s level of $1. WW: This is one of three tracking stocks for Liberty Media. As the Internet becomes more videooriented. They’re constantly refreshJanuary 31.48 billion $8. Overall.3% 3.I N V E S T O R I N S I G H T : Weitz Funds Highlighting another of your John Malone-related picks. but we believe QVC can more than hold its own.85 10. BH: QVC has been around for 25 years and is the undisputed leader in its field.S.85? BH: We estimate QVC generated just over $1 per share in free cash flow in 2010. we arrive at a current business value for QVC of $16-18 per share.com.S.
Sources: Company reports. interest January 31. limiting what they can earn on their float.and human-resourcesrelated consulting services to primarily corporate customers worldwide.9% 8. but we think there’s still room for improvement as the business turns up and management keeps a lid on costs.com Value Investor Insight 7 . we took the other side of what the arbs were doing. It generates 20% operating margins for Aon even in a soft market. Excess supply among insurers has also exacerbated a soft pricing market.7% 7. On top of all that.2 13. We don’t consider either of those a big risk.33 1.75 per share in cash earnings by 2015.3% $12. On the consulting side.10 – 46. Because of the economic contraction.8 13. because we trust Liberty management to insure that the value they said would be delivered to LINTA shareholders will be delivered. Aon Corp. But we don’t have to build in much optimism on those fronts to see this as attractive. Are there any risks around the spinoff? WW: There is an ongoing suit. with Aon. What attracted you to insurance broker and HR consultant Aon Corp. Share Information (@1/28/11): Trailing P/E Forward P/E Est. (@9/30/10): AON 18. We’ve chosen to wait and see on that. selling them our Hewitt stock while buying Aon.7% 5. Rowe Price Capital World Inv State Street Corp Vanguard Group Short Interest (as of 12/31/10): % Owned 8.I N V E S T O R I N S I G H T : Weitz Funds The marketable securities at current prices are worth another $5 or so per share.. other publicly available information www.28 billion $7.6% 2. Using a 13x terminal multiple and discounting back to the present.3% 50 Revenue Operating Profit Margin Net Profit Margin AON PRICE HISTORY 50 Shares Short/Float 40 40 30 2009 2010 2011 30 THE BOTTOM LINE Expecting only modest improvements in global demand for insurance “risk units” and in what has been a soft insurance pricing environment. When the acquisition was announced and Aon stock came under pressure. which hurts Aon because it gets twothirds of its brokerage revenues from commissions. So is your bet primarily on those negatives going away over time? BH: That’s certainly an important part of it – risk units will come back as the global economy recovers and sooner or later we will have a hard insurance pricing market. as does the fact that Liberty has reallocated assets among the tracking stocks in the past and could do so again before the spinoff gets done.6% 4. We see room for margin expansion in both brokerage and HR consulting.5% in 2010. expected to be heard in February. by Liberty Media bondholders claiming that the security of those bonds will be impaired by this spinoff. insurance risk-unit demand has been weak globally. we expect margins to increase from today’s 16.6 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 45. [AON]? WW: We owned Hewitt Associates when Aon agreed to buy it last year. On top of that. management sees considerable revenue synergies from cross-selling among practice areas.8% Company Southeastern Asset Mgmt T. Aon was on our monitor list because we like the insurance brokerage business and the shares were reasonably priced. That uncertainty probably leaves some investors cold. Aon has targeted $350 million in cost synergies from the merger. (NYSE: AON) Valuation Metrics (@1/28/11): Business: Provider of insurance brokerage and related risk. which more than tripled the size of Aon’s consulting business. Pretax margins in the brokerage business INVESTMENT SNAPSHOT have increased over the past few years from 16% to an estimated 20.32 35.2 S&P 500 18. Marsh & McLennan and Willis Group controlling a significant share of the large-corporate-client market. as companies have less to insure or choose not to insure certain risks. he believes the shares today are worth closer to $65. What do you like about the insurancebrokerage business? BH: It’s another capital-light business and basically an oligopoly.5% as Hewitt is integrated. 2011 rates have been low. but that would cause an incremental bump to earnings and margins. Brad Hinton believes the company can earn $5.68 billion 13.1% 5. with 20%-plus returns on capital and significant free cash flow.valueinvestorinsight.
com Value Investor Insight 8 .2% 0.5% to 9. Share Information (@1/28/11): Trailing P/E Forward P/E Est. has declined slightly over the past four years. with whom we had an excellent experience when he was CEO of Triad Hospitals several years ago. which could start a sharp revaluation upward. Weitz & Co Vanguard Group Short Interest (as of 12/31/10): % Owned 5. Other investors who like the business.95 19.25 per share estimate of cash earnings in 2011.valueinvestorinsight. He has since become non-executive Chairman with the naming of John Figueroa. Create an internal culture in which everyone is working toward common goals. We’re projecting 4% annual top-line growth over our forecast horizon.4 million.75 per share by 2015.8% 3. all the while paying himself a lot. the company has staked out a strong leadership position in selling pharmaceuticals to geriatric clients living in nursing homes. but we do expect the sales and service upgrades to help turn that modestly around. Its value-add is in packaging the drugs in ways meant to improve compliance and accuracy of usage.4 million beds in 47 states. who January 31. other publicly available information www. Joel Gemunder. With those assumptions. we expect EBIT margins to expand from a current 8.02 billion $6. our current appraised value is in the mid-$60s.0% 3.I N V E S T O R I N S I G H T : Weitz Funds At a recent $45. he values the shares today at $35. the biggest negative to the story in our opinion was removed last August when the board replaced the longtime CEO. While there are challenges to the business overall.8% 3. INVESTMENT SNAPSHOT That’s driven both by a continued shift in the product mix toward generics – on which Omnicare earns higher margins – and from nuts-and-bolts operating improvements. Using a conservative 13x terminal multiple and including the present value of cash generated in the interim.5% or so in 2015.30. 2011 had been president of McKesson’s U.7 S&P 500 18. (@9/30/10): OCR 77. Sources: Company reports. how cheap do you consider the stock? BH: The shares trade at less than 11x our $4. Is the business growing? BH: The number of beds served. repackages and distributes pharmaceuticals to nursing homes. WW: This is a classic example of the kind of opportunity we pursue.14 – 30. Wally Weitz believes the company’s greater emphasis on sales and service combined with nuts-and-bolts operating improvements can drive free cash flow growth from an estimated $3 per share this year to $4.2 13. and it uses its scale to negotiate better terms with suppliers and to fend off smaller competitors.13 billion 8.63 0. its management team and even its share price are deterred by the soft insurance market.70 by 2015. They seem to think they’ll magically be able to buy just before the market firms. assisted-living facilities and long-termcare facilities. We’d rather own it now and benefit fully when that happens.5 11. at around 1.6 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 25. We’re expecting cash earnings to increase to $5. On what should management be focused? WW: A lot of it is just making simple operating improvements: Support the people in the field interacting with customers.S.6% Company Harris Assoc Glenview Capital Schroder Inv Mgmt Wallace R. Without assuming anything heroic.2% 35 30 25 20 15 Revenue Operating Profit Margin Net Profit Margin OCR PRICE HISTORY 35 30 25 20 15 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE With its long-time CEO having been replaced. He tended to pick fights with executives internally and scrimped on customer-facing sales and service.5% $3. The interim CEO was board member Denny Shelton. We believe they’ll pay a higher price at that point. drug-distribution business.7% 7. which with margin expansion translates into mid-single-digit annu- Omnicare (NYSE: OCR) Valuation Metrics (@1/28/11): Business: Purchases. as the permanent CEO. hospices and assisted-living centers representing 1.0% 5. You’ve traded in and out of drug distributor Omnicare [OCR] for years. Take better advantage of the company’s scale in areas like procurement. Why is it interesting now? WW: Almost in spite of itself.
