Complete Notes On Special Sit Class Joel Greenblatt

Special Situation Investing Classes at Columbia University Business School
These class notes and supplemental materials are written by an investor who audited Joel Greenblatts Special
Situation Class at Columbias Graduate Business Program rom !""! through !""#$ %ierent years may
have an overlap o material and concepts covered by the prior years notes but the repetition and supplemental
material may improve retention$ &ny errors' omissions or aulty premises are the noteta(ers ault and not
implied or committed by the spea(ers or persons presented$ Please use these notes as a spur to your own
eorts and thin(ing in how to become a more eective investor$ I hope this help$ Comments welcome at
aldridge)#*aol$com
Greenblatt Class #1
Sept. 07, 2005
A Story Selling Gum
My goal is to teach you the course that I never had and that I wish I had. I started in business school 25
years ago. What I know about investing other than reading financial statements I learned on m own
readin! and ma"in! mista"es. !o"efully I can give you the benefit of my e#"erience.
A number of years ago I was trying to e#"lain to my son what I did for a living. !e is $$ years old. I s"oke
about selling gum. %ason a boy in my son&s class sold gum each day at school. !e would buy a "ack of gum
for 25 cents and he would sell sticks of gum for 25 cents each. !e sells ' "acks a day 5 days a week () weeks
or about *'+++ a year. What if %ason offered to sell you half the business today, What would you "ay,
My son re"lied -Well he may only sell three "acks a day so he would make *(+++ a year. Would you "ay
*$5++ now, Why would I do that if I have to wait several years for the *$5++,
Would you "ay a *$, .es of course/ 0ut not *$5++. I would "ay *'5+ now to collect *$5++ over the ne#t
few years which would be fair. 1ow you understand what I do for a living I told my son.
I sit around trin! to #i!ure out what businesses are worth, and then I tr to pa a lot less #or them. I
think you get the "oint.
2he Skills I Will 2each .ou
I really don&t think the skills that I am going to teach you are very valuable. It is not that you can&t make a lot
of money from what I am going to teach you. 2here are fundamentally better things you can do with your
time. My view is that the social value of investing in the stock market as being similar to being good at
handica""ing horses. 2here is a benefit to having markets for raising ca"ital3 they 4ust really don&t need you.
I think what I am going to teach you this semester is really how to make money and so whatever social benefits
there are to society it is not very large. So if you do end u" following my advice and it works for you I would
ask that you find some way to give back. I am one iteration removed so what I am doing,
I truly wish that I had the chance to have this course to hel" out in some way.
5ivergence between 6rices and 7alues8
6rices fluctuate more than values9so therein lies o""ortunity.
Why are "rices of each com"any so variable and volatile com"ared to the value of com"anies,
If I take out the news"a"er and I "ick out any large ca" stock like IB+' Cisco' ,Bay' --% Google' why are
the "rices all over the "lace, :ook at the wide divergence between the 52 week high;low. !ere is a business
that hasn&t changed much but the "rice has gone from *(5 to *<+. *< to *(+ and right now to *2+. :ook at
&./ and I.T0$
=uestions8
$
2hese are all "retty good com"anies and this has been the least volatile "eriod in many years and there have
been $++> moves over one to two year "eriods9why the huge dis"arity,
Are markets efficient,
Why do M0As and other smart "eo"le not do well in money management,
6eo"le invest with their emotions. 2hey "rocess information differently.
5oes it make sense that these "rices fluctuate so much while the values of the underlying com"anies do not
move around in a short "eriod of time, 1Price diverges rom value2$
Joel Greenblatt (JG$% It is very clear9"ick any com"any you want??the "rice is very volatile over short
"eriods of time. It does not make sense to me that the values are nearly as volatile as the "rices and therein lies
what should be a great o""ortunity. All these com"anies which have fairly established businesses 1%isney'
Boeing' 3al4+art2 the values are not fluctuating nearly as widely as the "rices. 2here should be great
o""ortunity yet there are not many winners in the market.
2he reason why that is@@.in the final analysis@@why do the "rice fluctuate so widely when values can&t
"ossibly, I will tell you the answer I have come u" with8 2he answer is I don&t "now and I don&t care. We
could waste a lot of time about "sychology but it always ha""ens and it continues to ha""en.
I don&t know and I don&t care. I 'ust want to ta"e advanta!e o# it. We could sit there and figure it all out but
I li"e to "eep it simple. It ha""ens3 it continues to ha""en3 the o""ortunities are there. I don&t know why it
ha""ens and I don&t care9I 4ust want to take advantage of "rices away from value.
In this course I am !oin! to teach ou how to ta"e advanta!e o# that. I will make a guarantee now8 If you
do good valuation work and you are right Mr. Market will "ay you back. In the short term one to two years
the market is inefficient. 0ut in the long?term the market has to get it right9it will "ay you back in two to
three years. Aee" that in mind when you do your analysis. .ou don&t have to look at the ne#t Buarter the ne#t
si# months if you do good valuation work9and we will describe what that means9what the best metrics to
use Mr. Market will "ay you. In the lon!(term )r. )ar"et eventuall !ets it ri!ht* he is very rational.
2hat is very "owerful. 2hat is the conte#t in which you should think this semester.
2he big "icture8
2here are lots of smart guys on Wall Street yet most of them go out and basically fail for many reasons9they
are unable to contribute value. I have a firm Gotham Capital3 we have averaged '+> "er year for 2+ years.
*$+++ would now be *C())C(. 2here are lots of smarter "eo"le who can do better s"read sheets than I can3
there are lots of smarter analysts than me. I think the difference to how we have been able to do it is that we
thin" simpl and a little bit di##erentl.
2he conte+t in which we put our analsis9not that our analysis is any better than anybody
else&s. We are not e#"erts in any "articular industry we are not smarter than anybody else
and we are not doing better analysis. 2he fact that you are here means you can do the
analysis. It is the conte+t in which ou put that analsis that ma"es the di##erence to
ou.
Simpli#, place valuation into conte+t, practice.
2hat should be encouraging to you that you don&t have to be smart or have to do a million hours of work or
tricky analysis but you have to be good. .ou have to know what you know9.our Dircle of Dom"etence.
.ou don&t have to be the best in the world at figuring stuff out. It is the conte#t which I will teach you those
sim"le things and then we will do a lot of "racticing??"ractice of doing valuation while kee"ing the sim"le
conte#t in mind. Even I have to remind myself to remember what is im"ortant. .ou must be able to cut
2
through all the noise. 2he 3all Street Journal has more info in it in one day than the entire world had <++
years ago.
!ow to 0eat the Market
Many "eo"le don&t beat the market so name some ways that you can do it.
Focus on small ca"s where the markets are more inefficient. 2here is less analyst coverage so less information
flow. .ou have the chance to find "rices more above or below value. Small caps have more opportunit to
#ind mis(priced stoc"s.
Small Da"s8 Another secret when money managers learn their valuation work and focus on small ca"s they
make a lot of money and they graduate from small ca"s. For a guy starting out there is always an
opportunit to do ori!inal wor". 2here is turnover in the ranks.
Activist Investing8 JG won a "ro#y fight and eventually made money but it was not worth the "ain. !is first
and last foray into activist investing.
S"ecial situations8 A corollary to small ca" investing. .ou go where other "eo"le aren&t. A more inefficient
area of the market. 7alue investing with a catalyst.
Student% Su"erior knowledge in an industry. 0inda Greenblatt focuses in retail.
Doncentrate your investments.
,ow Gotham !enerated !reat returns%
Gotham Capital stayed small. We returned outside ca"ital so we could invest in as many situations as "ossible
Gnot constrained by siHeI. We are very concentrated. We invest in 5 to C securities. -now our companies
ver well. Why that is more safe than diversifying, .ou "ick your s"ots. So if your holding "eriod is three
to five years and you only have ' to ) securities then you only need one or two ideas a year. 2hat is why I
have time to teach this class. It is more fun and it works.
.h /alue Investin! .or"s
Jichard 6Hena8
56#"4!"") S01 500 /alue 2enchmar"% 3ow 145, 3ow 14Sales 6i##erence
7eturns $$> $).(> 5.(
566) 7 !"""
7eturns $)(> <$> ?K$>
1ote the :2 out"erformance of 7alue Metrics but the 5 year or more "eriods of under"er?formance. 7alue
Investing works because it doesn&t work all the time
7alue investing works but it tends to work in cycles. P8ena lost <+> of his investors. 1ow of the *$' billion
he manages he only has ' G%oel G. is one of themI of his original investors.
Joel G% I was down 5> in $KKC?$KKK but worried about a bubble breaking in $KKK Ga macro worryI but I
could find chea" com"anies9look how chea" 0rk.a got in $KKK. 2hey ke"t doing what they were doing. !e
was u" $(+> in 2+++. 2he markets came back.
Jead8 What Works on Wall Street by James P 9Shaughnessy. !e started a fund in $KK)?$KK< but he
under"erformed the market by 25> and after three years in business of under"erforming he sold his com"any
at the bottom of the cycle. 8he !u who wrote the boo" 9uit his sstem: It seems like it is easy to do but
it is not easy to do.
2his book What Works on Wall Street has born out its wisdom. 2he two funds that are "atented that fool his
strategy have been "henomenal. !FDGL is the "atented fund based on his to" idea of Dornerstone Growth3
(
over the last 5 years it has had an average return of $(.''> "er year vs. the 7anguard 5++Ms ?2.+$> "er year
G);$;++ through 5;($;+5I. !FD7L is the "atented fund based on his 2nd to best idea of Dornerstone 7alue3
over the last 5 years it has had an average return of ).'<> "er year vs. the 7anguard 5++Ms ?2.+$> "er year
G);$;++ through 5;($;+5I.
2he most interesting "oint is that the author "oints out those investors often are to emotionally involved to
have the disci"line to see the strategy through. ;ot onl did the #irst reviewer bash the boo" because he did
li"e the returns strate! one ear a#ter the boo" came out, but )r. <=Shau!hness sold the #unds to
,enness >unds at the end o# 1??? a#ter it #ailed to surpass the returns o# the bubble that soon a#ter
collapsed. Seven years after it was "ublished an investor would be much wealthier had they followed the
books to" strategy instead of the investors who dog?"iled onto the stocks of the marketMs bubble.
We are going to try to understand wh it wor"s. Why it has to work over time. 2hat is the only way you can
stick it out.
2he math never changes8 2 N 2 O '. 2hat is the level of your understanding I want you to have by the time we
are done. If I get that right forget all this other stuff and noise I will get my money. 1o genius reBuired.
Concepts will ma"e ou !reat.
2here is a lot of e#"erience involved in valuation work but it doesn&t take a genius or high I= "oints to know
the basic conce"ts. 2he basic conce"ts are what will make you the money in the long run. We are all ca"able
of doing the valuation work.
Pverview of the course.
!is book !ow .ou Dan 0e a Stock Market Genius was written for the general "ublic but he learned that it was
written more at an M0A level.
Brian Gains was one of our analysts at Gotham. !e will be one of the s"eakers in this class.
The :alue Investors Club;
Si# years ago we found one of our best investments that was trading at Q cash value and it had a very good
business attached. We found it because of the very com"licated ca"ital structure. We thought we were the
only ones to find it. We found another "erson on .ahoo.com who had analyHed the situation correctly. !ey
there is intelligent life out there. Get together these smart "eo"le and share ideas.
If you get AN in this class you could get in.
2his is the a""lication "rocedure. .ou have to know certain metrics that .ahoo members don&t know.
I am not vouching for any write?u" in "articular. Jead the reviews above 5.< with many reviewers. .ou can
search by rating or "erson. Rsually 5.5 and above is "retty good. .ou can look at e#am"le after e#am"le and
see what ha""ened years later. .ou see smart investors asking Buestions. 2here is a lot to choose from here.
It is a great learning tool. A great research archive to build an investment thesis. I can&t recommend this
highly enough. 5o not share your I5 for the 7ID with anyone. 2his is a great learning resource for you.
.ou can search by investor and see what makes for a good write?u". We have found a number of su"erior
investors. A sim"le and clear thesis.
Jeview
Stocks bounce around a lot.
+r$ +ar(et eventually figures it out over three years.
2he market closes the ga".
We seek a margin o saety.
'
7aluation8
What are the different 7aluation Methodologies,
6C>% 6iscounted Cash >low G"roblemsI you have to make "ro4ections. 2he terminal value can change
drastically due to small changes in assum"tions. What earnings does the "rice im"ly, What growth rate and
what discount rate am I using to get to that valuation three years from now, What would 4ustify that future
"rice, I sort of work backwards and throw in a bunch of numbers like growth rate. What is this "rice I am
e#"ecting it to be worth im"ly, I use it as a reality check to decide and see if my assum"tions can be 4ustified.
What it tends to do is force me to use conservative numbers.
!ow do you know if you are conservative,
What if you can&t figure this out9like growth rate or discount rate, 6ass on it. If it is hard for me to figure it
out I !o onto the ne+t one.
7elative value% look at similar businesses and what they are trading at. 6roblems8 the businesses are not really
similar. It might be tough to find a good com"arable. Everything might be overvalued in a sector so you are
com"aring one overvalued asset with another. Dom"arables might be over or under valued.
7eplicatin! value9I don&t usually do that. 2he communists made sBuare wheels because they cost the same
to make as round wheels.
2rea"(up value% A com"any has two divisions one is making *( and the other is losing *$ GE6S O *( ? *$ O
*2I. 2he stock trades at *(' so 6E O *(';*2 O $<# but if you close down the bad business it really trades at $$
times or *(';*(.
Where the stock has traded in the "ast is noise. What is it worth, Where is it today G6riceI.
@c9uisition value% .ou have a discount brokerage account with $+++++ accounts that acBuires Brown Cos
5++++ customers so they can "ay more that com"any due to 4ust adding customers to thei5r infrastructure.
2he acBuisition value might be much higher than the 5DF value.
I don&t like to see values "er subscriber or # hos"ital beds. I still want to see the cash flows translated from the
hos"ital beds. I don&t like to see relative value.
Summary8 7aluing a Dom"any
We have four ways to value a com"any8
$. 5DF or intrinsic value
2. Jelative value
(. 0reak?u" value and
'. AcBuisition value
0alance Sheets Income Statements and Dash Flow Statements
A com"any trades at *) "er share and it has *5 "er share in cash.
Durrent Assets8 GDAI First we look at DAS!. We have often found com"anies are trading at close to its cash
"er share. 2echnology stocks in 2++2. *5 "er share in cash and
.ou can value the *5 in the com"any&s "ocket but it is not in your "ocket. What will the com"any do with that
cash, !ow will they rede"loy the cash,
5
Will they dissi"ate the cash or use it wisely like returning it to shareholders, :ook at management and decide
if they are ca"ital destroyers. !ow is their bread buttered do they own a lot of stock or are they "aid mostly in
salaries.
:ook at where the business is9is it earning money is it earning * in other businesses, Is management doing
good things with the money, If management is doing good things I may "ut full value on that cash. Pr I
won&t take it at face value if the business is losing money. Make sure it is net cash.
2hey may need more working ca"ital so I may have to haircut the cash figure. I usually give a discount to the
cash on the balance sheet. Generally ca"italism works. Are these guys& losers. 6eo"le running a business are
generally more entre"reneurial. Are these guys treating it like their own money or somebody else&s money,
2here always nuances. If I am not sure I will "ut a very conservative value on the cash to take care of that
uncertainty. .ou may say you know what3 this *5 should only be worth *(. 5o I still want to buy the com"any
with what is left,
2hat *5 really is worth *(.++. Something as sim"le as cash on the balance sheet there are many iterations of
how do I look at cash, A lot of "eo"le 4ust look and acce"t the cash value but I analyHe it. I will value that *5
at *' or *(. Rsually this won&t kee" me from investing3 I will 4ust "ut a big discount on it Gthe cashI.
6robably when the com"any makes a big acBuisition that is the time to sell.
@ccounts 7eceivables%
What are the considerations there, 5oes the receivable number make sense, If A;J is rising Buickly then
they are "um"ing out sales and e#tending credit9that may be good it may be bad.
Inventories8
2here are ways to look at that.
Durrent Assets "re"aid assets.
WD8 Accounts 6ayable short term "ortion of long?term debt.
Assets8 66SE Jeal Estate Ghow much have those assets a""reciatedI.
Intangibles8 goodwill9the e#cess "aid for assets above the book value of those assets.
A little secret8 P"erating "rofit. Rsually I use a '+> ta# rate. 2he number I like to use is o"erating "rofit9a
"re?ta# number so com"arisons are easier.
5SA are not cash e#"enses. 1ow you don&t amortiHe goodwill unless you write it off.
E0I25A9don&t show this in your re"orts. .ou have to subtract out the maintenance ca"ital e#"enditures
GMDLI. 1ow if the com"any is growing and you want to figure out -normaliHed earnings.T Da"ital s"ending
is the number to use. Da"e# is a cash e#"ense but de"reciation is a book entry not cash.
:et us say you are o"ening $+ new stores in addition the $+ stores you already have the ca"e# would include
kee"ing u" the ten stores you already have making ca"e# on those stores and the cost of o"ening the ten G$+I
new stores but you won&t get the benefit of those new stores in that year. For normaliHed earnings what you
really want for normaliHed earnings is maintenance ca"e#. !ow is this number re"orted, Ask the
management. 0reak out growth vs. maint. Da"e#.
I ask for an e#"lanation for mc# and how do they get there. Rsually the com"any understates mc#. When
E0I25A 5A O ca"e# then E0I2 O E0I25A U Da"e#. A Buick and dirty when you use E0I2. I try to get at
E0I25A U maint. Da"e#.
5iscussion of maint. ca"e# vs. growth ca"e#.
2he Dable Industry is in a continual u"grade cycle.
:ook at E7;Sales E0I2;E7. E7;E0I2 is "re?ta# earnings yield.
)
Why you use Enter"rise 7alue GE7I,
C<)1@;A @
*$+ E0I2
'+> ta# rate
*) in 1et Income
6;E $+
*)+ million Market Da". or E7 O *)+
C<)1@;A 2
*$+ E0I2
?*5 Interest E#"ense
O*5 million in "re?ta# o"erating
*( mil. in int. e#"enses.
*$5 mil in market ca" N *5+ mil in debt O *)5 in E7
A is chea"er with a 6E of $+ while Dom"any 0 has a 6;E of 5. 2he "rice of the E7 is lower for A at *)+ vs.
*)5 for 0.
I look at E7 to sales not 6;S. 2he "oint of this e#ercise is that when you show me your com"arables and you
say the average 6;E??every analyst re"ort shows the industry ratios where they say the industry is trading at
$(# and this com"any is trading at $2# so it is chea"??it doesn&t take into account market ca"italiHations
differences in ta# rates and things of that nature. And looking at things through an E7;E0I2 basis does.
2o make a""les to a""les com"arison we will use E0I2;E7.
2he Im"ortance of JPID vs. JPE
5o I care about the JPE, I care about the return on ca"ital GJPIDI.
2he first thing I look at JPID O E0I2; G1WD N 1et EBui"mentI. !ow good a business is this,
6re?ta# return;1et 2angible Da"ital. What ca"ital the com"any needs to use to be in business??1WD N EBui"t.
1et Working Da"ital G1WDI8 Rse financial A;J and eliminate the e#cess cash. Subtract Accounts 6ayable
1I0 debt.
Why eliminate goodwill, 0ecause it states historical costs. It doesn&t matter what I "aid. .ou want to know
going forward what ty"e of business you are looking at.
E0I2;E7 Earnings yield. What "rice am I "aying relative to earnings,
Avoid value tra"s Glow return businessesI.
!otel Da"e#8
S"end *$+++ for a hotel. 2hen s"end *25 "er year for MDL but then in year 5 I need to refurbish the hotel
for *'++ to stay com"etitive. So I would add G*'++;5 or *C+ "er year to the *25 "er year and deduct *$+5 "er
year in true maint. ca"e#I.
*25 Da"e#
N*C+ Da"e#
O*$+5 Da"e#
*25 Da"e#
*C+ Da"e#
O*$+5
Da"e#
*25 Da"e#
*C+ Da"e#
O*$+5
Da"e#
*25 Da"e#
*C+ Da"e#
O*$+5
Da"e#
*25 Da"e#
*C+ Da"e#
O*$+5
Da"e#
*'++ in fifth year so a""ortion
*C+ mil. "er year over regular
MDL
Summar o# .hat Boel teaches
<
in the 3ittle 2oo" 8hat 2eats the )ar"et
.ou will learn8
!ow to view the stock market.
Why success eludes almost all individual and "rofessional investors.
!ow to find good com"anies at bargain "rices.
!ow you can beat the market all by yourself.
8he "e is to understand the simple concepts in this boo"
Most academics and "rofessionals can&t hel" you to beat the market. .PR must do it yoursel$
.ou have to believe that the story is true. Most "rofessional investors have learned wrong and very few
"eo"le believe or else there would be many more successful investors. 2hey aren&t.
Compare <ur investment alternatives
We want to com"are how much we can earn from a safe bet like a R.S. government bond with our other long?
term investment choices. We want to make sure we earn a lot more from our other investments than we could
earn without taking any risk.
2uin! a share in a business
0uying a share in a business means you are "urchasing a "ortion Gor "ercentage interestI of that business. .ou
are then entitled to a "ortion of that business&s future earnings.
We have to estimate what the business will earn in the future.
!ow confident are we in our "rediction,
1est year is only one year. What about all the years after that, Will earnings kee" growing every
year,
2he earnings from your share of the "rofits must give you more money than you would receive by
"lacing that same amount of money in a risk free $+?year R.S. government bond.
>i!urin! .hat @ 2usiness Is 7eall .orthC
Why do the "rices of all these businesses move around so much each year if the values of their businesses can&t
"ossibly change that much,
Why are "eo"le willing to buy and sell shares of most com"anies at wildly different "rices over very short
"eriods of time, I 4ust have to know that they do/
Who knows and who cares, Maybe "eo"le 4ust go nuts a lot.
Ben Graham figured out that always using the margin of safety "rinci"le when deciding to "urchase shares of a
business from a craHy "artner like Mr. Market was the secret to making safe and reliable investment "rofits.
/aluation
!ow are you su""osed to know what a business is worth, If you can&t "lace a fair value on a com"any then
you can&t divide that number by the number of shares that e#ist and you can&t figure out what the fair value of
a share of stock is.
In the "rocess of figuring out the value of a business all you do is make a bunch of guesses and estimates.
2hose estimates involve "redicting earnings for a business for many years into the future. Even e#"erts
Gwhatever that meansI have a tough time doing that.
C

3earnin! the Concepts
.ou must make a willing sus"ension of disbelief.
It is hard to "redict the future. If we can&t "redict the future earnings of a business then it is hard to "lace a
value on that business.
If you 4ust stick to buying good com"anies9ones that have a high return on ca"ital9and to buying those
com"anies only at bargain "rices9at "rices that give you a high earnings yield9you end u" systematically
buying many of the good com"anies that craHy Mr. Market has decided to literally give away.
0uying good businesses at bargain "rices is the secret to making money.
Graham&s Formula8
!is formula involved "urchasing com"anies whose stock "rices were so low that the "urchase "rice was
actually lower than the "roceeds that would be received from sim"ly shutting down the business and selling off
the com"any&s assets in a fire sale. !e called these stocks by various names8 bargain issues net?current?asset
stocks or stocks selling below liBuidation valueI.
Graham stated that it seems -ridiculously sim"le to say that if one could buy a grou" of 2+ or (+ com"anies
that were chea" enoughto meet the strict reBuirements of his formula without doing any further analysis the
-results should be Buite satisfactory.T In fact Graham used this formula with much success for over (+ years.
Graham showed that a sim"le system for finding obviously chea" stocks could lead to safe and consistently
good investment returns. Graham suggested that by buying a grou" of these bargain stocks investors could
safely earn a high return without worrying about a few bad "urchases and without doing com"licated analysis
of individual stocks.
Magic Formula Jesults
Pver the seventeen years owning a "ortfolio of a""ro#imately (+ stocks that had the best combination of a
high return on ca"italand a high earnings yield could have returned (+.C "ercent "er year. *$$+++ would have
turned into *$ million before ta#es and transaction costs.
2o make the Magic Formula Work8
It will be your belief in the overwhelming logic of the magic formula that will make the formula work for you
in the long run.
!ow the Formula Works8
2he formula looks for the best combination of those two factors out of a (5++ com"any database. Getting
e#cellent rankings in both categories Gthough not to" ranked in eitherI would be better under this ranking
system than being the to"?ranked in one category with only a "retty good ranking in the other.
1o SiHe Effect
2he Magic Formula Jesults for the to" largest $+++ com"anies8 22.K> vs. $2.'> for the SS6 5++ over $<
years. 2he formula works for com"anies large and small.
2he Magic Formula seems to work in order of 5eciles. 2here should always be "lenty of highly ranked stocks
to choose from
!ow does the Magic Formula fare vs. the market,
K
2he formula fared "oorly 5 out of every $2 months tested. Annually the formula failed to beat the market once
every four years.
If the magic formula worked all the time everyone would use it. If everyone used it it would "robably sto"
working. 2he formula doesn&t work all the time.
For the magic formula to work for you you must believe that it will work and maintain a long?term investment
horiHon.
2imeless 6rinci"les
In order for the magic formula to make us money in the long run the "rinci"les behind itr must a""ear not only
sensible and logical but timeless. Ptherwise there is no way we will be able to -hang onT when our short?term
results turn against us.
We are buying on average above?average com"anies that we can on average buy at below?average "rices.
2he o""ortunity to invest "rofits at high rates of return is very valuable because it can contribute to a very high
rate of earnings growth/
2o earn a high return on ca"ital even for one year it&s likely that at least tem"orarily there&s something s"ecial
about that com"any&s business. Ptherwise com"etition would already have driven down returns on ca"ital to
lower levels.
In short com"anies that achieve a high return on ca"ital are likely to have a s"ecial advantage of some kind.
2hat s"ecial advantage kee"s com"etitors from destroying the ability to earn above?average "rofits.
So by eliminating com"anies that earn ordinary or "oor JPD the magic formula starts with a grou" of
com"anies that have a high JPD.
2hen the mf will buy only those com"anies that earn a lot com"ared to what we are "aying.
Why the mf works,
A good track record only hel"s once you understand why the track record is so good.
2he mf beat the market averages K5> of the time G$)+ out of $)K three?year "eriods testedI/ 2he worst return
was a gain of $$> vs. a loss of ')> for the market averages.
2here are two things you want to know about an investment strategy8
What is the risk of losing money following that strategy over the long term,
What is the risk that your chosen strategy will "erform worse than alternative strategies over the long term,
If an investment strategy truly makes sense the longer your time horiHon you maintain the better your chances
for success. 2ime horiHons of 5 $$+ or 2+ years are ideal.
Pver the long run Mr. Market gets it right.
I guarantee that if you do a good 4ob valuing a com"any Mr. Market will eventually agree with them. 2wo or
three years is usually all the time they&ll have to wait for Mr. Market. 2o reward their bargain "urchases with a
fair "rice. Pver time facts and reality take over. Smart investors search for bargains com"anies buy back
their own shares and the takeover or "ossibility of a takeover of an entire com"any9work together to move
share "rices toward fair value.
Dhoosing Dom"anies on .our Pwn
$+
Dhoosing individual stocks without any idea of what you&re looking for is like running through a dynamite
factory with a burning match. .ou may live but you are still an idiot.
2he mf looks at last year&s earnings. 0ut the value of a com"any comes from how much money it will earn for
us in the future not from what ha""ened in the "ast.
Ideally we should be "lugging in estimates for earnings in a normal year.
<I you too( our top iteen decisions out' we=d have a pretty average record$ It wasn=t hyperactivity' but a hell
o a lot o patience$ >ou stuc( to your principles and when opportunities came along' you pounced on them
with vigor$<
4 Dharlie Munger 7ice Dhairman 0erkshire !athaway
??
Greenblatt Class #2

Se"t. $' 2++5
Some definitions of Free Dash Flow O E0I2 U Maintenance Da"ital E#"enditures GMDLI U annual changes in
working ca"ital. Dhanges in annual working ca"ital GWDI are due to working ca"ital changes needed for
growth.
I can&t em"hasiHe enough my recommendation to study the :alue Investors Club because ou can obtain
more e+perience and learn #rom other&s mista"es.
Dlasses Pct. 5
th
S $2
th
rescheduled for Friday Pct. <
th
and $'
th
from K am to $2 "m U?IS ?oom @A!6 for a
make u" class. 1o class Pct. $K
th
.
I downloaded all the 0uffett :etters from 0erkshire&s Web?site and then used Google 5eskto" to search
through for any to"ic.
Assignment8
I left you with the magic formula last week. 1e#t Week ?ichard P8ena will talk about G0ear CorporationI and
read Baugen book9focus on the conce"ts. 6re"are 0ear Corp.
An u"dated chart from last week&s class. Dycles of 7alue Investing Aug. 2++5
Aug. K5 to Feb. 2+++8 a very tough time for value investors3 you remember the Internet "hase. Even if you had
a great com"any with e#cellent "ros"ects the market didn&t "ay for it. SS6 5++ u" $)(> cumulatively vs. u"
K$> for 7alue Investors9<2> under"erformance. If you are running a fund and you beat the value inde# the
lowest 2+> in 07 you would have under"erformed by <+> to )+> over five years. If that ha""ens "eo"le
leave. Even ?ichard P8ena' whose firm runs *5+ billion dollars in March 2+++ most of his investors had left.
!is "erformance since that time has been so "henomenal.
From March of 2+++ until today value has out"erformed the SS6 5++ by $<5> and P8ena did much better
than that. 6eo"le left at the wrong time as usual. If you stick to your guns and your clients don&t you can
understand the "ressures on a manager, .ou are looking at a chart through four years and say you will stick it
out through the value cycle but that is an awfully long time and many don&t survive. Some value managers
cheated with a value tilt to the SS6 and they got clobbered. 2hey were cheating to hang in there. Even
surviving long term with this sim"le value model is tough.
2his may seem like a minor "oint but this is the whole story. Jeally what I am alwas doin! is valuin! the
compan when I can.
$$
What ha""ens if it is very difficult to value a com"any, 6o somethin! else. 2hat is a very "owerful conce"t
if you have the lu#ury of looking at something else.
2he guarantee I made last week is that if your valuation is right it will usually only take +r$ +ar(et two or
three years at most9sometimes a lot faster??to get it right. 6o !ood valuation wor".
2hey way I define value is not low "rice to book or 6;E but intrinsic value. .ou can see "rice;book has gotten
a little less robust over time from out "erforming at )> to (.$> DAGJ.
We are talking about the dis"arity in "erformance.
2he lesser im"ortance of assets with service businesses as in the "ast industrial "eriod9"erha"s a reason wh
boo" value losin! its importance.
I analyHe each com"any from the bottom u". I am very value driven
I don&t "redict under or out "erformance of the value cycle.
)@GIC ><7)D3@S
$. .,@8 A<D 1@A% -1ormaliHedT E0I2;Enter"rise 7alue GWhat I "ay or "re?ta# earnings yieldI.
.ou would value E0I2 higher if ta# revenues are lower due to a "ermanent ta# change. 2ake the
after?ta# yield and see what the differences are. Is E0I2 re"resentative of true cash flow. E0I2 is a
short hand for E0I25A U Maint. Da"e#. 5ifferent ca"italiHation can skew net income. 5ifferences in
ta# rates. Rsing E0I2 is a way to com"are a""les to a""les.
2. .,@8 A<D 5@7;% E0I2;G1WD N 1FAI the denominator shows what I need to invest in the
business to get that E0I2. 5on&t forget to normaliHe investment ca"ital over the course of a year.
What I earn.
I told you about my -magicT formula as my starting "oint for looking at com"anies.
JG: .ou bring u" a very im"ortant "oint. 2hese are totally two different things.
2his is how much I earn based on what I "aid for it GE0I2;E7I.
2his is what I earn based on what the com"any "aid for the assets that created those earnings GE0I2;ID or
G1WD N 1FAI. 2hose are two totally se"arate conce"ts.
Jeturn on the ca"ital they made on the "ast. So what, Incremental dollars will make good returns but not as
high as they made in the "ast. I may earn )+> JPID on the new store versus <+> "reviously in the old store
but there are no other "laces to earn as high a return so I will still build that store. 0ut if my "reta# returns are
between $5> and 2+> it doesn&t take too much to ti" the balance.
Rse normaliHed E0I2. :ook at the normal environment. 8his is the art part. What I think a normal
environment might be. 2here is nothing s"ecial going on in regards to the com"any or the economy.
Pbviously it is an assessment now we are into the art "art of determining -normaliHedT.
!ere is normaliHed E0I2 over ca"ital invested in the business. 2his is my best guestimate of what ty"e of
business do I have,
When I ran a defense business I had a lot of contact with investment bankers who were "itching acBuisitions.
2hey would say -Well you can add 2+ cents to earnings and make a non?dilutive acBuisition by acBuiring a
business at K # E0I2 earning $$> "re?ta# and that is about flat in growth while borrowing K.5> "artly fi#ed
and "artly variable. 2he s"read is $.5>. Is this worth it for a cra""y business, 1o.
$2
8he slapped on the same multiple we had be#ore even thou!h we would be a lot more levered. 2he
investment bankers had a '++ "age re"ort with a nice cover on it but when you get down to it this is the bet
you are taking. It looks like a bad bet.
0oil the analysis all down to its essence9is it a !ood business at a !ood priceC Is the bet worth it,
5on&t throw out logic. Ask one sim"le Buestion. !ow much do I have to "ay, !ow much am I earning,
If you have to continually make acBuisitions to grow then it is a different animal.
Capital Intensity ,Cample Compan @ Compan
Current @ssets ( (
>i+ed @ssets 2 <
Goodwill 5 +
Current 3iabilities $ $
2oo" /alue *K *K
5arnin!s E2.00 per share in cash
7eturn on 8an!ible Capital 5+> 22>
.ou are earning 5+> on tangible ca"ital G*2;*'I unless you have to add acBuisitions to get future growth. All
you have to re"lace is fi#ed assets. .our ca"ital s"ending will be confined to re"lacing fi#ed assets. .ou don&t
have to kee" re"lacing Goodwill. Goodwill is a "ast cost. 1See 3arren Buetts writing in the 56DA &nnual
?eport o Ber(shire Bathaway on amorti8ation and intangible assets2$
2his took me a long time to learn but if I had read 0uffett&s letter in $KC( then I would have learned this
sooner.
Forget how the com"any got there. If the com"any made bad acBuisitions so debt is in the E7. Goodwill is a
sunk cost in "ast acBuisitions. If management is a serial acBuirer that makes bad acBuisitions then the future
earnings won&t be what they say it will be. Ad4ust.
I care about what I have to "ay today to generate returns today and in the future. E0I2;E7 takes into account
for what I "aid for it.
If they have land where their factory could be moved and the land used for a higher and better use don&t 4ust
take the value of the land without considering the cost of moving the factory. 5o the difference between the
industrial land and the value of the land.
Why are we taking 1et Fi#ed Assets G1FAI, It is not always right. Say we buy a hotel for *$+ and it is going
to last $+ years and we write it down over 5 years and now it is at *5. 0ut if this goes down to Hero I might
half to invest another *$+. 2his would give me G*5I a skewed return Gbeing too highI because of not
considering re"lacement and reinvestment into the fi#ed assets.
Say you have $++ hotels and they are all on different cycles then on average you will be correct in using 1FA.
$+> of your hotels will be refurbished each year over a $+ year normal cycle. 2hat is my Buick and dirty for
an ongoing business.
5o I have to ad4ust any numbers based on the uniBue circumstances of the business. 0eware of overstating
returns on ca"ital.
Boo(e author of Security Analysis said that you don&t control the com"any so you take the ca"italiHation as is
so use 6;E. It is the hand you drew. JG; I strongly disagree with this9reasonable minds differ9because I
have been doing this a long time and E7 to E0I2 works better than 6;E because if management doesn&t
o"timally use o"timal ca"italiHation then someone will come in and do it for you. Rsing 5/452I8 is the way
to go.
AcBuisition value is not the same as 6;E multi"le.
$(
If there are big bli"s in ca"e# then there will be a hybrid between gross and net.
-Joll?u"s mean lose money.T
.ou s"ent the money on the stores but you don&t receive the E0I2 yet so you must normaliHe the number for
E0I2.
Good 1rice Good 2usiness
E0I2;E7 E0I2;G1WD N 1FAI
If you are earning 5+> to )+> vs. $5> to 2+> then we are looking at two different animals. 2hen what are
their growth "ros"ects what is there growth rate bargain "rice good business,
2+> "reta# O $2> after ta#. 2he average for business is $2>.
I don&t make money because I am really smart I make money because I have a big "icture in mind for what I
am looking to do. 2he big "icture in mind9is the difference between 5+> to )+> vs. $5> to 2+>.
Capital Cost% <pportunit cost #or m capital
!ow JG com"ares investments.
For a *$ of earnings "er share after ta# what 6;E for a non?leveraged com"any,
1ow I have alternatives for my money the risk?free return is the $+?year bond is less than )> I use )>.
1ever lower than )> even if the rates are '.5>. .ou know 0uffett confirmed that when rates are below )> I
use )>.
1ow if the $+ year bonds are <> then I use <> as my bogie.
*$ at a $).)) "rice earnings ratio is eBuivalent to )> yield Grisk free rateI. If my *$ is going to grow to *$.'+
E6s in two years then I "refer growth vs. a static )>.
!ow do you 4ustify 2+# or 5> yield on *$, If it is growing and I am confident of that growth.
$+> "re?ta# O $+> # G$? '+> ta# rateI O )> after?ta#.
Dom"are the o""ortunities here versus my other choices. I com"are a growing 5> yield to a )> risk?free rate.
When I get the money it is after?ta# from the com"any com"ared to the after ta# stream from the bond.
E0I2;E7 "ortion. 2hen I look at the JPID "ortion.
2wo businesses8
Jasons Gum Store8 *'+++++ to build and *2+++++ in o"erating "rofit so 5+> JPID.
Jimbos Just Broccoli8 *'+++++ earnings *$++++ O 2.5> JPID. 0ut com"ared to the )> government bond
yield %imbo is actually losing G2.5> ? )>I (.5> a year. 2his is craHy unless he thinks the "rofits will grow
tremendously. 2hough it seems he is making a little bit of money G2.5>I he is actually throwing money away
G?(.5>I.
2his is how I evaluate each business9what are they doing. I won&t "ay for a value destroyer. Stay out of
7alue 2ra"s of 4ust buying low 6;E stocks. WE0 calls them -cigar butts.T
??
I want to look at two things8
$'
Am I getting a !ood return based on what I am pain! and what are the incremental returns 1+?9IC2 on
ca"ital, What kind of ca"ital do I have to "ut in to earn that ty"e of return,
What am I "aying and is this a good business, I want to stay out of the value traps. I am really looking at
normaliHed E0I2 three or four years out vs. last year&s E0I2.
!ow much of the money that I earn can I reinvest at the same rate. 2he incremental return on ca"ital will affect
my growth rate. It will affect how much my dollar will grow over time then it will what normaliHed growth
rates and earnings will be.
Generally the way I solve any issues like that are@I look for what things in three years will be worth *5+ and
I "ay *25 for them. If it is *'5 or *55 I don&t care3 I am not smart enough to fine tune it over time. I am
"icking my s"ots. 2here are not that many com"anies are trading at that discount. It is *(C going to *5C in
three years92'> "er year. 5e"ending u"on how confident I am in that return that may be a great rate of
return. Some times I need a higher rate of return de"ending u"on my confidence. I may take a $5> to 2+>
rate of return des"ite I like to make more than that. If I am wrong how much can I lose, If I have a lot of
room to be wrong and still not lose money. 2he risk is low.
If the cost of hanging in there is dead money for three years and the *25 goes to *(+ or wherever I get an PA
return. Generally if I am good and I get ' out of ) right or how many I get. I look out three years. I take my
best shot3 I look for a wide dis"arity. I always looking for a catalyst or the market will realiHe what I see.
What will make "eo"le see what I see,
2his is a s"ecial situations class so I would love to have a catalyst on everything I do. Eventually in three
years or more you don&t even need a catalyst. 2here are a lot of things that can ha""en. 8he e##icient mar"et
people are ri!ht but onl lon! term. 0ut eventually the facts come out. Whatever "eo"le were uncertain
about now over the ne#t two or three years they find the answer to. 2here are a lot of "eo"le out there trying
to figure out what something is worth.
So I thin" the #law with the e##icient mar"et theor is that it o#ten ta"es a lot more time. 2here is often a
lot of emotion in the short term and there is much more uncertainty involved and "eo"le take the discounts for
uncertainty but there is more o""ortunity if you have a longer term horiHon. In the short term I don&t think a
stock can trade at *2+ and *(5 and nothing ha""ens and they both can&t be right. 2he economy doesn&t
change that much. In the short term, the mar"et ma not be e##icient, but in the lon! term the mar"et
eventuall !ets it ri!ht.
Pther times a com"any may buy back stock if they think it is chea". 2hese little "ieces of "a"er re"resent the
whole com"any. Eventually all those things work together to get the right "rice.
We will talk about %u E Phelps. I learned from that.
0reak@@@
1See case study material on %u E Phelps beore reading this section2
ELEJDISE8 %u E Phelps@.0uy hold or sell, Students reviewed the annual report o %u E Phelps
without loo(ing at the subseFuent price$
2he best section is to look at the front section where they summariHed five years of financial and o"erating
history.
2his is a great business it is growing and it reBuires low ca"ital intensity. Every dollar they make is s"ent to
buy back shares.
.ou want to see how the management&s bread buttered. !ow much of their salary vs. share ownershi", If they
are giving themselves egregious o"tion "ackages then I will take that into account.
$5
Income grew but total assets did not grow. 2heir incremental return on ca"ital is infinite. 2hey can grow
without reinvesting their ca"ital.
5id anyone attem"t to value this,
%u E Phelps was s"un off at *<.
E0I25A is ($.25 and E0I2 is *2C.C.
E0I25A of *($.25 minus ca"e# of *2.5 O *2K.5(5
E7;GEbitda U ca"e#I.
2here are negative working ca"ital businesses like +ac%onalds$
Anyone see a "roblem with using a normaliHed earnings, :ook at the fast growth rate of earnings. 5o you
think that is sustainable,
I took a normal growth rate over five years.
2hree different E0I2 growth rates8 C> $(> 2+>. I chose a conservative C> growth rate.
E0I2 of *'(.<2 # .) for ta#es O *2).2( # $( 6;E O *('$. I shrank the number of shares due to the buy backs
down to (.5 million outstanding shares. I assumed that they were buying back shares with the shares
increasing in "rice by C> a year. 5on&t forget to make assum"tions about what they would do with their
e#cess cash.
*('$;(.5 O about *K5 to *$++ "er share.
So at *52 today at C> the stock "rice was *KK3 at $(> the "rice was *$22 and at 2+> the "rice was *$)'. If I
go out five years e#"ecting to earn 2+> "er year how could I earn the return sooner, 2ime com"ressed,
!ow could I make 5+> in a year, 2he market figures it out sooner. I make <)> if "ension funds wake u"
and discount the earnings at K>.
%u E Phelps was a small ca" stock with low liBuidity.
I am alwas loo"in! at value and where it is now.
2his s"in off was a good learning tool for 1Joels interest and wor( to analy8e and invest in2 +oodys$

%u E Phelps was taken over by /itch at *$++.
Dom"are the multi"le to the bond rate. I will take a 5> earnings yield with a great business and with growth
vs. )> bond yield that is flat.
=uality of Earnings E#am"le8 Commodore$ Work in 6rocess Inventory GWI6I growing faster than Sales.
Sunbeam Article in 0arron&s. Chain Saw &l stuffed the channels with inventory. Another trick is to write
down inventory to +. 'K+ million to *+. If there are any sales in future "eriods then sales will be inflated and
there will be e#tra "rofits.
*K2 million in 66SE removes 5SA so earnings are overstated.
5ro" in allowance for doubtful accounts is less conservative accounting. Sunbeam still lost money after all
these ad4ustments.
Perelman took stock at *'+ but the com"any was worth *< "er share.
5ach mista"e leads to better insi!hts and subtleties.
((
$)
Greenblatt Class #F
1resentation b )r. 7ichard 1Gena
Se"t. 2$ 2++)
2hree ob4ectives8
G$I I want to talk about value investing in general8 why does it works what are the characteristics that might
make you believe there is value and what makes them Gthe stocks or the com"aniesI chea".
G2I !ow do you actually analyHe a business, First generically9what makes a good business, I will s"end a
little bit of time talking about the difference between a good business vs. a bad business.
G(I 2hen I will use an e#am"le 0ear Corp as something that might be a value investment. We will try to
understand whether it is or is not a value investment.
Feel free to interru"t with Buestions any time.
$. 3et me start with value investin!.
I assume you have all read the same things the academic studies on value investing 2hey all say basically the
same thing that if you do invest and you are sensitive to the "rice you "ay relative to some metric of value like
book value sales earnings cash?flow you tend to naively do well. /ama E /rench studies show "rice
relative to book value metrics out"erforming an inde# as long as they have a "retty long "eriod to work with.
2hose studies are re"eated over and over again. In fact I don&t believe you can find a single 2+?year "eriod of
buying the lowest deciles 6;E 6;S or 6;0ook stocks where you wouldn&t do better than buying an inde#. 2here
are none. 0ut over the long term it is a strategy that works. I don&t have to use book value the same thing
works with sales cash flow and earnings??any tangible metric of the siHe of the business. If you buy a stock at
a low "rice relative to that metric you out"erform the market. .ote the large out4perormance o the value
metrics' however there are periods o underperormance 1shaded areas2$
Value Invest. Metrics Source8 What Works on Wall Street (
rd
Edition G2++5I by %ames 6. PMShaughnessy
Price/Earnings 1952-59 1960s 1970s 1980s 1990s 2000-2003
ALL Stocks 19.22% 11.09% 8.53% 15.85% 14.75% 5.91%
50 High P/E Stocks 19.27% 10.96% 2.26% 7.99% 16.99% -14.73%
50 Low P/E Stocks 21.84% 13.96% 8.89% 7.56% 13.58% 33.55%
Di!"!#c! 2.57% 3.00% 6.63% -0.43% -2.85% 48.28%
Price/B! Value
50 High P/$ Stocks 22.32% 13.13% 0.82% 1.97% 18.03% -31.17%
50 Low P/$ Stocks 18.86% 11.49% 17.06% 13.15% 15.83% 25.68%
Di!"!#c! -3.46% -1.64% 16.24% 11.18% -2.20% 56.85%
Price/"as# $l%
50 High P/%& Stocks 19.30% 8.02% -3.03% 8.77% 12.77% -27.77%
50 Low P/%& Stocks 18.71% 15.41% 13.57% 12.53% 12.86% 21.23%
Di!"!#c! -0.59% 7.39% 16.60% 3.76% 0.09% 49.00%
Price/&ales
50 High P/S Stocks 14.96% 11.99% 5.82% -2.02% -2.46% -42.37%
50 Low P/S Stocks 20.85% 11.15% 14.80% 20.43% 13.80% 19.94%
Di!"!#c! 5.89% -0.84% 8.98% 22.45% 16.26% 62.31%
$<
So wh doesn&t everone 'ust do it, i# it is so simpleC 2hat is the dilemma for me. Even recently where you
could study this data for decades. In the late nineties you had the rare ten?year "eriod that showed that value
investing didn&t work. We were in a -new worldT. 1ow we are in another -mini?newT world thesis where we
will be "er"etually short of industrial commodities and energy and those "rices will stay high forever. Almost
certainly that will end the same way Gbadly with "rice declinesI. .ou never know when but this is what
ha""ens in the world. 6eo"le love things3 "eo"le hate things.
1ow if I were today to look at stocks that were the chea"est on the basis of "rice to book value you would
"robably get a list that not one of you in this room would want to invest in. It would be the airlines the auto
manufacturers and the insurance com"anies insured against hurricane losses. It would be a list of com"anies
that you would look at and "ass on.
2hat is why "sychotics make better investors GInside %oke. Joel Greenblatt "laced a 1. 2imes article on the
board which had the headline V6sycho"aths make better investors.T before introducing +r$ ?ichard P8enaI.
0ecause normal "eo"le look at this and read the news"a"er and say that is craHy. So value investing continues
to work.
What really is the mechanism that is going on that creates the o""ortunity in value, I want to lay out some
data for you that demonstrate what goes on and what lies behind the efficacy of this strategy.
Pn this a#is I will measure time and the other a#is will be JPE. If I divide the SS6 today into five Buintiles
based on JPE where the highest ones are in the to" left hand corner dro""ing down in each Buintile.
If I could trace out over time what would I see, 2he com"anies with the highest "rofitability decline while the
lowest rise??convergence to a mean. .ou would find that Gthe mean reversion "rocessI in any market ca" any
market in the world any geogra"hic. Any time "eriod you use it always looks like this.
I do not think it is very sur"rising. If you have a com"any in the left?hand corner u" here making lots and lots
of money Ghigh JPEI then com"etitors want to enter that business to make those "rofits as well. So they try
and over time they drive down returns.
Someone has a uniBue retail conce"t like 3al4+art 25 years ago or you e#ecute it better than everybody else
then as you grow you start with the best locations and then you "lace new stores into less attractive locations.
.ou don&t know when to sto" building 3al4+arts until the JPE begins to decline. 2here is no formula as to
how many to build.
Pn the o""osite side what do you think these "eo"le are doing, 2hey are not 4um"ing off bridges3 they are
trying to fi# things. 2he low "rofitability G:ow JPE9lower left corner of gra"hI could be caused by over?
ca"acity in an industry so they take out ca"acity. 2he cost structure is too high they change the cost structure3
the sales force orientation is not working so they change the sales force orientation3 the "roduct "ortfolio may
not be working so they change the "roduct "ortfolio. Everybody not in the u""er left Buadrant Ghigh JPEI is
trying to get there and everyone down in the lower left Buadrant G:ow JPEI is trying to move u" there. Most
of them succeed.
$C
8ime% Donvergence to the
mean
!igh
to
low
7<5
A Growth Investor seeks
to "redict the continuation
of a !igh JPE Dom"any.
A bet against natural
$+> to $2 avg. JPE
8ime
What is interesting is that this data is not ad4usted for survivorshi" bias. 2his is including the ones that go out
of business. Pn average com"anies do not go out of business. Pn average "oor com"anies do better and on
average great com"anies that are doing wonderfully donMt do as well. 8hat is wh value investin! wor"s
because the mar"ets e+trapolate the same trends o# hi!h 7<5 companies continuin! with the same or
hi!her 7<5 while low 7<5 companies have lower to same trends e+trapolated into the #uture. 1eople
'ust don=t !et it Hreversion to the mean$ despite man ears o# evidence.
2he "eo"le who are buying high growth com"anies are trying to "ick the high growth com"anies that will not
revert to the mean. Some will be great growth or high Buality franchise?kind of investors but you are betting
against the odds when you do that. 6eo"le investing with the low JPE com"anies with low e#"ectations
should be able to out"erform the market.
From 2he 1ew Finance8 2he Dase Against the Efficient Markets 2
nd
Edition by Jobert A !augen VInvestors
tend to mistakenly "ro4ect a continuation of abnormal "rofit levels for long "eriods into the future. 0ecause of
this successful firms become overvalued. Rnsuccessful becomes undervalued. 2hen as the "rocess of
com"etitive entry and e#it drives "erformance to the mean faster than e#"ected investors in the formerly
e#"ensive stocks become disa""ointed with re"orted earnings and investors in the formerly chea" stocks are
"leasantly sur"rised.V 6age 2$.
All you have to do to better than mediocre is to say that you can make some 4udgment to eliminate the ones
which will go out of business. It is 4ust easier because you donMt do anything3 4ust "lay the odds by buying low
6;E or 6rice to 0ook. And I will not do any research and over time history shows me that I will win. 2hen you
can try to be more creative by doing better than that which is what we all s"end our time trying to do.
2he academic rational is very very clear for value investing. It is also clear for other ty"es of investing like
momentum investing where "rice trends tend to "ersist. 2here is evidence which suggests businesses doing
well kee" doing well. 2his short?term data contradicts the other long?term data. 6eo"le who are momentum
investors will be sitting on the edge of their chair trying to figure that out when to get out. I think that is hard
or harder but it is valid method backed u" by academic data. 2here is not a whole lot of academic data as you
would see going through the Baugen book.
We are doing the o""osite by buying com"anies having "roblems. 2here is another book What Works on Wall
Street by Shaughnessy which is a com"osite of trying any "ossible financial statistics and seeing if it worked.
2hings like buying high growth com"anies but it didnMt have "rice in the variable. I would buy a great
com"any with great management good growth rate and dominant market "osition and all of these
characteristics that everyone wants in their "ortfolio. It is the one thing where there is no academic evidence
that it works.
2he "remise we use is of dee" value investing because in the end all of these academic studies are using the
chea"est Buintile or the chea"est deciles of their universe. 2hey are not using what the inde# is using. If you
are familiar with the inde#es that institutions use to evaluate money managers the ?ussell :alue IndeC and the
?ussell Growth IndeC which takes the $+++ largest com"anies and breaks them into8 are they either value or are
they growth and "uts eBual market ca"s in both. And these consultants conclude that over time that they both
do the same so a smart strategy is to have your "ortfolio diversified into value and growth. 2his is the "remise
of the advice given by lots of consulting firms to institutions. Pne will work while the other doesnMt.
Pf course the ?ussell :alue IndeC is not a value inde#. It is not a value inde# in the academic sense. It is 4ust a
bunch of stocks that have some characteristics of value but you are not ca"turing dee" value or the academic
version of value. I am trying to distinguish here between a value a""roach that can buy com"anies that are low
JPE com"anies and acce"t that they are not "robably going to stay there Gmove to higher or im"roving JPEI
and ignore the high JPE com"anies.
When I make a "resentation to value investors or when I receive a call from my investors the single most
common Buestion from them is8 V5onMt you read the "a"ers,V 0ecause if you did then how could you be
buying@..didnMt you see that their earnings were terrible or they 4ust lost a big account or their customers are
bankru"t and on and on and on@..
$K
2hat is why these things are chea". 2hey are chea" for a reason. 2he "oint that I am making is that you never
never find things that are chea" for no reason. I ho"e to find one some day but it doesnMt ha""en. .ou have to
acce"t that you donMt get the best businesses with great management teams with high margins with great
growth rates and high market share selling at low "rices. .ou donMt get those. 0ut good businesses can sell for
low "rices generally when one or more of those things listed above are missing. When there is some blood on
the table.
A basis for contrarian investing8 2here is some evidence that suggests that markets do overreact to both good
and bad news es"ecially in the long term and that stocks that have done e#ce"tionally well or badly in a
"eriod tend to reverse course in the following "eriod but only if the "eriod is defined in terms of years rather
then weeks or months GSource 5e0ondt S 2halerI.
2. 2usinesses in General
:et us talk about businesses in general.
Student% What time horiHon are you s"eaking about regarding the JPE change and decline
for high JPE Dom"anies,
7ichard 1Gena H71$% About five years. Pn average their economics deteriorate while the low JPE
com"anies im"rove.
If you can combine a com"any that has a low valuation and should have a sustainable edge but may in the
"resent may not be e#"eriencing it for some??and it may be tem"orary??reason then you have this
unbelievably "owerful combination. I# ou can bu a !ood business at a low price, then ou have nirvana.
Dharacteristics of good businesses
!igh 0arriers to Entry
!igh Margins
Good management
6ricing 6ower
:ow ca"ital intensity??71% but doesn&t a com"any with low ca" intensity have low barriers to entry, GSees
Candy is a counter e#am"leI. I think ca"ital is a barrier. Would you "ursue com"eting against Boeing with
enough ca"ital and find a good "erson to do that, Is there a barrier to entry, Dlearly if no ca"ital is reBuired
then there is easier entry.
Why is it that Boeing over time "roduces good "rofit margins but Sprint or :eri8on 3ireless doesnMt??they are
both eBually ca"ital intensive, Answer8 !igh switching costs. Doncentration of the market"lace??wouldnMt
you say an industry with two "layers vs. eight "layers has a higher chance for rational behavior, 1Boeing and
&irbus ma(e up the two maGor air plane manuacturers in the world' so the structure o the mar(et is an
oligopoly with more rational pricing and high barriers to entry2$
Will GetBlue sustain its high "rofit margins, Would you want to bet that, 5oes GetBlue have a sustainable
com"etitive advantage for the long term, What is that, 0etter Buality of service. !ow do you account for the
fact that the GAirlineI industry has been unbelievably un"rofitable its entire life, :ast cycle South3est &irlines
1S3&2 was the JetBlue. 1ow S3& is history. !ow does JetBlue all of a sudden a""ear, And if JetBlue can
a""ear all of a sudden why would you be confident that another JetBlue doesnMt all of a sudden a""ear, G2he
Airline Industry has easy entry with no incumbent com"etitive advantagesI.
JetBlue has a no barriers to entry model. 2here may someday be barriers to entry unless there is a slot
restricted ty"e of markets. JetBlue could go to an air"lane leasing com"any so ca"ital was not a barrier. An
air"lane holds its value. If lease financing was not available and air"lane values were highly erratic then you
might have a different outcome.
2+
If one guy is standing out better than everyone else I would be nervous. GetBlue "robably has a good business
model given the industry. Dlearly the history suggests the industry is a bad business.
What are some barriers to entry,
!igh switching costs
!igh ca"ital costs
0rands
:ower o"erating costs Gairline with $ low cost fleet by o"erating in a certain way locks you inI
2obacco with its addicted customers
/alue investin! wor"s because it doesn=t alwas wor". %ust naively using value metrics would allow you to
out"erform the benchmarks.
0arriers to Entry
6atented technology
Government regulations 1o advertising in chewing tobacco so S-90 has an advantage
0rands
Dustomer ca"tivity and Economies of Scale8 An Airline with same models allows it to o"erate chea"er
than com"etitors which causes customer lock?in.
So we have a general view of what makes a good com"any@.I think the im"ortant "oint comes in many forms.
It could be sim"le like "hysical location where you have a ten?year concession to sell trinkets at the Statue o
0iberty$ .ou could have natural resources Glow cost co""er mineI low trans"ort costs GA Jock =uarryI so
"hysical assets and location could be one form of barrier to entry.
Another could be some form of com"etitive cost advantage like a mining com"any9a co""er de"osit that
costs $+ cents to e#tract while everyone else is at 5+ cents a "ound I would say that business is nicely
"rotected. It could be a "atent or a technology9you have something that no one else has or will have.
Coca4Cola has a franchise9nobody s"oke about franchises?? where it has been built over decades which give
Co(e a com"etitive advantage of high barriers to entry. Co(e is associated with good thingsH it has mind share$
I would define a good business where you can identify s"ecifically a reason why it should be able to earn an
e#cess return on its cost of ca"ital. It has to be a sim"le reason that you can clearly see.
2he Auto Industry is the e#act o""osite where it is actually easy to see why it wouldn&t earn the cost of ca"ital.
It is a commodity business because it is a high fi#ed cost business where ca"acity is relatively fi#ed and the
"roduct has a cyclical sales cycle so "eo"le kill each other because they can&t "roduce above their fi#ed costs.
.ou normally see it with their historical return on ca"ital or JPE over time. :ook at the last $+ or 2+ years of
the com"any and say -Is it GJPIDI high, Is the JPE high, If you do this analysis any com"any that has
been able to earn in e#cess of $+> to $2> on total ca"ital em"loyed after ta# over time you have to say to
yourself -PA this looks like a good business.
1ow can I identify why it is a good business, I would say JetBlue is earning above its cost of ca"ital and
therefore is a good business but do I understand why, .eah I get it. I think it is sustainable then you have a
good business.
I# I can combine a cheap price with a !ood business, that is what I am trin! to do.
Pne I want to talk about8 Is it a good business, 2hen go through the characteristics of the com"any and ask if
it is a good business or not,
Student% !igh JPID !igh JPE and you see it is sustainable9it looks like a good business. !ow do you
ascribe this to your earlier "oint of regression to the mean,
2$
71% 2y"ically good businesses where you are seeing that on a consistent basis you rarely see them chea"
they are not good stocks to invest in.
What creates value,
What creates value, We talked about how value gets resolved9the bad sto"s being bad and things don&t stay
good forever. !ow does value get created, 7alue gets created for almost the same reason because something
went wrong and because there is deterioration. Something went wrong.
2he "attern is almost always the same. If you have a com"any that is chugging along 4ust fine and something
falls off trend??that is what creates value. 2he stock "rice es"ecially if the "rice is looking far out into the
future for a continuation of earnings growth the "rice will fall dramatically if the earnings fall off their trend.
2he dilemma that every value investor faces8 the academic studies also show that buying a stock in a business
that is deteriorating is a bad idea because there is serial correlation in goodness and in badness9which is
counter to the JPE e#am"le and argument. 0oth of those "henomena are ha""ening. In the short term there
is serial correlation and in the lon! run there is competitive pressure. 2hey both have an im"act. It is
deterioration that creates value.
So if you buy a stock that is deteriorating you are an idiot. 2he "roblem is that if you wait for the earnings to
turn or the catalysts or the revisions from Wall Street then you will be too late and not get a chea" "rice.
Student% Would you have a "reference for a good business or a low "rice,
71% I would invest in only a chea" stock but I would give credit for a good business to the e#tent that that
good business 4ustifies better earnings "ower. For me the issue is "rice relative to the com"anies normaliHed
earnings "ower. So if I had to "ay u" for -9 4ust to feel better because -9 has a stable earnings base I
wouldn&t do it. 0ut if it translates into higher earnings than some other investment and I could Buantify that
my "rice is low relative to some future earnings "ower then I will GinvestI. I have never found -9 to be
chea".
What you find is the business deteriorates and management tries to do something and then the business
stabiliHes at a lower level. 2his is where I try to buy9in the trough of stabiliHation of the business. Most
"eo"le are unwilling to buy it here because most "eo"le don&t know if it is going to go back u" here.
.ou can s"eculate because it is a good business because of this this and this but it isnMt going u" right now.
0ut I am going to buy it because I know if it does go u" I am going to make a lot of money and if it doesnMt I
wonMt lose a lot of money. There is a better ris(Ireward trade4o$
7alue is created by deterioration. 2he "rice dro" relates to the deterioration while the value ca"tured is
associated with "rice reverting back to trend or the mean. .ou have to acce"t further "rice declines when you
buy while the business continues deteriorating and if you wait you will "ay u" while recovering and miss a
good o""ortunity. Pnce you can see a catalyst you are late and you are "laying "artial momentum here.
22
6rice
?ichard P8ena tries to buy in
here.
?ichard P8ena does not try
to buy in here after good
news.
SD))@7A
.ou have better odds in the value cam" because ou are plain! in a better #ield. So if I was mediocre I
would beat the market.
2ut to be !reat one must distin!uish??what this tells you Glowest BuintileI is that those com"anies are
e#"eriencing "roblems3 some are e#"eriencing tem"orary "roblems. 8he wa ou can add value is to
distin!uish between temporar and permanent problems. Getting a good business at a good "rice is
nirvana. A low "rice will be associated with "roblems surrounding the com"any and its business.
F. LEAR C<71<7@8I<;
What does 0ear Corporation G0,& U 1.SEI do, 2hey are a su""lier of "arts to the auto manufacturers. 2hey
make seats.
Is this a good business, It doesnMt look like a good business, Why, 2hey make a commodity9seats and auto
"arts,
2ad Characteristics o# LEAR Good Characteristics o# LEAR
G:2I SBueeHed by concentrated customers G:2I Established Buality re"utation?concentrated customers
GS2I SR7 Jeliance Gtwo years ago in the N columnI G:2I Ideal Putsourcer??this is why they grow
GS2I Dyclical 6eak Asian Growth
GS2I Euro"ean Slowness Jational ca"acity
G:2I !igh 5ebt??it can be a "ermanent issue.
GS2I Jising raw materials
Dharacteristics of long?term vs. current environment.
2oo much ca"acity is a bad thing but rationaliHation of ca"acity is a good thing.

:et us go back and review which of these characteristics are characteristics of the com"any and the markets in
which they com"ete in long term and which of these are ty"ical of the current market.
When I am asking about what makes a good business vs. what makes a bad business I am not talking about
current conditions.
Toyota outsource seat su""lies so why couldnMt 0ear su""ly in the future,
Euro"e is )5> outsourced while the RS is K+> outsourced. 0ear has a fle#ible low cost model. 2hough 0ear
has a union work force they can lay off workers and close down "lants.
2he auto manufacturer G/ord or G+I "uts investment into a model which will either do well or not. 2he
cyclicality will average out over time. 0ear is in a different fi#ed cost "osition than the auto manufacturer.
.ou can say that is bad because of their concentrated customer base.
Iuestions%
I think we are mi#ed about whether this is a good or bad business.
2(
/alue Investor8
Invest in fifth Buintile8
:ow "rice;0ook or 6;E
@dd /alue8
Is this a good business Ghigh JPI2DI,
:ow value due to "ermanent or tem"orary
"roblem, 5etermine the difference.
JPI2D for 0ear ($> $KK5
JPI2D after?ta# ('> $KK)
JPI2D 22> $KK<
JPI2D (+> $KKC
JPI2D (+> $KKK
JPI2D $C> 2+++
JPI2D (2> 2++$
JPI2D (+> 2++2
JPI2D 2+> 2++(
2he business has thin margins and a high return on invested ca"ital. 2here are low working ca"ital
reBuirements and eBui"ment needed. %ust in time inventory??the time they get the order before the seat is
delivered to the auto "lant is three hours. Donflicting signals8 thin margins but high JPI2D. !ow, 3ow
capital re9uirements. 2his is a bunch of guys in a warehouse throwing things together.
2here are a lot of assets on the balance sheet??goodwill??so when you see their return on ca"ital it is not as
good as shown. We are using tangible ca"ital not including goodwill.
Jemember my definition8 If the business has a JPD greater than its cost of ca"ital it is an indication that it is a
good business. 1ow we have to ask JIs it luc"* is it sustainableC .h is thatCJ
It is really rare to find that kind of ca"ital return. If you are generating (+> returns after ta# then you can "ay
down debt ra"idly because of slow growth absent acBuisitions. !ow do they achieve this,
2here are high barriers to entry which are high market share. 2hey are sole source su""liers on every one of
their su""ly contracts. 1ow their customers have the contracts bid out but there are only one or two
com"eting bids. Johnson Controls is their only other ma4or com"etitor. Johnson Controls "robably has a
similar cost structure to 0ear and would bid rationally.
2here have been two sources of growth in this business over the last twenty years Gin the industryI8 $.I More
com"le# seats with customer controls etc. or content "er vehicle is going u". Increasing seat content due to
two sources8 the seats are getting fancier and the cars are getting bigger. 2.I 2here is more outsourcing.
2here has been growth but still nobody has entered their business. Why, Dustomers are locked?in. A customer
is likely to say should I risk a new su""lier if there is a chance that they canMt deliver, 2he risk for hurting a
customersM "rocesses is too great too risk. 2he structure of the market is that you bid on the contract for the life
of the model so incremental business comes u" rarely. Another com"etitor is unlikely to take market share.
What is the JPI2D in 2++5, I think they will lose money this year. Dertainly they are running on a negative
rate of return so far as of end %une 2++5.
2here are two "ossibilities8 $.I 2his really is a cra""y business and now we should acce"t it or
2.I We have a tem"orary "roblem going on. We donMt understand
what it is.
What is causing these "roblems,
!igh raw material costs with fi#ed "rice contracts??a tem"orary "roblem. Pnce the contract is over there is
another negotiation. ,ow does the pricin! mechanism wor"C 5id anyone read u" on that, G+Ms only
choice is to sBueeHe su""liers Gthe 0ear ArgumentI.
Ask the guy who is running this business what he will do. 1ow letMs be analysts and ask. If you were in
charge of 0ear what would you do,
0ears re"ly -Pur 1umber Pne Strategy8 Grow our business with others who are not in such bad sha"e.T
2'
:et me ask a Buestion@.did anybody look at the com"etitor, Johnson=s Controls earnings went down by the
magnitude of their business to G+ which was not nearly the decline in 0earMs business. Why,
Lear and Johnson did not contract on the same basis. 0ear contracted on a com"any by com"any basis
while Johnson Controls contracted on a model by model basis. So 0ear didnMt care if they made money on any
"articular model. So when G+ said V.ou are making all this money on our SR7s can you give us a break on
car seats over here so we donMt show huge losses every time we sell a car. 0ear is ha""y if the whole contract
is "rofitable but when SU: sales colla"se then there is a "roblem.
What does the guy at 0ear Corp$ do,
:et us say you are selling a seat for *5++ which costs *)++ to make so you are losing *$++ and you are
selling a SU: seat for *$+++ that costs you *C++ to make so you are netting *2++. 2his is what 0ear was
doing. So what does 0ear do,
-E#cuse me but we have to raise "rices on this because we are losing money.T 2hey bring the numbers to
G+ and ask to raise the "rice. 2hey have "rice ad4ustment clauses in all the contracts. 2hat as always meant
in the "ast G+ saying we need 5> lower "rices this year. 0ear would say PA here is what a 5> lower?
"riced seat looks like. 0ear gives G+ a different seat??$;2 leather and $;2 "lastic.
Will 0ear be successful in their renegotiation, .ou have no idea. :ook how much steel and "lastic costs are
so we "ass on the costs to you. G+ says -.ou are killing me3 you make me break my "rices. I need a break.T
!ow will it be resolved,
:et us switch gears and 4um" away from what is going to ha""en now.
I want ou to #orecast what the earnin!s will be #ive ears #rom now. :etMs say the average contract is four
years the average model life is four years. I want to forecast the earnings of this com"any.
$. Auto "roduction of $> increase of to"?line growth in the industry. *$).5 million to *$< million in
sales as a starting "oint. Dars;unit mi# skewed.
2. Market share for market
(. Dontent "er vehicle. 0ig 2hree;Pthers market share8 )5>;(5> 55>;'5> )+>;'+> 55>;25>
7olume will stay the same at $> growth. Rnit sales will be flat. Dontent "er vehicle is 5> now so above
trend. I would argue we scale back the 5> to 2>. What about "rofit margins com"ared to the average of the
"ast two years& margins, We will kee" at 5> to 5.5>.
*$< billion in sales times 5.(> net margin O *K++ million minus *$<+ million interest e#"ense O *<(+ million
times G$ ? ((> ta# rateI O *'K+ million then divided by )< million outstanding shares O *<.(+ "er share. At
todayMs *(( share "rice with E6S of *<;share O less than 5 times earnings.
1ow letMs dig down into this. $5> of their business is bad. 2he interior "roducts business is selling a
commodity?like "roduct com"eting against Asian manufacturers. What do we do about this division, Shut it
down. C?A came out today where management describes the business8
>rom K(- >iled on Sept. 1?
th
, 2005
Section 2 L >inancial In#ormation Item 2.0M )aterial Impairments
In accordance with Statement of Financial Accounting Standards G-SFASTI 1o. $'2 -Goodwill and Pther
Intangible AssetsT :ear Dor"oration G-:earT or the -Dom"anyTI "eriodically evaluates the carrying value of
its goodwill for indicators of im"airment. SFAS 1o. $'2 reBuires the Dom"any to evaluate the carrying value
of its goodwill for "otential im"airment on an annual basis or on an interim basis if there are indicators of
"otential im"airment.
As "reviously disclosed in con4unction with :ear&s restructuring "rogram the Dom"any is continuing to
evaluate strategic alternatives with res"ect to its Interior se!ment. 2his segment continues to e#"erience
25
unfavorable o"erating results "rimarily as a result of higher raw material costs lower "roduction volumes on
key "latforms industry overca"acity insufficient customer "ricing and changes in certain customers& sourcing
strategies. 0ased on the foregoing :ear concluded on Se"tember $K 2++5 that the Interior se!ment&s
!oodwill has been materiall impaired. At this time :ear is unable to make a good?faith estimate of the
amount or range of amounts of the im"airment charge. Such im"airment charge will not result in future cash
e#"enditures. :ear will file an amended re"ort on Form C?A "ursuant to this Item 2.+) within four business
days after it makes an estimate of such amount or range of amounts. Further an estimate of the goodwill
im"airment charge will be recorded in accordance with SFAS 1o. $'2 in the Dom"any&s third Buarter 2++5
financial results.
I read that as no value. The Interior Segment should have no value ascribed to it$
We knock $5> off of our earnings forecast. *<.(+ knocked down to *).++.
:etMs not forget what ha""ens with no growth and )< million shares. !ow many shares outstanding you
su""ose they will have in five years, (What do they do with their FCF?). So *'++ million FDF "er year or
*2 billion after 5 years then at *(( "er share there is more than enough to buy back the whole com"any.
!owever we assume that 0ear will have *'++ mm in FDF ne#t year. It is better to assume *+ going to *'++
mm the ne#t year. 0ear will either "ay down debt and lower interest e#"ense to raise earnings or buy back
stock and that will raise earnings. If 0ear takes two years to reach normaliHed margins and o"erating income
then let us assume at the end of five years it has *$ billion to buy back shares Gover (+ million shares at *((
"er shareI or to "ay down debt.
Donservative Assum"tions
So even with these very conservative assum"tions8
1o to" line growth average margins and getting out of the cra""y businesses which by the way "robably
de"ressed the margins in the good business so closing that down will raise the average margin going forward.
It looks like there will be a lot of earnings. .ou have a margin of error here and a good risk S reward.
Management thinks that that they will be making *(.5 "er share ne#t year if you ask them. And what do they
know. 2hey know the status of negotiations with G+ S /ord and you donMt. It doesnMt mean that they are the
most credible and reliable "eo"le in the world but that is what they are saying.
0ear could miss earnings this year and ne#t year and you take a bet that steel "rices go down. I have no clue
about trading strategy but I wonMt bet that steel "rices kee" going u".
0ear has *) earnings "ower. *((;) O 5.5#s about 5
th
least e#"ensive in our stock rankinguniverse. We rank
each com"any to its earnings "ower so it is at a 5 6;E vs. $' 6;E for the market. Fair value is *) in normaliHed
earnings times $' 6;E eBuals *C'. It is a big number. If it took five years to tri"le your money would you be
willing to wait, I donMt think it is five years. I wouldnMt sell it unless it ran tomorrow from *(( to *<5. I do
thin" it is one o# the cheapest stoc"s out there, #or !ood reasons.
I never forecast "roblems. I say if there is trouble now I might wait. 0ear is renegotiating its contract it is
going to be better. Always things are going on. 2heir margins have to be higher barring a ma4or world
catastro"he. 2he fundamentals are not deteriorating. If things get better the stock will rise a lot but if
conditions donMt im"rove then you wonMt lose much.
Even if G+ S /ord go bankru"t they will still make cars. Interest rates go u" causing a consumer recession
could hurt. Auto su""liers as "roof. %elphiI:isteon sell little "arts??a lot of com"etition with no barriers to
entry. 0ig "arts like car seats are difficult to im"ort and have barriers to entry. 2here are big "arts and there
are small "arts??two different businesses.
Pur screen for 0ear 8
2)
Pur growth rate for :ear was $(> because of "ast acBuisitions and then the com"uter takes the industry
growth rate and averages it G$(> N C>I;2. We have *$2 "er share in earnings.
2here are two reasons for making the margins higher8
$. Dlosing down the cra""y business but sales will go down with it.
2. 2he Euro"ean market is not as good as the RS market and that will get better structurally in the future.
2hey are tied to a com"any G+ that is losing share.
*$ billion in debt coming due in three years.
Johnson Controls bought >or(9scary/
What is the to" feature of seats for commuters??comfortable seats.
2he to" feature for SR7 customers??"ower seats.
Pnce you have a large ca" com"any over *$ billion in market ca" the "ossibility of growth at high rates is
very low.

I think the earnings "ower for 0ear will rebound rather Buickly.
Johnson Controls over"aid for >or(. It is chea" too on the scale of the market as a whole.
((
Greenblatt Class #N
2ruce ;ewber!, an Independent Individual Investor
Se"t. 2C 2++5
2he ne#t class will be <ct. 5 on a >rida in 7oom F2? #rom ? @) to 12 ;oon.
We have another guest s"eaker for "art of the class today.
2<
?ichard P8ena
:ear Dor". *((.++
Se"t. 2$ 2++5
5;6
Joel Greenblatt (JG)% Anyone notice a "roblem with Jichard 6Hena&s methodology,
Student% !e uses a multi"le that is not tailored to the "articular business3 instead he uses a general multi"le of
$'.
BG% In Jichard&s defense a $2?$5 multi"le works "retty well there too.
What I saw is that he 1?ichard P8ena2 is a lot smarter than you or me. I left that class saying Gee if I have to
be that smart to make money then there doesn&t seem to be much chance for me. We are sort of at the same
level while Jichard is way u" here Ghand raised high above his headI. 2hat is the only flaw I saw. !aving said
that mere mortals can also do this stuff.
???????????
We also have an incredible "resenter Bruce .ewberg 1B.23 we all went to school together at 3harton
Business School$ !e a""roaches things a little bit differently. !e was actually head of convertible arbitrage at
%reCelIBurnham$ For the last $5 years he has been investing on his own incredibly successfully. 0eing an
individual investor gives you a lot of fle#ibility and this being a class on s"ecial situations he is a great
e#am"le. .ou can actually do a lot more with the less money you have.
Junning a smaller amount of money enhances fle#ibility and returns. Buett 13,B2 said he could earn 5+> a
year with *$ million a year. 1ow 3,B runs billions so he says that a large amount of money is the enemy of
"erformance. !e says he will have trouble e#ceeding $5> "er year. Bruce .ewberg looks at the whole world.
!e has many many war stories.
!e will recount a few today and he will go into how you might find interesting things for yourself.
2ruce 3. ;ewber! as 2rustee of the 1ewberg Family 2rust
$$)+$ Wilshire 0oulevard :os Angeles DA K++25
Bruce .ewberg 1B.28 Well I am not as smart as Joel Greenblatt and I am certainly not as smart as ?ichard
P8ena$ 0asically I have to find easier ways to make money than figuring out 0ear Corporation 10,&2.
I am going to talk to you about a situation in 2++2 that to me was "retty sim"le. It was a com"any called +IPS
Technologies that was a s"in off out of Silicon Gra"hics. See ne#t "age.
2C
In thousands)
MIPS
September
30,
2003
June 30,
2003

(unaudited
)
ASSETS
Current assets:
Cash and cash equivalents $ 73,692 $ 83,839
Short-term investments Close to $2/Share
in ash 4,975
!ccounts receiva"le, net 4,#$# 4,762
%re&aid e'&enses and other current assets 2,6#3 3,648
(otal current assets 85,28# 92,249
)qui&ment and *urniture, net 5,6#7 4,2#2
+ntan,i"le assets, net 3,62$ 3,769
-ther assets 3,59# 5,$29
$ 98,#98 $ $#5,349
!IA"I!ITIES A#$ ST%C&'%!$E(S) E*+IT,

Current lia"ilities:
!ccounts &a.a"le $ 523 $ 5#4
!ccrued lia"ilities 9,#34 $#,977
/e*erred revenue 2,248 2,592
(otal current lia"ilities $$,8#5 $4,#73
0on,-term lia"ilities 2,496 $,9##
$4,3#$ $5,973
Stoc1holders2 equit.:
Common stoc1 4# 4#
!dditional &aid-in ca&ital $8#,5$8 $8#,5#4
!ccumulated other com&rehensive income 7$$ 7#2
/e*erred com&ensation 3$,$764 3$,3374
!ccumulated de5cit 396,2964 39#,5334
2K
0egan "urchasing under *2. 5eletion from an inde# so
forced non?economic selling "ressure. Dom"any not
burning much cash. !e bought $(((C++ shares.
E7 of G?*(+ mm/I.
*2 in cash. A slight cash burn rate of *(
mil. "er Btr. Mgt. must lower costs.
At the low the stock traded at *$.22
(otal stoc1holders2 equit. 83,797 89,376
$ 98,#98 $ $#5,349

Three Months Ended
September 30,
2003 2002
6evenue:
6o.alties $ 5,#88 $ 3,533
Contract revenue 5,325 5,9#9
(otal revenue $#,4$3 9,442
Costs and e'&enses:

6esearch and develo&ment 8,$44 8,5#7
Sales and mar1etin, 2,796 3,243
7eneral and administrative $,644 $,83$
!cquired in-&rocess research and develo&ment 394
6estructurin, 3,233
(otal costs and e'&enses $5,8$7 $3,975
-&eratin, loss 35,4#44 34,5334
-ther income, net 2#8 655
0oss "e*ore income ta'es 35,$964 33,8784
%rovision *or income ta'es 567
8et loss $ 35,7634 $ 33,8784

8et loss &er "asic and diluted share $ 3#9$44 $ 3#9$#4

Shares used in com&utin, net loss &er "asic and diluted share 4#,$72 39,6$9

Three -onths
Ended
September 30,
2003 2002

-&eratin, activities:
8et loss $ 35,7634 $ 33,8784
!d:ustments to reconcile net loss to net cash used in
o&eratin, activities:
/e&reciation $,##2 $,$82
!cquired in-&rocess research and develo&ment 394
!morti;ation o* intan,i"les 3#8 65$
-ther non-cash char,es 334 3234
Chan,es in o&eratin, assets and lia"ilities:
!ccounts receiva"le 752 3,3$#
!ccounts &a.a"le $9 35674
-ther assets and lia"ilities, net 9#5 228
8et cash &rovided ". 3used in4 o&eratin,
activities 32,78#4 $,297

+nvestin, activities:
%urchases o* short-term investments 34,9754 35,###4
Ca&ital e'&enditures 32,4$#4 33344
!cquisition o* !l,orithmics 0imited and an a<liated
com&an., /=S3 0imited, net 3$,2654
%a.ment related to &urchase o* intan,i"le assets in a &rior
&eriod 39##4
8et cash used in investin, activities 37,3854 37,4994
(+

=inancin, activities:
8et &roceeds *rom issuance o* common stoc1 $5
0oan re&a.ment 33#24
8et cash &rovided ". 3used in4 5nancin,
activities $5 33#24
)>ect o* e'chan,e rate on cash and cash equivalents 3 2
8et decrease in cash and cash equivalents 3$#,$474 36,5#24
Cash and cash equivalents, "e,innin, o* &eriod 83,839 9#,7$2
Cash and cash equivalents, end o* &eriod $ 73,692 $ 84,2$#

Formation of MIPS Technologies, Inc. (MIPS). MIPS (echnolo,ies, +nc92s
&redecessor, MIPS Com&uter S.stems, +nc9, ?as *ounded in $984 and ?as en,a,ed in
the desi,n and develo&ment o* reduced instruction set com&utin,, or 6+SC, &rocessors
*or the com&uter s.stems and em"edded mar1ets9 Silicon 7ra&hics, +nc9 3Silicon
7ra&hics4 ado&ted the MIPS architecture *or its com&uter s.stems in $988 and acquired
MIPS Com&uter S.stems, +nc9 in $9929 =ollo?in, the acquisition, Silicon 7ra&hics
continued the MIPS &rocessor "usiness throu,h its MIPS 7rou& 3a division o* Silicon
7ra&hics4, ?hich *ocused &rimaril. on the develo&ment o* hi,h-&er*ormance &rocessors
*or Silicon 7ra&hics2 ?or1stations and servers9 +n order to increase the *ocus o* the
MIPS 7rou& on the desi,n and develo&ment o* &rocessor a&&lications dedicated to the
em"edded mar1et, in /ecem"er $997 Silicon 7ra&hics initiated a &lan to se&arate the
"usiness o* the MIPS 7rou& *rom its other o&erations9

+n !&ril $998, our @oard o* /irectors a&&roved a transaction &ursuant to ?hich
Silicon 7ra&hics trans*erred to us the assets and lia"ilities related to the desi,n and
develo&ment o* &rocessor intellectual &ro&ert. *or em"edded mar1et a&&lications9 =rom
the closin, o* our initial &u"lic o>erin, on Aul. 6, $998, until Aune 2#, 2###, ?e ?ere a
ma:orit. o?ned su"sidiar. o* Silicon 7ra&hics9 -n Aune 2#, 2###, Silicon 7ra&hics
distri"uted all o* its remainin, interest in MIPS in the *orm o* a stoc1 dividend o* Class @
common stoc1 to its stoc1holders9

.ears Ended %une (+

2++5 G$I 2++' 2++( 2++2 2++$

GIn thousands e#ce"t "er share dataI
Donsolidated Statements of P"erations
5ata8
Jevenue8
Joyalties * 2KKCC * 2('(K * $5)K( * $)<K$ * '$K($
Dontract revenue ($2($ 2''') 2((K< (+K<+ '2K<C

8otal revenue )$2$K '<CC5 (K+K+ '<<)$ C'K+K
Dosts and e#"enses8
Dost of contract revenue 25+ 25+ 25+
Jesearch and develo"ment 2$K$$ 2(K)2 (2C)( ('+'5 ((K+2
Sales and marketing $'C5$ $$C<C $(<5K $<$CK $5C((
General and administrative $+2C( C'C) C5+C <'(5 K++<
AcBuired?in "rocess research and develo"ment (K' $<(<
($
Jestructuring charge G2I 2<< (2(( $+2C2 '(<

8otal costs and e+penses '<(22 '<55K ))+5) )$+K( 5CKK2

P"erating income GlossI $(CK< (2) G2)K)) I G$(((2 I 25K$<
Pther income net 2'$2 5K$ (+( (+2C )2C<

Income GlossI before income ta#es and the $)(+K K$< G2)))( I G$+(+' I (22+'
cumulative effect of change in accounting
"rinci"le
6rovision GbenefitI for income ta#es $'++ 2''C 22'' GK$' I $2'+$

Income GlossI before cumulative effect $'K+K G$5($ I G2CK+< I GK(K+ I $KC+(
of change in accounting "rinci"le
Dumulative effect of change in accounting G<'$ I
"rinci"le net of ta# benefit G(I

1et income GlossI * $'K+K * G$5($ I * G2CK+< I * GK(K+ I * $K+)2

6er basic share amounts8
1et income GlossI before cumulative effect * +.() * G+.+' I * G+.<( I * G+.2' I * +.5$
Dumulative effect of change in accounting * G+.+2 I
"rinci"le
1et income GlossI "er basic share * +.() * G+.+' I * G+.<( I * G+.2' I * +.'K
6er diluted share amounts8
1et income GlossI before cumulative effect * +.(( * G+.+' I * G+.<( I * G+.2' I * +.'K
Dumulative effect of change in accounting * G+.+2 I
"rinci"le
1et income GlossI "er diluted share * +.(( * G+.+' I * G+.<( I * G+.2' I * +.'<
Bune F0,
200N 200F
@SS58S
Durrent assets8
Dash and cash eBuivalents * <C((5 * C(C(K
Short?term investments $5+'$
Accounts receivable net of allowance 2'CC '<)2
of Hero at %une (+ 2++' and *$C( at %une (+
2++(
6re"aid e#"enses and other current assets ($5K ()'C

2otal current assets KK+2( K22'K
(2
EBui"ment and furniture net (5<C '2+2
Intangible assets net ($<) (<)K
Pther assets 2K2) 5$2K

* $+C<+( * $+5('K

3I@2I3I8I5S @;6 S8<C-,<3657S= 5IDI8A
Durrent liabilities8
Accounts "ayable * $255 * 5+'
Accrued liabilities $2('' $+K<<
5eferred revenue ('+< 25K2

2otal current liabilities $<++) $'+<(
:ong?term liabilities 2+(C $K++

$K+'' $5K<(
StockholdersM eBuity8
Dlass A common stock *+.++$ "ar value8 $5
+ and $5+++++++ shares authoriHed at
%une (+ 2++' and 2++( res"ectively3 +
and $5'KK+$+ shares outstanding at %une (+
2++' and 2++( res"ectively net of + and
5($< reacBuired shares at %une (+ 2++'
and 2++( res"ectively
Dlass 0 common stock *+.++$ "ar value8 25
+ and $++++++++ shares authoriHed at
%une (+ 2++' and 2++( res"ectively3 +
and 25+5<<$5 shares outstanding at %une (+
2++' and 2++( res"ectively net of + and
$2+'' reacBuired shares at %une (+ 2++'
and at %une (+ 2++( res"ectively
Dommon stock *+.++$ "ar value8 25+++++++ '+
and + shares authoriHed at %une (+ 2++'
and 2++( res"ectively3 and '$+2++)$
and + shares outstanding at %une (+ 2++'
and 2++( res"ectively net of $<()$ and
+ reacBuired shares at %une (+ 2++' and
at %une (+ 2++( res"ectively
Additional "aid?in ca"ital $C$5$$ $C+5+'
Accumulated other com"rehensive income C)< <+2
5eferred com"ensation G)K5 I G$((< I
Accumulated deficit GK2+)' I GK+5(( I

2otal stockholdersM eBuity CK)5K CK(<)

((
* $+C<+( * $+5('K

2;% +IPS was a s"in out of Silicon Graphics. +IPS had two classes of stock A S 0. 2hey had '+ million
outstanding shares. 2he two securities traded at different "rices where the 0 shares traded below the A shares.
It was actually an arbitrage where they were both going to be converted into the same class of shares yet the A
shares traded at a $+> "lus "rice to 0 shares. 2he 0 shares had more votes than A and automatically converted
5 years after the s"in?off and there was a "otential that they could be converted before that.
In 2++$ technology came off of the Internet Bubble and a lot of technology was having a slow down. +IPS
had more than that. When +IPS went "ublic +IPS was in the business of licensing semiconductor technology
to "eo"le who were develo"ing chi"s. 2hose chi"s went into a lot of devices. 2heir first chi" went into the
.intendo #J video games. 1ow that was a short?lived e#"erience and it became a""arent at the end of 2++$ as
the 1intendo video games were "lunging.
What I want to show you first of all about the stock and then a little bit about the balance sheet. It goes to
show you about the efficient market theory as to the value of this com"any at *2.' billion dollars in 2+++. We
focused on +IPS in this range G*( to *2I while it became a""arent that +IPS sales were falling off the back of
the truck and the com"any was beginning to lose money. :et me show you what I was looking at back then.
1ow this com"any had '+ million outstanding shares so if you look at the Mar. +2 $+?=8
)arch F1, Bune F0,
2002 2001
Hunaudited$
@SS58S
Durrent assets8
Cash and cash e9uivalents E 7K,N2F * $$)52+
Short(term investments 1?,F75
Accounts receivable 55)< )''(
6re"aid e#"enses and other current assets C+52 <<2+

2otal current assets $$$'$< $(+)C(
EBui"ment and furniture net )<K( C+CK
Intangible assets '(K(
Pther assets 5()K $))$

* $2<K<2 * $'+'((
3I@2I3I8I5S @;6 S8<C-,<3657S= 5IDI8A
Durrent liabilities8
Accounts "ayable * ')C * ($C'
Accrued liabilities )(+K $+'<2
5eferred revenue (5K( '+)K

8otal current liabilities 10,F70 $<<25
StockholdersM eBuity8
Dommon stock (K (K
Additional "aid?in ca"ital $<)()( $<552+
Accumulated other com"rehensive loss G'5K I G)$5 I
('
Accumulated deficit G5C('$ I G522() I

2otal stockholdersM eBuity $$<)+2 $22<+C

* $2<K<2 * $'+'((

MI! 85C,;<3<GI5S I;C
0541042002
Income Statement
8hree )onths 5nded ;ine )onths 5nded
)arch F1, )arch F1,
2002 2001 2002 2001
H7estated$ H7estated$
Jevenue8
Joyalties * '$(5 * $)$+) * $(5C+ * ('2+'
Dontract revenue C)+< $2+2K 2()(5 ((+C2

2otal revenue $2<'2 2C$(5 (<2$5 )<2C)
Dosts and e#"enses8
Dost of contract revenue 25+ 25+
Jesearch and develo"ment C'') K5'( 25($5 2'C)<
Sales and marketing 'K$) '2<2 $(2<+ $$'$'
General and administrative $K'C 255< 55+) )C+$
AcBuired in?"rocess research and develo"ment $<(<
Jestructuring '(<

2otal costs and e#"enses $5($+ $)(<2 ')5$5 '(((2

P"erating income GlossI G25)C I $$<)( GK(++ I 2(K5'
Pther income net 5$+ $)5$ 2'$5 'CC(

Income GlossI before income ta#es G2+5C I $('$' G)CC5 I 2CC(<
6rovision GbenefitI for income ta#es G(C+ I 'C<5 G<C+ I $$+''

Income GlossI before cumulative effect G$)<C I C5(K G)$+5 I $<<K(
Dumulative effect of change in accounting G<'$ I
"rinci"le net of ta# benefit

1et income GlossI * G$)<C I * C5(K * G)$+5 I * $<+52

6er basic share amounts8
Income GlossI before cumulative effect * G+.+' I * +.22 * G+.$) I * +.')
(5
Dumulative effect of change in accounting G+.+2 I
"rinci"le

1et income GlossI "er basic share * G+.+' I * +.22 * G+.$) I * +.''

6er diluted share amounts8
Income GlossI before cumulative effect * G+.+' I * +.2$ * G+.$) I * +.''
Dumulative effect of change in accounting G+.+2 I
"rinci"le

1et income GlossI "er diluted share * G+.+' I * +.2$ * G+.$) I * +.'2

Shares used in com"uting basic net income (K+$' (C<<C (CK)K (C)5K
GlossI "er share

Shares used in com"uting diluted net income (K+$' '+2)2 (CK)K '+5C5
GlossI "er share
2hey had *KC mm in cash with '+ mil shares outstanding. And if you take cash minus D: or GG*<C'2( Dash N
*$K(<5 S2 InvsI. ? **$+(<+ D:I O *C<'2C or a""ro#imately KC mm ? *$+ mm O *CC mm or *CC;'+ O *2.2+
"er share in net cash. 2he stock at this time coming into Se"t 2++29there were lots of bad things going on9
Joel and I were talking about this before9we called it the tri"le witching hour.
!ave you discussed ta# loss selling, 2here is a time of the year usually by Pctober or at least by the end of
5ecember investors want to offset gains with losses and not have re"ortable ta#able income. 6eo"le tend to
sell losers to offset their winners. 1>ou want to ind motivated or distressed sellers2$ 2hat was going on in a
stock that had a significant decline. Secondly this stock was being deleted when it was trading at *$.22 from
one of the SS6 indices the SS6 Mid?Da" inde# and I think $+> to $5> of the stock was closely held by the
kind of funds Glike 5imensional Fund AdvisorsI that would automatically dis"ose of it with the deletion. When
this stock was being deleted it traded down to *$.22. So that is a market ca" of *'K million dollars.
So what can go wrong, If the com"any burns cash the value will decline. 2hey could acBuire somebody but
shareholders would not want it. 2he Enter"rise 7alue GE7I at *$.22 was a negative *(+ to *'+ million/ .ou
had some room in terms of a margin of safety.
:et me show you what the historical income statement looked like back then. 2he revenues fell from *'2
million in 2++$ to about *$< million in 2++2 due to the decline in 1intendo Game Jevenues. As ?ichard
P8ena always says -.ou want to find out if the "roblem is tem"orary or "ermanent.
0asically I found this stock looking at a s"in?off and also doing new lows list screens. :ooking for E7 to
revenues. 2his will always come u". 2hey were losing about *( million a Buarter. 2here are ways you can
lose money in these situations. 2he business could continue to lose money. .ou may have to shut "arts of the
business down and you could have the termination costs of em"loyees leasing costs of manufacturing s"ace
and other costs. .ou may have to "ay to e#it the leases so you have to look at all these "otential liabilities and
e#"enses.
I met this com"any before the SS6 delete. I filed a $(?G because I was not going to try to influence
management or try to control the com"any. Although I am glad to give them a recommendation I don&t want
to take control. I told that to the DFP after I filed a $(?G and he wrote back thanking me for my su""ort. I
wrote back saying we were not buying the stock for su""ort but because we thought that there was real value
here and you guys can do something to create value here. 2he market is saying there is negative value here. 2o
()
stay in business one could say the shut down e#"enses were not high. If they shut down and went to one
em"loyee and collected the royalty checks they collected for all that they created clearly you will create some
"ositive value.
Getting into it was actually "retty easy for me. 2heir JS5 was too high. 0asically here is how I looked at it.
2hey were like the rich guy9they made all this money on .intendo9then they got slo""y with their other
"ro4ects. 2hey had these royalties coming in and as they were making money and the stock was going u" they
would continue to take on "ro4ects maybe without the strict economic feasibility to work on all of those
"ro4ects. I am sure seeing me file a $(?G on the com"any9and I am not a scary guy9but having me talk to
them about losing control they knew they had to do something or face their shareholders.
0etween sto""ing s"ending on JS5 and the royalties that were coming in you would have a "ositive stream
of cash in the future, So I think they had a discussion with themselves and they had to re?evaluate some of
their "rograms and look at really using disci"line in how they use the cash. 2he *( million in Buarterly losses
is not that big a deal now but that *( million can turn into *) million loss which can turn into a *$2 million
loss etc and before you know it the margin of safety is gone. 2hey made an announcement that they would
focus on only those economic "ro4ects which had the long term returns.
Student% 5id you want to have a more activist investor with you to rattle the cage and be sure to have
management do the right thing,
2;% .ou can rattle the cage. I live in DA and getting to San %ose takes about an hour. I have been u" there to
visit with them. .ou have to count on ca"italism at work. Da"italism and "eo"le acting in their own self?
interest would s"ur change. I think management knew the game had changed. 2his management had been
"retty "romotional3 look at the market ca" this com"any had been at. What was in their best interests, !ow
should they behave, So I agree that you would think that they would want to do the right thing but sometimes
if they articulate that this is what they are going to do and this is how they are going to do it the market will
immediately react to what they have said and a good "art of the o""ortunity will be gone.
I went out there on s"eculation thinking that they were going to behave rationally and do what was in their best
interests and their shareholders best interests which ultimately would be in their interest. 2he com"any was
where they were em"loyed. If you lost a 4ob during 2++2 in Silicon 7alley the situation would be difficult. It
was not like trying to get a 4ob in $KKK.
Student% Dould management have cashed out a lot of their o"tions near the highs in $KKK U 2+++ and then not
care as much,
2;% 2hey could but then you would want someone that would care. I have seen situations that were cash rich
and where management could lower e#"enses that did not work out as well as this. Most of those com"anies
did not have a uniBue "roduct in its class no royalty stream coming in from other things they control. 2his was
a little bit difference.
2he beauty of it was this SS6 delete. When indices are rebalanced and stocks are added and subtracted and
you will know in (+ to )+ days out that this is a very likely candidate. And we 4ust ha""en to be there. .ou dot
the i&s and cross the t&s and wait for them to sell the stock. Sometimes you get it sometimes you don&t.
Sometime you have to "ay more. Would have I "aid *$.'+ or *$.5+, I don&t know. Actually one of the
negatives was that I had to file a $(?G based on 5> of the 0 shares. My "osition was $.' million shares but
that was not 5> of the whole com"any that was 5> of the 0 shares.
Student% 5id you buy shares before meeting management,
2;% I "robably bought my first shares before I met with management. Pbviously it is a big advantage to
follow something for awhile and then have the "rice come to you versus waking u" tomorrow and seeing a
stock have a big hiccu" and you are starting this morning and you have to make your decision by this
afternoon. I had tangentially looked at this com"any for a year. I had asked management when their stock was
*(.5+ if they would buy back stock at *2, .es they would. And it got there very Buickly9they had a bad
(<
Buarter they were losing *+.+C E6S there was ta# loss selling and under *5 a lot of institutions will not be able
to own the stock.
@nd I want to ma"e a bi! picture comment about an investin!. And that is you want to really focus on
things when other "eo"le have to sell. .ou want an imbalance of sellers vs. buyers. 2he biggest money was
made when the ?esolution Trust Corporation 1?TC2 decided that the Savings S :oans could not own high
yield bonds. Dan you imagine if you woke u" tomorrow and no one with the last name from A U 1 could own
1ew .ork real estate what would ha""en to the value of 1. real estate, And if you "ut it under a small time
frame those o""ortunities are created a few times in your life. So I ho"e it is PA to cover this in this class.
0ut the smartest guys that I know focus on situations where everyone is focused on selling everyone is very
negative9ne!ative sentiment is a !reat thin! when ou want to ma"e a purchase.
Pne of the things that the com"any did in its materials and the IJ web site??they would "ut out a line with
royalties and they would "ut out a line without royalties. So they showed that if you took out the .intendo #J
revenues their royalty stream outside of .intendo #J was growing.
0asically royalties grew. I think the com"any had E0I2 of *$) million in 2++' and that cash today is a""ro#
*$2+ million and the stock went as high after the fact as *$2. 2he hard Buestion today the com"any is making
*$) million in E0I2 and you believe the com"any is growing and it has *$2+ mm in cash. 5oes anyone want
to think of a range of valuations that the market might "ut on this, $+# to $'# *$) million of E0I2 "lus *$2+
mm O $)+ N $2+ to *22' N *$2+ or *2C+ to *(''. 5ivide by '+ mm outstanding shares O *< to *K.
$+ # E0I2 so that is *< "er share. 2he stock went to *$$. Pne thing I find in technology stocks the sentiment
swings "articularly in small ca"s. 2he swings can be significantly greater than in large ca" stocks. It is funny
because the stock is at *).)+ today. I "robably sold on average at about *C.++.
Pne of the great things about being a "rivate investor and managing my own money is that I don&t have to
re"ort or write letters to anybody. I# I don&t #ind anthin! to do that isn&t !reat then I wait. And I am very
focused. 2here is a lot you can do if you are not a fiduciary. 2here is a big difference between how often you
do things and when you "ull the trigger. If you look at great gamblers they will tell you to wait for the odds to
be stacked in your favor. We could look at a lot of situations but this is one where I thought the odds were
really really stacked in my favor. I sort of felt like tails I make a little and heads I make a lot. 2hose are
great. And there are "eriods where you can find a lot of those and "eriods when you can find very few of
those.
2ein! able to sit on our hands, to me, is an important #acet o# investin!.
Student% What do you think about today,
2;% Joel and I may disagree about this but I thinkUit is interesting@the o""ortunities@a lot of money has
gone into hedge funds over the last five years and I think that a lot of hedge funds are focused@@..I feel like a
little kid in the sand bo# where everyone is kicking all the sand around him. 2here is not as much to do. I
think there is so much money chasing investments that the dislocations that we used to get are not that great
but what can ha""en, 0asically if hedge funds under "erform large ca" growth what will ha""en to the flow
of funds, Money will be going to large ca" growth. !istorically "eo"le won&t realiHe that their strategy isn&t
working. And I think that there is o""ortunity. It is great that there is o""ortunity in the small stuff because
you can make multi"les of your money but you find an undervalued great com"any and you "ut it away. It is
not as easy as this money. 0ut I think this is not a great time for small ca" value.
Bloomberg is a great tool for those of us who are addicted to it. 2he worst Buarter +IPS had was the F. 2
nd

=tr of 2++( they lost *5 mm in negative o"erating income. I want to look at where cash bottomed out. 2hey
have a F. Ending in March. So the third Buarter of 2++2 cash was *K< million and went down to *K' to *K$
million and bottomed at *K$ million and went to *$+2 *$$+ and@. *$$). So they were never bleeding that
badly. We didn&t s"end much time talking about the business but in reality I wasn&t that attracted to the
business. I was attracted to the valuation and there is one thing that Proessor Greenblatt will teach you is that
valuation and E7 is unbelievably im"ortant. 2he one thing that investors miss which is unbelievably
im"ortant is valuation.
(C
2he other "arts of the business they were in network "rinters. 2hey made "rogrammable chi"s. If you are !6
and you are "utting out a network "rinter you don&t want to develo" a chi" for that network "rinter9it is
hugely e#"ensive. 2here is huge demand out there for chi"s that are "rogrammable. 2heir chi"s went into set?
to" bo#es and !27. In terms of understanding their business I didn&t know every nook of their business but I
did check to see who was signing deals with them. .ou see where the "roducts are going into to and you use
your common sense. Pr you consult an e#"ert.
Student% 5id you read through all the legal documents, !ow did you evaluate the legal risks,
2;% It actually is "retty sim"le. 2his is a "ro#y8 that is why the 0 shares are trading at such a discount to the A
shares. It doesn&t make any sense. Sometimes it doesn&t make sense and other times there is a reason for it.
2he "rice discre"ancy was not that great less than $+>. 2here really wasn&t a lot of risk being long and short
the same thing "lus I got a short rebate. I earn interest on the short. Fed funds minus 25 to 5+ b"ts. 2here is a
wide range of what you get in rebates de"ending on the stock9like General +otors. 6eo"le were hedging the
debt against the stock so you had to "ay to borrow the G+ stock.
Another War story@..
Joel you wanted me to cover how I screen for things.
2he ne#t com"any is called &rtesyn Technologies 1&ST.2. I really am not a technologist but I ha""ened to
"ick busted technology stocks. I can&t say why. 2he sentiment can really swing in a significant way.
MI!
In F. 2++( the royalties bottomed out at *$) million and came back in 2++' at *(+ million in 2++5. 2he
bottom was at *2( and got to *($ mil. 2hey sto""ed doing "ro4ects that didn&t make economic sense. 2hey
reduced their head count where they only took on "ro4ects where they could make a decent return on ca"ital.
Sometimes you have to make a lea" of faith. .ou have to make a lea" of faith that the guy GDEPI is actually
going to do that. I didn&t think management would want to take my "hone calls from "eo"le like me.
@785SA; 85C,;<3<GI5S
(K
I started looking at it around here
sold some of the stock around here
and started looking again at it around
here.
:et me give you the backdro"8
Artisan is in the business of 8
I85) 1. 2usiness
Be &rovide advanced &o?er conversion equi&ment and real-time su"s.stems to the
com&utin,, stora,e and communications industries9 Be are headquartered in @oca
6aton, =lorida, and are &rimaril. en,a,ed in the desi,n, develo&ment, manu*acture, and
sale o* electronic &roducts, &o?er su&&lies, &o?er conversion &roducts and &o?er
su"s.stems9 Be o&erate in t?o se,ments, %o?er Conversion and Communications
%roducts9 Bith one o* the "roadest &roduct &ort*olios availa"le, our %o?er Conversion
"usiness o>ers customers a ?ide ran,e o* hi,h e<cienc. !CC/C &o?er su&&lies, as ?ell
as advanced /CC/C and isolated and non-isolated %oint o* 0oad, or %-0, converters *or
distri"uted &o?er architectures9 (he Communications %roducts "usiness o>ers its
customers C%D "oards, B!8 inter*aces, and &rotocol so*t?are solutions that are at ?or1
on man. o* toda.2s leadin, (eledatacom net?or1s9 -ur customers include ?orld?ide
mar1et leaders in each o* their chosen mar1et sectors such as !lcatel, Ciena, Cisco
S.stems, Dell Com&uter, )EC, )ricsson, Fe?lett-%ac1ard, +@E, 0ucent (echnolo,ies,
Eotorola, 8ortel, 8o1ia, and Sun Eicros.stems9 Be also &rovide &roducts to man. other
com&anies in the com&utin, and communications industr. and maintain a ?orld?ide
net?or1 o* ?ell-re,arded distri"utors includin, !rro? )lectronics and !vnet9
=ounded in Earch, $968 as Com&uter %roducts, +nc9, ?e have &rovided com&onents and
service solutions to the electronics industr. throu,hout our histor.9 +n late $997, ?e
mer,ed ?ith G.tec Cor&oration and chan,ed our name to !rtes.n (echnolo,ies, +nc9
Since that time, ?e have *ocused on &o?er conversion and sin,le "oard com&utin,
solutions *or the com&utin, and telecommunications industries9 Be have also made
several strate,ic acquisitions to add technolo,ies and ne? &roducts *or our chosen
mar1ets and ?e have dis&osed o* "usinesses and lines o* &roducts that ?ere outside our
chosen mar1et *ocus9 Eore recentl., due to the si,ni5cant do?nturn in demand in our
end mar1ets, ?e have restructured the com&an. to ensure that our su&&l. ca&acit.
matches mar1et demands and that our cost structure is com&etitive9 /es&ite the
di<culties our end mar1ets e'&erienced in the last t?o .ears, ?e "elieve the industr. in
?hich ?e com&ete and the mar1ets ?e have chosen to serve ?ill &rovide us ?ith
si,ni5cant ,ro?th o&&ortunities *or man. .ears to come9
2;% 2hey do things inside servers com"uters and wireless infrastructure. A2S1 was a darling stock that had
'+ mm outstanding shares. At one time the com"any had a *$.) billion market ca". I want to show you what
their sales were looking like before this.
2hings were going along rather nicely from $KK< to 2+++ and they had done a nice 4ob of growing the
business nice returns@@@..
(he *ollo?in, ta"le sets *orth certain selected 5nancial in*ormation9

.or the .isal ,ears 2002 2##$ 2### $999 $998

3/ollars in (housands
)'ce&t %er Share /ata4

'+
(esults o/ %perations
Sales $ 35#,829 $ 493,968 $ 69#,#83 $ 594,$55 $ 532,392
8et income 3loss4 Fixed
Asset write-downs (001,1224 33$,7634 43,253 43,362 27,#44
%er share H "asic 329844 3#9834 $9$5 $9$6 #97#
%er share H diluted 329844 3#9834 $9$# $9$$ #967

.inanial 2osition
Bor1in, ca&ital $ 89,#25 $ $52,776 $ $76,$$3 $ $27,637 $ $2#,97#
%ro&ert., &lant I equi&ment,
net 78,63$ $#3,29$ $#5,#59 88,468 75,#32
(otal assets 3#3,587 426,483 497,8$5 359,#5# 325,392
0on,-term de"t and ca&ital
lease o"li,ations 69,52$ $##,399 73,3#$ 44,$54 5#,283
(otal de"t 69,533 $##,6#6 74,8$3 46,$$# 52,99#
Shareholders2 equit. $23,446 2$9,245 256,5$2 $99,9$2 $8$,#88
(otal ca&itali;ation $92,979 3$9,85$ 33$,325 246,#22 234,#78

.inanial Statistis
Sellin,, ,eneral and
administrative e'&enses
3includes amorti;ation o*
,ood?ill4 $ 36,593 $ 62,$38 $ 68,979 $ 52,4#4 $ 54,548
- as a J o* sales $#94J $296J $#9#J 898J $#92J
6esearch and develo&ment
e'&enses 34,34$ 4$,47# 44,867 36,4$3 33,4#$
- as a J o* sales 998J 894J 695J 69$J 693J
-&eratin, income 3loss4 3$2#,5694 33$,9454 67,$39 64,86$ 4$,98$
- as a J o* sales 33494
4
J 3695
4
J 997J 00345 634J
(otal de"t as a J o* total
ca&itali;ation 369#J 3$94J 2296J $897J 2296J
/e"t to equit. ratio 5693J 4599J 2992J 239$J 2993J
'$
+nterest covera,e ratio 3$49684 339774 $3942 2$9#$ $$9#6

%ther $ata
Ca&ital e'&enditures $ 5,23# $ 28,763 $ 39,256 $ 33,359 $ 26,795
/e&reciation and
amorti;ation 3includes
im&airment o* ,ood?ill4 $ 77,628 $ 33,59# $ 26,85# $ $9,746 $ $6,653
Common shares outstandin,
3###2s4 38,389 38,253 38,282 37,$27 37,882
)m&lo.ees 2,366 2,427 5,227 4,628 4,29#
(em&orar. em&lo.ees and
contractors 2,3$# 2,8$8 3,96# 3,269 2,326
2here were nice returns and then came 2++$. So what ha""ened, 2hey didn&t foresee the sales9the
technology slowdown. 6eo"le thought growth would continue while not seeing the decline in demand. 2his is
"ost the Internet bubble. :ots of com"anies were created who were or could be customers for networking
eBui"ment. 2here was a lot of money raised and a lot of ca"ital e#"enditure. It really got above trend line for
demand for some of this eBui"ment.
If you look at the o"erating income "erformance here@the years from $KK< to 2+++ the o"erating margins
went from a low of C> to a high of $$>. So if you think the business will kee" earning o"erating margins of
$+> but we were not thinking that initially when I started buying the stock. We thought the com"any could
get back to their business model once they had reached the bottom of their sales. 2he Buestion was where was
the bottom of their sales, 2his was a business that has done *<++ million so would it be *5++ or *(5+ million,
Were they going to be able to right the shi", I bought the stock at *5 while I made that +IPS "urchase at
*$.$+ and I was buying with both hands while I was tri"ling down. 2his was something that can be very
scary.
Student% .ou never "ick the bottom. !ow do you make the decision as to how much ca"ital you are willing to
"our in, !ow much do you allocate,
2;% In this "articular situation I ke"t going back and double checking tri"le checking my facts checking with
management and really trying to understand what the "lan was in how they were going to turn it around.
0asically you have to look at risk;reward and sometimes the market says at *2 you knew what the E7 value
was and the risk;reward. And at *$.$+ you have to say -Am I wrong, Will this business not be able to
survive,& 2he way I was looking at it at *$.$+9the com"any going out of business was the only way I was
going to lose. 2he good news was that buying 55++++ at *$.$+ was only about Q million dollars so it was not
as big a "osition as *2.5 million in +IPS though you do not want to lose the money.
Student% If you had found another o""ortunity that was com"elling would you have "ut this much money into
it,
2;% I think there is always a way to look at the o""ortunity sets in front of you. :ook at the u"side and
downside. 0y the way there is no better investor who understands the u"side and downside as your "rofessor
Joel Greenblatt. 2hat is one of his greatest skills. And for some of these small stocks you allocate ca"ital
based on what is available for you to be able to buy. 2his is not +icrosot$ If you want to allocate money to
+icrosot you can be filled in five seconds for whatever you want allocated. In something like this it is
different.
Student% Dan you give us an understanding about how you concentrate your "ortfolio, .our turnover,
'2
2;% Doncentration, I have had 2+> N "ositions. In terms of turnover today is different than the "ast. I am
having trouble finding ideas with the same o""ortunity. I can find ideas that are chea" but with not the same
u"side "otential. So I like to have dry "owder for these o""ortunities for real outsiHed returns.
I have made my money in a lum"y way9some years were big and others were not. 2he key thing at this "oint
is "reservation of ca"ital and not striking out at this "oint.
Student% 5id &ST. have cash to offset the debt,
2;% .es they did. 2hey went through a lot of different things. 2hey had a bank line and they re"laced it with
a convertible. When the stock went from *'+ to *5 and back to *$+ they did a convertible security Gconvertible
at *$+;shareI with a com"any in Aorea that I thought would buy them. 2here was no near term "roblems.
2hey ended u" refinancing. 2hey took out the guy from %eltec and they did a "ublic convertible. I think they
did it during 2++( when the stock was trading at the mid?*)&s.
I can walk through what ha""ened. .ou have to be resourceful. 8here is a lot o# 'ud!ment involved.
%udgment involved with allocation of ca"ital 4udgment about the business about the "eo"le and about the risk
9there is a lot of 4udgment involved here. My brother ha""ened to be best friends with the DEP of this
com"any. I got no inside information but I did think he was an honest man. And as you have seen in the news
for the "ast five years@before Sarbanes?P#ley "eo"le "layed it a little faster and looser than they do today. I
think that is an im"ortant thing to remember today.
Aou have to be independent. 6eo"le will tell you things and 4ust because management tells you L . and W it
doesn&t mean L. SW are true. .our 4ob as an investor is to double and tri"le check it and go around this way
and talk to a customer talk to a com"etitor. Get on the "hone and check out other "oints of view.
Student% !ow did you find this com"any,
2;% 2his was a low Enter"rise 7alue to historical E0I25A valuation. It was on my radar screen before.
Student% What serves as the screen,
2;; I use Bloomberg. 2he screen is 4ust a starting "oint. 0asically it identifies com"anies with certain
characteristics to make me drill down further. 2he great thing about the Internet today is the ability to get
information and mani"ulate it is greater than it has ever been.
Student% What is your "referred way to screen stocks,
2;% I screen with "retty basic criteria. A lot of times I will look at the new low list. I want to see if there is
some com"any that I know something about. .ou know I have been doing this for 25 years Gsince $KC+I. In
25 years you "robably figure one or two things and so you look at valuation metrics you look at com"anies
hitting new lows and you sort of have a sense of somebody who has a good business a cyclical business.
2here a lots of ways to screen.
Joel Greenblatt 1JG2; We will have a class on how to screen but really it is 4ust a starting "oint. I will give
you "lenty of "laces to go that are not that "retty but that are chea".
Student% !ow big a universe do you screen for,
2;% Well you can cut it off by market ca" or you can cut it off by country. 2here a lots of different ways to
screen on Bloomberg$ 2he way I look at it is8 how much ca"ital can I commit to it, And what is a 5>
"osition, :ook at it that way to decide if that will be meaningful enough to do the further work and drill down
on the "otential idea. Sometimes you don&t know where the idea will go. .ou start buying something and you
don&t know if it is going to get chea"er. .ou sort of have to have a data base of where values are??that is
everything. Dnderstandin! the values o# companies is a reall, reall valuable database to build. It is our
intellectual capital.
'(
Student% What allowed you to think that this com"any&s sales had hit bottom,
2;% Everything was being made overseas and that Dhina was going to kill all these com"anies. Everything
was going to the lowest cost "roducer. 0ut that is not really it. If you are in a "osition where you can shut
down somebody&s "roduction line because they do not have a "art then you are not 4ust a commodity "roducer.
If you are selling to %ell9first of all they don&t want to deal with thousands and thousands of vendors. So the
fear was that Dhina com"anies were going to take all the business. We s"oke to com"anies and how they like
to deal with their vendors and I was not really concerned about that situation. 0ut what this com"any had to do
was figure where they could manufacture the chea"est and how to get out of some of their ca"acity.
2here 4ust wasn&t going to be the ty"e of demand. So they took their hit. 2hey closed down "lants and
facilities. 2hey got back to their basic business that made sense. I can show you what had ha""ened.
Sales really did fall away. 2he *$+C m in net income loss in 2++2 was including significant fi#ed asset write
downs. It was not the eBuivalent of a cash loss. Actually they were generating cash because their receivables
were going down. So what ha""ened was that they right siHed the business. And a guy filed a $(?5 in the last
$( months. 2he com"any is su""osedly for sale. 2he stock is at *K.
Somebody asked a Buestion before about the margin of safety9the M of S might not have been here but the
risk;reward was certainly great. 0ecause if you believed that sales were going to bottom at *(5+ million or
near there and they got back to a $+> o"erating margin business then you would generate *<+ cents to *C+
cents E6S "re?ta#. It was not hard to see that you were going to make money. So@@@
Student% Douldn&t %ell outsource,
2;% 2hey could but %ell wants de"endable "eo"le Gsu""liersI as outsourcers to su""ly them with 4ust in time
delivery. %ell could design around them but %ell wants to outsource. %ell is an assembly and marketer. %ell
wants su""liers who can "rovide good "arts so they can assemble the com"uters and sell them. 2hey are a
huge marketing shi". Power49ne was a similar com"etitor.
When %ell saw the stock trade at *$.$+ Joe +c%onnell' the DEP had to go to %ell and hold their hand and tell
them that he was still going to be around in two years. 2hey did not want to give that business out. 2hey
wanted de"endable goods from &TS. at a fair "rice and good service while they focused on what they were
good at.
Student% 5id you have situations where the situations deteriorated.
2;% Sure. I have had a few. 2he good news is that I have had a lot more winners than losers. Pne that comes
to mine was "lasi# which was a s"in off from Campbell Soup. It was highly levered. 2hey make a lot of
different food "roducts and basically the com"any was over levered and it didn&t "erform and I did not
evaluate it "ro"erly. I thought the assets would be worth more than they were. And it didn&t work. I lost
money. :everage is a two?edged sword. It will make you a lot of money when things go right as you would
know from studying enter"rise value.
If you have *5+ mm in eBuity and *5++ mm in debt then a rise in value to *)++ mm will double your eBuity
and a dro" in value to *'5+ mm will wi"e you out. If it is worth *<++ mm you will Buadru"le your money. So
that was one of my mistakes. If I had to do it over again I might have done things a little bit differently.
7I!-I#8T%#, $el3 Sep 03, 2009 ! *ederal court in /ela?are (uesda. e'onerated
Campbell Soup Co9 o* char,es o* *raud in connection ?ith its s&in-o> o* Vlasic Foods
International3
Creditors had accused the Camden, 89A9, *ood com&an. o* &ac1a,in, its mone.-losin,
lines o* "usiness into the ne? &u"lic com&an. and sendin, it into the mar1et ?ith little
chance o* survival9
''
D9S9 /istrict Aud,e Kent Aordan ruled a,ainst them, 5ndin, that the Llasic "usiness ?as
solvent at the time it hit the &u"lic mar1et, so Campbell Soup isnMt lia"le *or the
com&an.Ms later colla&se into "an1ru&tc.9
(he la?suit ?as &art o* a continuin, e>ort to raise mone. to &a. creditors, mainl.
"ondholders, ?ho "ou,ht into a $2## million de"t o>erin, more than a .ear a*ter the
Llasic "usinesses ?ere launched into a se&arate com&an.9
+n addition to the &ic1le line, Campbell Soup &ushed its S?ansonMs *ro;en *ood and other
"usinesses into the ne? com&an.9
Bhile Campbell Soup admitted the "usinesses ?ere &oor &er*ormers, those associated
?ith Llasic thou,ht the com&an. had a chance o* succeedin,, Aordan ruled9
!ccordin, to (uesda.Ms rulin,, Campbell Soup didnMt launch Vlasic ?ith an e.e to?ard
de*raudin, the com&an.Ms creditors9
!s &art o* the s&in-o>, Campbell Soup trans*erred $5## million in de"t to Llasic, ?hich
?ound u& 5lin, *or Cha&ter $$ &rotection in Aanuar. 2##$9
Creditors had ho&ed to recover more than $544 million *rom Campbell Soup in the case9
/urin, the "an1ru&tc., Llasic, S?anson and other "rands ?ere sold to %innacle =oods
Cor&9 *or $335 million, ?hile sales o* other lines raised a"out $2# million in additional
cash9
Shares o* Campbell Soup sli&&ed 9 cents to 5nish (uesda. at $3#99# on the 8e? Nor1
Stoc1 )'chan,e9 )nd o* article9
1o more Buestions@@..,
BG% As you can see Bruce really is an amaHing investor. !e is the guy I call to go over a situation. !e has
seen a lot over the years. Pne of the things that hel"s9you are all smart enough to be good investors9that
there is a lot to be said about "ractice. I am still learning. I would say Bruce would say he is still learning. 2he
good thing is you don&t have to be ?ichard P8ena or Bruce .ewberg but
.ou do have to be very thoughtful
.ou do have to do your homework
.ou do have to have the right framework
I want to thank Bruce .ewberg for coming. A""lause@@@@@
5;6
Bruce .ewberg8 talking to students between the break@@@.
2;% I think there is 4ust too much money floating around in hedge funds. I think it is allocation of ca"ital. 2oo
much ca"ital has been "rovided to "eo"le who do not think they can "rovide value added. Money has moved
out of the big ca" stocks. If you look at "ension fund allocation and you see how much money was allocated to
long;short hedge funds si# years ago versus today I can guarantee that there is so much more money allocated
to these different strategies. And the other thing is that more money has gone to "rivate eBuity. 2here is more
money to fund buyouts. 2here is a multi"lier effect for all of these different strategies that have attracted
'5
ca"ital. 0ut you know you go through cycles. .ou don&t want to be involved in the markets from $K<+ to
$K<5. 2here will be different cycles where this will be a great business and where it won&t be a great business.
2he Donvertible Arbitrage market, I think that the market is @well what you had ha""en in the "ast year8
Interest rates have gone u" and volatility has decreased. 2y"ically convertible arbitrage guys are long
volatility and they are long the interest rate. So the bond forward value goes down when interest rates go u".
2he o"tion "ortion is worth less as the volatility comes in. 0ut if money floods out of converts you want to
go into it. Go to the area where money is flowing out of it.
Student% 5o you think there has been enough of a correction,
2;% It is "robably not over. 2he real Buestion is what ha""ens if we get a big move in some inde#, :ike
large ca" stocks do really well and hedge fund returns under "erform that by '++ to 5++ basis "oints net, 2hen
what will ha""en, 2ecause people tend to invest in the rear view mirror. 2he right thing to do is think
about what is going to ha""en though you won&t always be right all the time.
Second hal# o# Class
BG% .ou might say that there is a lot of hedge fund money out there and there might not be much o""ortunity
now. I am wasting my time. 2he "arty is over. In $KKC and 2+++ and 2++2;+( there were huge o""ortunities
in small ca"s. 2hat was not too long ago. Jight now I think the o""ortunities are in the large ca"s. I would
call the o""ortunities larger ca" with smaller u"side and better Buality businesses.
I don&t think the risk rewards have changed all that much but I think the rewards will be lower but less risky.
1ow you have better businesses to invest in at attractive "rices. .ou have to ad4ust for that.
In Bruces e#am"le of &TS.' the did not have the "ile of cash as a margin of safety but he could bet a *$ to
make *5 or *) or *<. It was a good risk;reward bet. .ou would take that risk;reward bet but ad4ust your
"osition siHe based on your ability to take the hit on that. In the first bet in +IPS was a margin of safety bet.
!e fell into the situation he assessed it and chose the risk reward bet.
Pbviously you want to work under somebody you res"ect. If you can I would look at it as a learning
e#"erience. !o"efully by the end of this course you will look at the world through a certain lens. 2his is not
the only way to look at the world but it is one "roductive way to look at the world. I would certainly try to get
myself into a "osition where I have some "ortfolio e#"erience.
.ou have to screw u" a bunch and learn from it. If you can value something and buy it for chea"er than it is
worth it doesn&t have to be a whole lot more com"licated than that.
I brought this book "ublished in $K5K and it is called !ow to 6rofit from S"ecial Situations in the Stock
Market by Maurece Schiller. 0ig "rofits from oversubscri"tions and rights offerings. My "oint is that "eo"le
have been doing this for a long time.
I was looking in the "a"er today about the hedge fund manager in +c%onalds. It is about a !F investor who
wants to take over the real estate owned by +c%onalds and then sale;lease back to free u" some cash. Article
below8
,ed!e(>und )an at M#$onald%s 1ershin! S9uare=s E2 2illion 2et Is 8hat the Chain Can 7evamp* 8ime
>rame ,asn=t 2een >ast. September 2K, 2005* 1a!e C1
In $KK< a brash young hedge?fund manager envisioned M#$onald%s Dor". selling off all its restaurants to
give shareholders a huge value meal. Eight years later 0ill Ackman has amassed a su"er?siHe stake in the great
American icon and is salivating as he "ulls u" to the drive?through window.
And yes ?? he wants fries with that.
')
+c%onalds stock has been roiled since it emerged in mid?Se"tember that Mr. AckmanMs 6ershing SBuare
hedge funds had accumulated stock and o"tions that could give his investors a '.K> stake valued at *2 billion.
2hat is one of the biggest single?stock "ositions ever taken by a hedge fund.
Mr. Ackman sees Mickey 5Ms as three se"arate businesses8 a franchising o"eration that accounts for about <5>
of its (++++?"lus restaurants world?wide3 a restaurateur that owns and o"erates the rest of the outlets3 and a
real?estate com"any that owns the land beneath nearly '+> of all of them.
0ack in the $KK+s he had a small stake and suggested that +c%onalds s"in off both its restaurants and the
real?estate business. 1ow he has a slightly different idea says a "erson familiar with it. !e still wants
+c%onalds to retain the crown?4ewel franchise o"eration and to sell off a ma4ority stake in the com"any?
owned restaurants as a se"arate "ublicly traded entity that would be one big +c%onalds franchisee. 0ut he
wants +c%onalds to kee" its real estate borrow against its unta""ed value and give the money to him and
other shareholders.
2he two businesses Mr. Ackman wants +c%onalds to kee" are as close to ideal as "ossible8 2hey have high
returns and low cost of ca"ital allowing it to raise money to run the business chea"ly via loans and stock sales.
2he franchisee business charges outlet owners '> of whatever they generate in revenue. 2he real?estate
com"any gets an additional K> to $+> in rent.
2he third business isnMt as good8 It has low "rofit margins and demands huge ca"ital s"ending to run the
restaurants. Founder Jay Aroc originally didnMt even want to own restaurants "referring to collect all those
"ennies on every burger. +c%onalds ownershi" of its own 4oints came later when it was throwing off so much
cash that it didnMt know what else to do with it.
2he real estate is 4ust sitting on the +c%onalds balance sheet without "roducing much cash for shareholders.
Mr. Ackman values +c%onalds real estate at *)+ billion based on the cash it "roduces says the "erson
familiar with his analysis. 0y com"arison the entire com"any right now has less than *5+ billion in stock?
market value and net debt.
All this may come off to many investors as audacious if not farfetched. S"inning off a "owerful gigantic
franchisee could backfire if it decides to fle# its muscles against its former owner. And adding debt to the
"arent would be risky too.
0ut the com"any might actually be giving the "ro"osals a sym"athetic hearing. Mr. Ackman and +c%onalds
e#ecutives met after one of the com"anyMs "eriodic meetings with analysts and investors last week.
VWe have a very high regard for +c%onalds ?? the com"any the brand and the managementV Mr. Ackman
says in an email. VWe are "articularly encouraged by managementMs shareholder?value focused agenda. 0ottom
line weMre lovinM it/V
V+c%onalds is always looking for ways to further increase shareholder valueV says Mary Aay Shaw the
com"anyMs vice "resident of investor relations in an email.
Mr. Ackman has met with +c%onalds before. In late $KK< and $KKC he "resented his "ro"osals to a
+c%onalds director and some e#ecutives including Matthew 6aull now chief financial officer. +c%onalds
was intrigued enough to hire boutiBue investment firm Greenhill S Do. to analyHe the divisionsM value
according to a letter Mr. Ackman wrote to his hedge?fund investors in March $KKK. 0ut the stock rose strongly
on its own and the urgency to do something faded.
Since then +c%onalds has become a dramatically different com"any es"ecially in the "ast two years. It
"ulled back on its growth "lans and became more shareholder?focused cutting ca"ital e#"enditures and
returning money to shareholders with increased dividends and stock re"urchases. It 4ust announced it would
"artially s"in off one of its subsidiaries the Dhi"otle Me#ican food chain. 0ut these initiatives havenMt made
the com"any as efficient as "ossible. 0uying back stock increases its ownershi" of everything including the
less?"rofitable restaurant o"erator.
'<
Mr. Ackman has a track record of fast?food activism. WendyMs in which he has a $+> stake initially resisted
his calls that the com"any s"in off its 2im !ortonMs doughnut division. In that case his "osition was big enough
to reBuire "ublic disclosure and he "ressured management with "ublic letters. WendyMs 4ust recently took his
suggestion and its stock is u".
!e hasnMt taken those ste"s with +c%onalds a signal that he "erceives management as more rece"tive. 2hat
may be because the stock is roughly 25> lower than where it was at its "eak in the late $KK+s. 0ut the
com"any is worth even more now8 Dash flow has im"roved and the real?estate "ortfolio has a""reciated. Pf
course that ha""ens to be what leveraged buyout firms or "otential acBuirers hunt for.
2hat means +c%onalds may have to become even more shareholder?friendly or risk becoming takeover bait.
Already Mr. AckmanMs "lay has "rom"ted s"eculation that /ornado 7ealt 8rust the big real?estate
investment com"any will make some sort of bid to get a hold of +c%onalds land. %ust the "ossibility "uts
"ressure on +c%onalds.
Mr. AckmanMs "ro"osals are reminiscent of the s"lit that Doca?Dola underwent in $KC) when it divided its
syru" business which had astonishing "rofitability from its bottling o"eration which demanded heavy ca"ital
s"ending. 2hat created immense shareholder value but was in "art built on an accounting illusion that the
bottler was an inde"endent com"any. Doke initially sold only 'K> of the bottling o"eration and effectively
still controlled it for years.
If nothing else Mr. Ackman has "ulled off a neat trick8 !e eked out his stake while only having *$.( billion
under management in his funds. 2he stake would be too much concentration for one fund so last month he
invited his investors to "ut money into a s"ecial se"arate fund to invest solely in a single stock the name of
which he didnMt disclose initially. !e raised about *25+ million in three days. Along with about *$5+ million
from his main fund he bought )2 million shares and o"tions that if fully e#ercised would bring his stake to
the full *2 billion says a "erson familiar with the matter.
Dritics of hedge funds deride them as vultures that swoo" in for short?term feasts. 0ut Mr. Ackman has been at
this since $KK<. And now we will see whether he ends u" with a ha""y meal.
.rite to %esse Eisinger at longandshortXws4.com
(
.
So there might be an o""ortunity to take out the cash without effecting o"erations. !owever once you do not
own the real estate anymore you start "aying market rates of rent so you have to ad4ust for that and see what
the net gain is. So that was in the "a"er today.
2he ne#t article in the Wall Street %ournal right under that is an article on the &merican ,Cpress s"in?off.
American E#"ress S"in?off Must 6rove It Dan Dreate More 7alue Pn Its Pwn
2 57IC@ C<1D3S-A Sta## 7eporter o# 8,5 .@33 S87558 B<D7;@3 !e&te'ber ()*
(++,- a.e C/
2hroughout much of the $KK+s American E#"ress Financial Advisors was the crown 4ewel of the @merican
5+press Do. em"ire.
At one "oint the Minnea"olis?based financial?"lanning unit contributed as much as '+> of "rofit while
American E#"ress struggled to revam" its sagging charge?card business and small international bank.
0ut more recently the unit has been the weak link at American E#"ress whose signature card travel?related
services and "rocessing businesses are highly "rofitable. Dom"ounding its "roblems the unit sustained a
"ublic?relations black eye when state regulators alleged that it defrauded customers by giving its advisers
undisclosed incentives to "ush its "oorly "erforming in?house funds3 the unit agreed to "ay *<.' million to
1ew !am"shire to resolve the allegations.
'C
1ow that Ameri"rise Financial Inc. the new name for American E#"ress Financial
Advisors is about to be s"un off to American E#"ress shareholders its challenge is
to convince investors that the business can create more value on its own. Pn Friday
AmE# shareholders are to receive one Ameri"rise share for every five American
E#"ress shares they hold and the shares will begin trading Monday on the 1ew
.ork Stock E#change using the stock symbol AM6.
Ameri"rise is betting it can distinguish itself by building on the financial?"lanning
business it hel"ed "ioneer three decades ago under the name Investors 5iversified
Services before it was acBuired by American E#"ress in $KC'. Ameri"rise ?? which
manages roughly *'++ billion has a network of more than $+5++ financial advisers
and boasts 2.5 million clients ?? faces com"etition from the likes of Fidelity
Investments Charles Schwab Dor". and )errill 3nch S Do. It ho"es to
differentiate itself by "roviding one?sto" financial "lanning to affluent baby
boomers a""roaching retirement.
VWe look at a clientMs whole "ictureV Dhairman and Dhief E#ecutive %ames
Dracchiolo said. V0y offering a combination of investment and insurance "roducts within the conte#t of a
com"rehensive financial "lan we hel" our clients not only grow but "rotect their assets.V Ameri"rise is one of
the few financial?advisory firms to offer an array of "roducts ranging from mutual funds to annuities to life?
insurance "roducts. It has more certified financial "lanners than any of its rivals. And it is targeting the mass
affluent ?? the roughly 2K million R.S. households with *$+++++ to *$ million in assets to invest.
So far not everyone on Wall Street is convinced. V2he com"any hasnMt been trans"arent with analysts and
investors on the earnings breakdown between different "roducts. 2his is adding to the com"le#ity of
understanding the com"anyMs story and where the return on eBuity im"rovement will likely emergeV said 1igel
5ally an insurance analyst at Morgan Stanley. Mr. 5ally doesnMt yet have a rating on the stock and his firm
doesnMt have a banking relationshi" with Ameri"rise.
In a "resentation to analysts earlier this month Ameri"rise defined its two o"erating units as asset
accumulation accounting for )$> of 2++' earnings and "rotection accounting for (K>. 0ut many analysts
view Ameri"rise as an insurance com"any in disguise. According to %ohn 1adel an analyst at Fo#?6itt Aelton
nearly half of the earnings of the asset?accumulation business come from fi#ed and variable annuities "roducts
that combine investments with insurance. 0ased on his analysis insurance and annuity "roducts generate about
<+> of the com"anyMs earnings.
Wall Street already has gotten a sneak "review of how Ameri"rise may be valued. Pn Se"t. $5 Ameri"rise
began trading at *(C.+2 in the Vwhen?issuedV market where investors can buy and sell securities before they
have been issued in the "rimary market. Although the stock has since fallen to *(<.25 down 5+ cents yesterday
at ' ".m. in 0ig 0oard com"osite trading it still a""ears to be a rich "rice relative to some analystsM estimates.
0ecause trading has been relatively thin some analysts argue that the current "rice isnMt a good indication of
how the stock will be valued when it begins officially trading.
V0ased on our fundamental valuation work as well as the "otential near?term selling "ressure from American
E#"ress stockholders we believe the stock should trade between *($ and *(' a shareV says Mr. 1adel of Fo#?
6itt Aelton who doesnMt yet have a rating on the stock.
Pne big unknown is whether investors who own big chunks of American E#"ress stock will dum" Ameri"rise
once they receive the shares. Durrently a large "ortion of American E#"ress shares are held by growth?oriented
investors who may be less inclined to own Ameri"rise which is generally e#"ected to attract more value?
oriented investors.
2o be fair AmE#Ms largest shareholder is one of the best?known value investors Warren 0uffett. Mr. 0uffettMs
2er"shire ,athawa owns roughly $2> of American E#"ress shares and whether he intends to stick with
Ameri"rise after the s"in?off is certain to affect Wall StreetMs thinking. Mr. 0uffett declined to comment.
'K
At least one "otential overhang on Ameri"rise shares was lifted earlier this week when Standard S 6oorMs
Dor". said Ameri"rise would be added to its flagshi" SS6 5++ Inde# at the close of trading Se"t. (+. 2he move
eliminates the "ossible near?term "ressure on the stock by inde# funds that would have been reBuired to sell
their shares. !owever Ameri"riseMs inclusion to the SS6 5++ Inde# may have disa""ointed some investors
ho"ing the selling "ressure would enable them to buy the stock on the chea".
VIf the stock falls below *(' then investors should want to own it because the downside in the stock is limited
and the u"side could be very attractive if management could e#ecute on im"roving the com"anyMs return on
eBuityV Fo#?6ittMs Mr. 1adel said.
Ameri"riseMs return on eBuity is currently K> to $+>. Management is targeting a return on eBuity of $2> to
$5>.
2o accom"lish that goal management "lans to roll out new "roducts refocus on e#"anding the institutional
asset?management business by investing in sales and ca"abilities infrastructure and e#"and distribution of
mutual fund and annuity "roducts through third?"arty channels such as banks and brokerage firms. !owever
analysts say the com"anyMs future growth de"ends largely on whether it can continue to im"rove the
"erformance of its in?house mutual funds.
While there are signs of a turnaround money is still walking out the door. So far this year investors have
"ulled *< billion out of American E#"ress stock and bond mutual funds according to AMG 5ata Services in
Arcata Dalif. 2he stock and bond funds now have roughly *55.5 billion in assets. Pverall firm wide mutual?
fund "erformance has im"roved but isnMt striking says Jussel Ainnel a Morningstar Inc. analyst. Pn average
the funds did worse than )5> of similar funds over the "ast three years on an asset?weighted basis according
to Morningstar.
Analysts also are concerned about how the business will fare without the American E#"ress name one of the
most highly recogniHed in the financial?services industry.
5es"ite these risks several investors believe the stock is a good investment because there is value to e#tract.
As Ayle Derminara a financial?services analyst at 2. Jowe 6rice Grou" Inc. sees it8 VAmeri"rise is viewed as
a relatively ine#"ensive stock that has "otential for Yreturn on eBuityZ im"rovement.V
.rite to Erica Do"ulsky at erica.co"ulskyXws4.com
$
1ow &KP is s"inning off the Amer. Fin. Advisors which has been an under managed business. It also
unleashes the stand alone charge card business which is a great franchise with high JPE good market
"osition good growth "ros"ects and things of that nature. So that will trade on its own. 6eo"le might say gee
everyone knows about this. It is not obscure situation.
1ow I thought I would hand out more detail on the cases that were in my book. Pn the front are s"in?offs that
you can use for your cases. .our first assignment8 I am e#"ecting a one "age write?u" with backu". Give me
the investment thesis. If you did the work and you find that the com"any is not chea" then show your
valuation work. I want to see the original thesis as to why you chose this com"any. What you find out. .ou
will do your com"arable analysis you will do your absolute analysis of what you think earnings will be.
7aluation and things like that on the back. I want to see your work. I don&t want to see 6;E and 6rice;Sales.
6art of the e#ercise is to get my comments back. .ou only have two more classes after this and then there is a
vacation. 1e#t week I will hand out some write?u"s that I thought was very good.
What you have in front of you is a list of "ending s"in?offs. 2he ne#t "age is the Sears e#am"le. %ust read
about Sears and then we will discuss it.
5iscussion of Sears S"in off. S"in off of &ll State and %ean 3itter. 2his idea was e#"lained by Michael
6rice in 0arron&s. 2his comes out in A"ril or May but I com"letely missed it des"ite being a s"ecial situation
5+
guy. Sears will s"in off C+> of 5ean Witter. 2hen the %uly 5
th
issue of 0arron&s because I read an article on
Michael 6rice.
Sears at *5' seems valued much too low. 2hat *5' includes $ share of &ll State so for $ share of Sear you get
*2C worth of &ll State and *$5 worth of 5W so that leaves *$$ for Sears then take out *2 or *( for Doldwell
0anker and *( for Sears Me#ico and it leaves *5 for Sears. A market ca" of *$.5 billion with *2< billion in
sales. D!EA6/
2here is no debt here. So you get )> on the dollar for sales. What does a com"arable look like, So I turn the
"age on J$C$ Penny So let me com"are it to another crummy retailer9J$C$ Penny. %D was the closest I could
find. I used the tear sheet9we didn&t use the Internet in those days9and if I go through the math is trading at
)+ cents on the dollar for sales.
Sears is ) cents on sales versus J$C$ Penny which is at )+ cents on the dollar of sales while also going through
other com"arables such as margins earnings etc. Everything was "retty close. 2his was as good a metric to
use to show the dis"arity in "rices. So what did I do ne#t, 2his is all laid out for me by +ichael Price$
I am looking at a ten times difference in valuation from Sears to J$C$ Penny. What did you think I did ne#t, I
bought as much as I could over the ne#t two weeks. I did this after the article after they were giving out the
shares. I bought as much as I wanted at the stocks Michael 6rice was s"eaking about. I effectively created
Sears for *5 which could have been worth *5+. 2he ga" was huge.
What ha""ened after they s"un out &ll State, 2he Sears went u" to *(+ where we sold most of our stock and
two months later it went to *5+. !ow can that be,
I missed it and +i(e Price lays it all out for me and I am still able to buy it. !ow can that be, 2hese are well?
known com"anies. 2here were $+ analysts who were following Sears. I am a little baffled. I guess the retail
analyst does not cover insurance and brokerage com"anies. 2hings fall through the cracks.
2he answer is that I don&t really know. I am 4ust telling you that it ha""ened. .ou can say it is so hard.
Sometimes it is and sometimes it is not. It was a s"ecial situation over ten years ago. .ou may claim that there
are so many hedge funds today that that o""ortunity would not e#ist and that may be to some e#tent be true yet
there have been "lenty of o""ortunities in the "ast five years. &merican ,Cpress is doing a s"in off. Maybe
the s"in off gets beat u". 6lenty of stuff goes on. Even if the o""ortunities are not as glaring as this one but
there will be others. 2he efficient market theory says this shouldn&t ha""en.
Dom"arable things were trading at J$C$ Penny&s level not at Sears level.
6eo"le said I was an idiot to write the book on s"in offs because then the o""ortunities would disa""ear. A
year after I wrote the book s"in offs did not do "articularly well in aggregate but then the returns came back.
.hat I sa about spin o##s% It is a #ertile !round to #ind mis(priced opportunities. Sometimes they are
over"riced because too many "eo"le are following or sometimes the s"in offs are under "riced because of too
much selling "ressure. 2here is a dislocation and change. Weird stuff is ha""ening. American E#"ress will be
able to trade on its own so "eo"le will see how good a business they really have.
I am "ointing out the amaHing dislocations you could have. A few years ago during the Internet bubble you
could own ACom which was inclusive of Palm at a negative *() dollars. For fun we shorted Palm against
ACom$
=uestions, I don&t have any answers but to say stuff ha""ens and it is worthwhile to look. We don&t own any
3al4+art but we are looking. 6eo"le ask me when they should buy s"in offs. Should you wait two months
should you buy right away, I don&t use a formula. I analyHe each situation inde"endently. :uckily there is no
magic formula.
6erha"s the com"any being s"un off is small so the institutions won&t want it. 2he large ca"s have not moved
in 5 to < years but the earnings have moved u".
5$
Pur worst years were $KKC to $KKK then we made $++> in 2+++. When things look obvious things ha""en.
:ook at the a""lication on the value investors club for things you should "resent.
Go to "age $2 :iacoms "urchase of Paramount Communications. 0asically the winner of the bid ran out of
money so :iacom offered lots of "a"er to its shareholders as "ayment.
So if you are an institutional investor and you get all this stuff what do you think is going to ha""en when you
get this, .ou will sell it. Institutional investors won&t "ay read about Contingent :alue ?ights 1C:?s2$ 2here
will be a fire sale. I hadn&t seen a D7J or what the warrants were.
5iagram the combinations of values you can obtain.
We have a three year warrant struck at *). 2hey had borrowed a ton of money so the eBuity stake of :iacom
was like a leveraged buy out. 2here is a lot of leverage here so these warrants may be worth something.
2he e#changeable convertible debentures are basically 4unk but they were worth )+ cents on the dollar but I
can use them as money to buy something of worth. I had to come u" with *<+ worth of debentures. *<+ #
+.)+ O *'2 for five year warrants. I lowered my cost by '+>. 2hese subordinated debentures have over *$
billion in face value.
Making the debentures available for the warrants made the warrants more valuable. :iacom sim"ly ran out of
money so they created e#changeable "a"er.
Any time you see anything remotely com"licated try to take the big "icture view of it. 2he market looked at
:iacom as if it way over"aid for Paramount$ 2he way I looked at it was like this8
2hey only "aid half of it in cash and the rest of it with 4unk. If they didn&t lay out cash then I don&t care if they
over"aid from a credit worthy stand"oint. 2he rest they "aid in 4unk. I was ne#t in line.
I also made a lot of money in +G+ because Turner "aid half in cash and half in "a"er. !e bought a film
library so he had low "rogramming costs.
1e#t we will look at Bost4+arriot.
2he big "icture here8 1o one likes the over levered !ost Marriot. What I thought was "otentially attractive8
there is *'++ million in eBuity with *2.) billion in debt so *( billion in value. 2he debt was non?recourse to
the "arent. Pf the *'++ million in debt *(++ million was only on the San. Francisco Marriot. *2 billion
guaranteed by the subsidiary and not the "arent.
*<++ million ? *$++ debt O *)++ million.
2his was a good risk reward. 2his was a leveraged bet. *' "er share for !ost but worth *) "er share of the
6arent. 2here is nothing you can learn at school that says to go look at this stuff. 2his was a good risk reward
where I lay out *' for ) value with no debt and some u"side.
I don&t have to get to that "oint where I do a lot of work. If I have a thesis and it kee"s holding u" you kee"
going or if not then dro" it. I don&t care what I don&t do but what I actually do do. .ou wait for your "itch.
2he good thing about working for yourself is that you can sit on your hands.
2he valuation work is never wasted. 2he broader your circle of com"etence from doing different industries the
better. 2he key is doing good valuation work and having the disci"line. 2he key is what conte#t to look at the
world. What matters is doing well what you do. I don&t care about what I missed.
52
1e#t week read the Buett stuff. Jead his letters. 2he ne#t Friday or the following Friday we will have a
guest s"eaker. E15
1ovember +C 2++5
6ro4ect for Pct. $)
th
?choose one of these com"anies. 2hese com"anies have not been chosen randomly. All are
interesting.
JDII 20: DP:M
:LA AD6 56W
I6G DEDP EF5
6FE ASWS A0ES
MA2 AG A15
RS2 M7: :IW
AEPS 1DPG 6E2D
F: P72I 6GI
FPS: 26L WGP
G6S I1S6 DPDP
2rack $<8 %oel Greenblatt8 I want to go over your "a"ers. In general for a first attem"t they were very good. I
guess big big "icture I would like a more concise "itch.
I read an article about 0ill Miller who runs the :egg Mason funds and he has done tremendously and he has
beaten the market for the last $' or $5 years. !e is an interesting value investor but they run billions and
billions of dollars.
!e wants a "itch very concise and fast. It hel"s you if you can summariHe your "itch very Buickly. 2his
com"any is trading Uit is out of favor now3 it is earning less money but if you look at normaliHed earnings it is
trading at 5 times normaliHed earnings and JPID are 5+> they are closing their money losing division so that
is why "eo"le don&t see it. 6eo"le see it this way and that is why it will get better. .ou should be able to say
it.
.ou should be able to s"it out the "itch and the valuation "ortion of why you think it is chea" in a few lines but
then I want to see the back u". It is 4ust very good "ractice for you to understand why you are or are not
buying something. Pr this is what I thought and this is how it turned out. It is a little harder when you are
assigned something because you might not have a strong "itch on it. It looks fairly "riced. I went through
normaliHed earnings it comes out within the range of fairness. Pr I can&t "redict what normaliHed is. I you can
"ick BBI 1Bloc(buster2 and say I don&t know where earnings are going to be so I have to stay away. !ere are
three scenarios and if it hits this one I am going to lose a lot of money and I don&t have a lot of confidence
which one is going to hit yet.
In answer to the Buestion which was asked of 0rian by the way which is8 -!ow do you value a com"any
whose earnings are going to dro" off a cliff in three years five years or whatever, It is really nothing more
than a discounted cash flow Buestion. .ou make your assum"tions about future cash flows and if you can buy
it at half of all the cash you would collect then you would buy it. It is not a Warren 0uffett "ick but it is a way
to make money if you think you will collect that money. It is not su"er com"licated9you are trying to figure
out the thing you are buying9what is it worth and "ay a lot less for it. 2hat is what you are trying to do.
2he way I answer most Buestions is that if I can&t figure it out then I say I don&t know. 2hen I have no
business investing in that.
Student8 !ow would you think about the terminal value used for 00I,
5(
%G8 .ou know what, Me "ersonally I would not get that com"licated. What are they going to earn in year $
year 2 @@..ear C and then figure out what that is worth to me. If I "ay *5 now will I get *$+ within C years.
* of the dollars could be ne#t year and the following year I would receive *$. If I can make an IJJ Ginternal
rate of returnI on the money I have invested that might look "retty good. A. who cares what I make in year K
because it will be ne#t to nothing based on my assum"tions. I am not looking for e#act answers. I am looking
for9hey I think it is going to be worth *$+ and it is trading *5 to *). I think that is a "retty good bet there.
Eric&s "resentation on Jisk Arbitrage. 5oes anyone have any Buestions, I think many have misconce"tions
over what I wrote in the book. 5on&t try this at home. 1ot that it isn&t a bad "lace to be but it isn&t for
amateurs who don&t do a lot of work.
What Eric said is that s"reads are so thin. 2raders are investing in situations with C> annualiHed returns or
4ust above the risk free rate. I never looked at the business that way. And I think that is the flaw. I look at it
as a risk reward business. I can make a dollar but I can lose *$+ and all this ha""ens in three months. A lot of
"eo"le set it u" as an annualiHed return business. Pne annualiHed return can be a lot better where you make ten
and lose a dollar.
6eo"le look at it the wrong way which was always my com"laint. 2here is too much money chasing returns.
I don&t think it is "articularly relevant right now because "lain vanilla arbitrage is not too good. 2here are
always interesting things when something is changing. 0rian 4ust went through the takeover battle for
!ollywood. 2here was a *$' bid and it went down to *$+.25 that is an interesting one to think about. If you
have a strong valuation o"inion and you understand how takeovers work there is a lot of back of forth and
game theory involved as the buyer tries to get a chea" "rice. What are the incentives here, 2he DEP is not
trying too hard for them to cut the "rice and they still are interested. 2hey didn&t walk away because the
business is going nowhere. 2hey "robably wouldn&t show u" again.
2rack $C8 2here is a lot of stuff going on there so it is still fertile ground. And we talked about merger
securities to look at sometimes there is overbidding or management is trying to take it "rivate. 2here is a
chance to make money along the way. I am not saying ignore this are com"letely. I am saying it is its own
s"ecial area. I originally did not write that book for M0As. I hadn&t taught M0As yet. I wrote the book for
M0A level readers but I had been doing it for $5 years so I didn&t realiHe that. I really meant for lay "eo"le.
Domments on Students "a"ers
2his is in no "articular order I 4ust went through the "a"ers and made comments. 5on&t take it "ersonally.
I bunch of "eo"le sla""ed on a bunch of $2 # E0I2 numbers. I would not do that lightly3 it has to be a "retty
good business to trade at $2 # E0I2 and "eo"le threw out "retty high numbers. Well it is trading at half that.
2hat might be but that is a "retty high number. We talked about $+ # E0I2 with a '+> take rate is )> after?
ta# return that is a "retty good business to trade off for a government guaranteed bond. 2o take $2 # E0I2 you
would want to be "retty certain of the business and the growth. I wouldn&t throw those numbers around so
lightly. 2here are certain business that are worth that or more than that but it ain&t chea"/
Pnce again if it is tough to know what normaliHed earnings are the best thing is move on to something you can
analyHe. If you can&t analyHe normaliHe earnings then you don&t have a clue.
??
!ow to Make 6resentations to 6ortfolio Managers by 0ill Miller 6M of :egg Mason
2)% I want to em"hasiHe in your "resentations that if you go into ca"ital markets you will realiHe that
"ortfolio managers have ultra?short attention s"ans. @nd there is basicall no success#ul port#olio mana!er
o# m ac9uaintance who has ever wanted to hear a stor lon!er than ninet H?0$ seconds. 6eter :ynch
when a senior analyst came into a "itch him a stock would turn on an egg timer for K+ seconds. 2he analyst
had to com"lete the "resentation within K+ seconds and be out of there.
5'
If you can&t get the "ortfolio manager&s attention within that time with a convincing case then they will assume
that you either don&t have a convincing case or you are not able to articulate it and you should go back and
figure it out.
Stories not Atoms
2he world is made of stories not of atoms. Most "eo"le think of the world as analyHing atoms and its
constituent "arts and then I am going to figure out how to value it and then describe it. 2he alternative way to
think about it is to construct a convincing story. 2ake all your material together and construct a convincing
story.
If you s"eak to a "ortfolio manager the best thing to say is -I want to talk to you about Bomestore G!PMI. It
is at *2.25. 2he 52?week range is *' to *2 and the all time high was *$++ in 2+++. I think it is a buy for the
following five reasons8
$. 0am
2. 0am
(. 0am
'. 0am
5. 0am
2he stock is trading a *2 and change. I think it is worth *) or *C or whatever. !ere is why I think it is worth
that. !ere are the risks. 2hen you are done.
In the "resentations8 no more than five "ositive "oints and three negative "oints. What is it worth and then you
are done.
??
Greenblatt Class #K
1ovember +C 2++5
!o"efully you will read the Magic Formula book for ne#t Dlass
Linda Greenblatt 1resentation on investin! in retail stoc"s.
Joel Greenblatt 1LJGM2; 0efore she s"eaks 4ust to give you a conte#t :inda sticks to one area8 consumer
products and retail. She has been in that area for $+ years and has averaged high 2+&s "ercent returns staying
in that little niche that she knows well. She finds enough o""ortunities in that one area. !er returns have been
no more volatile than other concentrated investors. She has "henomenal returns focusing on what she knows.
2here is a great lesson for you. It doesn&t have to be retail but an industry that you understand. She "icked
something she really en4oys??that is a very im"ortant lesson.
A number of "eo"le have come u" to me before class and said they will 4oin a big firm and they are afraid they
will be "igeon holed. 2hat may be true but to really learn an area very well and still be very "rofitable. As
you invest over a long "eriod of time you will come to know more areas. Anowing one area well is
tremendous.
She will talk about areas she is working on@@.
What is a girl from :ong Island doing in retail,
0inda Greenblatt 1L0GM2; So what is a girl from :ong Island doing in retail, 6ick an area that you can know
and that you can understand well and that you en4oy. I li"e shoppin!. It is definitely an area I have to come to
know well. .ou start to see "atterns. Pver a ten?year "eriod you learn how a "articular industry grou" trades
that gives you a big advantage over "eo"le who are first looking at the stock and coming in cold and not having
the background.
55
I like retail because you are constantly getting information. .ou get it on a monthly basis and sometimes on a
weekly basis. Jetailers "ut out same store sales numbers?Dom"arable sales in stores for a year?over?year
"eriod. Monthly basis but most industry grou"s you normally get Buarterly numbers. 2he more information
you have the more "eo"le try to trade on the information before after and during. .ou get a tremendous
volatility in this sector. A lot of "eo"le don&t like volatility. As far as I am concerned I can live with volatility
if there is a good o""ortunity over the long term. And if I am taking a two years time horiHon that is actually
my greatest o""ortunity??are these monthly numbers.
Inevitably these com"anies are going to miss because of their fault or no fault of their own due to the macro
environment. 2here will be a missed number and the market tends to have no mercy. So the market kills these
stocks. Pne day it is trading at 2+ times and the ne#t day it is trading $+ times 1earnings2 but nothing has
fundamentally has changed. 2hat fundamentally is your o""ortunity. So you must live with a little bit the
an#iety. 0elieve me when these stocks are down (+> to '+> it is hard to "ull the trigger but that is usually
the best time to buy. 7olatility is your friend.
I don&t know how to "ick the ne#t trend. I really don&t know fashion. I say this8 nobody can "redict fashion. It
is really is not about hitting the ne#t trend on a continuous basis. @re these companies runnin! a !ood
business over the lon!(termC Are they running a business that can weather the u"s and downs,
2he best time to get in is when they missed a season of merchandise because if you look at the fundamentals of
the com"any and it is well?run and the stock gets crushed because they miss a season of merchandise then it is
an o""ortunity to own for the long term. It is really irrelevant if they "ick the hot trends or not.
It is very interesting because the Street misses the "oint on retail. Most analyst re"orts focus on how this
com"any will do in Pct, !ow will this com"any be affected by Aatrina or higher heating "rices for
Dhristmas, 2hese are all relevant Buestions but not relevant if this is a good business. Fundamentally it will
be around. If you buy it at the right "rice it really doesn&t matter what is ha""ening to the customer today
because they will be around and they will continue to buy.
A Buote from Fortune last year from a !edge Fund manager who often invests in retail -I have my "eo"le visit
stores to see how much the items are marked down or if there are long lines at the register and I buy if this
com"any will beat numbers and short it if it misses numbers. It is that sim"le.
,e reall misses the point. It is not that sim"le. If I had to invest that way I would lose slee" over whether I
could consistently do that. Maybe I would get it right only 5+> of the time. I would have a lot of an#iety in
between. If you can take a longer time horiHon for one to two years. Aou have to bu these thin!s when
people hate it because that obviously is when your o""ortunities are available. So you have to be a
contrarian.
Dan you see my slide8 2his is a "rice chart of &,9S' &merican 9utitters.
5)
!ere is the two year "rice chart it was u" then down. So the first thing you notice there is a lot o# mone to
ma"e in this stoc". 2wo years ago it traded at *<.5. !ere at *$+ they had *( to *' dollars of cash on the
balance sheet you knew they were not going under. .es they missed sales9is anybody familiar with this
story,
0asically they were off?trend for a while. 2hey were not sure how to "osition themselves in the market"lace.
2hey tried to com"ete against G&bercrombie' &./ but they didn&t have the cache. 0ack in 2++' they were not
addressing their customer9the fickle teenager. 0ack in 2++(;2++' they were missing the boat with their
customer3 they were not meeting their needs.
Fast forward si# months they got their inventory under control and they turned their merchandise around.
Dom"arable store sales turned around that was key. 0ack in 2++' it wasn&t that their earnings "otential was any
less than si# months later it was the fact that com"s 1comparable same store sales2 were negative. 2his
com"any doesn&t deserve this multi"le because they are showing negative com"s so it should trade at si# times
"otential earnings net of cash. 2o me this is a com"any that will be around. 2hey have a healthy balance
sheet. .es they have merchandise misses3 yes their same stores sales are down. 0ut they are making changes
to their management team3 they are on to" of their inventories. 2hey got hit on inventories in 2++'. Dertainly
there is "otential there.
As soon as "eo"le as "eo"le saw com"s stabiliHing and they recogniHe that they could get back to more
normaliHed earnings and margins the stock basically tri"led. 2his is one e#am"le how you can make money in
retail if you get in at the right time.
1e#t Dhart8 &./8
5oes anyone know the story here, 0asically the same thing ha""ened. Dom"s were negative for awhile3 there
were merchandise misses they tweaked their management team. 0ack in their 2++(;2++' area des"ite the fact
that they had a strong balance sheet and strong customer base the stock was de"ressed. &./ has a loyal
following and they were not going away. If they could 4ust stabiliHe their margins. Again they had the
highest margins in the business3 they had the best JPD in the business9a solidly run business. 2he one caveat
was that their com"s were negative. 2hat is why "eo"le knocked the stock down to those levels. 2he stock was
basically a tri"le from 5ecember of 2++( to %uly of 2++59the stock went from *25 to *<5.
%G8 0y the way :inda was here in class touting these stocks at the lower "rices.
5<
&eropostale
Anybody know a little bit about this com"any, Anyone been into an &?9 store, !ave you ever not bought
something on sale, If they mark something at *(+ it immediately has 2+> off. .ou immediately feel like you
are getting a bargain. 2hat is certainly different from what &./ is trying to do. Most retailers are only taking
their mark downs when they have too. If you see "eo"le not buying I am not going to buy too.
We want our customers to feel like they are getting a bargain. 2heir "rice "oints are about (+> lower than
,agle and ,agle is about (+> lower than &.?. It "ositions them very well in the market"lace. 2here is
certainly a "lace for them in the market"lace so they are not going head to head with the other guys. 2his is a
one year stock chart. 2he stock was as low at *$C.5 last week and as high as *(5 a few months ago. 6erha"s
there is an o""ortunity here. Around *$C was where we were buying it.
5C
0inda Greenblatt
mentions &./ to Students
We are going to build out their store base and figure out what we think it is worth in a three?to?five year "eriod.
We want to figure out a "rice target of our own.
So obviously what got me interested was the "reci"itous fall in the stock "rice. It certainly made me take a
second look. And I knew estimates had been in the two dollar earnings range with *( in cash so *$5 and
"otential for *2 E6S gives you <.5 #s. 2he stock seems "retty interesting3 I want to do more work.
What ha""ened for the decline to have occurred8 2hey missed their com" sales their merchandise was slightly
off3 inventories were u" ((> "er sB foot while same store sales were down 2> so they were over inventoried
it will "robably take them a few months Gnot a one Buarter "roblemI to clear out the inventory. So they were
having big sales to get rid of stale inventories to bring in fresh inventories so margins get crushed in the interim
fire sales. It is a very stable com"any. 2hey will get their merchandise back on track. 2hey 4ust needed time to
weather the storm. A com"any with heavy debt that misses several merchandising seasons could go bust. 2he
wheels are in motion management issues??if there are any??are being addressed and inventory issues are
addressed. I would rather see you take a hit and get your inventory "roblems behind you rather than stretch
their "roblems out over a year.
2hey started to have these issues and everyone "iles onto the band wagon Ginvestors sell immediately3 all the
analysts downgrade the stockI. .ou can&t own it here because the "roblems will carry over into the ne#t
Buarter. 2he ma4ority of analysts either have holds on it or sales on it. 1obody wants to get ahead of
themselves. 2hey see that this will be a "roblem for a Buarter or two so they don&t want to go out on a limb
and "redict a turnaround no matter how chea" the com"any becomes. 2hey can&t "redict over the ne#t few
months but as you know it is irrelevant what same store sales are going to be. 2ecause what is relevant is i#
this compan !ets past these issues, can the compan be bac" to normaliGed mar!ins and earnin!s and
when the do, what is this compan worthC
%G8 Sto" :inda right here and look at that chart and say isn&t it great that the world works like that. GStock
chart shows a colla"se from *(5 to *$CI. :inda has been making money all these years and that is what the
chart looks like every time.
:G8 .ou don&t want to listen to the sell?side analysts. Analyst8 At *$K we are underweighting &?9 because
they will continue to miss estimates G-sellT it at the lows or buy high and sell lowI because they have too much
inventory Gno kiddingI. 2hose trends will likely continue into s"ring G%an?FebI. Maybe so but we are taking a
one to two year time horiHon. We don&t care what ha""ens into s"ring we care about what ha""ens when they
get through these issues.
-We think it makes sense to underweight stocks with earnings momentum slowing.T I think that is e#actly the
wrong way to think. 5ownside earnings miss. It is the wrong way to think about things. 2he time to buy is
when everybody knows they are missing com"s have inv issues etc. .ou know what if she knows it then
everyone knows it. 2his is the time you have to be looking at it and thinking like a contrarian.
%G8 She has always has done it that way she is going to kee" doing it that way.
:G8 6ulled off the 0loomberg. Earnings were su""osed to be *$.)5 range and the number for ne#t year was
su""osed to be in the *2 range. 2his is now8 earnings came down to *$.() for the year and they took earning
down to *$.<+ for the following year. .h did the ta"e the #ollowin! ear&s earnin!s downC It makes no
sense. 2hey can&t kee" their estimates for ne#t year the same if they lower this year&s earnings. 2hey
automatically bring ne#t year&s estimate down regardless of the business. Dould the business do *2 ne#t year,
Pf course they could. I think there is a really good chance to make *2. 6er share once they get through their
inventory issues.
2he fact that they numbers come down means that you shouldn&t be fooled that something has fundamentally
changed with the business that is causing numbers to come down for ne#t year.
Student8 What do you do to differentiate among management teams,
5K
:G8 Management??I like to see someone who has been around for awhile. I like to see a "roven management
team. As I do more research I look at8 Who is their customer base, Who are their com"etitors, Is there a
reason for their being, Is there a reason "eo"le sho" at this store vs. their com"etitors, .es because of "rice.
&?9 will win on "rice. 2here is a reason for their being. 2hey are com"eting with the discounters and there
are not many other s"ecialty store conce"ts in the malls that are com"eting directly with them. 2his is the
"rice "oint they are looking to.
Student% Why didn&t you look at &merican ,agle as an investment, 2hey both are way off of their highs
they both are well run and they have a reason for being.
:G8 It is interesting because those are e#actly the two com"anies I was looking at to add to the "ortfolio. I
looked at ,agle and you are right on all counts but the one ma4or difference was that &?9 is a si# hundred
store chain and they have more "otential to grow to $+++ to $2++ store with their conce"ts like %immy&s. 2he
growth "otential is tremendous. I look at that an American ,agle that is fully saturated at K++ stores. 6erha"s
they can o"en another $++ stores. I believe growth will be better with &?9. It will be a few years before
,agle has any growth "otential. AEPS can o"en a new conce"t but it will take a year for a test "hase and a few
more years to get momentum. I like &?9 "rimarily for that. &?9 was a little bit less a fashion conce"t than a
fashion follower. I like that "osition a little better. &?9 doesn&t have to be in the lead on fashions they can
be a ste" behind.
Student% What about falling same store sales,
:G8 Same store sales falling and growth in stores, It really de"ends u"on the issues. 2hey didn&t have much
to" line growth but margin growth then that might be of interest. I don&t necessarily have to see $5> to 2+>
to" line growth de"ending u"on the situation.
.ou want to understand why the SSS are declining. Ask how the com"any is addressing the "roblem or if they
are addressing it. If management is blaming it on the weather oil "rices etc. I like com"anies that take the
blame and take res"onsibility to fi# the "roblem. .ou know what there are some macro issues but we have a
"lan to fi# our issues.
Student8 !ow do you know when a retail conce"t is reaching saturation,
:G8 It de"ends u"on whom they are catering to8 what malls are they in8 A0D Malls. .ou could see an AEPS
in an A or 0 or D mall. A $+++ to $2++ is ma# saturation for a retailer to go into all three mall ty"es. An &./
)+
will ma# out at '++ malls because they are only in A ty"e malls. .ou won&t see them in a D mall. 2hat is why
they launched the !ollister conce"t which was for lower Buality malls8 0 and D.
Student% Whom do you talk to when doing your research,
%G8 I will talk to anyone who will talk to me. I will talk to store managers because they often know a lot. I try
to talk to senior managers. .ou will get different information from a senior merchandising manager than a
DFP.
We talk to "eo"le who come out of the store with or without bags. We s"eak to store em"loyees. It de"ends
u"on what we are trying to find out at the time. When looking into &?9 we wanted to see a loyal customer
base. Are customers coming in and not buying, What do they think of the merchandise, Are the customers
still coming in des"ite the weak merchandise, Pne of the basic things we try to understand is what is
ha""ening to their customer base during this "eriod of time when they have these merchandising misste"s.
.ou go in with a thesis on the stock. .h is the stoc" cheapC .ou go in and try to delve further.
2he nice thing about retailers is that you have more access to their customers. Again the more information
the better. I go the malls my "artner and a "erson in her twenties who s"ends a lot of time in the malls9we
all go to the malls to check out stores.
I send my mother or anyone who I know is a "otential customer to the store. Everybody has a valid o"inion
when it comes to retail. We are based on the East Doast so certainly we have a very war"ed "ers"ective of the
world. It is im"ortant to be careful not to e#tra"olate from the East Doast to the whole country. If you are out
doing that Bualitative research you focus on the entire area not 4ust one area.
Student% What about macro issues that can hurt retailers,
:G8 When it is a chea" retailer like this this is the customer who will be hit the hardest because of the high oil
"rices but on the other side the customer who used to sho" at ,agle will now sho" at &?9 because they have
less money. I do not spend too much time on spendin! trends.
I tr to avoid the macro stu##. 5o I think the news of the Macro economy is out there already in the market.
5o I think that every article I have read for the "ast four months is already in the market, .es.
I ask whether this is a chea" stock today and do I think over the ne#t two years there will there be a normal
environment.
Student% 5o you short stocks,
:G8 Sometimes I short. I "refer to short more of a basket than a "articular stock. 2hese stocks can go to even
more ridiculous valuations on the u"side. I don&t have the two?year stomach to wait for a stock to dro" like I
do for the long side.
If I do see a com"any "osting double digit com"s for several months in a row and it is trading at 5+ times
earnings do I think it is sustainable, 1o. I don&t know when it is going to turn but I know it is unsustainable.
.ou know the day will come. ?eversion to the mean$
Student% !ow do you value growth,
:G8 !ere is a Buick look at the numbers to say this stock looks chea" so "erha"s we want to do more work on
it. If you notice it&s E7 to E0I2 is C times but this is year coming off of de"ressed margins because they
messed u" on merchandise. So that C.5 E7;E0I2 is not that relevant. .ou really want to look out a year. 2hat
E7 to E0I2 is not really that relevant either. 6eo"le took down their numbers not because the business is
changed but because they got hurt this year.
I like to "ut together my own numbers for ne#t year. My own numbers show E7 to E0I2 of ) times so it looks
"retty chea" so I want to do more work.
Slides8
)$
2his slide is on store "otential8 It looks "retty e#citing for &?9. %ust some Easy numbers to calculate for
why the stock looks "retty chea" to me. 2hose 6;Es are not net of cash so net of cash they are even chea"er so
that is interesting. .ou asked about growth.
&?9 with the "otential for another '++ stores and the other %immy conce"t could be C++ stores. I was more
conserve with )++ stores but there is a lot of store "otential there.
!ere is a situation where "eo"le are looking at this year&s numbers and they are really focusing on that
o"erating margin number of $+.C>??under "ressure. 2he analysts write that the margins are really under
"ressure3 we hesitate to recommend it until the get back to better margins 1investing in the rear view mirror2. It
wasn&t that long ago that the com"any did north of $'> in margins. It wasn&t that long ago the com"any did
north of $'>. I believe the com"any can do $(> while the street is at $$.5>. Is it difficult for them to get
back to $'> o" margins considering nothing in their business has changed in the way they run their business,
2his says to me Wow there is '++ basis "oint of o"erating margin im"rovement in o"erating margin here.
2hey have big room for im"rovement $$.5> to $'>. .ou need to look at normaliGed mar!ins not de"ressed
margins. If I look at norm in the $(> area because they did $'.5> last year. 2hat 2his leads me to a valuation
of the stock. 0ut the "oint being is that I see $+.<> o"erating margin with "otential to go to $'> so there is
u"side here. I get e#cited. Most "eo"le say -the stock is $+.<> margins I am going to knock it down.T
2here is huge "otential u"side here from $+.5 margin to $'.5 margin.
:G8 .ou like to see that has e#"erience o"ening a large number of stores in a year. 2y"ically you don&t want to
see a com"any go from $++ to 5++ stores in a year the risk is high. .ou want to be sure that they have a good
model they can format the store they know what their customer is looking for and they are earning attractive
JPIDs. As they gain confidence then the store o"ening can accelerate.
%G8 A new store may not do as well as a more mature store. If the com"any has "oor merchandising then it
doesn&t matter if they o"en many stores or not to hel" JPD. Ask if there are too many stores o"ening
GsaturationI or something else is going on.
I always want to discount their e#"ansion. What is a fair discount for growth,
I try to be very conservative on my terminal value.
0e aware that the Buality of merchandising may affect same store sales more than the number of stores o"ening
or the com"any being close to a saturation "oint.
1ew Slide8
%G8 2his slide is a little confusing but it hel"s you come u" with a thesis as to when the stock is chea"3 where
you want to buy. I try to take a look out over a five year "eriod and "lace a terminal valuation on the stock
over that five year "eriod
2.2 billion for arrow with "ot for '++ another $.' billion SB ft %immy&s currently only has C stores 1ow this is
a sit where they are in a test mode and they will continuye to test for another ) mos. When I make may
assum"tions I want to be very conservative. So I assume they test for another two years then they slowly
o"en 5+ stores a year.
If you look at how Arrow o"ened their store base once they has their conce"t down they o"ened $++ stores a
year. 2hese are conservative estimates. My assum"tions are not aggressive in terms of how I do my valuation.
Pver ne#t five years they have 2.2 billion SB. and 2 bil sB fot "otential. Arrow doing *525 a sBuare foot. 2hat
is the number I am using for the additional store o"enings. I am not assuming big things for com"s again.
%immy&s not as "rod as Arrow. 2hey are doing *'++ "er sB ft for their category which is more in line with
retailers that com"ete in their category. %immy&s is catering to $C to 25 year old customer. .ou can take a look
at com"etitors to get the numbers.
)2
What is the "otent earnings "ower over that five year "eriod, 1ormal margins9"eak margins were $'.)>.
Mind you that the com"any believes it has the "ot to do north of that. I assume a $(> margin which I believe
is a normaliHed margin certainly in line with other retailers and well below what the com"any thinks it can do.
2hey are earning *$.)( on $(> margin and *$.'2 with additional margins. If the Arrow can do a $(>
margins and %immy&s doing a higher margins? Earnings over that five years is *(.+5 and "lace a low $2
multi"le Gbased on conservative assum"tionsI. %immy has the "otential to o"en C++ stores but they will only
have $5+ stores o"ened by the end of five years.
2hen the build u" of cash over the five years. *$$+ then adds back de"reciation and subtracts maintenance
ca"e# and it gets you to *C "er share in cash and there is *( in cash today for a total of *$$ "er share in cash. I
am assuming that management does not "ay dividend or buy back stock they 4ust sit on their cash. !ere you
have *(< "lus *$$ gets you to *'5 stock "rice at the end of a 5 year "eriod. If you remember Arrow&s stock
chart basically you had a month and a half to buy at *2+ or under to buy this stock. If you had done these
calculations you have a return of $K> over the ne#t five years. 2hat is one way to look at it.
%G8 Jight. 2he way we talk about is that when everyone figures out what &rrow will earn and it could be a
*'C stock you could have the stock revalued faster and within two years you could have a *'C stock. Pther
investors could discount that back at $+> since that is a normal return of what you e#"ect to get from a stock.
2he stock could be at *() within two years which is an C+> return. 2hough :inda "resents the return as $K>
annualiHed over five years when most "eo"le start to figure it out you could get a big chunk of your u"side in
the ne#t two or three years.
I 4ust want to make another im"ortant "oint that :inda made9she built out her store base. In other words
most "eo"le say -Well they are growing their stores at L "ercent and it deserves that 6;E or that 6;E9"eo"le
4ust "ick numbers out of the sky based on a growth rate that will be short?term. Whatever the growth rate may
be "eo"le 4ust "ick9I don&t know what they do. 0ut what :inda does is 4ust so logical. She builds out the
whole conce"t3 it makes sense. She used conservative margins and store o"enings. She built u" the new
conce"t by only 2+> of the "otential but she still comes u" with huge numbers. So this e#ercise is figuring
out what it is worth and being su"er conservative. If there is a big ga" between what it is worth and what you
are "aying then you have something that is "retty good.
:G8 Another way I look at it is that if the com"any can get to that *2 in earnings run rate over the ne#t cou"le
of years then other investors once they get off same store sales and onto earnings and then they look at sBuare
footage growth and say -Ph they are growing at $5> to 2+> so this com"any deserves a $5# to 2+# multi"le
so you have a *(+ to *'+ stock over the ne#t two years. 2he bottom line is that I am not including what I
could have "ut in additional assum"tions which would im"ly a more aggressive u"side for the new conce"t of
Jimmys which includes a more aggressive roll?out of the stores. 2hey could have 5++ stores at the end of the
five years not 4ust $5+ stores like I mentioned in my assum"tions. I am assuming a flattish "ick?u" of same
store sales but they could do better. 2hey do a stock buy back and the margin "erformance is doing better than
that $(>. 2he com"any takes ste"s to im"rove the margins beyond $'>.
Student% What are the JPID&s on the stores, What ty"e of return do mall based stores ty"ically have,
%G8 .ou "robably should figure out what the inventory will be.
:G8 2his has 2+> after ta# JPID so it is very good.
Student% !ow did you figure out *2+ million "er year for ca"e#,
%G8 2hey break out the ca"e# for stores then I multi"ly by the new stores they o"en "er year9that is how I
reach that number. In terms of MDL it varies.
What are the assum"tions or the things that could ha""en in a good way which I am not including, I am very
conservative.
Student% Mr. Market rewarding you faster then so you sell,
)(
:G8 I would e#it if the "rice was revalued much faster than my five year estimates. I have yet to sell a stock at
its "eak.
5;6
1e#t week you have your 2
nd
"ro4ect due.
Assume we are in the $
st
Btr of $KK) for Munsingwear.
Dlass [K 1ovember $) 2++5
S(ip Benewit8 1SP2 from -ir(wood Capital is here to ask you Buestions about your "resentations.
.our assignment is to read my book G2he -:ittle 0ookTI for ne#t class.
2he e#am will be a test of your valuation skills. 2he one thing about the final is that I generally kee" them so
when someone asks me about you3 I can see the results of your e#am.
S8D65;8 175S5;8@8I<;S
Student 6resentation on 2imberland G20:I8
Students% A *2 billion Mkt. Da" Dom"any manufacturing and selling active wear and footwear. <.< E7;E0I2
and 5K> JPID.
Boel Greenblatt HBG$% 5id you use E0I2A minus MDL for your "ro#y for E0I2,
Student% We see it chea" for a number of reasons8 1egative sentiment. Miscues in "roduct rollouts
We believe there is a 25> u"side today and 5+> in two years. Pn a net basis for 2'> and if you hold it more
than two years you have a 5+> return.
2ake the current multi"le @.
)'
2hey have no debt and strong cash flow. 2hey have "rofitable investment o""ortunities. 2hey are growing.
Every dollar they "ut back into the business they earn '+> on ca"ital.
2he management team is solid. 2hey are fully vested. 2hey have announced a stock buy back. !ow many
shares outstanding, *)C million. Shareholder friendly management. Dor"orate res"onsibility is good.
!uman rights are one of their concerns.
Jisks8 1ot getting the fashion trends right. Jisk is mostly in the RS business.
Dalculating Enter"rise 7alue GE7I8 2imberland has no debt and *$++ million in cash.
Dalculating E#cess Dash for Enter"rise 7alue GE7I
BG% Pne of the "oints that always come out is do you subtract GallI cash, 2he answer is no3 you subtract
-e#cessT cash Gcash that is not needed to run their business on a yearly basisI. .ou have to decide whether any
of that cash is needed. 1egative working ca"ital businesses Glike Mc5onald&s Jestaurants where customers
"ay cash or credit card while "ayables are (+;;)+;K+ daysI usually have the total amount of e#cess cash on the
balance sheet e#ce"ting of course for "etty cash in the registers.
Jemember that retailers need to kee" cash in their registers all the time so do not subtract the full amount of
cash on the balance sheet.
Dom"etitors8 3olverine$
2hey have a loyal following of customers9construction workers.
2he multi"les and the margins9we took them down from where they have been. 2here "eer grou" is trading
at $$# E7;E0I2. 2his is trading at $+ # E7;E0I2. 5+> return if you hold it for two years and you get $+#
E7;E0I2 on an e#it or sale.
BG% !ow about on an absolute basis, !ow do you 4ustify that,
Students% 2his is a great com"any over a long "eriod of time.
BG% 5id you factor in how much room they have to e#"and9grow their store base, !ow much more
e#"ansion do they have,
$+# "re?ta# GE7;E0I2I, Rsually I would take off '+> for ta#es so you would have a )> return G$+> ? '>I.
If the ta# rate is lower due to overseas o"erations sometimes they can&t re"atriate the money. Ask why that ta#
rate is lower or if that ta# rate is sustainable,
Student% 2imberland is growing abroad so we do not see re"atriation as an issue. We also discounted back two
years in our valuation.
@nalst% !ow does the business break out between domestic and international o"erations regarding o"eration
margins, What are international com"etitors doing, Since you say their international division is growing 2+>
to 22> overseas.
!ow much of their business comes from the work boot area versus their entire sales because you said their
strong margins are due to their strong customer loyalty in foot wear.
Student% Timberland messed u" on a""arel in the RS so earnings for 2++) are de"ressed Gtem"orarily we
believeI. E0I2 margin of 2++5 is $$>.
@nalst% 5id you break out their licensing revenue from other revenue, :icensing revenue is very high
margin revenue.
)5
Student% 1o but it is very small.
@nalst% Dom"anies will tell you if you ask them to break out their licences. Jevenue. .ou can always
assume the licenses. Jevenue is an C+> margin business.
/ootloc(er' Inc$ 1/02$
2here are three main reason to buy F: as it sits at *2+ with our "rice target of *2) which is a (5> u"side.
2hree G(I main reasons to buy F:8
Increase in o"erating margins. 2he management is shutting down over?siHe big store conce"ts in early 2+++
and im"roving their o"erating margins. $5> average over the last ' years and mgt. stated a target of $+> with
it currently at <.'>. P". margins.
5omestic growth is uncontested in Footwear for teens. Growth in mall s"ace across the RS.
2hey have Strong "ortfolio of business with different footlocker "roducts and Dhance with an $$> E0I2
margin.
7aluation8
Average store siHe (++ sBuare feet. .ear?by?year growth in sB. footage. DAGJ is 2.5> over the last five
years. Sales "er SB. Ft. is *52K.
BG% 2hey have been closing some of their stores and that will sto" so using net sBuare footage number may be
misleading. So I would look inside that number to see what was the growth of the smaller stores e#?the closing
of the big?store conce"t.
What you said is that they are closing the big store conce"t while their sBuare footage is growing 2.5> "er
year. :ook at growth with 4ust the small store conce"t. 2rea" out the concepts:
E0I2 margin for whole com"any is $+>. *5+ million in E0I2. Rsing a <> E0I2 margin you get *(5+ in
E0I2 to be conservative. 2he best case is $+> margin. We do think there will be com"etition from /inish
0ine$ We "ut an C multi"le on that since the business is not growing. 2hen you add *'++ million for the
online business and build u" of cash.
))
@nalst% 6ension GdebtI in regards to Enter"rise 7alueN 1%id you adGust the Pension liabilities i needed and
add to your ,:N2
Student% We did a standard E7;E0I2 analysis. We e#"ect "er share a""reciation of 2<> for the base case.
BG% 5id you break out the domestic and international divisions, 2hey have different margins and margin
o""ortunities. 2he market went way down in Euro"e Gmargins colla"sed from $C> to $+>I. 2heir margins
used to be $C> so the Buestion is do they normaliHe at $+> or higher. 0ut if 0inda 1GreenblattI were here she
would "robably say the margins "robably normaliHe around $2> margins that would be her best guess.
I think you have the big "icture and you did a nice 4ob with not much time. I am trying to "oint out what I
would do.
8he more ou can brea" it Hthe Compan$ apart the better. In some businesses the different "arts feed on
each other. 0ut in F: there is enough dis"arity in the growth o""ortunities the margins and the com"etitive
landsca"e in Euro"e vs. the RS where you need to "ick a"art the different businesses se"arately. 2here is
e#treme margin contraction from $C> to $+>. 2here is a lot of room there. 2he Buestion is where it lands.
Management believes that their margins can be double digits. I am trying to bring u" issues as how I would
a""roach it. 2heir com"etitive "osition is very strong since their nearest com"etitor is five times smaller,
Student% .es it is.
@nalst% 2his a""lies to both "resentations??o"erating margins are the value investors& growth number. 2he
scariest thing to get into earnings is that you feel the urge to go to a reversion to the mean thesis or
management estimate thesis like F:. Pften those are the best answers you can come to but the best you can do
in all cases is to try to get as bottom u" to that number as you can. 5o what %oel suggested which is to se"arate
the businesses. .ou did that with o"erating leases and how they made "rogress at F:.
Student% !ow do you treat o"erating leases,
@nalst% In most cases it doesn&t matter. In some cases where rent is different than market rates it can matter
so you have to ad4ust for market rates to figure out normaliHed.
6ensions. 2he most im"ortant time to add "ension debt to the E7 is when the com"any is not funding e#"ense
through the income statement. Say you have *(++ million in "ension assets and you are really "aying *(+
million a year into that "ension for em"loyees that are already retired and those that are in service. Sometimes
"ensions get screwed u" because it is done on a lagged smoothed basis. So you must make sure you add back
the "ension debt on an ad4usted "resent value basis if it is under funded.
BG% If management is using an unrealistic assum"tion of K> returns for their "ension "lan but you think the
returns should be 5> or <> then I would ad4ust the "ension liability and use your ad4usted number.
Claire Stores%
Students% A mall based Store. *2.<$ billion market ca". 2hey have 2C++ stores. 2he stock is *2< and we get
to a valuation of *2< to *(' de"ending u"on your assum"tions going out five years.
We use a 22> margin for the RS and international is $<> margin in E0I2 so we used
BG% What ty"e of growth do you use for them, Is there inflation growth,
Students% We use 5> annual growth.
)<
BG% Why are they not growing now, So you are assuming mature growth in five to ten years, What did you
do with the cash,
Students% We built u" cash of *< "er share.
Students% 2heir Ggross,I margins are 55>.
BG% Why are their margins so high9they can source their goods very chea"ly,
Students% 2hey have an efficient o"erating model.
BG% 0uy one3 steal one9a store that had small chea" 4ewelry for teenagers.
@nalst% What are their JPID in their stores, .ou gave it a low multi"le of $2 but this com"any has
"rofitable growth9"erha"s it deserves a higher multi"le9es"ecially where the market is currently trading at.
Students% 2<>.
Dross Dhecking .our Multi"le
BG% 5id you do a discounted cash flow analysis to determine an a""ro"riate multi"le,
Student% 1o we did not.
BG% A 5DF analysis would hel" you determine a "ro"er multi"le as a cross check. A 5> growth in "er"etuity
will blow out most growth models and gets you a very high multi"le. So the Buestion is what ha""ens at (>
or 5> growth in "er"etuity, It might be interesting to have a matri# of various growth rates to 4udge the
multi"le. What multi"le theoretically is 5> growth in "er"etuity, Where does your $2 multi"le fit into that,
.ou figured a $5# multi"le G).)> yieldI after ta# was a reasonable "rice for Claire Stores. I say use a
minimum )> hurdle rate. At best what we will get out of here is that it is a great business it won&t lose much
money and at some "oint it will get a higher multi"le. .ou are "robably being too conservative which is PA
because you are trying to buy it at a huge discount.
)C
If you start growing 5> a year and you feel very confident about that then that "otentially becomes worth a lot
o# mone some da and it deserves a hi!h multiple. 1ow if you can find things a lot chea"er than that fine.
0ut instead of "icking $2 multi"le out of the air it is nice to go through that matri# to determine the
a""ro"riate multi"le. 1%ont Gust assume a multiple even i conservativeOcross chec( it2$
-(Swiss designs and outsource the manufacturing of footwear. A nice stable growth business.
1o comments@@..
C<C<
)K
2he com"any takes si# or seven years to integrate an acBuisition of a new cam"us. 2hey have made C+
acBuisitions in the "ast four years. We think the com"any is worth *22 while it is currently trading at *$2.
We assume im"rovement in o"erating margins.
BG% 5o you trust these guys, E#"lain the big "icture thing. 5on&t they get funding from the government for
the tuition and aren&t there claims of fraud against the com"any,
2here are no convictions but I&m a great guy, Are they goosing the numbers are they too aggressive why is
the o"erating margins dro""ing9what did they do in the "ast that is different now,
@nalst% <2> u"side, .ou think it will be worth *22 in 2+$+, Why do you think it will get there Buicker,
E#"lain what you mean by cam"uses.
Student% JPID regarding acBuisitions, Would goodwill be a good "ro#y for ca"ital9a decent "ro#y for ca"e#
since they are constantly buying cam"uses, If they didn&t acBuire cam"uses then they would have to build the
schools,
BG% 2hey are buying these cam"uses for their earnings "ower not the cost of their assets to be able to "ut the
schools together. Wouldn&t it cost them to e#"and, 0asically you have to use logic on each one.
Sim"lify everything9what is it worth now if they 4ust sto""ed and grow, 2hen if they take some of their
incremental dollars ca"ital and buy stuff what kinds of incremental returns do I think they are going to get on
that, So I break things into two "ieces generally. 2hey have what they have now. Incrementally if they sto"
growing what is that worth, If they can generate this much cash so what will they do with that cash, 2hey
can distribute cash G"ay a dividendI buy back stock or acBuire stuff. I have to make an assum"tion of what
will they do with that cash. If they start acBuiring stuff I have to ask -Will that be a good use of the cash or
not,T And value it that way. It gets to be too amor"hous if you start assuming if they are going to buy these
many at this time or at this "rice, If that all changes it mucks u" the whole works.
I take what I have and then if they are going to s"end some cash do I think is it going to be a good thing or a
bad thing Gthe com"any which is making acBuisitionsI. And then I ask -!ow much do I think they are going to
earn on that,T 2hat is the way I take a"art your Buestion and try to attack it.
=uantify Growth Mathematically9Growth Matri# of 1ew and Maturing Schools
Another thing that is very im"ortant es"ecially with retailers9here was a situation??any time you can Buantify
something. !ere was a Buestion where $;( of the schools were two years old a $;( were four years old and a
$;( were at saturation at ) years you can figure out what the growth rates are going to be 4ust from the stuff
that you have until maturity. .ou can "ick out the normaliHed growth rate and margins instead of taking the
margins that are there now. If I really did think the two year schools would mature over the ne#t four years and
increase margins and the four year old schools will increase over the ne#t two. .ou can figure out with a
matri# as to where it Gthe margins and growth rateI will be at maturation and then how much growth from
there. .ou can do the math and it is always hel"ful to it. 2his is similar to figuring out store bases that take a
time to mature. .ou can see how many stores are o"en over the last three years or last two years and see what
is going to ha""en in the future and you can almost "ro4ect "art of that. A lot of "eo"le don&t do it and it is the
easy stuff. It is 4ust math and you can get a feel for the Gfuture growthI.
Second 6art of Dlass 0ack From 0reak@@@@@@
I;/5S8I;G DSI;G B<53&s 3I8835 2<<-
The Little Book That Beats the Market (Hardcover)
by %oel Greenblatt
5iscussing his new book@@@T2he :ittle 0ookT
A few years ago during the Internet craHe his G%oel Greenblatt&sI students 4ust ignored him and called him an
idiot and they said -:ook at Price4line/ It will double. 2his is the ad in Barrons at the time to attract
<+
members to his :alue Investors Club. 7alue investing was so bad back then we showed an outline of a dead
man. GSee a""endi# for slide "resentationI.
0ack to the story@..so over the years it became a""arent to me that Graham was one side of the eBuation
which was chea" and Buett was8 -I would like to buy a good com"any that could earn good money and had a
good franchise that was going to stay there and be able to earn good money going forward.T So the Buestion
was8 OCan ou combine !ood and cheap at the same timeCP
We did a little bit of a test. We defined the same things I taught you. Good com"anies we define as having
high returns on ca"ital which is o"erating income divided by net working ca"ital and net fi#ed assets. We use
high returns on tangible ca"ital. So that is how we defined good. !igh return on tangible ca"ital gives a very
good indication that this may be a good com"any. Dhea" was E7 to E0I2 GEarnings .ieldI which is a little
more so"histicated than a 6;E analysis taking into account different ca"ital structures and being able to
com"are com"anies over a wide array on a fair basis. 2his eBualiHes ca"italiHations.
2he Study
We used last year&s numbers we didn&t use "ro4ections. So what we did was in the study8 we ranked
com"anies $ to (5++ based on their 6re?ta# Jeturn on Invested 2angible Da"ital GJPIDI. 2he best JPD
com"anies we will rank the highest. So we take the (5++ largest stocks in our database and rank them on JPD
4ust straight out. And then we did the same thing for chea" we ranked (5++ com"anies on earnings yield8 $ U
(5++ on earnings yield. We used last year&s numbers. It was the first thing we tried. It Glast year&s numbersI
is good information to have but certainly it is not dis"utable information to have.
We wanted to make it easy so we used last year&s numbers. We didn&t use five?year averages or "ro4ections.
2his is the first thing we tried we ke"t it sim"le. .ou can imagine all the "roblems with using last year&s
numbers they are not normaliHed. 2here are aberrations. It is good information to have but it is certainly not
dis"utable information. It wasn&t "ro4ections. It is not using an arbitrary number or average over the "ast five
years. When you are back testing it is dangerous because "eo"le ad4ust all the time or use estimates. 2he
Buestion is that analysts get better over time they over estimate they underestimate9everyone evolves. So
we didn&t use any of that. Analysts& estimates ad4ust slowly so they change slowly. We use the sim"lest
number9last year&s numbers.
We sought com"anies with high JPID and a high earnings yield. It doesn&t sound that com"licated. We
ranked from $ to (5++ on JPD and $ U (5++ on earnings yield. We combined the rankings. If you had the 5+
th