it's natural for our performance to be lumpy. The stock traded at $60 a few years ago and there’s no reason it couldn’t again. Buying opportunities seem to crop up when. If the market keeps going up the cash will be a drag on our performance. 2011 www.70 by 2015.I N V E S T O R I N S I G H T : Weitz Funds al EBIT growth. In an operating turnaround. we could easily see a premium to the 13x multiple we assume for 2015. it will figure out how to adjust in order to maintain the spread. What upside do you see in the share price.valueinvestorinsight.” Are you OK with that? WW: Given that our funds are concentrated both in the absolute number of positions we hold and in the number of industries that are represented. We've been selling into the rally and now have 15-20% cash in our two largest equity portfolios. Wally. the good news here is that the comparisons should prove to be fairly easy. we would much prefer to be streaky but good. It all gets more interesting on a per-share basis. If it doesn’t succeed in doing that. In March 2009 the average stock we held sold for less than 50% of our estimate of business value. How is your humor today? WW: The stocks in our portfolio are obviously not as undervalued as they were a year ago. you mentioned your mood improving as stocks get cheaper. Today our stocks on average sell at about 75-80% of appraised value. We estimate free cash flow of $3 per share in 2011. our margin estimates will be too high. but the opportunity cost of having some extra cash right now doesn't strike us as particularly high. Morningstar calls your funds’ performance “streaky but good. given the company’s opportunity to use free cash to significantly shrink the share count over the next five years. and are certainly much more expensive than they were two years ago. What are the key risks? WW: We expect continued pressure on reimbursement rates. there’s also always execution risk. you least expect them. and that was with extremely conservative expectations. but not one that gets us very excited. If the alternative is being consistent and mediocre. If they generate the earnings growth we expect. now around $26? WW: Our appraised value today is around $35.com Value Investor Insight 9 . rising to $4. VII January 31. and where. a level from which we’ve earned reasonable returns in the past. and we believe the stock could move to that level simply by regaining respectability in investors’ eyes. but we are assum- ing that as the company gets squeezed. In addition to our having faith in new management.
We put the same emphasis on companies that earn high returns on capital and have attractive reinvestment opportunities. still in place today. 2010) kind of took away our thunder. Your strategy descends from none other than Warren Buffett and Charlie Munger (see box on this page). and they conclude the true number is somewhere in the middle of the box. we put primary emphasis on market structure. Describe its basic outlines. ours is relatively simple. If you have to compromise somewhere.” says Ende. informed Buffett and Munger's original thesis for Source Capital itself. The assumptions you have to make tend to be so uncertain that we don’t find it a particularly useful way to look at a company. we tend to be very long-term investors – our average holding period runs about seven years – in order for this virtuous process to bear fruit. Ende took over Source that year. and management’s track record in creating shareholder value over time. then maybe it's not a very good deal. The problem is that the range of supposedly legitimate potential outcomes can be a share price from $10 to $100. Describe how you define your circle of competence. we’re interested in companies that are better than their competitors and which have shown the ability to take the cash they earn and do something smart with it. the sustainability of the business’s competitive advantage. Because growth is driven by earning high returns on capital and successfully reinvesting cash flow. EE: We’re looking at companies that trade primarily in the United States with market caps between $500 million to $5 billion. Relative to more elaborate valuation disciplines you may hear about from others. No discounted-cash-flow models? Steven Geist: We find that even using a consistent discount rate you can come up with anything you want in a DCF model. If you have enough time. not a change in valuation. and now co-manages it and the FPA Paramount and FPA Perennial mutual funds with Geist. there’s no reason you shouldn’t get the attractive long-term returns we believe we and our predecessors have produced. Historically we’ve managed to pay mid-teens trailing earnings multiples for pretty good companies.valueinvestorinsight. low-teens if we’re really fortunate.” Michaelis delivered market-trouncing returns at FPA’s Source Capital closed-end fund before dying in a bicycle accident in 1996. They have strong balance sheets.com Eric Ende. but it’s more of a burden. If you step back and think about the basics of what we’re doing. why they’re “on the cowardly side” in establishing positions. as most of what he said about strategy sounded awfully familiar. but to the extent you can apply it. Copart. understand the business dynamics and not pay foolish prices for things. They redirected it under Michaelis to focus on high-quality businesses that can compound shareholder value at high rates for many years. Because of that orientation. Wabco Holdings and Graco.I N V E S T O R I N S I G H T : First Pacific Advisors Investor Insight: Eric Ende First Pacific Advisors' Eric Ende. 2011 What constitutes not paying foolish prices for things? EE: We’re basically willing to pay average or below-average valuations for companies we believe will continue to have better-than-average performance. “but if that $1 is being managed incompetently or following a dumb strategy. Steven Geist Down the Line While they took unconventional paths to become investors – Eric Ende worked for 13 years in corporate finance. For example. January 31. paying a high-teens multiple can work out.” Value Investor Insight 10 . Michaelis' mentors were none other than Warren Buffett and Charlie Munger. There’s nothing earth-shattering about that. Dubbed by one author as the “apostle of return on equity. We believe the most important contributor to the long-term investment performance of the companies we own is earnings growth. with debt accounting for no more than 35% of total capital and usually much less. and why they see particular upside in O'Reilly Automotive. Eric Ende: Your recent interview with Morris Mark (VII. “It's all very good to buy $1 for 50 cents. You often see these 2x2 or 3x3 valuation tables in Wall Street research that give share-price targets under a mix of assumptions on the key inputs. our view is that compromising on quality is not a good thing to do – paying a little more for a consistently good business is the better way. December 2. while Steven Geist spent a comparable period as an engineer – they both had the good fortune to land at First Pacific Advisors under the wing of George Michaelis. Steven Geist and Gregory Herr explain what matters most in identifying stocks they hold for an average of seven years. The strategy. the mistake they find most difficult to avoid. We try to avoid fast-changing businesses with short-life-cycle products www. however. our companies today have on average about 10% net debt. who independently bought shares of Source in the mid-1970s when the floundering fund traded at 50% of net asset value.