best JPD and the $++
th
best earnings yield your combined ranking was $5+ G5+
th rank in JPID
N $++
th in earnings yieldI O
$5+th ranking
. 2his is very hel"ful. Pbviously we would rather have a normaliHed number than a trailing number but
there was no dis"ute about this.
2his is for the to" (5++ com"anies. 2his is what we did in $KCC we did 2<> using the magic formula vs.
2'.'> using a market eBually weighted average. In that (+ stock "ortfolios of highest ranked stocks Gthe to" or
$
st
decilesI and each stock was held in the "ortfolio for one year. What we did was %an. $KCC to %an $KCK then
Feb. $KCC to Feb. $KCK and so on@.. We measured $K( "eriods during the $< years using rolling one year
"eriods. We used many many "ortfolios and it was the average of those "ortfolios. 2he bottom line is that we
used a lot of time "eriods and stocks. 2he magic formula stocks G(+ out of the (5++ stocksI did about (+>
We used market ca"s above *5+ million and we had criteria that those small ca"s had to have a certain amount
of volume to be included. We had a minimum trading volume reBuirement also. 6eo"le couldn&t say that the
results were because of the small ca" effect where investors wouldn&t be able to buy the shares.
Student% What weighting created the highest market return,
Boel Greenblatt HBG$% :et&s talk about that later. We 4ust used high return on ca"ital and 4ust chea" Ghigh
earnings yieldI and then combined the two rankings using an eBual weighting of high JPID and high E0I2;E7
or earnings yield.
Student% What about other metrics like "rice;Sales or low 6;E to high JPE,
<$
BG% :et&s 4ust say this did a lot better.
So you could say -.ou know the stocks are too small.T So9as you will see in the book??we did the same
thing for the largest $+++ stocks with *$ billion market ca" and over. C+> of the managers each year can&t
beat the SS6 5++. And that doesn&t mean the same manager doesn&t beat the market each year. 2o beat it over
time is tough but we basically doubled the return of the SS6 5++ G$2.'> return vs. 22> for our "ortfolioI. We
ranked stocks based on the best return on ca"ital G$ U (5++I and earnings yield G$ (5++I and then combined the
rankings using an eBual weighting. A com"any might not make the list because it wasn&t that chea". 2he
ranking de"ends u"on the best combined rankings. 2here were $2 "ortfolios a year so we averaged the returns.
So we got a lot of years out of each test. 2he returns weren&t due to 4ust a lucky %an. or a lucky %uly it was a
combination of all of those GmonthsI.
A few things looking at this chart.
!olding 6eriods
2here were times it didn&t beat the market like in 2++2. In 2++2 it was down 22.<> vs. the market being down
22>??a difference of negative +.<>. 2he magic formula wasn&t much more volatile than the market during the
bad times for the big stocks. 2ad stu## happens which is tou!h but ou have to sta the course because
thin!s wor" out in the end. My argument here@..what would be the flaws in the largest $+++ stocks, 2here
were ()+ stocks each held for a year. 2urnover was for one G$I year. Every stock was held for one year.
Small Da" Effect
Small ca"s in this "eriod did no better or worse9it really wasn&t the small ca" effect. When you buy value
stocks no matter what databases you are looking at ou are !enerall buin! smaller stoc"s because the
stocks are out of favor. 2he market ca"s are de"ressed because they are out of favor and they have low "rices.
Market ca" is "rice # fully diluted outstanding shares so value stocks are skewed toward the smaller market
ca"s. 2he stocks are out of favor so "eo"le are not "aying a lot for them. 2he higher "riced ones are "o"ular.
2he sales are not different but the market ca" is smaller because they are out of favor and "eo"le are not "aying
a lot for them.
.ou could argue that liBuidity was a "roblem here. %ust as Grahams stocks disa""eared?? his G%oel
Greenblatt&sI thirty favorites even though he did it every year and every month between the three tests we did
we did over '5++ stock "icks over the time??you might argue that the "icks might go away like what ha""ened
to Grahams stocks. 2he market could get more efficient etc. I don&t think it is "articularly valid. 0ut that is
one argument I would be sensitive to.
2he P""ortunities 5isa""ear
So we did another test of the to" 25++ stocks and we divided them by rankings into deciles. 2he best ranking
was deciles $3 the second best ranking was in deciles 2@ to deciles $+. 2he "erformance matched the
declining deciles almost "erfectly. 2he to" deciles made $C> then the second did $<.5> the third did $5>
etc. My argument is that if the first (+ don&t work the ne#t (+ stocks will do well. It wor"s in order. If you
know a cou"le of things and you know what a stock is going to do in the future that is "robably valuable
information.
What %G 5oes or !ow Gotham 6artners Invests vs. What the 0ook Suggests
We 1Gotham Partners2 know a little bit more than what I wrote in the book. 0ut I figured if you could double
"eo"le&s returns in stocks or close to tri"le the return in small stocks that was worthwhile. .e do loo" #or
these two thin!s Hhi!h 7<IC and hi!h earnin!s ield$ but instead o# loo"in! at last ear&s earnin!s we
use normaliGed earnin!s. Most "eo"le can&t figure that out. We can&t figure it out for most stocks but for
those stocks where we can figure it out we are looking for com"anies with high returns on tangible ca"ital on a
normaliHed basis and high earnings yield based on normaliHed earnings. 2hat is 4ust very logical.
<2
I have been doing this for 25 years so I am "retty good at it. And you are Dolumbia M0A&s who are good at it
and who will kee" getting better at it as you "ractice. So that is what I tau!ht ou in this class this ear. 0ut
it is 4ust nice to know. I really wrote this book so my kids could understand what I do.
0asically it is much more im"ortant than that. 8hese are the basic #undamentals thin!s that will "eep ou
ma"in! mone over time and !ivin! ou somethin! to #ocus on.
So what I would use this for instead of setting u" a formula thing is to say OClin! to this.P And say -What I
am doing makes sense. If I get my normaliHed earnings right then what I am doing makes a heck a lot of sense.
And even if I screw u" or even if the market doesn&t agree with me this year or ne#t year if I kee" doing this
then ho"efully I can beat this rather than using last year&s earnings and not thinking and finding these things.
.hat I am hopin! this does #or ou is to use this as a !uide to #ind companies Gthis is written for the
masses so the masses have to go do this9stick to the formula a""roachI.
If you know how to figure out normaliHe earnings then fine. 0ut K5> of the "eo"le shouldn&t use normaliHed
earnings because they can&t figure it out and I wouldn&t trust their o"inion but I would trust yours es"ecially as
you "ractice on. And if you do that and cling to this notion of what you are doing makes sense and I go through
later why this makes sense then you can withstand the difficult times. And we will discuss this in our review
session.
Dh K in my book describes why 7<C is so important. And I go through the book why this makes sense. 2he
most im"ortant cha"ter in the book is cha"ter nine GKI. Why JPD is so im"ortant and what does that get you.
Why high JPD com"anies are more likely to have moats and earnings growth. 2hat is what you are really
shooting for. 2o know how the numbers stack u" is very "owerful. I think it is very "owerful to say that if I
s"end my time in this area G$
st
deciles of Magic Formula StocksI this is how they average out and maybe I "ick
the winners. I can "ick u" $C> Gbeing in the to" deciles of Magic Formula StocksI or maybe I can do better.
Student% Aren&t you costing yourself a lot of money Gby giving this information outI,
BG% Actually no. 2he answer is this@.the answer is that it is very hard to do and I will get into that so I am
not worried about it at all. I will tell you two stories.
2hat is a great Buestion by the way3 I assumed it was going to be the first Buestion I would get. -Aren&t I a
blabber mouth, 5idn&t I ruin everything,T Why I am not worried too much.
2he first story is about a book written called What works on Wall Street G2++5I by Shaughnessy about
investing formulas. 2he guy back tested '+ formulas on what worked in the market. !e tested doHens of
formulas and "icked the ones that "erformed the best and started a mutual fund. 2he first year the fund didn&t
do so well then the second year his fund under"erformed by 25> and then the third year he under"erformed
com"ared to all his com"etitors. So after three years he suffered terrible under"erformance. After that he sold
his fund to someone else and the he found something else to do.
8he !u who wrote the boo", who did all the studies and who "new that it wor"ed, he 9uit and sold his
#und mana!ement compan to someone else. 2his "erson who "urchased Shaughnessy&s business continued
to use the formula and has been tremendously successful. Shaughnessy couldn&t take it. 2his is not a straight
thing3 it doesn&t work all the time. I# it wor"ed all the time, it wouldn&t wor" at all.
Another story is about ?ichard P8ena who started his business in$KK). !e was under"erforming for four
years. !e decided to kee" doing what he knew worked 1Be bought the mar(ets lowest price to earnings
stoc(s on a normali8ed basis2$ 2hat takes fortitude to stick to it when all your customers are walking out the
door. If he wasn&t working for himself he would have been fired. Jich used a formula and "icked stocks from
that formula. It had worked for many many years and it wasn&t working.
2oday flash forward five years and he is in the to" $> of all money managers he has over *$5 billion of
institutional money and many investors. !e has $++s of institutional investors but he has only ' of his
original investors and I am one of them because I am his friend.
<(
It works about )+> of the months G$K( $?year rolling "eriodsI it works 2 out of three years. If you go with 2
year rolling "eriods it works 5 out of ) years. It even under"erforms three years in a row. It really is "robably
no different than the e#"erience ?ich P8ena would have "icking stocks. 2here will be a rolling three year
"eriod where you under"erform the market. It doesn&t always work. 0ut under"erforming for five years is
tough to take.
2here is also the e#am"le of my son who started in March. My son is doing well. And my daughter who
started in Aug is getting killed. .ou can imagine how many "eo"le would Buit. My Editor is doing this and he
is getting killed. !e says to me -Alright now I get it.T I talk about it in the book imagine buying a book and
you start losing real money. .ou are 4ust following a com"uter and you are buying stocks like 0ear 10,&2 and
you are losing money. -Wait/ Why am I buying this, 2he market is telling me it stinks.T
.hen the mar"et is tellin! ou it stin"s, it is ver hard to do. It is the same argument studies have been out
for many many years and it continues to work. I am not "articularly worried about ruining your life.
%ust telling you guys to do this stuff and you go out and run billions of dollars and I have been doing this for
ten years Gteaching M0AsI this info is out already there.
Warren 0uffett GWE0I wrote u" if you go back about return on tangible ca"ital in $KC( 1see appendiC about
Buetts write up on ?9IC2. !o"efully this is a little clearer. I still think there will be many "eriods where this
doesn&t work. And most "eo"le won&t do it es"ecially institutions. I am ho"ing individuals do it.
I am onl tal"in! about beatin! the mar"et not ma"in! mone. Most "eo"le are very short term oriented
so you should measure GresultsI over three year "eriods. From the rolling three year "eriods it never lost
money though it didn&t beat the market in some "eriods.
Student% Are there other factors that allowed the formula to work better like the market going u" vs. going
down,
BG% We look at results over three year "eriod. In $)K rolling three year "eriods the magic formula never lost
money. It didn&t beat the market in some but it never lost. 2he worst three year "eriod was down '+>. 2here
is a big difference there.
Student% Are there any "eriods for the magic formula that were es"ecially good like when there was a good
market,
BG% 1o most "eo"le are short?term oriented so they should look at a three year "eriod. 1o rolling three year
"eriod ever lost money.
!olding 6eriod
.e are usin! trailin! one ear results. If you hold it for more one year say two years it still works. I "icked
one year for ta# "ur"oses9it wasn&t actually the best "eriod. Pne year gives the freshest data because if you
hold for another year you are using two year old data. .ou would rather have fresher data than way outdated
data so we refresh the "ortfolio each year on a rolling basis. Pnce you have faster than one year turnover then
you get into transaction costs. .ou sell your losers in less than a year and your winners in more than one year.
So one year is more efficient and more ta# efficient.
Student% Would you use this to short stocks,
BG% I wasn&t "re"ared to share that.
My Buibble with long;shorts9the guys who do s"ecial situations in shorts where it is a scam or the com"any
will run out of money. I like those ty"e of shorts though I am not "articularly good at them. If you are doing
valuation shorts then I don&t like that. 2hat strategy blows u" every seven or eight years9the shorts go u" and
the longs go down and that ha""ens to every Buant guy. I am not saying a long;short hedge funds doesn&t
make sense. 0ut If I don&t value short term volatility because I take a three or four year view. 2hen why give
<'
u" 2.5> a year in returns by shorting. I am not adding value. 2his doesn&t add value because I am losing
2.5> a year and I don&t care about volatility.
Student% When you "ick your to" (+ do you start with your to" deciles,
BG% When we find stocks we do various things like look at stock screens. 2hen we look at com"etitors of the
com"any we are looking at we do reading. I would be less structured as this I care about normaliHed high
returns on ca"ital though I don&t care if its 5+> "re?ta# JPID or C+> JPID but I 4ust say good is good and
really good is really good. And then chea"@.there are other elements here. Aou pic" normaliGed earnin!s
and ou also want to pic" a normaliGed !rowth rate and how con#ident I am in those pro'ections.
0uffett wants the certain one where he is "retty certain about normaliHed earnings and its growth rate. 2hose
are other elements to decide how chea" it is taking into account the long term growth rates and things of that
nature. Pnce again drive a truck through it Git should be obvious3 it is chea"I. I am not running to a
com"uter to see how chea" it is. When we did an analysis of Aero"ostale we all came to a conclusion that it
was chea" and we weren&t risking a lot and we could make money if the new conce"t takes off. I would go
through the same thesis and use my head to figure it out. I would this for to give you confidence.
What I would use this G2he Magic Formula and the list of magic formula stocksI for is to give you confidence
if you know it in your gut 1that it ma(es sense and it wor(s over time2$ What I said in the book knowing two
"lus two eBuals four Ghow to value something is very powerul2$ It doesn&t matter what other "eo"le say or the
news"a"er says or how un"o"ular it is if two "lus two eBuals four. If you know two "lus two eBuals four then
you stick with it. In two weeks we will go over why this makes sense es"ecially in the basket a""roach. .ou
will stick with it when you have those down 2+> years.
0elieve me when you look over $< years and you calculate the averages it looks like any idiot should know
that this works. 2ut in the middle o# doin! it when ou are down 25Q ou don&t reall "now i# it is still
wor"in!. 5oes it make sense, !ave things changed, Is it really going to earn that ne#t year, Pr news"a"ers
were a great franchise but they are no longer a great franchise and they are running down.
Bloc(buster had high earnings last year and but that is a dying business. Am I really doing the right thing, It
gets tough. 2hat 1ollowing the +agic /ormula2 is easy to do when you first start doing it but when you are
losing money doing it or everyone else is doing much better it becomes a totally different thing. I am usually
accused of making everything sound too easy9I am guessing. G:aughter from studentsI.
I do have this in my head. What I am doing makes sense and what I am calculating makes sense. And I have
to kee" telling myself that a lot of times but to have things like this to cling to3 that what you are doing makes
sense. I go ste" by ste" in the book why this makes sense. Why high JPID makes sense and you need to
know that what you are doing makes sense.
Priginally P"ening R" a !edge Fund
I raised money from +ichael +il(en after working for a few years for a hedge fund doing merger arbitrage.
:esson from +il(en8 he could stay very focused on this one "oint. !e stayed focused on what he was doing at
the time no matter what the distractions. A good lesson for me.
My claim to fame was that I ke"t ?on Perelman waiting for an hour while negotiating my deal at age 2<
If I made (+> in the first year was my break even. It was a high cost business. 0ut I took half of what he
offered me because I knew there was an unlimited checkbook if I did well.
Student% Are there com"anies that kee" cro""ing u" in your Magic Formula :ist,
BG8 .es there are and I don&t know if they are the ones you want to be buying but we took what we got.
Dom"anies that are always chea" maybe there is something wrong with them.
<5
2he averages were calculated on a large amount of stocks so the results were more robust. We used a database
from Compustat$
Arguments against the Magic Formula Investing.
2he data was not available at the time so you were back testing. So we used the Compustat%atabase. 2hus
survivorshi" bias was irrelevant. -Well they cleaned u" the database by taking out the bankru"t com"aniesT
critics could say. Again it was irrelevant. Small com"anies can&t be "urchased without high transaction costs.
We used $+++ big ca" stocks and the formula still worked well.
2he /ama E /rench Study?everything was determined by low;"rice to book 0eta and small ca" effect. My
o"inion was that it was a ridiculous study. Small ca"s were one indication of being out of favor3 low "rice to
book ha""ens to be chea" but it is not why it is chea". 2hey 4ust ha""en to be chea". 2his is a much more
direct way of finding chea" stocks. 2hey ha""en to be chea" that is not why it is chea". Pn the side it works
that is really not how the market works. I think that study is com"letely missing the "oint.
0ut they came out and say -1ot only did we beat the market with our low "rice to book stocks but they were
less volatile. It is not that the market is inefficient it is because of risks we can&t find. 1StupidP2
A comment on 0eta. If you think of owning a share of a com"any how volatility makes any difference
regarding risk is nonsensical. !ow volatile the stock "rice is over the "ast si# months makes no sense in
analyHing risk.
2hey found out that the stocks with low "rice;book values were less volatile and had better returns. 2he
returns have to do with other risks we can&t find or can&t describe. .ou take on more risks to make more
money. 2hese com"anies are crummy com"anies9that is why they beat the market Ghidden risksI.
/ama E /rench can&t make this argument against the Magic Formula Stocks. Pn average these stocks are
good com"anies. Many don&t have much debt they are not going bankru"t and they don&t need much ca"ital.
2hey are earnings a lot of money.
Even if they were right which they are not then the ne#t argument is data?mining. .ou s"it out a lot of data
and find out what factors work great then show the results. 8he answer to that is that this is the #irst thin!
we tried. 2his is based on the way we invest not based on any "revious study. We invest based on Buality and
"rice. We did no "revious studies. We were 4ust curious to see how well it worked.
2he other answer as to why I wrote this was to come u" with an easy metric for "eo"le to use. I had no idea it
was going to work this well. I still think the same arguments a""ly which is there have been many market
beating studies value investin! is hard. .ou can set u" a fund to beat the market with low 6;E stocks. 2here
are guys who have set u" funds to beat the market investing in low 6;E stocks and nothing else. 0elieve me
there are guys who have <$ factor models. 2his two factor model beats the seventy one factor model. 2here
are models to beat the market but it is still tough to stay in business and do that.
Student% !ow do you get the data, 5o you do a 0loomberg dum".
BG% I learn from reading. 3harton 0usiness School still teaches efficient market theory. I learn by reading
Graham %reman and Buett. I always thought about one day writing as a way to give back. 2hat is why I
teach also I en4oy doing it. I was writing this book and I started looking for databases to for readers to use. I
looked at 0usiness Week database because 0W is owned by SS6 which owns Dom"ustat but the 0W site
doesn&t use the Dom"ustat data which was the data we used for the study. We wanted to avoid the gibberish of
many databases because this book was written for the masses. For you guys it is fine because you can actually
use your head and say -Well that doesn&t make sense because of a s"ecial item there etc. I wouldn&t
recommend blindly doing this. 0ut if I am writing this book for the masses I am a little worried because they
are "rogramming in E0I2 and return on tangible ca"ital. It is kind of tough to do and you can&t really do it in
some of these.
<)
0y the way some of you are in that class where low 6;E and high JPE is used G7on Mueffling DlassI. It turns
out that low 145 and hi!h 7<5 investin! is prett darn !ood. 2his is better but the conce"ts are similar.
:ow 6;E and high JPE is great. 2his GMagic FormulaI is obviously better because it takes into account
differences in ta#es and ca"ital structure much better in my o"inion and the data bears that out.
We leave out finance and utility com"anies in our study. I would say low 6;E and high JPE would work
"retty well there too.
Student% 5id you take a look at 4ust investing in high JPID com"anies regardless of "rice8
BG% If you don&t take into account "rice I don&t call that investing. I would never invest without considering
"rice es"ecially using a com"uter. I guess the market could always underestimate high JPID businesses but I
would never think of using that metric without combining it with "rice. What ty"e of business is it and can I
buy it chea", PA, I am 4ust sticking to those two things.
8he hard part comin! up with normaliGed earnin!s. 8he hard part is reall livin! with our choice and
stic"in! to our !uns when the mar"et disa!rees with ou. 2hat is the hard "art. 2hat is the whole ball of
wa#.
Student% 5oes this ty"e of investing work in Euro"e,
BG% Every value study that has ever been done has worked across all markets over time. 2here has never been
a contradiction to this.
1e#t time read the book and we can discuss it further.
5;6 o# Class
@115;6IC5S%
1. 2u##ett .ritin! on 7<IC
2. )a!ic >ormula Slide 1resentation b Boel Greenblatt
F. @rticle on Boel Greenblatt
Goodwill and its @mortiGation% 8he 7ules and 8he 7ealities H257-S,I75&S 1?KF @nnual 7eport$
G%iscussion o using tangible return on capital as a Gudge o businesses2
0ook 7alue vs. Intrinsic 7alue
We re"ort our "rogress in terms of book value because in our case Gthough not by any means in all casesI it is
a conservative but reasonably adeBuate "ro#y for growth in intrinsic business value ? the measurement that
really counts$ 0ook value&s virtue as a score?kee"ing measure is that it is easy to calculate and doesn&t involve
the sub4ective Gbut im"ortantI 4udgments em"loyed in calculation of intrinsic business value. It is im"ortant to
understand however that the two terms ? book value and intrinsic business value ? have very different
meanings.
0ook value is an accounting conce"t recording the accumulated financial in"ut from both contributed ca"ital
and retained earnings. Intrinsic business value is an economic conce"t estimating future cash out"ut
discounted to "resent value. 0ook value tells you what has been "ut in3 intrinsic business value estimates what
can be taken out.
An analogy will suggest the difference. Assume you s"end identical amounts "utting each of two children
through college. 2he book value Gmeasured by financial in"utI of each child&s education would be the same.
0ut the "resent value of the future "ayoff Gthe intrinsic business valueI might vary enormously ?
from Hero to many times the cost of the education. So also do businesses having eBual financial in"ut end u"
with wide variations in value,
<<
At 0erkshire at the beginning of fiscal $K)5 when the "resent management took over the *$K.') "er share
book value considerably overstated intrinsic business value. All of that book value consisted of te#tile assets
that could not earn on average anything close to an a""ro"riate rate of return. In the terms of our analogy the
investment in te#tile assets resembled investment in a largely?wasted education.
1ow however our intrinsic business value considerably e#ceeds book value. 2here are two ma4or reasons8
G$I Standard accounting "rinci"les reBuire that common stocks held by our insurance subsidiaries be
stated on our books at market value but that other stocks we own be carried at the lower of
aggregate cost or market. At the end of $KC( the market value of this latter grou" e#ceeded
carrying value by *<+ million "re?ta# or about *5+ million after ta#. 2his e#cess belongs in our
intrinsic business value but is not included in the calculation of book value3
G2I More im"ortant we own several businesses that "ossess economic Goodwill Gwhich is "ro"erly
includable in intrinsic business valueI far larger than the accounting Goodwill that is carried on our
balance sheet and reflected in book value.
Goodwill both economic and accounting is an arcane sub4ect and reBuires more e#"lanation than is
a""ro"riate here. 2he a""endi# that follows this letter ? -Goodwill and its AmortiHation8 2he Jules and 2he
JealitiesT ? e#"lains why economic and accounting Goodwill can and usually do differ enormously.
.ou can live a full and rewarding life without ever thinking about Goodwill and its amortiHation. 0ut students
of investment and management should understand the nuances of the sub4ect. ) own thin"in! has chan!ed
drasticall #rom F5 ears a!o when I was tau!ht to #avor tan!ible assets and to shun businesses whose
value depended lar!el upon economic Goodwill. 2his bias caused me to make many im"ortant business
mistakes of omission although relatively few of commission.
Aeynes identified my "roblem8 -2he difficulty lies not in the new ideas but in esca"ing from the old ones.T My
esca"e was long delayed in "art because most of what I had been taught by the same teacher had been Gand
continues to beI so e#traordinarily valuable. Rltimately business e#"erience direct and vicarious "roduced
my "resent strong "reference for businesses that "ossess large amounts of enduring Goodwill and
that utiliHe a minimum of tangible assets.
8ood:ill and its Amorti;ation< The (ules and The (ealities
(his a&&endi' deals onl. ?ith economic and accountin, 7ood?ill H not the ,ood?ill o*
ever.da. usa,e9 =or e'am&le, a "usiness ma. "e ?ell li1ed, even loved, ". most o* its
customers "ut &ossess no economic ,ood?ill9 3!(I(, "e*ore the "rea1u&, ?as ,enerall.
?ell thou,ht o*, "ut &ossessed not a dime o* economic 7ood?ill94 !nd, re,retta"l., a
"usiness ma. "e disli1ed ". its customers "ut &ossess su"stantial, and ,ro?in,,
economic 7ood?ill9 So, :ust *or the moment, *or,et emotions and *ocus onl. on
economics and accountin,9
Bhen a "usiness is &urchased, accountin, &rinci&les require that the &urchase &rice 5rst
"e assi,ned to the *air value o* the identi5a"le assets that are acquired9 =requentl. the
sum o* the *air values &ut on the assets 3a*ter the deduction o* lia"ilities4 is less than the
total &urchase &rice o* the "usiness9 +n that case, the di>erence is assi,ned to an asset
account entitled Oe'cess o* cost over equit. in net assets acquiredO9 (o avoid constant
re&etition o* this mouth*ul, ?e ?ill su"stitute O7ood?illO9
!ccountin, 7ood?ill arisin, *rom "usinesses &urchased "e*ore 8ovem"er $97# has a
s&ecial standin,9 )'ce&t under rare circumstances, it can remain an asset on the
"alance sheet as lon, as the "usiness "ou,ht is retained9 (hat means no amorti;ation
char,es to ,raduall. e'tin,uish that asset need "e made a,ainst earnin,s9
<C
(he case is di>erent, ho?ever, ?ith &urchases made *rom 8ovem"er $97# on9 Bhen
these create 7ood?ill, it must "e amorti;ed over not more than 4# .ears throu,h
char,es H o* equal amount in ever. .ear H to the earnin,s account9 Since 4# .ears is the
ma'imum &eriod allo?ed, 4# .ears is ?hat mana,ements 3includin, us4 usuall. elect9
(his annual char,e to earnin,s is not allo?ed as a ta' deduction and, thus, has an e>ect
on a*ter-ta' income that is rou,hl. dou"le that o* most other e'&enses9
(hat2s ho? accountin, 7ood?ill ?or1s9 (o see ho? it di>ers *rom economic realit., let2s
loo1 at an e'am&le close at hand9 Be2ll round some 5,ures, and ,reatl. oversim&li*., to
ma1e the e'am&le easier to *ollo?9 Be2ll also mention some im&lications *or investors
and mana,ers9
@lue Chi& Stam&s "ou,ht See2s earl. in $972 *or $25 million, at ?hich time See2s had
a"out $8 million o* net tan,i"le assets9 3(hrou,hout this discussion, accounts receiva"le
?ill "e classi5ed as tan,i"le assets, a de5nition &ro&er *or "usiness anal.sis94 (his level
o* tan,i"le assets ?as adequate to conduct the "usiness ?ithout use o* de"t, e'ce&t *or
short &eriods seasonall.9 See2s ?as earnin, a"out $2 million a*ter ta' at the time, and
such earnin,s seemed conservativel. re&resentative o* *uture earnin, &o?er in constant
$972 dollars9
(hus our 5rst lesson: "usinesses lo,icall. are ?orth *ar more than net tan,i"le assets
?hen the. can "e e'&ected to &roduce earnin,s on such assets considera"l. in e'cess
o* mar1et rates o* return9 (he ca&itali;ed value o* this e'cess return is economic
7ood?ill9
+n $972 3and no?4 relativel. *e? "usinesses could "e e'&ected to consistentl. earn the
25J a*ter ta' on net tan,i"le assets that ?as earned ". See2s H doin, it, *urthermore,
?ith conservative accountin, and no 5nancial levera,e9 +t ?as not the *air mar1et value
o* the inventories, receiva"les or 5'ed assets that &roduced the &remium rates o*
return9 6ather it ?as a com"ination o* intan,i"le assets, &articularl. a &ervasive
*avora"le re&utation ?ith consumers "ased u&on countless &leasant e'&eriences the.
have had ?ith "oth &roduct and &ersonnel9
Such a re&utation creates a consumer *ranchise that allo?s the value o* the &roduct to
the &urchaser, rather than its &roduction cost, to "e the ma:or determinant o* sellin,
&rice9 Consumer *ranchises are a &rime source o* economic 7ood?ill9 -ther sources
include ,overnmental *ranchises not su":ect to &ro5t re,ulation, such as television
stations, and an endurin, &osition as the lo? cost &roducer in an industr.9
0et2s return to the accountin, in the See2s e'am&le9 @lue Chi&2s &urchase o* See2s at
$$7 million over net tan,i"le assets required that a 7ood?ill account o* this amount "e
esta"lished as an asset on @lue Chi&2s "oo1s and that $425,### "e char,ed to income
annuall. *or 4# .ears to amorti;e that asset9 @. $983, a*ter $$ .ears o* such char,es,
the $$7 million had "een reduced to a"out $$295 million9 @er1shire, mean?hile, o?ned
6#J o* @lue Chi& and, there*ore, also 6#J o* See2s9 (his o?nershi& meant that
@er1shire2s "alance sheet rePected 6#J o* See2s 7ood?ill, or a"out $795 million9
+n $983 @er1shire acquired the rest o* @lue Chi& in a mer,er that required &urchase
accountin, as contrasted to the O&oolin,O treatment allo?ed *or some mer,ers9 Dnder
&urchase accountin,, the O*air valueO o* the shares ?e ,ave to 3or O&aidO4 @lue Chi&
holders had to "e s&read over the net assets acquired *rom @lue Chi&9 (his O*air valueO
?as measured, as it almost al?a.s is ?hen &u"lic com&anies use their shares to ma1e
acquisitions, ". the mar1et value o* the shares ,iven u&9
<K
(he assets O&urchasedO consisted o* 4#J o* ever.thin, o?ned ". @lue Chi& 3as noted,
@er1shire alread. o?ned the other 6#J49 Bhat @er1shire O&aidO ?as more than the net
identi5a"le assets ?e received ". $5$97 million, and ?as assi,ned to t?o &ieces o*
7ood?ill: $2894 million to See2s and $2393 million to @u>alo )venin, 8e?sQ
!*ter the mer,er, there*ore, @er1shire ?as le*t ?ith a 7ood?ill asset *or See2s that had
t?o com&onents: the $795 million remainin, *rom the $97$ &urchase, and $2894 million
ne?l. created ". the 4#J O&urchasedO in $9839 -ur amorti;ation char,e no? ?ill "e
a"out $$9# million *or the ne't 28 .ears, and $97 million *or the *ollo?in, $2 .ears, 2##2
throu,h 2#$39
+n other ?ords, di>erent &urchase dates and &rices have ,iven us vastl. di>erent asset
values and amorti;ation char,es *or t?o &ieces o* the same asset9 3Be re&eat our usual
disclaimer: ?e have no "etter accountin, s.stem to su,,est9 (he &ro"lems to "e dealt
?ith are mind "o,,lin, and require ar"itrar. rules94
@ut ?hat are the economic realitiesQ -ne realit. is that the amorti;ation char,es that
have "een deducted as costs in the earnin,s statement each .ear since acquisition o*
See2s ?ere not true economic costs9 Be 1no? that "ecause See2s last .ear earned $$3
million a*ter ta'es on a"out $2# million o* net tan,i"le assets H a &er*ormance indicatin,
the e'istence o* economic 7ood?ill *ar lar,er than the total ori,inal cost o* our
accountin, 7ood?ill9 +n other ?ords, ?hile accountin, 7ood?ill re,ularl. decreased *rom
the moment o* &urchase, economic 7ood?ill increased in irre,ular "ut ver. su"stantial
*ashion9
!nother realit. is that annual amorti;ation char,es in the *uture ?ill not corres&ond to
economic costs9 +t is &ossi"le, o* course, that See2s economic 7ood?ill ?ill disa&&ear9
@ut it ?on2t shrin1 in even decrements or an.thin, remotel. resem"lin, them9 Bhat is
more li1el. is that the 7ood?ill ?ill increase H in current, i* not in constant, dollars H
"ecause o* inPation9
That probabilit= e>ists beause true eonomi 8ood:ill tends to rise in
nominal ?alue proportionall= :ith in@ation3 (o illustrate ho? this ?or1s, let2s
contrast a See2s 1ind o* "usiness ?ith a more mundane "usiness9 Bhen ?e &urchased
See2s in $972, it ?ill "e recalled, it ?as earnin, a"out $2 million on $8 million o* net
tan,i"le assets 325J 6-+C49 0et us assume that our h.&othetical mundane "usiness
then had $2 million o* earnin,s also, "ut needed $$8 million in net tan,i"le assets *or
normal o&erations9 )arnin, onl. $$J on required tan,i"le assets, that mundane
"usiness ?ould &ossess little or no economic 7ood?ill9
! "usiness li1e that, there*ore, mi,ht ?ell have sold *or the value o* its net tan,i"le
assets, or *or $$8 million9 +n contrast, ?e &aid $25 million *or See2s, even thou,h it had
no more in earnin,s and less than hal* as much in Ohonest-to-7odO assets9 Could less
reall. have "een more, as our &urchase &rice im&liedQ (he ans?er is O.esO H even if
both businesses were expected to have fat unit volume H as lon, as .ou antici&ated, as
?e did in $972, a ?orld o* continuous inPation9
(o understand ?h., ima,ine the e>ect that a dou"lin, o* the &rice level ?ould
su"sequentl. have on the t?o "usinesses9 @oth ?ould need to dou"le their nominal
earnin,s to $4 million to 1ee& themselves even ?ith inPation9 (his ?ould seem to "e no
,reat tric1: :ust sell the same num"er o* units at dou"le earlier &rices and, assumin,
&ro5t mar,ins remain unchan,ed, &ro5ts also must dou"le9
"ut, ruiall=, to brinA that about, both businesses probabl= :ould ha?e to
double their nominal in?estment in net tanAible assets, sine that is the Bind
C+
o/ eonomi reCuirement that in@ation usuall= imposes on businesses, both
Aood and bad3 ! dou"lin, o* dollar sales means corres&ondin,l. more dollars must "e
em&lo.ed immediatel. in receiva"les and inventories9 /ollars em&lo.ed in 5'ed assets
?ill res&ond more slo?l. to inPation, "ut &ro"a"l. :ust as surel.9 !nd all o* this inPation-
required investment ?ill &roduce no im&rovement in rate o* return9 (he motivation *or
this investment is the survival o* the "usiness, not the &ros&erit. o* the o?ner9
6emem"er, ho?ever, that See2s had net tan,i"le assets o* onl. $8 million9 So it ?ould
onl. have had to commit an additional $8 million to 5nance the ca&ital needs im&osed
". inPation9 (he mundane "usiness, mean?hile, had a "urden over t?ice as lar,e H a
need *or $$8 million o* additional ca&ital9
!*ter the dust had settled, the mundane "usiness, no? earnin, $4 million annuall.,
mi,ht still "e ?orth the value o* its tan,i"le assets, or $36 million9 (hat means its
o?ners ?ould have ,ained onl. a dollar o* nominal value *or ever. ne? dollar invested9
3(his is the same dollar-*or-dollar result the. ?ould have achieved i* the. had added
mone. to a savin,s account94
See2s, ho?ever, also earnin, $4 million, mi,ht "e ?orth $5# million i* valued 3as it
lo,icall. ?ould "e4 on the same "asis as it ?as at the time o* our &urchase9 So it ?ould
have ,ained $25 million in nominal value ?hile the o?ners ?ere &uttin, u& onl. $8
million in additional ca&ital H over $3 o* nominal value ,ained *or each $$ invested9
6emem"er, even so, that the o?ners o* the See2s 1ind o* "usiness ?ere *orced ".
inPation to ante u& $8 million in additional ca&ital :ust to sta. even in real &ro5ts9 !n.
unlevera,ed "usiness that requires some net tan,i"le assets to o&erate 3and almost all
do4 is hurt ". inPation9 @usinesses needin, little in the ?a. o* tan,i"le assets sim&l. are
hurt the least9
!nd that *act, o* course, has "een hard *or man. &eo&le to ,ras&9 =or .ears the
traditional ?isdom H lon, on tradition, short on ?isdom H held that inPation &rotection
?as "est &rovided ". "usinesses laden ?ith natural resources, &lants and machiner., or
other tan,i"le assets 3O+n 7oods Be (rustO49 +t doesn2t ?or1 that ?a.9 !sset-heav.
"usinesses ,enerall. earn lo? rates o* return H rates that o*ten "arel. &rovide enou,h
ca&ital to *und the inPationar. needs o* the e'istin, "usiness, ?ith nothin, le*t over *or
real ,ro?th, *or distri"ution to o?ners, or *or acquisition o* ne? "usinesses9
In ontrast, a disproportionate number o/ the Areat business /ortunes built up
durinA the in@ationar= =ears arose /rom o:nership o/ operations that
ombined intanAibles o/ lastinA ?alue :ith relati?el= minor reCuirements /or
tanAible assets3 +n such cases earnin,s have "ounded u&?ard in nominal dollars, and
these dollars have "een lar,el. availa"le *or the acquisition o* additional "usinesses9
(his &henomenon has "een &articularl. evident in the communications "usiness9 (hat
"usiness has required little in the ?a. o* tan,i"le investment H .et its *ranchises have
endured9 /urin, inPation, 7ood?ill is the ,i*t that 1ee&s ,ivin,9
@ut that statement a&&lies, naturall., onl. to true economic 7ood?ill9 S&urious
accountin, 7ood?ill H and there is &lent. o* it around H is another matter9 Bhen an
overe'cited mana,ement &urchases a "usiness at a sill. &rice, the same accountin,
niceties descri"ed earlier are o"served9 @ecause it can2t ,o an.?here else, the silliness
ends u& in the 7ood?ill account9 Considerin, the lac1 o* mana,erial disci&line that
created the account, under such circumstances it mi,ht "etter "e la"eled O8o-BillO9
Bhatever the term, the 4#-.ear ritual t.&icall. is o"served and the adrenalin so
ca&itali;ed remains on the "oo1s as an OassetO :ust as i* the acquisition had "een a
sensi"le one9
C$
R R R R R
+* .ou clin, to an. "elie* that accountin, treatment o* 7ood?ill is the "est measure o*
economic realit., + su,,est one 5nal item to &onder9
!ssume a com&an. ?ith $2# &er share o* net ?orth, all tan,i"le assets9 =urther assume
the com&an. has internall. develo&ed some ma,ni5cent consumer *ranchise, or that it
?as *ortunate enou,h to o"tain some im&ortant television stations ". ori,inal =CC
,rant9 (here*ore, it earns a ,reat deal on tan,i"le assets, sa. $5 &er share, or 25J9
Bith such economics, it mi,ht sell *or $$## &er share or more, and it mi,ht ?ell also
"rin, that &rice in a ne,otiated sale o* the entire "usiness9
!ssume an investor "u.s the stoc1 at $$## &er share, &a.in, in e>ect $8# &er share *or
7ood?ill 3:ust as ?ould a cor&orate &urchaser "u.in, the ?hole com&an.49 Should the
investor im&ute a $2 &er share amorti;ation char,e annuall. 3$8# divided ". 4# .ears4
to calculate OtrueO earnin,s &er shareQ !nd, i* so, should the ne? OtrueO earnin,s o* $3
&er share cause him to rethin1 his &urchase &riceQ
R R R R R
Be "elieve mana,ers and investors ali1e should vie? intan,i"le assets *rom t?o
&ers&ectives:
$. In analysis of o"erating results U that is in evaluating the underlying economics of a business
unit U amortiHation charges should be ignored. What a business can be e#"ected to earn on
unleveraged net tangible assets e#cluding any charges against earnings for amortiHation of
Goodwill is the best guide to the economic attractiveness of the o"eration. It is also the best
guide to the current value of the o"eration&s economic Goodwill.
2. In evaluating the wisdom of business acBuisitions amortiHation charges should be ignored
also. 2hey should be deducted neither from earnings nor from the cost of the business. 2his
means forever viewing "urchased Goodwill at its full cost before any amortiHation.
Furthermore cost should be defined as including the full intrinsic business value U not 4ust
the recorded accounting value U of all consideration given irres"ective of market "rices of
the securities involved at the time of merger and irres"ective of whether "ooling treatment
was allowed. For e#am"le what we truly "aid in the 0lue Dhi" merger for '+> of the
Goodwill of See&s and the 1ews was considerably more than the *5$.< million entered on
our books. 2his dis"arity e#ists because the market value of the 0erkshire shares given u" in
the merger was less than their intrinsic business value which is the value that defines the true
cost to us.
-&erations that a&&ear to "e ?inners "ased u&on &ers&ective 3$4 ma. &ale ?hen
vie?ed *rom &ers&ective 3249 A Aood business is not al:a=s a Aood purhase D
althouAh it)s a Aood plae to looB /or one3
Be ?ill tr. to acquire "usinesses that have e'cellent o&eratin, economics measured ".
3$4 and that &rovide reasona"le returns measured ". 3249 !ccountin, consequences ?ill
"e totall. i,nored9
C2
Boel Greenblatt&s Slide 1resentation% Graham&s /alue >ormula L Dpdated
Slide 1% /alue investin! isn&t dead.
>ive ears a!o, at the hei!ht o# the Internet 2ubble, we ran this ad in 2arron&s%
/alue investin! isn&t dead. It is alive and well at /alueinvestorsclub.com
Slide 2% 8he -e to Success#ul Investin!% Invest in Good Companies .hose Stoc"s are Cheap
Good companies have hi!h returns on capital H7<IC$
6e#ined as operatin! pro#it H52I8 or 52I86@ L )CR H)aintenance Capital 5+penditures$$
divided b wor"in! capital plus net #i+ed assets
Cheap stoc"s have hi!h earnin!s ields
6e#ined as pre(ta+ operatin! earnin!s divided b enterprise value
Slide F% )a!ic >ormula 7esults
Magic $r'ula (esults )i**erence
+ear
Magic
$r'ula )i**erence
Investing
,10-000
Mar!et
.verage &/P 500
1988 27.10% 2.30% '10(230.00 24.80% 16.60%
1989 44.60% 26.60% '12(951.18 18% 31.70%
1990 1.70% 17.80% '15(256.49 -16.10% -3.1
1991 70.60% 25.00% '19(070.61 45.60% 30.50%
1992 32.40% 21.00% '23(075.44 11.40% 7.60%
1993 17.20% 1.30% '23(375.42 15.90% 10.10%
1990 22% 26.50% '29(569.91 -4.50% 1.30%
1995 34% 4.90% '31(018.83 29.10% 37.60%
1996 17.30% 2.40% '31(763.29 14.90% 23%
1997 40.40% 23.60% '39(259.42 16.80% 33.40%
1998 25.50% 27.50% '50(055.76 -2% 28.60%
1999 53% 16.90% '58(515.19 36.10% 21%
2000 7.90% 24.70% '72(968.44 -16.80% -9.10%
2001 69.60% 58.10% '115(363.10 11.50% -11.90%
2002 -4% 20.20% '138(666.45 -24.20% -22.10%
2003 79.90% 11.10% '154(058.42 68.80% 28.70%
2000 19.30% 1.50% '156(369.30 17.80% 10.90%
.vg. 30.81 18.51 12.31 12.01
) *h! +,-"k!t -.!"-g! "!t/"# is -# !0/-112 w!ight!3 i#3!4 o o/" 3(500-stock
/#i.!"s!. E-ch stock i# th! i#3!4 co#t"i5/t!s !0/-112 to th! "!t/"#. *h! S6P
500 i#3!4 is - ,-"k!t w!ight!3 i#3!4 o 500 1-"g! stocks. L-"g! stocks 7thos!
with th! high!st ,-"k!t c-8it-1i9-tio#s: -"! co/#t!3 ,o"! h!-.i12 th-# s,-11!"
stocks.
Slide N%
2argest 1-000 &tc!s
Magic $r'ula (esults )i**erence
+ear
Magic
$r'ula )i**erence ,10-000
Mar!et
.verage &/P 500
1988 29.40% 9.80% '10(980.00 19.60% 16.60%
1989 30.00% 2.40% '11(243.52 28% 31.70%
1990 -6.00% 1.10% '11(367.20 -7.10% -3.1
1991 51.50% 17.10% '13(310.99 34.40% 30.50%
1992 16.40% 6.10% '14(122.96 10.30% 7.60%
C(
1993 0.50% -13.90% '12(159.87 14.40% 10.10%
1990 15% 14.80% '13(959.53 0.50% 1.30%
1995 56% 24.50% '17(379.61 31.40% 37.60%
1996 37.40% -78.80% '3(684.48 116.20% 23%
1997 41.00% 21.40% '4(472.96 19.60% 33.40%
1998 32.60% 22.70% '5(488.32 10% 28.60%
1999 14% -20.70% '4(352.24 35.10% 21%
2000 12.80% 27.30% '5(540.40 -14.50% -9.10%
2001 38.20% 47.40% '8(166.54 -9.20% -11.90%
2002 -25% -2.60% '7(954.21 -22.70% -22.10%
2003 50.50% 9.10% '8(678.05 41.40% 28.70%
2000 27.60% 10.30% '9(571.89 17.30% 10.90%
.verage 22.90% 11.20% 11.70% 12.40%
) *h! +,-"k!t -.!"-g! "!t/"# is -# !0/-112 w!ight!3 i#3!4 o o/" 1(000-stock /#i.!"s!.
E-ch stock i# th! i#3!4 co#t"i5/t!s !0/-112 to th! "!t/"#. *h! S6P 500 i#3!4 is -
,-"k!t w!ight!3 i#3!4 o 500 1-"g! stocks. L-"g! stocks 7thos! with th! high!st
,-"k!t c-8it-1i9-tio#s: -"! co/#t!3 ,o"! h!-.i12 th-# s,-11!" stocks.
34 11 "'4anies %it# M!t. "a4 5 2 Billin , as * 11/11/05
"'4an6 3ic!er M!t. "a4
Pre-3a7 Earnings
+iel8 Pre-3a7 (9I"
3M " ;;; 58.6 8% 50% - 75%
.**iliate8 "'4 &vcs-"2 . A%S 6.97 8% 50% - 75%
.'erican &tan8ar8 "s- Inc. ASD 8.2 9% 25% - 50%
.'er. Eagle 9ut*itters AE<S 3.9 13% = 100%
.'4#enl "r4 APH 3.5 8% 50% - 75%
.ra'ar! "r4 >;? 4.6 9% 25% - 50%
C'
.3/3 *ick!" 15.9 14% 25% - 50%
.utliv Inc. AL@ 3.7 12% 25% - 50%
.ut:ne Inc. AA< 6.6 12% 25% - 50%
.V9; Pr8ucts A@P 2.7 9% 75% - 100%
Blc! </( H>$ 7.9 13% =100%
-illionE$ollar -aAi by %ames 0oric
%oel Greenblatt is not famous...!e is merely rich.
:ast week I discovered why he is so rich. My discovery could easily "ut a few e#tra dollar bills in your "ocket
as well...Maybe even millions of dollar bills.
Joel Greenblatt is a !arvard 0usiness School graduate but letMs not hold that against him. !e is also the
founder and managing "artner of Gotham Da"ital a "rivate investment firm established in $KC5. !e started
with *< million of outside ca"ital ? mostly from 4unk bond king Michael Milken. Pver the ne#t decade he
earned 5+> a year ? com"ounded. Even after "aying back all of the original seed ca"ital and factoring out
e#"enses Greenblatt grew his *< million stake to over *(5+ million. A mere *$+++ investment was worth
*5<))5 in $KK5. A *$++++ investment was worth more than a half a million dollars.
So when Greenblatt took the "odium at the recent 7alue Investing Dongress in 1ew .ork Dity I
listened...intently.
Greenblatt declared that he had a sim"le two?"art investment "rocess that could deliver far greater returns
than the rest of the market. !e called the "rocess his Vmagic formula.V I thought to myself VWow thatMs "retty
corny...but maybe thereMs something to it anyway.V As it turns out there is.
GreenblattMs formula relies on a Vvalue?orientedV "rocess that ranks stocks on the basis of two variables 9 the
earnings yield and the businessMs return on ca"ital.
2he first "art of his formula reBuires that a stock trade for a bargain "rice relative to earnings "ower Gor yieldI.
2he idea is sim"le. If for e#am"le a com"any canMt earn more than 5> a year ? the return you would receive
from $+?year R.S. 2reasury note ? it isnMt a business you want to be in. =uite sim"ly it isnMt chea" relative to
the risk you must take.
2o calculate a com"anyMs earnings yield you divide its annual earnings "er share by its share "rice. For
instance...If a com"any earns *$ "er share for an entire year and its stock "rice is *$+ its earnings yield is
$+>. Since $+> is double the return of a $+?year 2reasury it may be a com"any worth looking into. 0ut if you
find a com"any in the same industry that earns *2 "er share and trades for *$+ that may be an even better
investment o""ortunity. It has an earnings yield of 2+>/ Pbviously the higher the earnings yield the better the
bargain.
0ut earnings yield is only one half of the magic formula. Investors must also ask a second Buestion8 Is the
business a solid one, 2he last thing you want to do is to buy stock in a com"any that is chea" for a good reason
? because it stinks.

Greenblatt determines whether a com"any is VgoodV or not by looking at its return on invested ca"ital. In other
words is it investing its ca"ital wisely ? adding to its earnings "ower, Pr is it wasting its cash on frivolous
investments that will create no Gor even negativeI value for shareholders moving forward, For instance...
If a com"any s"ends *$ million on a new factory and it is able to crank out an additional *5+++++ in "rofits
the ne#t year the result is a 5+> annual return on ca"ital. 2hatMs outstanding. It says management knows how
to s"end .PRJ shareholder money to create added value. Dlearly com"anies with high returns on ca"ital will
grow more Buickly than com"anies with low returns.
C5

YEditorMs 1ote8 0y the way Greenblatt has authored a terrific book about his magic formula entitled V2he
:ittle 0ook that 0eats the Market.V !e has also created a Website dedicated to the "rocess which may be
found at www.magicformulainvesting.com. For the record we have no business association whatsoever with
Greenblatt. We are merely "roviding this information as a courtesy to youZ.
So Greenblatt wondered how much money you would make if you invested P1:. in good com"anies Gthose
with a high return in invested ca"italI that trade for a bargain "rice Gcom"anies with high earnings yieldsI.
2o answer that Buestion he researched the historical returns of the stocks his magic formula would have
identified. S"ecifically he went back and e#amined the to" (5++ American stocks Gfrom your large behemoths
like Microsoft on down to micro ca" com"anies with market ca"s of *5+ millionI from $KCC?2++' according
to his formulaMs ranking system. !e ranked each stock in terms of earnings yield and return on ca"ital ? from $
to (5++.
2he idea was to invest in the com"anies with the best combined score U those with the highest earnings yield
A15 the highest return on ca"ital. So if a com"any ranked $++th in terms of earnings yield and 5+th in terms
of return on invested ca"ital it got a score of $5+. And if another com"any ranked )th in terms of earnings
yield and $+th in terms of return on ca"ital it got a combined score of $).
After generating a score for each com"any Greenblatt created a "ortfolio of the to" (+ com"anies. Greenblatt
created a new V2o" (+V at the beginning of every year within his test and then calculated the return an investor
would have received by investing in each yearMs to"?(+ stocks.
From $KCC?2++' if you had bought the to" (+ com"anies generated every year using GreenblattMs formula you
would have averaged a (+.C> return for $< years. 5uring that same time frame the market averaged a $2.(>
return.
So GreenblattMs ideal "ortfolio Gusing his two?"art formulaI beat the market by almost three times over. And it
gets even better...
2here was 1E7EJ a three?year "eriod between $KCC and 2++' where this "ortfolio of (+ solid bargain stocks
was not "rofitable. Indeed there was never a three?year "eriod in which it failed to beat the return of the SS6
5++. In other words an *$$+++ investment in $KCC in GreenblattMs magic formula stocks would have been
worth over *$ million by 2++'.
As a small?ca" s"ecialist I was "articularly intrigued by the fact that the small?ca" value stocks within
GreenblattMs system dramatically boosted the overall results. For e#am"le when Greenblatt e#cluded the
smallest 25++ stocks from his sam"le universe of (5++ he discovered that his magic?formula "ortfolios
"roduced an annual return of VonlyV 22.K>. 2hat result was still far better than the SS6 5++Ms but the not
nearly as good as the (+.C> annual returns that resulted when the mid? and small?ca" stocks were included.
In other words small ca" value stocks are some of the marketMs most valuable stocks of all. So I wondered
what small?ca" com"anies in todayMs market would meet GreenblattMs stringent value criteria, I ran some
numbers of my own and came u" with $+ com"anies that had at least a 25> return on ca"ital and an earning
yield north of K>. Dheck Mem out...
;ovember F0, 2005 7eview Class
2he test ne#t week will be closed book.
2he "ur"ose of today&s class is8
We will do some review for the e#am
C)
We will discuss "ortfolio management which we haven&t talked much about it.
We will then discuss anything from the book9I assume you have read it.
I. Iuestions about the boo", 8he 3ittle 2oo" that 2eats the )ar"et.
Student% 5oes Ebit O Ebitda U Maintenance Da"ital E#"enditures GMDLI used in the book,
BG% Jight I "ut a little note in there for the +B& Students in the book. I assumed MDL O 5SA for sim"licity
"ur"oses. Figuring out MDL for a lot of these com"anies is "retty hard. Pn average it Gusing ,BITI is "retty
close to being right for sim"listic "ur"oses. If I were doing it myself I would check to see the true MDL and
subtract that number from E0I25A. .ou might use E0I2 as a check to see if you are close.
Student% When your sister 0inda Greenblatt was here she said that retailers were great to invest in due to their
"rice swings Ghigh "rice volatility allows for advantageous "urchasesI. Jeal Estate swings. Were there any
other consistent sectors in your database that ke"t showing u",
BG% 2here was no "articular e#"osure but there were a lot of consumer e#"osure in general because those
businesses de"ending u"on whom was doing the categoriHing do not reBuire a lot of ca"ital to earn their returns
GA low ca"ital return modelI.
2he big "icture here is the not trying very hard model right, .ou sort of use last year&s earnings and you do
not make heroic assum"tions and you do not use very many factors. It shows how power#ul the basic
concept is.
I had fun with this because I read a lot of the academic 4ournals 1on inance2 because I am a wild and craHy
guy. Four years ago they took some firms in efficient markets. Everything has to be laid out in that conte#t Go
eicient mar(et theoryI. 2hey 1academicsI have never really gotten off that. It is "retty amaHing how you can
argue in the face of so much information that you can beat the market doing something this sim"le$ 1Though
ships will sail around the world or centuries' the /lat ,arth Society prevails4 3arren Buett2$
I wrote the book for the masses9that was the audience for this book. If you can really insert your estimates of
normaliHed earnings that would be so much better. 2he fact is that some of you will find some com"anies that
you feel confident in doing that means that if it works this well doing nothing to work well actually thinking
about it as long as you don&t get messed u" with the emotions when it is not working out for you.
Student% !ow do you com"ile the stocks every year, !ow are stocks added or eliminated, !ow does that
change from year to year,
BG% !ow is the "ortfolio "ur"osely constructed, I left that "ur"osely nebulous because it was com"licated.
2he basic idea is that there is always a (+ stock "ortfolio and you accumulate that "ortfolio over time so that
each stock was held for a year. We started in %an. $KCC and although we assumed we started buying stocks in
%an $KC< with some stocks held for ) months and some held for nine months etc as I described in the book I
suggested that you bought si# stocks every two months until there were (+ stocks accumulated in the "ortfolio
over the year by %an. $KCC.
As I described in the book we used a ste"?by?ste" "rocess. We had stocks held for three si# nine months etc.
In year two you will have (+ stocks starting in year two you have thirty stocks in the "ortfolio then you sell si#
stocks and bought ) new stocks. What I described in the book for a thirty stock "ortfolio you would be buying
) stocks every two months. 2hen you would sell stocks held for more than a year. 2hink of starting in year two
and that is how we started measuring the (+ stock "ortfolio.
Student% Was there any reason you "icked $KCC for the starting year,
BG% .es we used a database called Compustat "oint?in?time database which was the e#act data that someone
would see back then. I said in the back of the book these were the reasons things get attacked and one of them
is survivorshi" bias where they 4ust take bankru"t com"anies out of the inde# so you have a bias to do well
C<
because you got rid of the loser. !ere this was the e#act data the Compustat customer had at that "oint in time
and it only goes back until then G$KC<I. So we went to the beginning of the database. .ou could argue that it
might not have worked but we didn&t want to have any argument and this is the easiest database to use because
the data is very uniform.
2here are many many "roblems and the reason we set u" the www.)a!ic>ormulaInvestin!.com. Website
was because I didn&t want to write the book and then we didn&t want "eo"le to use crummy databases and
"eo"le have to "lug in all the formulas. 6eo"le would be trying to "rogram tangible ca"ital and all those kinds
of things. So I had "lanned to use Business 3ee(s data base but it doesn&t use Compustat data Gthough it is
owned by SEPI. So I felt kind of obligated to do this because the readers would not have accurate or easily
obtained data to use the Magic Formula and then they go buy the wrong stock. We tried to make it as sim"le as
"ossible.
Student% 5id you think of using two year&s data,
BG% 2hat is a good Buestion. In other words I say it is a good long term strategy and I say to turn it 1the
portolio2 over ever year9one a year was sim"le and two to take losses in less than a year for short term
losses and two to take "rofits after holding the stock for a year for a long term gains es"ecially if you were an
individual. It works well using two year old data as well.
We are using last year&s data instead of using "ro4ections. After a year you have fresher data than a year ago
and that always makes more sense than using two year old data. We thought a year was as good as anything
else for ta# reasons and for turnover costs it was a com"romise to a longer term Gtwo years or moreI strategy.
And we wanted to kee" it sim"le.
Student% 2he lowest deciles were the most risky, 5id you notice a number of com"anies going bankru"t in
the lowest deciles, Are the lowest deciles the most risky, Some stocks in those deciles tri"led and some went
bankru"t,
BG% 1o. .e are buin! hi!h 7<IC stoc"s earnin! a lot o# mone, companies that are earnin! mone.
.e are not choosin! low price to boo" stoc"s. 2heir argument goes out the window. We didn&t see much.
1&cademics might say +agic /ormula Investing Stoc(s will do better because o the higher ris(s inherent in
the stoc(s2$ And there isn&t much in the low "rice to book results as well. 1&cademics say2 -It GriskI doesn&t
come out in volatility where they 1&cademics in inance2 measure risk everywhere else so it must be some
other risk because our theory can&t be wrong. It is "atently ridiculous. At the end of class I will tell you what I
really think. 10aughter2$ Pne thing I did sli" in the a""endi# is that if we are valuing stocks based on future
earnings discounted back@.why would low "rice to book stocks be im"ortantQ$$1garbled2
:ow "rice to book stocks are a subset of stocks that are su"er chea" and are already out of favor. A subset of
stocks that are chea" will trade close to book value but that is not why they are chea". 2hey 4ust ha""en to be
chea"9it is an indication they may be chea". So a more direct wa to test whether a compan is cheap%
6oes it earn a lot relative to what I am pain! and is it in a !ood businessC 2his should work a lot better
than low "rice to book stocks.
:ow "rice to book is 4ust a subset that you would tend to get and actually the Tros(y Study show less than half
of the low "rice to book stocks beat the market but the ones that do beat it by a lot. So what he tried to do is
throw out some of the worse low "rice books stocks to see if he im"roved which he did. 0ut his methodology
did not work for large ca" stocks. I think that is the beauty of this 1+agic /ormula2 one. 2hat was why we did
the large ca" stock study which worked well for us922> average annual returns for large ca" stocks over
$KCC to 2++( testing "eriodI.
Student% 5o you remove cyclical GstocksI from your study, Douldn&t you be buying cyclical stocks at the
worst time because their earnings would be "eak earnings giving you a high earnings yield,
BG% I wouldn&t say that. I wouldn&t say that. In most cases@..What we try to do here rather than@. 2his is
the thing that we tested first and it worked. We didn&t test many things to "ick the one that worked which is
comforting because it shows that logic works. 2his is the not trying method.
CC
.ou don&t want to "ut too many factors in there. I actually got an email from 9Shaughnessy who wrote What
Works on Wall Street.T I beat u" on him in my book. 2he only one left on the list is Baugen who has a <2
factor model GreFuiring monthly turnoverP2 that doesn&t work as well as the two factor model. So one down
and one left.
Student 5id you consider leverage,
BG% 1o I didn&t but 5/452I8 includes levera!e. All the studies done in the "ast9the low 6;E studies??are
not low E7;E0I2. When I gave you those "assages to read and that guy 1Boo(e' the author o Security
&nalysis on 3all Street2 said take what you get regarding ca"ital structure so use 6;E as o""osed to E7;E0I2.
I said that I didn&t agree with that. I think it is very clear through statistics that on average this is much better.
So that hel"s in that analysis.
I try to e#"lain why this works in the book but I have to be frank I was Buite amaHed at how well it worked.
BG% Who thinks I was an idiot to write this book in the first "lace,
Student8 :aughter. Will the Magic Formula diminish over time,
Investing is like dieting. It is easier to know what to do than actually do it, 2here is a "retty strong argument
that not many "eo"le will be able to follow this. It "robably might diminish somewhat.
BG% :ow 6;E hasn&t 1diminished as a value metricI but low "rice to book G6;0I has. 0ut low 6;0 really didn&t
make much sense to me. I think one reason low "rice to book has diminished over the years is that the
economy has been less asset based earned and more services industry oriented over the last $5 or 2+ years. So
that the com"anies that are trading closer to book value with a lot of assets to generate earnings are some of the
worse com"anies to invest in. 1egative results from low 6;07. 2hat is one of the things that I am banking on.
2his method like the low 6;E strategy won&t diminish and hasn&t diminished over the "ast '+ years. 2he
strategy to buy high earnings yield G:ow E7;high EbitI com"anies which have high JPID Ghigh E0I2;:ow
Invested Da"italI should remain robust.
2he other thing I am banking on is that if you look at the to" of the list Gof Magic Formula StocksI they are
hard to own. !ow I know why these stocks are trading there9bad near term news abounds. 2here are not too
many takers to buy. So I think as long as@..
Even if you look at the Baugen study where he had with <$ factors Gof criteria to buy su"erior "erforming
stocksI and he wrote a trilogy of books??all of them worth reading with various benefits with each. GSee shaded
segment on "age 22I. Pne of them had to do with his <$ factor model and he shows you the to" ten factors
that he used and si# of them were low 6;E and high JPE. It is not that Buants don&t have this stuff Gon what
Buantifiable criteria out"erform the marketI. 2he average guy doesn&t. 2hen you have to decide does it work
with the analyst working with big com"anies who set "rices or com"uter robots,
2he reasons that =uants go out of business is because they have to kee" reinventing themselves9the
Buantitative model. 2hey find anomalies that work for a day a week a few weeks whatever and they may
converge the way they are su""osed to go. And if you look at the results here for the sim"le model Gfor the
Magic FormulaI and in 2++2 the model is down 25> and the market is down 22> but "eo"le can&t eat that
volatility. If things converge Buickly the "eo"le have "atience. If things converge slowly over a year or two
years and things go badly in between "eo"le don&t have that "atience. It is very hard for "eo"le to ado"t that
model 1o +agic /ormula Investing2$
1eople don&t have to patience to wait #or conver!ence. It is very hard. .ou can imagine if this doesn&t work
this year "eo"le will say this 1method2 doesn&t work either.
For e#am"le my daughter9she??started in August and my son started in March but their results differ because
of their starting "eriods and the stock chosen in that "eriod.
CK
Student% :ong term e#"ectation, What would you think for this to go away, Pr because "eo"le are irrational
this will never go away,
BG% 2hat is what I am ho"ing for. I assume human nature doesn&t change.
Student% What would it take for this to go away that is the real Buestion,
BG% I think it would be very hard because like I said it is very very lum"y GreturnsI so that@. 2here will
always be things going out of favor. 2here are two ways this works. Pne of the ways which is what I said in
the book. Good companies at cheap prices. I think that is certainly true for the first and second deciles and
why they out"erform the last two deciles. I think it is very clear on average that is what you are doing.
.hen ou !et into the top tier Hdeciles$ o# companies, ou are wor"in! more as an insurance compan
1so you need a pool o bets to have the odds more in your avor$. Individually it is hard to own them because
they are out of favor and they may work out or they may not. 0ut as a grou" on average there are enough
winners that work out. So you are really taking an insurance grou" bet rather than an individual stock bet.
2here will always be stuff out of favor and stocks will be "riced that way until the Buants take over the world.
And when the Buants take over the world it sto"s working. 2hen it will work again because the Buants will be
out of business.
0ut generally@..If you think about what a Buantitative model is9it is 4ust a bunch of numbers to somebody
and it blows u" at some "oint and then you don&t know whether it blew u" or things had changed or you are
doing the wrong thing. .ou are actually analyHing com"anies. Frankly that is 1iguring out normali8ed
earningsI my day 4ob and your day 4ob because you can do it. 2his is for the guy not doing any work. ) da
'ob is #i!urin! out what normaliGed earnin!s are and plu!!in! it into the model((not loo"in! what
happened last ear. 2his is sort of an easy thing for "eo"le to do. As far as making money in the future
there is always stuff that is in and out of favor. ,uman nature doesn&t chan!e.
Student% 2his can never go out of favor,
BG% In ten years, I am not e#"ecting it to no. I think that is a fair assessment.
Evaluating Managements
8he main point is not to memoriGe rules. 0ecause "eo"le ask me about this??evaluating management??
throughout the semester but I am 4ust trying to evaluate how certain "eo"le will act in their own best interests.
!ow is this guy incentiviHed, I try to use logic. What is his incentive to do this, If "eo"le are not incentiviHed
to do a good 4ob they generally won&t do it. 2here are some great "eo"le in the world that will do the right
thing regardless of incentives but on average human nature "revails. .ou must e#"ect "eo"le will act in their
best interests and know how they are incentiviHed. I would go in e#"ecting that.
What "ercentage of the com"any is best to own, It is either a strong "oint for the com"any whether
management is incentiviHed well or not. 5o they kee" stealing as much as they can and kee" blowing it out,
If they are buying back stock over the last five years I assume it is chea" or they wouldn&t do that. .
Student% 6ortfolio managers won&t want to hold these ty"es of stocks 1+agic /ormula Stoc(s with LbadM
near4term news2 in their "ortfolio,
BG% ?ichard P8ena when he is selling to institutions and telling them what he owns they say to him -5on&t
you read the "a"ers,T 0ecause there is something wrong with his com"anies. For some it is a sale and for
others it is a negative.
It is hard to do the stu"id thing and lose9that is the hard thing. If it works everyone is ha""y.
Student% .ou think the ma4ority think that way,
K+
2here is too much uncertainty or things will turn down. 2here is too much uncertainty. It is tough. 2hings are
down. .ou say -Ph I knew that stunk and now it is down from *(( to *25. It is not usually the time when
guys say let us 4um" in here.
I do not think about what others are doing or thinking. Bust thin" about what ou should be thin"in!. 2o
cut to the chase the idea here is to cut out the e#traneous stuff. It becomes a very sim"le "rocess. Forget about
what he thinks or what is ha""ening ne#t. >i!ure out what the darn thin! is worth and bu it #or less. 2o
figure out what it is worth then figure out what are normaliHed earnings down the road. 1ot what ha""ened
last year or this year or ne#t year, Most of the time you won&t be able to do that. May be the business is too
uncertain or too tough or you don&t really know. 2ut i# ou can do that in the companies ou do "now, that
is the whole analsis.
It looks chea" enough and we are getting "aid to take our "osition. Rnless the stock bottoms we have never
bottom ticked a stock. Rsually it doesn&t work out so well.
.ou know you have something great when you are rootin! the stoc" down after you have bought a lot. 2hat
doesn&t ha""en that often where you have that confidence.
Student% Pn small amount of money9those transaction costs will add u".
BG% I was thinking about the IJA investor who can "ut in *'+++ the first year into an IJA so I am figuring
that is "retty much the minimum Gamount of investmentI. 2here is this site called www. FolioF1.com so you
can buy stocks at $K.KK "er month. 2he cost is )> in the first year or *2'+ a year for a *'+++ "ortfolio which
is the smallest suggested beginning "ortfolio siHe.
Pr you can do Scott Trade which is *< a trade and you can buy 2+ stocks the first year which is *$'+ "er year.
2he advantage for you is that you can do small ca"s.
0ut you are right and I was concerned about that. .ou can do small ca"s which have done $C> a year better
than the market during the study "eriod G$KC< to 2++(I and that will take care of a lot of the transaction costs
as the account grows. 1.ote; Small Caps are not necessarily on average more undervalued but they are
subGect to more mis4pricing o either being more overvalued or more undervalued2$
Jight now the first time in 25 years I am finding better bargains in the large ca" area. 2hough it works great
for large ca"s so that is the best argument.
If you think of other Buestions@@@..
I thought one of the most interesting things was on the last "age where we talked about the !augen model
which was a <$ factor model and it involved turning over the "ortfolio every month. 2hey did com" to the
two factor model. !is difference between $ and $+ was $<> and the difference for the two factor model was 5
"ercent and change. 2hat was very "owerful. !is worst () month "eriod was minus '+> and the two factor
model was "lus $'>. So I thought that was good.
6ortfolio Management
I also talked a little about 6ortfolio Management so I also think we should talk about that a little bit now.
When you guys get out of here GDolumbia Graduate 0usiness SchoolI it might be difficult to8
A. have the confidence to own 5 to C stocks and
0. !ave someone who is craHy enough to let you do that.
I imagine you can do that in8
A. your "ersonal account and
0. where you have control over things
K$
2here is an argument to have a very concentrated "ortfolio. .ou really are buying "ieces of the business. 2he
way I look at it. 2hink about it as your own business where you own "ercentages of other good businesses that
you researched well and bought at a discount. And if you can buy it for 5+ or )+ cents on the dollar you
wouldn&t worry about where "eo"le were "ricing it all day long.
All the measurements you would get in a traditional M0A in how to do "ortfolio management would look silly.
What ha""ens in the institutional business, When they "ut out money to money managers they don&t go
inside the "ortfolio Gthe "ension fund managers for e#am"le don&t know the reason why those "articular
stocks were "urchased by the fund managerI. 2hey don&t have trans"arency they don&t know why you bought
those stocks and they only know that your returns bounce around. If that is all you have?4ust the numbers?I
understand the "rocess could take longer than three years to work out. If your numbers are no good why
should I "ick you, Sort of like 3arren ,$ Buett 13,B2 -I look for < foot basketball "layers.T
It is sort of the same conce"t. If someone has not done well for three years you should ditch them to go with
"eo"le who have done well. If it is not working well now then why will it work now or in the future,
I am on some institutional GinvestmentI boards and that is the thinking. 2hat is the great thing. 2he guy who
doesn&t do well over three years so he has to sell all his stuff because his money is "ulled9so his stocks get
even chea"er. 1Ironically usually Gust beore the turnaround2$ .ou can see the institutional reason why this
does ha""en.
2he best e#am"le annual volatility then $+ year volatility it is about eBual to the market. Rsing trailing ()
months "eriods P8enas volatility is about half the markets& volatility. I am not a big "ro"onent of either
1measuring volatility2$
Who cares how much it bounces around in the interim if returns are good, If you look at the statistics what are
your draw downs during the course of the year, All of those measures seem a little silly when you own a share
of a business at a good "rice.
Student% What was the one mistake over the "ast twenty years you wish you did a little bit differently, What
was your most common mistake,
BG% I will tell you something encouraging I have done so many stu"id things and I hate to talk about them
and I am not done9it brings u" bad emotions. I have sold too soon and at wrong times. .et if you do enough
stuff right you can still get great returns I think that is encouraging. 0elieve me If I go back over the "ast (+
years and recount my mistakes9it is too embarrassing??but I did sell a stock at 25 cents that is now *$5.
8here was no lo!ic to sellin! it. I was raising money. !ow much could I raise, If you knew how many
mistakes I have made@@not 4ust selling too early though that is one that we often do.
I think I had a contest with ?obert Goldstein my "artner. We made )+> to <+> on our money with +oodys
and it unfolded e#actly as we "redicted but the "osition tri"led. We went back and forth for (+ minutes. What
about all these stocks that tri"led after we sold them, 2hat was certainly one mistake we have made and
continue to make.
Another mistake we have made8 mis?assessment of a business and being in denial. 0ut of denial was that we
owned so much that we couldn&t get out. It wasn&t so much we couldn&t get out.
We never worry too much about liBuidity if I can buy it well. If I am wrong I should "ay for it. :iBuidity
constraints in com"anies that we bought a lot of have more than "aid for the ones we couldn&t get out of. If
you have a long enough horiHon over time it works.
Student% .ou do so much in the small ca" area. !ow small Gare the com"anies stocksI do you look at,
BG% Jight now the ty"ical investment we own is in the multi billions. 2hat is another great thing about
investing in small ca"s which I think I mentioned before. 2he "eo"le who get good at this stuff get wealthy so
then they can&t look at the small ca"s any longer. 2hey go to the large ca"s. So there is always a new cro" of
K2
"eo"le. 8here is alwas room to start there. I try to make it clear in the book too. It is not so much that small
ca"s are better. 1Small caps tend to be more mis4priced both on the up and down side2$
2hat is another stu"id thing that academics generally do@. 2hey say..TWell you left out this or you didn&t
include that@@
I figure I will get attacked eventually because Academics will say -.ou did not take out the small ca" effect
the low "rice;book effect.T 2hey try to take out all these effects??but for that effect you eBualed the mkt. 0ut
the "oint is that the small ca" effect if there is one they are too small to buy. 0ut the small ca" effect if there
was one occurs because the stocks out of favor tend to have smaller ca"s more than the average stocks because
their "rice is low.
I think a small market ca" stock ha""ens because it becomes out of favor. Same with low "rice book. 2he
stock ha""ens to have a low "rice to book because it ha""ens to be out of favor. It is not chea" because it has a
low "rice to book value. It is coincidental. It coe#ists. It is not a good buy because it is low "rice to book. As
o""osed to what this is??Jather than what I looked at??which was "rice relative to what the com"anies would
earn. It makes more sense to me. It seems silly to me to 4ust use low book value to "rice.
Student% 2heoretically the com"anies we work for will be firms that have billions of dollars of ca"ital where
we wouldn&t be allowed to buy com"anies under *'++ ? *5++ million in market ca".
2he 6ur"ose of the Dourse
BG% 2he whole "oint of this course is to give you a conte#t in which to do your valuation work. All you are
doing is valuing com"anies and trying to buy them for less. And then understand the conte#t and how the
market works over time. 2he market may not agree with you in the short term but you have to stick it out to
get right.
@ll ou are doin! is valuin! companies and buin! them #or less. @nd then what is the !lobal conte+t
ou are loo"in! atC If you are valuing large com"anies then figure out the cash flows. It is no different than
for small ca"s. 2here is no line drawn somewhere. :arge ca"s tend to be better more established com"anies
and therefore they are not one "roduct com"anies. 2hey have maybe a stronger market "osition than small
com"anies but you might look at the same attributes. It might be a small niche market that the large com"any
has a great share in that market.
It is all about valuin! companies no matter how man studies I blabber about. If you can value
com"anies and buy them chea"er and have the conte#t to know that 2 "lus 2 eBuals ' then that is all you need
9forget the rest. If you can buy good com"anies that are making money over time at a discount you will
make money. 2hat is really what this course is about.
6utting things into conte#t which I am good at and doing the valuation work which I think I am average at.
0ut I am very "icky and I "ick the things I know how to evaluate. And I think all of you can do that because
you are all here.
I might flounder at a big firm because my guess on a "articular industry might be no better than anyone else
because I don&t understand the dynamics of that industry. 0ut it is a good "rocess. If you learn three or four
industries. 0inda 1GreenblattI has made a good living knowing one industry retail. Pne industry you
understand in your bones like manufacturing because that is your background. It is the 3arren Buett circle of
com"etence conce"t.
Bill +iller Gportolio manager o 0egg +asons :alue TrustI is an e#traordinary e#am"le is someone who has
e#"anded his circle of com"etence to com"anies you generally don&t look at. !e is trying to figure out what a
com"any is worth and buying it for less. !e is trying to understand what "eo"le consider very com"licated9
Google' &ma8on' ,Bay$
Student% What do you look for,
K(
BG% I am always looking for a dis"arity between what it is worth and where it is trading. 2hen what are my
alternatives, Jight now because we have some big ca" stuff we are fully invested. I am worried about the
indebted consumer. We were scared in 2+++ also. We owned a lot of com"anies earning a lot of money. We
knew the Internet bubble would burst also. 2he SS6 5++ dro""ed in half. 2here are not many times in your
life that will ha""en I guarantee it. We were u" $++> in 2+++ and the market got "ummeled. 2hat is sort of
what we are doing now. We are fully invested. If we found something else we would sell something else
because we don&t use leverage.
:everage
If you are going to be a very concentrated investor you should not use leverage. WE0 said you make a lot of
money if you only had a 2+ card "unch card with 2+ choices. I will give you a 2+?hole "unch card for the ne#t
ten years to hel" you be disci"lined.
.ou can&t leverage because you need to live through the downturns and that is incredibly im"ortant.
0ig "icture??the things I look at8 What I have in my "ortfolio. 2his is 4ust "racticing now. .ou have )
securities in it and you are $++> invested. 1ow if we find something else we like??it has to boot something
else out of my "ortfolio. We run a fund of funds. And we found a money manager from the :IC. !e ran a
fund with (+ names because he wanted to slee" well. 0ut he was smart and he had a big staff so he could
source a lot of ideas. !e had insights we didn&t have.
We came u" with a way to work with him. We said -:isten we only want your five best ideas not (+. If you
want to add an idea you have to sell the other.T What are your five favorite things at a time, I would
recommend to ou a M to ? stoc" port#olio. It is a wa to !et rich actuall. It is a very disci"lined strategy to
always kee"ing the best ideas in your "ortfolio and concentrate. Pnly kee" the best things in your "ortfolio.
WE0 says he has more money than ideas but I don&t think you will have that "roblem for a while. If you do
"lease look me u".
Student% Is there anything else you look at,
BG% Pne thing we did not em"hasiHe enough which is inherent in what we are doing because we are buying
stocks chea". :ook for asmmetrical ris" reward investments. It is inherent in what we do. Following the
margin of safety "rinci"le we are looking for good risk reward?? a dollar down and five u". 2he stock is worth
ten and you can buy it *5 but the stock could go down. .ou certainly are not going to buy a large ca" stock
now at a 5+ cent dollar. 2he way I would look at a 5+ cent dollar -Well I am going to hold this for two or
three years and in two or three years with the accumulation of cash it will be worth *$+ but I can buy it for *5
or *) now.T 2hat is a "retty good return. Sometimes it ha""ens sooner and the market fast forwards those
earnings u"front. 6erha"s the market will recogniHe what I am seeing sooner.
It is interesting because we talk to our "ortfolio managers a lot. Pne of the things we bring to the table is that
we can hel" the "ortfolio manager. .e met a !u who ran E100,000 in 15 ears into E25 million HNN.5Q
C@G7 #or 15 ears:$ never running outside money. We convinced him to run money for us. Pne day he
went through all the metrics of the com"any and it is worth *$+ where the stock is trading at *'. We said
-Everything you said makes sense which sounds great. -And one other thingT !e said -they 4ust "ut the
com"any u" for sale.T So this sounds really good to me. Jight,
Why do you only have <> of your "ortfolio in it instead of 2+>, If you were not lucky enough to buy at *2
would you buy a hell of a lot more at *' if you hadn&t been so lucky,
!e said -I see your "oint.T 2he ne#t day a big block of stock comes u" in the stock and he tri"led his "osition.
2hree weeks later the com"any is taken over for *K.
All the stuff I say@6eo"le accuse me of trying to make it seem all too easy. It really is not. When you look at
these results GMagic Formula Stocks u" ('> and 22>I over seventeen years it seems obvious. .hen ou are
in the trenches and ou are livin! throu!h the ear and a hal# and it suc"s, it doesn&t seem so obvious.
Why am I an idiot, It is different. It is much easier to look at an accumulation over time or an average and say
that it is obvious and it works.
K'
2he same thing in "ortfolio management. 2here is all the "sychological things like anchoring the "rice you
"ay. 2hese things naturally go on. I thin" the clearer our thou!ht process, the better. .hich is% It is
worth this it is tradin! here, I have this much con#idence in m opinion. Aou 'ust "eep !oin! bac" to
basics. 2he basics are the market will get it right eventually in three or four years and I have to hang out. If I
am wrong I will be wrong some of the time. If I am wrong a lot of the time I have got to find another line of
work. Pr I have to find some industry that I do know how to value and that is the learning "rocess.
2he !ard 6art
Student% What is the hard "art,
BG% I think the hard "art is limiting yourself to those com"anies that you can figure out the normaliHed
earnings. I onl limit msel# to those companies I can #i!ure out((or are eas to #i!ure out((the
normaliGed earnin!s.
Student% Pver time what is the difference in this methodology com"ared to your first book,
BG% It de"ends where the o""ortunities lie over time. I didn&t get turned on to 3,Bs focus on good
businesses until the early $KK+&s. I got burned in crummy businesses. If there is *$+ in value and it is going
to *$2 then great but if it is going to *C then your margin of safety is degraded. 2ime is against you instead of
working for you.
Student% 2his 2+?hole "unch card is for the "ur"ose of making great 2+ investments,
BG% 6ut half your "ortfolio into stocks using your "unch card. .ou "ut in $+ ideas and you hold them $ to (
years. As I have gotten older slower and working less hard I have e#tended my timeframe and increased my
concentration.
I don&t know if you have done the math. .ou will use u" your twenty "icks. It really is more of a reminder
that less is more. .ou can only focus on your best ideas. If you don&t think it is great then "ass. .our
o""ortunity set is not what is in front of you. 2he future is unknown. 0ut your o""ortunity set is not in buying
what is the best out there today but what mi!ht come alon! i# ou wait. I am really losing an o""ortunity to
buy when there is a great o""ortunity. 2here are times when there are huge o""ortunities and it is good to have
dry "owder.
I am giving you metrics??your hurdle rate should be very high you should be really confident. :oad u" on
your best o""ortunities. What I consider loading u" is more than most "eo"le. We "ut 2+> to (+> of our
ca"ital into an idea. We look at it Gan eBuity "ositionI as owning a "iece of a great business.
When we found a great idea is was because we did the work and we found it in an unusual s"ot. -Ph it is
trading chea"ly because this division could be closed down then the value will be revealed. It is not like we
figured out Google$
2wo more Buestions and then we will take a break.
Student% Are you fully invested,
BG% We have seen a lot of good o""ortunities in the last si# months.
Should I have sat on my hands, Sometimes we are fully invested and are looking. 2he thing you bought goes
down and the thing you sold goes u" but I have learned to ignore the "ain.
2hat is the key/ .ou must think two or three ears out when everyone is thinking about the ne#t Buarter.
3,B was s"oiled by Graham to find only chea" stocks.
K5
BG% 2o me it took me a long time to get to a long time horiHon because there were a lot of neat things to do.
.ou can make money at both. .ou have more wea"ons in your arsenal. . It is all the same thing. .ou get
values coming out of weird situations.
0JEAA@@@..$+<
Final E#am
BG% Why don&t we talk about the final, 2he final is designed to test your analytical skills. Some Buestions are
a matter of o"inion. 2he "oint is to touch on the right "oints.
I might ask for strategic advice after you have seen the $+?A. Some general Buestions about the s"eakers we
had.
.ou have to figure out an arbitrage s"read. .ou have an o"tion Buestion.
I am the easiest grader in the school. I kee" your test in my file so I can answer Buestions about you if anyone
asks me.
I like "eo"le in interviews to disagree with me. 6ick u" the issues and argue well.
We saw s"eakers8 +att +ar(' ?obert Goldstein' ?ichard P8ena' 0inda Greenblatt' Brian Gains and Bruce
.ewberg$
Domments on student "a"ers8
In general I thought your "a"ers were very good. I will tell you your true grade9the grade you should have
gotten9versus what I "ut on your "a"er. 2hese are somewhere in between but in general they were good.
$$+8 A cou"le of comments@@@.
Dom"arables and 7aluations
A student "resented five different ty"es of value8
E7;E0I2
6rice;Sales
liBuidation value
6rivate transaction value
and one or two others
2hen he averaged the five. I say "ick one9something that is more relevant. If they are all in the same range
it doesn&t matter. %ust "icking an average doesn&t mean much. I think the same thing with relative value9
"icking com"arables. A lot of "eo"le 4ust list a bunch of com"arables. Even if some did the JPID and
E7;E0I2 analysis and com"ared and that is good. It is much better than doing 6;E ratios where there are
different ta# shields and everything else. 0ut those eight or ten com"anies were not really great com"arables
necessarily. I would still "ick out the businesses the most likely to be similar and do com"arables on two or
three com"anies instead of an average of C or $+. I think that might be more useful rather than 4ust getting the
4ob done.
2here are other com"anies that don&t have good com"arables but cash is cash and what I would do on
that@...ou know I gave a s"eech at Stanord Bernstein to the young analysts there G5+I. It is kind of great
and sad in a way but I get these kinds of Buestions. An analyst raised his hand and said -Well I do tech stocks.
2hose are valued differently than the others so how would I go about valuing them,T Well I said cash is cash
and you are valuing the earnings stream??they are all green. It de"ends u"on your confidence level and
everything else. It is in the way you get into an institutional mindset and they are still doing it that way.
Sanord Bernstein is a great "lace. <ne o# the advanta!es ou have is thin"in! strai!ht.
K)
If you can&t find a good com"arable then try to find a com"arable business with similar metrics like returns on
ca"ital and similar growth "ros"ects. ?ob Goldstein Ghis "artnerI com"ared +oodys to Co(e when 0uffett
bought it because there were attributes to those businesses that were similar. 2here were differences and
similarities but it is nice to have a benchmark of some sort. So if you can&t find a good com"arable within the
industry of what you are trying to do com"are it to a com"arable with similarities. .ou have confidence in
those cash flows the JPID in that business.
So that is what I would look for. 2hat is how we have made a lot of money over the years where "eo"le only
view this industry a certain way. 0ut hey things can change but it is s"inning out cash. Maybe it will get
revalued. :ook at these two metrics they match u". 2his is trading at *25 to *(+ and this is trading at *$2. So
that doesn&t continue to last that long if they do continue to s"it out the money you have to wait two or three
years but that is a really really "owerful model to #ind a comparable when ou don&t have one. Pr to
analyHe an industry a little differently than it has traditionally been analyHed. 2he industry might be efficiently
"riced relative to each other but they all could be chea". 6eo"le are not used to "aying for@@@
6eo"le 4ust used to "ay only $+ times for banks but then "eo"le started to "ay more for them because they
were earning more as businesses3 they went into different businesses.
If it is tough finding com"arables find something similar in market share attributes and "ros"ects.
Jetailer8
2hey said the average 6;E over the "ast five years was this or the highest 6;E over the last five years was that
and I think the "rice will go back to that. 2hat doesn&t make sense sometimes because the business could have
been much different with different growth "ros"ects back five years ago. 1ow the com"any is in $+++ malls
and five years ago they were in only '++ malls. Five years ago they were in ' countries and now they are in C
countries. 2he retailer&s growth "ros"ects could be different.
%ust to say it will go back to its historical 6;E you can see the flaw in that logic. 5on&t fall into that tra".
@nother 5+ample o# Conventional 8hin"in!% $ELL
From8 2he 5etective and 2he Investor8 Rncovering Investment 2echniBues from the :egendary Sleuths by
Jobert G. !agstrom
In those critical early years of $KK2 through $KK' most investors and analysts who followed com"uter
com"anies were still o"erating on old assum"tions. Donventional wisdom at that time held that the time to buy
stocks of 6D manufacturers was when the "rice was si# times earnings and the time to sell was when it hit
twelve times earnings. 2hat was the historical trading "attern and few "eo"le saw any reason to Buestion it.
2he sim"listic view of most on Wall Street was 2his rule of thumb has worked reasonable well in the "ast so
why change it,
2he conce"t of economic value added hit the mainstream financial "ress in $KK( with a cover story in Fortune.
Anyone reading the article carefully would come away with an im"ortant message8 If a com"any&s cash
earnings re"resent a high return on ca"ital that should bode well for its future stock "rice.
At that "oint thoughtful investors could have reasoned their way to a "rofitable conclusion8 I should be
looking for com"anies with strong earnings and low cost of ca"ital. And if they were looking at com"uter
com"anies they would have hit on 5ell.
2he lesson8 Why would you as an investor sell 5ell when it reached twelve G$2I times earnings if its JPID
was high and going higher. 5ell&s economic model is built on maintaining low ca"ital costs.
What is e#cess cash,
Dnderstand the business be#ore deductin! cash #rom 5nterprise /alue. Some businesses run with 4ust a
little cash. Some business use negative working ca"ital. I assume the acBuirer doesn&t need the cash so you
K<
would get it back then. A retailer has a lot of cash to weather a bad season or two. 2here are times that when
you deduct the cash from Enter"rise value it is the wrong thing to do. Some retailers need to kee" a certain
"ercentage of cash in the til to accommodate customers. In summary before deducting cash from Enter"rise
7alue determine the cash needed to annually run the business for e#am"le8 $> to 2> of sales.
Dhea" on E7 analysis. 2he stock is at *) with *5 in cash and the stock is going to *< in two years. 0ut you
are laying out *) and it is only going to *<. 2he E7 doubles G$++>I but your return is C> annually
com"ounded over two years. Also think about how management will s"end the e#cess cash.
Marvel Entertainment
2here was a great re"ort on +arvel but I struggled with that one. It is on the +agic /ormula Investing Site as
one of the recent "icks. 2he a""roach taken was reasonable. .ou have a big movie then they make money over
the rights to the characters. 2hey do have a stable of characters so there is some recurring nature to the
business with their characters but the Buestion is8 what are normaliGed earnin!sC In a cou"le of years there
will be two movies out and it will do this but last year they had one movie out. Should you normaliHe at 2
movies or $ movie a year. !ow long will it last, 2he "erson "icked $.5 movies "er year. Rnless it is su"er
chea" I might "ass on something like that. It is a "articularly good business9licensing brand names9
however I struggle in figuring out normaliHed earnings. .
An P"tion =uestion8 Weighting your "osition in Stocks vs. P"tions
:et us say you find something interesting how much do you weight your "osition in o"tions vs. a stock
"osition,
BG% 2hat is a great Buestion. 2his is how I would view it. If I had a (+> "osition in a stock I don&t think I am
at risk for that (+> of the "ortfolio because the investment is in an unleveraged com"any. I view a disaster as
being down ((> Gor $+> of the "ortfolio9((> # (+>I because if I am going to be buying a (+> "osition I
am buying it at Q of intrinsic value. So I am buying at *5 and I think it is at worth *$+. So I assume it goes
down to *(.5+ or *(. 2hat is how much I have at risk. 0ut with a lea"@
What is great about investing in stocks9one way to look at them??is that they are like "er"etual o"tions. 2hey
never e#"ire unless the com"any goes bankru"t. So@the comfort you have being a value investor is it may
take an e#tra year but I think it will get to fair value so I may have to hang out for two or three years.
2hen you go buy an o"tion that e#"ires in two years you are taking that off the table. We have a few bets like
that. We have some combination of stocks and some o"tions that e#"ire in two years and some in 2.5 years.
.ou are adding another risk because stuff ha""ens. 2he market could crash3 the housing market could crash3
the consumer dro"s dead3 another K;$$. I know that if I draw a line from now until the ne#t five years I know
where the business will be9sort of a 3arren Buett thing3 I feel very confident from here to there the business
will grow and go u". 2he business will grow <> to $5>. I feel very confident that the business will grow
$5> during that time. If things stink and there is a big dro" in the middle it will still grow <> from today
until five years from now.
With an o"tion it may get very lum"y so I take that into account. 2he way I com"are a 2+> "osition to risk
'+> of my money so right away I risk C> in that "osition. 2hen I take the time element Gof a wasting assetI
because I could get it right but have the timing wrong. So I take the "osition down to 5> from C>. I assume I
could lose all my money in my o"tion. So an o"tion "osition might not e#ceed 5> of my "ortfolio not $5> to
(+> of a stock "osition.
What I mean by not leveraging is that they can&t carry me away with my entire "ortfolio. When I make money
I look at it "re?ta# and when I lose money I look at it "ost?ta#. Ph I lost 5+> on that but after?ta# it was only
$+>. 2here are little mind tricks you can "lay.
Student% 5o you buy in the money or out of the money o"tions, !ow do you choose what strike "rice of an
o"tion,
KC
BG% Generally I buy a little bit in the money. A Dall o"tion or a Dall;:ea" is the same as buin! a put and
buin! a stoc"* the are identical to each other. Generally I don&t want to "ay a lot of money for the "ut so
usually I would rather take a lower strike "rice where the Dall strike "rice is struck at a lower "rice so the "ut
o"tion as"ect of the Dall is not worth as much. I am not investing as much money in my "ut the lower the "rice
I go.
So bottom line9another way to look at it is your ris" 0 reward. 2here are two ways to look at that in answer
to your Buestion. Pne is the risk;reward. :et us say I own I0M and it is *)+ and I think my valuation thesis is
that in two and a half years I think it has a good shot it can be worth *K+. Pk, I can buy these *<5 calls for a
*$ for a $5 to $ "ayoff. Pr alternatively I could say -:ook right now I could buy the *55 calls at *K9they are
*5 in the money9the stock is at *)+ and it is costing me *K or *$+ to buy that but that *$+ can go to *(+ so I
tri"le my money and even if I am wrong I will get back all my money back if the stock is at *)5.T So I will
factor that in. It would be unlikely to lose all my money if I am close to right because I am thinking *K+. 2o
lose all my money it would have to go to *55. I factor that in but it is not a science.
8he thin! that I showed ou wasShow do I "now to bu the E55 calls at E10 instead o# the EM0 calls at
E7.50 when the stoc" is at EM0C Which is better of the two Dall strike "rices, What I say is -I always I look
at the call s"read9a bull s"read.T What that involves is buying the *55 call and selling the *)+ call. If I
bought the *55 call for *$+ and sold the *)+ call for *<.5+ for a net cost of *2.5+ G*$+ ? *<.5+ not including
commissionsI. 2he most I can make if the stock is above *)+ is *5.++ or a $++> return. If the stock is at *55
then I lose $++>. 2he s"read is worth *5. If the stock is at *5<.5 I am at break even G*55 Dall Strike 6rice
"lus *2.5+ "aid for the call s"read O *5<.5I.
If the stock is above *)+ it will be a double in 2.5 years because I believe the stock will be at *K+. 5oes that
sound like a good bet based on my thesis, I think the stock will be at *K+. So I will buy the 55 call because I
am effectively buying the s"read of *55 call;*)+ call.
It is an e#ercise that I do in my head when I want to own an o"tion outright.. I don&t really buy the s"read. 5o
I want to own the 55 call or the )+ call, So I com"are the two by doing the bull s"read in my head. 0y laying
out an e#tra *2.5 to buy the *55 call at *$+ vs. the *)+ call at *<.5+ I am effectively choosing a bull s"read.
2he most I can make is *5 but the s"read will never close until the end. I would never "ay *'.5 for e#am"le.
2he *55 calls are "lus *$+ or lay out *<.5+ for the *)+ call, 2uin! the E55 vs. the EM0 is e##ectivel li"e
ownin! the spread. If I buy the *55 call I am effectively "aying for the *)+ call and the *55;*)+ call s"read.
:aying out the *2.5+ brings me *5.++ if I am right for a $++> return. %ust go home and think about it in your
head.
Student% Why would you ever buy a stock when you can get a higher return with an o"tion,
BG% If the stock goes down C> over the ne#t two years because the world is a craHy "lace I lose C> in owning
the stock but $++> of my money owning the o"tion s"read.
2he "roblem is that I am wrong a lot des"ite what I tell you in here so that is risky. If it is a good bet??and I
would call any o"tion or s"read "osition a bet??I will win over time but not necessary on any one bet. I want
to be the betting house where I will win a series of bets over time if my valuations of the com"anies in the
grou" of bets are correct.
Anyone read Fortune&s Formula9it is a new book out GSee shaded bo# belowI. It talks about the o"timal way
to structure a "ortfolio. It is about horse racin! and odds. What is the o"timal way to structure a "ortfolio if
you have good odds, If I could fli" a coin and I could get *$ if it is heads and lose *+.5+ if it is tails. .ou
want to do that a lot but if you have a "ile of money you wouldn&t "ut $++> of your money on that "articular
bet. Even though it is a great bet you wouldn&t "ut all your money into it because you could hit a bad run and
lose all your money.
From www.bankstocks.com Solve the following "roblem. .ou&re at the track with *$+++ in your "ocket and
see that the "osted odds on a certain horse winning an u"coming race are 5 to $. .ou Gand only youI have a
secret line of communication to the horse&s trainer and learn that the horse&s chances of winning are
KK
meaningfully higher than the "osted odds9say $ in (. Which is to say you have a material in#ormation
advanta!e over other bettors. !ow much of your *$+++ do you bet,
2hat in a nutshell is one of the most crucial and least discussed dilemmas in the ca"ital allocation "rocess.
While DA6M ty"es "reach about the virtues of diversification the Warren 0uffets of the world know better.
5iversification only assures mediocre returns they "oint out3 the real money is made when ou put a lot o#
capital to wor" in those rare opportunities when ou have a true ed!e. :ike say the $?in?( shot above
that&s going off at 5?to?$.
William 6oundstone gets at this issue in Fort1ne%s For'1la: The Untold Story o the Scientiic Betting System
That Beat the Casinos and 3all Street$ 2he book is a history of a formula called the O-ell CriterionP that
allows gamblers Gand other ca"ital allocatorsI to ma+imiGe their pro#its on a series o# bets where the have
an in#ormation ed!e but without betting so much that they risk going broke. 2ake the horse?racing e#am"le
above. .es you&ll want to bet more than you normally would to make the most of your insider knowledge. 0ut
you don&t want to bet everything8 even by your own reckoning the horse has 4ust a ((> chance of winning.
Pnce you&re bankru"t you can&t get back in the game. 2he o"timal bet siHe is somewhere in between.
2he namesake and inventor of the Aelly formula is a man named %ohn Aelly a mathematician at 0ell :abs in
the $K5+s and $K)+s. Aelly develo"ed his formula by building on the work of another 0ell :abs
mathematician Dlaude Shannon. 6oundstone says Shannon is considered by many to be the second?most?
brilliant individual of the twentieth century after Einstein. In "articular Shannon is the father of -information
theoryT which serves as the broad mathematical #oundation #or essentiall the entire electronics and
di!ital revolutions. Everything from integrated circuits to fiber?o"tic cable to 51A seBuencers rely at rock?
bottom on Shannon&s work. !is models a""ly to any kind information conduit electronic or otherwise. 2hey
allow communications engineers to minimiHe the amount of noise9static gossi" whatever??in a given
conduit and ma#imiHe the amount of information the conduit can carry. Which is to say Shannon essentially
developed a mathematical wa to convert uncertaint into certaint.
Dommunications engineers aren&t the only ones with an interest in separatin! in#ormation #rom noise, o#
course. 0ettors and investors could use some hel" there too. So it&s "erha"s not coincidental that some of
Shannon&s math can be "ut to use at the race track the black4ack table and on Wall Street. Pne of the first to
a""ly Aelly&s formula was a young "hysics grad student Edward 2hor" who used it in con4unction with a card
counting system he develo"ed for black4ack. G2hor" later wrote a book on card counting called Beat the
%ealer that&s now considered a classic among black4ack aficionados. :ater on he ran a hugely successful Buant
fund 6rinceton?1ew"ort 6artners that eventually got tangled u" in Judol"h Giuliani&s "ursuit of Michael
Milken in the $KC+s. 0ut that&s another story.I
!ow does the Aelly formula work you ask, It&s "retty sim"le. 2he formula says that the o"timal wager siHe is
determined according to the following fraction8
,dgeI9dds
2he denominator odds is the "ublic odds "osted on the track&s tote board. 2he numerator edge is the amount
ou stand to pro#it, on avera!e, i# ou could ma"e this same bet over and over and over. :et&s go back to
the horse racing hy"othetical in the first "aragra"h and see how it works. 2he "osted odds are 5 to $. So we&ll
"ut a 5 in the denominator. 0ut recall that you believe the true odds are $ in ( not 5 to $. If you bet *$+++
then you&ll have a ((> chance of winning *)+++ G*5+++ "lus your original *$+++ wagerI or *2+++ on
average. Pn a *$+++ bet your "rofit is thus *$+++. 2hat&s your edge. For the formula&s "ur"oses the *$+++
becomes a $.
So according to Aelly the edge is $ and the odds are 5. 6lug in the numbers and you get $;5. Aou should bet
20Q o# our ban"roll.
$++
A few comments are in order. First off this onl wor"s in instances when ou have a true, material
in#ormation advanta!e. If you don&t your edge is Hero so you shouldn&t bet. Second the only time the
formula will tell you to bet all you&ve got is when you&re absolutely "ositively sure you&ll win. In the real
world that hardly ever ha""ens. 2hus Aelly "revents bettors avoid being wi"ed out com"letely so that they&ll
have ca"ital to "ut to work when the ne#t o""ortunity rolls around. 2his is no small advantage. Pther ca"ital
allocation strategies gamblers use most notably -martingaleT in which the "layer doubles down after a losing
bet in order to Buickly recou" losses a can be Buick tri"s to bankru"tcy. Finally using Aelly on a series of bets
is the most efficient way to com"ound your winnings. Models show that say a more aggressive -Aelly times
2T strategy actually leads to lower long?term returns.
Aelly&s advantages shows the results of various strategies for betting on a series of hy"othetical coin fli"s
where the bettor has a 55> chance of winning.
It scarcely needs to be added of course that the economics pro#ession has rou!hl Gero use #or all this. First
off the formula was develo"ed by a mathematician not an economist which naturally makes economists
ske"tical. Second the notion that an investor can have a true edge is anathema to the efficient?market dogma
that still dominates most economics de"artments. 6aul Samuelson is "articularly scornful of Aelly Gor -gT as
it&s referred to in economics circlesI calling it a -fallacy.T
2he Aelly criterion&s virtual absence in economics and M.0.A. curricula e#"lains why the formula is not well
known on Wall Street. It shouldn&t be. It is hard enough to find ideas where an information advantage is even
"ossible. When those do occur investors can use all the help the can !et in figuring out how much ca"ital
to a""ly. Aelly may not be as ideally suited to Wall Street as it is to black4ack but it sure seems like a good
"lace to start.
Student% 5o you use the -elly /ormula,
BG% It Ginvesting in stocks S o"tionsI is not as clear as the -elly /ormula. What are the odds of doing that.
.ou are not taking bets where you lose it all3 it is not as clear as the -elly /ormula. 2here is not an o"timum
way to bet on stocks.
A. It is uncertain and
0. .ou don&t lose all the money you "ut u".
Student% What if you have an inkling of IB+ moving Buickly to *K+.
BG% If I "ut on a bull s"read@. 2he o""osite of a bull s"read is a "ut s"read. 2he "uts at *)+;*55 by
definition has to be at *2.5+ because they Gcall and "ut "ricesI have to add u". 2here is still a chance that
within a year the s"read will still be worth something. Sometimes in the s"reads a shorter e#"iration is better
than a longer e#"iration. If it is e#"iring . .ou have a whole year for the stock to fall. 2here is an interesting
dynamic in s"read. A lot of this stuff has been learned the hard way$ 1Study the time decay o options2$
+oody Corporation E#am"le
Student% Dould you go over +oodys E#am"le,
BG% 2his took a long time to learn but ho"efully it won&t take a long time to teach. :et us say that when
Buett bought Co(e it was growing at $2> "er year and +oodys was growing at $2> and they both are
earning *$ "er share. For Co(e to continue to grow at $2> it has to take 2+ cents for every dollar and "low it
back into its business for working ca"ital etc. Co(e uses the 2+ cents of the dollar they earn to continue to
grow at $2> so the remainder is C+ cents for other uses. +oodys meanwhile needs *+ to grow $2>. So what
we said was that a *$ from Co(e is worth C+ cents com"ared to *$ for +oodys. +oodys earnings are worth
25> more GC+ cents to $++ cents or 2+ cents;C+ cents for 25>I.
$+$
2he dollar of +oodys earnings was worth 2+ cents more G2+;C+ cents O 25>I *$ vs. *+.C+ for Co(e. Pr 2+
cents;C+ cents so Moody&s earnings is worth 25> more. Co(e will eventually grow 5> a year so they don&t
need to invest as much to grow at 5>. So C years from now they only have to invest $+ cents "er year to grow
at 5>. So +oodys won&t be worth 25> more forever it might be worth $+> more. So on average a dollar of
+oodys earnings is worth $5> more than Co(e&s earnings of *$. +oodys earnings would be worth $+> more
not 25> over time. I assume both grow at 5> forever but Co(e "uts in $+ cents "er dollar while +oodys "uts
in *+.
Student% What about the reinvestment rate, 2he "ayout rate,
BG% I would say these C+ cents will be growing at a certain rate. .es to grow you need more working ca"ital.
In that "articular business GMDPI you don&t need more working ca"ital but with Co(e I assumed that you need
more working ca"ital to grow. 1ow you are talking about returns on working ca"ital of over $++> for
+oodys. .es you have to lay out for working ca"ital. We looked at history to determine reinvestment rates
for Co(e and +oodys.
:ook let us say interest rates were the same so a""les to a""les we can "ay $5> more for that. Co(e moved to
some "rice and now it has come down but let&s ignore the craHy "rices that it traded at in the late $KK+&s. 0ut
the ne#t two or three years the stock G+oodysI tri"led. We are com"aring the two because we thought we
could get a tri"le in two or three years. 0ut don&t forget remember the truck driving thought the huge ga".
5on&t try to fine tune it. If you have to fine tune it then the investment thesis is a little too close.
Forget about the craHy "rice Co(e traded at9)5 times earnings in $KKC.
Go look at %u E Phelps change in tangible assets as they grew. 2here was no change they s"ent every
nickel on stock buy backs. 2hey didn&t need any ca"ital to grow. 2hey were very similar to +oodys. 2his is
the best business you will ever going to see.
I gave out that one first Gthe +oodys E#am"leI so you have something to com"are it to. Almost all other
businesses will be inferior. !ow good a business is it relative to +oodysN
We were looking at &merican ,Cpress recently and so we were com"aring it to Co(e$ It is a lot closer to Co(e
than +oodys. It is a nice way to com"are. It is nice to have that ty"e of metric.
0uffett&s Advice to Students
BG% I 4ust want to "lay one thing@@@. A video of 3arren Buett s"eaking to business students@@@
0122ett 3ecture8 +augham at Salomon Brothers never once s"oke about salary. !e worked $C hours days for
months and months. !e showed uncanny 4udgment on what to bring u" to me. I often use this illustration in my
talks to classes. If one of you could "ick one of your classmates in order to share in their earnings for the rest
of their life. And you could "ick anyone you wanted and you would get $+> of their earnings of that
individual for the rest of their life what would you think about in terms of whom you "icked, Would you
think about the "erson with the highest I=, 2he highest grades, 6robably not. Aou are thin"in! about a
whole bunch o# 9ualities o# character.
Every one of those Bualities is attainable. .ou are not thinking about who can throw a football )5 yards. Ben
Graham wrote down all the Bualities that he admired in other "eo"le and the Bualities that he found
ob4ectionable. 2hose Bualities are ones that you can chose. 8he chains o# habit are too li!ht to be #elt until
the are too heav to be bro"en. 2he right habits that you would want to obtain of someone you would want
to own $+> of their earnings. 2he "eo"le I see who function well are the ones who don&t have the biggest
motors but the most efficient motors. It is those Bualities of character that are most im"ortant. What on the left
hand side of this list Ggood BualitiesI I can&t achieve myself and what on the right hand side of the list I can&t
get rid of myself Gbad BualitiesI. In the end decide that you will be the one you would buy $+> of.
$+2
2hink how few "eo"le actually kee" that in mind9think of those in the business world. I think you can all be
very s"ecial. .ou all have the ability and the intelligence. .ou can decide to be very successful in very many
ways by trying always to do the right thing. I en4oyed teaching you.
&PP0&US,$
5;6
@ppendi+
0ooks by ?obert Baugen8
2he three books about the behavior of the stock market that he wrote were8
2he Inefficient Stock Market. What 6ays Pff and Why. 2his focused on e#"ected?return factor models
which in "art attem"t to e#"loit error?driven volatility. 2he "ositive "ayoff to chea"ness results from the
market&s overreaction to success and failure. 2he "ositive "ayoff to intermediate?term momentum results from
the market&s under reaction to "ositive and negative sur"rises in individual earnings re"orts.
2he 1ew Finance focused on the market&s ma4or systemic mistake. In failing to a""reciate the strength of
com"etitive forces in a market economy it over?estimates the length of com"etitive forces in a market
economy it over?estimates the length of the short run. In doing so it overreacts to records of success and
failure for individual com"anies driving the "rices of successful firms too high and their unsuccessful
counter"arts too low.
2he market doesn&t under react to a uniBue event.
0east on Wall Street focuses on stock volatility. It contends that stock volatility has three com"+onents.
Jational and unbiased res"onses of stock market "rices to real economic events are the source of event?driven
volatility.
5nd
((
)a!ic >ormula o# 3ittle 2oo" Bust )a .or" 1ovember K 2++53 6age D$
As hard as it is to envision hedge?fund titans and other masters of the universe soon will be tucking
themselves into bed with a thin tome bearing a cutesy title8 V2he :ittle 0ook 2hat 0eats the Market.V
!ereMs why8 2he author is %oel Greenblatt a former hedge?fund manager. !is first investment guide "ublished
in $KK< also s"orted a hokey title V.ou Dan 0e a Stock Market Genius GEven If .ouMre 1ot 2oo SmartIV and
sold about (C+++ hardcover and soft cover co"ies.
1ot bad as first books go but it also became a cult hit in the insular world of hedge funds "assed like samiHdat
from manager to manager. A book of war stories and case studies written clearly and laced with 4okes it had
two "rofound insights say hedge?fund managers who have "ressed the book on me.
Pne was that there are secret hiding "laces in the stock market like s"in?offs and restructurings where
bargains tend to lurk. 2he other was there wasnMt any com"elling reason to have a giant "ortfolio of doHens of
stocks when a well?designed concentrated "ortfolio could accom"lish the same goal of achieving high returns
without adding risk.
V!is book on investing is by far the most valuable thing I have readV says 5avid Einhorn who manages a
large successful hedge fund Greenlight Da"ital.
$+(
0ut hedge?fund managers Vwere not Buite the under"rivileged grou" I was shooting for when I wrote itV he
says. So for his second book Mr. Greenblatt says he wanted to write an even more basic and fundamental book
on investing that would a""eal beyond Wall Street. 2hink 0en4amin Graham does 0orscht 0elt.
Mr. Greenblatt '< years old says his goal was to "rovide advice that while so"histicated could be understood
and followed by his five children ages ) to $5. 2hey are in luck. !is soon?to?be?released V:ittle 0ookV is one
of the best clearest guides to value investing out there. I have some minor Buibbles but in a world where
individual?investor advice is dominated by 4argon?filled short?termism on the one hand and oversim"lified
throw?u"?your?hands inde#ing on the other Mr. GreenblattMs a""roach is valuable.
It is so sim"le and cute that an investor with a little bit of knowledge might mistakenly dismiss it. Mr.
Greenblatt titles his investment a""roach a Vmagic formula.V !is tongue is in his cheek but not entirely. !e
writes as if he were %.M. 0arrie s"inning a 6eter 6an?esBue fairy tale but with the fervor of a true believer8
V.ou have to take the time to understand the story and most im"ortant you have to actually believe that the
story is true. In fact the story concludes with a magic formula that can make you rich over time. I kid you not.V
What is the magic formula, Invest in good com"anies when they are chea". As Mr. Greenblatt might say8 See,
We told you it sounded obvious. .eah so whatMs VgoodV, And whatMs Vchea"V,
Good com"anies earn high returns on their investments he e#"lains while chea" com"anies s"ort share "rices
that are low Gbased on "ast earningsI. !is "ro#ies for these criteria are return on ca"ital Go"erating "rofit as a
"ercentage of net working ca"ital and net fi#ed assetsI and earnings yield G"reta# o"erating earnings com"ared
with enter"rise value which is the market value "lus the net debtI. 2o his credit however Mr. Greenblatt
e#"lains all that "arenthetical 4argon in terms that shouldnMt insult his "eers but that will ring a bell for the
unschooled masses.
2o make things sim"ler still his free Web site www.magicformulainvesting.com screens com"anies using his
criteria. !e advises individual investors to buy a basket of to" stocks and turn them over on a strict schedule
de"ending on how they "erform. GFor ma#imum ta# advantage sell losers 4ust before a yearMs u" and winners
4ust after a year.I
It sounds too easy. 0ut in fact his a""roach is difficult not because it is hard to understand but because it
reBuires "atience and faith that you are right when the market is saying youMre wrong.
2his is based on Warren 0uffettMs investment "rinci"les. 0ut they bear re"eating. Even a die?hard value
investor like Mr. Greenblatt says he didnMt realiHe that trying to find chea" good com"anies rather than 4ust
chea" ones was so im"ortant until the $KK+s. While Mr. Graham Mr. 0uffettMs mentor was looking for starkly
chea" com"anies Mr. 0uffett wants only the great ones.
VI didnMt get 0uffettiHed until the early $KK+sV says Mr. Greenblatt. VI wish it ha""ened earlier.V
:ooked at retroactively the returns of the Vmagic formulaV beat the market handily. From $KCC through 2++'
according to Mr. GreenblattMs book the high?return;low?"rice stocks of the largest $+++ com"anies had returns
of 22.K> annually com"ared with $2.'> for the SS6 5++.
2he most convincing "art of Mr. GreenblattMs argument is that when 25++ com"anies are ranked for "rice and
returns Gbased on the formulaI the to" $+> out"erformed the second $+> which out"erformed the third $+>
and so on. V2he darn thing works in orderV he says.
2here are some limitations to the a""roach. It seems "rone to tossing u" stocks whose high returns and growth
may be in the "ast. Magic?formula stocks with more than *$ billion in stock?market value include lots of fast?
growing s"ecialty retailers and niche "harmaceutical com"anies. Some of these will flame out.
$+'
2hatMs why Mr. Greenblatt argues that novice investors buy at least 2+ or (+ of them. For himself he buys a
smaller number that he can know dee"ly. 0ut that reBuires something not easily taught in a book8 good
instincts and 4udgment to distinguish true chea" gems from one?hit wonders.
2hough he always was a value investor his hedge?fund firm Gotham Da"ital wasnMt always run on his magic
formula es"ecially in the early years when he tended toward com"le# arbitrage. !e started Gotham in $KC5
and ran it for outside investors for $+ years achieving com"ounded annual returns before fees but after
e#"enses of 5+>. !e started with *< million mostly raised through 4unk?bond king Michael Milken. After
five years he returned half the outside ca"ital. !e finished with more than *(5+ million and returned all the
remaining outside ca"ital.
2hese days he s"ends his time teaching at Dolumbia 0usiness School and hel"ing run a Web site for "ros the
7alue Investors Dlub. !is wealth is mostly tied u" in Gotham Da"ital which manages *$.) billion including
some outside money in a fund of hedge funds he started a few years back.
!is home cooking isnMt 4ust good enough for Mr. Greenblatt. !eMs got his kids eating it too. !is eldest son is
doing well following the bookMs advice. A daughter at it for two months is having a rougher time. VIMm not sure
if she didnMt have me as her daddy sheMd be hanging in thereV he says.
%oel Greenblatt Dlass for S"ecial Situations Investing

Wednesday March 2( 2++5
2rian Gains o# Sprin!house Capital
Case Stud o# Investin! in a J6in!J Industr
Italics; Transcript by John Chew
Joel Greenblatt Introduction8
9ur guest will not sing' but he is really smart and he runs a und called Springhouse Capital$ Be started in
!""!$
I hope you too( a loo( at BBI' +9:I and Bollywood$
Brian Gains' /ounder o Springhouse Capital
+y title is; )a"in! mone in a Jdin!J industr
I will ta(e you through how I came up with the idea' the wor( I did and then a couple o dierent case studies'
which I thin( will be pretty interesting along the way44the acts or the things that were going on44so you can
eCperience what I was thin(ing or the thought process I was trying to go through$
&s you (now rom your studies o the stoc( mar(et' there are oten hated industries where you want to go i you
have more o a value bent$ Some o the places I go to ind investment ideas$
Idea Generation
52 week low lists
!igh short interest
InvestorsM 0usiness 5aily negative momentum
S"in?offs
5istressed 5ebt8 !ighest yielding areas
$+5
,veryone ma(es un o Investors= Business %aily but you can go in there and ind negative momentum
industries where everyone hates the industry1s2$ >ou can see what people hate$ Start with some industries that
may give you some ideas$ I am sure Joel has spo(en about spin4os$ >ou can see what is in the distressed
area$ 9bviously' i debt is trading at )" to #" cents on the dollar' people don=t li(e it44that would be a good
place to start$ This leads you to a place to loo( or ideas$
Dhallenge is figuring out if the hate is logical Gthere are reasons why businesses are hated.I
Dom"anies fall in one of four categories8
?? Rnsustainable business
Avoid
??0ad balance sheet GDellular in 2++2I