the balance sheet became clean enough that we we’re able to invest in the equity a couple years ago. 2011 petitor Frontier Drilling. but the valuation reflected that until the downturn in late www. That depth of knowledge. were companies in industries that were essentially two-firm oligopolies. they demonstrate an ability to add well-priced assets at an opportune time. EE: We’re generally reluctant to invest in crummy-return businesses.7 billion acquisition of smaller comJanuary 31. the private-equity firm. We don’t have anywhere near that many good ideas in a year. There’s a legitimate question as to whether the world has changed in commodities. Why have you decided on that level of concentration? EE: When we see competitors holding 75100 positions. After hoarding capital the last few years. Another example of that we own is Actuant [ATU]. You wouldn’t think spending on pet healthcare would be that discretionary. the largest operator of animal hospitals and veterinary diagnostic labs in the U. which came public in 2001 and caught our attention for the attractive reinvestment potential in buying veterinary practices and for the excellent profitability of the lab business. for example. That’s still weighing on the stock. and probably representing a higher portfolio weight. which is a duopoly. Gregory Herr: We’ll often follow a business for years until for company-specific reasons or due to market conditions an opportunity presents itself. VCA Antech was an example of a company whose debt we owned in Source Capital [First Pacific’s closed-end balanced fund]. As bondholders. but over time in the past they haven’t done better than provide commodity returns. where we have to ask what our competitive advantage is in analyzing the business. and historically that’s been true of those tied to commodities. that eventually became attractive as an equity investment. often with fairly concentrated industry structures. and leasing out capacity on new deepwater vessels and rigs prior to actually committing the cash to buy them. but people have clearly been putting off or skipping some treatments for their pets. We consider oil services different in its fundamentals from the exploration and production side of the business. More important. but we tend to Value Investor Insight 11 . We recently went through the portfolio and found that roughly one-third of the names. This had been a buyout by Leonard Green & Partners. we knew the company well and as it paid down debt. and also announced $1 billion in spending to buy two ultra-deepwater drillships. which should result in good returns for shareholders. All that greatly reduces risk and has resulted in better-than-average returns. . In this case. we’re either very impressed with their ability to keep track of 150 or more companies … or we’re skeptical of their ability to credibly follow that many companies.S. the price has remained attractive because the volumes at the vet hospitals have been anemic for the last 18 to 24 months. It had everything we like in a business. delivering capital projects on time and on budget. Those deals increase Noble’s backlog from $7 billion to $13 billion. so we didn’t care. You can have an irrational market whether there are two firms or ten. . second in the industry only to Transocean. There’s clearly a strong cyclical component. we can devote 10 times the amount of time some others can spend on any given position. which means we should know the business better. How do you size positions? EE: We consider a position full at about 3% as we’re purchasing it. ON DIVERSIFIED RIVALS: We’re either impressed they can track 150 or more companies . Noble. with 75-100% annual turnover. How do ideas tend to get on your radar screen? SG: We maintain a list of companies that meet all the criteria Eric mentioned and monitor it to identify when the market is giving us an opportunity to buy. backed by 10-year contracts from Royal Dutch Shell. but we don’t believe that tendency will persist for the long term. the impact of which can be reduced by the length of our time horizon. So we focus on relatively easy-tounderstand businesses. We were surprised to see decent representation in your portfolio of highly cyclical oil-services stocks. which is quite helpful for profitability and allows companies to make rational reinvestment decisions. Noble last June announced the $2. but most of the time the more concentrated businesses are well-behaved.valueinvestorinsight. but we also believe that the way the companies are managed can generate incrementally higher returns on capital. A good example of that in the portfolio today is VCA Antech [WOOF]. or skeptical of their ability to credibly do so. We also tend to avoid complicated technology and biotechnology businesses.I N V E S T O R I N S I G H T : First Pacific Advisors because they’re inherently more difficult to forecast. Often it’s as simple as a missed quarter or a change in analysts’ estimates. Given our number of holdings and our turnover. has done an excellent job over time in timing capital investments.com 2008 and we were able to buy it at a price that made sense. Your portfolios tend to hold 30 to 40 positions. combined with the quality of the businesses we want to own. is our primary risk-management tool. a small conglomerate of energy-focused industrial businesses that was split off from the electronics business of Applied Power maybe 10 years ago.or ten-year period. like Noble [NE] and FMC Technologies [FTI]. which is all a lot of noise much of the time and isn’t relevant to whether the company is in an attractive business and is likely to reinvest its money successfully over a five. reducing the possibility that things are going to hit us from left field.