AnalyHe the ca"ital structure
Pften times akin to an o"tion bet and understanding ca" structure
determines the maturity of the o"tion.
??Dyclical GDommodities in down cycleI
1ormaliHed earnings
??5ying businesses G6hotogra"hy 6hotoco"ying etc.I
!ow long will it last,
Is it really dead,
What are the "eo"le on the inside doing,
Where is the cash going,
The challenge is iguring out i there is a logical reason1s2 a business is hated$ I li(e to thin( that things all
into our dierent categories;
$. Rnsustainable 0usiness8
A7PI5
&n unsustainable business is li(e an eToys$com' Pets$com$ Something that collapses in !""54!""! and
you are loo(ing at it$ >ou can say it is really cheapH the stoc( used to be at R)" and it is at R! now$ In
reality' it is not a business44no matter how much cash it has or the capital structure' eventually it wasn=t
going to wor($ So that is one eCample$
Student; General +otors 1G+2N
B?I&. G&I.S; G+s business is probably sustainable$ Sure it has problems with its debt structure' but it
ma(es cars that people need$
2. 0ad 0alance Sheet8 GDellular in 2++2I
AnalyHe the ca"ital structure
Pften times akin to an o"tion bet and understanding ca" structure determines the maturity of
the o"tion
Then I put Bad Balance Sheet' which I thin( Cellular companies in !""! are a prime eCample$ The important
thing there is analy8ing the capital structure$ ,veryone (new that cellular phones would be around' but it is a
$+)
Fuestion o they had too much debt on the balance sheet$ Sprint and all these dierent companies' i they could
pay the debt' they clearly could ma(e money$ They way to loo( at it is to analy8e the capital structure$ >ou
literally have an option bet$ &nd you have to igure out' <&re the ban(s going to ta(e this underN< &nd i you
can survive past that point44i the debt is due in ive years' which is long enough or the company to survive44
you probably have a great option bet$
(. Dyclical 0usiness GDommodities in a down cycleI
1ormaliHed Earnings
Ri#hard 3ena is the (ing o normali8ing earnings or cyclical businesses$ These businesses have a reason to
eCist' but you have to loo( or the middle point$ >ou have all been through that$
'. 5ying businesses G6hotogra"hy 6hotoco"ying etc.I
!ow long will it last,
Is it really dead,
What are the "eo"le on the inside doing,
Where is the cash going,
I will tal( about the last category' the allegedly dying business$ +aybe it is dyingH maybe it is not$ &nd some
people would say non4digital photography' photocopying' aC machines$ I will tal( about video rental$ &nd the
(ey Fuestions are; <Is it really deadN< Bow long it is going to lastN .umber three is (ey; 2ollow the insiders to
see i2 they ha4e #on2iden#e in their b1siness. That is a great (ey to see i this thing has some legs let in it$
&lso (ey is where is the cash goingN 0e#a1se when yo1 are dealin. with these sto#5s* it is less abo1t a
'1lti&le and 'ore abo1t how '1#h #ash they are .oin. to .enerate and what are they doin. with the #ash.
It is really important when you are loo(ing at the return to thin( about the neCt two years' they are going to
generate R! dollars a share in cash and i you are buying the stoc( at RD' well that is pretty good$ >ou still
have to igure out how long that will last$ But ollowing the cash is (ey$
@nalGin! the Jdin!J business
6rocess involves going through all the negative arguments and constructing a thesis as to the merit
of each. 1Thesis vs$ &ntithesis2
??Most time intensive activity
Some things to acce"t before attem"ting this at home8
??.our behavior and gut instinct "robably wonMt su""ort your thesis
??6eo"le will say you are nuts
??.our friends at other funds will tell you they are short the stock and you are nuts.
??At times you will come to believe they are right and you are nuts.
The way I tend to loo( at things is that I pic( up an industry and I go through all the reasons why people hate
it$ 0ist all o the things that are really' really bad about it$ Then try to ind a reason$ 9-' is it as bad as they
thin(N Is there a reason why it is not as bad as they thin(N
So right now someone pointed out General +otors 1G+2$ >ou can see G+ down and then you loo( at all the
auto parts guys and list all the negative thoughts on the industry$ Then construct a thesis as to why the
business is not as bad as people thin( because o &BC$
>our behavior and gut instinct are probably not going to support what you are doing$ I you are loo(ing at
video rentals' you are probably saying' <I don=t rent videos anymore$< The one (ey to remember is that you
are not the target audience$ >ou are not li(e most o &merica$ /or one thing' you are younger and more
$+<
urban$ & lot o things you do will be more technologically advanced$ So i it is aCing or renting videos you
will say' I don=t do that anymore so orget that industry$ >our riends will say you are cra8y$
.hat=s 2ad about /ideo 7entalC
Sell?2hrough
??:ong?term trend,
??6ricing continuing downward,
7P5
??'5 day window
??Additional features;2' hour limit;!5 and selection constrained
1etfli#;!ome delivery
??1iche "roduct
??Instant Gratification
5igital 5istribution
??Dom"uter watching
??2ime to download relative to length of movie
??=uality;!5
6iracy
2I7P
Ever e#"anding entertainment o"tions.
Brian Gains; So what is bad about the rental businessN 3hy wouldn=t you li(e the :ideo ?ental BusinessN
Students; .etliC' 3al4+art selling %:%s$ :9%$
Brian Gains; 3al4+art sells cheap %:%s' so people don=t need to rent$
9ne o the things I would add is ile sharing' piracy and digital distribution$ I would tal( to dierent people
and as( what is not good about the business$ &nd then sell through$ Is the selling o cheap %:%s44R# or two
%:%sOgoing to continue$ Is this a long4 term trendN Can the price continue downwardN 3al4+art is selling
%:%s at a loss to drive traic$ The studios love this$ 3hat other business has the distributors o their
product intentionally selling the product at a lossN
&nyone have any thoughtsN
So' I guess the way to loo( at this is that this is a ris($ So we can accept that we don=t (now what is going to
happen in pricing$ 3e (now that the studios currently ma(e a lot o money o o %:%s and you can establish
that$ &s to pricing it is very hard to predict$ That is going to be one o those variables where you Gust don=t
(now44is pricing going to steadily creep downN >ou (now these guys 1studios2 don=t want to cut the prices$ I
the %:% are growing every year' they have no incentive to cut the prices$ It costs about R! to ma(e a %:%
and they are selling new releases or R5S to R5D$ 6hey (the st1dios) ha4e no in#enti4e to #1t &ri#es.
?esearch will show you that 3al4+art is selling new %:%s at a loss$ So 3al4+art is doing the studios a avor$
Bow oten do you see a distributor o your product sell at a lossN It is inreFuent$ 3e (now the studios are
pretty happy$ They have no desire at this point to cut prices$ So logically' the studios don=t have an incentive to
lower prices$
:9%; It is important to understand how new releases enter the theatres and they are there or two or three
months' then they sit on the sidelines$ Then they go to %:%$ J) days$ .ew releases are important or video
stores$ D"T o their rentals are new releases$ The studios don=t want it to go to :9%$ They ma(e R5) every
time they sell a %:%$ TBIS IS C?ITIC&0 because someone can say :9% will destroy the video rental stores$
$+C
>ou can ma(e a case that the studios ma(e so much money o o selling1%:%s2 that they will not collapse the
window o time or the video stores to sell the %:%s beore the releases go to :9%$
>ou can=t say that it 1:9% eliminating %:%s and videos2 isn=t going to happen$ It is a 71estion o2 how
71i#5ly &eo&le #han.e their habits. !T o all music sold is digitally distributed$ So 6DT o all music sold is
through C%s$
I would say eventually it is going to happen' it is Gust how long will it ta(e$
The other thing about :9%' you need to have digital cable so you are tal(ing about a smaller portion o the
country$ >ou need to not have 1or not care about2 additional eatures li(e eCtra scenes$ Studios are moving
toward high deinition %:%' so you have another reason not to buy :9%$
.etliC home delivery$ .etliC has about !$# million customers$ Bloc(buster has S)"'""" customers$ It is a
dierent business$ It has Premier customers44people who want more category depth$ & lot o niche ilms$
These aren=t the same customers$
%igital distribution ta(es too long to download$ In reality it ta(es time too much time or the average
consumer$
TI:9 came out' but people still want to watch movies$ People want to watch new movies$ & truism no matter
how distributed$ People go to movies because o the eCperience$
,ver eCpanding entertainment options$
.hat=s Good about /ideo 7entalC
Good cash flows
Good returns on new investments
'5 day window
??Economics of 575
More stable than "eo"le think
??1ote that most businesses will last longer than "eo"le think
Mom and 6o"Ms still hold '+> share
What else can they do with their infrastructure,
??Jetail;7ideo Games;Rsed
Brian Gains; 3hat is good about the video rental businessN
Student; The cash lows are good$
Brian Gains; The cash lows are great$ They have a great retail boC$ :ideo stores can sell other stu$
The returns on new video stores are absolutely ama8ing$ Because it doesn=t cost much 1to set up a store with
inventory2$ It is R5)"'""" to open a Bloc(buster$ The beauty o it' is that i it doesn=t wor(' then you can move
it eight miles down the road and try again$ >ou can move the business easily$ The returns are high and you
can aord to screw up a little bit$ The J)4day window is critical or video stores 1allowing :ideo Stores to sell
%:%s2$ This is more stable than people thin($ A lot o2 b1sinesses last a lot lon.er than &eo&le thin5. /or
another !" or A" years people will still be buying videos$ People are still buying phonographic records and
there is a replacement or records$
$+K
There still is a A"T to J"T share o the mar(et in mom E pop stores$ It is (ind o evil sounding but it is
capitalism$ I the small business owners still have share' as a chain li(e Bloc(buster' you can go in and you
can ta(e them out$ So Bloc(buster can still gain share$
3hat else can they do with the inrastructureN
So that is where a lot o the research is done$ & lot o time tal(ing to people to igure out how much o this is
real$
)acro to micro
Sim"lest "lace to look to find all these factors rolled u" into one easy measure of video rental "erformance is
the same store sales of the res"ective stores.
??Mitigating factors that will disru"t this analysis
9-' so how do I ma(e money o o thisN Beore it was all4theoreticalH beore you were (ind o thin(ing about
the industry$
/or :ideo rental perormance' the same store sales 1SSS2 statistic is (ey or orming how much o this is
coming to lie$ >ou orm all these theses$ &nd then try to ind out where it will show itsel44in the video guise o
same4store4sales$ But the one thing to remember in the video business there are many mitigating actors that
will aect SSS as any business 1weather' eature presentation schedules' political events' days in the Fuarter2$
In this case why SSS may not be indicative o the business$ &ns; Bloc(buster releases drive customers to
stores44hit driven productIsales causes lumpy sales$ eo&le loo5 at #o'&s and say that #o'&s are down 89
witho1t ad:1stin. 2or what e22e#ts the #han.e. 3eather can aect sales$ 5! wee(ends in a Fuarter44one bad
wee(end can have an aect$
I would also say' children=s movies44they sell they don=t rent$ -ids have a propensity to watch the same movies
over and over again$ It would not be normal behavior or adults$
It is the type o movie that the store rents$ Sometimes political events may cause people to watch more T: then
rent movies$
The Bloc(buster 1BBI2' Bollywood 1B0>32' +9:I are all ta(ing share rom the mom E pop 1stores2' then it
will ma(e it loo( li(e the business is worse' but they are ta(ing more share$ Their business is surviving'
because they opened a Bloc(buster 1store2 but the local video store shut down$ So everyone who went to that
local store will go to the Bloc(buster$
4444444444444
$$+
.ow we will go through what I went through with ;ollywood "ideo (;L<W)$ Bloc(buster has #'""" stores
while Bollywood has !'""" stores but in the same (ind o areas though more 3est coast oriented$ Consider it
identical$
The 1stoc(2 mar(et had a great !""A and I am sitting around in %ec !""A and there is nothing too interesting
going on$ So I am screening dierent stu$ So I say 9-' everyone hates the video rental guys$ So I do all that
irst stu we tal(ed about$ Then I go to an investor presentation$ I go to see Bollywood :ideo$ &t that point I
(new nothing other than I had some arguments as to why this industry could eCist$ 0et=s loo( speciically at
Bollywood :ideo$
3hat you will see in the Bollywood story is that they are opening up Game Cra8ies' which are li(e a game
store boutiFue$ They are getting great returns$ The C,9 is also saying he is going to open 5)" new stores a
year and getting great returns$ So you say' <Bey' maybe the business doesn=t last so long' but he 1C,9 o
B03%2 seems to thin( so$ Be is still opening stores$ Be is mildly positive$
The C,9 owns 5"T o the stoc( and this will come into play a lot in this case$ Because we went through all
the arguments and we can say' I believe him and I can get pretty comortable' but what is someone on the
inside sayingN In this case' he 1C,92 owns 5"T o the stoc( and he is the one ma(ing the decisions to build
the new video stores$ That is important to remember' because the guy who owns 5"T is saying he still wants to
build these things$ +aybe he is dumb' maybe he is not' but you have to give him more credit or (nowing more
about the business than you do because he is living it 1the business2 day to dayH he is seeing the numbersH he is
running all the dierent tests that say to him44this is still (ind o wor(ing$ &nd it is his money and he will
probably have more money at sta(e than you probably will$
So really' really important in this case and in a lot o businesses that are dying to see what insiders are doing$
I the insiders are bailing out and you thin( the business is dying44it probably is$
,ollwood /ideo
0egan looking at it late 2++( after attending an investor "resentation
??!igh returns on Game DraHy G!:.WMs version of Gamesto" or Electronics 0outiBueI and new 7ideo
Stores.
??Mom;6o" still re"resents '+> of industry
??DEP owns $+> of the stock
$$$
B0>3 is at R5A to R5J buc(s$ So this is the news release on Jan #
th
$
%an ) !:.W 1ews Jelease
HOLLYWOOD ENTERTAINMENT ANNOUNCES 2003 FOURTH QUARTER
SAME STORE SALES
PORTLAND, OREGON - Januar !, 200" - H#$$%##& En'(r'a)n*(n' C#r+#ra')#n
,Na-&a./ HLYW0, #%n(r an& #+(ra'#r #1 *#r( '2an 3,400 H#$$%##& 5)&(#
-u+(r-'#r(- an& a++r#6)*a'($ !00 Ga*( Cra7 8)&(# 9a*( -+(:)a$' #u'$('-,
'#&a ann#un:(& '2a' -a*( -'#r( -a$(- 1#r '2( 1#ur'2 .uar'(r )n:r(a-(&
32;< C#n'r)=u')#n '# -a*( -'#r( -a$(- 1r#* r(n'a$ +r#&u:' r(8(nu( %a-
n(9a')8( 2; %2)$( :#n'r)=u')#n 1r#* *(r:2an&)-( -a$(- %a- 3";<
A- a r(-u$', '2( C#*+an (6+(:'- n(' )n:#*( 1#r '2( .uar'(r '# =(
a++r#6)*a'($ >0<3! +(r &)$u'(& -2ar( an& (6+(:'- a&?u-'(& n(' )n:#*( 1#r
'2( 1u$$ (ar '# =( a++r#6)*a'($ >3<"0 +(r &)$u'(& -2ar(<
On Januar @, 200", '2( C#*+an +r(+a)& '2( >20 *)$$)#n 200! a*#r')7a')#n
#1 )'- -(n)#r =anA :r(&)' 1a:)$)'< Dur)n9 '2( 1#ur'2 .uar'(r, '2(
C#*+an a$-# u-(& >3! *)$$)#n '# r(+ur:2a-( -2ar(- #1 )'- :#**#n -'#:A<
T2( C#*+an (6+(:'- '# r(+#r' )'- 1#ur'2 .uar'(r an& 1u$$-(ar 2003
r(-u$'- #1 #+(ra')#n- #n T2ur-&a, Januar 24, 200"<
So what stri(es youN This business could be dead$ People are saying this business is gone$ %on=t touch it$ So
what stri(es you about this news releaseN They have great merchandise sales 1+erch$ Sales up 5JT2$ They are
buying bac( their stoc(' it is (ic(ing o cash and they are prepaying debt$ B0>3 is buying bac( R5# million o
stoc($ Buying bac( eCpensive stoc( could be a bad thing$
They are still spending R6" million to open stores$ The C,9=s interest lies in the stoc(' not his salary$ Be
stopped in 9ctober !""A his 5"B4)"5 sales44a positive signal$
I go right to the negative !T comps$ ,veryone says this business is dead$ &nd we tal(ed about the mitigating
actors o weather and all this dierent stu that can ta(e your numbers up )T or down )T$ Bis comps are
only down !T$ %oes it loo( li(e something that is going to all o the ace o the earthN It is not comping
down much in the grand scheme o things$ There are businesses that comp down )T' ST' DT and people still
thin( that those are great businesses$
The stoc( is at R5J and or me I see he 1C,9 o B0>32 is loo(ing to ma(e R5$J" and it is trading at 5" times
neCt year=s earnings$ So that is Jan #
th
' !""J
So now go to Jan !6
th
' !""J when they come out with ull year results$
HOLLYWOOD ENTERTAINMENT CORPORATION REPORTS
FOURTH QUARTER AND FULL YEAR 2003 RESULTS
PORTLAND, OREGON - Januar 24, 200" -
H#$$%##& 5)&(#/
F#ur'2 .uar'(r r(8(nu( an& -a*( -'#r( -a$(- 1#r H#$$%##& 5)&(#, (6:$u&)n9
Ga*( Cra7, %(r( >3BB *)$$)#n an& n(9a')8( 3; r(-+(:')8($CC F#ur'2
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=)$$)#n an& 3; r(-+(:')8($< F#r '2( 1u$$ (ar, '2(r( )- n# *a'(r)a$
&)11(r(n:( =('%((n Dr(n'a$ :#*+-D an& H#$$%##& 5)&(# :#*+-< Fu$$ (ar
2003 #+(ra')n9 )n:#*( %a- >20@ *)$$)#n< Dur)n9 2003, H#$$%##& 5)&(#
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Ga*( Cra7/
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*)$$)#n an& 3@; r(-+(:')8($< Fu$$ (ar 2003 #+(ra')n9 $#-- %a- >20
*)$$)#n ,a1'(r '2( a$$#:a')#n #1 a++r#6)*a'($ >2 *)$$)#n #1 9(n(ra$ an&
a&*)n)-'ra')8( (6+(n-(- 1r#* H#$$%##& 5)&(# '# Ga*( Cra7 1#r )n1#r*a')#n
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(n&)n9 '2( (ar %)'2 @4@ -'#r(-<
C<< C#**(n')n9 #n '2( C#*+anE- +(r1#r*an:(, MarA Wa''$(-, '2( C#*+anE-
F#un&(r, C2a)r*an an& CEO -a)&, DW2)$( I %a- &)-a++#)n'(& = Ga*( Cra7E-
+(r1#r*an:( )n '2( 1)r-' n)n( *#n'2- #1 '2( (ar an& = H#$$%##& 5)&(#E-
+(r1#r*an:( )n '2( -(:#n& 2a$1 #1 '2( (ar, '2( C#*+an -')$$ *ana9(& '#
9r#% '#'a$ r(8(nu( = 33; an& a&?u-'(& n(' )n:#*( = 3!;< T# +u' '2a' )n
+(r-+(:')8(, %( 9(n(ra'(& 3; -a*( -'#r( -a$(- )n a *a'ur( )n&u-'r, %2)$(
=u)$&)n9 Ga*( Cra7, %2):2 %a-
(--(n')a$$ a r('a)$ -'ar'-u+, )n'# #n( #1 '2( $(a&)n9 9a*( r('a)$(r- )n
'2( :#un'r<D
F)r-' Quar'(r 200" Gu)&an:(
H#$$%##& 5)&(#/
A$'2#u92 =u-)n(-- 2a- =((n 'r(n&)n9 %(aA(r '2an (6+(:'(& .uar'(r-'#-&a'(,
H#$$%##& 5)&(# )- *a)n'a)n)n9 '2( 9u)&an:( )' +r#8)&(& #n D(:(*=(r 3,
2003 #1 *)&--)n9$(-&)9)' n(9a')8( -a*( -'#r( -a$(- 1#r '2( 1)r-' .uar'(r
#1 200"<
Ga*( Cra7/
Sa*( -'#r( -a$(- 1#r Ga*( Cra7 ar( (6+(:'(& '# ran9( 1r#* 32; '# 3"; 1#r
'2( 1)r-' .uar'(r #1 200"<
--------------
Brian Gains; So negative 5T comps or the ourth Ftr$ but or the ull year in !""A' the video business still
comped up AT despite everyone thin(ing the business is dead$ It is still comping up AT$ Be opened 5"! new
stores in !""A$
To put this into conteCt' that when you start loo(ing at multiples o operating income$ 3hat is (ey in Cra8yN
3hat stri(es me there is that he lost R!" million in Game Cra8y' which is a start4up$ It is a growing business'
comping up a lotH he is allowed to lose money$ &t some point that44R!" million loss 1in Game Cra8y2 at some
point will turn positive$ Be can stop opening new immature stores$ Be also has a lot o new stores with
inventory in them$ ,ven i it is a disaster' he can liFuidate the inventory$ So he is losing negative R!" million$
3hen you are loo(ing at the poor results or Bollywood' you must remember he has one division' which he can
separate$ Be can do all sorts o dierent things with where he is losing R!" million$ This division has inventory
value$ So you have negative R!" million' value o inventory and plus it is probably going positive$
In a lot o these dying businesses' you need to loo( at another area where they are ma(ing money$ There is a
reason why this could get better$
Second half of the "ress release.
Fu$$ Y(ar 200" Gu)&an:(
$$(
H#$$%##& 5)&(#/ A--u*)n9 a n(u'ra$ :#*+ar)-#n #1 a99r(9a'( 2#*( 8)&(# n(%
r($(a-(- &ur)n9 '2( n)n( *#n'2- 1#$$#%)n9 '2( 1)r-' .uar'(r #1 200", an&
a&?u-')n9 1#r '2( 8#$a')$)' an& %(aAn(-- -((n #8(r '2( $a-' -(8(ra$
*#n'2-, H#$$%##& 5)&(# .uar'(r$ -a*( -'#r( -a$(- ar( (6+(:'(& '# ran9(
1r#* n(9a')8( 2; '# +#-)')8( 2; 1#r '2( $a-' '2r(( .uar'(r- #1 '2( (ar<
H#$$%##& 5)&(# )- *a)n'a)n)n9 '2( 9u)&an:( )' +r#8)&(& #n D(:(*=(r 3,
2003 #1 n(9a')8( 3; '# n(9a')8( 2; -a*(
-'#r( -a$(- 1#r '2( 1u$$ (ar 200"<
In a&&)')#n, H#$$%##& 5)&(# +$an- '# #+(n 3@0 n(% -'#r(- )n 200",
%()92'(& '#%ar& '2( -(:#n& 2a$1 #1 '2( (ar<
Ga*( Cra7/ Fa-(& #n '2( $)*)'(& )n1#r*a')#n a8a)$a=$( r(9ar&)n9 u+:#*)n9
-#1'%ar( r($(a-(- an& #'2(r 1a:'#r- a11(:')n9 '2( 9a*( )n&u-'r, -a*(
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&)9)' 1#r '2( n)n( *#n'2- 1#$$#%)n9 '2( 1)r-' .uar'(r an& '2( 1u$$ (ar
200"<
H#$$%##& En'(r'a)n*(n' C#r+#ra')#n/
Fa-(& #n '2( a=#8( a--u*+')#n- 1#r H#$$%##& 5)&(# an& Ga*( Cra7 -a*(
-'#r( -a$(-, '2( +$ann(& #+(n)n9 #1 3@0 n(% H#$$%##& 5)&(# -'#r(- an& 3@0
n(% Ga*( Cra7 -'#r(-, an& '2( r(:(n' 8#$a')$)' an& %(aAn(-- (6+(r)(n:(&
= H#$$%##& 5)&(#, '2( C#*+an =($)(8(- 200" n(' )n:#*( +(r &)$u'(& -2ar(
:#u$& =( $#%(r '2an 2003 a&?u-'(& n(' )n:#*( +(r &)$u'(& -2ar(, =u' &#(-
n#' (6+(:' )' '# =( $(-- '2an >3<33 +(r &)$u'(& -2ar(< In a&&)')#n '#
#+(ra')n9 H#$$%##& 5)&(# an& Ga*( Cra7, '2( C#*+an )- (8a$ua')n9 #'2(r
$#n9-'(r* -'ra'(9): )n)')a')8(-< S2#u$& '2( C#*+an :2##-( '# +ur-u( #n(
#r *#r( #1 '2(-( )n)')a')8(- &ur)n9 200", )' )- $)A($ '2a' (arn)n9-
%#u$& =( n(9a')8($ )*+a:'(& = a *a'(r)a$ a*#un'< A--u*)n9 '2a' n#
-)9n)1):an' n(% -'ra'(9): )n)')a')8(- ar( )*+$(*(n'(& )n 200", '2( C#*+an
(6+(:'- '#'a$ -+(n&)n9 1#r 9r#%'2, )n:$u&)n9 )n8(n'#r an& -'#r( #+(n)n9
(6+(n-(- a--#:)a'(& %)'2 n(% H#$$%##& 5)&(# -'#r(- an& Ga*( Cra7 -'#r(-,
'# =( a++r#6)*a'($ >40 *)$$)#n<
44444444
Student; The press release seems luy and uncertain
Brian Gains; There are a lot o things that the C,9 can=t predict$
Be is still not ma(ing money in Game Cra8y but he is comping up 5!T to 5JT 1in that segment2' so eventually
he will ma(e money$ &nd the reason he is not ma(ing money is because he is opening a lot o new stores$
3hen you open a new video store' no one shows up$ It ta(es time to change people=s patterns$ It ta(es time or
that business to mature$ Be is still growing Game Cra8y$ & lot o this relates to his owning more than 5"T o
the stoc($ 3hat stri(es me is that he is still opening video stores$ Be still thin(s the returns are good$ I you
told someone who thought the business is dead that the C,9 is till opening 5)" new stores' they would reply
that he is nuts$ Be owns 5"T o the stoc($ Be has more o an incentive than I do$
The C,9 tal(s about developing a strategic initiative to develop a .etliC4li(e product$
The C,9 (nows the business better day in and day out than I do$ Be has the best data$ 3hether he is using it
well is another Fuestion$
Student Fuestion; Bow do you assess the C,9N
Brian Gains; 0oo( at his trac( record$ Be has been smart about his ability to grow his business$ 3hen did he
buy stoc(s and when did he sell his stoc($ Is he smart with his stoc(N & C,9' li(e this one' who has been
called LshadyM can mean sel4interested$ >ou will hear people be eected by their emotions$
$$'
Be was thin(ing about spending R5)" million to compete against .etliC$ Be will do what is right$
Be is going to do something that will have a return$ +aybe he thin(s the return is A"T pre4taC$ +aybe he
thin(s it is S"T or maybe 5"T$ I am Gust saying he has these parameters set and let=s hope that he hits them$
.ow it is /eb$ +arch and I am starting to buy the stoc($ The stoc( is at R55$)" to R55$)" and it starts to trend
down$ Bere are two years trailing;
What stri5es yo1 here? ?eally high ?9IC' ,BIT' good operating margin and it is really cheap$ So I have
operating income and I need to set a maintenance capeC level$ So what does it cost to (eep one o these video
stores goingN I all hell brea(s loose' nothing is good' he is not spending any money' he stops Game Cra8yH he
stops building new stores$ 3hat is it going to cost him to (eep this business goingN &nd A$# multiple is cheap
and someone pointed out the ?eturns on Capital44it is worth noting that when you do ?9C44there is a
company4wide ?9C and ta(ing operating income and dividing by net wor(ing capital' his PP, 1Property'
Plant and ,Fuipment2 and in this case his rental inventory$ &nd then there is the incremental returns on capital
1?9C2 on his new stores$ &nd the incremental ?9C on his new stores may be higher because he doesn=t have
SGE&44it is Gust incremental$ Bere on the whole company he is doing a company4wide pre4taC ?9C o greater
than J!T$ It is still antastic$
Student; 3hat is the type o the leaseN Capital or operatingN
Brian Gains; This is an operating lease$ They have two or three 4year leases so it is not a big actor$
Student; Bow did you calculate ?eturn on Invested Capital 1?9IC2N
Brian Gains; So all I am doing is ta(ing net wor(ing capital and net PP,$ In this case 1rental2 inventory as
well$ I did not capitali8e the leases because they are only or three years$ I assumed they could brea( the lease
i their business is not wor(ing$
Ta(ing that as operating cost$ .et o all rental cost$
Student; I the stores are having to constantly replenish inventory44is that capitali8edN
Brian Gains; .o$ I treat it as an eCpense44an operating eCpense$
9ne thing you wouldn=t have (nown44B0>3 had an .90 asset$ It has a net operating loss 1.902 o RSA
million so that is an asset$ Be will reali8e it all pretty Fuic(ly$ That is an asset$ It is important to (now
whether they are paying cash taCes or not$ 9perating income is running 5DS million dollars so he will reali8e
all o his .90 right away$ With these #o'&anies with a lot o2 #ash* it is i'&ortant to 1nderstand their ta=
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sit1ation. Are they &ayin. ta=es in #ash or not. 3hen you are loo(ing at multiples' you would deduct the
.90 rom ,nterprise :alue 1,:2$
&nother thing to note44despite everyone saying the business is dying44 you went rom !JJ stores to !)!H
operating income was up as well$ &nother thing I noted was that his rental gross proit44the part o the
business everyone hates44well' you can say merchandise is growing 5!T' that is not a great a business because
he has lower gross margins44he too( rental gross proit rom RDS# to R6J) and he grew the rental gross
margin$ To me this doesn=t loo( so awul$ I am actually seeing a business that is trending up$ &nd getting it
or A$#C ,:I,BIT%&4+CK or or a !DT pre4taC return$
So at this point I am eCcited$ I am buying the stoc( here between R5" and R55$
!ow bad is it,
Bow bad is itN Be has Game Cra8y where he is getting good returns and he has low +CK and everything
above is a summary$
!:.W Donclusion
Bere is my inal wor( 1below2$ I said how many dierent ways can this turn out 9- or meN
The normal case44what the C,9 is telling you he will do in !""J44R!A" in ,BIT%&$ Bis capeC is; he has
!'""" stores and R5"'""" per store so R!" million plus he has corporate capeC$ So let=s say he Gust goes +CK
then he has interest' so I calculate /ree Cash /low 1/C/2 taC adGusted is44he has a .90 but we set it aside Gust
to be sae$ 0et us loo( at this ully taCed$ Be is doing R5$6" in cash ,PS$ I put a D multiple on that so you get
to R5) per shareOthe business is not dying as Fuic(ly as people thin($
Then you say over the neCt year' you will get R5$6" bac( in cash' that is what I tal(ed about beore44how much
cash you will get bac( right away$ >ou will get bac( R5$6" right away$ So I said' 9- i this (ind o wor(s out in
this ashion' i people loo( at it as i' 9-' it were really dyingH it is really bad' I could get S"T$
I the people in the end say it is really a growth business' I may get something much better$ Then I said it does
R!!) and I am wrong on CapeC and it is RA)' so maybe my return is only A#T$ But then you can go through
these numbers and see how bad does it have to be to get to R5" where the stoc( is trading$ &nd you have to
ta(e it down Fuite a bit to say' 9-' it is worth what it is 1now2$ &nd in one case I am saying it could be worth
S"T more$
In this last eCample' I am saying he is losing R!" million on Game Cra8y per year$ Be is actually estimated to
lose R5# million or !""J' so let=s add that bac($ 0et=s say he liFuidates Game Cra8y so interest eCpense is not
as high because he has )"" storesH he sells the inventory$ So he immediately sells that down$ In that situation'
he ends up withR5# per share and R! in cash and he gets R5D per share or D!T i I bought the stoc( at R5" per
share$ So there are a lot o ways this could wor( out$
$$)
7ideo
Jevenue *$5++
7ideo SSS $>
7ideo Jental ?2>
7ideo P"
Inc. *2+5
1ew 7ideo
Stores $+2
Ending $K2+
Game DraHy
Jev *$C+
Game DraHy $5.+>
P" Inc G*2+I
1ew Stores ($K
EP. 5K5
7ideo Jental,
Game DraHy,
Maintenance Da"e#
Businesses isn=t as bad$ 9r i it is bad' and i +CK is what really comes into play because he reali8es things
are alling apart44so he stops doing it$ I am still probably going to do 9-$ &t this point I say' 9-' I will ta(e
the bet$
In the worse case scenario at the end o the year' I have a R5" stoc($ But I thin(' I ma(e a lot o money on this$
There is chance I ma(e D"T$ 1"T to 5"T downside or a A#T to D!T upside2$
This summari8es what I was tal(ing about$
A lot of ways to win@@.
In *millions ;ormal Case 2ase Case Game CraG 3osses
E0I25A *2(+ *225 *2')
DL (+ (5 (+
Int. 25 25 2+
FDF $<5 $)5 $K)
2a# Ad $$(.<5 $+<.25 $2<.'
E6S $.K+ $.<+ 2.+2
Multi"le C# <# C#
7alue $5.2 $$.K $).2
Dash Gen $.K+ $.<+ 2.+2
2otal 7alue *$<.+) *$(.)2 *$C.2+
Jeturn <+.)(> ().$K> C2.++>
!:.W Donclusion Gcont@I
Since DEP owns stock he will do the right thing with high return Game DraHy
Margin of safety from backing out Game DraHy losses 1P: value of inventory at GD stores and bare
level of
Maintenance ca"ital e#"enditures GMDLI.
:ogical reasoning of video rental business durability.
Brian Gains; The margin o saety is the Game Cra8y stores because they are losing money' but they could be
ma(ing money44more upside$ That is where I came to buy B0>3 between R5" and R55$
So March 2K
th
2++5. Jead the whole thing and what strikes you the most,
On Mar:2 2B, 200", H#$$%##& En'(r'a)n*(n' C#r+#ra')#n ,'2(
DC#*+anD0(n'(r(& )n'# an a9r((*(n' an& +$an #1 *(r9(r ,'2( DM(r9(r
A9r((*(n'D0 %)'2 Car-# H#$&)n9- C#r+#ra')#n ,DH#$&)n9-D0 an& )'- %2#$$
#%n(& -u=-)&)ar< H#$&)n9- )- a %2#$$ #%n(& -u=-)&)ar #1 L(#nar& Gr((n
G Par'n(r-, L<P< ,DLGPD0, a +r)8a'( (.u)' 1)r* '2a' *ana9(- *#r( '2an
>3<! =)$$)#n #1 +r)8a'( (.u)' :a+)'a$C<An& (a:2 -2ar( #1 C#*+an :#**#n
-'#:A %)$$ =( :#n8(r'(& )n'# '2( r)92' '# r(:()8( >3"<00<
MarA Wa''$(-, H#$$%##&E- F#un&(r, C2a)r*an an& CEO %)$$ :#n')nu( )n 2)-
:urr(n' :a+a:)')(- 1#$$#%)n9 '2( *(r9(r< Mr< Wa''$(- %)$$ (6:2an9( a
-u=-'an')a$ +#r')#n #1 2)- (.u)' 2#$&)n9- )n H#$$%##& 1#r @0; #1 '2(
:#**#n (.u)' )n '2( -ur8)8)n9 :#*+an<
Brian Gains; .ote that the /ounder and C,9 is going to ta(e 5"T o the eFuity o the company44now he will
ta(e )"T o the company$ So maybe he was sure' but now he is doubling down' tripling down$ Be won=t ta(e
any cash o the table' I am going to throw all the cards in with these new guys coming in at R5J per share$ I
you (now 0eonard Green' they are airly well regarded$ .ote that the C,9 thin(s the business is good' now he
thin(s it is great$ Be is willing to ta(e everything in at R5J$
$$<
So the stoc( rallies and everyone happy' but you see that the C,9 gets to roll in or )"T o the eFuity$ I want
in on that$ So I sold$ The stoc( was trading at R5A$)" and I say there are merger arbs who can do better wor(
than I can do 1no more edge2' so I sold$ I will move onto the neCt one$
Move on to the ne#t one and use your edge@
I# ou have done the wor" on an industr Hparticularl one with a lot o# an!les$, alwas loo" at the
competitors.
??A""lying !:.W take?out multi"le Gwhere DEP of !:.W is buying his own businessI to Movie Gallery
GMP7II im"lied a *2+ stock "rice.
MP7I arguably a better business so worth doing more work
So you have done all this wor( in understanding the :ideo business$ %on=t give up at that point$ &nd this is
where there are other people in the business$ Go loo( or other stu$ People loo( at insider sales44well' here
you have an insider buying hal the company$ >ou see insiders buying 5"'""" shares$ Be 1B0>3 C,92 is
willing to buy A" million shares$
+9:I; This same multiple given to B0>3 applied to +9:I Gallery would give you at R!" stoc($
)</I
Jural version of !:.W and 00I
Fewer than $;( of stores com"ete with either !:.W or 00I
??Mainly single o"erator com"etition
!igh JPID on new stores
Stable com"s
Jural nature im"lies less technology risk
DEP owns $5> of stock
6ossibility of reca" or stock buyback.
+9:I Gallery is in the rural areas o the country' so or all the tal( about other entertainment options' +9:I
Gallery has none o that$ Plus' we will see some other stu that ma(es it (ind o interesting$
$$C
So it is trading right around R!"$ So you are not getting a steal the day the merger happens$ +aybe you are
getting something good$
So +9:I has less technology ris( i I was worried about that' not much competition and the comps in +9:I
Gallery are still comping up and are really' really stable$ 6he CE> o2 M>"I owns /,9 o2 the sto#5. This
capital structure does not have debt on it$
So B>03 had some debt on it$ This has no debt on it' so there is a possibility to lever it up because he has a
lot o cash' you get a taC shield rom putting the interest eCpense against the pretaC income$ &ll sorts o
dierent things you can do$
)</I >I;@;CI@3S
Be has cash on the balance sheet$ I am not giving you any yrIyr stu so you can=t even ta(e a loo( at those$
3hat is interestingQ$ So it costs him R5!'""" to open these +9:I Gallery stores and three years out he ma(es
#!T$ & mature store three years out ma(es #!T pre4taC returns on capital and he has been opening stores
successully$ Be has !""" stores now and he is adding !"" stores a year$ &nd this' I am sure you (now this
$$K
Dommon
Shares
(( mil.
6rice *2+
Mkt. Da". *))+
Dash 5(
E7 )+<
E7;P" Inc. ).5(#
E7;Forward 5.<(#
88) F4F14200N
Jentals *))(.'
6roduct )(.<
2otal Jevenue <2<.+
Jental DPGS $CC.)
Jental G6 '<'.C
Jental GM <$.)
6roduct DPG 'C.'
6roduct G6 $5.(
6roduct GM 2'.+
Store o"e# ('<.5
GSA 'K.5
P" Inc. *K(.+
rom retailers' with #!T 1returns2 you build all day without screwing up$ #!T returns on capital' you can=t
probably ind better alternatives$
,ven in year 5' it is A)T without it being mature$ Particularly' a business trading at # C ,BIT
2!JPWI1G away money,
Aear 1 )ature .orthwhile
investmentC
Investment *$2) *$2)
N wall operatin! pro#it *'5 *<K
1re(ta+ 7<IC (5.<> )2.<>
.ow we get another piece on &ugust #
th
' !""J
August K 2++'
6PJ2:A15 PJ August ) 2++' 9 !ollywood Entertainment Dor"oration G1asdaB8 !:.WI owner and
o"erator of more than $K5+ !ollywood 7ideo su"erstores today announced that :eonard Green S 6artners
:.6. an affiliate of Darso !oldings Dor"oration G-,oldin!sTI and its wholly owned subsidiary Gthe entities
with which !ollywood entered into a merger agreement on March 2K 2++'I has informed !ollywood that
due to industry and market conditions :eonard Green S 6artners believes that the financing condition to the
consummation of the merger will not be satisfied.

!ollywood and the S"ecial Dommittee of its 0oard of 5irectors are considering !ollywood&s alternatives to
determine the course of action that would be in the best interests of !ollywood&s shareholders. 2here is no
assurance that a merger with !oldings will be com"leted or if com"leted that it would be com"leted on terms
that do not differ materially from those in the merger agreement.
It is (ind o vague' but it 44what is the most important sentence here besides you lose i you are in the stoc( and
you are an arb$440eonard Green is bowing out because o the inancing condition$ It wasn=t because o the
conditions or Fuality o B0>3=s business$ 0eonard Green probably couldn=t get something done in the high
yield mar(et$ They are saying' we are not leaving the deal' but we don=t li(e it at R5J$ So you can guess what
happens now' so the stoc( trades bac( to R5"$ >ou (now the inancing didn=t get done' the numbers are
probably 9- and you are bac( to where you were$
5verbod loves a !ood spin
7iacom adds $0 of debt to 0lockbuster and says donMt let the door hit you on the way out.
Jamifications of the newly inde"endent 00I,
+9:I has traded down a little bit that day$ &t the same time as this' BBI is trending lower$ Coincidently BBI
pays a special dividend to :iacom ater being spun4o rom :iacom$ ,verything is bad at B0>3' Summer
?edstone over at :iacom says BBI gives me a lower multiple' I am sic( o it' get rid o it and at the same time
pay a special dividend4R)$ They (ic( it o$ BBI had everything to loo( or in a spin4o that may be hatedO
big debt load' bad industry' etc$ .ow BBI is completely independent$ I missed this$ I didn=t get it$
)ore Chances to win..
!:.W and MP7I trade down
??Significance of MP7I ca"ital structure,
Is MP7I affected,
DEP of !:.WMs thoughts,
00I,
$2+
B0>3 and +9:I traded down$ Since +9:I has cash on the balance sheet' a trade down in +9:I Gallery is
huge' because it is cash rich$ &ny all o in price is pretty signiicant on a multiple basis$
Is +9:I aected by what happenedN .9$
3hat is the C,9 o B0>3 thin(ing about everything that is going on around him$ This is the C,9 who
wanted to triple down$ %oes he care where the merger happens44he would preer a lower price$ Be is more
eCcited i 0eonard Green comes bac( and oers RA$ & ta(e4under$
@and then it becomes a food fight
:eonard Green comes back on $+;$';+' and offers *$+.25
Pn 1ovember $$;$$ 00I confirms interest to acBuire at *$$.5+
Movi offers to acBuire !:.W at *$(.25.
0eonard Green shows up again on 9ct 5J
th
$ 3e will do it or R5"$!)' then they hang around$ Classic private
eFuity guys who say' the C,9 doesn=t care about a lower price' so let=s oer RJ less$ Then a wrench gets
thrown in their plans' because a newly independent bloc(buster comes bac( says they will do it or R55$)"$
Then +9:I gets interested to acFuire at R5A$!)$ &ll these strategic buyers get eCcited$ 3ith a (ey event' you
had a BBI spin4o and you had 0$ Green get greedy and then a ood ight begins$ It is unny how this stu
wor(s$ 0 Green wo(e everybody up to it is not so bad$ ,verything transpired rom there$
The B0>3s C,9 oers to acFuire hal o B0>3=s stores$
3hat I did when the merger announcement came out when +ovi was going to acFuire B0>3 at R5A$!)' I said
BBI runs into anti4trust problems because they have #"T o the mar(et$ >ou do some Fuic( math on +9:I
and say wow this is a home run$ >ou can say they can cut costs' they can do the same thing as 0$ Green$
I am in +9:I but not in B0>3 the second time around$ Putting a D multiple on +9:I=s RA$)"' you could get
a R!D stoc($ So you could get really eCcited with +9:I i they get it and i they don=t' then a lot o time in
these mergers' BBI is orced to sell o stores i BBI were to acFuire B0>3' then +9:I could acFuire those
stores on the cheap$
&nother thing about BBI=s bid is that it is in cash and stoc($ &nd any Board o %irectors will avor cash over
stoc($ It is the easier to go with the cash bid$ BBI is at a disadvantage because they have too much debt$ This
is what is happening with Uuest and Bori8on44+CI=s Board is saying we want to go with :eri8on since they are
oering cash$
The B0>3=s Board is tired$ They (now there is very little upside$ They (now it will be acFuired$ The Board
personally does not want to be sued$ Clean this up and get out o town$
6namics o# mer!er
E#?!ollywood DEP comes out and wants to buy $;2 !:.W stores
MP7I All cash bid
??=uick math on MP7I acBuisition says they could do *(.5+ in E6S if they acBuire !:.W
Doncessions from 00I if they donMt win
1o overla"
00I issues
??Antitrust
??Dash and stock bid
Im"lications for the board
So we will Gust inish up the story$ B>3 trades bac( to R5J and +9:I to R!#$ BBI pops as well$ >ou could do
well in any o these companies$
$2$
,.%
Uuestions and &nswers
I put 5"T in B0>3' since I did all my wor(' I (new the downside was R6 to R5" and the upside was good$
/or me' !"T would be huge' but 5"T is usually my position$
3hat is your best bet44+9:I seemed better$
I you (new +9:I was a sure deal to acFuire B0>3' then +9:I would be over RA"$
In the end' people rent videos near where they live$ 3ith BBI' will it be able to be successul against .et4liCN
E?$
DASE S2R5.
)unsin!wear, Inc. Case Stud Instructions
1riGe%
6retend you have traded in your hush "u""y shoes or sandals in for a "air of wing?ti"s. .ou are now an
investment banker who is being asked to hel" Munsingwear Inc. -enhance shareholder value.T !ow would
you advise the DEP in im"roving their o"erations and "rofitability, .our fee if your advice salvages value
for shareholders and;or turns this com"any around would be *(+++++.
Instructions%
Rse only what is in this case study for your analysis. If you feel critical information is lacking then state what
is missing and how it "revents you from advising your client. .ou will have a chance to s"eak to the DEP Mr.
:owell Fisher in class.
$22
After reading the $+?A what would you advise, Why, 6lease give no more than a written "aragra"h answer.
6rovide a brief "ro?forma of your analysis if necessary. What value might you "ut on the com"any after your
recommendation, Show work and assum"tions.
2his case test your strategic thinking ability and business sense.
Good luck in your new wing ti"s/
???
)unsin!wear, Inc. Case Stud
><7) 10(-
For the fiscal year ended %anuary ) $KK)
Munsingwear Inc.
IJS [ '$?+'2K)2+
C+++ W. <C
th
Street Suite?'++ Minnea"olis Minnesota 55'(K
2ele"hone number8 )$2?K'(?5+++
5elaware8 State of Incor"oration
2he aggregate market value of the voting stock held by nonaffiliates of the Jegistrant at A"ril $ $KK) was
*K(C'+++ based on the closing "rice of *<.25 "er share at that date.
2he number of shares of common stock outstanding at A"ril $ $KK) was 2+(<+<C
@. G5;57@3 65/53<1)5;8 <> 2DSI;5SS
2he Dom"any was incor"orated under the laws of 5elaware in $K2( as the successor to a business founded in
$CC). 2he Dom"any&s "rinci"al e#ecutive offices are located at C+++ W. <C
th
Street Suite?'++ Minnea"olis
Minnesota 55'(K and its tele"hone number8 )$2?K'(?5+++. As used in this document the term -Dom"anyT
refers to Munsingwear Inc. and its subsidiaries unless otherwise noted or indicated by the conte#t. At %an. )
$KK) the Dom"any had one subsidiary Munsingwear RA :imited which was idled in $KK'.
After suffering a severely weakened financial condition "rimarily due to losses of *CK 2'(+++ during the
years $KCK through $KK+ the Dom"any on %uly ( $KK$ filed a voluntary "etition for bankru"tcy under
Dha"ter $$ of the RS 0ankru"tcy Dode together with a "ro"osed 6lan of JeorganiHation. 2he Dom"any
emerged from bankru"tcy on Pct. 2K $KK$.
6rior to the reductions in o"eration im"lemented during $KCK through $KK$ the Dom"any designed
manufactured and distributed a broad range of men&s and children&s a""arel through several o"erating divisions
and subsidiaries. 2oday the Dom"any&s o"erations consist of what was formerly the Men&s A""arel 5ivision
and sell "rimarily men&s knit s"ort shirts under the following ma4or brands or labels8 Munsingwear \ Grand
Slam \ Grand Slam 2our ] 6enguin S"ort ] and Slammer \. In addition the Dom"any licenses its trade
names and trademarks for use in a variety of "roducts.
In the recent two fiscal years the Dom"any&s sales by channel of distribution have undergone significant
change. In $KK5 sales to "remium;s"ecial markets and golf 6ro sho" customers rose 52> collectively over
$KK'. 2his is the result of management&s attem"t to reduce the Dom"any&s reliance on sales to traditional retail
a""arel channels of distribution where heavy "romotional "ricing discounting and advertising activities are
reBuired.
In late 1??5, the Compan retained the services o# an investment ban"in! #irm to e+plore a ran!e o#
opportunities to ma+imiGe shareholder value.
$2(
2. >I;@;CI@3 I;><7)@8I<; @2<D8 I;6DS87A S5G)5;8S
2he Dom"any o"erates in one industry segment a""arel manufacturing. As of %an. ) $KK) the Dom"any&s
foreign o"erations were not material.
C. ;@77@8I/5 65SC7I18I<; <> 2DSI;5SS
6rinci"al 6roducts8
2he Dom"any sells "rimarily men&s knit s"ort shirts under four ma4or brands or labels8 Munsingwear \ Grand
Slam \ Grand Slam 2our ] and 6enguin S"ort ]. Grand Slam \ and 6enguin S"ort ] "roducts are sold
"rimarily to de"artment stores s"ecialty stores and Sears. Munsingwear \ "roducts are sold "rimarily to
"remium;s"ecial markets customers and to national chain stores such as Montgomery Ward. Grand Slam 2our
] is sold "rimarily through golf "ro sho"s.
Sources and Availability of Jaw Materials and 6roducts8
A""ro#imately )+> of the Dom"any&s "roducts are manufactured domestically. 2he other '+> is sourced
"rimarily from manufacturers in the Far East through a relationshi" with Associated Merchandising
Dor"oration GAMDI. 2he Dom"any also sources some "roduct through the C+< "rogram in the Daribbean
0asin. 2he "rinci"al raw materials used in the domestic "roduction "rocess are cotton synthetic and
cotton;synthetic blended goods obtained "rinci"ally from Rnited States sources. 2he Dom"any "urchases most
of its "iece goods from a""ro#imately ten sources. 2here are currently no ma4or "roblems in availability of
raw materials and alternative sources are available. 2he Dom"any&s Fairmount 1D manufacturing facility
includes a material warehouse cutting sewing and embroidery o"erations and finished goods distribution
center. 2he com"any also utiliHes contract swing manufacturers in close "ro#imity to its 1orth Darolina
facility to meet demand during "eak "roduction "eriods. All "roducts both domestically and offshore
"roduced are distributed to customers from the 1orth Darolina facility.
2rademarks and 2rade 1ames8
In $KK$ management initiated the strategy to actively "ursue licensing as a vital "art of the Dom"any&s growth
"lan. 5uring the "eriod $KK$ through $KK( the Dom"any entered into eleven license agreements and in $KK'
renegotiated its licenses with Fruit of the :oom which among other things e#tended the original agreement
for twenty?five years. In $KK5 the Dom"any entered into four additional license agreements. Management
intends to continue develo"ment of its licensing "rograms and believes that its advertising styling and brand
name identification established over many years are im"ortant to the com"etitive "osition of the com"any. 2he
Dom"any has the following license agreements8
A license with Fruit of the :oom Inc. to market underwear and active wear.
A license with a 1ew .ork entity to market slee"wear.
Five licenses with Montgomery Ward to market men&s "ants outerwear accessories dress wear and
shirts.
A license with a Danadian cor"oration to market knit shirts.
A license with a 1orth Darolina entity to market men&s and boys& hosiery.
A license with a 6eo"les Je"ublic of Dhina entity to market a variety of clothing and accessories.
A license with a South Darolina entity to market sweaters.
A license with a Missouri entity to market outerwear.
$2'
A license with a 1ew .ork entity to market woven shirts.
A license with a South African entity for a""arel.
Management&s em"hasis on licensing activities in recent years has led to a dramatic increase in the Dom"any&s
royalty income from *$$)2+++ in $KK$ to *')+K+++ in $KK5.
Seasonal As"ects of the 0usiness8
Sales of the Dom"anyMs "roducts can vary significantly by season with "eak shi"ments normally occurring in
the first and second Buarters of the fiscal year.
Working Da"ital 6ractices8
2he Dom"any maintains a secured bank line of credit to meet its working ca"ital needs. 6eak borrowings
under this agreement normally occur in the first si# months of the year during the heavier shi""ing "eriod and
during the fourth Buarter when inventories are increased to meet the additional first and second Buarter sales
volume. Seasonal increases in inventory are normal for the a""arel manufacturing industry. 2he bank line of
credit is also used for letters of credit that are reBuired for generally all of the Dom"any&s "urchases from
offshore sources. 2he Dom"any allows returns of merchandise as a result of shi""ing errors damaged
merchandise and for other reasons. Jeturns have been less than '> of sales in each of the "ast two years.
Dustomers8
2he Dom"any sells to a""ro#imately '5++ customers. Sales to Sam&s Dlub Ga division of Wal?Mart Stores
Inc.I in $KK' and $KK( were $)> and 2$> res"ectively of net sales. In $KK5 no single customers re"resented
more than $+> of total Dom"any sales.
0acklog of Prders8
2he Dom"any&s backlog of unfilled orders at %anuary ) $KK) was a""ro#imately *$5)+++++ as com"ared to
*$CC+++++ a year ago. 2he decrease was due "rimarily to management&s em"hasis on reducing reliance on
traditional retail a""arel customers. 2he unfilled order backlog does not necessarily relate directly to future
sales.
Dom"etition8
2he a""arel industry in the Rnited States is highly com"etitive and characteriHed by a relatively small number
of broad line com"anies and a large number of s"ecialty manufacturers. In addition there are unbranded and
"rivate label com"etitors as well as numerous small s"ecialty manufacturers com"eting with the Dom"any.
2he "rinci"al methods of com"etition in the a""arel industry are "ricing styling Buality Gboth in material and
"roductionI inventory re"lenishment "rograms and customer service. 2he Dom"any seeks to maintain its
com"etitive "osition in the markets in which it o"erates through the use of all these methods.
Jesearch and 5evelo"ment8
2he Dom"any is involved in limited e#"erimental research activities related to the develo"ment of new fabrics
and "roduction methods. Jesearch and develo"ment e#"enses other than for "roduct design are not
significant.
Environmental Donsiderations8
2he Dom"any&s manufacturing o"erations are sub4ect to various federal state and local laws restricting the
discharge of materials into the environment. 2he Dom"any is not involved in any "ending or threatened
"roceedings which would reBuire curtailment of its o"erations because of such regulations. In $KK5 the
com"any&s ca"ital e#"enditures for environmental control facilities were not significant and no significant
ca"ital e#"enditures related to environmental issues are "ro4ected in $KK).
$25
Item 1% 5mploees%
As of %anuary ) $KK) there were ('( em"loyees none of whom were re"resented by a union.
6. >I;@;CI@3 I;><7)@8I<; @2<D8 ><75IG; @;6 6<)5S8IC <157@8I<;S @;6
5R1<78 S@35S
Sales to unaffiliated foreign customers located outside the Rnited States and its territories for the "ast three
years were not significant.
Item 2. 1roperties
1ropert S94 >oota!e @ppro+.
1ercenta!e
DtiliGed
3ease 5+pires
Minn. M1 != 2K2++ 5+ $KK)
Fairmont 1D U Dutting and sewing "lant
warehouse and distribution center

$(K$++ $++ Pwned
1ew .ork 1. U Sales office;showroom $+++ $++ $KK<
5allas 2L U Sales office;showroom 5++ $++ $KK)
At %anuary ) $KK) the Dom"any occu"ied the following "ro"erties8
Management considers facilities adeBuate for current o"erations. At %an. ) $KK) no facilities were occu"ied
Rnder ca"italiHed leases.
Item F. 3e!al 1roceedin!s
1one of a significant nature.
Item N. Submission o# )atters to a /ote o# Securit ,olders
1one.
E#ecutive Pfficers of the Jegistrant
2he following information is furnished with res"ect to the Dom"any&s e#ecutive officers as of the date hereof
"ursuant to Item '+$ GbI of Jegulation S?A. Each of the officers has been a""ointed to serve in his res"ective
office until his successor has been elected.
;ame and @!e 1osition <##icer Since
:owell M. Fisher G)(I
5irector of the Dom"any3
6resident and DEP Pctober $KK(
to
$KK(
@2<D8 8,5 C<)1@;A
2he Dom"any was founded in $CC) as a manufacturer of men&s underwear. 2hroughout the early $K++&s the
Dom"any was an innovator of new te#tile and a""arel manufacturing "rocesses and during the $K'+&s and
$2)
$K5+&s e#"anded its "roduct lines acBuired a women&s intimate a""arel com"any and in $K55 introduced the
Gran Slam GJI collection of golf a""arel bearing the well?known 6enguin \ emblem. 5uring the $K)+&s and
$K<+&s manufacturing facilities were added te#tile research and develo"ment de"artments were established
and the Dom"any entered into numerous licensing agreements for the use of its trade names and trademarks.
2oday the Dom"any derives its revenues "rimarily from the sale of men&s s"ortswear a""arel and the licensing
of men&s underwear active wear and other related a""arel. 2he Dom"any&s "roducts are sold "rimarily
through "remium;s"ecial markets de"artment stores golf "ro sho"s national chain stores s"ecialty stores
s"orting goods stores and wholesale clubs. 2he Dom"any designs manufactures im"orts markets and
licenses branded men&s lifestyle a""arel under the Grand Slam \ Grand Slam 2our\ Munsingwear \ and
6enguin S"ort ] labels. 2he Dom"any is headBuartered in Minnea"olis M1 and has ('( em"loyees in
com"any?wide o"erations.
358857 8< S8<C-,<3657S
Jevenues for $KK5 were *5).$ million a ('> increase over last year. 5ramatic sales growth in our
"remium;s"ecial markets and golf "ro sho" businesses more than offset a small decline in business with our
traditional customers such as de"artment and s"ecialty stores national chain stores and wholesale clubs.
6remium;s"ecial markets volume increased seven?fold while golf 6ro sho" volume increased 52>. In $KK5
these two businesses re"resented '+> of our total sales volume and are e#"ected to e#ceed 5+> of total
Dom"any sales in $KK). As recent transition the Dom"any has undergone over the "ast two years significantly
reducing our e#"osure to the difficult retail a""arel market"lace.
Joyalty income was u" slightly to *'.) million. As a reminder $KK' royalty income had increased 25> as a
result of additional license agreements and a twenty?five year e#tension to the Fruit of the :oom license which
will also lead to lower cash recei"ts from e#isting licensing agreements starting in $KK). 2he Munsingwear
trade names and trademarks have always signified Buality to the licensing market and we will continue to
actively "ursue additional license agreements.
While we achieved significant revenue growth in $KK5 we were not successful in becoming "rofitable. 2he
loss of *2.( million *$.$( "er share was "rimarily the result of dee" markdowns on e#cess end?of?season
merchandise related to the retail de"artment store channel of distribution losses related to an unsuccessful
entry into -Friday?wearT increased advertising e#"enses in su""ort of the retail de"artment store business and
restructuring costs related to com"leted staff reductions and reduced office s"ace reBuirements. In addition
costs associated with our 6GA 2our endorsement "rogram increased yet we feel this "rogram is necessary to
give Munsingwear brands consumer e#"osure. We were successful in reducing selling general and
administrative e#"enses as a "ercent of sales U from (2> in $KK' to 2<> in $KK5. Interest e#"ense was u"
significantly due to inventory build?u" reBuired to service the e#"losive sales growth in the "remium;s"ecial
markets business. 2hroughout the year we also e#"erienced higher than "lanned levels of inventory for the
retail de"artment store business which did not meet sales forecasts. Rltimately we sold this inventory at dee"
discounts.
:ooking ahead to $KK) we "lan to continue to grow the "remium;s"ecial markets business which has achieved
e#ce"tional results the "ast two years. Munsingwear&s strong consumer brand recognition the 6enguin logo
Buality "roduct and the agility to merchandise across a broad "roduct line give us a com"etitive advantage. We
are confident that increased revenues and a return to "rofitability will be achieved due to the following8
Dontinued strong sales growth in "remium;s"ecial markets and golf "ro sho" businesses.
Dost reduction "rograms.
Dontinued focus on core ca"ability U men&s short sleeve knit and moderately "riced golf shirts.
G6icture of :PWE:: M. FIS!EJI
Innovative designs and fabrics throughout all "roduct lines.
Dontinued u"grading of management information systems.
$2<
Strengthening of our 0oard of 5irectors by the addition of three new members 2homas 5. Gleason
who was named non?e#ecutive Dhairman of the 0oard in %anuary of this year and Aevin S. Moore
and William %. Morgan who re"resent the Dom"any&s two largest single stockholders.
In late $KK5 we retained the services of an investment banking firm to hel" us e#"lore a range of o""ortunities
to ma#imiHe shareholder value and we e#"ect this activity to accelerate in $KK). 6lease refer to the
Management&s discussion and analysis section in this annual re"ort for additional financial analysis and a
statement regarding forward?looking information.
Although $KK5 was a difficult year for retailing the Dom"any achieved e#tremely "romising revenue growth
in our two most "rofitable businesses9"remium;s"ecial markets and golf "ro sho"s. 2hese results reaffirmed
our decision to continue the Dom"any&s transition U e#"anding markets enhancing "roduct Buality increasing
consumer value and investing in infrastructure. As a result we are now in a much stronger strategic "osition
and I look forward to working with 2om Gleason and the 0oard in continuing our efforts to ensure the long?
term success and "rofitability of the Dom"any.
In closing I would like to thank our customers su""liers and lender who have continued to su""ort us
throughout the Dom"any&s transition. Finally I would like to take this o""ortunity to thank all Munsingwear
em"loyees for their hard work and effort which led to s"ectacular $KK5 sales growth and reinforces our
o"timism for $KK).
Sincerely
;s; :owell M. Fisher
:owell M. Fisher 6resident and DEP.
DP1SP:I5A2E5 S2A2EME12S PF P6EJA2IP1S
GAMPR12S I1 2!PRSA15S ELDE62 6EJS!AJE 5A2AI
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1et Sales * 5$5$2 * (<'+< * (< )(5
Joyalties ')+K '52C ()2'
5M,121 N1,?F5 N1,25?
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Dost of goods sold '2<$' (++2K 2C<C(
SGSA $(K)$ $2$(' $$C)K
Jestructuring costs G1ote KI 52+ ??? ???
GGainI loss on closing of facilities
G1ote KI
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<157. I;C<)5 H3<SS$ H1,07N$ H12K$ 157
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Pther 2 $<< G<'I
:oss before inc. ta#es and
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H2,2F0$ HF0N$ H20F$
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:oss before e#traordinary item G22(+I G(+'I G2+(I
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e#tinguishment
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E#traordinary item ??? G.+CI ???
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Weighted avg. PS 2+)) 2+)) 2+K(
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2he accom"anying notes are an integral "art of these financial statements
C<;S<3I6@856 2@3@;C5 S,558S H@)<D;8S I; 8,<DS@;6S, 5RC518 S,@75 6@8@$
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6re"aid e#"enses $++' $2C)
8<8@3 CD775;8 @SS58S 2N,2NN 20,71M
66SE
:and $5 $5
0uildings and leasehold im"rovements 5)C 55+
Machinery and eBui"ment (K2C (+'$
'5$$ ()+)
:ess accumulated 5SA $5C' $((+
2K2< 22<)
2JA5EMAJAS net of accumulated AmortiHation of *$2<' and *$+$+ '$<( ''(<
5eferred ta#es 1E2 PF 7A:RA2IP1 A::PWA1DE PF *$$<K) A15
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:ine of credit borrowings * $+CK+ * 55K2
Durrent maturities of long?term debt 2$ $K
Accounts "ayable 5++C (<)+
Accrued "ayroll and em"loyee benefits $++K $+2C
Rnearned royalty income 2KK( ($5K
Pther accruals (K< ($$
8<8@3 CD775;8 3I@2I3I8I5S% 20,F1K 1F,KM?

:P1G?2EJM :IA0I:I2IES8
:ong?term debt less current liabilities 22 (C
6ostretirement benefits ($K ($2
Rnearned royalty income $+ 2++
(5$ 55+
2P2A: :P1G?2EJM :IA0I:I2IES (5$ 55+
S2PDA!P:5EJS& E=RI2.
Dommon Stock *+.+$ "ar value 2+)55K' shares issued and issuable 2$ 2$
Additional "aid?in ca"ital $5$$2 $5$$2
G2$'KI $C5
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$2K
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Jeceivables G(')CI G(C+I G<$)I
Inventories G'22I G5KC)I G'25I
6re"aid e#"enses 2C2 G25'I G$K2I
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I17ES2I1G AD2I7I2IES G$2+$I GC)5I G'K+I
6urchases of 66SE
1E2 DAS! RSE5 I1 I17ES2I1G AD2I7I2IES G$2+$I GC)5I G'K+I
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1et Dhange in new line of credit borrowings 52KC 55K2 ??
6rinci"al "ayments on long?term debt and
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* )2 * <( * ''$
Su""lemental disclosures of cash flow information8
Dash "aid for ta#es * $<C * $22 * $5(
Dash "aid for interest * $+<C * (<+ * 2<(
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5;6
Interview with /alue Investor Boel Greenblatt
0y 0ill Mann G2MF PtterI 5ecember 2$ 2++5
2he :ittle 0ook that 0eats the Market. &udacious titleN +aybe' but Joel Greenblatt has the chops and the
record to bac( it up$ Bis investment returns are amongst the most incredible in investing' with returns
eCceeding J"T per year over the last ! decades$
2ill )ann% Pne of the things that you talked about in the beginning of this book is that you felt like your first
book >ou Can Be a Stoc( +ar(et Genius was a little more advanced than you had intended it to be. So you
wrote The 0ittle Boo( that Beats the +ar(et with your kids in mind. 5escribe for us some "rocess that you
went though in creating the book,
$($
Boel Greenblatt% Ph sure. Well the way it really ha""ened was is that there are a few sim"le things I have
been teaching for ten years over at Dolumbia. My students are always accusing me of making things sound too
sim"le so we sort of boiled down to what we have done for the last twenty years at Gotham Capital to a
cou"le of im"ortant conce"ts.
What those conce"ts were were buying good com"anies at bargain "rices. 2he way we define Vgood
com"aniesV was com"anies that earn a high return on ca"ital. What that might mean is that if for instance a
com"any o"ens stores and each store costs *'+++++ and you can earn *2+++++ on a store that is a 5+> return
on ca"ital. If another com"any o"ens stores that also cost *'+++++ but they only earn *$++++ a year that is a
2.5> return on ca"ital. Sim"ly we said Vgee the com"any that earns 5+> a year on the ca"ital invested is a
lot better than the one that earns 2.5>.V 2hat is generally the course we have taken to define what a good
com"any is something that earns a high return on ca"ital. 2hen we said V:etMs try to buy those good
com"anies chea"ly.V 2he way we defined Vchea"V was com"anies that earn a lot relative to the "rice we are
"aying. So we call that earnings yield which is the inverse of 6;E. So that 4ust means that if you can buy a lot
of earnings for a chea" "rice that makes the com"any chea".
So if we can buy a good com"any that is also chea" in combination that strikes me as being a good thing.
2hat is what we tend to look for when we are looking for investments at Gotham Capital. 2hose conce"ts are
not too hard for kids to understand. If you e#"lain to them that way that I am 4ust trying to buy good
com"anies at bargain "rices they tend to understand that.
ItMs very im"ortant that you understand what you are doing not 4ust following what I call the Magic Formula. If
you are 4ust following a Magic Formula that formula doesnMt always work. 0ut if you understand what you are
doing you will say Vyou know what, It 4ust makes sense to buy good com"anies at bargain "rices and
eventually this will work.V We did a study showing that large?ca" com"anies can double the marketMs return
4ust following this formula. With small ca"s you could actually almost tri"le the marketMs return.
2ill )ann% I wanted to make this "oint. When you say VweV you are talking about Gotham Capital$
Boel Greenblatt% My "artners at Gotham Capital yes.
2ill )ann% And 4ust to be clear this is "art of the "rocess that you have used to manage money at Gotham
Capital for more than 2+ years.
Boel Greenblatt% .es. 2he Magic Formula from the book is not something that we fished around for by back
tested e#tensively using '+ different formulas until something looked like it worked. 2his is the absolute first
thing that we tried and the in"uts a""ro#imate how we invest "rofessionally. So when we talked about
com"onents for a back test we thought V:etMs kee" it sim"le. :etMs look at what com"anies do. If we rank them
based on earnings yield and return on ca"ital and "icked the com"anies with the best combined ranking of
those two factors how would a "ortfolio of stocks like that do,V 2hat is what we back tested and that was the
first thing we tested and that is what I wrote u" in the book because it is so sim"le and obvious.
2here is a slight difference in what we do at Gotham Capital. For my kids I did not think they were ca"able of
"ro4ecting earnings out into the future. At Gotham Capital what we do is instead of using least yearMs
earnings which is what we used for the Magic Formula and what got those great results of double and tri"le
the marketMs returns we used what we think normal earnings will be several years out three or four years from
now.
We canMt make those "ro4ections for most com"anies but for the com"anies that we can make those "ro4ections
for or we feel confident about our "ro4ections then we "lug those into the Magic Formula rather than last
yearMs earnings. So there are two really different strategies that we use. Pne for the Magic Formula when we
are looking at last yearMs earnings we buy a "ortfolio stock either 2+ or (+ com"anies because on average
they do incredibly well were the results I 4ust mentioned. For Gotham Capital we do a much more
concentrated "ortfolio "erha"s five or eight com"anies generally are C+> of or "ortfolio and those are
com"anies that instead of "lugging in last yearMs earnings we "lug in our "ro4ections for normal earnings
several years out for the com"any but we are actually "lugging it in to the Magic Formula.
$(2
So we are more concentrated and we do a lot more work on each com"any that we own because of that. For
most investors who donMt do this for a living they are better off looking at last yearMs earnings and buying a
"ortfolio of 2+ or (+ com"anies that on average will do tremendously well.
2ill )ann% It is such an im"ortant conce"t and one of the facts that I thought was great about the book is that
you are not talking about what will be. .ou are not talking about laser beams and dental technology and all of
these things that "eo"le get e#cited about that may not have earnings at "resent. 2he basis for the Magic
Formula rests u"on what is what earnings the com"any already has generated.
Boel Greenblatt% 2hat is really I think what "eo"le can do. 2here is no argument about it. .ou know what
ha""ened last year and that is all you need to know.
I wouldnMt suggest "eo"le without doing any work "ick individual stocks but if you are willing to own a 2+ or
(+ stock "ortfolio based on these sim"le conce"ts on average you are going to do tremendously well.
2ill )ann% What about the argument of if this works very well with the 2+ and (+ why wouldnMt you "ick the
to" three and concentrate, I mean if you could determine what they were.
Boel Greenblatt% Even though what I said in the book was the formula actually works in order. In other
words we take the combined ranking of chea" and good com"anies and we combine those ranks into a Magic
Formula ranking.
I said in the book that if you divide all (5++ com"anies we modeled into deciles where you take the to" $+>
as ranked by the Magic Formula then the ne#t $+> then the ne#t $+> the Magic Formula works in order. 2he
to" decile beats the second decile and so on. 2hatMs over a large amount of stocks so there really is not much
statistical difference between "icking any of the to" letMs say 25 stocks versus one so the to" three donMt
necessarily do better than number 22 to 2'.
2ill )ann% And you would in fact increase risk by being concentrated because you are trusting a formula.
Boel Greenblatt8 Jight on average it works so to 4ust "ick a few names if you have something on average that
works you might as well shoot for that average. .ou may do better with the three stocks but you may do a lot
worse. If you have almost a sure thing why throw it away,
2ill )ann% Pne of the things that you did in the study was to bifurcate what would you do if you concentrated
on the largest com"anies and then you went down as low as *5+ million. What about going smaller than that,
Boel Greenblatt% It should work amaHingly well there but I didnMt want to write a book that "eo"le couldnMt
e#ecute and I also wanted to show how robust the Magic Formula was. It worked amaHingly well with small
ca"s. Rsing a small ca" model of (+ stock "ortfolios that we tested over the $< years it earned over (+> a
year.
It is 4ust that I want to make sure "eo"le realiHe that the formula was very robust and that you could actually
e#ecute you could actually buy enough stock and if you are buying a book that ho"efully a lot of "eo"le will
read we even showed how it worked for the to" thousand com"anies.
It didnMt work Buite as well as with the small ca"s because there are many more small ca"s to choose from than
large ca"s but it worked incredibly well. It more than doubled the marketMs return. 2ough to beat that.
2ill )ann% So if a com"any that trades 5+ shares a day and shows u" on that list that makes it functionally
irrelevant for most investors because you canMt e#ecute a trade.
Boel Greenblatt% Well we didnMt 4ust have a minimum market ca" we also had a minimum trading
reBuirement so that you actually had to be able to trade these stocks to be "ut into our model. Sure the small
investor has many advantages over the large investor and if you arenMt running so much money that you are
"revented from buying smaller ca" stocks then you have a big advantage. .ou can choose from a lot more
com"anies.
$((
2ill )ann% 0ecause youMre dealing with a mechanical strategy one of the books that "eo"le will inevitably
make a "arallel to is %im PMShaughnnessyMs 3hat 3or(s on 3all Street$ !ow is this different from what
PMShaughnessy did,
Boel Greenblatt% Well number one he tested doHens of formulas over a long "eriod of time and then "icked
the ones that worked the best. What we did is we "icked a formula based on what we actually do and we
tested it. 2his was it. 2his formula ranks stocks in order from best deciles to worse and so it wasnMt 4ust
"icking the to" outliers. It was really actually "icking what we think goes into making money in the stock
market which is buying good com"anies when they are chea" so it was really done somewhat differently.
I actually thought %im PMShaughnessyMs book was e#cellent.
2ill )ann% I absolutely agree. 2he early history of 2he Motley Fool was built "artially around %im
PMShaughnessyMs work so I certainly am not casting as"ersions. As you mentioned there is a mutual fund
com"any now that runs some of his formulas and does very very well. V,ditor=s .ote; That mutual und
company is ;ennessy Ad4isors 1.asdaF; B..&2' which we have highlighted as a Tiny Gem$W
Boel Greenblatt% Well it is very interesting what ha""ened. I actually wrote u" the history of formula?based
investing system where a fund did start using one of PMShaughnessyMs formulas and did very badly for the first
three years. 2he fund didnMt do well and the fund manager ended u" selling the com"any and then the "erson
who bought it continued with the same formula and ended u" doing very well right afterwards. So since
ince"tion that fund has done incredibly well yet the original investors and the original fund manager are gone
because it didnMt do well in the beginning.
I think that is what so great about the Magic Formula. It doesnMt always work. If it always worked everyone
would do it. 2here are one two or three?year "eriods of the Magic Formula that we are talking about where it
doesnMt beat the market but over long "eriods of time it always beats the market and that is very very
"owerful.
I used the e#am"le the conce"t of 2N2O'. Everyone knows that that is the case and no matter what anyone
tells you 2N2 always eBuals four. It doesnMt matter how smart they are how long they tell you you are going
to stick to your guns. So you will also stick to your guns if you understand what you are doing here which is
if you truly believe what you are doing is buying good com"anies at bargain "rices you will kee" doing it
because it makes sense even though the market doesnMt agree with you for long "eriods of time.
2ill )ann% We saw in the late $KK+s where a lot of com"anies that were 4ust making a lot of money were very
very chea" because it seemed like the investor class as a whole was distracted by things that ended in dot com.
Boel Greenblatt% Well that is the best e#am"le. In the year 2+++ we owned a lot of good com"anies at chea"
"rices that the market didnMt really care about and we werenMt doing very well with them. Pn to" of that we
thought the Internet bubble was going to burst any day because stocks were at ridiculous "rices and wouldnMt
that drag down our investments along with the crash in the Internet stocks that we eventually thought might
take "lace but we decided Vhey listen we own good com"anies at bargain "rices. We are 4ust going to 4ust
kee" doing what we know makes sense.V
What ended u" ha""ening is the market did get crushed. 2he SS6 got crushed. 2he 1AS5A= got crushed in
2+++ yet our "ortfolio was u" more than $++> so if that doesnMt tell you to stick with what you think makes
sense I donMt know what will. So the market could do badly but as long as you are doing smart things over
time you will do Buite well.
2ill )ann% I think that was one of the things about the Magic Formula that immediately attracted me. It
wasnMt something where you said VWell if you buy it on the first 2hursday of the month it works out better.V
2hese are two very defensible investing com"onents. 2hey are at the core of what good value investing is.
Boel Greenblatt% Well I would say that I have learned a lot. Pne of the reasons I wrote this book is because I
am really a self?taught investor even though I got a 0S and an M0A from Wharton As far as investing all they
taught me was that you canMt beat the market.
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Investing I learned from reading and I was reading books by 0en4amin Graham. I was reading the writings of
Warren 0uffett. 2hose are the things that really taught me. 2he readings of 5avid %reman and so Graham and
%reman taught buying chea" is a good thing to do and it works over time. 0uffett added the com"onent of
buying good com"anies when they are chea".
I wouldnMt "resume to say oh this is a formula that is similar to Warren 0uffett but what I would say is that the
conce"ts are the same. 0uffett says VI am going to stick to good com"anies and buy them when I can buy them
at a good "rice.V 2his is systematically what the Magic Formula does for you e#ce"t you get to choose from a
lot larger universe of stocks than 0uffett does now that he is running *C+ billion.
2ill )ann% ItMs interesting that you mention what you didnMt learn about investing at Wharton. A lot of
individual investors will look immediately to what schools a "erson has gone to or as they say Vthis "erson
obviously has to know about investing. !e has a !arvard M0A.V 0ut reality is so much different e#ce"t it
seems at one "lace U Dolumbia. .ou teach at Dolumbia 0usiness School so you may really be able to s"eak to
this. Dolumbia is really uniBue in that it has a long history of actually teaching investing to students.
Boel Greenblatt% Well I always start each class to my students and say VI aim to teach the class that I wish I
had when I went to business school.V I want to give young "eo"le the benefit of the e#"erience that I have been
through. From a "ractical stand"oint in investing this is hugely beneficial. Every investor makes tons of
mistakes. It doesnMt matter whether they are Warren 0uffett or how long they have been doing it or everything
else "eo"le make mistakes over time. 2hat is not the "roblem. 2he "roblem is sticking to continually trying
to do things that make sense over long "eriods of time.
I think that is the most im"ortant thing to teach "eo"le. What does make sense, .ou are valuing com"anies
and you are trying to buy them at a discount. Pf course you will make mistakes valuing com"anies. 2his is a
guarantee I give to all of my students. I say if you do a good 4ob valuing com"anies the market will agree with
you. It could take two or three years. It usually takes only at most two or three years but eventually the
market will agree with you as long as your evaluation work is correct.
I think statistically that is what we are trying to do with the Magic Formula which is we are buying a grou" of
com"anies that are in good businesses on average that are chea" on average and that grou" of com"anies will
go back to fairly "riced within not too long a time es"ecially if you follow the strategy over a "eriod of years
and you are almost guaranteed to make money over the long term if you are "atient.
2ill )ann8 Why do you su""ose that most business schools teach that those discounts donMt e#ist,
Boel Greenblatt% .ou know I think business schools '+ years ago took a wrong turn into efficient market land
and through it a lot of statistics and issues about volatility and things of that nature. When you go back and
you look at investing as buying a "iece of a com"any and buying it when you think it is at a chea" "rice then
how much the stock bounced around over the last si# months really ends u" being sort of a silly thing to look at
rather than thinking about it as owning a "iece of com"any.
When you actually look at what you are doing which is buying a "iece of a com"any not a security not a
share of stock but you are actually buying a "iece of a com"any all the statistics and all the theory and
everything else that business schools teach end u" making no sense whatsoever.
2ill )ann% 2his has become a very nice advertisement for Dolumbia 0usiness School right, 10aughs$2
Pne of the stories that I really en4oyed from the book was on your first day of class. 2he other thing that you
did was you had someone 4ust name a com"any and you had the business section of the "a"er in your hand and
discussed the "rices how they varied within a one?year "eriod.
Boel Greenblatt8 Jight. What I do is at the beginning of a semester I call out to my students V%ust name a
com"any.V 2hey will "ick GM or GE or Foot :ocker or something ?? Abercrombie and Fitch for instance. So
if you "ick something like Abercrombie and Fitch I will o"en u" the news"a"er and I will look at the 52?week
high and low. So the 52?week high letMs say is <'. 2he 52?week low is '(. 2he com"any is "retty much
unchanged during the course of the year if the stock has fluctuated between '( and <'. If you go over the last
two years it is even a wider range. 2he stock has been between 2( and <' even though this com"any hasnMt
changed very much in the last cou"le of years. !ow is that "ossible, !as the value of this com"any changed
so much during that time, !ow do you e#"lain that, 5oes this make any sense, My students s"end a lot of
$(5
time coming u" with e#"lanations as to why this makes sense and actually there are whole fields of academic
study to e#"lain why this makes sense.
So I ask the Buestion I ask my students Why do you think the stock can be *2( one day and *<' several
months later, 5oes this make any sense, My conclusion is I donMt know why it ha""ens and I tell them I
donMt care why it ha""ens.
2ill )ann% I thank my lucky stars that it does ha""en.
Boel Greenblatt% Jight it does ha""en. All I have to know is that even though the "rice is bouncing around a
lot it is unlikely that the value of the com"any is bouncing around nearly as much. So what the Magic Formula
is trying to do is "ick out those com"anies that are unreasonably low "riced at the times when they are low
"riced. We are doing that automatically systematically by "icking com"anies that have certain characteristics.
2hey are chea" and they are still good businesses.
2ill )ann% .eah and again I think that that is really the core element of sound investing is looking at those
two is looking at those two things. Graham said it and 0uffett said it and now you are saying it.

Boel Greenblatt% Well I like to follow in good footste"s.
2ill )ann% 2he book is called The 0ittle Boo( That Beats the +ar(et and it is available now is that correct,
Boel Greenblatt% It is.
2ill )ann8 PA well fantastic. We wish you the best of luck and thank you so much for s"ending time with us
here at 2he Motley Fool.
Boel Greenblatt% 0ill thanks so much for everything.
2ill )ann% 2ake care %oel.
Bill +ann owns shares o Bennessy &dvisors$
&nother Semester
Greenblatt Class # 1
%an $C 2++5
2his weekend outsiders must email Joel Greenblatt about auditing class.
Summary; 3hat Joel does or a living; buying something or less$ 9pportunity in value investing$ 3hy dont
smart people do betterN 3hy value investing wor(s$ Problems with valuation techniFues$
What is the social utility of "assive investing, 1one that %oel can see. It is similar to being good at "icking
horses at the track. Boel is !ood at handicappin! to ma"e mone.
What does he do for a living, 0uy ' "acks of gum for 25 cents and sell one back each for 25 cents. !e sells (
"acks a day. $5 weeks # () for ) years or GG' # *+.25I ? *+.25I # 5 # () # ) O *C$+.++. !e "ays *$.25 # 2$) O
*2<+.
@ll he does% ,e #inds out what businesses are worth 0 bu them #or less. 2his is the "ower of knowing
the value of a business.
:ook at stocks8 ,Bay from *)' to *$$C. G+ from *2K to *55. &&P0 from *2+ to *<+. -rispy -reme *5+ to
*5.
$()
1ame any com"any8 Why such a GwideI range if the market is efficient, Intrinsic values change slowly but
"rices change ra"idly and widely. 1ote the discre"ancy.
<bserve that prices move around a lot and values move slower. Who knows and who cares, 2his "resents
me with an o""ortunity if I can value businesses correctly. 2he "rice at *(5 or *55??both canMt be right.
0eating the market is not easy.
7alue com"anies
Wait for the right "rice
$. 1eople can=t control their emotions.
2. 1eople don=t do the valuation wor".
2hus "rices move around more than value.
+r$ +ar(et is craHy
!ave a margin of safety
$(<
0ut there is no translation into action for many investors including smart M0As.
Gotham Capital has com"ounded ca"ital at '+> "er year. ,e 'ust does the obvious.
Why has he out"erformed if8 $.I he canMt value better, 2.I !e is no smarter than others,
2ecause o# the wa he loo"s at the world and his abilit to wait #or !ood ris"4reward opportunities.
Simpli# thin!s. If your valuation is good??that is the key. If he canMt value then he walks away. If he canMt
figure it out he walks away. Swing at fat "itches. If it is hard then "ass.
Greenblatt will invest in technology like when those com"anies had tons of cash and he could buy the business
for free.
A good book8 Stocks for the :ong Jun by %eremy Siegel
Why donMt smart "eo"le from Columbia Business School and 3harton do better, 2hey get confused ? 2hey "ut
value investing in the conte#t of efficient markets.
In one year you have a 2;( chance of losing C> or gaining 2C> if you hold for less than $ year.
In $KK) ?ichard P8ena under "erformed the market and lost clients yet he was doing what he always was
doing.
( to 5 years is his minimum time horiHon. 2his is the most inefficient "art of the market.
In 1??? value was dead. For '.5 years there was under"erformance. 9a(mar( fired their manager and
brought in a new guy who ke"t doing the same thing and now is doing great.
/alue investin! doesn=t alwas wor", because i# it did, then it wouldn=t wor". 1This contradiction ma(es
investing very diicult because o the persistence' patience and discipline reFuired2$
:ook at s"ecial situation investing ? uncovered areas a different way of looking at the world. Aee" the
conte#t.
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!ow he sees the world. 1ow he owns three stocks ? concentrated. ,e is not levera!ed. !e believes that the
market will eventually get it right. 2he market can often "resent e#treme values.
S"ecial situations ? 2ime frame involved not so"histicated. 0igger "ick. 0uy a com"any for '.5 # E0I2 the
business will do PA.
Also the way we conduct our "ortfolio. !ow we view risk is different than the norm.
2his course is about what I know. 0asics of finance and accounting. 8his is the course I wish I had while in
business school. Find things worth a dollar and "ay 5+ cents for it9Ben Grahams "hiloso"hy.
2he "ress is de"ressed because something bad ha""ened "eo"le are worried about it. What will it earn two or
three years from now, Most focus on the short term "roblems versus the long term return.
When the smoke clears what will it be worth,
Ben Graham8 0uy for 5+ cents a crummy business but now the *$ is worth <5 cents. 2he danger with buying
-cigar buttsT is that time is the enemy of the bad business.
7alue your businesses and assume it will "ay you. Estimate of growth but donMt know way.
Doncentrated "ortfolio. Gotham returned all outside ca"ital and stayed small. Money Managers focus on ne#t
Buarter.
2here are different ways to value business. 2riangulate or cross?check your work.
5DF Analysis.
Jelative AcBuisition 7alue.
0reak?u" value Greal estateI.
AcBuire value ? discount brokerage has $+++++ clients but worth more to another brokerage firm that has
5+++++ clients. Donsolidation of clients means that a strategic buyer can "ay more.
Flaws with Each 7aluation Method
$. Intrinsic valuation U 5iscounted Dash Flow G5DFI has flaws small changes in in"uts lead to huge
swings in valuation. Rse when the business is very stable and you should be very conservative Gin
your assum"tions of growth and discount rateI.
2. Jelative value ? 6;E similar but other "ublic com"anies are overvalued. Most acBuisitions fail. 6ay
only $;2 of 25+ # earnings. 1ot com"arable ? industry consolidating.
(. 0reak?u" value. Pne division is earning *( "er share while the other loses *$ "er share. So *2 "er
share and if the stock is at *(( then it trades at $< times E6S. $$ # E6S if U G*$.++ close down our
loss divisionI has flaws.
So we use several valuation methods to cross check. Rse conservative assum"tions.
Rse a long?term bond yield. *$;E6S at $).)) #s vs. )> long bond. Dom"are a growing dollar vs. a
certain dollar. )> from govt. bond but if *$ grows then good. If the current long bond GFeb. 2++5I is '>
use )> at least as a minimum hurdle rate or discount rate. !ave a margin of safety.
*2+ ????*$ E6S but the bond yields )> while the stock yields 5> but if it can grow then better.
*$+ ????*$ E6S now but normaliHed earnings show *+.5+. 5o you rather own a risk? less bond or this, Is
it going to grow or not,
$(K
A com"licated ca"ital structure8 buy $;2 cash value and a good business.
/alue Investors= Club H/IC$. $;2 are "rofessionals. 2he rest are so"histicated "rofessionals in finance.
2here are good write?u"s. Why chea",
Some turnover because each member must contribute 2 ideas a year but less than ).
Jeview the a""lication for 7ID.
S$C. Sherritt
ST+$:
J,/
C&B
BI/4U
Groupe Bull
9lympia G& RJ$5A
+S9
BU0$/P
1e#t week8 Income Statement Dash flow and 7aluation Work.
Rse E0I2 not 6;E ratio in your valuation work.
Jead Dha"ters $2 ? $( S $< from !ookeMs 0ook. 2here are some areas in that book where I disagree.
5uff S 6hel"s case study? *52
5;6
?????
Greenblatt Class #2
%an 2) 2++5
Joel will not be having a Feb. K
th
class. Make u" on Friday,
1e#t Dlass we will have ?ichard P8ena "resenting his idea of /?,. 6re"are /?,ddie Mac G/?, ? 1.SEI
Summary; Balance sheet analysis$ Good business and good price$ %u E Phelps Case Study$ ?9, vs$ ?9C$
2oday we will look at 0alance Sheets Income Statements DFs as an investor.
8erms @bbreviations
1et Working Da"ital 1WD or GDA ? D:I
Fi#ed Assets FA
Durrent :iabilities D:
Durrent Assets DA
I. C@S,
We said last week that 5DF is theoretically the way to look at things but it is difficult to estimate the cash
collected over a long "eriod of time. 2he "roblem is figuring that out. Rsing 5DF is like using the Bubbell
Telescope one small change and you are looking at another gala#y.
E#ce"tion for using 5DF.
$. Answer8 A crummy retailer with negative cash flow but great real estate. 2he "ro"erty is worth more
than the 5DFs of the retailing o"erations. !idden Asset that can be eventually but uncertainly turned
into cash flows. Future wealth creation
$'+
2. Another e#am"le8 two discount brokers8 $ has 2+++++ customers and G2I another broker that has
$++++++ customers buys it. After the acBuisition 0roker 2 has $.2 mm customers with same cost
structure. 0roker $ is worth more to an acBuirer who can drive o"erational im"rovement??mostly cost
reduction. 2here is more value to a strategic buyer.
In general 5DF is theoretically the normal way to value businesses. If that is the case then why bother
looking at the balance sheet,
$. More cash on the balance sheet than is necessary. 2he e#cess cash is *5. !ow to value and deal with
the cash, DF from cash Ginterest earnedI an investor must se"arate from the o"erating business.
Forget the interest income line.
2. ,ow will mana!ement deplo cashC 2he *5 is not in your Gthe investorMsI "ocket. What are
managementMs investment o""ortunities, What is the history of the management in de"loying cash,
Dash is easy to see on the balance sheet but that is not the end of your analysis. 2he *5 is not in your "ocket so
what you have to determine based on the history of management the history of the com"any the o""ortunities
in their s"ace what is going to ha""en to that cash, If the stock looks chea" one of the things management
could do with the cash is buy?back stock and accrete value to the remaining shareholders. 2hat would be a
good use of cash assuming the stock was undervalued. 2he com"any could go on an acBuisition binge and
you may or may not like that since <5> of takeovers end in failure you might think that cash will be
dissi"ated. Aou have to determine what will happen to the e+cess cash.
2hough you see the cash??mathematically it is *5?? on the balance sheet you need to determine what that cash
is worth to me the investor. If I think they can grow their business with that cash like buy an add?on ty"e of
business or if they are buying back stock I may give the cash full value. Pr the com"any may sit on the cash
and only earn $> or 2> a year so I discount the cash on the balance sheet. Generally I look at that *5 on the
balance sheet. And how much is it worth to me. I may value it as low as *$ or *2 or at full value.
6on=t 'ust ta"e the E5 at #ace value. If it were all mathematically sim"le the o""ortunities wouldnMt be as
great.
2here is another flaw when you use Enter"rise 7alue. E7 O Mkt.Da". 6lus 1et 5ebt. *) debt N *5 cash O *$
E7. Say a com"any has $ share "riced at *< "er share or a *< Mkt. Da". *5 in cash so E7 O *< mkt. ca" ? *5
in cash O *2 in E7.
.ou estimate that E7 will be worth *( or 5+> higher Gat *2 a conservative 5+> discount to *(I. So you can
lay out *2 in E7 and have something at *( in value. .hat is wron! with that analsisC .ou canMt
immediately unlock the value of the e#cess cash.
0ack to e#am"le8 E7 is *2 and you value it at *( however if you value the cash at "ar you are "utting a big
weight on the *5 in cash. .ou are laying out *5 now for a future return and you may have to wait 2 or ( years.
So *5 N *2 O *< ???????going to *( N *5 O *C. 2he *5 could be dead money so there is less u"side. 1ote
o""ortunity costs.
.ou can wait round for 2 or ( years for +r$ +ar(et to revalue the business. 0ut here donMt be fooled??you "ay
*< for a return of *C after two years??your return is not that high??less than <> com"ounded. G).K(> to be
e#actI.
DS5 5nterprise /alue H5/$ @;@3ASIS
Should we use 6;E or E7;E0I2 analysis, In this class we will alwas use 5/452I8 analsis because in my
2+ years in the business??if you donMt make the best of your business someone will come in and do it for you.
So in one sense in the book I assigned you GSecurity &nalysis by Boo(eI the author says that you donMt have
control over the ca"ital structure of the com"any so 6;E analysis is fine. 2he Dom"any has the debt it has and
you should 4ust leave it at that.
$'$
I disa!ree and thin" ou should alwas use 5nterprise /alue H5/$ analsis not mar"et cap and 5arnin!s
per Share H51S$ analsis. Dse 52I8 or H5bitda L maint. Cape+$.
In general I think the 6rivate Market 7alue G6M7I is the best. Figure out what the whole business is worth to
somebody then "ay a big discount for it.
II. @ccounts 7eceivable ( li9uid in a ear.
Inventories
Jefer to Dha"ter C of Thorton 9=Glove=s 0ook Uuality o ,arnings.
Doncerns8 credit Buality and collectivity. Work in 6rocess GWI6I vs. Finished Goods. :ook at them as risks. If
you sell on credit you can sell more stuff.
Inventories ? salability
Co''odore Int@l ?4F04KN Q Ch!. ?4F04KF Q Ch!. ?4F04K2
;et Sales HF months$ *2''.2 $).< *2+K.( $+2.) *$+(.(
@ccts. 7ec., ;et *25'.< ('.$ $CK.K 5.5 $C+.+
Inventories '(<.' K.< (KC.< 22.+ (2).C
Good inventories only u" 22> and A;J u" only 5.5> in C2?C( while sales are u" $+(>. Dustomers are
"aying Buickly or in cash for a hot "roduct.
!owever in C'?C( A;J ballooned ('> while sales only u" $).<>??note divergence. Inventories only u"
K.<>. A;J u" because of slow "ayers or easier credit terms. Pr because of a sales slow down. .ou look for a
dichotomy between these two things??sales and A;J.
Co''odore Int@l Sep F0, 1?KN Sep F0, 1?KN
Inventories
7aw )aterials and ..I.1. *2'(.2 *2<+.(
>inished Goods *$K'.2 *$2C.'
1ote big 4um" in finished goods/ Pld goods not selling/
1ot e#"ecting as many sales since finished goods "iling u" in the warehouse. 1ow $KC';$KC( receivables are
ballooning 2# as much as sales. 2his Dom"any subseBuently blew u".
Ask if receivables and inventories growth is in line with sales growth. 3oo" #or @berrations and
diver!ences.
5etermine if inventories are good??should I give the A;J and Inventory a haircut,
Dould be an industry in distress. Future sales shoved into inventory. Work in 6rocess Inventory GW.I.6.I u"
5+> while finished goods are u" $+> ? big boom in sales. Dheck the divergence out.
Are inventories and receivables in line with sales growth, Anow what inventories are made u" of.
Aee" the big "icture in mind.
III. Goodwill
1ow some general goodwill is not being amortiHed. *5 2angible Assets with *$+ E67 so "urchase "rice of
*$+ in book value has *5 in goodwill. Pr *5 in goodwill G"remium "aid in acBuisitionI N tangible assets *5 O
*$+ book 7alue.
I originally "aid *$+ but now the value is *< so *( written?off G*$+ ? *<I. 2here is a Goodwill im"airment of
*(.
$'2
Dom"any $8 Durrent Assets of *(
Fi#ed Assets of *2
Goodwill of *5
?Durrent :iabilities *$
0ook 7alue O *K
Dom"any 28 Durrent Assets of *(
Fi#ed Assets of *< Gmore fi#ed assets means more re"lacement cost during inflationI
Goodwill of *+
?Durrent :iabilities *$
0ook 7alue O *K
0oth com"anies earn *2 "er share in cash. .ith compan 1, ou don=t have to replace tan!ible assets so
ou would pre#er the business with !oodwill. :ess tangible assets means more investment to re"lace those
assets in order to kee" the business running as is. I GinvestorI "aid a "remium over the tangible assets of *5
because of the high Earnings 6ower 7alue of the business. Pnce I have "aid that "remium I own the business
and the greater returns will allow me to grow with less investment in fi#ed assets. I don=t have to "eep pain!
the premium over tan!ible net assets. HWE0 e=&lained this in his /A)A ann1al re&ort).
Durrent Assets ? Durrent :iabilities O Working Da"ital GDA?D: O WDI.
Capital emploed8 1WD N FA. So Dom"any $8 WD O *2 N FA O 2 ???*' in ca"ital. JPID O *2;*' O 5+>. *2
in cash earnings "re?ta#;total investment ca"ital O *2;*' O 5+>.
For every *$ invested the business earns 5+ cents. 2his
business doesnMt need a lot of Fi#ed Assets to grow. .ou
would have to buy less FA to grow than Dom"any 2.
G:ess ca"e# reinvestedI.

Dom"any 28 WD O 2 N FA O *< ????*K in ca"ital. JPID O
*2;*K O 22>. For every *$ invested it earns 22 cents.
2here is goodwill on the balance sheet because before someone "aid less than me. Asset heavy.
Accounting records what you or someone else "aid in the "ast.
@lwas loo" at pre(ta+ return. E0I28 Earnings before Interest S 2a# or P"erating Income. E0I2 allows an
a""les?to?a""les com"arison between com"anies because firms have different ta# and interest rates. !ow much
the business is earning regardless of the ta# rate or interest "aid or owed. !ow much is the business earning,
!ow much is the business earning to make an acBuisition, !ow much of a dollar of sales dro" to o"erating
earnings??the bottom?line.
E0I2;G1et Working Da"italI N 1et Fi#ed Assets or E0I2;investment ca"ital.
E0I2 is your "re?ta# return;what ca"ital that had to be em"loyed to generate that E0I2.
DA ??????A;J ? D: ????????A;6 G/?,e loanI. Assume no e#cess cash or take out the e#cess cash and add
back after your analysis. .ou have to finance these receivables minus the money that is lent to you /?,ely
through A;6.
Pn the denominator we take the 1et Working Da"ital??what you need to run your business "lus you need to
finance your fi#ed assets or your "lant and eBui"ment. Forget goodwill and everything else.
What you need to generate E0I2 is in your 1WD "lus Fi#ed Assets ?????? Jeturn on Invested Da"ital GJPID or
JPDI. E0I2 ; G1WD N FAI or o"erating income;invested ca"ital.
$'(
Which is the 0etter 0usiness,
GBM !6>RE
Jason o"ens a gum store for *'+++++ which includes WD N Inventories N FA and building?out the store.
Every year he makes E0I2 of *2+++++. !e makes *2+++++;*'+++++ O 5+> Jeturn on ca"ital GJPDI.
JB!6 0R>CC>LI
1ow he has a friend named Jimbo who o"ens a store Just Broccoli and he made *$++++ for each store he
o"ens. *$++++;*'+++++ O 2.5> JPD.
Who would you give money to e#"and, Give ** to Jason because of higher JPD.
.ou want to ask how much it costs to e#"and and how much will you make on the investment,
0e in a business earning high JPD. 0orrow $+> to make 5+>???that is a good deal.
:ook at "reta# rate to sim"lify. Dom"are "reta# return to "reta# return.
Jimbo is really throwing money away earning a 2.5> JPD vs. a )> risk /?,e rate from govt. bonds. !e is not
earning 2.5> but losing (.5> G)> Jisk /?,e Jate ? 2.5> return earned from his storeI. P""ortunity Dosts.
Aour !oal as an investor% ou want businesses that are earnin! hi!h returns on capital and returns above
our cost o# capital.
Rsing ca"ital regardless of how fi#ed assets are financed. !ow good a business is this Gnot measuring eBuityI,
If I "ut in * how much do I earn on it,
5enominator is ;.C T >@??why using net and not gross working ca"ital, Pn average that is the right thing
to do. 0ecause in general what ha""ens to your fi#ed assets you buy something and you de"reciate the assets
so the value of your asset goes down but to maintain your asset there has to be on?going ca"e#. 5e"reciation
and Da"e# cancel out Gassume 5e"rec O Maint. Da"e#I. If ca"e# is more than de"reciation then FA will
increase accordingly and you will be u"dated. If you are in e#"ansion mode you build new stores and the FA
balloon before you earn on those assets so your JPD will decline??so you must normaliHe or ad4ust for that.
Fi#ed Assets minus de"reciation "lus Maint. Da"e# is why I use a 1et number.
So 1FA N 1WD is what I look at. A Buick and dirty analysis. We only buy a few situations. We may have to
look at 5+ to $++ situations to buy $ or 2. 5ro" or evaluate to study further. 5o intensive research on a few
things. Gotham Partners are very selective in our investments.
5+plain the bi! picture. .our "redecessors GM0AsI failed over a long "eriod of time. It has nothing to do
about their ability to do a s"read sheet. It has more to do with the big "icture. I focus on the big "icture.
8hin" o# the lo!ic, not 'ust the #ormula.
Thorton 9=Glove was recently interviewed and he wrote the book Earnings =uality. I looked at the footnotes
but they are not the big "icture. 5onMt lose the "ers"ective of the big "icture. :isten I lost the big "icture.
Savvy guys say the footnotes are im"ortant but thin" o# whether it is a !ood business and am I !ettin! it at
a !ood price.
$BFF C ;EL! 5+ample
2he "roblem with E0I2;ASSE2S O *2C.';*''.2 O )'>. What is wrong with that, 2ake out goodwill of *2$.<
million. E0I2;2angible Assets O $2)>. Fantastic returns/
E0I2;G1WD N FAI or Gtangible assets ? current liabilitiesI. D: or 1on Interest 0earing Durrent :iabilities
G1I0D:I
$''
2his is a great business because it is asset light but with huge returns to ca"ital. 2he business needs little
ca"ital to grow. It drowns in cash.
Student% after?ta# E0I2;E7 is ).5> or about the :2 0ond Jate. !old.
E0I2;Assets O 2C.';''.2 O )'>. 2ake out Goodwill of about $;2 the assets.
Boel%
Pver $++> return on tangible ca"ital. 2his ha""ens to be a great business with huge JPD.
.hat to >ocus on%
$. First I am looking for good businesses. E0I2;G1WD N FAI or E0I2;2angible Assets. 2his is what
the business is earning "re?ta# or "re interest cost or benefit.
2. 2hen a bargain "rice8 E0I2;E7 or my earnings yield. 2his is what I am "aying for those "re?ta#
earnings. *$++ "aid but earning *K so the yield is K>.
(. Is the earnings stream growing declining or staying the same, !ow confident am I of this, I focus on
normaliHing earnings two to three years out instead of all the little "roblems in the near?term. 6ro4ect
my E0I2 two years out??will it be at risk will it be growing or shrinking, !ard stuff. 6ro4ect my
E0I2 two or three years out. 2his is where your circle of com"etence is im"ortant.
'. !ow much am I "aying relative to my normaliHed earnings, If the K> yield is growing Buickly??it
could be a good buy. If it is a business with high JPID then good. Am I getting a good "rice, !ow
much am I "aying, Am I getting a good return,
5. If I am unable to normaliHe earnings then "ass on the o""ortunity or set aside.
8he hard part is determinin! the normaliGed number and what is happenin! to that number. ?egression
to the mean$
If I can figure the normaliHed E0I2 three years out how confident am I of that, Is this a good franchise or not.
What is my JPD, !ow confident can I be of the future, 2his de"ends on the 0arriers to Entry com"etitive
advantages and management etc.
2hen how much will I be "aying for that,
I loo" at thin!s in that simple wa. Most of the time I canMt "ro4ect normaliHed earnings. 0ut when I can then
I have confidence in the business. 2he s"ace is growing their new stores will be earning a lot. 2he business has
a franchise.
Sim"lify
%ust :earn to first ask8
Good 2usinessC Is this a !ood priceC
E0I2;1WD N FA Gor 2A ? D:I
6re?ta# o"er. inc.;Inv. Da".
Is this a good business with normaliHed earnings
and future normaliHed earnings,
E0I2;E7
6re?ta# o"er. inc.;Enter"rise 7alue
Am I getting a bargain "rice,
$'5
Pnly invest where and when you have confidence. .ou donMt have that lu#ury. If you have a choice then wait
for the "erfect "itch. If a business or a normaliHed return "roduces less than 2+> "re?ta# the investment must
have more going for it than that.
When interest rates are below )> Glike today '.5>I I use )> because when Interest rates are less than 2> you
get craHy multi"les. Rsing )> or above is an added margin of safety.
Student% Mgt. is getting too much money. Greenblatt8 this is a brains business so you might need mgt. !e
likes to have management incentiviHed with shares.
So the com"any is earning *2 "er share but you feel normaliHed earnings three years out will be *5 "er share.
Rsually what ha""ens is that when you grow sales you have to grow 1WD and FA during that time. 5onMt
fine tune it. I am trying to choose between the 0roccoli Store with 2.5> JPD and the Gum Store with 5+>
JPD. 2he choice should be obvious.
Sales growth
Every dollar at %u E Phelps of FDF can go to buying back shares. E0I2 growth of 5$> in $KKC. %um" in
sales growth due to structured finance.
2he business is a semi?oligo"oly. Firms need to have bonds rated by an agency like %u E Phelps SS6 or
+oody=s$
2his is a good business
Rse of cash to buy back stock.
0ecause of share buy backs then 1et Income grew at $C> while E6S grew faster at 2K>.
Sales growth of $(> to 25>
In 5 ears, what would $122 C hel&s loo" li"eC
$. 2C.' E0I2 grows at 2'> "er year because it is a good business and has a niche with Barriers to ,ntry
1B4t4,2 and Competitive &dvantages 1C&s2$
%u E Phelps is using all their earnings to re"urchase stock. Assets are not growing des"ite sales growth of
2+> ? 25>. It only has tangible assets of 2( mm??only growing by *2 million over five years des"ite sales
doubling. 2hen looked at E0I2 growth. 5$> growth in $KKC due to increase in the structured finance area.
2heir business could grow without increases in assets. 2here is good increase in sales and FDF without adding
investment.
All in all this business looks good. Every nickel used to buy back stock so a good use of cash??E6S growing
faster than earnings.
What would this business look like in five years,
Greenblatt ma"es three assumptions #or three scenarios%
If we donMt have confidence in our estimates this is a waste of time. E0I2 grows faster than sales. E6S grew
at (+> "er year and sales grew at 2+> "er year.
$. grow C>8 E0I2 of *2C.' ???*'$.2 N *2 million O *'(.2 # C multi"le O *('$;(.'5 mm PS O *KK "er
share.
2. grow $(> *52.( N *2 O *5'.( # $( O *(2.5C after?ta# O *$22 "er share.
(. grow 2+> O 2C> annualiHed return over five years O *$)' "er share.
$')
What about cash earned over 5 years, I will assume that I will add the cash to the balance sheet. 0ut in this
case I assume for every *$ there is a buy back of stock. Assume "rice is u" C> "er year. All their earnings
used for share re"urchase. ('<+++ shares "er year bought back??so reduce at the end of five years by $.5 mm
shares. 5 mm ? $.5 mm F5 outstanding shares O (.5 mm outstanding shares. Pro$ Greenblatt noticed the
declines in outstanding shares because of continuous share buybacks.
1lace a Mar.in o2 !a2ety in our assumptions b bein! conservative. At most an investor will lose cost of
carry if the business doesnMt grow.
Sim"licity of e#ercise. In footnotes ? "ut *2 million back. Mgt. owned 25> of com"any so management is a
big stakeholder. A good sign of management alignment with investors.
<.C> after?ta# yield for a $( 6;E vs. )> bond.
0arriers to Entry with huge JPID. !e learned from this to invest in +oody=s. !e invested in +oody=s at 2+ #
E6S for a 5> yield which was less than )> bond yield.
3earn an industr. 0ecause of studying 5uff S 6hel"s he knew to look at MDP when it was being s"un off.
$(> growth in five years O *$22. It turned out that 2'> growth a year was conservative.
@ssessin! )ana!ement%
2he trick is that if a DEP is being "aid *5+++++ a year then $;2 million "oint for every *$ u". Where is their
bread buttered, Pro$ Greenblatt wants mgt. to be large stakeholders relative to their salary. 2o fight or change
management there is not a lot you can do e#ce"t by a "ro#y fight.
Mgt. of %u E Phelps s"ent *'.5 mm buying back stock in $KK) *$(.K mm in $KK< and *$).< in $KKC.
1et Income of *K mm in $KK) *$+.< mm in $KK< and *$).< in $KKC.
-5A 8< 35@7;%
Step 1% Good 2usinessC
E0I2;G1WD N FAI
P"erating Income;1et 2angible Investment
Step 2% 2ar!ain 1riceC
E0I2;E7 or
Enter"rise 7alue;P"erating Income
Dan you normaliHe E0I2 or not, )> GRS :ong term bond yieldI is the bogie to beat. $).)) # 6;E vs. )> RS
bond yield. $+ # E0I2 is my initial bogie. Growing or Shrinking,
Gotham Capital invests in a very focused "ortfolio of ( to K "ositions.
!ave a focused "ortfolio. Pnly do things you feel comfortable about or know a lot about.
!ow to ad4ust to this framework to new stuff like s"ecial situations, !ow to create o""ortunities and e#"and
our universe, )> is eBuivalent to8 *$).));*$.++
?????????????????
8he point o# the $122 C hel&s e+ample is the simplicit o# the e+ercise and the di##erent thin!s ou need
to thin" about. If you looked at the footnotes you see they would sto" "aying *2 million a year. What are
they doing??buying back stock. Mgt. owned 25> of the com"any so they were stakeholders. 2he business
had a franchise. 2here were barriers to entry.
<.C> after?ta# yield GC 6;EI or )> bond, I would rather own %u E Phelps Jarely will you find a business
this good in your travels. In fact the only other business I found was MoodyMs when it was s"un off when it
was selling 2+ # earnings or yielding 5>. 2heir earnings were tem"orarily de"ressed.
$'<
I saw this opportunit because o# m prior stud o# this industr. Rltimately /itch took over %u E
Phelps at *$++. In one year we got *$++. 2he ga" between "rice and value closed Buickly. @ll "nowled!e in
this business is cumulative.
End of lecture.
??????????????
Band49ut www.sherlockinvesting.com
7eturn on 59uit or 7eturn on Capital% .hich is the better !uide to per#ormanceC Bohn 1rice.
2wo brothers &be and Xac both inherited *$+++++ and each decided to start a "hotoco"y business. After one
year &pple the com"any started by &be had an after?ta# "rofit of *'+++. 2he "rofit from Xebra Xac=s
com"any was only *(+++. Who was the better manager, For sim"licity su""ose that at the end of the year
the eBuity in the com"anies had not changed. 2his means that the JPE for &pple was '+> while for Xebra it
was (+>. Dlearly &be did better, Pr did he,
2here is a little more to the story. When they started their com"anies &be took out a long?term loan of
*$++++ and Xac took out a similar loan for *2+++. Since ca"ital is defined as eBuity "lus long?term debt the
ca"ital for the two com"anies is calculated as *2++++ and *$2+++. Dalculating the return on ca"ital for &pple
and Xebra gives 2+> GO*'+++;*2++++I for the first com"any and 25> GO *(+++;*$2+++I for the second
com"any.
So for this measure of management Da# did better than Abe. Who would you invest with,
6erha"s neither. 0ut su""ose that the same benefactor who left money to &be and Xac also left you *$++ with
the sti"ulation that you had to invest in the com"any belonging to one or other of the brothers. Who would it
be,
Most analysts once they have finished talking about earnings "er share move to return on eBuity. For "ublic
com"anies it is usually stated along the lines that eBuity is what is left on the balance sheet after all the
liabilities have been taken care of. As a shareholder eBuity re"resents your money and so it makes good sense
to know how well management is doing with it. 2o know this the argument goes look at return on eBuity.
:etMs have a look at your *$++. If you loan it to &be then his ca"ital is now *2+$++. !e now has *2+$++ to
use for his business. Assuming that he can continue to get the same return he will make 2+> on your *$++.
<n the other hand, i# ou loan it to Xac, he will ma"e 25Q on our mone. From his "ers"ective Xac is
the better mana!er since he can !enerate 25Q on each e+tra dollar whereas &be can onl !enerate 20Q.
25> return vs. 2+> on total ca"ital em"loyed.
2he bottom line is that both ratios are im"ortant and tell you slightly different things. <ne wa to thin" about
them is that 7<5 indicates how well a compan is doin! with the mone it has now, whereas 7<C
indicates how well it will do with #urther capital. GIn a later article I will e#"lain in more detail how to use
JPD to estimate the growth of earnings.I
0ut 4ust as you had to choose between investing with &be or Xac if I had to choose between knowing JPE or
JPD I would choose the later. As I said it gives you a better idea of what a com"any can achieve with its
"rofits and how fast its earnings are likely to grow. Pf course if :2 debt is small then there is little difference
between the two ratios.
3arren Buett is well known for achieving an average annual return of almost (+> over the "ast '5 years.
0ooks and articles about him all say that he "laces great reliance on JPE. In fact I have never seen anyone
mention that he uses JPD. 1evertheless a scrutiny of 2he Essays of Warren 0uffett and 0uffettMs :etters to
Shareholders in the annual re"orts of his com"any 0erkshire !athaway convinces me that he relies "rimarily
on JPD. For e#am"le in one annual re"ort he wrote V2o evaluate Geconomic "erformanceI we must know
how much total ca"ital??debt and eBuity??was needed to "roduce these earnings.V When he mentions JPE
generally it is with the "roviso that debt is minimal.
$'C
If your data source does not give you return on ca"ital for a com"any then it is easy enough to calculate it from
JPE. 2he two basic ways that :2 debt is e#"ressed are as :2 debt to eBuity G52EI and as :2 debt to ca"ital
52D. G52D is also referred to as the capitali8ation ratio.I In the first case JPD is calculated from JPE by
7<C U 7<54H1 T 685$ and in the second case by 7<C U 7<5 + H1(68C$.
For e#am"le in the case of &be we saw 52E O *$++++;*$++++ O $ and JPE O '+> so that according to the
first formula JPD O '+>; G$N$I O 2+>. Similarly 52D O *$++++;2++++ O +.5 so that by the second
formula JPD O '+> # G$? +.5I O 2+>. .ou might like to check your understanding of this by re"eating the
calculations with the results for Xac=s com"any.
If you com"are JPE vis?a?vis JPD for a com"any like General +otors with that of a com"any like Gillette
you will see one of the reasons why 0uffett includes the latter com"any in his "ortfolio and not the former.
5;6
??
Greenblatt Class #F
7ichard 1Gena 1resentation
February +2 2++5
1e#t Friday GFeb. $$ 2++5I K8(+ AM in classroom (2K.
Summary; ?ichard P8enas Presentation on /reddie +ac 1/?,2$ 3hy :alue Investing wor(s$ ?egression to the
mean$
Joel Greenblatt Introduction% ?ichard P8ena is the smartest guy on Wall Street that I know and "robably the
smartest guy I know.
5onMt let that discourage you. .ou donMt have to brilliant to be successful. Most of us are intelligent but not
brilliant. .ou can be average and do very well. And without further undue@@
?ichard P8ena8 We will talk about /reddie +ac 1/?,2. I forgot what the annual re"ort of FJE looked like??
and I think this is one of the reasons why value investing works 1?ich P8ena holds up the annual report o /?,
which is J"" pages long2' because you have to read this kind of stuff and you have to try to make sense of it.
And it scares most "eo"le when they read about the "roblems of /reddie +ac.
Why 7alue Investing Works
Some of the evidence for why does this style of investing work. I try to use real e#am"les of the kind of things
that "eo"le are forced to invest in to be true value investors. And maybe it will give you a sense of the human
nature and the behavioral "sychology that creates value o""ortunities. And why they will continue forever.
2he data is fairly com"elling. 2here have been many academic studies over the course of time trying to find
the best things that work in the stock market. What works on Wall Street is a book that tests every available
metric. 7alue metrics whether they are low "rice to DF 07 or sales or low E7;E0I2 tend to be a good
"redictor of future "erformance. 2hat seems silly as you can get because you would think these o""ortunities
are arbitraged away.
If I were going to look from the $K)+Ms G'5 yearsI to 2++'. 2he SEP )"" "erformed $$.5> a year. If you took
some sim"le metric of valuation??lowest "rice to book value Buintile??and bought the chea"est Buintile. .ou
would make about $<> or 5.5> out?"erformance "er year for '5 years or C times as better.
!ow can that be, 2here are a cou"le of e#"lanations8 2he tendency of "eo"le investing in markets is to act
like human beings. Well what does that mean, 2y"ically this is how they forecast8 they sim"ly e#tra"olate
trends. Good businesses continue to do well3 bad businesses continue to do "oorly3 and stability stays stable.
$'K
6eo"le forecast by looking at the "ast Gdriving while looking through the rear?view mirror93arren BuettI.
6eo"le use that history to e#tra"olate into the future.
0ut the actual behavior of com"anies es"ecially at e#tremes does not look anything like that. 2he actual
behavior is re!ression to the mean. 1ote decline of high JPE com"anies and rise of low JPE Dom"anies.
If you use any "rofitability metric like JPID Margins or JPE you would find that the best com"anies start in
the to" Buintile Gbased on "rofitabilityI and I will track their "rofitability over the course of time. What would
I find@@I would find a slow deterioration to the mean. 6eo"le assume that the "rofitability will continue so
they "rice these com"anies at very high "rice to book so they might be "riced at 5 # book value but earning on
average (+> JPE while the lowest Buintile might be "riced at $ times book value with a JPE of 2>. Many
"eo"le would say well these com"anies with the (+> JPEs are 4ust better. So "aying 5# times book for (+>.
I get G(+>;5I or )> vs. G2>;$I 2> return so those com"anies G(+> JPE com"anies are better.
2he data we use does not have a survivorshi" bias so it includes the com"anies that go bankru"t. What
"ercentage of the lowest Buintile com"anies go bankru"t, Pnly $ "ercent.
A Solid Statistic over time 1 ear 5 ear 10 ear 20 ear
$<> vs. $$.5> out?"erformance )5>
"robability
C5> K5> $++>
2hat is looking back over time. Pbviously that doesnMt guarantee what the future will be but it doesnMt seem to
change with time. With every generation there seems to be a .ity /ity the Internet Bubble. 2here is
something that gives rise to unbelievable valuation s"reads des"ite the lessons of history for $++s of years.
Why,
!ave you read books from the .ew ,ra, Pne book said that the historical rules of su""ly demand had been
re"ealed. 2he greater the su""ly the higher the value. 2he greater the su""ly the lower the "rice but the
higher the value. 2hose were the books that "eo"le were reading and believing. .ou look back on that and
say what were they thinking,
2oday we have gone almost back to the other e#treme. 2oday "eo"le are looking at commodity businesses that
are clearly bad businesses with decades of history of lousy returns on investment. 2he only thing today that
counts is "hysical "ossession of steel oil or lumber.
.ou have better odds in the value cam" because ou are plain! in a better #ield. So if I was mediocre I
would beat the market.
2ut to be !reat one must distin!uish??what this tells you Glowest BuintileI is that those com"anies are
e#"eriencing "roblems3 some are e#"eriencing tem"orary "roblems. 8he wa ou can add value is to
$5+
2ime8 Donvergence to mean
!igh to
low
7<5
/alue Investor8
Invest in fifth Buintile8
:ow "rice;0ook or 6;E
@dd /alue8
:ow value due to "ermanent or tem"orary
"roblem, 5etermine the difference.
distin!uish between temporar and permanent problems. .ou can avoid the bankru"tcy issue by avoiding
the com"anies with debt.
0ut some of the $<> return comes from taking that bankru"tcy risk. !ow many managers can claim for '+
years to have returned $<>, .ou would have C times as much money returning $<> vs. $$.5> after '+ years.
AnalyHing Dyclical Stocks
Student8 !ow to value cyclical stocks, !ousing Stocks have low "rice books with high JPEMs. Is that the
best of both worlds,
3ena8 I would believe that those housing stocks have no chance of maintaining that "rofitability. 2hat would
scare me. If you bought into the home builder story??all the mom and "o"s are out of businesses and the
industry is consolidating??those earnings will be sustainable. Pne "ossible e#"lanation.
Any "roblem with highly cyclical com"anies with a "rofit margin swing??you get booms and busts in demand??
letMs use steel??the "rice goes from *2++ a ton to *)++ ton and now you hear it is a -newT world. Dhina had
huge demand there will be shortages of material. It ignores $+++ years of human behavior. .ou build a lot of
steel "lants. .ou canMt ignore the su""ly side issue. What sets the "rice is the amount of su""ly Gand the
number of "lants builtI. When su""ly comes on it comes on in huge amounts. 2here is a sudden shift in
su""ly.
2he electricity market had a su""ly "roblem8 Calpine had huge GhighI JPEs "ower "lants will never be built
due to environmental issues. So Calpine gets valued at 2 times the re"lacement costs of a "ower "lant. So
they have *$ billion in "ower "lants but they are valued at 2 times. So what should CalpineMs business strategy
be, In one year they added 2+> to su""ly. It is rare to find a sustained commodity "eak because the su""ly
side9the increase in su""ly in res"onse to high "rices. The law o supply E demand is immutable$
!ome builders have a history of "oor returns on eBuity and now all of a sudden they are having s"ectacular
returns on eBuity.
:ast week I visited a home?builder. What I heard was in 2++' they built (<+++ homes and their "lan for 2++)
is to build )++++ homes. 2hey acBuired all the land and infrastructure. When you ask what about a
downturn, 2heir res"onse is that you do not have to worry about a downturn because the little guy will suffer.
When you ask the regional guy what he will do he says that you cut the "rices Buickly and move the inventory.
5onMt worry we will take it out on the contractors.
8he whole purpose o# price ccles is to chan!e behavior. 2he market canMt absorb the new su""ly. It is not
4ust them but all their com"etitors who re"licate the same strategy. It will ha""en Gthe cycle turnsI but I donMt
know when it will ha""en??ne#t year or the following year but it will ha""en.
I am not saying that the "eak canMt go on for awhile but you are "laying with fire in that kind of investment.
2his is momentum investing. I am going to ride this bubble and get out before the market turns. I can show
you statistical evidence that momentum investing works. 2here is a serial correlation between what ha""ens
today vs. what ha""ens tomorrow. If todayMs earnings are good then there is an C+> chance that tomorrowMs
earnings will be good.
When the market turns it turns violently. 2he "eo"le "laying momentum are s"ending every day on the "hone
with the homebuilders asking how many "eo"le looked at homes.
While I do believe value and momentum investing are sensible strategies??I have a lot of trouble understanding
growth investing.
If I randomly buy the highest growth stocks I will lose. 2he higher the growth rate the lower the returns??
why, 2ecause everone sees the same thin!. In fact if I did the same gra"h as before substituting growth
rate for returns I would get e#actly the o""osite??the higher the growth rate the lower the returns. Why,
Everyone sees the same thing so they "ay a high "rice. 0ut what are the odds of such growth continuing, If
you were to study com"anies with a billion dollars of market ca" about $2++ of them what "ercentage of
$5$
those com"anies have sustained $5> growth rate for ten years based on historical analysis??less than five G5I
"ercent. It is reall, reall hard to have !rowth rates o# 15Q #or ten H10$ ears.
6eo"le when they do growth stock investing are com"aring 6;E to growth rates as if those growth rates would
continue forever as if the growth rate will never change. So when you try to understand the valuation of
Cisco the reality is that Cisco sto""ed growing as fast as the market ho"ed. 2hey GinvestorsI had to believe to
"ut a 5++ billion valuation on a com"any that was earning *$billion. 2hey had to believe that *$ billion will
grow a lot. .et the odds are so heavily stacked against you in that kind of a bet it doesnMt seem reasonable to
try to make that bet. 2hatMs the fundamental under"inning.
:et us actually take a look at com"anies trading at low "rice to book.
Student8 In the homebuilderMs e#am"le why did you go out there to visit them, 5id you go there to think
about shorting stock,
3ena8 I went there for educational "ur"oses because I want to be ready buy when the colla"se comes. I
conclude that the colla"se will be very s"ectacular. !istorically these com"anies have sold below their book
value when they have colla"sed. 2he argument today by the homebuilders is that their book values are
understated because the value of the land has gone u".
I have no doubt that that is true but also there are at least $+ other "ublicly traded com"anies which are well?
financed bidding "ro"erty values sky?high. 2hey are doing it using o"tions but they are giving a lot of the
economics away to the land?owners. 2hey will do fine as long as they are bailed out by rising "rices.
2hey do all their economics assuming no "rice rise and they only do "ro4ects with a 2+> rate of return. 3ena
asked the Dom"any V!ow would you have done over time using that metric,V If we were not bailed out by
rising "rices we would not have made it on a single develo"ment. I believe it because 2+> is a ridiculousGly
highI return. 2he reason they donMt make their numbers is because develo"ing "ro"erties is difficult and they
donMt ha""en on the time schedule they e#"ect. So when housing "rices are rising they have windfall "rofits.
Student8 When would you buy the homebuilders,
3ena8 I would bu the homebuilders when their 7<5s are below normal??not when they are above
normal. If you read in the news"a"ers that Pulte has an inventory of unsold homes or where margins have
colla"sed. 2he bad news is "ublic. 10ower prices have already discounted bad news2$
S5@7C, C7I857I@
I look for three things8
$. :ow valuation
2. 2he business is good so it should earn a decent return on invested ca"ital
(. 2he current earnings are below normal.
When you are "laying around with earnings above normal??and obviously you have to make some 4udgment
about what VnormalV earnings are??even the Pulte=s GhomebuildersI of the world say their margins are above
normal. 2his is not a normal environment for housing "rices. So I would wait for the o""osite then you win
not only from valuation but a "ositive change in earnings. It is much better to be riding a "ositive wave in
earnings vs. a negative wave in earnings even if the valuation is chea".
!ousing Economics
Student8 !ow would you look at the unit economics of the housing cycle,
3ena8 I would look for some signs that ordering rates are slowing. :ook for cancellations and slowing
develo"ment. What ha""ens if interest rates rise and "eo"le cancel, Everyone will cancel so now the
$52
homebuilders have unsold inventory??what do they do, 5iscount the "rice ra"idly. .ou can monitor these
things on an on?going basis.
???????
Screens8 :ow "rice to book.
What do we have on low "rice to book stocks,
Student8 A lot of us had :on +ueling=s class and his criteria are hi!h 7<5 stoc"s and low price to boo"
value or low 145. What are your comments for that strategy,
3ena8 I would Bualify it G:on +ueling=s strategyI and say that the current JPE is not the correct or
VnormaliHedV JPE. If I can buy low 6;E and high normaliHed JPE that combination is good. I would want to
do that too. .hen ou do current hi!h 7<5 as a metric, ou will tend to pic" everthin! at a cclical
pea". 2he earnings are above trend so the 6;E is low and has a high JPE. .ou will be buying every
commodity or manufacturer Glike todayI at its cyclical "eak. 0e careful of blind screens.
.ou would have to believe that those earnings are not sustainable so you will not use those earnings in the
current 6;E ratio.
.e don=t invest in thin!s where we can=t #i!ure it out li"e the #ashion industr, #or e+ample li"e Reebo5.
We call u" the com"any and the issue was that they did not have the right fashion in the stores so ne#t year
they will. And they did but we couldnMt figure it out.
I donMt invest using "rice to book. I am 4ust telling you that it works. PA. It is a nice sim"le thing to use. I use
price to normaliGed earnin!s. I want some downside "rotection in case I am wrong in my analysis. 2hat
may not be assets it may be the com"anyMs franchise or base of business. I am not wedded to 6;0
methodology. We miss many "otential o""ortunities.
Student8 !ow do you define VnormaliHedV earnings,
3ena8 I define normal as what should the business earn given the industry structure given the com"etitive
strengths and weaknesses given the management??it is a 4udgment but is highly a function of history. !istory is
usually a good guide of what the business is ca"able of earning??es"ecially if you take a long history.
I would look at five years of history of JPEs and if it looks good or if I looked at the com"any;business and it
is in an incredibly com"etitive business;industry and I think they got lucky for five years. 2his is why I think it
was luck and not returns based on the structure of the industry.
???????
I know U.U+ P?9:I%,.T 1U.+2. 2he com"any offers individual and grou" disability insurance. It is a
notoriously bad business. 0ecause their selection of customers tends towards adverse claims. 2he com"any is
stuck with tons of adverse "olicies. If you start reading about U.U+ you would say I have no idea what the
book value really is so I am going to "ass.
:etMs go ??Time 3arner has lots of goodwill on the books??they havenMt written off &90 yet. As soon as they do
then I will look.
We ha""en to be in a "eriod where there is not a lot of controversy in the world. 1ormally you would find
every airline stock as a low "rice;book "ortfolio. 2hen you look at that so you walk away because of all the
bad stuff they read about the com"anies and industry. 2hey are too risky Jetblue is killing them. And yet they
should do well Gthe bad news is already "riced inI. 0uy airline stocks for e#am"le today.
In fact I always 4oke is that the most common Buestion I get from my clients is8 V5onMt you read the "a"ers,
!ow could you buy /?,N 2he DEP of /?, is a crook. :etMs sto" for ten minutes and return at 28(+.
/reddie +ac 1/?,2
.ou can buy good business at low "rices. First we need to define what a !ood business is8
$5(
,i!h pro#itabilit8 high JPID JPE JPA margins??/?, has high JPE. We tend to use current
eBuity because it is a regulatory constraint and a growth constraint. Pver history /?, has had a high
JPE.
2arriers to 5ntr??/?, has a government charter a Buasi?govt. status that allows them to access to
credit markets that others donMt have.
1ricin! 1ower??/?, has a cost advantage due to its access of lower cost credit.
Growth <pportunit??/?, is holding and insuring a "ortfolio of mortgages. 2heir business is tied
to the debt outstanding. 2he trends are very strong??)+> to <+> home ownershi" with a booming
mortgage market. Dredit has been available and lower interest costs have driven demand. 2he
demogra"hics are favorable for growth. What is their addressable market8 total mortgage debt
outstanding. Forecast growth in mortgage debt outstanding.
>avorable Industr Structure((/?, is one of two "artici"ants
1ow we say our ob4ective is??we see all of the above??in general we seek a low "rice low current "rofitability
and a good business. Are those all mutually e#clusive, 1ot really. A good business to me could be having
some sort of tem"orary "roblems. If you can find that combination you can make a lot of money. 2hat is
what we seek. 2hat is it. It is "retty sim"le to say.
;ow let us tal" about Freddie Ma#. >irst, wh is this a !ood businessC
2he trends are strong??looking at the last $+ years the rate of homeownershi" has gone u" to )+> almost <+>
so you have had a booming mortgage market historically you also have had??you could say that trend has
"eaked. 0ecause why has that ha""ened, 0ecause interest rates are low because credit is available. It is
chea"er to buy a home than it is to rent an a"artment. :et us stay with the conce"t of demogra"hics.
What is their addressable market, 0asically mortgage debt outstanding??total mortgage debt outstanding.
!ow would you forecast growth in mortgage debt outstanding for the ne#t ten G$+I years,
!ousehold formation is growing8 $?$.5>
6rice of housing8 the median "rice of a house has never declined8 '>
!ome ownershi" rates8 $>
Donvert credit card debt to 2
nd
mortgage debt8 $.5>. 8otal 7.5Q
If you ask /annie +ae G/.+2 or /?, about this??they would say <.5>. I think it will be less than that. Is that
good, .es it is better than the 5> nominal economic growth of the economy.
What do you think the growth rate of the SS6 5++ has been over nominal G56, It is actually a little slower
than G56 because the big com"anies grow less fast than smaller com"anies. Pver time the SS6 5++ trails
nominal G56 by $>.
I would rather have the money now than in the future. If it is chea" and I can get the money now then great.
If you donMt have to "ay for the growth??I love that.
What are the negatives for /?,, A big risk8 /?, is under the whim of the govt. to "ull their charter. 2he
structural risks in the financial markets. Pn the other side "eo"le will say that the govt. wonMt mess with this.
8he DS is the onl countr in the world with a F0(ear #i+ed rate mort!a!e mar"et where ou can
borrow K0Q o# the value o# our house. :ook at the history of this country "re?/.+ and /?, the
mortgage terms were you could "ut '+> down and borrow for ) years. A very big difference. 2he counter to
this is that "eo"le will say other financial institutions will "ick u" the slack. 2he banks will ste" in with a
stee" yield curve.
Management
$5'
:et us talk about management. 1o one mentioned management in the criteria for a good business. 0ased on
the metrics we would say /?, and /.+ are well managed because they make high returns on eBuity.
WouldnMt you conclude that management is doing a good 4ob,
Is this a well?managed business, What do you think, Pld management worked had to kee" their advantages.
0asically we agree that /?, has a great franchise if it can kee" its franchise. /?, has most of the
characteristics of a great business. It is assumed you would want to own this business if it was at a chea"
enough "rice.
7aluation
!ow would you go about valuing /?,N 2his is not an easy one to do by the way. Es"ecially given the
accounting issues in this com"any. !ow would one determine the normal sustainable earnings "ower value of
/?,,
What sort of cash is the com"any generating, :et us start with what they do.
2hey buy mortgages and sell them of into the market. 2hey are buying a "ool of mortgages that were
originated by someone else Gno origination like Countrywide Credit??$5> of all mortgages in origination by
Countrywide Credit??which would reBuire an unbelievable amount of ca"ital if they did not "ackage them and
sell them to institutions like /?, and /.+I. /?,Ms biggest business8 buying mortgages.
2hey engage in credit "rotection. 2hey buy mortgages and sell bonds to fund those mortgage "urchases.
JE7E1RES8 2he interest rate on those mortgages and the fees they receive. !ow do you fund that mortgage,
/?, buys mortgages and they issue debt to "ay for those mortgages??they make a s"read. If there was no "re?
"ayment o"tion on the debt and no "enalty??how do you fund that and not absorb any risk, 2hey issue callable
debt.
2he mortgage is )> and /?, issues 5> callable debt for a s"read of $>. If the mortgage holder "ays me
early /?, calls in its debt if the mortgage holders does not "re"ay then /?, continues to hold the debt to
maturity. /?, has e#actly matched its interest rate risk.
Foreign govts. will buy bonds from /.+ and /?, which allows the Government Sponsored ,ntities 1GS,s2 a
lower cost of ca"ital. .ou must simulate the callable debt and you must model the behavior of the mortgage
market. 2he com"etition for /?, and /?+ is coming from the big commercial banks GCiti' Ban( o &mericaI.
2hose banks take risk by "laying the yield curve. 2he s"reads are wide enough Gyield curve is stee" enoughI to
take on duration risk.
/.+ and /?, take duration risk and mismatch on the e#treme tails. 2hey hedge KC> of an interest rate move.
2he cost of a "erfect hedge would make this a mediocre business.
Foreign govts. 0uy /?, and /.+ "a"er because they receive a higher interest rate and there is the belief that
the RS govt. will stand behind this "a"er in the case of default by /?, and F1M.
:imit how much of your "ortfolio you "ut into /?,??so you diversify.
>ind out%
2he normal "rofitability of their mortgage business, 2he normal "rofitability of their credit risk business,
2ake in an insurance "remium and "ay out a loss.
1ormaliHe earnings8 normaliHe the interest rate s"read. 2hink about the businesses that takes credit risk and
their other business which insures credit risk. 2he credit risk business is very "rofitable because it reBuires
little ca"ital.
$55
2here is nothing that canMt be screwed u" so that is why you have to have some diversification. F1MMs worst
loss was ) b"s. 2he worse credit losses in their history were $$ b"s. 1ow they are at $ b"s. .ou can make
some assum"tions about what are the normal credit losses. 2y"ically they have low risks.
2he incentive for someone to bail on his or her mortgage is very low??so credit risk is low. 2hey reBuire 2+>
eBuity down. 2he dis"ersion of mortgages is wide. I can come with some normal credit risk and normal
credit losses and I can do the same with their credit insurance business.
2hey make net about C> b"s on their credit business.
;ow let=s !et to earnin!sC FRE can ma"e up an number the want under G@@1.
First of all G&&P rules doesnMt a""ly here because they donMt make sense. In essence for G&&P you mark to
market the asset side of the balance sheet but not the liability side GmismatchI. 2hese com"anies try to smooth
their earnings.
0ad management is doing sleaHy things to get their o"tions e#ercised or their bonuses9to enrich themselves.
2he most generous way to describe it is that they are trying to meet their ca"ital reBuirements and they can
meet their shareholderMs needs for stability by e#"loiting the accounting rules to get hedge accounting for as
much of their balance sheet. !edge accounting says that if you can link your assets directly to a liability then
you can mark both to market since you have a "erfect hedge.
My contention is that no matter what they choose you shouldnMt believe it. G&&P doesnMt work in this kind of
business.
2he biggest source of o""ortunity for us these "ast few years since 2+++ or since ,nron is fear of accounting.
2he reality is??you shouldnMt count on it.
2hey actually "ut out their mark to market balance sheet or what they call their fair market balance sheet Gthey
estimate their assets and liabilities marked to market??giving you the net asset valueI so you can know what is
going on with these com"anies. See "age <) in $+?A.
Why you should trust these com"anies fair value estimates because these assets and liabilities are short?term
liBuid and they trade freely in the market. .ou can see e#actly what they make. Pn average they make 2+>
"er year on a fair value basis over time. It is less volatile than re"orted through GAA6.
PA so now I know what the fair value of their "ortfolio is I know what their returns are. If you were
evaluating a leveraged hedge fund you would 4udge the fund by its returns. .ou wouldnMt ask to see GAA6
financials.
Management had all these tools to mani"ulate earnings. 0ut it is nothing com"ared to the value of this
franchise. 2here is a risk that this business franchise Gthe charterI may be withdrawn. So how do you evaluate
that risk, 2ake the liBuidating value to the business today if the charter was withdrawn.
Fair value is *25 billion and on )C+ million shares8 *(< "er share GeBuity value leveraged 5+ to $I fair value of
their mortgage "ortfolio and it earns 2+> a year. So I get *<.'+ E6S for their mortgage "ortfolio.
2hen we have their guarantee business which earns about *$.( billion a year??*$.K< "er share.
So total is *<.'+ N *$.K< or E?.F7 per share. 2he stock is at *)5. 1ow we can Buestion every "art of this. We
can say it wonMt earn 2+> "er year the s"reads wonMt really stay where they are because of bank com"etition.
Worst case analysis8 2he govt. forces them to liBuidate their "ortfolio. 2he "rocess of liBuidation would be
assumed gradually over a $5 year "eriod. It is not in anybodyMs interest to have a forced liBuidation.
2ake the "resent value of that cash flow stream. 2he value would be greater than *(< "er share Gtheoretically
the *(< would be the value if liBuidated todayI because they have embedded above market discount rate
$5)
returns in this investment. So we do this arithmetic and their share goes from $5> of the mortgage market to +
gradually over $5 years to come u" with the value.
2ake the current earnings and take the "resent value over $5 years so it is roughly *'' "er share Gthe 67 of
liBuidating the mortgage "ortfolio??running it off over time because it is earning above the discount rateI. 2his
is roughly *2 "er share of earnings Gcredit risk businessI or $+ times earnings.
2otal liBuidating value8 *'' N *2+ O *)' "er share. 2oday the stock is *)5. 8he worse case is the same
valuation as toda. In the case that everything bad ha""ens it would be the same valuation as today. 6rior to
today the stock traded down to *') "er share but it had roughly the same value. In a normal value it should
earn *K "er share??$5# earnings??or *$'+ "er share. If it got over *$++ I might sell it. 8he e+cess capital is
embedded in the earnin!s.
/?, doesnMt know what their financials are. F1M is a year and a half behind. .ou are investing in a com"any
that is not "roducing any statements.
2+> is change in fair value year?to?year. 2hey can leverage their "ortfolio more than anyone else.
Student8 your mortgage analysis,
3ena8 We looked at what the yields were and what the cost of various callable debt was. What should /?,
have earned on their "ortfolio.
We are big shareholders of commercial banks. Da"ital s"ending is 4ust turning now. 0anks make more money
in that environment.
In a normal yield curve the arithmetic doesnMt work for the banks. 0anks would much rather make industrial
loans than invest in mortgages.
When /?, went u" to the <+Ms then you saw some downside risk because of the "rice being u". We bought
/?, $C months ago when it was in the 5+Ms.
??????????
Student8 What stock screens do you use,
3ena8 Pur screens are e#tra"olating re"orted earnings. Screens are relying on GAA6 earnings. 2he stock
"rice colla"sed com"ared to re"orted earnings.
I had done work on /?, $+ years ago because I wanted to understand how they make so much money. I
concluded that they did not "ut on a "erfect hedge?which was why they made so much money. 6lus their
com"etitive advantage. I did a model of their mortgage business. We looked at /?, for a cou"le of months.
/?, isnMt going anywhere tomorrow. 2his 1bad press' accounting scandal and congressional concerns2 will be
in the "a"er for awhile.
8he political will to disrupt the mort!a!e mar"et doesn=t e+ist. /?, and F1M have huge su""ort in
Dongress. !omeownershi" is "art of the American 5ream. 2inkering with change will occur.
Student8 What ty"e of time horiHons do you use,
3ena8 Financial statements being re"orted is no. $ a clearing of the regulatory environment is no. 2.
1ormally we look at a ( to 5 year time horiHon. 6on=t #or!et that these numbers are !rowin! all the time. It
isnMt static. .ou get to "artici"ate in the growth in all of this. 2his year the range is *)+ to *$'+ while ne#t
year it will be *<+ and *$5+. 2hey still are making good returns on their "ortfolio.
We use Compustat %atabase and we have our own model that looks at $+ years of historical data. It screens
things for us. Are "rices selling at a low "rice to what history suggests the com"any should own, 2hen you
$5<
can go in and do the work to see if the "roblems and fears are tem"orary. We do five year forward earnings.
And we ca" the growth at $5> "er year.
Student8 Which true barriers to entry do you focus on,
3ena8 Dan this com"any earn a return in e#cess of its cost of ca"ital, :ocation com"etitive cost "osition a
dominant market "osition it could be a brand or a franchise or an industry structure&s. Boeing 1B&2 has only
one com"etitor??a good industry structure. Computer &ssociates 1C&2 was controversial due to accounting
issues but customers were ca"tive??they couldnMt switch. C& "rovides system tools for commercial "rocesses.
Dustomers canMt afford to shut down their businesses to switch to other com"etitors. If IB+ came in and
offered their software for free would you switch, Dustomers said. I run a 2';< data center??this is not
strategically im"ortant/ We view C& as Con ,dOa utility.
C& under *$+. It was yielding *2.<5 "er share in free cash flow and it was at *C.++. 3hirlpool and +aytag$
Tenet 1TBC28 Management came into our office to close $;( of our hos"itals that were losing money. 2he
market rallied on that news which I found unbelievable. We were counting on those hos"itals to make money
and 4ustify the earnings "ower value.
E?$
??
Greenblatt Class #N
February $$ 2++5

Summary; Spin4o eCamples; Sears' Paramount' Bost4+arriot$ Bow Joel places inormation into conteCt$
S"ecial situations have been around for awhile. 2his book was written in $K)) and the first edition was $K5C.
2he book describes turnarounds mergers reca"s tenders s"in?offs.
Someone asked me after reading my book .ou Dan 0e a Stock Market Genius if it is harder to make money
now since these techniBues are better known, 2he answer really is no. 2here are so many hedge funds out
there and so much money out there chasing o""ortunities. I find that "retty amaHing. I do think during the last
si# months to a year the stock market has gone higher3 many more things are full?"riced. 2his isn&t a
$5C
Feb. +2 2++5
6rice *)'
"articularly "lentiful market to find bargains but then again I don&t have to go back very far9to the S"ring of
2++( or the Fall of 2++2 and there were incredible bargains all over the "lace. .ou have to go back to $KKK
when insanity reigned and there were huge o""ortunities on the long and short side in the short term. 2he
market goes craHy sometimes on the downside and on the u"side. .ait #or opportunit.
What o""ortunities might be out there today, I was looking at the "a"er this morning and I saw an
announcement on Sara 0ee9they will s"in off some assets. I get a cou"le of these re"orts that follows s"in?
offs G2he S"in?Pff DalendarI.
Sara 0ee
!ere is a hand?out on Sara 0ee9basically they make food and a""arel. It is a huge com"any with tons of
different brands. What caught my eye when I read this8 The branded apparel segment o the business or
instance' generated a single digit operating margin and an 55T return on assets in !""J' while the beverage
and household products divisions produced margins and returns on assets o about 5#T and !"T or more$
2his could be a cra""y business but chea". It could do better on the $$>??not static.
So 2+> JPA in the household "roducts division they are selling some they are s"inning some off. 2hat could
be a good business. So we went through that analysis where we are looking for high E0I2;tangible assets.
Student; It could be chea" and s"un?off.
Joel8 I learned #rom the school o# hard "noc"s to bu better businesses. I understand why that 2+> JPA
is interesting but why would the $$> be interesting, So maybe the "erformance could get betterUthe $$> is
not static. 2he $$> could im"rove.
2he s"in?off does better than the "arent9usually if the s"in?off is the smaller com"any. I would look at both
they could both be o""ortunities. 0asically there is a conglomerate discount9you are forced to buy '+> of
some business you don&t want. When things s"lit u" you have that going for you. Pne of the things they said
in the "a"ers today is that they will sell off some divisions. 2hey will s"in off some divisions I don&t know
what that $$> really means. 2here could be some high JPA in that branded a""arel category. $$> could
re"resent an average. 2here could be some (> and 2+> businesses in the branded a""arel business. Someone
smart in new management they begin to get rid of bad "erforming business. Sell or liBuidate.
BP 6otential S"in?off
At first brush it doesn&t look that attractive at least com"ared to the other one. 2here are o""ortunities in both
com"anies. 2o the Buestion does this still go on, 2his is a big com"any. We have in yesterday&s 3all Street
Journal8 2hey oust Carla. 2here was a big dis"ute on the BP4CompaF merger. A combination with a low and
a high return business. 2he original Founder fought the merger. !e fought Carla /iorina. We have one good
business9a "rinter business which su""lies ink to the "rinters Ga high return on ca"ital businessI9and you
want to combine it with a crummy business9com"uters. Carla doubled down on the crummy business and she
would make cuts and im"rove o"erations and that kind of failed. S"eculation is that they will s"lit u" the
business. 2here is "otential here for another s"in?off here. .ou have a good business with high market share
9the "rinter business and the com"uter business. .ou have a huge market ca" com"any in disarray. 2here is a
lot of uncertainty here thus there could be o""ortunity.
Student8 When would you start working on this situation,
Joel8 1ow I look for more low hanging fruit or when the s"ecial situation is further along in the "rocess but
there is a lot of money to be made now. If I were your age I would start working now and tear a"art the
com"any now and develo" a first guess as to the combined com"any would be worth on a conservative basis.
Sometimes you can do it and sometimes you can&t. 2hey haven&t "ut it into "lay. 2his is very early stage.
Sara 0ee8 2his will take a year and a half and cost savings will come over 5 years. 2hat tells me these guys are
very slow.
$5K
?ichard P8ena "ut out that chart. 8hin!s revert to the mean. .ou 4ust don&t sit there and take it9things
stink. .ou shut down a factory you close a division and you cut costs. 2he natural thing is to make choices.
Sometimes when I own a com"any and if it is very chea" I ho"e it gets worse because I want these guys gone.
If things get any worse these guys won&t have a choice9management will have to be fired. !ave a margin of
safety to suffer through the short term decline. 2hat is one of the benefits of having a long?term time horiHon. If
you are a money manager and you are looking to make money in the ne#t ) to $2 months that is tough to live
through. 0ut if I am getting a big discount and I am looking out three years I can sit through the near term.
2hey G0oard of 5irectors8 0P5I can&t live through this. I want some s"ecial situation to ha""en8 Where they
decide to close down the "oor "erforming division they re"lace management.
Carla 1/iorina2 was wrong and the three years are u". 2hese GS"ecial SituationsI are always "ercolating.
2here are always com"anies in trouble or things not going "articularly well. S"ecial Situations like mergers U
em"ire building strategic acBuisitions. Em"ire building then restructuring and s"in offs.
I am trin! to !ive ou an idea o# how I loo" at these thin!s. !ey the 2+> JPE business is interesting and
hey the $$> JPE business is interesting9breakout the brands9there could be a huge dis"arity here. 2he
Buestion is when do I start looking at these, If I looked at Sara 0ee at *2( and thought it could be worth *()
I would start looking now. !ow do I figure that out, If I thought Sara 0ee was worth *2< I wouldn&t "lay
now. If there isn&t enough of a margin of safety there I "robably wouldn&t "lay there now. All the numbers are
guest?imates or estimates. If someone says this is a growth story I am more ske"tical. Pn the other hand if
someone says they are going to cut these costs. I discount cost cutting strategies as well. Carla cut costs but
the business got worse.
I gave you the s"in off calendar for %anuary.
2his is an e#traordinary event for a com"any like this. 2his is the kind of thing they Ganalysts who follow the
com"any on a regular basisI are 4ust not good at. 2hey will sus"end a rating or they will sus"end until things
are clear.
AE(AEFA Spin(o##% Financial Advisory business for middle income Americans. 1ot many com"anies grow
$2?$5> for long "eriods of time. &KP is a great business. Economies of Scale GEPSI work very well. A
tough business to break into. I looked at these $+ years ago when they s"un off 0ehman Brothers. 2he good
business was the financial advisor business which was growing at 2+> "er year and they messed it u". 1ow
they are the "oor relative.
2he ne#t line says $2> ? $5> growth sounds interesting. It is the high end of its eBuity return targets which is
2C> to (+>??that is a "retty darned good business.
Financial Advisor&s 1&,/&2 JPE is $$>??not great for a stand alone com"any9"erha"s it is being
mismanaged.
Any o""ortunities here, 2hey are screwing something u" since they should have a very good business here.
It is out of favor but it should have done better. It shouldn&t be a low JPE business. When I was looking at
the last one. I thought it was a good business. I think that having them sell &+,K "roducts and having those
ty"es of conflicts hurt them. I met with Barvey Golub $+ years ago. We had a discussion. !e claimed the
markets were efficient. 8he price was EN0 but we thou!ht it was worth EM0. 2ut he was tellin! me the
mar"et was e##icient. @ disconnect.
2here was a disconnect here. 6eo"le say we can&t beat the market so what would it lead you to do9it would
lead you to not hire the best "eo"le because all "eo"le are fungible. I will not "ay for the best guy. 2he culture
might have been dysfunctional. A terrible attitude to have.
&,/& turned into an allocation business but selling low Buality funds comes back to bite you. 2here is room
for im"rovement here. Also there should be different "arts of the business so I would look and see which "arts
are doing well and which aren&t doing well.
$)+
Aour assi!nment #or .ed is to analGe this spin(o## o# A'e=. 2ell me where you think the "otential value
and o""ortunities are. 1I&CI Spin4o2
2hat was interesting. 6art of the business is lending money or running u" the balance sheet. .ou are lending
to "eo"le at C> and borrowing at 2>. Dost of Da"ital is 2> and lending at C> but you borrow it. !uge asset
siHe on a small eBuity. :ow JPA but high JPE is the way banks work because of high leverage.
2his "articular business where you have a high JPE because of sales or critical mass. 2hey make money on
the margin. 0reak?out the businesses8 What is in the finance business GJPEI and then what they are getting in
the 2JS business, Pne "art of the business could be getting $5> and the other (5>. I did a Buick and dirty
on what the two divisions earn9I read an analyst re"ort. 2he -goodT 2JS could earn *2.5+96;E of 2+ or
*5+ and the -bad businessT could earn *+.5)9$) multi"le or *K. !e gave a total break?u" value of *5K G*5+ N
*KI. 2oday the stock is at *55. At one sense you could say it is not a great o""ortunity. 2he time to look at this
is now. I see o""ortunities in both areas.
When I read the "a"er what do I see, 2o give you an idea. I don&t know if any of this comes out to "lay. I am
giving you some conte#t for your work Wed. 0asically my o""ortunities are $I in the -badT business they
may be able to earn more on de"ressed earnings. .et this isn&t a huge driver of value but *K to *$( could be
very good but on a *55 stock9so not the main driver. It might be worth owning if I do enough work and the
com"any GFinancial Advisory businessI is worth *K conservatively so I would be "aying *') for the rest of the
business. 0uy the good business for *2.5+ in E6S and it is then trading at $C times 6;E. 0ut I might be willing
to buy this business now. I don&t know if this is how it is going to "lay out.
If I give a conservative value to American E#"ress Financial Advisors GAFAI and I conclude *K is
conservative so the other business Gthe "arent?&KPI is *'). I don&t have to wait because I am buying two
things I might want to own. 2he o""ortunity of the good business may be in the earnings growth. 0elieve it or
not being a chea" value investor the o""ortunity may be in the 6;E side because you are now unleashing an
im"rovement in JPE in the "oor business. See how high one business JPE is versus the financing business. It
could be sold off. 6erha"s I own a '+> to 5+> JPE business if I stri" out the financial "art. I don&t really
know.
A number of years ago one of my best "ositions was +oodys. 0ecause I learned about their business through
researching %u E Phelps' another rating com"any. 2he business earned $++> on ca"ital didn&t reBuire any
ca"ital s"ending to grow and it could return ca"ital to shareholders. 2his was a great business worth (+ # E6S.
JPID U g O e#cess JPID.
Pne of the better businesses was Co(e. :et&s com"are what Buett "aid for Co(e vs. what we could "ay for
+oodys. +oodys was actually a better business because Co(e had to reinvest 2+> of their earnings back into
their business to grow and +oodys did not. .ou could get the same growth for no reinvestment. +oodys
dollar was worth more "er *$ than Co(e&s dollar GC+ cents left over after reinvestmentI. +oodys you got to
kee" the full dollar. 2his is an e#am"le for why I might "ay a high multi"le for a business if you can get a
high return on ca"ital. If this is truly growing $2> to $5> "er year I could "ro4ect 2 or ( years what the
com"any could be earning if I believed that story and "ut a multi"le on it.
;ever use less than MQ #or an opportunit cost #or capital. 2+ 6;E is a 5> yield vs. )> minimum G$+ year
bond yieldI. 2his can com"ete G5>I vs. G)>I if it can grow over many years. &KP could be yielding 5.5> to
)> while growing $2> to $5>. I want to see how much ca"ital needs to go into that business to grow. What
JPID is there after I stri" out the financial business. &KP gave that guidance9$2> to $5> earnings growth.
I am 4ust telling you the formulation of a thesis after reading this one article and getting one re"ort to see the
break down of the businesses. 1ow I need to check it out and see if the numbers work and add u" and not 4ust
taking the numbers they gave me. !ow I break down the numbers to see how they got there. What&s a good
business what is a bad business, 2hat is a lot to figure out in '+ seconds.
It wor"ed that wa last time. .hat we are trin! to do in this class is practice and !et as much
e+perience as possible. 8hat is wh I want ou to read the "al1e In4estors Cl1b ("IC) site. 7ead as
much as possible, and ou will learn #aster. Stud.
$)$
Assignment Wed. is to come back with some of your answer. What makes sense Gfor AL6 S"in?off,I
I think the o""ortunity might lie with &G/& in the earnings. And I think here if they can grow $5> then there
could be multi"le e#"ansion G2+ 6;E to (+ 6;EI. 0ig investors might think MDR at (+ 6;E is a good deal.
I have never found a better business than +oodys. I think &KP is "otentially a great business. 2C> to (+>
JPID is good but I don&t know how good95+> JPE business,
Student8 !ow do you think about the multi"le, U )> is a $).)) multi"le or $;$). I think of "re?ta# returns.
*$++ stock and earning *) "er share or )> G*);*$++I. !ow long and how much will earnings grow, !ow
good a franchise is it or what is the rate and duration of earnings,
0eing a 7alue Investor
2he beautiful thing about being a value investor is8
$. Most businesses I can&t figure it out so I ski" it. I "ick my s"ots wait for the fat "itch.
2. If I can value the business I will only do it if I have enough room. I think the stock is worth *$+ and I
can buy it at *5 to *). It will be worth *$+ in two years. So if I am wrong I kind of break even.
2hus many o""ortunities are screened out.
I don&t measure risk by volatility but by if I can lose money. !ow confident am I that if ten things go wrong
can I still make money, :ike fli""ing a coin where if I fli" heads I make *5 and if I fli" tails I lose nothing.
6age $8 The Spin4o Calendar. 2hese are com"anies with stakes in other "ublicly trade eBuities.
!EAR! C@S5 S8D6A
6ages $+2?$+C of the book Bow >ou Can Be a Stoc( +ar(et Genius8
In Se"t. $KK2 Sears announced its intention to sell a 2+?"ercent stake in two of its subsidiaries to the "ublic. In
the case of %ean 3itter Sears also announced its intention to distribute its remaining C+?"ercent interest
directly to shareholders at a later date some time in $KK(.
Sears was selling or distributing business it already owned. 0y taking Sears stock "rice and subtracting the
market value of its remaining stakes in %ean 3itter and &llstate a value for the rest of Sears assets "rimarily
the de"artment store could be calculated.
In the beginning of %une Sears sold a 2+> stake in &llstate for *2< "er share. 0y the beginning of %uly 4ust
before Sears distribution of it s remaining stake in %3 this is how things stood8 %3&s stock was trading at
a""ro#imately *(< "er share3 &llstate&s stock was trading around *2K3 Sears stock stood at about *5'.
Sears announced that it would distribute its remaining C+?"ercent stake in %3. 2his meant that for every $++
shares of Sears a distribution of '+ shares of %3 would be made. GSears was distributing $() million shares
outstanding9so the distribution ratio was $();('+ or +.'.I 2herefore in mid?%uly each Sears shareholder
would receive shares in %3 worth a""ro#imately +.' Gthe announced distribution ratioI multi"lied by *(< Gthe
trading "rice of %3&s stockI a""ro#imately *$5 worth of %3 stock for each share of Sears owned.
Since Sears was trading at *5' "er share before the distribution this translated to a net "rice of *(K for the
remainder of Sears. What was that remainder, 6rimarily it was Sears remaining C+ "ercent stake in &llstate
its foreign and domestic de"artment store business and various real estate businesses Gincluding Coldwell
Ban(erI.
Sears owned a""ro#imately ('+ million shares of &llstate. Sears itself also ha""ened to have a""ro#imately
('+ million shares outstanding. 2his meant that if you owned a share of Sears you also indirectly owned a
share of &llstate. With &llstate at about *2K or about *$+ "er share G*(K net stock "rice less *2K "rice of
$)2
&llstateI you were getting the foreign and domestic Sears de"artment?store business and its real?estate
business. Was this a bargain,
+ichael Price in Barrons %uly 5 $KK( laid out the case8 -2hat *5' a share includes one share of &llstate at
*2C so hat leaves *2) G*5' ? *2CI. 2hen you get +.' share of %3 which is *$5. 2hat leaves G*2) ? *$5I *$$
or *$+. About *2 or *( of that is Sears +eCico and Sears Canada. 2hat leaves about *C. Coldwell Ban(er is
worth *2 or *( a share. So that leaves *5 a share or a market ca" of about *$.5 billion of the retailer9with
*2< billion in sales. 2he new mgt. seems very focused. It is an almost debt?free retailer with huge real?estate
o""ortunities.
Sears had *<K "er share in sales. If those sales could be "urchased for *5 a share Gdebt freeI then that worked
out to a "urchase "rice of 4ust over ) "ercent of sales G5 divided by <KI. Pn the other hand a look at J$ C$
Penny Ga com"arable -crummyT retailerI showed sales of about *<C "er share and a market "rice of about *''
"er share9that was over 5)> of sales. Pf course there are many other measures of relative value Gearnings
for instanceI but all indications were that the domestic retail business of Sears could be created at an
incredibly chea" "rice.
3oo" #or partial spin(o## opportunities.
After the %3 distribution the *(K remaining investment in Sears was u" 5+> over the ne#t several months.
&llstate was only u" from *2K to *(( during the "eriod. Pbviously the market finally took notice of the
inherent value of Sears other assets.
.es it was "ossible to simultaneously buy Sears stock and short &llstate stock creating only the "ortion of
Sears that was clearly a bargain. In some cases this is a smart way to "lay es"ecially when the value of the
chea" "ortion9a *5 "er share de"artment store "urchase9is a small "art of the "urchase "rice8 *(K "ost %3
distribution. !owever in this case the dis"arity between the bargain "urchases "rice of the de"artment store
segment and true value was so huge no such fancy tactics were necessary. GEnd of book "ortionI.
First announcement of Sears. Se"t. $KK2 announcement. Sears had two big subsidiaries9&llstate and %ean
3itter G%3I. 2hey would sell off 2+> to the "ublic and s"in off the remaining C+>. Why would they sell 2+>
to "ublic rather than to s"in?off. Pne answer is to establish a value, .ou can&t sell off more than 2+> to have
a ta#?free s"in?off.
Why would you sell 2+>, 2o get the cash/ 2he reason to s"in?off stuff is to get money or because it didn&t
work out or you are not getting the value from the stock market. Somethin! is not !oin! ri!ht. 2hat is
somewhat a "ainful thing to do9admit your mistake and s"in it off.
First sell 2+> of com"any to "ublic then s"in off the remainder. 2hey would also sell 2+> of &llstate to the
"ublic and kee" C+>. Sears will not dis"ose of the remaining C+> of &llstate9but what they really mean is
that they will dis"ose of that interest. 0ecause there is no other logic to that move. What they are saying is
that we will try to hold on to this com"any. 1o way is that going to ha""en.
Sears is a de"artment store &llstate is an insurance com"any and %ean 3itter is a brokerage so there is no
strategic reason for the combination of these com"anies.
In those days Sears was a eu"hemism for loser. Rnder "ressure they do the s"in?off. I assume I will
eventually get the value. My horiHon is three years. 2his came out Se"t K2 so now we move to A"ril $KK(.
2hey did a "ublic offering of %ean 3itter and now they are getting ready to s"in off the remainder.
For every share of Sears you own you get 2' shares of %ean 3itter G%3I. If %3 is at *(5 you get +.' you
get *$' for every share of Sears that you own. Sears at the time was at *5(. .ou could either short %3 that
was out there and create the rest of Sears for *(K G*5( Sears ? *$' %3I. Pr you could wait for your
distribution and sell it off when you were done. 2ake the risk that %3 moves in the interim.
$)(
If you own $ share of Sears and Sears has '++ million shares outstanding. Sears owned $<) million of %3
after the s"in?off. If they say we are going to s"in off the shares to investors. For every share of Sears you
own +.' shares of %3. If there are ''+ mm shares outstanding and you will get $<) mm shares of %3??each $
share of Sears will get +.' of %3. If Sears is trading at *5( then +.' # *(5 O *$'. So what is left of Sears
which includes the retailer and &llstate trades at *(K.
1e#t "age is when they fess u" to the fact that Goffering in %uneI they will sell <C mm shares of &llstate
GInsurance com"anyI in the range of *2' to *2<. Sears will own C2> of the outstanding common stock. So
now &llstate Sears will sell <C mm shares at *2' that will leave them (+( mm shares. For each share of
&llstate will eBual the shares of Sears. For each share of Sears you get a share of &llstate.
Announcement %une $C
th
. Pne "age C +i(e Price is interviewed in Barrons9he "oints out the o""ortunity.
Sears has gone faster than e#"ected in its sales of &llstate and %3.
So *5' for Sears which includes $ share of &llstate so subtract the "rice of &llstate G*2CI so the remainder is
*2) then subtract %3 G*$5I so the remainder is *$$ then subtract Sears Danada G*2 to *(I for a remainder of
*C to *K then subtract the value of Coldwell Ban(er Greal?estate firmI of *2 leaving *5 to *) "er share of Sears
Gretail o"erationsI. Sears has no debt. *$.5 billion market ca" for *22 billion in sales or )> for *$ of sales.
Dra""y retailers sell for more. J$C$ Penny has *$K billion in sales with a *$+ billion market ca"955> of
sales. Sears is now K to $+ times chea"er than J$C$ Penny GJelative 7alueI. Sears is a debt?free retailer. 2he
new management seems very focused. In this "articular case Sears had no debt.
8his is when I #inall wa"e(up. MQ o# sales #or !ears vs. 55Q o# sales #or J.C. ennyFal'ost /G/+ as
#hea&H
2urn to "age $+ I looked at the SEP tear sheet for J$C$ Penny. :ook at "age $$ J$C$ Penny UI categoriHed as
a crummy retailer. I did a Buick and dirty. Pf course you would have to com"are earnings but Sears is $;$+
th
the "rice of J$C$ Penny.
2wo weeks later Sears s"ins off the other two com"anies. I was left with *5 for Sears and worth "otentially
*5+. 2his went from *5 to *(+ in two months or )#s/
!ow the heck did that ha""en, 2he o""ortunity was announced for months. +i(e Price lays out the
o""ortunity in Barrons for the entire world. !ow will you make money with &meC Sara 0ee or BP on the
front "age on the 3all Street Journal. 2here is "lenty of time for "eo"le to find it. !ow is the o""ortunity
"ossible,
1eople said that when I wrote the boo", I had ruined it #or everbod. 2he first year after I wrote the book
s"in?offs did "oorly but now they have done well. 2hings don&t change. 2his guy wrote the book about s"in
offs mergers and restructuring in $K5). 2his was a high "rofile o""ortunity9+i(e Price is a high "rofile guy
in a high "rofile magaHine Barrons I am telling you that I am not worried about making money doing this
stuff. It&s messy. Institutions don&t want to own it. I don&t "now wh these opportunities e+ist, and I don&t
care.
I bought ACom and shorted Palm. I was able to hold ACom for a negative (( dollars. 2hat was really
ine#"licable. 2he bottom line this stuff ha""ens. 2his is a "articularly blatant one. 2here is a lot of money to
be made. I tried to hel" you in the beginning.
If you as a money manager own (+ to '+ stocks you will not have the time to look at the messy situations.
2here are "lenty of other hedge funds out there but they are sub4ect to all the same biases. It is that it is
com"licated or you have to think about it in a slightly different way. I am better at it than I was 2+ years ago3 I
have seen a lot of things and e#"erience is good. It is somewhat hiding in "lain sight. It is that it is
complicated. 8hin" in a di##erent wa.
2his stuff is out there and in the last three days there is tons of fodder. 2here is "lenty of time to get in.
Sara 0ee
$)'
&+,K?&G/& If I think *K for &G/& is conservative I may be able to "lay right now.
BP Gfuture "otential divestitureI
In the Sears e#am"le I shorted the &llstate because I wanted to own a lot of 4ust Sears.
I am on the e+treme scale o# concentration. When I see an o""ortunity this good???buy for *5 and have the
"otential to make *(+ to *5+9I load u".
ARAM>B?6 C<))D;IC@8I<;S4"IAC>M C@S5 S8D6A
In Se"t. $KK( :iacom agreed to "urchase Paramount Dommunications for stock and cash. :iacom a media
conglomerate controlled by Sumner ?edstone was the owner of cable services like +T: .ic(elodeon' and
Showtime cable systems broadcast stations and television and "roduction divisions. In what a""eared to most
analysts to be a good fit with :iacom a combination with Paramount would contribute a leading "roducer and
distributor of motion "icture and television "rogramming a book "ublisher GSimon and SchusterI more cable
channels more television stations and two s"orts teams. 6articularly attractive to :iacom was Paramount&s&
e#tensive library of "ast movie and television hits as well as access to the future out"ut of Paramount&s film
and television studios.
:iacom was com"eting in this merger against Barry %iller of /oC .etwor( and U:C Bome Shopping service.
:iacom in an effort to strengthen its offer :iacom merged with Bloc(buster ,ntertainment. 2hat merger was
scheduled to close shortly after the successful acBuisition of Paramount.
At the time :iacom was able to "urchase for cash 5+.$ "ercent of Paramount&s shares outstanding. Although
the contest was over the o""ortunity to "rofit from the merger had only begun.
What wasn&t so formal was the method of "ayment for the remaining 'K.K "ercent of Paramount. While cash
was the sole from of "ayment for "urchasing the first half of Paramount&s stock "ractically everything e#ce"t
cash was the form of "ayment for the second half of the merger9known as the back end of the merger.
2he back?end "ayment for each share of Paramount consisted of8
:iacom common stock
E#changeable subordinated debentures of :iacom
Securities known as contingent value rights or G-D7JT one for each share of :iacom stock received in
the mergerI
2hree?year warrants to "urchase :iacom common stock at *)+ "er share and
Five?year warrants to "urchase :iacom common stock at *<+ "er share.
2he vast ma4ority of Paramount shareholders were interested in owning the shares of an entertainment
conglomerate or the stock of a takeover candidate. While the :iacom common stock might have been of
interest to some of these shareholders the e#changeable debentures the D7J and the two ty"es of warrants
were going to be sold9without looking at the "ro#y document and without regard to their true value G2hey sell
without economic reasonI.
2he :iacom stock issued to the "ublic as "art of the merger consideration would nearly tri"le the su""ly of
:iacom stock in "ublic hands.
What is all this stuff, It was answered in -Paramount Merger DonsiderationT.
Dombining the "urchase of one share of :iacom common stock with the "urchase of one D7J created a uniBue
investment o""ortunity. 2he D7J was a security issued by :iacom to hel" guarantee the value of the back?end
securities that Paramount shareholders were to receive in the merger. It was "robably this guarantee of value
by :iacom that was res"onsible for its victory in the bidding war over Paramount.
2he D7Js worked this way8 If :iacom common stock traded below *'C one year after the com"letion of the
Paramount merger :iacom would make u" the difference through a "ayment to holders of the D7Js. GE.g. if
$)5
:iacom stock traded at *'' on the one?year anniversary of the merger&s close :iacom would "ay *' for each
D7J3 if :iacom traded at *(C :iacom would "ay *$+ for each D7J.
0y "urchasing one D7J for each share of :iacom he owned an investor could ensure that the combined value
of the two securities would be at least *'C in one year. If :iacom traded higher than *'C Ulet&s say to *559
then although the D7J would be worthless the combined value of the two securities would be *55 even
better than the guaranteed *'C "rice. Since shortly after the merger was com"leted one D7J and one share
of :iacom stock could be "urchased for a combined "rice of *(< a guaranteed "rice of *'C in one year looked
"retty good9a (+> annual return with little risk and no u"side limitation.
:iacom limited the "ayout on the D7Js to a ma#imum of *$23 even so :iacom stock could fall to *25 before
an investor who bought both the D7J and :iacom stock for a combined *(< would lose money. For another
:iacom could e#tend the "ayment date of the D7J9but only in e#change for a "ayout larger than *$2.
I sim"ly read the "age in the "ro#y that told me how they worked. !owever I did have an advantage in all
this. It pas to chec" out mer!er securities:
2he five year warrants to buy :iacom stock at *<+ "er share looked "articularly interesting. 2hese warrants
gave the holder the right to buy :iacom stock at *<+ "er share for a "eriod of five years. Since :iacom stock
was trading at about *(2 "er share in %uly $KK' the right to buy :iacom stock at *<+ didn&t look too enticing.
Pn the other hand with this ty"e of situation I like to think about the old story of the "easant who is brought
before the king and sentenced to death. @ lot can happen in a ear.
2he five year warrants gave the holder the right to buy :iacom stock at any time during the ne#t five years for
*<+. In the case of an ordinary warrant this could mean that the warrant holder was entitled to receive one
share of :iacom common stock in e#change for *<+ in cash. 2he *<+ could be "aid in cash9and there was
nothing unusual about that. !owever the *<+ could also be "aid with *<+ in face value of one of the other
Paramount merger securities. Which merger security, 2he e#changeable subordinated debentures I
mentioned earlier9item [2 on our list.
Shortly after the Paramount merger was com"leted these merger securities were trading at )+> of their face
value. 2his meant I could buy *<+ of face value of these securities for only *'2 G)+> of *<+I. I would
effectively have the right to buy :iacom stock not for *<+ but only *'2 worth of merger securities. I would
have this right for five years. :iacom was at *(2. 2he right to buy stock at *'2 for five years was a lot more
valuable than the right to buy stock at *<+. If I hadn&t read the "ortion of the "ro#y covering merger securities
there was no way I could have known this o""ortunity e#isted.
0uying both the warrants and debentures was a winning trade.
7emember to read the pro+ o# mer!er securities. Gend of book sectionI
ARAM>B?6 L 1a!e 12.
2his is the back?story to the e#am"le in the book G.ou Dan 0e a Stock Market GeniusI. 2he Paramount
situation was a hostile battle for control of Paramount back in $KK'. What eventually ha""ened was two sides
bidding for Paramount and they ran out of money so they threw out "ieces of "a"er. 5ifferent rounds. 2he
winner of :iacom??they would buy half your stock in a tender offer 5$> for cash and then give you all that
stuff that they didn&t have on the back end. 6art of the deal ha""ened in cash then give you "a"er on the back
end.
It really was one of the most com"licated deals ever. 2hey didn&t have value to give. 2he front end was done
9:iacom bought 5$> of Paramount for cash9then you had the clean u" ( or ' months later. 2his "ro#y
came out in $KK'. 2his was no longer on the front "age. :ook on "age $29this is what you were getting in
the "ack end of that deal.
.?F0M5 o# a share o# a levera!ed compan H"ia#o' 2 Stoc"$. :iacom bought a com"any bigger than itself.
:iacom traded at *2C 5;C before this battle it was at *(' and change. 2he stock gets "ummeled because they
are issuing millions of shares of stock and they over"aid the winners curse.
$))
8hen ou !et E17.50 o# KQ subordinated debentures o# "ia#o'. 2hey are e#changeable and subordinated.
2here is "lenty to trade here.
.?F #or a contin!ent value ri!ht HC/7$
.5F o# a three(ear warrant. 2he difference between a warrant and an o"tion, 2hey work the same way but
with a warrant the money u"on e#ercise goes back to the com"any. 2he stock has to double within( years.
.F o# a #ive(ear warrant.
When issued trade8 if the event occurs.
D7J8 *'C S mkt. "rice. At *2C. 1ot ^*$2. If *2) ???*'C O *$2. *5$ second date. *55 third date.
If you are a mutual fund9you don&t want the 4unk on the back end. 2here will be selling9so this "resents an
o""ortunity. I will describe what a C/7 is. It is an interesting security. 2his is com"licated stuff. What is
this D7J,
Well if you looked at the table of contents of the "ro#y9so you go and read what a D7J is. 2urn to "age $(
or $'. 2he basic 4ist is8 listen if our stock is not at *'C but at such a time9two years out9we will "ay you
the difference of the market "rice and *'C. 0ut they will not "ay you more than a ma#imum of *$2. So at *()
the D7J will be "aid off at *$2 and if :iacom is at *'+ then G*'C?*'+I *C will be "aid to the D7J holder.
D7J guarantees the *'C "rice unless below *().
We can e#tend the D7J then it is at *5$ then ne#t at *55.++. Such an amount of *$2 can be "aid at the
discretion of :iacom. What does that mean, 2his means you will get C5 cents to K5 cents on the dollar.
Wall Street s"eak means that they will screw you in the end. A eu"hemism.
So when you do your margin of safety analysis you need to account for the haircut.
2hen again this "resents an o""ortunity of buying :iacom and if you are bullish on :iacom and this D7J is
trading at *( then for *($ 5;C you will have some security. :et&s say you buy $.5 D7Js for every share you
buy of :iacom then at *(( you have the u"side above *(( but the downside is covered. 2his was uniBue to
this deal but every deal has uniBue as"ects.
.hat I am trin! to !et ou to do is read the #ine print o# the deal and "now where to loo".
So for $ share of :iacom stock you get $ D7J and if you are an enter"rising investor maybe there is some
ratio I can do here. 0ut at least know what you are getting.
2he warrants when they e#"ire??*<+ warrants e#"ire in five years and three year warrants at *)+. What do
you think attracted me to the warrants, :iacom 4ust bought something for debt that was bigger than them,
I was thinking more of leverage U you have a com"any with *2 in eBuity and *C in debt for an E7 of *$+.
What would ha""ened if those assets became *$2 so for a 2+> move in the underlying assets in ( years you
could get a double in eBuity value Gfrom *2 to *'I for a move u" of 2+> in total assets. I viewed :iacom
stock as a :0P. In three years *2C could turn into *)+ because of the leverage. 2he warrants could be worth
something.
6age $) first "aragra"h8 in the case@@@@@@.if you e#ercise all the warrants@@..
.ou have to "ay *)+ to get your stock so if your stock is at *<+ then your warrant is worth *$+.
2o e#ercise the five year warrants you have the choice of "aying *<+ in cash or you can contribute *<+ of face
amount of the cra" they were giving you from the merger9the su"er subordinated Gwe don&t have to "ay youI
debenture was trading )+ cents on the dollar. So buying some of these five year warrants and some of this
$)<
"a"er you could use it to "urchase :iacom stock at face value. So I could contribute *<+ face amount of
e#change debentures that gets my e#ercise "rice effectively down to *'2. 2hese are five year warrants now
had a strike "rice of *'2 Gnot at *<+I. .ou could turn *<+ warrants into *'2. .ou could make these debentures
worth more because combined with the warrants they were worth more than *<+. It was a way to get you face
value relative to the cost of the funds. 2hose )+ cents on the money debentures looked good.
1o.$ I can tell you want I think. I am 4ust a guy reading this. It is what it is. We created money. It was a way
to give money that they G:iacomI didn&t have in five years. 2hey did a really stu"id thing they went out to buy
Bloc(buster 1BBI2 for stock so there would be more stock and more debentures.
I love this bet and it seemed like a way to own a "iece of a :0P. If they issued a lot of stock for Bloc(buster
they would get a lot of current cash flow but they over"aid.
Aou #ind this b loo"in! at obscure opportunities.
.hen ou see a complicated securit there is hu!e bene#it. 2ecause when we loo"ed at !ears which was
on the #ront pa!e o# ma'or newspapers, we still made mone. 2ut here when ou !et into esoteric
securities, weird stu## and it seems prett borin!, there is opportunit. Aou completel understand wh
people miss this. I# ou do this #or oursel#, ou will never run out o# opportunities. Gus that are ver
!ood, !et bi! #ast and start loo"in! at other opportunities instead o# small opportunities.
Smaller ca" situations are good. 0y knowing this kind of stuff you can really com"ound your own ca"ital. I
don&t think these o""ortunities Gsmaller ca" stuffI will ever go away. 1eople don&t "now where to loo" or do
the wor". 2he more you see the more you know what to look for. Instead of shifting through the '++ "age
"ro#y you can hone in on the o""ortunity.
In addition to looking at &merican ,Cpress we will look at 3arren Buett Gread the Essay&s on 3arren
BuettI. Feel free to bring in ideas. I 4ust found three things in three days which are huge s"in?offs. We can
analyHe them together. I am giving you e#"erience that I have. .ou won&t look at it that way. A lot of it you
have to do yourself. I am pushin! ou alon!.
Why would I look at this why wouldn&t I,
MARRI>6I;>!6 MARRI>6.
6age '(. In the book I thought I was writing for the lay "erson but after a year at Dolumbia I realiHed I was
writing at the M0A level. So I left out a lot of details. It is a lot more com"licated than I made it sound.
0PPA8 Bost +arriot;+arriot International
5uring the $KC+s +arriot Corporation aggressively e#"anded its em"ire by building a large number of hotels
but the cream of their business was not in owning hotels but charging management fees for managing hotels
owned by others. C/9 Bollenbachs idea was to leave all of the unsalable hotel "ro"erties and the low?growth
concession business?burdened with essentially all of the com"any&s debt in one com"any Bost +arriot and
s"in off the highly desirable management?service business more or less debt free into a com"any to be called
+arriot International.
According to the "lan 0ollenbach would become the new chief e#ecutive of Bost +arriot. Further +arriot
Intl Gthe -goodT +arriotI would be reBuired to e#tend to Bost +arriot a *)++ million line of credit to hel" with
any liBuidity needs and the +arriot Corporation would continue to own 25 "ercent stakes in both +arriot
International and Bost. 2he s"in?off transaction would be done by the middle of $KK(.
!ere was a case where in one fell swoo" an a""arently e#cellent hotel?mgt. business was finally going to shed
billions in debt and a "ile of tough to sell real estate.
$)C
I was interested in the -to#ic wasteT3 the -badT +arriot 1Bost +arriotI. Who the hell would want to own this
thing,T was the way my thinking went.
I am contrarian because i# I&ve thou!ht throu!h an issue I tr to #ollow m own opinion even when the
crowd thin"s di##erentl. Bost +arriot looked like it had unsalable real estate and crushing debt9on the
surface@@.
What I look for in a s"in?off8
Institutions don&t want it and their reasons don&t involve the investment merits. Bost +arriot looked so awful
that most institutions would be discouraged from doing any further research on the new stock. I vowed to read
it9first to see if Bost was going to be as bad as it looked and second because I figured almost nobody else
would.
Another reason why institutions wouldn&t wish to own it was its siHe. 1ot on its investment merits.
Bost would account for only $+> to or $5> of the total value being distributed to shareholders with the rest of
the value attributable to the -goodT business +arriot Intl. Bost was going to own hotels while the business
that attracted investors was the mgt. business. Indiscriminate selling might create a buying o""ortunity.
(. Insiders want Bost +arriot.
Insider "artici"ation is a key area. Are managers of the new s"in?off incentives along the same lines as
shareholders, When all the reBuired "ublic docs about the s"in?off have been filed I usually look at this area
first. Bollenbach was going over to lead Bost +arriot Gthe -badT com"anyI.
2he +arriot family was still going to own 25> of Bost after the s"in?off. A good sign.
A "reviously hidden investment o""ortunity is created or revealed. In the case of Bost +arriot there was
tremendous leverage. Bost would trade at *( to 5 "er share but have *2+ to *25 in debt. 2hat would make the
a""ro#. value of all the assets in Bost *(+. 2hus a $5> move u" in the value of Bost&s assets could "ractically
double the stock G.$5 # *(+ O *'.5+I.
2he good +arriot G+arriot IntlI would be on the hook to lend Bost u" to *)++ million. It seemed the
leveraged "ayoff had the makings of an e#citing bet.
Pne of the "rimary reasons a cor"oration may choose to s"in off a "articular business is its desire to receive
value for a business it deems undesirable and troublesome to sell. What better way to e#tract value from a
s"in?off than to "alm off some of the "arent com"any&s debt onto the s"in?off&s balance sheet, Every dollar of
debt transferred to the new s"in?off com"any adds a dollar of value to the "arent. 2hus there are many
inordinately leveraged s"in?offs.
2he rewards of sound reasoning and good research are vastly multi"lied when a""lied in these leveraged
circumstances.
Bost could be a good "ick because8
Most sane investors were going to sell their Bost +arriot stock before looking at it which would ho"efully
create a bargain "rice.
Aey insiders sub4ect to more research a""eared to have a vested interest in Bost&s success and tremendous
leverage would magnify our returns if Bost turned out for some reason to be more attractive than its initial
a""earances indicated.
2+> of new com"any stock Bost +arriot was made available for mgt and em"loyee incentives. 2he debt
was structured better than the news"a"ers made it a""ear. Bost +arriot Gthe -badT com"anyI tri"led within
four months of the s"in?off.
$)K
End of book "ortion
+arriot has a big franchise. So they had a big name. 2hey know they have a certain standard. 2hey had a
good business. A real estate downturn caught their real estate holdings. S"lit the management business from
the owning hotels. Stuck with many built hotels in a real estate hotel.
S"in?off crummy businesses into Bost +arriot and kee" the mgt. business in +arriot International.
I was always 4ealous of the leverage buy?out G:0PI guys. :everage can be a good thing if the value is there.
6age 2C you had com"licated financials. 6age ($ Bost +arriot 6ro?Forma. !ugely leverage. 6age (2 had a
diagram of the business. :osing money on a "ro?forma basis.
Ski" to the chase. 2here was a "arent cor"oration +arriot International was the credit guarantor for Bost
+arriot. 2his subsidiary owed less money than what "eo"le thought. It did not owe *$.C billion of the *2.2
billion.
!ere is a "arent that doesn&t owe all that debt. It owes *'++ million not *$.C billion in debt. 2here is a big
discre"ancy from what the market thinks.
2he San Francisco +arriot ? *25+ million of debt was on that hotel but the debt was non?recourse. 2hey
couldn&t attach the hotel. What looked like a huge leveraged thing when it was written u" in the "a"ers was not
really true. 1ow I almost have a debt free business in the "arent. We were "aying about *' "er share. :et&s
write off the San Francisco +arriot9a leveraged "lay there??the rest of the assets were worth about *) "lus we
had a call on anything above *$.C billion in debt. 2hey were "robably worth more. Worth *( to *). We had a
debtless "arent worth *) "lus a call on this "lus I was only "aying *'.
It all came #rom sain!, O,e, what was reall !oin! on.P
In a s"in?off I look at how management is incented and the timing of when management is incented. So in
other words if the "rice is based on the first week of trading and the incentive is to strike the o"tions at that
"rice they want to make it look bad. Mgt. doesn&t want you to figure it out.
2he ne#t one was 0iberty +edia$ When you see a great o"erator like that look carefully. +alone the DEP
took all his com"ensation in stock and he made it difficult to understand the "lan. !e created a big o""ortunity
for himself. !e wanted to make it difficult for others to buy the stock.
So althou!h this stu## loo"s complicated, there is opportunit. Almost the more "ur"osely com"licated the
better. Rnfortunately those are the ones you want to look at.
We had a "referred issue in +arriot and the "referred was convertible into the common shares of +arriot. .ou
had a choice of converting your "referred into common or into the bad business. 2hey had to "ick a
conversion "rice. Mgt. made it look so ugly and I wanted to own the ugly business Bost +arriot. 2hey
wanted us to convert into +arriot Intl instead of Bost +arriot. 2he nether world of looking at obscure
com"licated securities.
Pn Wed. we will talk about &meC and Buett.
E?$
Greenblatt Class #5
February $) 2++5