Serving the professional trade requires bigger investments in distribution and service. That’s critical to success on the commercial side of the business. where mechanics typically work with time-sensitive schedules. If the share price cooperates. and we’ve owned it for a long time.valueinvestorinsight. since 2000. the company has performed. some of the remaining shareholders revolted and with the help of new activist owners forced the company to abandon the deal in July.S. after ten years of making smart acquisitions in related businesses they understood well. yes. That’s doubly true when the valuation is also pushing the upper limit of what we would consider reasonable. Needless to say. While there was a legitimate strategic rationale for the deal. bought a company called JLG Industries. if we buy and the stock pops 20%. As an addendum to the story. The most vivid example of that was four or five years ago when what was then called Oshkosh Truck [now Oshkosh Corp. so we sold immediately. Value Investor Insight 12 . we spend a lot of time trying to understand how management has reinvested cash flow in the past and the criteria for how they plan to do so in the future. That should result in it taking significant market share. Larger positions are mostly the result of success. Our thesis has been that Lincare’s cost advantage over its competition will allow it to earn decent returns while others lose money and withdraw from markets. primarily the challenge of keeping WuXi’s two thousand Chinese scientists happy. we don’t feel compelled to move from a less than “full” position. we’ll probably start trimming it back. Walk through your investment case today for O’Reilly Automotive [ORLY]. the leading Chinese provider of early-stage drug development ON MISTAKES: It’s very hard to foresee when management acts totally out of character and makes a horribly destructive investment. Can you generalize about where you’ve tended to make mistakes? EE: Given our focus on companies that reinvest wisely. 2011 basically rats and mice – is a great business. How did you handle long-time holding Lincare [LNCR] after healthcare regulatory concerns knocked a third off the share price last summer? EE: We’ve owned Lincare. but there’s a good deal of uncertainty.]. We also saw significant integration risks in the acquisition. The problem that’s very hard to foresee is when management acts totally out of character and makes a horribly destructive investment. prior to regulators backing off on price cuts because of sharp declines in service levels. so we’ll take our time building a position and hopefully the passage of time will increase our understanding of the business and our confidence in what the future looks like.6 billion to buy WuXi PharmaTech.to 100-basis-point positions. and 50% from the retail doit-yourselfer. and they overpaid for it.. It was outside their core business. In July the Center for Medicare Services announced the results of a competitive bidding process in which overall prices fell more than expected. but the resulting higher sales productivity per store has generated excellent returns for O’Reilly over time. The story here revolves around the July 2008 purchase of CSK Auto. about where reimbursement rates are going for its products and services. We continue to hold our position and with new rates going into effect in the test markets now.com the ability to take on new customers in certain test markets. we’ll buy up to the 3% position. We bought well. at a time when Charles River shares traded at 2x revenues and 11x EBIT. When they announced the deal the stock went down 15-20% and we got out as quickly as we could. along with AutoZone and Advance Auto Parts. Then in April of last year they announced they planned to pay $1. Over the past two years management has been methodically integrating the two businesses. They have completely overhauled the inventory and layout of CSK stores. with roughly 50% of the business from the professional mechanic and garage trade. GH: O'Reilly is one of the three big autoparts retailers in the U. to put it mildly. highly cyclical. What sets it apart is its traditional customer mix. The company’s core business of selling research models – January 31. and Lincare lost www. starting with 50. with dominant worldwide market share and low-30% operating margins.I N V E S T O R I N S I G H T : First Pacific Advisors be on the cowardly side at the beginning. which is the leading provider of home oxygen equipment. the price was 6x WuXi’s sales and 30x EBIT. this thesis is controversial. Did something similar happen with Charles River Labs [CRL] last year? EE: In many ways. which resulted in a 70% increase in O'Reilly's store base and gave it a national platform to roll out its dual-market strategy. CSK was in almost all respects a suboptimal operator and commercial sales represented only about 10% of its revenues. so there was significant opportunity for O’Reilly to enhance the productivity of the acquired stores as it merged them into its infrastructure and strategy. The only consolation was that we avoided it going from $45 down to $4 in the financial crisis. In almost all respects it’s superior to its competitors. we should know relatively quickly whether our argument is valid. At the same time. while significantly improving parts availability and service by adding new distribution capacity. The deal made us lose confidence in management’s ability to intelligently reinvest cash flow. We’re most comfortable buying stuff that is going down. When something like that gets to 6-7% of the portfolio. They had been adding to that core with related businesses that support healthcare research or drug development. services.