$<+
.our assignment is due ne#t class on .ed. )arch 1M, 2005. I could make u" a session later. A one "age
re"ort. We will have one guest lecturer on March 2
nd
Gclass was cancelledI.
My office hours are always $ hour before class Joom ($+.
Summary;
3e will be tal(ing about eCamples or your paper$
3e will tal( about &+,K spin4o$ &lso' ?esearch ,CamplesOCharlieJS6
>ou can as( Fuestions o 3arren Buett$
March $)
th
you can meet ,ric ?oseneld a Canadian Carl Icahn$
Another s"eaker is Brian Gains he runs a s"ecial situation value fund 1Springhouse Capital2 with a cou"le of
good war stories. A smart guy.
My sister 0inda Greenblatt who has made high 2+> rates of return investing in the retail business.
.our Assignment is due March $)
th
. Pne "age investment thesis backed by your work. 5o your own
calculations not 4ust a cut and "aste of a $+?A. Show a clear thou!ht process.
Is this chea" absolutely or relatively, !ow did it "an out when you did the analysis, I am looking for your
analytical skills. If you made some "ro4ections I want to see how you arrived at them. A few "ages of back?
u".
5on&t "rint out com"arable 6;E ratios from 0loomberg. Rse an E7 analysis or 6rice;Sales analysis. I want to
see E0I2;E7 or E0I25A U Da"e#;E7. .our return on ca"ital analysis. Rse "re?ta# cash flow.
E0I2 to 1WD "lus 1et Fi#ed Assets. 5o some digging. Ad4ust accordingly.
What do I mean by Maint. Da"e#, See :IC e#am"le.
!ow would you go figuring that out, :et&s say you built a few stores but they haven&t o"ened yet but s"ent the
money. Where does that show u", Dall and ask the com"any. 2hen you can not believe what they tell you.
0asically it is an estimate.
:IC E#am"le8 SiC /lag ?ides; Maint. Da"e# the ride is u" but you have to re"lace the ride every $+ years. 0ut
here they have to add two rides every year or else they will have declining revenues. Consider this
maintenance cap4e+ not !rowth cap4e+ because it is needed to maintain the current level o# revenues. .ou
may disagree with his argument but it is an argument to have. Another thing about Maint. Da"e#8 .ou own a
hotel business and it looks like maint. Da"e# goes along every year but it is not e#"anding. What is wrong
with saying it is normaliHed after three years of average ca"e#. 2he hotel business can bum" along for ( 5 <
years without refurbishing charges and then you are hit with a big ca"e# charge. .ou need to account for that.
1ormaliHe the big e#"enditures into the non?refurbishing years.
Burlington Industries GWE0I making ca"e# by investing in new machines for "roduction. 2hat is a false
"ayback "eriod because everyone else buys the machine so the "ayback is almost never. Everyone else is
doing that as well. A commodity industry with big ca";e# reBuirements and com"etitive environment is a "oor
investment. If you have a de"artment store and you are in a com"etitive environment so you have to s"end
more to stay in "lace. Why he likes good businesses with a moat. All these things go into maint. ca"e#. It is
kind of an im"ortant Buestion.
What I like about it Gkind of hard to figure out sometimesI is that there is your chance to make some money.
I# the told ou the answer, then there would be no opportunit.
Maint. Da"e# Ulevel to maintain the level of sales. :ook at 66E;Sales ratio.
$<$
Maintenance ca"e# what it would take to kee" earnings the same amount in the year you are looking at. What
this says don&t fool yourself into thinking you have a better business than you think you have.
Short hand8 E0I2;E7. E0I2 assumes ca"e# O 5SA. Rsually you don&t have a huge "icku". Rsually you
have to s"end your de"reciation unless you are in a huge deflationary environment. !aving said that that is
another thing to consider.
2he com"any he won in a "ro#y fight. 2hey were in the midst of doing a big acBuisition. 2hey bought a new
"lant which would not need new ca"e# for a long time. 5e"reciation was a lot bigger than ca"e#. 2he "lant
was at low ca"acity. If you are in business you don&t think of that9most "eo"le not looking at that issue.
2his was a huge "ick u" and it was what made the deal work. !uge de"reciation on a "lant that didn&t need to
be re"laced.
66E ???$++ year life;de"reciation. What are the real cash flows, Ad4unct facts to that flow. Ski" it if you can&t
figure it out. Pr make a very conservative estimate and if it still has a huge margin of safety then you can
invest.
.h not include !oodwillC :ook at the o"erating business not the acBuisition skill of management. :ook
forward not backward at sunk costs. What are returns based on tangible assets. What you "aid historically for
those assets doesn&t matter it is what those assets really cost. .our goodwill is how much more you "aid for
those assets than the original guy. 0ut internally I have to "ay maint. ca"e# and I have to e#"and this is telling
me how much those assets are really going to cost me.
What kind of incremental return I will get. .our historical return on those assets may not be your future return
but that is where I would start or that is my single best guess. What ty"e of incremental return I will get,
What kind of business do I own, Is this "reta# return on the ca"ital I invest in the business??2> or 5+>, If I
want to be stuck in a business with low returns on ca"ital I can always say there will be a big boost to
earnings. In a big warehouse whether you have 5 or 2+ stores you don&t have to add ca"e# incrementally.
1ow all incremental growth can use that base then your returns on ca"ital will rise. 3oo" at store based
Hunit based$ economics.
:ook at single store base contribution instead of historical average.
!ow much money to "ut into the business,
A;J U A;6 O 1WD Gthe money you have to lay outI
Free money to others Free money to me.
2hen you lay out for inventories. I took out the e#cess cash9cash greater than $> to 2> of sales.
1egative WD business?+c%onalds. As the business grows you generate ca"ital. It reverses if your business
slows down. 5o you count that as cash or something else, Eventually you will have to "ay that cash. .ou
have an industry loan.
Insurance com"any8 "remium income and investment income then "ay out losses in the future. 3,B gets
chea" ca"ital from the insurance business and then he invests this cash or "remiums at a higher return in
eBuities.
1et Fi#ed Assets 8 gets u"dated9buy FA then de"reciate then re"lace it. Assume ca"e# O de"reciation over
time9a constantly u"dated number. 0ought fi#ed assets then de"reciate and eventually re"ay. 5e"reciation O
ca"e#. 5on&t throw out your brain. Everything has its own Buirks. .ou ad4ust to the "articular situation.
@void #ormulaic thin"in!.
Investment ,andouts
Great investor;analyst and thinker8 CharlieJKA. 1&n Investor who wor(ed or a distressed investing undOa
very clear thin(er and great investor2$
$<2
I liked his thought "rocess. .:? e#am"le.
M42042001 ?%2?%00 @) ?"R HE1NF.00$ V?"R, Inc. W b charlieN7?

7atin! )
.< G$K us
ersI
6escription%
.:? is a homebuilder. 2heir o"erating model which is uniBue Gand which is described laterI allows them to
assume the least risk in the industry and "roduce returns that are the largest.
!omebuilders are generally dismissed because theyMre cyclical and interest?rate sensitive Greally though which
industry isnMt,I and downturns inevitably leave homebuilders holding large inventories of unsold "ro"erties ??
the unlevered builders then suffer large inventory write downs while the levered builders go into bankru"tcy.
!owever .:?Ms model will "revent it from suffering the same fate and indeed .:? will "ros"er in a downturn
at the e#"ense of the weaker builders.
2wo of the most im"ortant facets to its o"erating model are8
G$I .:? acBuires control of land inventory through o"tions contracts. 2hese contracts give .:? the right to
buy finished lots from develo"ers. .:? secures a su""ly of land for its homebuilding o"erations through the
use of these o"tions whereas other homebuilders "urchase land outright and engage in land develo"ment. 0y
avoiding that s"eculative "ractice of land "urchase;develo"ment and instead using o"tions .:? is able to
control large blocks of land GyearsM worthI in its markets while em"loying less
ca"ital to do so. 2he lower ca"ital reBuirements of this method translate into lower inventory risk and greater
returns on ca"ital.
G2I .:? "re?sells nearly all of its homes. Pther homebuilders ty"ically "artici"ate in some s"eculative
construction. .:? does not. 0efore .:? begins construction an order must be "laced and a de"osit made.
2his "ractice reduces risk and working ca"ital reBuirements which further enhance returns on ca"ital.
In addition to .:?Ms su"erior model consider the following8
(( 3ow valuation% .:? trades at a 6;E of C.)# trailing G<.$# 2++$E E6SI and a 2E7 ; E0I25A of '.<#
GtrailingI. 2E7 ; GE0I25A ? Da"e#I is '.C# GtrailingI. 2E7 ; FDF is <.C# GtrailingI. I am defining FDF as 1et
income "lus 5SA minus Da"e#.
(( 2ac"lo!% .:? has a backlog of 5<)5 ordered homes. 2hese homes re"resent *$.'K billion of revenue. 2o
"ut this into "ers"ective this is nearly three fiscal Buarters of revenue. In addition the homes in backlog carry
higher gross margins than the ones in the historical results. All of this should translate into higher E6S.
GManagement says 2++$ E6S should be 4ust under *2+ "er share. In the short history that the com"any has
"rovided guidance G"reviously they refused toI they have consistently been ridiculously conservative. 2heir $=
results and the backlog indicate to me that the *2+ E6S estimate continues to be the caseI.
(( ,i!h 7<IC% 2he low ca"e# nature of its business G*(+$ mil :2M homebuilding E0I25A versus
consolidated :2M Da"e# of *5 milI and the low working ca"ital reBuirements of its model allow .:? to
"roduce su"erior returns on invested ca"ital8 '5.(> in 2+++ and 5?year average JPID of 25>. 0onus
fact8 In 2+++ .:? sold *(25 mil more homes than it did in $KKK yet inventory Gthe bulk of a homebuilderMs
working ca"ital reBuirementI increased only *$$ million.
(( Intelli!ent allocation o# e+cess capital% !igh returns on ca"ital and e#cess cash flows are only useful if you
have a management that is smart about de"loying it. In .:?Ms case management has chosen thus far to de"loy
that ca"ital to buy back its own stock. 0etween $2;($;K( and $2;($;++ the com"any reacBuired $(.5 mil shares.
In the first Buarter of 2++$ .:? "urchased another +.C5 mil shares For "ers"ective there are only C.$ mil
"rimary shares out today GIMm using "rimary shares to illustrate this but I use diluted shares for enter"rise value
calculationsI.
(( ,omes a basic necessit% 6eo"le will always need homes to live in. 2he "rocess of building a home has not
$<(
changed materially in decades. 1either of these statements is likely to change in the ne#t year the ne#t 5 years
or even the ne#t 2+ years. 2here is minimal technological or obsolescence risk.
(( 6ominant in its mar"ets% .:? com"etes in $C geogra"hic markets. It is the [$ "layer in $+ of them. As
for the remaining C it is usually [2 or [( Galways at least in the to" 5I. 2he rest are markets that .:? has
4ust recently entered and will dominate with time.
(( 8a+ #actors% 2he industry has indirectly en4oyed the benefits of a government subsidy in the form of ta#
deductible mortgage interest. Additionally in the last few years homebuyers no longer have to "ay ta# on the
first *5++k of ca"ital gains on a home. 2his lowers the effective "urchase "rice of a home for a consumer
increases the relative attractiveness of a home as an investment and adds a little boost to demand for .:?Ms
"roduct.
.:?Ms "rofits and market dominance are all the more amaHing when you remember that the results have been
achieved without land develo"ment. .:? has margins better than its com"etitors des"ite the fact that other
homebuilders benefit from the gross margin boost of s"eculative develo"ment in an inflationary environment.
Catalst%
2he small number of shares outstanding occasionally creates large downward ga"s. .:?Ms recent 25> dro" is
one such o""ortunity. Also share re"urchases will continue to drive the stock. ItMs hard to
overem"hasiHe the magnitude of the re"urchases or the wonderful track record of buybacks8
$2;($;K58 $5.2$ Gmillions of shares outstandingI
$2;($;K)8 $(.5<
$2;($;K<8 $$.+K
$2;($;KC8 $+.(K
$2;($;KK8 K.$<
$2;($;++8 C.C)
+';$C;+$8 C.$'
);2';2++$ $+8(K8++ AM
8o% elan$K >rom% charlie'<K Sub'ect% elan
I understand your e#am"le but I think your conclusion is incorrect. IMll show that .:?Ms model actually
"roduces _inferior_ absolute "rofits versus the com"etition in a stable or inflationary environment Gas a
tradeoff for better returns on ca"italI but "roduces su"erior absolute "rofits versus other builders in a
deflationary environment. Given that we have been in an inflationary environment for the last < years
or so it is all the more amaHing that .:? has been able to "roduce "rofits consistent with o"erators which are
using a riskier Gbut in an inflationary environment inherently more "rofitableI model.
:et me use an e#am"le with slightly different numbers than you did8
$. .:? buys a two year o"tion on a "iece of land with a current market value of *$++k. 2he o"tion costs *5k
and entitles them to buy the land for *$++k. GI believe these figures are closer to reality ? it costs about 5> of
land value for an at?the?money land o"tionI.
2. !omebuilder <?:.< buys the same "iece of land for *$++k.
:etMs consider ( scenarios8 an environment of rising "rices stable "rices and falling "rices.
Jising "rices. In one year if the land "rice rises to *$$+k and .:? and ?:. build a house on the land and sell
it ?:. will have an embedded "rofit of *$+k on the land whereas .:? will have an embedded "rofit of *5k.
$<'
?:. and .:? will sell the house to the consumer at the same "rice but ?:. will realiHe a higher "rofit.
Stable "rices. If the land "rice stays at *$++k the result is similar. ?:. has no embedded "rofit while .:?
has an embedded loss of *5k. Again ?:. will realiHe a "rofit that is *5k higher than .:?Ms.
Falling "rices. If the land "rice falls to *K+k ?:. will have an embedded loss of *$+k but .:?Ms loss will be
limited to the *5k value of the o"tion. .:? will sim"ly not e#ercise its o"tion and instead "urchase the land at
the current market "rice of *K+k. G1P2E8 I think you incorrectly im"ly in your e#am"le that ?:. is no worse
off than .:? in this case because it can also "urchase the land at the current market "rice of *K+k and incur no
loss. 2his is not correct. ?:. has already "urchased the land ? it cannot "urchase it twice. Even if ?:. finds
an identical "ro"erty that it can buy for *K+k it does not eliminate the fact that it has an embedded loss of *$+k
on the first "ro"ertyI.
2here are two additional observations that can be drawn8
$. In a deflationary environment buyers may not at all be interested in the s"ecific "ro"erty that .:? and
?:. bought/ 0uyers may instead want a "ro"erty in the ne#t town or something near the highway or
something in blue. .:? will be able to res"ond by walking away from their o"tion on the "ro"erty and then
buying the lot in the ne#t town near the highway with the color blue. ?:. will be stuck. It will have to wait
for a buyer to show u" for its "ro"erty risking further "rice decreases in the meantime.
2. 2heoretically ?:. could also try to buy the blue "ro"erty in the ne#t town to satisfy the buyer. !owever
?:. will likely face ca"ital constraints when it looks in its "iggy bank for funds to buy the second "ro"erty.
Jemember ?:. has already incurred *$++k of debt to buy the first "iece of land that it holds in inventory. ItMs
unlikely theyMll be able to borrow another *K+k. G?:. may have enough cash to do this the first doHen times
but multi"ly these figures by the thousands of lots that builders have in inventory to see why the debt amounts
would be too large. 1ote that most builders currently have significant debt. .:? has almost Hero net debtI.
.:? meanwhile has only incurred *5k of debt so it has the financial fle#ibility to "urchase the land.
);2';2++$ )8('8++ 6M
8o% elan$K >rom% charlie'<K Sub'ect% elan
Management has said that o"tions are ty"ically )> to <> of land value. 2his is not Buite as chea" as the 5> I
used in my e#am"le but I agree with you that itMs still fairly chea". I will try to confirm these "rices again.
.ou raise a good follow?u" Buestion8 if the o"tions are so reasonably "riced why donMt the other builders go in
and bid on them, I have two theories on this8 G$I 2he other builders still "refer outright land "urchases instead
of o"tions because of the greater "rofit "otential in an inflationary or rising environment. 2herefore
com"etition for land is always intense but not necessarily for o"tions. G2I 2here are local oligo"olies in the
homebuilding industry. 0uilders need a certain threshold level of construction and sales activity in an area to
reach economies of scale for "urchasing materials showcasing model homes having sales agents etc. If there
is a builder that already controls most of the land in a locality GyearsM worth evenI it is difficult for another
builder to get enough inventory to su""ort a critical level of sales Gregional economy of salesI. 2herefore even
if there are o"tions here and there to acBuire at chea";reasonable "rices com"etition for them is limited to
e#isting builders in the area with enough scale. 1ote that .:? is the largest builder in over half its markets
and is number 2 or ( in almost all the rest.
.our Buestion deserves a more thorough answer so I will attem"t to get managementMs o"inion about why
other builders donMt com"ete vigorously for these o"tions and what motivates develo"ers to sell o"tions at such
"rices.
I agree that this could be one reason management does not like to communicate with the street. 2he other
rumored reason is that .:? has been an eager acBuirer of its stock and management is interested in increasing
its stake relative to the "ublic float at the chea"est "rice "ossible. IMve never Buite believed this Gsounds too
$<5
much like a cons"iracy theoryI. I think the most likely answer is they 4ust donMt like the Street and "refer to
focus on the o"erating the business than "romoting the stock.
$+;2++$ )8+28++ 6M
8o% charlie'<K >rom% charlie'<K Sub'ect% follow u" for elan
2he e#am"le we were using was a little too sim"lified and ignored cost of ca"ital. 2herefore the e#am"le
"roduced a result that showed the develo"er was not being com"ensated for his cost of ca"ital Gor his
develo"ment effortsI if he went down .:?Ms o"tion "ath.
In reality the develo"er would be com"ensated for cost of ca"ital and their develo"ment efforts. For e#am"le
for a lot worth *$++k in 2 years that .:? would "ay a *5k de"osit for today a develo"er might be able to sell
that same land now but they wouldnMt get *$++k for it. 2he sale "rice would be something lower ?? with the
difference being the "rofit that the develo"er gets in return for holding and develo"ing the "ro"erty over that
time "eriod.
2his does not alter the conclusions of our "revious e#am"le. Pther builders will en4oy higher embedded gross
"rofits "er unit than .:? in a stable to rising environment but they will tie u" more ca"ital Gand "roduce lower
returnsI to do so. Pbviously the other builders assume more risk and it shows u" in the falling "rice
environment. .:? will not have large amounts of ca"ital tied u" in a recession and its losses on inventory will
be lower than the other builders. 2he other builders will likely be left with large amounts of debt while they try
to liBuidate e#cess land.
5es"ite this inherent gross "rofit disadvantage in the recent inflationary environment .:? has in recent years
been able to generate gross margins that com"are favorably to other builders. I am re"eating what IMve already
said in "revious "osts but I believe this is a result of their o"erational efficiency and dominant "osition in its
markets.
K;$K;2++$ $$8(<8++ AM
8o% go"har5<$ >rom% charlie'<K Sub'ect% go"har
which com"anies in the s"ace do you feel are most overvalued, ? is there a "aired trade o""ortunity that
makes sense,
I generally discoura!e a paired trade in this industr. 2his is not because I disagree with your assessment
that most of the com"anies in the sector are bad businesses but because many of these com"anies already trade
for e#tremely low 6;Es. 2he "otential downside of shorting something with a low 6;E Geven in a "aired tradeI
can be massive.
2hat said if you insist on shorting something as "art of a "air IMd do a sim"le screen and "ick out the most
leveraged lenders. 2hese are the ones run by aggressive management who have been unable to resist
accumulating inventory. Dente# "o"s u" at the to" my
screen.
5;2<;2++2 <8(+8++ 6M
8o% mark22< >rom% charlie'<K Sub'ect% P"tions
2he o"tions grants for this com"any are e#cessive and the boardMs allowance of it is re"ulsive. 2his is the main
negative of this stock.
2he $+A has the correct issuance number in 2++$. 2he e#act number is not im"ortant. 2he bigger "oint to
realiHe is that this com"any is reducing its stated earnings by a significant measure by issuing o"tions every
$<)
few years.
2here isnMt a lot of reassuring things I can say about the o"tions "rogram. ItMs essentially one of the costs of
owning this otherwise very sound o"eration. I have drafted a letter to the board but have not gotten around to
sending it. 6erha"s several letters from 7ID members will get them to change their long?term com"ensation
"olicy.
2;$$;2++( (8(C8++ 6M
8o% charlie'<K >rom% charlie'<K Sub'ect% tim(2$
2he cash flow statement is indeed "retty good. 2here is almost no ca"e# so all of the o"erating cash flow is
available for share re"urchases which they have been eagerly doing.
Management indeed "ays no attention to wall street coverage. ItMs a great thing.
I noticed your "revious msg. I would send you an email but the address seems to be deleted from the "ost. ItMs
"robably better to "ost the Buestion on 7ID anyway.
Joel s comments on .:?
.:? has good returns on ca"ital because they use o"tions instead of owning huge tracks of land. 2hat is his
thesis8 they don&t lay out a lot of ca"ital. 2hey "re?sell so they don&t do much s"eculating. !ow big an amount
do "eo"le "ut down on their homes. In a recession "eo"le walk out on their de"osit so .:? gets stuck with
inventory.
Geogra"hically diversified. 2his was written u" in 2++$. A high return on ca"ital business at a low multi"le
'.C # with smart management that is buying back stock. I would look out three or four years and ask what a
normal environment might be9is this a good business, Are we way above normal earnings, All we have to
do is be well ca"italiHed enough to get to normal. !e makes a very good thesis.
1142742002 11%15%00 @) ;I,6 HEF.N1$ ?II ;oldin.s b charlieN7?

7atin! )
.) G(5 us
ersI
6escription%
.II Boldings which was formerly named .eCtel International is the first investment idea in over a year that I
have found worth "osting.

.II Boldings was incor"orated in $KK) as a wholly?owned subsidiary of 1e#tel Dommunications G.KT0I to
hold all of .KT0s international wireless assets. 0etween $KK) and 2++2 .KT0 invested over *5++ mil in .II
and bondholders invested an additional *2 bil. in the com"any to finance the build?out of .II&s wireless
network.
Struggling under the weight of its massive debt load the com"any decided not to "ay a cou"on due to
bondholders on February $ 2++2 and the com"any then filed for bankru"tcy in 5elaware on May 2' 2++2. In
the ensuing months the com"any and its advisors G!oulihan :okey and 0ingham 5anaI worked with creditors
on a "lan of reorganiHation and on 1ovember $2 2++2 .II Boldings emerged from Dha"ter $$ with a
substantially de?leveraged ca"ital structure.
2he following are the main arguments for investing in the com"any now8
$. Dnder(researched, ne!lected e9uit U !aving 4ust emerged from bankru"tcy .II&s shares began
trading on the P2D 0ulletin 0oard a few days ago. 2here are no eBuity analysts following the situation. Much
$<<
of the financial detail is buried in hundred?"lus "ages of disclosure statements and "lan documents.
2. 3ow valuation U 2he com"any&s enter"rise value is 2.C # current annualiHed E0I25A. 2he
valuation isn&t easily discerned from the "ublic filings so I will "ost the details in a follow?u" "ost.
(. Spectrum ri!hts U S"ectrum rights are a source of -moatT much like cable 27 franchise rights or
broadcast radio license rights. .II owns the rights to s"ectrum in the C++ M!H region in 0raHil Me#ico
Argentina and 6eru.
'. 6i##erentiated wireless o##erin! U .II offers all of the wireless calling features that traditional
wireless o"erator&s offer. !owever .II offers the 5irect Donnect feature that its com"etitors do not Gand cannot
without e#"ensive network overhaulsI. 5irect Donnect is a walkie?talkie?like function on 1e#tel "hones that
"rovides an instant connection to other users in one&s designated calling grou". For e#am"le field su"ervisors
can simultaneously convey work order changes to multi"le field agents using 5irect Donnect.
2his 5irect Donnect feature has two "rimary benefits8 G$I it is a service which is "referred by many business
users Gsuch as the above field agentsI which tend to generate higher average revenue "er user than traditional
wireless users and G2I once users get set u" into a calling grou" there is a natural reinforcement against
switching to other carriers Gthe field agent that leaves 1e#tel in the above e#am"le would cut himself off from
5irect Donnect messages from others in his workgrou"I. Indeed all of the 1e#tel com"anies have shown
higher AJ6R and lower churn rates than the traditional wireless carriers over a sustained "eriod of time.
5. Capital structure has been #i+ed U .II&s "lan of reorganiHation converted *2.' bil of bonds into
eBuity. In addition several credit facilities "aid down and a *$++ mil Argentina facility was settled for *5 mil.
). 1ublic comps trade at hi!her prices. While I&m not a fan of com"arable com"any analysis it&s
worth noting that investors are willing to "ay ).K# 2++( E0I25A for .KT0&s eBuity and over $+# for 1e#tel
6artners& eBuity G.KTPI. 2he average of the traditional wireless carriers is ).<#. G1ote that I am using 2++(
E0I25A for the "eers but current run rate in calculating the multi"le for .III. If .II were to trade at a 5#
E0I25A multi"le the stock "rice would be *2C.$+.
<. ;on(core assets not included in valuation ?? In addition to the $.2 million subscribers it has in its '
"rimary markets G0raHil Me#ico 6eru and ArgentinaI .II owns wireless assets in Dhile and the 6hili""ines.
2he latter two do not contribute to cash flow and .II is in the "rocess of selling its 6hili""ine
stake.
C. Strate!ic importance to ;e+tel Communications. .KT0 customers are able to roam on to .II&s
international network. As an indicator of how im"ortant this is to .KT0 G"articularly in the ad4acent Me#ico
regionsI .KT0 agreed during the bankru"tcy to "ay *5+ mil to .II to ensure the build?out of certain regions in
.II&s territories. .KT0 has also made an additional investment in the reorganiHed .II. .KT0 now owns ()> of
the common stock of .II.
Catalst%
$. Emergence from bankru"tcy.
2. Eventual move off of the bulletin board onto 1AS5A= should raise the "rofile of .II.
Investors in .KT0 and .KTP will start to notice .II. 7aluation will normaliHe to 5.+#
E0I25A from 2.C# E0I25A currently. .II would trade at *2C.$+ if it were to
achieve a 5.+# E0I25A multi"le.
$+;(;2++( 28+)8++ 6M
8o% charlie'<K >rom% charlie'<K Sub'ect% legg mason
ItMs shameful to "ost this but luckily I am a shameless guy.
$<C
I thought 7IDers might find it funny that the title of the re"ort is VAttractive Early?Stage P""ortunityV
JESEAJD! A:EJ2?:egg Mason starts .II Boldings with MbuyM D!IDAGP Pct ( GJeutersI ? :egg Mason
on Friday started coverage of .II Boldings Inc. which "rovides wireless service in :atin America with a
VbuyV investment rating and a $2? to $C?month "rice target of *C2 "er share. V.II offers a better com"etitive
dynamic than the R.S. wireless market with only three to four "layers "er market no wireless local number
"ortability e#"osure or "ush?to?talk com"etition and the ability to transfer 1e#telMs "roven business model to
:atin AmericaV analyst Craig +allit8 said in a research note.
.II a former unit of 1e#tel Dommunications Inc. sells wireless service in countries such as Me#ico 0raHil
and Argentina to "rimarily business customers. Its selling "oint is a uniBue walkie?talkie feature that lets users
connect to others instantly with the "ush of a button instead of dialing a number.
Shares of .II rose *(.$$ or nearly 5 "ercent to *)5.K$ in 1AS5A= morning trading. 2he stock has risen
more than ten?fold since last 1ovember when the com"any emerged from Dha"ter $$ bankru"tcy "rotection.
Je"orting by .ukari Iwatani3 editing by %ohn Wallace3 yukari.iwataniXreuters.com3 Jeuters Messaging8
yukari.iwatani.reuters.comXreuters.net3 ($2?'+C?C<C<II
Joels comments on .II
1e#t e#am"le8 Datalyst8 4ust came out of bankru"tcy. It will go onto 1AS5A=. 2here are reasons that it will
become more discovered. 1ot to say it will be a "o"ular stock. 2he reason he is using E0I25A is because they
already have sunk Q billion into the network so ca"e# is baked into the number. :ow valuation 2.C
E7;E0I25A. :ook where the their bread is being buttered. Watch mgt. 1e#tel owns ()> of this com"any.
2his com"any may have staying "ower because 1e#tel needs these guys. In fact 1e#tel did "ay u" for a build
out of their network.
!e builds a thesis8 it is chea" low relative value analysis. 2hey have a differentiated "roduct3 they have a
moat there is growth o""ortunity. %ust at (+> of similar business valuation the stock would go u" by <+>.
8he stoc" will triple i# we !et an tpe o# reasonable valuation.
It can make sense and not work out.
?????????????
M4?4200F ?%F7%00 @) !G$E HE?.72$ !&orts'an%s G1ide b charlieN7?

7atin! )
.2 G(< us
ersI
6escription%
Sportsmans Guide has an unleveraged return on eBuity of over (5> and trades at '.C5# free cash flow Gdefined
as o"erating cash flow minus ca"ital e#"endituresI.
2he com"any is a retailer of s"orting gear and other outdoor items. It sells its "roducts "rimarily through its
catalogs and web site. If you are not familiar with this com"any&s wares "lease check out
www.s"ortsmansguide.com and s"end freely.
$I 2he com"any has a strong niche brand. Its customer following has been cultivated since Sportsmans Guide
was founded in $K<+ as a catalog of "roducts targeted at deer hunters. Pver the years founder Gary 9len has
broadened the original catalog into a business "roducing *$C+ mil in revenue "er year through a series of
monthly catalogs with a distribution of ') million "er year.
Indicative of the loyalty of the customers is the success of the com"any&s recent 0uyer&s Dlub initiative.
0uyer&s Dlub members "urchase a yearly membershi" for *2K.KK to receive catalogs with limited run items
available only to members. Members also receive 5>?$+> discounts on most items. 2he number of members
was ($++++ at $2;($;+2. Membershi" grew 22> last year and has continued to grow in the $st
$<K
Buarter.
2I A key com"etitive advantage for a catalog marketer is its database of customer names. C5> of the
com"any&s revenues come from e#isting names in its database of s"orting and outdoor enthusiasts. Sportsmans
Guide has 5.2 million names with demogra"hic data and "urchasing history in its customer files. Pf these $
million names have "urchased a "roduct within the last $2 months. Pver time the com"any has used res"onse
data to subdivide this database into subsets of customers. 2hese subsets receive different s"ecialty catalogs in
addition to the main S"ortsman&s catalog. 2he s"ecialty catalogs have different "roduct focuses8 government
sur"lus cam"ing shooting hunting etc. Subdivision im"roves res"onse rates which reduces unnecessary
mailing costs and im"roves economic returns.
Ever since the launch of the online Sportmans catalog the database has also been su""lemented with email
lists. 2here are a""ro#imately K++k names in the email database and nearly all of them receive a broadcast
email every $ or 2 weeks.
(I 2he com"any&s -bargainT focus is hard to re"licate. 2he com"any has develo"ed a customer following
"artially because of its history of value?"riced bargain items in its catalogs. 2hese items are 25>?)+> off
retail. 2he com"any is able to offer these "rices to customers because the com"anyMs buying agents comb for
discontinued ;liBuidation;overstock items through a network of $2++ su""lier contacts. 0ecause
the su""ly of overstock items is irregular it&s critical to have the ability to "urchase o""ortunistically and store
chea"ly.
All inventory is stocked in S"ortsman&s warehouses in Minnea"olis. Datalogs are customiHed to include these
overstock items shortly before "rinting so the inventory carrying "eriod is minimiHed. 2he com"any&s customer
base of bargain hunters allows SG%, to move these items faster than other com"eting retailers. What cannot be
sold via its regular catalogs and online store is liBuidated through its bargainoutfitters.com site and a small retail
location the com"any has in Minnesota. Everything from the low grade "a"er in the com"any&s catalogs to the
incentive systems for maintaining high shi""ing accuracy is aimed at selling chea"ly and "roducing a solid
return on ca"ital.
'I I believe there is a fundamental shift in SG%,&s business that is reducing costs in the com"any and
im"roving return on ca"ital. It&s this fancy new thing called the internet.
R" until $KKC all of the com"any&s business was done through "rint catalogs. Millions of these catalogs were
distributed each year with each one incurring shi""ing and "rinting costs. 2here&s also higher "roduction costs
and longer "roduct lead time reBuired when doing business by catalog. 2he com"any began its web site in $KKC
and by February $KKK had its full "roduct offering on the web. Sales generated through its web site have grown
each year from $KKC to 2++28 *$ mil *$' mil *2' mil *() mil *5( mil. 2he com"any is encouraging this
transition by "rominently mentioning the web site in the catalogs it continues to distribute. In the '= of 2++2
internet sales generated (+> of total com"any
sales.
So what, Well aside from the reduced ca"ital needs the com"any has a chance to take out a ma4or "ortion of
its o"erating e#"enses if it can successfully transition its business to the internet. Its current cost of distributing
catalogs is a""ro#imately *(+ mil a year. A large "ortion of any reduction of this *(+ mil in e#"enses would
dro" to the bottom line. Donsidering that free cash flow is currently *C.( mil even a small amount of savings
would "roduce a large effect. 2he com"any has reduced catalogs mailed from C+ million in $KKK to ') million
in 2++2. SGSA Gwhich include the catalog costsI has been falling8 ('.C> of sales to (+.C> in 2++$ to 2K.(>
in 2++2. 2hese are the initial signs of the internetMs im"act on S"ortsmanMs business.
Catalst%
2he com"any has recently initiated a share re"urchase "rogram to retire u" to $+> of its outstanding stock. 2he
com"any has a history of returning ca"ital to stakeholders. *<.' mil of debt was "aid down in 2+++. *5.2 mil
of debt was "aid down in 2++$. GIn 2++2 cash sim"ly built u" because debt was retiredI. 1ow that the
com"any is debt free it is using a "ortion of its cash hoard Gcurrently eBual to about 2+> of market ca"I to
retire a substantial number of outstanding shares.
$C+
);K;2++( $28'C8++ 6M
8o% charlie'<K >rom% charlie'<K Sub'ect% ben$$$ Free cash flow
IMve been measuring free cash flow over calendar year "eriods so that may "roduce our difference in
calculations.
For the last ( years I have8
.ear
PDF ? Da"e# O FDF
2++2 K.2 ? +.K O C.(
2++$ $(.+ ? +.5 O $2.5
2+++ $+.2 ? $.5 O C.<
I chose to use the 2++2 *C.( mil for free cash flow in my calculation. For enter"rise value I get *'+.( mil
G*').( mil market ca" "lus *'.K mil for o"tions minus *$+.K mil of cash at (;($;+(I. 2his gives me a
E7;FDF multi"le of '.C5#.
I su""ose it doesnMt matter much whether multi"le is '.C5# or 5.2#. ItMs "retty chea" either way. 2here are few
com"anies with free cash flow yields of around 2+>.
2hanks for "osting this. Wish you had told us about it two years ago before it went from *2 to *$+.
IMll "ost it earlier ne#t time 8I 0ut hey I wish someone would have told me about 0erkshire !athaway decades
ago.
I tr not to loo" at the historical charts too much. 8he should be irrelevant to investment decisions
toda. IMve found that staring at the charts sometimes leads to irrational Gand sometimes harmfulI buy;sell
decisions.
);K;2++( $82(8++ 6M
8o% HHH++< >rom% charlie'<K Sub'ect% HHH++< Insider sales
I donMt ty"ically look at insider sales because itMs as critical to me as the Buality of the business and other
factors. It is an interesting fact that you "oint out though. I believe Palet8 is retired and draws no salary from
the com"any Gthe other co?founder is still an em"loyeeI so he may be selling shares to "rovide for some
retirement e#"enses.
Shiel had "lans to retire this year from the board of directors. I sus"ect that his selling is related to his
retirement as well.
);K;2++( $$8+$8++ AM
8o% ben$$$ >rom% grant(C< Sub'ect% Je8 cash flow
Dharlie I think this is a fantastic idea.
0en in regard to cash flow figures if you look back over the "ast three years youMll get an average FDF GDFF+
? 66EI O *K.CMM.
$C$
If you take an E7 of about *(<MM now I get a E7;FDF of (.<C.
If the to" line continues to grow a bit and they kee" wacking away at the e#"ense side cash flow will continue
to grow at a healthy rate. 2his is a very good story.
Dharlie I also really liked your =RI6S write?u" and your legal analysis was $++> correct...it is a shame that
big money sometimes tram"les over the little money in this world leaving the little guy with no leverage
whatsoever.
1e#t one8 !G$E.
It is amaHing what you can say in one "age. What differentiates this business9they are good at sourcing goods
9chea" s"ortsman&s stuff. 1ow they can do the same thing on the Internet. 0ut others can do the same,
Pne of my concerns would be growth ham"ered by lack of close out merchandise. 0omans had to manufacture
4unk rather than buying the stuff.
SG%, 0omans couldn&t scale. Find 4unk vs. manufacturing. Grow9can they source close outs.
SG%, worked3 it went to *2'. Dhea". :esson8 2u cheap with !ood 7<C. !e makes a case that they have a
great network. In effect they have a brand name. 6eo"le know this is a "lace to buy low "riced s"orting
goods.
2he Internet brings com"etition.
6art of this is the very low valuation. 2here is *2 "er share in cash. 6aying 5 times cash flow or 2+> yield and
interest rates are '> this would work out. I bought this one because he "icked the other two. 2his was the
weakest of the three he "icked.
Pne of the best classes is to go over the mistakes from the "a"ers handed in on the $)
th
of March. We will
review on March 2(
rd
.
Jead the first one8
Dse the /IC write(ups as a model.
Why "re?ta# numbers vs. after?ta# numbers.
:ast year&s ta# was weird. Factor in the long?term ta# effects. 2ake away aberrational effects of ta#. Factor in
different ta# rates.
If I am looking at an acBuisition for a com"any I look at "re?ta# returns.
6ay $+> to borrow and "ay C.5 times FDF or $2> yield. Investment bankers will say this will be accretive to
earnings. I will not look at the 5+ "age investment bankers& book. I 4ust say look my "reta# cash flow based on
what I am "aying G$2> and very stableI vs. what I must "ay $+> debt Gcost of moneyI. I buy these assets for #
"rice GC Q times FDFI they will generate a cou"on over time of y. 2hat cou"on "reta# eBuals $$> and
borrowing costs were K.5> then I can leverage u" and make the s"read. 0ut the debt is a floating borrowing
rate. I am buying an $$> cou"on which could shrink and I am "aying K.5 "ercent for a tiny s"read $.5>. I am
wasting my time for a com"any with $+++&s of em"loyees and a lot of moving "arts.
.ou can see how you can leverage. Aou !et no mar!in o# sa#et. Sim"le analysis says -What are you
kiddingT 1o matter how good they make it look. 2his may seem like a sim"listic way to look at the world but
I think it is a clear way to look at the world. It is not that hard. 0ut they can make it look really hard.
I# ou wal" out o# this class thin"in! these simple thou!hts, ou will be ahead o# ??.? percent o# the
people who "now how to use the spread sheets and put to!ether the bi! boo"s. Buett says -:ook at it as
a cou"on.T I am choosing to look at it "re?ta#. Is the cou"on growing or shrinking, !ow confident are you of
the business, If you can&t answer those Buestions you have no business being there. And if you can then you
$C2
try to get the best deal you could. It is reasonable to have ball "arks. When I say look at E7;E0I2 and E0I2;
GJPDI what I really want to determine is how good a business is this, What are normaliHed earnings three or
four years out, Is it a (+> or $5> or 5+> JPD business,
What am I looking at, And then how chea"ly I can buy the business. 2here is a matri# between what e#tra
JPD is worth. ,ow much ou can reinvest in that business to !et the 7<C. !ow much growth with or
without investment. I bet when Buett makes his decisions in (+ seconds -!ey it is worth about *$+ and I can
buy it for about *5.5+ so maybe it worth *K or *$$ but the *$+ is going to be growing over the years. It is
trading at *<.5+ and the *$+ is going to be worth *$( two years from now. !ow to get a (+ to )+ cents dollar.
!e is doing that in his head. If you have got a good business you have a "articular niche.
2he reason it is sim"le because you can choose the ones you do have an o"inion on and then it does become
easier. It isn&t easy because you "ick and have to analyHe $+++ com"anies. It is a big ga".
AMEE Spin o##
Any thoughts, 0ig "icture8 they had two businesses8 &merican /inancial &dvisors &/& is a financial
advisory business that isn&t earning high returns on ca"ital. 2here could be an argument why aren&t they
earning higher returns on ca"ital. Is the business not being run well, 2here are values not being realiHed. In
the T?S business those will be 2C> to (+> once we stri" out the &/& business G$$> JPEI.
5) cents ne#t year for &/& and he sla""ed a $) multi"le on it Ggood or bad I don&t knowI and said it is worth
*K. Since the stock is trading at *55 now and it will ha""en in ) or < months. If I think there is an o""ortunity
in &/& then I have to wait for when &/& starts trading. Its value is a small "art of the whole. I need to be
ready when it comes out to assess the value.
Pn the other hand I could look at the -goodT business the T?S business now. In this "articular case I think I
can look now because the moving "iece that I have to "ay for now is reversed9the *55 stock has *') in value
for the good business. I can today in effect buy now. If the stock is *55 now and the &/& is only worth *K
then *') value is with the good business. I can analyHe that business now rather than wait for the s"in off. Pf
course I have to value &KP to know what I am "aying for the T?S business to see if there is an o""ortunity
there. 2his is why I would look now.
2houghts,
2he terms of the deal. 2he "ress release was a bit confusing. 2here was a conference call off the net. I think
this is "retty much what they say8 the se"aration of two businesses9one with high JPD and the other with low
JPD that have no synergies.
!ey will I get a higher multi"le businesses on the good business, 1ow I will own a business which has high
JPD. If you 4ust buy T?S you get a "urer business with high returns.
&KP has a billion and a half shares and everyone is looking at it. 2here are many analyst re"orts. I still look at
it. I made money in Sears. Even in a sim"le one9I would rather have a big mess. !ere what you see is what
you get.
Student% &/& Gfinancial advisorsI used to be a good business. In the bubble they earned 22> to 2'> JPE. It
seemed like it was still a "retty good business. 0ut you are develo"ing a thesis. It is $$> and if JPE gets back
to $K> then earnings will go u" <C>. 0ook value would be a better metric com"aring to Schwab and
&lliance Capital,
Joel% What I try to do I take everything down to earnings "ower. Why aren&t they trading three times book,
Is Schwabs business better, If other "eo"le can do it they can to. 0ut at the end of the day when you do your
valuation. I am very sus"ect of the number of hos"ital beds going for *#. I want to be very comfortable what
they will earn four or five years out on a normaliHed basis. What will earnings look like and translate Schwabs
earnings and then com"are. If &/& is trading at $.5 times book while Schwab is at ( times then maybe there
is room here.
$C(
If they are getting rid of it may be it stinks Gone analystI. Buett owns $5> of &KP. 2hey wouldn&t make a
move without his a""roval. My first guess is that a high JPE should get a big multi"le. Mgt. focus and better
direct com"ensation due to the s"in off. Da"italism works. Buett will hold both "ieces. 6erha"s they are not
getting a high multi"le on their good business and there is no synergy between the businesses. I am looking at
the combined. I look for a three to five year horiHon.
3,B -A fat wallet is the enemy of returns.T Gee if I had *$ million to work with I think I could make 5+> a
year. Somewhere between $5> to 5+> lies your o""ortunity I think to do things differently. !e has to buy
good businesses and not trade them in large siHe because he can&t get out. 2ime is the enemy of a bad
business. If he GWE0I is stuck in a bad business he will get low returns. !e can&t trade -cigar buttsT returns.
&/& was a good business in the "ast and it should be a better business in the future. 2hey did enough to screw
it u". We will have K.) billion in assets Gin DD available on the web?siteI. 2he good business will have higher
returns since we are se"arating the lower return business G$$>I.
Joel% I will show ou what I did re!ardin! AE.
I did develo" a thesis. &,/& 1spin4o rom &KP2 is too small for me to focus on now. A "age from the C?A
announcement.
If you have a business growing $2> to $5> with (+> JPE you should have a good multi"le you should be
buying back stock or "aying a dividend. Why wait around to fi# the business, 2his is "robably a more
strategic way to o"erate the com"any.
:ooking at "age from C?A. !ow would you look at newly announced s"in?off and what ty"e of thesis could
you come u" with, !ow much work do you have to do, 2his is somewhat of a com"licated business.
Most of &KP&s business is charge cards. 2hey 4ust won a lawsuit against +asterCard and :IS& who were not
distributing &+,K cards. It is a "articularly good business.
Frankly we bought +oodys for 2+ # earnings and I thought it was too low. I am not turned off by this
business at 2+ # E6S9a high multi"le??if I think it is a really good business. It can&t "ossibly be as good as
+oodys but it could be good given the JPD.
If you buy from a store &+,K gets $.5> or 2> of the "urchase. 2heir cards will be distributed more widely
after winning the lawsuit.
2hey have a lending business9
2ravel commissions and fees is *$.C billion9I thought it would be a lot bigger number. A recession could
have been a "roblem. K;$$. 2his was a $.C billion five years ago. 5ro" off of (++ million. After ta# $2 to $5
cents loss in a bad downturn. 2his year T?S will earn *2.5+. 1ot going to be a big mover Frankly I don&t
know if we are above trend because of the dro" off. .ou can argue we are not way above normaliHed.
Another business8 give out &+,K money card. 6re?"aid card. 2hat business is growing. .ou give them the
money and you get a traveler&s check. A very high "rofit business.
2hen they have Finance charge revenue which was *2.2 billion "lus they securitiHed their credit card
receivables9&+,K takes those receivables and "ackages them into a security and sell that security to another
institution. &+,K kee"s "art of the risk to get a better "rice. 2hey don&t have to tie u" their ca"ital3 they can
make their s"read right away. My "roblem with this is that it is not a high multi"le business9an $$ to $2
times business9because losses are below normal due to good economy.
5oes &+,K have a better business not what "ercentage of its business9you don&t know how to allocate how
much in e#"enses to this business. .ou don&t know how much income is coming from this business. If you
were to evaluate each of their businesses whether it is the charge card business or T?S business you want to
"ut different multi"les on each of those businesses to figure out what the "ieces are. .ou would have to gra""le
$C'
with the issue8 what "ercentage of income do I a""ly that low multi"le to, And what I would struggle with8 are
they really com"arable to those lower multi"le businesses, 2hey have a higher credit "rofile they have a
closed network9it feeds each other because if you use their discount card it still adds to the discount revenue
9you don&t know how to untie all those things they are all mi#ed together.
So one of my thesis for liking this a lot8 I will tell you the Buick and dirty on that8 6erha"s C+> of the things
you look at you won&t get a good answer. .hat are the issues to decideC
JPD is growing I would normaliHe the credit s"read. In 2++< what will the 2++< T?S business earn, $5>
rate of growth in this business net of the cor"orate overhead will earn *(.2+ "er share and *55?K O *').
We are earning above average s"reads. 1ormaliHed s"read would be 2< cents a share. In three years this will
earn *( and this business should earn '+> JPD three years down the road because they are taking ca"ital out
of the business that they don&t really need it . 2hey also said in the release last year between stock buybacks
and dividends we "aid out over C<> of our earnings. 2hey are able to grow without much reinvestment.
2hey "ledged no less than )5>. I am guessing it is over <+> to <5>. 2he rest they will have to reinvest back
to grow at the rate they say they will. I don&t know if I am right about where the *( goes to.
2ake the $+ year bond yield U )>. :et us try a 2+ multi"le on the business of 5> earnings after?ta# yield
which is growing $2> to $5> a year with high JPD Gassuming I believe that9you heard Jich 6Hena saying
there are only a few com"anies which have sustained such a growth rate over $+ yearsI vs. my o""ortunity cost
of )>,
Any growth over C> in a dividend discount model you get "rices off the charts. 2ake three years of $2> then
C> then 5>. I would rather have 5> growing than )>. 2his has never been a business by itself.
Assume a 22 multi"le Gfor a great businessI and assume &,/& is *K and e#clude any other earnings net of
what they "ay in dividends so we collect another *( or *' dollars. 22 times earnings you can make a case for
*C+.
22 # *( E6S O *)) then N *K for &/& O *<5 and the earnings from the bank *$ and add earnings net of
dividend "ayments let&s say you collect another *( so *<K to *C+ "er share. 2hat is a 2+> rate of return from
here. .ou get back your money *K in a year.
2hat is the beginning of a thesis. I don&t know if that is fat enough for me. I do know it is hard to find a
business that is as good. I don&t know if I should count on the stock getting to 22#. +oodys went to (+ times.
2his isn&t +oodys.
2he earnings are a reasonable target but not a safe bet. Pbviously that is the beginning of a thesis and I will
have an o""ortunity to look at the s"in?off9&,/& later.
A com"licated business with a lot of moving "ieces. Most of the time I do this I ski" it because there are
Buestions I can&t answer and I need to make certain metrics. I don&t want to ski" &KP because this is a good
business. I will also discuss o"tion situations.
&,/& re"orted numbers8 *(++ "rofit "er client that they have. 2.5 million Dlients # *(++ net income "er client
9what is this worth to someone else, 2he list of com"anies with *5+ million to buy &,/& is short.
Generally that is a good thing to look at. :ook at the takeover value to someone else. .ou would have to "ay a
full "rice.
&,/& is a "otentially "oorly under?managed firm. !ow much do they have under management is it relatively
chea" from that stand "oint.
Student8 What kind of time frame do you give yourself,
Joel8 As soon as I finish my work I move. 2his situation has a lot of stock out there. I don&t think there will
be a lot of com"etition because it is not the chea"est thing I have ever seen. ) !eneral rule is I am not a
$C5
trader so I take a "osition if the o""ortunity is there. I am good at valuing businesses but not trading them. I
have never met anyone who has made a living trading.
If you can value businesses and are very disci"lined then that is the main strategy.
%oel as 0uffett
Joel will pla Warren 0122ett. @n 9uestions ou have #or .arrenC
I want a business earning good returns on ca"ital. I want good managers but if I have mediocre managers in a
great business I may ask for a bigger discount. In two or three years out the market will eventually get it
right9value the business correctl and the price !ap will close.
I do have "eo"le that work with me who go out and visit management. I am more of a numbers guy but I look
at the actions of management over a long time "eriod.
I am always looking for a big enough margin of safety in case I am wrong I will still make money.
My biggest "osition now which I will not name gets huge JPD and has a big shareholder in it. 2hey "low
their earnings back into buying stock. We are confident that they will continue to do that. 2here is a moat
around the business. We will have five or si# things that are C+> of the "ortfolio.
I started as a cigar butt investor with net;nets. Graham said that if the business is selling below net liBuid
assets then on average you will do well. Ber(shire Bathaway was a te#tile manufacturer which was earning
low JPD but he bought it below liBuid assts. !owever if the business is dissi"ating ca"ital then the
liBuidating value will decline. Rnless you liBuidate the business you are stuck with a "oor business that is
losing value.
8hat is wh ou should not bu a business with poor economics. !e now would rather "ay *C for a
business worth *$+ that is growing to *$2 instead of "aying *) worth *$+ that is going down to *C.
1<78><3I< )@;@G5)5;8
Buett ignores 0eta. 7is" is permanent loss o# capital. I don&t care if the "rice goes down for &KP if I can
get back to normaliHed earnings. If we are at "eak earnings then I would be worried about reaching
normaliHed earnings.
I look at risk;reward. If I am wrong and &KP is *C+ and the stock is *55 now. 2here is a lot of room between
*55 and *C+ or *(5 to make money.
I am concentrated but not leveraged. Walk into a town and buy the best businesses you can find. 6ick five
good business at decent "rices and "ut 2+> in each. Instead of inde#ing by "utting money in all the businesses
in town. If one or two businesses doesn&t work out but the other two or three do very well.
7olatility is a stu"id metric. If you have a three to five year horiHon at a minimum you will do PA.
I have missed some huge things??*2 to *$2 to *+. I got out at *$.++ so I only lost half my money. Some years
I lose 5> and other years I make $++>. 3oo" #or asmmetric rewards. With &KP I am betting *+ or *5
Gwhatever is my cost of carryI at *55 and have e#"ected u"side of *(+ or 5+>??*5 down and *25 u" or 5 to $
return. If I feel confident of my valuation and the business does well so how the business bounces around 4ust
ignore it. 0ut if you are in a ( to 5 year horiHon then you are in good sha"e.
Pnce again Buett has huge amounts of ca"ital so his universe is much smaller. !e must hold for a long
"eriod of time. !e has a more limited universe in which to "ick from than you. 8here are more opportunities
to #ind the un"nown when ou are smaller.
$C)
My favorite "eriod is forever but he did say he wished he had sold Co(e when it was worth 2.5 times its worth.
I may sell C+ cent dollars to buy 5+ cent dollars. 2hat doesn&t ha""en to Buett now.
Buett has advantages o"erating an insurance com"any in Pmaha 1E because he can invest in eBuities. If you
don&t have the balance sheet and the confidence to not worry about volatility.
Co5e (L>):
I will see you March 2
nd.
:ook at the s"in?offs in the sheet I gave you.
5;6
Greenblatt Class #M
March $) 2++5
35@1S%
%oel&s P"tion 2rading 5ays at Bear Stearns
P"tions were not as efficient back then as they are now. If I could create a situation if our borrowing cost was
$+> and make $2>??it was a risk?less s"read at 2>. I was doing forward conversions.
N
I s"ent the whole summer trading o"tions.
Another way to look at a Call is it is similar to owning $++ shares and $ "ut. $++ shares of stock and $ "ut G$
"ut has $++ sharesI. 2he "ut "rice is e#"ressed on a "er share basis. A "ut "rice of *(.<+ costs *(<+.
2he eBuivalent of owning a Call is like buying a stock and a "ut. Why is that, Pnce I own a "ut at *5+ strike
"rice I canMt lose money below *5+. I have to lay out ** for the interest cost of owning the stock at *5+. 2hat
is the same as owning the Call at *K. 2he economics are e#actly the same other than the interest difference.
$C<
Pver C5 6;E
Rnder $K
5ividend Issue8 .ou have to ad4ust for dividends because if you own the stock you are getting dividends and if
you own the Call you are not getting dividends.
2he Call gives you the right to own stock at *5+ and the right not to lose money below *5+. So here I own the
stock and I bought the "ut.
So what I was doing all summer at Bear Stearns was to buy the stock and a "ut while selling the Call ??and
make money. I was e#ecuting orward conversions.
If I bought the stock at *5+ and the "ut at *(.<+ Gidentical to owning a CallI and I sell the Call at *K??this is an
arbitrage.
I bought the stock at *5).)5 and sold a Call for K.++ which will e#"ire %an. +<.
@rbitra!e or >orward Conversions
If the stock is at *)+ or above.
So whole "osition is *5).55 and *)+ O *(.'5 and I have the cost of laying out the *5).55 for two years. *(.'5
in interest for two years. If I "ut this down *5).55 minus *K GCallI O *'<.55 is the cost of the trade. 1ow I
own a stock and I own a "ut and I sold a Call. 2he stock is at *)+. !ow much is this *'<.55 worth with the
stock is at *)+,
I laid out *'<.55 and I get *5+ two years later.
If the stock is at *'+ or below.
What ha""ens if the stock is at *'+ at e#"iration, Pwn the stock at *'+ and a "ut that is worth *$+ G"ut stock
at *5+ when the stock is trading at *'+ for a difference of *$+I. 2he Call is worth *+.
What if the stock is at *5+ the trade is worth *5+. 0ecause the "ut and the Call are worthless and I own the
stock at *5+.
I "ut trade on at *'<.55 I collect *5+ no matter what ha""ens to the stock "rice. 2he difference is *2.'5 so the
cost is *2.'5;*'<.55 O 5.2> and annualiHed over two years is 2.<>. 2his rate eBuates to the risk?free rate for
the amount of time of the trade.
Gee if I Ga trader at 0ear StearnsI could borrow money at (> and I can make 5> it is risk?less.
8he "e is thin"in! o# buin! a call as the same thin! as buin! a stoc" with a put attached.
2here is no difference. When you are investing you want to know what you are doing.
When I buy a :ea" I am basically buying a stock with "rotection. 2he difference in any "rice has to do with
dividends and any interest that is "aid out but it is fairly "riced. It is a chea" way to borrow money. 2he
im"lied borrowing costs in the Call will really be the risk free rate. .ou will be borrowing close to the risk?
free rate.
2he volatility will come into what is the "ut worth, If the stock can vary widely then the "ut wonMt be "riced so
chea"ly.
5onMt worry about volatility or any com"licated stuff. Jemember that when you buy a Call??you are buying a
stock and a "ut G"rotectionI.
8he #undamentals re!ardin! @merican 5+press H@R1$.
$CC
Donstructing a thesis.
In Se"t. 2++5 they will s"in off the financial advisory business. An analyst said it would earn 5) cents and he
gave it a $) multi"le so it is worth *C or *K. :et&s say it is at *K so you are buying the other business Gwhich I
am interested inI at *'(.C5.
:etMs construct a thesis for &KP. Analyst estimates were roughly *2.5+ for this year. 2he com"any is telling
you that they will grow earnings at $2> to $5> "er year. 2his works out to *(.2+ in earnings "er share in
2++<. Since the o"tions e#"ire in two years in %an 2++< what is the multi"le of earnings in 2++<,
2he Buestion now is8 are loss ratios in credit cards lower than normal or are their s"reads larger than normal,
Are they making more than normal "rofits, Pr is this situation now normal earnings, We can Buibble if this
*(.2+ E6S could turn into *(. I will argue that it will be *(.2+.
When we went to analyHe this thing??and this e#cludes the American E#"ress 0ank which earns about a *+.$+
and is not a high multi"le business??so I give that a *$ at the end of the day.
So the Buestion is what is that *(.2+ worth, Jemember when the 2+ year govt. bond is below )> we will use
)> as a safety net then we com"are our investment in &KP to this. What multi"le should we "lace on the
*(.2+, 2his is a "retty good business. Actually when they suck out money from s"inning off the financial
advisors they wonMt have to s"end money anymore on that division their returns on eBuity will a""roach '+>
at that time. 1ot Buite +oody=s or not Buite Co(e??but a good business. 2here are no natural barriers to entry.
Ame# will grow with the economy. &KP has unending growth as long as the economy grows. 2here is no
natural end to their business. As long as the financial world grows and +oody=s can retain share +oody=s will
grow.
2hey can do stock re"urchases or through dividends??last year they returned C<> of cash through buybacks
and dividends. 2hat reminded me of a Co(eI+oody=s ty"e of situation. +oody=s could return $++> of their
ca"ital and still grow while Co(e could do the same with C+> of their ca"ital. Co(e needed to reinvest 2+> in
their business to grow. I am thinking they 1&KP2 are saying )5> and they are "aying out C<> while they could
do <5> or C+> in the future. 2his is a decent multi"le business. 8he 9uestion is how much o# a multiple
and that is more art than science at this point.
!aving seen a lot of things would I rather have a 5> on AL6 earnings that it is growing $2> to $5> or a )>
bond. I would rather have the 5>.
A conservative 6;E of 22 # *(.2+ in 2++< O *<+.'+
2hen we have *$ from the bank. 2hen we have *K from the s"in?off.
2he s"in?off is su""osed to ha""en in Se"t. 2++5. 0ut we are buying o"tions for %an 2++<. So what ha""ens
to my o"tions with the two se"arate com"anies "ost s"in?off, .ou get both of those com"anies??the right to
buy the s"in?off and AL6 at *5+. If you buy the *5+ Call you get each share.
Which risk;reward do I like better, I value it *K in two years. 2o s"end to get to this earnings growth of *(.2+
in two years you will collect dividends and buybacks. Add another *2.
*C2.'+ in two years. 2he %an +< Calls bought at *K.++ are worth *(2.'+ G*C2.'+ ? *5+.++I.
If you own the stock at *52.'+ and sell in two years at *C2.'+. So you make *(+ or 55> return over two years
or 25> annualiHed. 2he o"tions you will make (++>.
At *<+ then you would make $'.5> a year but the o"tions would be worth *2+ or a "rofit of *$$ or $++>
return.
2he market turns down and the market will not "ay a multi"le. .ou have to include your interest carry.
5o a decision tree but I give it a (+> chance of it being worth *(+ and I give it a 2+> of being worth *<+ and
give it a 25> of being *)+ or 25> for *5+. An e#"ected value of *2+ for these *K.++ Calls.
$CK
.ou would not buy as much of these Calls as a stock but it gives you an o""ortunity to get more leverage and
a greater risk;reward. With the stock you donMt know your risk reward e#actly??the stock could be at *(+.
!ere with o"tions you know your loss is no more than *K.++. 0uying a stock and buying a "ut is the only
difference.
2he way I choose to look at a :EA6 ? owning a :EA6 is buying the stock and owning the "ut. What is the
difference between interest cost in laying out the *52 or "aying the interest cost of the *K CallN !ere I am
"aying *).$5 above the intrinsic value of the Call. :ook I am "aying *).$5 in interest over 22 months to
borrow *52.C5 and *K. Pr@@..*)$.C5 or '.C> "er year.
I am "aying *).$5 which is $'> cost of money over two years G$'>;2 O <>I. So my effective borrowing cost
is <>. So instead of saying I am borrowing money at the risk free rate and buying a "ut to get my :EA6.
What I am saying is forget the "ut. :et us add the cost of the "ut to my interest cost.
2he difference between my buying this stock and this :EA6 is that today??instead of laying out *52.C5 today
and "aying the interest on that??I am "aying an additional *).$5 Gall interestI. And what I get in e#change for
the "ut and my effective borrowing cost is not (> "er year but <> "er year. So I get to borrow at <> but I
canMt lose any more money than this. I am basically borrowing at <> but I have a non? recourse loan. In other
words, i# it doesn=t wor" out, I owe the interest, but I don=t have to pa the loan bac".
In effect I buy the "ut. I say look they are lending me money at <> but I have to "ay the interest no matter
what but if things donMt work out I donMt have to "ay the loan back. 2hat sounds like a better deal. .ou "ay
high interest rates but you donMt owe the loan.
7eread the chapter on 35@1S.
.ou "ay your interest costs u" front. .ou are "aying the difference between the value of what you are buying
Gall interestI?? what that "ut is giving you is a non?recourse loan?? and my interest rate instead of being the risk
free rate of (> I "ay <>. Say I "ut C> of my "ortfolio into these lea"s. I 4udge by how much I am wiling to
lose. C> over two years or '> a year. I wonMt lose it all at once.
:isten if I have these o""ortunities and they donMt come along very much I will try to take as much as I can of
them. And I think if I did this and my e#"ected value is *2+ and I am any good at this at handica""ing horses
then if I do ) or C or $+ of these and I have a horiHon of five years and my e#"ected value is $++> over what I
am "aying then I can afford to lose a few??as long as I am !ood at handicappin!. I have been doing this
awhile.
I would like to know as o""osed to buying the stock at *52.C5 and when the stock goes to *<+ and I make #
"ercent with whatever im"licit risk reward is there. Pr can I take my bet this way or could I take "artial stock
and "artial lea"s. It is a different risk;reward. It is a different alternative that is worth working at.
I donMt know if I am right but I think if I looked at $+ of these I would get C of them right or < of them right.
2here is a case for 25 6;E for AL6.
I am com"aring the ) bond yield to the o""ortunity. I might use $' or the economy turns down and the
consumer dro"s dead besides bad credit and loss reserves. .ou canMt lose more than *K. In my lea"s I would
lose some of my <> interest a year and wonMt have a stock loss. 2hat is the way I choose to look at it.
0R:: S6JEA5
2here is another choice in o"tions. .ou donMt want to be as aggressive. .ou bought these 5+Ms at K and sell the
55s for *).2+ for a net *2.C+ cost. 2he stock is worth *55 so the 5+ Call is worth 55 or *5 and the Call at 55
e#"ires worthless. 6rofit is *5 N *).2+ ?*K or *$$.2+ ? *K O *2.2+. In short you laid out *2.C+ to make *2.2+
net "rofit for a <K> return on your ca"ital. 2he s"read you "aid *2.C+ for you will make *5 on any stock "rice
above *55. .our break?even is at *52.C+. So you can create all sorts of interesting risk reward situations even
$K+
if the stock doesnMt go very far. 2here a lot of things you can do to with o"tions to create interesting
risk;reward situations.
S5@7S
2here was a lecture on Sears. %ean 3itter 1%32 and &llstate s"un?off. 2he deal was announced in Se"t. and
+ichael Price said in %uly??Sears is s"inning off Sears and &llstate. Pnce they s"in off &ll State and %3 by
buying Sears and shorting those two com"anies you could create the rest of Sears the de"artment store for *(5
"er share. 2he de"artment had *K "er share in sales. It was trading at )> of sales G5;K+I. When we looked at
JC Penny it was trading at )+ cents "er dollar of sales??$+ times higher. 2hat *5 you could create Sears for *5
and it was worth *5+. 0y Se"t. the *5 had moved to *(+ then I sold my stock. 2hen the stock moved to *5+.
!ere we have the catalyst3 it is not 4ust a :EA6??that is the thesis anyway. 2here is a s"in?off coming in Se"t.
Pnce the subsidiary is s"un off "eo"le will have a new com"any too look at. 2hings will be reassessed. What
are the attributes of that com"any, .ou say it doesnMt work that way but Sears was "retty darn big. I can
guarantee you I have done this many many times since that time. And so stuff ha""ens. It may not make a ton
of sense. 2his G&KPI may not work out.
.ith 3eaps ou can create a ver e+citin! ris" reward pla i# ou have a stron! opinion, and ou are
ri!ht. It is a nice weapon to have in our arsenal.
????
5iscussion of :EA6S in 0ook .ou Dan 0e a Stock Market Genius by %oel Greenblatt G"gs8 2$(?22+ 2() and
2'2I.
35@1S H3on!(term 59uit @nticipation Securities$.
2his is a way to create your own version of a stub stock. A situation that has many of the risk;reward
characteristics of an investment in the leveraged eBuity of a reca"italiHed com"any.
A Call is merely the right but not the obligation??to buy a stock at a s"ecified "rice for a limited "eriod of
time. A %une Call to buy I0M at *$'+ "er share gives the owner of the Call the right to buy I0M at *$'+ "er
share until the Call e#"ires in %une. :etMs assume that I0M is trading at *$'C in A"ril two months "rior to %une
e#"iration. In A"ril these Calls are worth more than the intrinsic value of *C G$'C "rice ? *$'+ Strike 6riceI.
2heyMre more likely to be trading closer to *$$.(<5.
Why, First the owner of the Calls doesnMt have to lay out *$'+ for another two months yet he is entitled to all
of the stockMs a""reciation until %une. 2o com"ensate for this the amount of interest that could have been
earned on the *$'+ for the two months until e#"iration should be reflected in the "rice of the Call. 2his is
Called im"uted interest rate which is the rate for the amount of money the Call buyer didnMt have to lay out for
the two months is also included in the Call "rice.
2hat is how we move the from a Call "rice of *C??the intrinsic value of the Call??to a""ro#imately *K.'+??the
value of the Call including the interest on the *$'+ the buyer of the Call did not have to lay out. 0ut I said the
Call should trade at a""ro#imately at *$$.(<5. What accounts for the nearly *2 difference between the *K.'+
already figured and the actual "rice of *$$.(<5, Dlearly there has to be another benefit to owning Calls??and
there is.
2he buyer for the Call can only lose the amount of money invested in the Call. If I0M falls to *C+ "er share
the Call buyer only loses *$$.(<5 while the owner of I0M at *$'+ would lose *)+. 2his is "robably worth
about *2. So if you "ay the *2 in V"rotection moneyV as "art of the "urchase "rice of the Calls then your cost
of *K.'+ moves closer to *$$.(<5. 2he *2 cost for assuming the risk below *$'+ is actually the same as the
cost of the "ut o"tion.
2uin! calls is li"e borrowin! mone to bu stoc", but with protection.
2he "rice of the Call includes your borrowing costs and the cost of your V"rotectionV??so you are not getting
anything for free but you are levera!in! our bet on the future "erformance of a "articular stock. .ou are
also limiting the amount you can lose on the bet to the "rice of the Call.
$K$
Pwning a Call isnMt too much different from owning a stub stock.
S2R0 ELAM6:E8 2he com"any with a *() stock reca"italiHed by distributing *(+ to its shareholders the
result was a leveraged stub stock at *) that magnified changes in the value of the underlying com"any. 2here
a relatively modest 2+?"ercent increase in earnings resulted in one scenario in an C+?"ercent gain on the stub
stockMs "rice.
Pn the other hand if the com"any declared bankru"tcy an owner of the stub stock was only at risk for the
amount invested in the stub not for the *(+ of debt taken on by the com"any to com"lete the reca". Stubs have
unlimited life unlike o"tions which have e#"iration dates.
:EA6S which are long?term o"tions can be "urchased u" to two and a half years before they e#"ire.
Additionally two and a half years is often enough time for many 4ust "lain chea" stocks either to be discovered
or regain "o"ularity. :ong?term gains are another advantage of holding investments "ast one year.
Investing in :EA6S will come about as a by?"roduct of your research efforts. 0eing able to com"are the
risk;reward of a stock with the o""ortunities available through an investment in the related :EA6S will
"rovide you with another good investment choice.
5;6
MP15A. %R1E C $KKC
5angerous Games
%id <Chainsaw &l< %unlap manuacture Sunbeam=s earnings last yearN
2 B<;@8,@; 7. 3@I;G
@lbert 5unla" likes to tell how confidants warned him in $KK) that taking the to" 4ob at the small?a""liance maker
Sunbeam Dor". would likely be his 7ietnam. For a time the )+?year?old West 6oint graduate seemingly "roved the
Dassandras wrong. As the "oster boy of M1ineties?style cor"orate cost?cutting he delivered e#actly the huge body counts
and "unishing air strikes that Wall Street loved. !e dum"ed half of SunbeamMs $2+++ em"loyees by either laying them off
or selling the o"erations where they worked. In all he shuttered or sold about C+ of SunbeamMs $$' "lants offices and
warehouses.
SunbeamMs sales and earnings res"onded and so did its stock "rice rising from *$2.5+ a share the day 5unla" took over in
%uly $KK) to a high of 5( in early March of this year.
0ut last month Sunbeam suffered a reversal of fortune that was as sudden and traumatic for 5unla" as the 7iet Dongo&s 2at
offensive was to R.S. forces in $K)C. After several mild warnings of a "ossible revenue disa""ointment Sunbeam shocked
Wall Street by re"orting a loss of *''.) million for the first Buarter on a sales decline of (.)>. In a trice the Sunbeam
cost?cutting story was dead along with VDhainsaw AlV 5unla"Ms image as the su"reme ma#imiHe of shareholder value.
1ow Sunbeam stock has fallen more than 5+> from its "eak to a recent 22.
And 4ust as suddenly what was su""osed to be an easy s"rint 5unla"Ms last hurrah as a cor"orate turnaround artist has
turned into a grinding marathon. :ying in tatters is his growth scenario for Sunbeam based on su""osedly se#y new
offerings such as soft?ice cream makers fancy grills home water "urifiers and air?filter a""liances. Many of the new
"roducts have bombed in the market"lace or run into serious Buality "roblems. Moreover Sunbeam has run into all
manner of "roduction Buality and delivery "roblems. It recently announced the closing of two Me#ican manufacturing
facilities with some 2C++ workers citing the facilitiesM lamentable "erformance. 5oHens of key e#ecutives members of
what 5unla" 4ust months ago called his 5ream 2eam are bailing out. And now he faces another year or more of the
wrenching restructuring thatMs needed to meld Sunbeam with its recently announced acBuisitions including the cam"ing?
eBui"ment maker Doleman Do. the smoke?detector "roducer First Alert and Signature 0rands RSA best known for its Mr.
Doffee line of a""liances. 2hese acBuisitions will double the siHe of a com"any whose wheels are coming off. 2his may
not be 7ietnam but it sure isn&t Aansas 2oto.
Sunbeam declined to discuss the com"anyMs "roblems with Barron=s . In some ways 5unla" seems to have mor"hed into a
latter?day Dolonel AurtH of the movie A"ocaly"se 1ow increasingly out of touch with the grim realities of SunbeamMs
$K2
situation and sus"icious of friend and foe alike. For e#am"le Wall Street is still buHHing over a confrontation that 5unla"
had with 6aineWebber analyst Andrew Shore at a Sunbeam meeting with the financial community in 1ew .ork three
weeks ago. Shore had the temerity to ask several Buestions that 5unla" deemed im"ertinent and 5unla" snarled V.ou son
of a bitch. If you want to come after me IMll come after you twice as hard.V
Shore the first ma4or analyst to downgrade SunbeamMs stock in A"ril when word began to circulate of a "ossible first?
Buarter earnings debacle is still u"set over the incident. VAs far as IMm concerned Al is the most over?rated DEP in
AmericaV he grouses. V!eMs nothing but a bully who s"eaks in sound bites and com"letely lacks substance.V
5es"ite SunbeamMs latest reversal of fortune donMt e#"ect Al 5unla" to be headed for the "oorhouse any time soon.
2hough the swoon in Sunbeam shares has va"oriHed the value of the o"tions held by most of the com"anyMs e#ecutives and
managers 5unla"Ms huge o"tion and stock grants are still worth about *<+ million down from a "eak value of over *(++
million when the stock was at its high. Moreover in February 5unla" negotiated a new contract doubling his annual base
salary to *2 million. Rnder a rich benefits "ackage Sunbeam even foots the bill for 5unla" and his wifeMs first?class air
fare from Florida where Sunbeam is headBuartered to 6hiladel"hia so that 5unla" can visit his "ersonal dentist to kee"
his latest bridge comfy and "early white. :imo charges and overnights at the Four Seasons hotel are included as well. All
this from the self?styled cham"ion of shareholder value.
We canMt say we are sur"rised by SunbeamMs current woes. In a cover story last year entitled VDareful AlV G%une $)I we
cast a ske"tical eye at 5unla"Ms growth ob4ectives in the low?margin cutthroat small?a""liance industry. We also "ointed
out the yawning ga" between SunbeamMs "erformance claims and reality. We took s"ecial note of SunbeamMs accounting
gimmickry which a""eared to have transmogrified through accounting wiHardry the com"anyMs monster $KK) restructuring
charge G*((< million before ta#esI into $KK<Ms eye?"o""ing sales and earnings rebound. 0ut to no avail. Wall Street
remained im"ressed by SunbeamMs earnings and the stock continued to rise from a "rice of (< at the time of the story.
SunbeamMs financials under 5unla" look like an e#ercise in high?energy "hysics in which time and s"ace seem to fuse and
bend. 2hey are a veritable cloud chamber. Income and costs move almost im"erce"tibly back and forth between the
income statement and balance sheet like charged ions whose va"or trail has long since dissi"ated by the end of any
Buarter when results are re"orted. 2here are also some signs of other accounting shenanigans and "uffery including sales
and related "rofits booked in "eriods before the goods were actually shi""ed or "ayment received. 0ooking sales and
earnings in advance can com"ly with accounting regulations under certain strict circumstances.
VWe had an amaHing yearV 5unla" crowed in SunbeamMs recently released $KK< annual re"ort taking an im"rom"tu
victory la" for the "rofit of *$+K.' million or *$.'$ a share on sales of *$.2 billion. Sunbeam had every incentive to try to
shoot the lights out in $KK<. 5unla" and crew were convinced they would be able to attract a buyer for the com"any 4ust as
they had done in the second year of their restructuring of Scott 6a"er in $KK5 when 5unla" managed to fob Scott off on
Aimberly?Dlark for *K billion. 2hey o"enly sho""ed Sunbeam around in the second half of last year but the offer never
came. 2he rising stock "rice made the com"any too e#"ensive and would?be buyers were also deterred by the nightmares
Aimberly?Dlark e#"erienced after buying Scott.
.et sad to say the earnings from SunbeamMs su""osed breakthrough year a""ear to be largely manufactured. 2hat at least
is our conclusion after close "erusal of the com"anyMs recently released $+?A with a little hel" from some "eo"le close to
the com"any.
Start with the fact that in the $KK) restructuring Sunbeam chose to write down to Hero some *K+ million of its inventory
for "roduct lines being discontinued and other "erfectly good items. Even if Sunbeam realiHed 4ust 5+ cents on the dollar
by selling these goods in $KK< Gin some cases they re"ortedly did even betterI that would account for about a third of last
yearMs net income of *$+K.' million.
Pne has to go to the $KK< year?end balance sheet to detect more of motherMs little hel"ers. Pne notes a striking *2(.2
million dro" from *'+.' million in $KK) to *$<.2 million in $KK< in "re?"aid e#"enses and other current assets. 2hereMs
no mystery here according to a former Sunbeam financial ty"e. 2he huge restructuring charge in $KK) made it a lost year
anyway so Sunbeam "re?"aid everything it could ranging from advertising and "ackaging costs to insurance "remiums
and various inventory e#"enses. 2he result8 Dosts e#"ensed for $KK< were reduced markedly if unnaturally. 2his artifice
$K(
alone "robably yielded an additional *$5 million or so in $KK< after?ta# income.
Why did SunbeamMs VPther Durrent :iabilitiesV mysteriously dro" by *$C.$ million and VPther :ong?2erm :iabilitiesV fall
by *$K million in $KK<, 2he answer is sim"le according to folks close to the com"any. 7arious reserves for "roduct
warranties and other items that were set aside during SunbeamMs giant $KK) restructuring were drained down in $KK<
creating "erha"s an additional *25 million or so in additional net income for the year.
Pn to" of all that as "art of the $KK) restructuring charge Sunbeam reduced the value of its "ro"erty "lant eBui"ment
and trademarks by *K2 million. 2hough some of these charges a""lied to assets Sunbeam was selling off the bulk of the
charge related to ongoing o"erations. 2his allowed Sunbeam to lower its de"reciation and amortiHation e#"ense on the
$KK< income statement by nearly *K million. 2hat would create about *) million of additional after?ta# income.
Pddly enough the figure for net "ro"erty "lant and eBui"ment on SunbeamMs balance sheet still rose during $KK< to *2'$
million from *22+ million the year before. 2his is likely an indication that such costs as "roduct develo"ment new
"ackaging and some advertising and marketing initiatives were ca"italiHed or "ut straight on the balance sheet instead of
being e#"ensed in the year they were incurred as was the "revious "ractice. In this manner e#"enses could have been
shifted from $KK< into future years when they can be burned off at a slower more decorous "ace afforded by multi?year
de"reciation schedules. Why else would SunbeamMs advertising and "romotion e#"ense dro" by some *$5 million from
*<$.5 million in $KK) to *5).' million last year, 6articularly when Sunbeam trotted out a s"lashy national television ad
cam"aign in $KK< to boost consumer demand for its new "roducts. 2his advertising shortfall alone contributed another *$+
million to SunbeamMs $KK< "rofits.
2he com"any also got a nice boost from a )'> dro" in its allowance for doubtful accounts and cash discounts from *2(.'
million in $KK) to *C.' million in $KK<. And this decline occurred des"ite a $K> rise in SunbeamMs sales last year. 2he
milking of this bad debt reserve in $KK< likely "uffed net income by an additional *$+ million or so.
2hen thereMs the mystery of why SunbeamMs inventories e#"loded by some '+> or *K( million during $KK<. =uite
"ossibly Sunbeam was "laying games with its inventories to hel" the income statement. 0y running "lants flat out and
building inventories a com"any can shift fi#ed overhead costs from the income statement to the balance sheet where they
remain ensconced as "art of the value of the inventory until such time as the inventory is sold. 2o be conservative letMs
assume this inventory buildu" might have hel"ed SunbeamMs "rofits to the tune of say *$+ million.
:astly there are more than su"erficial indications that Sunbeam 4ammed as many sales as it could into $KK< to "um" both
the to" and bottom lines. 2he revenue games began innocently enough early last year. Sales were a""arently delayed in
late $KK) a lost year anyway and rammed into $KK<. :ikewise The 3all Street Journal re"orted several instances of
Vinventory stuffingV during $KK< in which Sunbeam either sent more goods than had been ordered by customers or
shi""ed goods even after an order had been canceled. 0ut these are com"aratively venial sins that com"anies engage in all
the time to make a BuarterMs results look better. 0esides Sunbeam gave the "lausible e#cuse at the time that glitches in a
com"uter system consolidation in the first Buarter had them flying blind for a time.
0ut as $KK< dragged on and the "ressure to "erform for Wall Street intensified Sunbeam began to take greater and greater
liberties with sales terms to "uff current results. 2he latest $+?A for e#am"le discloses that in the fourth Buarter of last
year Sunbeam recorded some *5+ million in sales of cooking grills under an Vearly buyV "rogram that allowed retailers to
delay "ayment for the items as long as si# months. Moreover some *(5 million of these Vearly buysV were categoriHed
Vbill and holdV sales and never even left SunbeamMs warehouses.
Sunbeam engaged in bill?and?hold transactions in other "roduct lines too according to a number of "eo"le in the
a""liance industry. In the second Buarter for e#am"le Sunbeam booked a sale and Vshi""edV some *$+ million of blankets
to a warehouse it had rented in Mississi""i near its !attiesburg distribution center. 2hey were held there for some weeks
for Wal?Mart . 2he com"any also "um"ed millions of dollars of goods into several national small?a""liance distributors on
such easy "ayment terms as to call into Buestion whether a sale ever took "lace. Some with knowledge of SunbeamMs
business "ractices say the a""liance maker in some instances transferred title for the goods to distributors but then agreed
to not only delay "ayment but actually "ay the distributors what amounted to a storage charge for taking the goods. 2hese
sources also said that in some cases distributors also had the right to return the items to Sunbeam without suffering any
$K'
loss.
!ow much did various ty"es of Buestionable sales add to $KK<Ms net income, 1o outsider can know for sure. 0ut we can
make an educated guess based on the fact that SunbeamMs receivables or un"aid customer accounts 4um"ed by (C> or
*C2 million in $KK<. 2aking into account SunbeamMs "rofit margins it seems that Buestionable sales could have boosted
$KK< net income by as much as *C million.
We by no means are "rivy to all SunbeamMs techniBues for harvesting current earnings from "ast restructuring charges and
future sales. 5econstructing Al 5unla" is a daunting task. 0ut to save our gentle readers the effort our total estimate of
artificial "rofit boosters in $KK< came to around *$2+ million com"ared with the *$+K.' million "rofit the com"any
actually re"orted. 2hus one is left to wonder whether Sunbeam made anything at all from its actual o"erations des"ite
5unla"Ms claim to have realiHed some *225 million in cost savings as a result of his restructuring "rowess.
Pur dour view of SunbeamMs current financial health is only confirmed by the com"anyMs consolidated statement of cash
flow in the latest $+?A. 2hese numbers of course are harder to finesse because they track the actual cash that flowed in
and out of the com"any during $KK<. And the statement doesnMt "aint a "retty "icture. 5es"ite $KK<Ms eye?catching *$+K.'
million net "rofit Sunbeam still suffered negative cash flow from o"erations of *C.2 million after taking into account the
e#"losion in SunbeamMs inventory and accounts receivable during the year. And that o"erating cash flow deficit would
have been an even larger *)<.2 million if not for the sale of *5K million in receivables in the last week of $KK<. After
ca"ital e#"enditures of *5C.( million is thrown into the eBuation SunbeamMs free cash flow deficit amounts to more than
*$25 million.
SunbeamMs first?Buarter earnings debacle is yet another sign of a com"any thatMs in anything but the "ink of health. 5es"ite
management assertions into A"ril that SunbeamMs first?Buarter sales would finish comfortably ahead of those for the first
Buarter of $KK< they ended u" declining '>. Even more shocking to 5unla"Ms fans was the *''.) million loss in the
March Buarter com"ared with a "rofit in the year?earlier "eriod of *).K million. Sure *().C million of that first?Buarter
loss was the result of nonrecurring charges mostly a handsome new "ay "ackage 5unla" managed to negotiate in
February. 0ut the o"erating loss Sunbeam suffered of *<.C million was a clear sign of its true earnings "ower once the tank
from the $KK) restructuring charge had run dry.
5unla" trotted out a whole raft of e#cuses for the com"anyMs lamentable first?Buarter "erformance. !e cited dumb deals his
former 1o. ( e#ecutive had made with ma4or retailers before Dhainsaw fired him in A"ril the effect of bad weather on
grill sales caused by El 1ino and so forth.
Whatever the case the first?Buarter disaster wasnMt the result of any lack of effort on SunbeamMs "art to "um" u" the
results. 2he com"any recorded *2K million of additional Vbuy now "ay laterV grill sales. In fact the com"any is now
holding so many grills in various warehouses around its 1eosho Missouri grill "lant that it has had to lease warehouse
s"ace in nearby Pklahoma. Who knows how many of these grills will ever make it to the selling floor,
Sunbeam also e#tended its Buarter by three days from March 2C to March ($. 2his allowed the com"any to book an e#tra
*2+ million in sales both from ongoing Sunbeam o"erations and two days of sales from Doleman Gits acBuisition closed on
March (+I. 0ut to no avail. Sunbeam still fell *K million short of last yearMs sales of *25(.5 million.
Je"orts are rife that Sunbeam tried to strong?arm su""liers into VrebuttingV their invoices for various goods and services so
that Sunbeam would officially owe less money. 2he "roviso was that the su""liers would be allowed to add back the
amount forgone "lus interest in invoices submitted after the first Buarter had ended. A Sunbeam financial official denies
the VrebuttingV charge and characteriHes the activity by the com"anyMs "rocurement de"artment as the normal give?and?
take that goes on between su""liers and com"anies seeking rebates.
0ut thatMs not the understanding held by an official at one Dhina?based su""lier. When contacted by 0arronMs this official
readily acknowledged that he had sent Sunbeam a check for *5+++++ or 5> of the business he does annually with the
com"any in late March. V2he only reason I sent them a check rather than a new invoice is that we had no invoices
outstanding at the time we received the callV he e#"lained. VWe figure our contribution dro""ed right down to the bottom
$K5
line if Sunbeam actually booked it. I donMt know what ha""ened though.V
For the ne#t few Buarters e#"ect the recent acBuisition of Doleman First Alert and Mr. Doffee to restore a measure of
calm to SunbeamMs financial "erformance. 2he giant restructuring charges that Sunbeam is taking to integrate the new
units at *(K+ million before ta#es will give the com"any "lenty of fodder with which to "lay earnings games. 2he
com"any is even forecasting earnings of *$ a share this year and *2 ne#t year ?? before e#traordinary items naturally.
0ut 5unla"Ms days at Sunbeam may be numbered. 2he already?ailing com"any now has to struggle under *2 billion of
additional debt and a negative tangible net worth of *C++ million. And his enemies including disenchanted shareholders
angry securities analysts and bitter former em"loyees are growing in number and circling ever closer to the com"anyMs
headBuarters in 5elray 0each. Pf course 5unla" could always esca"e by using the buildingMs flat roof to cho""er out
should it come to that. Pne can only ho"e heMll remember to take the American flag with him.
Greenblatt Class #7
March (+ 2++5