the shares are far more attractive against the $5 per share in earnings power he believes the company can generate in the next few years.05 0. average sales will be in the $2.2% 2. We think there’s an argument for earnings power within a few years of closer to $5 per share.5-2. Overall. we don’t expect growth to be overly impacted by an uptick in new-car sales.I N V E S T O R I N S I G H T : First Pacific Advisors The results of all this have already been positive. with consensus estimates calling for $3. as an economic slowdown causes people to hold on longer to their old cars.7 million range.3% Company T.2% 7. The CSK stores were generating around $1.50 this year and bit under $4 in 2012. and there’s opportunity to fill in where they already have a store footprint.3% 3.com . (@9/30/10): ORLY 20. There’s no guarantee they get there. but the earnings-growth potential here is good enough that a 19x trailing multiple is more than palatable. other publicly available information January 31.1% 80 70 60 50 40 30 20 Revenue Operating Profit Margin Net Profit Margin ORLY PRICE HISTORY 80 70 60 50 40 30 20 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE The market isn’t recognizing upside still available from integrating acquired CSK Auto stores into the company’s infrastructure and strategy. but it has made AutoZone a much more benign competitor.0% $7. and believe 200225 per year is a reasonable expectation in coming years.0% 4. There’s also growth potential outside of the CSK stores. To put that in perspective. That’s been financially successful. With higher margins and the fact that they’re embarking on their first-ever share buyback plan. What’s the competition doing while all this is going on? EE: Advance Auto Parts doesn’t have a presence in the Western markets in which CSK was strong.4% 3. expect another 170 this year. tools. you’re talking $1.5 16. equipment and accessories sold to both professional and do-it-yourself customers in the U. from new stores and increased sales at existing stores. 2011 www. supplies.9% 3.300 stores you’re talking about an additional $300-350 million in sales over current levels – worth probably 25 cents per share in earnings.58 – 63. and management and Wall Street are focused on that getting before long to around $1. EPS growth may be closer to 15% annually.8 16.S. which had limited O’Reilly’s use of vendor financing because inventory had to be pledged as collateral. the hedge fund manager. That restriction has gone away.valueinvestorinsight. If they INVESTMENT SNAPSHOT ultimately get to $2. One balance sheet issue I’d mention is that the company just refinanced its credit facility. with 1. which require more upkeep. They opened 150 new stores in 2010.1 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 56. how are you looking at valuation? GH: The company likely earned about $3 per share in 2010. That’s been true for years and we expect it to continue. we’d expect annual top-line growth of around 10%. but we believe it’s a legitimate possibility over the next five years. O’Reilly is still mostly absent in Florida and in the Northeast. who has been very skilled at getting cash flow out of the business – one way of which to do so has been to minimize reinvestment. The key point there is that the company is controlled by Eddie Lampert.7 million. and we expect Value Investor Insight 13 O’Reilly Automotive (Nasdaq: ORLY) Valuation Metrics (@1/28/11): Business: Retailer of automotive aftermarket parts. if they get to $2 million per store.50.8 million. but we believe the biggest upside is still to come.51 37. Sources: Company reports. which leaves AutoZone as the main competitor. But given the magnitude of what can happen with the CSK stores.3 Nasdaq 12. Share Information (@1/28/11): Trailing P/E Forward P/E Est. says Gregory Herr. But if the productivity ultimately gets to the level of O’Reilly’s traditional stores.4 million in average sales prior to the acquisition.26 billion 13. Rowe Price Vanguard Group State Street Corp Lone Pine Capital Select Equity Group Short Interest (as of 12/31/10): % Owned 13. With the shares at $56. While somewhat pricey on trailing earnings.2 billion in extra sales and maybe 75 cents in incremental EPS. Does O’Reilly face a headwind if the newcar market continues to improve? GH: The auto-parts business is somewhat countercyclical. We don’t pay that much attention to forward multiples.89 billion $5.
6 15. When they go. 2011 with Copart’s operating margins typically coming in above 30%. and we think there are other markets in Copart (Nasdaq: CPRT) Valuation Metrics (@1/28/11): Business: Seller through online auctions of “totaled” and high-mileage cars for insurance companies.87 0. store it and then auction it off to the highest bidder. which is tied almost entirely to miles driven.” Sources: Company reports.S. there are only two companies of size in the market. The real estate itself can be difficult to find.28 – 40. The auctions are done entirely on the Internet. Broad scale is also important. while AutoZone’s is 107%. Just because Allstate decides not to fix a car in Los Angeles.1 million 30. With expected annual EPS growth in the double digits and a management team with an “owner’s mentality. and U. That’s a result of more expensive stuff being built into cars.8 16. they give you an honest answer with no spin.21 billion $800. which basically involves buying holding lots in order to better serve customers and to reduce the distance the cars have to be towed. describe what appeals to you about carauction company Copart [CPRT]. Every 500-basis-point increase in the ratio is worth $100 million in cash flow.S.6% 4. EE: Copart’s primary business is managing auctions for salvage vehicles.. Allstate will contract with Copart to haul the car away. says Eric Ende.I N V E S T O R I N S I G H T : First Pacific Advisors the company to free up working capital by increasing its payables-to-inventory ratio from a current level of around 48%.11 31.3% 19. What are the key demand drivers? EE: The most important generator of demand is accident frequency. and the track record over a long period of time justifies that.” he expects to “hold on to this for a number of years. We trust them. which share around 75% of market. For comparison. The company expanded into the U. Copart and KAR Auction Services [KAR]. and getting zoning approvals can make it even harder. Profitability levels are quite high.3% Company Concert Wealth Mgmt Baron Capital Capital Research Global Inv Neuberger Berman Wasatch Adv Short Interest (as of 12/31/10): % Owned 10.7% 5. Share Information (@1/28/11): Trailing P/E Forward P/E Est. As a result of all this. If an Allstate client has an accident and the determination is made that the car can’t be fixed at a reasonable cost.6% 2. (@9/30/10): CPRT 21. retaining a percentage of the proceeds as a fee.1 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 39. They’ve shown an ability to successfully take their model outside the U. which has expanded the potential buyer base significantly. and here there has been a secular increase in the percentage of accidents that result in cars being totaled. fleet owners. The severity of accidents is also important. especially outside the U.S.com Value Investor Insight 14 .2% 50 Revenue Operating Profit Margin Net Profit Margin CPRT PRICE HISTORY 50 Shares Short/Float 40 40 30 30 20 2009 2010 2011 20 THE BOTTOM LINE The company has capitalized on its strong market position and expanded successfully into new geographic and product markets that leverage its online selling platform.0 Nasdaq 12. banks.K. as national insurers prefer to deal with a salvage company with a national footprint. which you need a lot of to minimize hauling distances. other publicly available information www. Advance Auto’s payables/inventory ratio is 71%. a few years ago and now has a leadership position there. The primary assets are the holding lots. EE: We’ve met O’Reilly management at least 15 to 20 times over the years and they are absolute straight-shooters – you ask a question.K. where there are different regulations and cost structures. January 31. that doesn’t mean someone in Nigeria or Venezuela or Poland. Staying within the automotive world. making it modestly correlated with economic activity. with some 25% of the market.2% 4. can’t fix it economically.S. charities and auto dealers in the U. such as airbags and fancier lighting systems. Are there other growth opportunities? EE: Copart still does make acquisitions in the U.valueinvestorinsight.0% $3. INVESTMENT SNAPSHOT the car is more likely to find its way to Copart.1% 3. We like that the business has substantial barriers to entry.
manufactures and sells braking.S. Management runs the business with an owner’s mentality – the founder is still Chairman and his family controls about 10% of the stock – and is willing to return capital to shareholders as conditions warrant.com Value Investor Insight 15 . and increased penetration of the company’s high-end components in all markets to fuel growth in revenues and profits that he believes will make today’s 16x trailing multiple on the stock appear exceedingly cheap. and Europe. Has it gotten pricey? EE: On estimated earnings for the year ending in July of $2. other publicly available information www.5 billion in 2009.S. What’s behind your optimistic revenue outlook? EE: Part of it is just an expected rebound in unit truck production in the U. Emerging-market competitors are generally limited to low-end products.97 0. (@9/30/10): WBC n/a 15.6 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 57. quality and safety. where Wabco is less active. which might be cars coming off lease. the multiple is around 17x. It’s a global business.5%) Company T.3% in 2005. Share Information (@1/28/11): Trailing P/E Forward P/E Est.2 13. It is a leading worldwide manufacturer of technologically advanced heavy-truck components.4% 1. and Wabco Holdings (NYSE: WBC) Valuation Metrics (@1/28/11): Business: Develops. As revenues bounced back to an estimated $2. we wouldn’t expect Wabco’s competitive position to be under threat for some time. headquartered in Belgium.2% 80 70 60 50 40 30 20 10 0 Revenue Operating Profit Margin Net Profit Margin WBC PRICE HISTORY 80 70 60 50 40 30 20 10 0 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE Eric Ende expects a rebound in truck production in the U.S.01 billion 8.70 billion $2.2% 4. followed by Germany’s KnorrBremse at #2.6% 9. India and Brazil.09 – 63.6% (-12.30 per share. including Germany and France. including air disc brakes.2 billion last year.valueinvestorinsight. Why are you so high on prospects for truck supplier Wabco Holdings [WBC]? EE: Wabco was founded as Westinghouse Air Brake Co. continued truck-demand growth in emerging markets. A recent tender offer to buy back 15% of the outstanding shares has helped push up the price.2 S&P 500 18. 140 years ago and was spun off in 2007 from American Standard. the U. up from 2. as well as in rapidly growing countries like China. with Wabco holding a 40-50% global share.4% 3. or fleet cars that dealers. with major operations in developed markets in Europe. Because of their buyer base and established online selling platform. We would expect to hold on to this for a number of years. electronic braking and stability control systems. they believe they can get attractive prices compared to the used-car auctions of companies like Manheim. 2011 The market has two premier players. which we believe can drive annual EPS growth in the low double digits. and Japan. banks or companies may be looking to unload on a regular basis.0% 8. and has the potential to continue to grow nicely. Based in Belgium.4 billion in 2007 to $1. While still not back to pre-crash levels.9% the year before.3%. Rowe Price Lord Abbett Fidelity Mgmt & Research Vanguard Group Times Square Capital Short Interest (as of 12/31/10): % Owned 10. This business now accounts for 20-25% of Copart’s vehicles sold.I N V E S T O R I N S I G H T : First Pacific Advisors continental Europe. They eliminated 23% of their global workforce and have accelerINVESTMENT SNAPSHOT ated shifts in manufacturing and the sourcing of parts and materials from high. As revenues continue to grow rapidly – which we expect – the lower cost base should result in margins easily surpassing the peak level of 12.28 24. Sources: Company reports. we believe operating margins came in at 10. and automatic transmissions. suspension and transmission-control systems primarily for commercial trucks. stability. or repos.to low-cost countries. Given the premium in the market on technological innovation. We’ve held on to our shares because the company has proven it can deploy capital to grow and earn attractive returns. They have also built a profitable business selling what they call “high-mileage” vehicles. with revenues falling from $2. the stock at a recent $39 has done quite well lately. But they’ve done an excellent job of using that adversity to cut costs. The downturn hit the company hard. January 31.0% $3. with similar potential.
to $1. says Steven Geist.4% Company Mairs & Power Select Equity Group Vanguard Group Waddell & Reed Franklin Resources Short Interest (as of 12/31/10): % Owned 5.6 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 42.6% 3.82 – 42. where build rates fell by two-thirds in the recession and have only recently started to pick back up as those economies show signs of life.S.6% 6. The story has not gone unnoticed. Given the company's strengths.3 S&P 500 18. are in process to require shorter stopping distances in the U. truck and housing markets and secular growth in the usage of paint-spraying equipment should help drive EPS growth of more than 10% per year.1% 50 40 30 20 10 Revenue Operating Profit Margin Net Profit Margin GGG PRICE HISTORY 50 40 30 20 10 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE Cyclical rebounds in car. mix and dispense a wide variety of fluids and semi-solids. processing. but a manufacturer of industrial equipment that is used to pump.valueinvestorinsight.15 25.6% 4. with the shares having more than doubled in the past year to a recent $57. The question then is how much revenues will grow.1% 13. Graco (NYSE: GGG) Valuation Metrics (@1/28/11): Business: Global manufacturer of fluidhandling equipment used in a wide variety of industrial. (@9/30/10): GGG 27.S.2 13. with the pumps as the razor and the related hoses and nozzles – which tend to wear out quickly – as the blades. 2011 tions on the expectation that the surprises are much more likely to be positive than negative. All these numbers are very likely to go up as government regulators. making Wabco an excellent vehicle for participating in emerging-market growth. Another key factor is that expanding economies need trucks to transport goods. from perhaps $300 in China. manufacturers and buyers put increased emphasis on safety and improved productivity. for example. construction and maintenance applications. to $3. The recent growth pace won’t continue. “we're likely to do very well from here even if the multiple is a bit higher than a new buyer might like. and anti-lock braking systems in Brazil. The value of Wabco content on a new truck varies widely from market to market. – requiring more sophisticated brakes – electronic stability control in Europe. The final part of the growth story is increased content in each truck produced.50 per share. he says.4% 4. but which will improve at Graco when overall economic conditions more fully recover. business generates roughly half of total sales. Share Information (@1/28/11): Trailing P/E Forward P/E Est.5 21. You could argue that’s expensive for a cyclical business. all of which helps produce excellent returns on equity that are running north of 30%. Revised regulations.I N V E S T O R I N S I G H T : First Pacific Advisors Western Europe.75 2.000 in the U.9% 2.30.0% $2.S. but we believe the secular growth story. The company has guided to 40% revenue growth in North America this year and mid-teens growth in Europe. All of this plays to Wabco’s strength as an innovator and technology leader. Explain your case today for long-time holding Graco [GGG]. is fairly profound. We also like very much that their nonU. but we’ve made the stock one of our largest posiJanuary 31. Unit truck production in China. It’s a classic razor/razor blade type of business. SG: This is not the Graco that makes baby strollers and car seats. enhanced by the operating leverage.000 in Europe. India.. The company is known for the high quality of its products. other publicly available information www.1 million 20. The company has suggested that it can earn operating margins in the 25-30% range on incremental revenues. which most companies would die for. and for strict manufacturing cost control. for investing in new-product development.52 billion $693.” Sources: Company reports. EE: The stock has gone up a lot and now trades for just over 16x estimated 2010 earnings of $3. but these markets for Wabco are anything but mature. Total operating margins are just above 20%. and Brazil grew probably 40% in 2010 and those countries now account for about a quarter of the company’s sales. INVESTMENT SNAPSHOT Roughly 50% of total revenues come from delivering replacement products to its installed base.com Value Investor Insight 16 . It’s tough for us to be terribly specific about that.
As that production ramps back up – and. Non-VII subscribers still pay only $199. has been well ahead of the world in replacing brushes and rollers.I N V E S T O R I N S I G H T : First Pacific Advisors So is the basic bet on recovering economic conditions? SG: We see a few levers to the upside. the attitude is much more positive today than it was two years ago. as Eric mentioned. consumers. we’ve earned a 16% annualized return. but that is changing over time as penetration levels steadily increase in both Europe and Asia. or if it’s just an endorsement of the companies we were fortunate enough to buy and own a couple years ago. which accounts for around 55% of revenues.valueinvestorinsight.S. equity markets as well. that fell off a cliff in the downturn. high returns on capital and that kind of longterm profit growth. we’re likely to do very well from here even if the multiple is a bit higher than a new buyer might like. That continues to result in our gravitating toward businesses with significant geographic diversification in their operations. So at today’s price. has both cyclical and secular upside. Subscribe Online » Mail-in Form » Fax-in Form » Want to learn more? Please visit www.. which generates around 35% of sales and sells things like paint sprayers to painters and striping equipment for highways and parking lots. I’d say we’re undecided on whether that gives us confidence in the future. given that these same businesses showed little or no ability to foresee the latest downturn. How are your views on the economy’s prospects informed by ongoing conversations with the management of companies you own? GH: Particularly in more industrial and cyclical businesses. where operating margins are running at roughly half the more typical levels of 25% or more.S. Something like a high-end clothing retailer we’d be quite leery of today. EE: We have been surprised by how well companies in general responded to the demand shock of the crisis.valueinvestorinsight. dollar will weaken over time. which is tempering our outlooks for retail and other consumer-discretionary companies. I wouldn’t say we put a lot of stock in that. with a great balance sheet.S. The Industrial business segment.com *For current Value Investor Insight subscribers. VII Expand Your Idea “Grapevine” Subscribe now and receive four quarterly issues of SuperInvestor Insight for as little as $149*. isn’t the valuation – more than 20x consensus 2011 EPS estimates – a bit on the high side? SG: Yes. SG: We’re also quite aware of the debt overhang that still exists for U. The decline in the housing market has hurt both revenues and profits in this business. For such companies we’re not counting on a return to historical volume levels or rates of growth for some time.com Value Investor Insight 17 . No one is counting on a imminent turnaround. we first bought shares in 1996 at a split-adjusted $4 per share.S. Those to-date have been listed almost exclusively in the U. and by how well they’ve enhanced profitability as revenues have come back in the last quarter or two. there are early signs of life – Graco will benefit. To the extent we own a consumer-focused business.S. but we’re making a concerted effort to look at non-U. where the spending is less discretionary because people need to keep their cars working. serves original-equipment manufacturers in markets. Our feeling is that over time the recovery and expansion of the revenue base will drive annual growth rates in earnings per share in the low double digits. With the shares trading at around $42. The Contractor business unit. If we can own a market leader in good industries. Or call toll-free: NEW ISSUE OUT iN FEBRUARY – SIGN UP NOW! 866-988-9060 www. Have you held this for a long time? January 31. before dividends. The U. which you’d expect to an extent for a company coming off depressed earnings. Our conversations with management are much more focused on understanding the business dynamics than on trying to get a sense of what their economic outlook is for the next year. Are any macroeconomic views particularly influencing the makeup of your portfolio today? GH: One that is certainly not unique to us and that we’ve been talking about for some time is our expectation that the U. it’s likely to be like O’Reilly. like cars and trucks. but any reasonably good news on housing would clearly have a positive impact on the company’s results. 2011 SG: In fact. The secular trend working in Graco’s favor is increased usage of spraying equipment by painters in international markets. however.
com. says James Tierney.1 ORIGINAL BOTTOM LINE – NOVEMBER 30. Corporate Express. Even after taking down his out-year multiple expectation. and the use of free cash flow to buy back shares and pay off debt. but if it happens. recently at $22. including new-store openings. “this stock will just kill it. The primary reason is that one key aspect of Tierney's thesis has yet to arrive: “There's been no economic tailwind to speak of. other publicly available information www. Wal-Mart has been taking floor space away from office supplies. which works INVESTMENT SNAPSHOT against what those three are trying to do.3 NASDAQ 12.com Value Investor Insight 18 . but also to make strategic investments that will enhance their competitive advantage when overall conditions improve. through aggressive pricing. Assuming 14% annual EPS growth through 2015. It continued to undercut competitors on price. Costco and Amazon. Tierney pegs the company's fair value today at $30 per share. he says. As the economy healed. That's fed by a wide variety of factors. November 30. 2009 The company is pressing its advantage over weak competitors. or nearly $2 per share. to $1. It was opening new stores while its floundering competitors Office Depot and OfficeMax were cutting back. What's Staples worth? Assuming a more-conservative-than-before 15x multiple. improved international margins. he puts the shares’ fair value today at $32.45 – $26. he puts the fair value of the shares today at $30. That's particularly true in office-supply retail. store growth and an expanded delivery business. Stewart's James Tierney saw Staples doing just that 14 months ago (VII.30.28 – the share price. Sometimes that can involve a wait. Prior to paying its dividend.S. the investment case for Staples is stronger than ever. 2011 gined Staples-brand products. Staples' enhanced competitive strength would drive earnings – and the stock price – much higher.4 billion in free cash flow in 2010.16 in cumulative dividends and a discount rate of 9.valueinvestorinsight. an ongoing mix shift to higher-marJanuary 31. 2009). Tierney considers such fears overdone: “The nature of the category is to sell things that are relatively low-priced and bulky. SPLS 19. which remain anemic in the U. Smart companies typically use adverse market cycles not only as an impetus to tighten their belts. I can think of plenty of other areas they'd pursue first before expanding here in a big way. Tierney argues that despite the economy's sluggishness. since such companies can do particularly well as times improve.” In fact. all the while maintaining industry-leading operating margins. NEW BOTTOM LINE While the company’s execution has been excellent. While Staples has executed well – 2010 earnings per share increased an estimated 12%. $2.A F R E S H L O O K : Staples Delayed Gratification It's typical for value investors to favor market leaders pressing their competitive advantage when times are tough.5%. Even assuming a modest 2-3% rise in annual comparable-store sales – which would be higher if economic growth accelerated – he believes the company can generate 1520% EPS growth over the next few years. continued synergies from the Corporate Express acquisition.00 Trailing P/E Forward P/E Est. Tierney argued. has gone nowhere in the past 14 months. $4.” VII Staples (Nasdaq: SPLS) SPLS PRICE HISTORY 30 30 25 25 20 20 15 15 10 2009 2010 2011 VII. one oft-cited fear among analysts is that Staples over time faces increased competition from low-price retail behemoths such as Wal-Mart. he says the company generated an estimated $1. While this could be said of almost any large retailer. He refuses to count on meaningful improvement in the employment picture.85 in 2016 EPS.” he says. W. At a time when the worst of the economic crisis was only tentatively past. one key aspect of James Tierney’s investment thesis has yet to manifest itself: an overall economic tailwind. The #1 office-supply retailer had significantly expanded its direct-delivery business through the purchase of a leader in the segment.P.32 $17.4 14. 2009 10 Share Information (@1/28/11): Valuation Metrics (@1/28/11): Price 52-Week Range $22. where fortunes are most closely tied to employment numbers. Sources: Company reports. he says. November 30.8 16.
It's hard to argue with the time-tested advice to “sleep on” difficult decisions.” says Gilovich. the greater may be the value of procrastination. “'Should I delay a decision?' is only the first question. they found. especially when it reflects an unwillingness to acknowledge a mistake or hubris in parting with a winner. Dodd and Buffett have all said. while the other half were allowed to delay it. Time for reflection can also allow time for more digging. On its face this is neither good nor bad – the “normative” option can be a better or worse choice – but it highlights that the choice to delay a decision isn't a neutral act and can alter decisions in a predictable way. and they often look for additional information in hopes that it may facilitate the choice.” The problem. But the choice to put off a tough call isn’t always a neutral act. there are potential pitfalls in delaying the tough calls. the more likely it is to exert undue influence on a decision. as Akerlof points out. you're generally better off making it now.” In an investment context.valueinvestorinsight. “the status of this additional information is only to increase the Consumer Reports sample by one.” academ- ic researchers Anthony Bastardi and Eldar Shafir found that people often arrive at a decision point. But when someone at a cocktail party says his brother-in-law owned a Volvo that was a lemon. “We at times infer our attitudes from our behavior. Deciding not to act is still a decision. Economist George Akerlof cites as a thought experiment the example of a new-car purchaser. the advisor offered an alternative. you should have concrete reasons why it's better to wait. One of which to be aware is that the act of choosing to delay a decision can actually influence the ultimate decision made. Half of the subjects were asked to make an immediate decision. however. which based on the information provided was meant by the researchers to offer an almost indistinguishable choice. you should always remember that you don't have to swing at every pitch. In case they didn't like the recommendation. the prospective buyer is likely to abandon his choice posthaste. while only 56% of those who chose to delay did so. www. To the extent that an inability to pull the trigger on a buy decision reflects discomfort with one's analysis or the risk and uncertainty involved. If you don't. not acting has value. and can in fact alter decisions in predictable and not-always-benign ways. delaying decisions to buy or to sell would appear to have somewhat different opportunity costs.com The more conspicuous the new information. investors can concoct new reasons to hang on in the face of objective evidence that it's time to go. the downside of waiting is quite low.” which in this case was to go January 31. who after doing research that includes poring over Consumer Reports' safety and reliability ratings decides to buy a Volvo. As a result. “On the Pursuit and Misuse of Useless Information. “not with wellestablished and clearly ranked preferences. “followed quickly by. Mean repair records are likely to remain almost unchanged. What happened? An overwhelming majority of the immediate-choice group opted to go with the financial advisor's recommendation.” For all the benefits.” says Gilovich. In either case. which is unlikely a recipe for success. The perspective gained by not acting in the heat of the moment or just letting time pass as you grapple with an uncertain or unpleasant choice generally leads to a more rational decision. we forfeit the option of waiting until new information comes along. As Baupost Group's Seth Klarman puts it: “As Graham. Another potential mistake is ascribing excess import to new-found information. even though. You can wait for opportunities that fit your criteria and if you don't find them. “It's hard to imagine that giving greater prominence to input just because you've waited for it will result in a better decision. The more uncertain the outcome. 'What do I gain by doing so?' For a decision that needs to be made.OF SOUND MIND What Are You Waiting For? People delay difficult decisions for any number of good reasons.” says Cornell's Gilovich. In a study titled. As investment strategist and author Peter Bernstein once put it: “Once we act. That lack of confidence makes people less likely to choose the normative or intuitive option. is that people often treat such new information – which would have had no impact on the decision had it been available earlier – as instrumental to the decision after it has been pursued.” VII Value Investor Insight 19 . but rather with the need to determine their preference as a result of having to decide. 2011 along with the advisor's suggestion. Thomas Gilovich of Cornell University and Niels van de Ven of Holland's Tilburg University asked research subjects to imagine they had just received an inheritance and that a financial advisor had recommended investing it in a particular stock.” Potentially more problematic is dithering over selling decisions. “Delaying a choice that could have been made earlier can be seen as a cue that we aren’t confident of which alternative is best. patiently wait.
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