2uin! MC> at 21+ >orward 5arnin!s or
,ow .e 3earned #rom Buett&s 1urchase o# Coca4Cola
;otes% John Chew
6rofessor Joel Greenblatt Introduction8
6resentation by Robert Goldstein* my "artner from Gotham Partners. !e has been with me for the last $5 or
$) years. !e is a brilliant investor.
!e will talk about how we are value investors but we also are "aying a lot more than we were accustomed for
some com"any. Jedefining value based on what it is worth rather than low "rice;book or low 6;E. And it sort
of o"ens u" a similar discussion to what we talked about with &meC to some degree. It is sort of another
tool;arrow in your Buiver or in your arsenal. 2o "ay a decent "rice for a good com"any. .ou do not have to go
through life doing that. I think it is harder to do because you have less room for error. I# ou are !oin! to
pa up, ou better understand the business and "now wh it should be worth more. It is hard to do
because you can screw u". 2his e#am"le certainly shows how im"ortant returns on ca"ital are when you are
trying to figure out a fair multi"le for that earnings stream.
Summary8 Jeturn on Invested Da"ital is key but what multi"le is fair, 2here is less room for error in buying
great businesses since you must really understand the business.
?ob will go through an analysis of a com"any where we "aid u".
2he second half of the class we will go through screening techniBues
Robert Goldstein (RG)8 We were looking at +oodys 1+C92 business after it&s s"in?off from %un E
Bradstreet but it was "riced at 2$# forward earnings. Was the greatness "riced in,
8o help answer that 9uestion we chose to compare our potential purchase o# Moody%s with Buetts
purchase o# Co5e. 1This is a creative comparison o two companies in separate industries2$
Buett began buying Co(e in $KCC. Buett figured out that by buying a great business he could make a
fortune. In $KCC Buett invested *)5+ million in Co(e stock. !e "aid $5 times trailing earnings. $2 years later
he was u" $+ times his initial investment. Pbviously he knew what he was doing. 2he Buestion then is why
$K)
Co(e is a great business, It was growing it had high returns on ca"ital and it had a very long lasting
com"etitive advantage so five years down the road you are still going to have Co(e and its advantages9the
same as when you initially bought the com"any.
2o give you a little bit of history8 originally +oodys revenue came from bond investors who "aid for +oodys
ratings. 2hen the rating industry changed dramatically in the $K<+s because the rating com"anies began to
charge issuers as well as investors. And this was a huge deal for +oodys because it meant that rating agencies
had gained so much clout they could charge com"anies who wished to issue debt or else they would face
higher borrowing costs in the market.
2oday +oodys and SEP both have about '+> of the rating industry. FreBuently com"anies get ratings from
both rating agencies. Since ratings are very im"ortant in the ca"ital market com"anies issuing debt will get
ratings from both com"anies since these com"anies do not want to be de"endent u"on one rating agency.
MC>&s 2000 >A 7evenue Growth 7ate <peratin! 1ro#it Growth 7ate
Growth rate for $K years $5> $<>
In $K years only $ year of decline in revenue. 7ery stable.
5oes "ast success O future success, Sometimes it does and sometimes it doesn&t. +C9s growth rate is
"henomenal considering its long time "eriod.
:ook at the market share stability. 2he global "ublic debt market grew ra"idly over the "ast 25 years.
0asically what was ha""ening was that there was disintermediation in the debt markets. 0anks were doing less
lending so com"anies were moving to issue more debt in the "ublic markets therefore they needed more
ratings. .ou had more securitiHations for mortgage loans car loans9the financial markets were evolving. 2he
market share had not changed much9it was "redominantly +oodys and SEP. It was our conclusion that
+C9&s growth was likely to continue. Euro"e and Asia emergence can "rovide future growth. :ess
com"etitive "ressure.
It was easy to understand there would be a lot of future growth and not much com"etitive "ressure. 0oth rating
agencies had to be "aid. It was very unlikely someone could enter the business because you need credibility.
1o matter how "rofitable the business or fast it was growing a com"etitor could not obtain the confidence of
the customer&s DFP nor enter the market easily. It is like "aying the Mafia.
In 5ecember $KKK %un E Bradstreet announced that they would s"lit into two businesses. %EB was selling
for *2< a share and you were going to get Q a share of +C9 and we assume in a worse case scenario that one
share of 5S0 was worth *$5 so the half share was at *<.5 "er share. .ou were effectively "aying *2' a share.
At the time I e#"ected +oodys to earn *+.K5 "er share in 2+++.
Joel Greenblatt8 At the time we had no idea where %EB would trade so the *<.5+ we were using was very
conservative so we thought this was a worst case of what we were "aying.
L> MC>
#I56DD AI!"""
6rice *5 *2+.25
E6S *+.(( *+.C5
Forward E6S *+.(K *+.K5
2railing 6;E $5 2'
Forward 6;E $( 2$
2his meant that at a *+.K5 E6S we were "aying 2$# forward earnings. Much more than Buett "aid *'.5 to *5
for Co(e9he "aid $(#U$5 #s for Co(e.
Joel Greenblatt8 2his was a new animal for us. We had never seen a business G+C9I this good with a $K?year
growth rate and no need to reinvest money. So we went back to the Master Buett and "icked something
$K<
1-92 that worked out well for him. So at first blush if you looked at Gthe chartI this is what we saw. Were we
getting as good a deal as Buett did buying Co(e in $KCC, At first blush it does not look that way.
RG: 2his is how Ber(shire did on its investment in Coca4Cola8
Co(e returned C+> of its invested ca"ital return to shareholders and the 6;E e#"anded from $( to '+. $;( of
the gain came from 6;E e#"ansion.
3arren Buett "aid *5 for Co(e and in $2 years it went to *5C Gnot including dividends receivedI.
Investment at %une 2+++8 *'.<5 in dividends # )> rate of return O *) in dividends by %une of 2+++. *5 to *)'
or G*5CN *)I in $2 years. :eave ta#es out so you get a 2(> DAGJ.
!is initial outlay of *5 turned into *)' in $2 years. 2hat brings us to the ne#t Buestion9why did Co(e do so
well,
Answer8 Co(e&s JPE was high for a very long time.
C>LE&s @nnual C@G7 10 Aears 15 Aears
Rnit Dare 7olume <> C>
Jevenues C.C> )>
P"erating Income $2> K.K>
E6S $5> $$.(>
Share buybacks hel" grow the E6S by $5> a year. Co(e&s management invested 2+> of their earnings back
into the business to "roduce that growth and they returned C+> of each dollar invested in the firm of dividends
or share re"urchases. 2hat had a lot to do with why the return was so good. In addition the 6;E multi"le went
from $( #s to '+ #s9the 6;E e#"ansion caused $;( of the "rice gain.
2he ne#t $+ years looked good as well due to Co(e &s com"etitive advantages of strong brand distribution
good management and cor"orate governance. 2his is in "art what made investors "ay u" for the stock.
$KC
Buett buys Co(e in $KCC and he still
holds over 2++ million shares. !e
regretted not selling in the late $KK+&s
:et&s go back to +C9 for a moment. Pur assum"tions for growth, +C9s $<> o"erating income growth
which des"ite this high growth rate was very stable.
!t1dent: .ou might see a lot of trends within those $K years9"erha"s growth in trailing off in the last year,
RG: Actually the growth was very stable.
!t1dent: Assume no growth and then back into a growth assum"tion,
7G% 2here really is no science to it. We assumed $2> growth rate because many of the factors that drove their
growth were still in "lace. Even though +C9 had grown annually at over $<> management basically had us
lower our growth assum"tions to $2>.
We try to "ick something Ggrowth assum"tionsI that we feel comfortable with and we think is very
conservative and then see if it still makes sense. ;othin! !rows #or 12Q #orever. So we assumed $2> for
the ne#t 5 years to $+ years.
We felt +C9&s growth factors were still in "lace. We try to be very conservative. $2> growth for 5 to $+
years. 6ublic financial markets growing vs. bank lending. We assumed Asia&s market and Euro"e&s market
was a source of additional growth o""ortunities for +C9. 2his business will grow with global growth.
Da"ital needs were minimal9no real ca"ital needs. +C9 was basically some guys in a room with
com"uters.
,ow does MC>&s no need #or capital to !row #i!ure into how much more we would be willin! to pa #or
MC>C
Co(e was growing its o"erating earnings $2>. Co(e sent back *+.C+ to shareholders for every dollar invested.
+C9 could send back *$ or more for every dollar invested. *+.C+ for AP vs. *$.++ for +C9 returned or 25>
more.
1ow we focus on +C9&s JPD. It&s JPD was infinite because they use almost no ca"ital Gchairs desks and
com"utersI.
,ow much more could ou pa #or MC> than Buett paid #or his Co5eC
Earnings O Free cash flow with no ca"e# needs. With Co(e 2+ cents had to be retained in the business so they
re"aid shareholders through share buybacks and dividends the eBuivalent of C+ cents of every dollar.
Every *$ of +C9 is worth 25> more than Co(e&s *$. .our cash flow as a +C9 shareholder will be 25>
higher than Co(e&s.
For Co(e to grow $2> a year it has to invest 25> more than +C9. When Co(e re"orts a *$ "er share in
earnings that is really only worth C+ cents to you com"ared to the dollar you get back from +C9. 5own the
road when growth slows so say when growth slows to 5> with +C9 you will still get back *$ for each *$
invested. With Co(e you will get back K+ cents on each dollar. Why would you get K+ cents back when
growth slows, 0ecause of less growth ca"e#.
2ake a growth rate of 5> and a 5+> return on ca"ital gets me a $+> reinvestment rate.
6lug into a formula of growth rate;JPD O reinvestment rate8 5>;5+> O $+>. So that 25> dis"arity will
shrink to $+> to $$> at some "oint.
Buett "aid $( times earnings but we are willing to "ay $5> more so $(# multi"lied by $.$5 O $5# earnings
for +C9 because +C9&s earnings are worth $5> more long term to us.

We can "ay $5 times forward earnings to get the same result that Buett got based on that different JPD which
is a long way off from 2$# earnings.
$KK
+C9 came "ublic in Se"tember and we looked at it in 5ecember. Buett was a buyer. We still had to
understand what we are doing. Buett won&t allow management to be stu"id with the shareholder&s ca"ital.
Pur hurdle for buying com"anies is much higher than his. We "ick and choose other than large ca"s. $5>
return might be great for him but our hurdle might be 2+>. We did know it was a 3,B business with these
numbers 1a ranchise4li(e business with strong economics and barriers to entry2$
MC> is a service business with repeatable business and !rowthSthe "e 9uestion to answer is
repeatabilit and !rowth prospects. Good for them not to have to use much ca"ital. 2he numbers are the
numbers. !ow good are the "eo"le and the franchise to kee" those numbers growing or stable.
Interest rates were '+> higher when Buett bought Co(e in $KCC. If Buett "aid '+> more than *5 then he
would have "aid *< "er share for Co(e. 2hen he would have earned 2+> DAGJ vs. 2(>.
Dom"are a (+ year 2?bond yield GK>I then to now G)>I. Jemove the dro" in interest rate to ad4ust
"erformance. 6;E as an earnings yield. 5uring $KCC U 2+++ Interest rates were higher. 8his was "e
because interest rates #ell #rom ?Q to MQ, a N0Q decline. So, in 2000 the #uture earnin!s would be
worth N0Q more.
If our ad4usted 6;E is $5 Gvs. $( for Co(e because +C9&s earnings are worth moreI and you multi"lied that by
$.' Gbecause of the lower interest rates now "revailing in 2+++I you get 2$#. !ow would Buett have done,
*5 to *') Gvs. *)'I. Anock -9 down by (+> to get a <+ cents dollar.
A )> $+?year 2?bond. What 6ension Funds e#"ect to earn in stock??2> to C>??"ick a number.
Buett&s investment rose because of the interest rate dro". So let&s take the dro" in interest rates out of the
eBuation. Buett&s return dro"s from 2(> to 2+> now we assume $)> minimum return. We take (+>
discount to the end result gets you <+ cents on the dollar to <+> # )' O '5.
6art of what you lose in this interest rate environment. E#"ectations on future stock returns are lower. So if
we take our minimum ) "ercent bond and say "eo"le over time in their "ension funds e#"ect to earn C> a year.
So here ?ob said if 3,B didn&t have the benefit of interest rates falling he would have returned 2+> a year
instead of 2(>.
We are "aying a "remium for what we are "aying for +C9 so we are not going to assume interest rates will go
our way. We will make $)> a year.
Joel Greenblatt (JG): I look at it this way8 let us go three years out or five years out and say the story "lays out
as e#"ected. 2he com"any earns grows $2> a year they are buying back their stock and "eo"le see that it is a
good business. .ell, in three ears i# the price MC> to return KQ a ear, so the stoc" ma double. Aou
ma collect 50Q o# that in two ears& time because everone sees what ou see. .e ma !et paid up#ront
b a #aster rise in the stoc" due to a bi! multiple bump.
6eo"le may say what do I have to "ay to get C> a year if it is going to be worth L in a few years, 2hat is how
you get your multi"le e#"ansion and sometimes fairly Buickly.
Mr. Market usually gets it right if you have done your analysis correctly. If in $+ years I believe it will earn
$)> a year then in three years I may be averaging '+> "er year. A big chunk of my return may come in the
near term if the market charges a C> discount rate.
In effect that is what ha""ened to +C9&s. It went from a 2$# multi"le to a (+# multi"le then the return dro"s
to C> a year after that. 2he stock "rice will not move in a linear fashion.
I don&t know if you remember when we looked a %u E Phelps and we had three scenarios of growth. .et we
still undershot the growth rate. 2here was in effect an e#"losion in the different uses for +C9&s "roduct but
you knew the trend was going your way3 they had only "enetrated a small "ercentage of the market. 2he trend
2++
in earnings grew (+> to '+> for a few years. 2his ha""ens with a s"in?off where they do things efficiently.
It is com"licated to make these assum"tions and sometimes you are wrong.
Frankly we bought it at *2$ and sold it at *(5?*(). In our good scenario we had a *<+ stock. Pne of our
reasonable scenarios was three years. 2he stock did go there. We didn&t hold it9any reason to do the wrong
thing.
2here are so many im"ortant "oints in what ?G brought u" today. It is not onl important how much a
compan earns but how much ou !et to "eep and still !et our !rowth rate. Growth and JPID
???e#amine the ca"ital investment reBuirements to grow.
Pbviously Co(e had to "ut 2+> of their cash flows back into their business to maintain their growth rate but
+C9 even had a better business where they did not have to reinvest anything and those earnings were worth
more. 8his is a ver important wa o# loo"in! at the world. .ou can do all your calculations and say $)>
annual returns??that is "retty good??not great. 0ut if you look at the world this is what I think it is going to
earn in three or four years and if it gets a fair multi"le at that time based on JPD and earnings growth I could
get an astronomical rate of return.
+C9 was a uniBue business a considerably great business. If we could have com"ared this to SEP as a stand
alone I guess we would have done that. 0ut most of our money is not made on com"arable analysis3 it is a
check. Either the com"arables are trading much higher and this is a better investment and you want to know
why your stock is not trading at those com"arable levels.
Pr all of the industry is trading too low and either you stumble across or you did the analysis and this is the
chea"est of the bunch or you like their business the best. And you are willing to "ay u" a little bit. So it is a
combination of factors. Rsually we are finding a situation where we Uwe don&t make thematic investments
based on the "rice of commodities or oil.
8his was the #irst time we paid 21 times normaliGed earnin!s #or a compan. 2his was sort of a wake?u"
call. We really don&t want to do this. 0ut let us do this e#ercise to see if we can 4ustify this because it works. If
you are doing something that works it is very hard to do something different. Pbviously this can ha""en to a
lot of com"anies that are doing well. 2hey don&t see the com"etition coming because they want to hold onto
their core business. 2hey get blind?sided.
In this "articular case there is always money to be made in many different ways. %ust because I am teaching
you the way we do it it is not the only way to make money. It is a way that I think works. If you have
something better to do that is fine. We have always had an o""ortunity to invest in chea" stuff. In what I call
a good business at a little higher "rice. 2his is something more to com"are and another wea"on in your
arsenal.
It is very seductive to be in great businesses and see a lot of good things flying off of that to then go and buy
cigar butts after that. 2here is "lenty of money to be made at that. It is a bit of a little different game. Buett
can&t "lay in that anymore.
It is almost taking a lea" of faith to assume that the business will continue as it has. What is your "lan to get
those great results in the future, What will they do with the ca"ital, With something like +C9 there are not
many calls you can make.

6art of the analysis is taking a background of the industry. Jead analyst re"orts. )ost people would have
said a !ood business but #airl valued. In three years from now +C9 could be at (+# U (5#s "ros"ective
earnings. 2here is no business I would give a (+# multi"le to on normaliHed earnings for the same reason I
would never use less than a )> yield on a long term bond. (+# would be (.(> return9a return too low for
the risk.
We were ho"ing for more growth than $2> but used that for a conservative rate. .ou hear a lot of smart
"eo"le but we are not that smart. We s"ent Q hour going over stuff we sold that subseBuently doubled. We
made a lot of errors. It is good to make a lot of different errors and still make money.
2+$
We looked at +C9 because it was a s"in?off number $. 6eo"le wait to see it ha""en. I don&t want to waste
too much time on the pscholo!ical reasons people wait. 2$# doesn&t look that enticing. !ow good this
actually was. 2he Buestion would be that Buett filed on it and yet we bought it 5 months later. We look at
s"in offs anyway. So I would say that if you see something at 2$# then look at it if the business is e#ce"tional.
!t1dent: !ow often do you migrate to higher Buality businesses,
1ort#olio )ana!ement
JG: Everything comes u" rarely. .e hold 5 to K securities #or a ear to 2(5 ears. We may only need to
find one idea a year. We may do &merican ,Cpress for a few weeks. &KP is similar to Co(e and it may be
better in some ways.
Jight now the market for small ca" stock was u" 5+> to $++> in 2++( and it was u" again in 2++'. )ost o#
the values are in bi!!er, !ood companies ri!ht now. When the small ca" market gets killed and I can buy
retailers at )# earnings then I am not "icky I will go do that. Jight now some of these better com"anies are
where some of the better deals are.
I am not measuring one against another. It Gmy interest;investmentI de"ends u"on which I found first. What is
chea" enough to meet the hurdle. 0asically it is a big world out there there is "lenty to choose from. It is more
what you know and what you feel com"etent in. .our circle of com"etence.
8hin" how power#ul that isS"nowin! what somethin! is worth is ver power#ul. 8hat in#ormation is
almost everthin!. And you have the ability to look ahead three or four years and not worry about the ne#t
year or two. And not worry about how other "eo"le are doing. 2hat is the whole ball game.
Aou are all smart enou!h now to do valuation wor". @nd "now when ou "now it and that is where
practice comes in. .ou are smart enough now but you don&t have the e#"erience. And you need to go through
the school of hard knocks and you will kee" getting better. I would say we kee" getting better at what we are
doing. We still make tons of mistakes so it is good that we got better but we make different ones. It gives us
more to choose from as we kee" learning. Aou alwas "eep learnin! and ou alwas !et better. When you
think you have it knocked you don&t. E#"ect to be right more than you are wrong.
Bac( rom brea(
Joel Greenblatt8 .ou can&t get this analysis of +oodys from a te#t book and it took us a long time to think this
way. ?ob and I wished we had this good stuff. Ask Buestions if you don&t understand this.
2his was the end of the lecture.
&dditional .otes rom other sources
From 2he Essential Buett by Jobert !agstrom8 .h Buett purchased Co5e in 1?KK
When Buett first "urchased Co(e in $KCC "eo"le asked8 O.here is the value in Co5eCP 2he com"any&s
"rice was $5 times earnings and $2 times cash flow U (+> and 5+> "remiums to the market average. Buett
"aid five times book value for a com"any with a ).)> earnings yield during a time of K> long?term interest
rates. !e was willing to do that because of Co(e&s e#traordinary level of economic goodwill. 2he com"any
was earning ($ "ercent JPE while em"loying relatively little ca"ital investment. Buett e#"lained that "rice
tells us nothing about value. 8he value o# Co5e is determined b the total owner earnin!s e+pected to
occur over the li#e o# the business, discounted at an appropriate interest rate.
In $KCC owner earnings of Co(e eBualed *C2C million. 2he (+ year 2reasury bond Gthe risk?free rateI traded
near a K "ercent yield. Co(e&s $KCC owner earnings discounted by K> would "roduce an intrinsic value of
*K.2 billion. When Buett "urchased Co(e the market value was *$'.C billion Ga )5> "remiumI suggesting
that Buett might have over"aid for the com"any.
2+2
,owever, when a compan is able to !row owner earnin!s without the need #or additional capital, it is
appropriate to discount owner earnin!s b the di##erence between the ris"(#ree rate o# return and the
e+pected !rowth o# owner earnin!s.
If Co(e were able to grow its earnings on average 5> for a long long time then
*C2C million;GK> alternative rate of return U 5> long term average growth rate in earningsI O *2+.< billion or
round u" to *2$ billion.
So if Buett "urchased Co(e at a *$'.C billion value its intrinsic value was *2$ billion or higher?? or Buett
was getting a '+> discount to a conservative a""raisal of Co(e&s intrinsic value.
7eturn on retained capital
From 0uffettology8 3arren could reason that in $KK' if he "aid *2$.K5 for a share of Coca4Cola stock that had
"er share earnings of *+.KC a share he would in effect be getting an initial after?cor"orate?ta# return on his
investment of '.5> G*+.KC ; *2$.K5 O '.5>I. And this rate of return would e#"and because Co(e&s "er share
earnings were growing at an annual com"ounding rate of $<.2> to $C.'> a year.
3arren believes that a com"any should retain unrestricted earnings only if it is reasonable to "ro4ect that the
management would be able to do a better 4ob investing those unrestricted earnings than would be the
shareholders.
,ow do we as investors measure a compan and its mana!ement&s abilit to pro#itabl allocate
unrestricted earnin!sC What is the management skill in allocating ca"ital and management effectiveness,
We take the "er share earnings retained by a business for a certain "eriod of time then com"are it to any
increase in "er share earnings that occurred during this same "eriod.
In $KC( Co(e made *+.$< a share. 2his means that all the ca"ital invested in Co(e u" until the end of $KC(
"roduced for its owners *+.$< a share in $KC(. 1ow between the end of $KC( and the end of $KK( Co(e had
total earnings for this ten year "eriod of *'.'' "er share. Pf that *'.'' Co(e "aid out in dividends during
$KC(?$KK(8 a total of *$.CK a share. 2his means that for the ten?year "eriod between $KC( and $KK' Co(e had
retained earnings of *2.55 a share G*'.'' ? *$.CK O *2.55I.
So between $KC( and the end of $KK( Co(e earned a total of *'.'' a share "aid out in dividends a total of
*$.CK a share and retained to its ca"ital base a total of *2.55 a share.
5uring $KC(?$KK( Co(e&s "er share earnings rose from *+.$< a share to *+.C' a share. We can attribute the
$KC( earnings of *+.$< to all the ca"ital invested in Co(e u" to the end of $KC(. We can also argue that the
increase in earnings from *+.$< a share in $KC( to *+.C' a share in $KK( was caused by Co(e&s management
doing an e#cellent 4ob of utiliHing the *2.55 a share in earnings that Co(e retained between $KC( U $KK(.
If we subtract the $KC( "er share earnings of *+.$< from the $KK( "er share earnings of *+.C' to get *+.)<.
2hus we can say that the *2.55 a share that was retained between $KC( and $KK( "roduced *+.)< in additional
income for $KK(. 2his means that the *2.55 in retained earnings earned *+.)< in $KK( for a total return of
2).2> G*+.)< ; *2.55 O 2).2>I.
Co(e&s management earned a 2).2> return in $KK( on the *2.55 a share in eBuity that Co(e retained from
$KC(?K(.
E?$
2+(
Greenblatt Class #7
March (+ 2++5

2he E#am is the last class on 2+;A"ril U closed book.
6resentations ne#t week. 6a"ers due.
.our "a"ers are due ne#t week unless you are one of the grou"s who are going after that.
Stoc" Screenin! and Generatin! Ideas%
I wanted to talk about stock screening later in the class. I found this yesterday in the 3all Street Journal;
.uveen S"in?off
.uveen Invest down C>3 St. 6aul to Sell Dontrolling Stake
/-B A-8)S 8)BSB+6)S Mar#h ()* (++, /:,M &.'. @. !n,ela %ruitt -* /-B A-8)S
8)BSB+6)S
1EW .PJA ?? .uveen Investments Inc$ G%1DI shares fell C.$> in mid?day trading Monday following news of
"lans to make the asset manager a fully inde"endent and "ublicly traded firm.
.uveenMs "arent com"any St$ Paul Travelers Cos$ 1ST&2 announced Friday that it will im"lement a three?"art
"lan to sell its controlling stake in .uveen in a secondary offering. 2he "ro"erty?and?casualty insurer owned
about <C> of .uveenMs outstanding voting securities as of early March.
.uveen shares recently were down *(.+C at *('.K2 on volume of <))C++ com"ared with average daily
volume of $$$+++. St. 6aul shares were u" $5 cents or +.'> at *().'$.
St$ Paul=s strategy was not une#"ected as market analysts antici"ated that some sort of secondary offering or
sale to a third?"arty buyer would be the routes taken. !owever investors a""eared to have stacked more of
their chi"s on the "robability that another institution would cough u" the money to buy .uveen.
VI think the reason the shares are down is because the market was e#"ecting someone to buy them outV said
John 0eonard a research analyst at S.0 /inancial in Dharlottesville 7a.
VI think there was a reluctance to buy G.uveenI at the to" of the market given that Buality asset managers are
trading at "remium "ricesV he said.
.uveen said St$ Paul Travelers will sell (K.) million of the com"anyMs shares or '2> of total shares
outstanding in a secondary offering. Rnder the "lan .uveen also will buy back *)++ million of its shares from
St$ Paul Travelers at the "rice of the secondary offering.
St$ Paul Travelers announced in late %anuary that it was reviewing o"tions to sell its .uveen stake valued at
about *( billion. 8he move is aimed at raisin! cash a#ter a E?22 million char!e related to its asbestos
reserves.
Given the hefty float of .uveenMs shares set to be unleashed on the market suppl concerns also ma be
!ettin! the best o# ?14een=s stoc", analsts said.
2+'
.uveen is the largest issuer of closed?end funds and has *$$5 billion in total assets under management. 2he
com"any in %anuary re"orted *C.$ billion in gross sales for the fourth Buarter of 2++' a KK> increase over the
"rior year. In addition .uveenMs fourth?Buarter net income 4um"ed $5> over the same "eriod a year earlier.
V.uveen might be better off because they will have...higher float GandI more research coverage from Wall
StreetV said Jim Johnson an analyst at -eee Bruyette E 3oods of the secondary offering. !e added that
investors "robably thought a third?"arty buyer would swoo" in or that a bidding war for .uveen would unfold.
V.uveen is a high?Buality com"anyV %ohnson said.
1either 0eonard nor Johnson owns .uveen shares and their firms donMt do investment banking work for the
com"any.
6otential P""ortunity8 A motivated seller
What would interest a s"ecial situations investor in this article, A motivated seller. Jight a motivated seller.
St Paul wants to sell to raise cash by selling K22 million shares. Jight away these guys are blowing out of this
because they screwed u" in their insurance business.
It may be going down because there will a lot of stock for sale all at the same time so we may get a good "rice
as a value investor??"ossible. 2he com"any is going to buy back *)++ million of the stock that is held by St
2+5
6aul so the stock is at *('.25 and change so they are buying back $<.5 million shares. 6erha"s this will have
debt to leverage a good com"any. If indeed it is chea". Anything else,
*'2.5+ buyout "rice is the baseline "rice for a sale. Maybe that is a baseline for what someone would "ay. Pr
gee the thing was for sale and no one would buy it. 2raditionally they sell closed?end bond funds that is a
valuable income stream. It is tough to lose that income stream9an annuity?like business.
C+> of your float has been owned by a big insurance com"any where it was not considered im"ortant as far as
siHe. 2hat might get management focused. 2he stock dro""ed *< or *C to *(' so it is chea"er than it was. 2he
seller is a motivated seller for non business related reasons for this business. 2he com"any is buying back
stock so they are changing the ca"italiHation of the com"any to create that. Management is "erha"s ha""y to
do that. !ow much will they Gmgt.I own,
Management
Wall Street tends to over"ay "eo"le a lot so I would worry about that. In management com"anies where your
resources9there is not much ca"ital in these business??go home every night mgt. ends u" taking all the "rofit
for them. So I would like to see how their shares are bread and buttered. 2hat has ha""ened at other
com"anies. 2his is a *( billion dollar com"any so management can be "iggy and there is still a lot of value left
for us.
Analysis
So what I did was I took out the "ros"ectus9read this. So anyway I did a Buick and dirty. I may look at 2+
or (+ of these. I ha""en to know these are high return businesses we used to own a closed end fund GthisI for
other reasons.
2he Buick and dirty8 E0I2 was *25' and E7 is *(('K so $(.5# E7;E0I2. JPID was over $++>. So it looked
like a valuable franchise. I was looking at the break down of what the business looks like.
2hey have *$$5 billion assets under management but included in that *5+ billion is in E#change 2raded Funds
GE2FsI. 2hat is a big business but how "rofitable is that business. Are those dollars as valuable as the closed?
end funds, Mutual funds??there is only $2.< billion so you have *5+ N *$2.< then you have *(< billion in
managed accounts or retail. And you have *$5.) billion in managed institutional accounts. So each of those
businesses is a little bit different. 2rea" out each business. I want to go through each one of these. Each one
has a little different stickiness to it3 each one has a little different multi"le to it. Dash?flow characteristics for
each. 5o they stink at what they are doing, Managed accounts might be "retty diffuse which is good. I want
to see how "rofitable are the E2F funds??*5+ billion. If it is "rofitable they may be able to e#"and that
business.
It didn&t seem like mgt was going to own much stock relative to their salaries. 2he DEP earned *) million a
year. So let us say he had an o"tion on million shares. *) million in salary vs. *() million in stock. 2hey
think they have a great "latform and they are well?"ositioned in ra"idly growing segments es"ecially in E2F.
2hey will e#"and their marketing and distribution.
Going inde"endent may be a catalytic event. 2hey may be able to make earnings e#"lode more than $2> to
$(> a year over the last four years which is "retty good but the market has been good as well. I would make
all those assessments because $(.5# E0I2 may look e#"ensive but E0I2 may grow (+> over the ne#t few
years. 2hen you are down to $+# E0I2 in a business that is earning $++> return on ca"ital. I wouldn&t write it
off right way because of the "retty high "rice because of this event.
So that is the beginning of an analysis. If this was at $+# E7;E0I2 I would be buying the stock and asking
Buestions later but at $(#s I am asking a lot of Buestions and "robably not buying the thing. 0ut I will go
2+)
through the analysis and look to see whether I should or not. Already there is a thesis built from reading the
article.
My analysis is not dissimilar to our analysis of &KP. &KP has two businesses8 one business has a high JPE
and the other a low JPE. PA I want to look at that. Also the market is kind of weak lately so this is the
kind of thing that could really get crushed. 2hese guys really need the money. St Paul 4ust wants to get the
deal done. Pnce you are at this "hase there is a big cheering sBuad 1investment ban(ers2 to get this deal done.
We may see the stock down another *) or *< from here.
&merican ,Cpress 1&KP2
2he thinking on &KP is this8 usually when I buy the stock it goes down. 1umber two is this8 if I am truly
taking a three or four year horiHon in my valuation then what is ha""ening in the short term does not matter.
.hat matters is what I thin" normaliGed earnin!s will be three ears #rom now. Which should take into
account the fact that account if loss ratios are lower than usual income credit s"reads are bigger than usual.
2here are a lot of things that go into that. I analyHe that. 2hey are 2+ cents above normal but they are also 5+
cents above normal in s"ending in this area. So they traditionally cut back in this area9it is not a big factor.
Aou have to decide what is material and what is not. It turns out a lot of stuff is not material if you are
looking out normaliHed earnings three or four years. :ike I said before about &meC9whether I bought them
or not it does not matter. 2his analysis is very im"ortant that we did with +oodys. It should be worth in ( to 5
years L dollars but if someone wakes u" in the ne#t year or two before my lea"s e#"ire I will get most of that
money u"front instead of the e#"ected return of C>.
8he ris" in the 35@1 is that there reall is no intelli!ent wa to "now where the mar"et will price AE
in the ne+t 22 months. 2here is an intelligent way to know where the market will value &KP in three to five
years. 0y owning a stock you have that comfort level of whenever it ha""ens it ha""ens. If you are in a
:EA6 with a 22 month e#"iration and this market can do anything you are in a window of risk. .ou are
making a risk;reward bet.
If I have the wherewithal and my o"tions e#"ire I will GcouldI re?u" and buy another set of :EA6s. It is a
cheap wa to borrow mone.
2hat is one way to read the "a"er. I am trying to show you even obvious stuff. 2he efficient marketeers would
have you believe it is already in the "a"er so the twenty dollar bill is not there because someone would have
"icked it u". 2his is the way it really works.
Stoc" Screens
So I will do a stock screen 4ust for fun. 2his is off of +ulteC$ 2his screening "ackage cost *$5++ a year9it is
sold by ?euters. And maybe it is a little easier to use. A great screening "ackage for a cost of a cou"le
hundred dollars a year is from &&II$com Powerinvester$com' Smartmoney$com' there are a lot of web screening
"ackages. 2hey all use the ?euters data.
I use the screening "ackage but it is not worth the money. Pne thing you want to be careful with the ?euterss
5ata is that it is not that good. Sometimes the data is not accurate. All I am saying is that if you get something
su"er chea" use that as a first ste".
Compustat is a great "roduct. 0ut use stock screens as an idea generator.
0ook 7alue "er share last Buarter. Instead of doing E7;E0I2 we will do sim"le trailing 6;E trailing twelve
months. 5ivide that by tangible book value. Why did I multi"ly JPE by 07;2angible 07, I am goosing u"
2+<
the JPE because JPE is based on re"orted book and I am trying to say I really care about looking at JPE and
tangible book value.
Rse uniBue screening criteria/
E?$
Greenblatt Class #K
A"ril ) 2++5
S"ecial Situation Dlass
A"ril 2+ 2++592he last day of class.
1e#t week we will have a few "resentations. Also +att +ar( runs Jet Capital and he will discuss distressed
investing.
!ow to Invest in Jetail Dom"anies
2oday we have a s"ecial guest +s$ 0inda Greenblatt who has run a hedge fund for the last $+ years with an
e#traordinary record. She invests almost e#clusively in retail stocks and some consumer stocks. She has had a
tremendous record sticking to what she knows. In other words her circle of com"etence didn&t have to be that
large. She has been able to build a nice "ortfolio with huge returns over those ten years. And it shows that you
don&t have to know many different things. .ou will hear from :inda how what level of analysis you can
:ast year her "ick that she discussed in class was &bercrombie 1&./2 which went from *25 to *5C for a N
$2+> return.
6resentations8 Corinthian College' 3innebago and BE? Bloc(
Corinthian College8 An attractive "rice to earnings and cash flow. 2he com"any is being sued because some
students can&t transfer their credits. We believe that the com"any will be e#onerated because there is no
evidence of wrong doing. Every student signs a binding arbitration.
Growth has slowed. !istorical "rofit margins of 2+> was not sustainable. 2he Street is s"ooked but it is not
4ustified. 2here is slower growth and margin com"ression with ca"e# tem"orarily higher.
*$.' billion in market ca" and *$ billion in sales. E7 is less than Mkt. Da". 2+> E6S growth and $5>
revenue growth. More ca"e# last year so there will be a 4um" in FDF.
We define Free Dash Flow8 E0I25A U DA6EL and Dhg. In 1WD and 2a#es. Pr after ta# E0I2. *$++ million
in FDF.
With a <> to C> WADD O *(+.
E7;E0I2 C.5 with JPE of (5> JPE
Growth Da"ital C+> to K+>
Maint. Da". 2+> JPID.
All management has to do is o"en satellite cam"uses. Joom for more stores. Da"acity to grow and the need to
s"end more.
<r!aniGe Aour 1itches.
2+C
Peter 0ynch used a three minute egg timer to hear analysts pitches$
Joel Greenblatt; 6rovide the big "icture8
What are you "aying,
What are the returns on ca"ital,
What are the normaliHed earnings,
What are the growth "ros"ects Gof normaliHed earningsI,
So you organiHe yourself when making a "itch use those "oints.
0ill Miller8 Says you should give your main "oints8
2hesis then
0am
0am
0am
Jisks
And be done.
5;6
A"ril ) 2++5

3inda Greenblatt&s 3ecture on Investin! in 7etail Companies
and a 7etail @nalsis o# @nn 8alor Stores H@;;$
1ro#. Boel Greenblatt HOBGP$%
2oday we have a s"ecial guest +s$ 0inda Greenblatt who has run a hedge fund Saddle Jock 6artners for the
last $+ years with an e#traordinary record. She invests almost e#clusively retail stocks and some consumer
stocks. She has had a tremendous record sticking to what she knows. In other words her circle of com"etence
didn&t have to be that large. She has been able to build a nice "ortfolio with huge returns over those ten years.
And it shows that you don&t have to know many different things. :ast year her "ick that she discussed in class
was &bercrombie 1&./2 which went from *25 to *5C.
2+K
:inda Greenblatt will discuss her current idea how to evaluate it and what her thoughts are now.
3inda Greenblatt HO3GP$%
I will talk a little bit about how I started and why I went into retail. I really wanted to find a niche for myself.
Something I could relate to. I like the consumer sector. I li"e to shop. I focused on those com"anies easy to
understand where you could get out there touch feel and understand. I could get the customers&
understanding and get their feedback. So it is one of the easier sectors in my o"inion to understand and
analyHe. Another thing I really like about retail is that you are getting a lot of info and it comes out on a
monthly basis for e#am"le like same store sales GSSSI??Store sales of stores that have been o"ened for at
least twelve months.
Rnlike other industries where you are getting numbers on a Buarterly basis. .ou are getting a ton of
information coming out of these com"anies on a monthly basis which is good and bad. It is bad because it
creates tremendous volatility in this sector but that is the reason it is good. 0ecause you get the o""ortunity to
buy things when they are unfairly chea". .ou get to buy things when "eo"le are often trading them. If you
have a value orientation and a longer term orientation9when I say longer?term I mean one to two years
because "eo"le are mostly focused on the ne#t months& numbers. If you can take a ste" back and see the big
"icture there often a lot of o""ortunities out there.
And a lot of "eo"le hate this sector for that reason. I can&t analyHe what the ne#t hot trend is. I don&t know
whether &B,?C?9+BI, 1&./2&s S"ring line looks good. @nd that doesn&t matter and that is the beaut
o# it. .ou really don&t have to understand -Whether management get the right denim skirt doesn&t matter
what you have to get right is if management knows how to run a business are they generating good returns on
ca"ital, And if they miss so what, I get another chance ne#t season. And they certainly are not going under
in the meantime.
So &B,?C?9+BI, 1&./2 is a case in "oint if you look at their stock chart and you can go back a year ago
you could have doubled your money between then and now. I can&t say that a lot has ha""ened in the business
fundamentally that has changed from what kind of business they are running or who their customers was.
2here was a management change but in my o"inion it was not significant but what was ha""ening for a good
year and a half "rior is that they were generating negative same store sales GSSSI and negative com" store
sales. 6eo"le throughout the industry could not focus on what ty"e of business they were running.
2$+
:inda Greenblatt discusses &B,?C?9+BI, E /itch' Inc$ 1.>S,4
&./2 for "urchase on Pct 2K 2++(. Sold in Mid?*'+s.
And they were generating E0I2 margins close to 2+> amongst the highest in their "eer grou". And all
anybody could focus on was on whether their ne#t com" stores sales was negative. In 2++2?2++( you could
have taken a ste" back and said I recogniHe that com" store sales are negative "erha"s there are
merchandising issues here but I can see they run a good business and if they could stabiliHe that com" if they
could 4ust generate at the bottom of those com" numbers9they were running negative K negative 5 negative
K but once they could stabiliHe their com"s "eo"le thought -Ph wow look at this business/T 2his is a great
business and all of a sudden "eo"le were not 4ust focused on the SSS but on what the actual business was
doing.
2his article Gincluded belowI interviewing a money manager who covers retail stocks and his Buote is very
similar to how a lot of "eo"le think about retail stocks and how most or all of the sell side thinks about retail
stocks. 0asically he said8
+ have m. &eo&le visit stores and malls to see ho? much the items are mar1ed do?n
and ho? lon, the lines are at the re,isters9 +Mll "u. a stoc1 i* + thin1 the com&an. is ,oin,
to "eat num"ers and short it i* it is ,oin, to miss num"ers9 +t is that sim&le9
I;/5S8I;G% -in! o# the 7etail Bun!le F>R6B?E 2uesday March 22 2++5
!edge fund manager %avid Berman "rofits by thinking like a "atient "redator.
VI used to be a victim of "eo"le like meV says hedge fund manager and onetime accountant %avid Berman.
VEvery time I bought a stock someone smarter than me was selling it. Every time I sold someone smarter was
buying.V So when he formed a firm to manage his own money in $KK< Berman decided to focus on a single
sector and master it. !is choice, Jetail. 2his son of a furniture maker s"ent a year walking malls and
eventually develo"ed a custom inde#9the 5ee0ee Gas in %avid BermanI9to com"are sales vs. inventories at
R.S. retailers. !is s"ecialiHation strategy has "aid off8 0erman says he has averaged a return of $<> after fees
over the "ast eight years with only three down months. !e now manages more than *$++ million through
5urban Da"ital a hedge fund he named for his hometown in South Africa and launched in 2++$. A big "art of
his formula is that heMs willing not to buy if "rices arenMt right. FPJ2R1EMs %ulie Schlosser "honed 0erman in
Da"e 2own Gwhere he s"ends three months every yearI to chat about the sectorMs latest batch of strong sales
re"orts why they donMt necessarily bode well for stocks and what investors can learn from crocodiles.
$espite laBluster holida= sales, the SF2 900 retailinA inde> is up 005 /or the
past =ear3 Can retailers Beep beatinA e>petations in 2009G
=e"ruar. sur&rised ever."od., retailers included9 +t sur&rised me9 (here are a "unch o*
theories ?h.9 %erha&s ta' re*unds are "etter than &eo&le thou,ht the.Md "e9 =ashions
are &rett. ,ood9 !nd + thin1 ?eather has "een a &ositive *actor9 +t ?as a"out *our
de,rees ?armer than usual across the countr. in =e"ruar.9 @ut to a lar,e de,ree, durin,
this time o* .ear the retail ,rou& ,ets moved *or macro reasons9
7hih maro /ators aHet retailersG
Sometimes the "est months *or retail sales have "een the ?orst months *or stoc1s9 +* it
is the "est month *or retail, ?hat ha&&ens to interest ratesQ (he. ,o u&9 !nd thatMs not
,ood *or retailers9 Nou ma. have that no?9 (he =ed hasnMt "een a"le to slo? the
econom. do?n, "ut "ond .ields are ,oin, to do the :o"9 7reens&an has "een ver.
ine>ective ?ith raisin, rates9 @ut the lon, ran,e is out o* his control9 (he rates have
,one u& to over 42J9 Fome loans ma. start ,oin, hi,her, and that ?ill slo? thin,s
do?n9 +Mm not a "ond e'&ert, "ut those .ields ma. ?ell ,o hi,her "ecause this econom.
is reall. roc1in,9 -r at least &eo&le thin1 itMs roc1in,9
'o: do =ou IAure out i/ a stoB is a Aood ?alueG
2$$
+ maintain that + am not smart enou,h, and + donMt thin1 an.one reall. is, to 1no? ?hat
the %C) should "e9 E. :o" is to understand ?hat the )%S Searnin,s &er shareT should "e9
+ loo1 *or *acts9 (hatMs ?h. + measure inventories9 + have m. &eo&le visit stores and malls
to see ho? much the items are mar1ed do?n and ho? lon, the lines are at the re,isters9
IJll bu= a stoB i/ I thinB the ompan= is AoinA to beat numbers and short it i/
it is AoinA to miss numbers3 It is that simple3
,our $ee"ee inde> measures sales Aro:th ?s3 in?entor= Aro:th3 Is that ho:
=ou predit :hether a ompan= :ill beat 7all StreetJs earninAs estimatesG
Be summari;e ever. &u"licl. held retailer in !merica9 (hatMs almost 3## com&anies9
BeMve "een doin, this quarterl. *or man. .ears9 -n an individual level, it ,ives us a
,reat sense o* ?hich com&anies are ,oin, to do ?ell "ecause their inventories are ?ell
controlled and ?hich ones have &otential *or missin, num"ers9 +t ,ives us a sense o* the
&ro5ta"ilit. o* the ,rou& ,oin, *or?ard9 !nd it also ,ives us a sense o* the *uture
stren,th o* the econom., "ecause retail leads the ?a.9 +* inventories are de&leted ?hat
does that meanQ +t means retailers are ,oin, to "e orderin, *aster, and that means the
"ac1 end o* the econom. is ,oin, to do ?ell9 +t is a lot o* ?or1, "ut it is reall. ?orth it to
us9
7hat do =ou mean :hen =ou sa= =ou use a KCroodile ApproahKG
Aust ?ait and "e &atient *or the ri,ht o&&ortunities9 (he crocodile can ,o *or almost t?o
.ears ?ithout eatin, *ood9 +t has ver. small le,s and canMt ,o ver. *ast9 +t ?aits ". the
river"ed9 +* its &re. doesnMt come, it :ust slee&s all da.9 Nou ?ant to "e li1e the crocodile
and ?ait *or the &re. to come to .ou9 Nou donMt ?ant to rush o> to the &re.9 Nou ?ant to
?ait *or the "i, ;e"ra and ,ra" him and eat it u&9 Bith that in mind, +Mve never "een
a*raid to "uild u& a "i, cash &osition9 Nou canMt lose mone. i* .ouMre in cash9 (hatMs ?h. +
donMt have man. do?n months9 +Mve never used levera,e9 +n *act, some o* m. investors
?ill "e u&set ?ith me, "ut until recentl. + rarel. had much more than 5#J o* m. mone.
invested"oth lon, and shortat one time9 (hat means + am hal* in cash9 + reco,ni;e
that is too lo?9 +t needs to increase9 @ut itMs "ecause o* the Crocodile !&&roach9
!ast month Federated e!artment Stores, parent o/ Mac"#s and
$loomingdale#s, Ann Talor Stores !A""# announed plans to aCuire Ma"
e!artment Stores3 Is it a siAn that the department stores are trul= d=inAG
(he mer,er is a *unction o* $al%Mart&s &o?er9 $al%Mart ". our num"ers has 2$J o* the
sales o* &u"licl. held retailers, e'cludin, autos9 !nd rou,hl. 8J o* total sales9 !lmost
one in ever. ten sales in !merica is done in $al%Mart9 (hat has totall. chan,ed the retail
landsca&e9 !s a result the de&artment stores are reall. "ein, squee;ed9 (he.Mre havin,
to scram"le to sta. com&etitive9 +t is &ro"a"l. :ust a natural evolution o* the retail
landsca&e9 (here is :ust a slo? deterioration in the de&artment store mode9
7hat is the $ee"ee inde>Js topErated stoB riAht no:G
+ can tell .ou ?ho is ,ood on m. inventor. list "ut the. mi,ht alread. have a hi,h %C)9
!t the to& is American %agle &'t(tters (A%&S, $24)3 +t :ust re&orted sales u& 37J
?hile inventories are u& onl. $4J9 (hat "odes ?ell *or *uture mar,ins and &ro5ts9 @ut a
lar,e amount o* that is rePected in stoc1 &rice9 + o?n it, "ut +Mve "een reducin, m.
&osition9 !merican 'a(le has ,ot ,reat mana,ement9 (he.Mve "ee*ed u& their sta> over
the last cou&le o* .ears9 (he. :ust hired some ,ood &eo&le *or a ne? conce&t that the.
?ill "e announcin, soon9 +t ?ill ,ive them another le, o* ,ro?th9 (he. are 5rin, on all
c.linders9 #ordstrom (J7#, $99) also had ,ood results, ?ith sales u& 9J and
inventor. u& onl. 2J9 (hatMs the "est in the de&artment store cate,or.9 (he &ro"lem is
2$2
that those results are alread. *actored into the stoc1 &rice9 6emem"er, the conce&t o*
?ho is ,oin, to "eat earnin,s and the stoc1 &rice are t?o di>erent thin,s9
So the roodile isnJt runninA out to snap up ;ebrasG
+ am reall. concerned that the retail ,rou& has had a nice run9 Ean. com&anies are
loo1in, ?orse this .ear in terms o* inventor. ,ro?in, *aster than sales9 +tMs hard to 5nd
,ood lon,s9 +Mm in slee&in, mode, ?aitin, &atientl. *or o&&ortunities9
!inda 8reenblatt (!8) continuedUUU
!nd + sa. to .ou that is .our o&&ortunit.9 +t is that sim&le9 (here are so man. &eo&le
out there doin, that ?hether the. miss their num"ers or not9 +t creates so much
volatilit. and so much o&&ortunit. *or .ou9 !nd .ou ?ill read an. anal.st re&ort,
&articularl. a .ear a,o in A)'*C*+M)I' !A",#, the. 3Ball Street !nal.sts4 tal1ed a"out
the A)'*C*+M)I' !A",# core "usiness and the *act that it couldn2t ,enerate dou"le
di,it SSS as the. had in the &ast9 -r anal.sts ?ill *ocus on ?hat the stores loo1ed li1e in
Earch and !&ril9 !s o&&osed to ?hat the com&an. ?as doin, and ho? &roductive their
store "ase ?as9 @ut the. had tremendous ,ro?thnot so much in their core "usiness--
"ut in their -ollister "usiness ?hich is their secondar. "usiness, ?hich has "een a ,reat
,ro?th vehicle *or them9
-nce a,ain tremendous o&&ortunit. here i* .ou are loo1in, at the ri,ht stu>9
Student< Bhat ?as the )LC)@+( multi&le *or A)'*C*+M)I' !A",#Q
0inda 7reen"latt 3!84 H it ?as at 7' "ut our tar,et ?as $#' - $$' )LC)@+(9 6-+C ?as
hi,h teens a*ter-ta'9
Amerian %agle %utItters (L%agleM AE%S)
Student< Bhat has ha&&ened ?ith this "randQ A'+S chan,ed their merchandisin,9
8o? the. are more sur* oriented than conservative9
!8: (he. de5nitel. ?ere havin, merchandisin, issues and the. ?ere reall. havin,
trou"le 5ndin, ?hat their identit. ?as9 (he. ?ere "ein, squee;ed at "oth ends9
A)'*C*+M)I' !A",# ?as at the hi,her endHthe 1ids ?ho ?anted to sho& A)'*C*+M)I'
!A",# and ?anted the A)'*C*+M)I' !A",# "rand9 Bhile on the lo?er end, the. ?ere
"ein, hurt ". Aeropostale !A*+# ?here the. couldn2t com&ete ?ith those &rices and
A*+ ?as 1noc1in, o> a lot o* ?hat 'a(le ?as doin,9 'a(le had de5ned a niche *or
itsel*, "ut the. ?ere also shoo1 u& their merchandise team in order to im&rove their
merchandise o>erin,9 (he. also had some little hel& *rom their com&etitors ?hen
A)'*C*+M)I' !A",# simultaneousl. announced that the. ?ished to ,o more u&scale9
'a(le has tried to *ocus on the hi,h school customer9 A)'*C*+M)I' !A",# has ,one a
little older and a little "it hi,her end ". &uttin, in hi,her &rice &oints9 So 'a(le had a
cou&le o* thin,s ?or1in, in their *avor9
!"out a .ear a,o .ou ?ould see, ?hen 'a(le2s &rice ?as at $$3 to $$5, &eo&le "asicall.
had ?ritten them o> and had decided that the. ?ere never ,oin, to re,ain their *ootin,9
Bhat ha&&ened durin, that time, i* .ou loo1ed at )@+( mar,ins, those mar,ins ?ere
headed do?n to the 8J ran,e9 !t the time i* .ou had loo1ed at it, ?hat mi,ht have
"een attractive to .ou is that the )@+( mar,ins ?ere tradin, in the 8J ran,e and t?o
.ears "e*ore the )@+( mar,in had "een in the $2J ran,e9 A)'*C*+M)I' !A",# as .ou
mi,ht have remem"ered *rom the last slide ?as in the $8J to $9J ran,e9 (here could
2$(
"e a lot o* o&&ortunit. here i* the. could :ust ,et it ri,ht9 @asicall. the common stoc1
?as tradin, at 8 times earnin,s9 %eo&le had ?ritten them o>V the. had ne,ative com&s9
S1i& *or?ard 6-8-$2 months later, .ou can see the stoc1 has dou"led9 +t has ,one *rom
$5 to $3# over the &ast 295 .ears9 !nd ?hat has ha&&ened durin, that time, the. have
im&rove their merchandise and some o* their com&etitors have moved a?a. so the. are
not com&etin, head on9 @ut the other thin, &eo&le started to ta1e notice and a stoc1
that ?as tradin, at 8's "ac1 in 2##3 is no? tradin, closer to $7'sor over a $##J
earnin,s multi&le e'&ansion9
Student: Bhat ha&&ened to store count in 2##2Q
200
0
2000 2002 2003 200N
Stores 79# 864 9$5 "ou,ht a
Cdn9 Chain
846 887
!8: Bhat ha&&ed ?as the. "ou,ht a Canadian chain and "asicall. "le? it the moment
the. "ou,ht it9 So the. ?rote it o>9 +* .ou notice in the store count ?hich is on the
"ottom linethe. are &rett. saturated9 +* .ou as1 them, the. sa. the. can o&en u& to a
$### stores, "ut there are onl. so man. malls that e'ist9 So the. reall. needed a ne?
,ro?th vehiclehavin, said that, the stoc1 is still tradin, at $8' to 2#'s, in s&ite o* no
ne? ,ro?th vehicle9
J8: Bh. is it tradin, at such a hi,h multi&leQ
!8: @ecause the. are ,eneratin, ,reat com&s 3SSS49 (he &oint "ein, that ?hen these
stoc1s are in *avor, &eo&le *ocus on the ?ron, thin,9
Student< Bhat .ou had to ,et ri,ht in this stor. ?as to ,et the merchandisin, sales
trend correctl.9 So are .ou not havin, to ,uess on *uture ,ro?th in SSSQ
2$'
!8: +t is the *act that the. 3mana,ement4 reco,ni;ed that the. had issuesV the. shoo1
u& their merchandisin, team9 %lus the. 1ne? the. ?ere havin, a hard time com&etin,9
Bhat .ou have here, thou,h, is a com&an. that de5nitel. has a customer "ase9
/e5nitel. ?hat .ou ?ere startin, to see is the. ?ere ,oin, to *ocus on a &articular
customer9 Bhat ha&&ened is that the. ?ere all over the "oard9 (he. ?ere *ocusin, on
the 2# .ear old 1id, on the $5 .ear old 1id and the. reall. couldn2t ,et their *ocus do?n
and that ?as lar,el. in &art to their merchants ?ere not "ein, a"le to tar,et their
customer ?ell9
So the ans?er is+ didn2t 1no? *or sure the. ?ere ,oin, to ,et it ri,ht, "ut the. ?ere at
an 8J )@+( mar,in and a cou&le o* .ears earlier the. had $2J mar,ins ?hen the. had
run thin,s :ust a little "it "etter and their closest com&etitor 3!8=4 ?as at $9J mar,ins9
(his smells li1e o&&ortunit. to me, "ecause actuall. the. did ever.thin, ?ron, and the.
ran an 8J )@+( mar,in9 So i* the. laid out a 5ve ste& &ro,ram to im&rove?ell i* the.
,et t?o or three o* those &oints ri,ht, there is certainl. a "i, u&side o&&ortunit. there9
!nd, as + said, another thin, ?ent in their *avor ?as an e'ternal *actor in their industr.9
J8: 0et me add to that9 Bhen *ich P.ena ?as here, he said lo? 6-) com&anies ma1e
chan,es: the. 5re mana,ement, the. close *actories9 (he. do stu> "ecause it is not
?or1in, 3(he @oard o* /irectors or ne? mana,ement ma1e chan,es to im&rove or sto&
losses49 (hat is ?hat ha&&ens here in retail9 'ere it :as tradinA at a lo: multiple
o/ depressed earninAs3 (he. ?ere doin, ever.thin, ?ron,, "ut the. ?ere still earnin,
some mone.9 (he. ?ere not ,oin, out o* "usiness and the. had a stron, "alance sheet9
So the question ?asthe ,reat thin, a"out retail is that i* S&rin, stin1s 3their
merchandise assortment o* customer acce&tance4, then =all ?ill "e "etter or Binter9 So
i* .ou "u. them chea& enou,h, the. didn2t have to ,et it ri,ht in this short o* &eriod o*
time9 Nou see it ?ent *rom $5 to $3#9
+* .ou have a t?o to three .ear hori;on and .ou sa. loo1 + still have a &on. on the trac1
and it still is runnin, and the race is still ,oin, on9 + am still in "usinessV + am not ,oin,
out o* "usiness9 (his season stin1s, "ut ne't season ?on2t9 Ea."e ?e ?ill hire this ,u.V
ma."e the. have the &lat*orm to reall. do it9
+* .ou had ?al1ed into their stores last Christmas and the. couldn2t ,ive stu> a?a.9 !nd
i* the. continue to "e this "ad and the. still are ,eneratin, some mone. and .ou could
see that the stoc1 is tradin, at a lo? multi&le, then can it ,et an. ?orseQ -r the. could
,et a *e? thin,s ri,htQ !nd i* the. ,et a *e? thin,s ri,ht, then &eo&le ?ill start to sit u&
and ta1e notice9 (hen the stoc1 can trade at a ,reater multi&le$# to $2 'so> a
,reater earnin,s "ase9 @ecause these ?ere incredi"l. de&ressed earnin,s9 (hen all o*
a sudden .ou ,et .our returns *rom $5 to $$# ?hich is a &rett. ,ood return9 !/ou are
(ettin( a double upside from both an increase from depressed earnin(s to normali.ed
earnin(s and a multiple expansion as other investors (ain con0dence#1 +* .ou are
&la.in, *or a $5 to $$# return, .ou don2t have to "e &la.in, *or a return o* $5 to $3#9
J8: Bhen 0inda ?as tal1in, a"out A)'*C*+M)I' !A",# ?hich she did o?n, she "ou,ht
at $25 on sort o* on a similar thesis and no? it is at $589 She sold out in the mid-$4#s,
?hich is still a &rett. ,ood return 38#JW49 Fere .ou mi,ht ar,ue 3?ith !)-S4 this is
sli,htl. overvalued9 (hin,s are ,oin, ?ell, there are not a lot o* ,ro?th &ros&ects and it
is tradin, at $7's - $8's so .ou &ro"a"l. don2t last till then9
Student: /o .ou loo1 at retail li1e c.clical com&anies ?hen their earnin,s are
de&ressed the. mi,ht have hi,her multi&lesQ
!8: !,ain the ans?er is that &eo&le love to "eat u& these thin,s u&9 %eo&le love to
?rite o> retailers9 )ver."od.2s thin, ?ith retailers is--"ecause ?hat is their reason *or
2$5
"ein,Q +* another retailer *ell ". the ?a.side, ?ho ?ould careQ 7hen people see
thinAs on a neAati?e trend, these thinAs (retail stoBs) Oust Aet battered3 So
havin, *ollo?ed retail *or as lon, as + have, the lo? end o* multi&les is 8's to $#'s and
the hi,h end is 2#'s time ran,e%C) multi&les9 ! lot o* retailers these da.s carr. a lot
o* cash9 So that also ,ives us some securit. to last throu,h the "ad times9
Student< +nvestors once the. see a do?ntrend, the. ?rite-o> and sell their stoc1 ?hen
the. see the "ad num"ers in com&sQ
!8: %s.cholo,icall. ?hen .ou are seein, month a*ter month o* ne,ative num"ers it is
tou,h not to &anic9 + can tell .ou havin, lived throu,h ?hen a com& sales &osts a
ne,ative $5J com&, not to sa., ma."e the. are ,oin, out o* "usiness, ma."e no one
?ill ,o "ac1 into the store9 +t reall. is tou,h to ta1e a ste& "ac1 and sa. it is a one
season thin,, or one .ear thin,, "ut ?hen the. ,et it ri,ht, there is so much &otential
and the o&eratin, levera,e is hu,e9
Student: So ?hen o* .our ed,e is that .ou are so &atient, .ou are a contrarian to the
other ,u.s9
!8: (hat is ho? + li1e to loo1 at it9 + ta1e a lon, term &ers&ective in an industr. ?hich
&eo&le *eel doesn2t ?arrant that9
Student: (he industr. is &rett. levera,ed ,iven the ca&e' *or the stores9 +* the sales
,o do?n, the &ro5t ,oes do?n9 Nou mention the volatilit.9 Fave .ou thou,ht o* usin,
the o&tion &ricin, model to &rice stoc1sQ
!8: + li1e to 1ee& it sim&le9 J8< (he ans?er is no9
Student: 0oo1 at com&an. $et Seal9 Fo? do .ou 1no? i* it ?ill survive or not9 !
turnaroundQ
2$)
Student: Betseal is another teen retailer to teena,e ,irls, that is :ust a"out "an1ru&t9
!8: Nou mean Slutt. teena,ersQ
Bet Seal is a com&an. that de5nitel., the. o&ened ?a. too man. stores and stores ?a.
too lar,e and ran into a &ro"lem ?hen their com&s turned ne,ative9 Bhat is ha&&enin,
no? is that the. are closin, a ,ood &ortion o* their "ase o* un&roductive stores and the.
are ,oin, to tr. to ,ive it a ,o ?ith some o* their more &roductive stores9 (he. reall. ran
into a &ro"lem9 (he. ?ill tr. to ,ive it a ,o ?ith their more &roductive stores and ,ive it
a ,o ?ith their smaller store "ase9 (he. ,ot rid o* their t?o other o&eratin, chains9 -ne
the. soldV another the. closed9 (he. are reall. ,ettin, "ac1 to "asics9
(he. ?ere a 7## store chain, the. ?ere runnin, three di>erent conce&ts, and a lot o*
their stores ?ere un&roductive9 @ut ?hat reall. came out ?as that the. had a lar,e
num"er o* their stores that ?ere un&roductive9 @ut the ho&e no? is that the. have
&ulled it do?n and ,otten "ac1 to a mana,ea"le si;e and "ac1 to a sim&le "usiness9
(he. ?ant to sim&li*.9 !t the ver. least, the. have closed man. o* their mone. losin,
stores9 +* the. can 1ee& their head a"ove ?ater ?hile the. ,et their act to,ether, at $4 it
could "e a ,ood &la.9 ! &otential turnaround9
Student: /o .ou 1no? ?hen these com&anies store conce&t reach saturationQ
!8: +t reall. de&ends u&on t?o thin,s9 (he ?a. .ou loo1 at it is: *or the most &art there
are !, @ and C malls9 (hen there these thin,s called 0i*e St.le Centers, then there are
street and other non-mall locations9 Nou have ,ot to loo1 at the com&etitive landsca&e
and 5nd out ?ho is their customer "ase9 +n 'a(le, ?hich is a lo?er &rice &oint store, can
have some?here in the nei,h"orhood o* 9## to $### stores, "ecause their model ?or1s
in ever. one in these di>erent cate,or. malls9 So .ou can loo1 at an 'a(le and sa.,
Nes, + understand ?h. $### stores ma1e sense9 @ut in A)'*C*+M)I' !A",# it ?ill not
?or1 in a C mall ?ith their 3hi,h4 &rice &oints and it ?on2t ?or1 in ever. @ mall either9 So
A)'*C*+M)I' !A",# ?ill ma' out *or the core division in the 4## to 5## store ran,e9
Nou have to 1no? ?ho .our customer is and ?hat the &rice &oint is9 !nd loo1 at other
com&etitors i* the. can o&en a num"er o* stores9 Nour :o" is to 5,ure out i* that
!mana(ement2s expansion plans and store (rowth# is realistic or not9
Student< +n addition to Com& store sales are their an. other metrics .ou loo1 atQ
!8: + ?ill ,et to that9
+ thin1 there are t?o ?a.s in the e'am&les o* 'a(le and A)'*C*+M)I' !A",# ?here .ou
could have made mone. in "oth o* them9 Bhere A)'*C*+M)I' !A",# has lots o* ,ro?th
le*t in their Follister unit and that is ?h. + reall. li1e A)'*C*+M)I' !A",#9 +t ?as not as
much a mar,in &la. ?ith A)'*C*+M)I' !A",# "ecause mar,ins ?ere alread. ?a. u&9
'a(le, on the other hand, doesn2t have the ,ro?th le*t, "ut 'a(le2s &la. ?as :ust ,ettin,
the ,ro?th o* ?hat the. had "ac1 to the o&eratin, &roductivit. o* ?hat it could "e and
should "e9 Nou can de5nitel. ma1e mone. in man. di>erent situations9 + li1e to see a
,ood ,ro?th o&&ortunit. "ut there are &lent. o* situations ?here the. don2t have much
square *oota,e ,ro?th le*t, "ut the. have &lent. o* o&&ortunit. to ,et their current
"usiness ri,ht !nd + thin1 o* those o&&ortunities as equal to the ,ro?th o&&ortunities9
Nou can ma1e mone. "oth ?a.s9
Student< (here ?as *ear a"out canni"ali;ation "et?een "rands in A)'*C*+M)I'
!A",#9 Customers ?ould ,o to Follister to "u. a chea&er version o* car,o &ants rather
than sho& in !"ercrom"ie9 Fo? did .ou ,et com*orta"le that the. ?ere not hurtin, the
more e'&ensive "randQ
2$<
!8: (he ar,uments &eo&le ma1e+ am ,oin, to tal1 a"out A"" Talor in a little "it9
A"" has their core "rand and the. have a ne?er conce&t called A"" Talor 3oft--that
?hen .ou o&en a ne? conce&t that is 3#J chea&er than .our core conce&t, ho? can .ou
ma1e mone. at "oth and ?h. ?on2t a customer ,o *rom one conce&t to the other
"ecause it is chea&erQ !nd the ans?er is .ou have to "e com*orta"le ?ith the *act that
mana,ement has di>erentiated the conce&ts enou,h that .ou are reall. dealin, either
?ith t?o di>erent customer "ases or .ou have a customer ?ho is ?illin, to "u. "oth9
!nd 1no?in, that .ou continue to loo1 at mar,ins as the. roll-out9 =or e'am&le, in
A)'*C*+M)I' !A",# ?hen the. rolled out -ollister, mar,ins did not *all a&art9 So even
thou,h com&s ?ere do?n in !"ercrom"ie, it ?as not the result o* -ollister9 !nd, .ou do
have to do the ?or1 and develo& a level o* com*ort9 )ver. time a retailer rolls out a ne?
conce&t that is the ar,ument a,ainst it9 Some do ?ell and others don2t9
Student: Sa. i* A)'*C*+M)I' !A",# has a mar,in o* 2#JW ?hat is its sustaina"le
com&etitive advanta,e 3SC!4 and ?hat ,ives .ou con5dence that A)'*C*+M)I' !A",#
can continue to have hi,h mar,insQ
!8: Nou to have con5dence in the mana,ement team and that the. are thin1in, the
ri,ht ?a.9 +* .ou thin1 that this is a mana,ement team that ha&&ened to luc1 into a
,reat conce&t in A)'*C*+M)I' !A",# and the. are ?illin, to launch a ne? conce&t that
is ,oin, to "e dilutive+ don2t thin1 that is the ?a. these &eo&le thin19 Eana,ement is
thin1in, ho? can ?e develo& a conce&t ?ith the "est "an1 *or our "uc1Q Be are not :ust
loo1in, to ,ro? the store "ase or the sq9 *oota,e, "ut ?e are actuall. loo1in, to
,enerate ,ood returns on ca&ital that ?e had in the &ast9
J8: A)'*C*+M)I' !A",# had the chance to 1noc1 do?n &rices, and the. s&eci5call. told
ever.one and made the decision that the. ?ere not ,oin, to dilute their "rand ".
lo?erin, &rices9
!8: )ver.one ?as tellin, A)'*C*+M)I' !A",#--?hen it ?as a ver. com&etitive and
&romotional environment last Christmas ?hen 'a(le ?as &romotin, ever.thin, out o*
their store--to dro& their &rices, .ou ?ill never sell an.thin,9 @ut mana,ement
res&onded ". sa.in,, XNou 1no? ?hat, ?e have to maintain the inte,rit. o* the "rand ".
maintainin, &rices9Y +* ?e miss this season, ?e miss it9 Be can2t start ". cuttin, &rices
and havin, our customers e'&ect to sho& on sale ever. time the. come into the store9
Aust "ased on their trac1 record"ac1 to .our question--it ,ave me the con5dence that
the. 3mana,ement4 ?ouldn2t launch a conce&t that ?ould not ,enerate the t.&e o*
returns their core conce&t had9
Student< + ima,ine it has to "e more than :ust mana,ement "ecause then a cou&le o*
&eo&le could ,o and start as com&etitors9 -r .ou can hire these &eo&le9 Bhat is the
com&etitive advanta,e "e.ond mana,ement 3so as to "e con5dent o* the com&an.2s
lon,-term advanta,eQ4
!8< !ll + am sa.in, is that the. have a conce&t that ?or1s9 (he conce&t ,enerates the
1inds o* returns that are e'cellent returns9 (he. understand the *ormula and the. ?ill
tr. to du&licate that *ormula in another *orm9 So there is not an. sin,le *ormula-h, a
4,### sq9 *t9 store ?ith an avera,e &rice &oint o* Z is the *ormula9 %art o* it is "uildin, a
"rand9 A)'*C*+M)I' !A",# has "uilt a &remium &rice &oint "rand ?here the. can
maintain their &rices and that is ?h. the. have such &henomenal mar,ins9 !nd the.
1ne? i* the. launched another conce&t, then the. ?ould have to "uild another "rand9
(he. :ust couldn2t :ust o&en stores9 (he. had to develo& mar1etin,9 (he. had to
develo& somethin, that s&o1e to their customer "ase and ,ave the "rand le,itimac.9 So
2$C
the. could have ,one out and o&ened 4## Follister2s "ut the. ?ent out and o&ened 2#
Follister2s9 (he. tested the conce&t, the. "uilt the "rand and then the. e'&anded it9
J8< + ?ould li1e to move on to Ann Talor Stores !A""#, and then she can ans?er more
questions9 -ne thin, + can sa. is that ?hen 0inda "u.s stu>, it is chea&V it is "eat u&9
Nou ?ill see, in the ne't e'am&le, she is not "u.in, the com&an. at $7' earnin,s ?ith
*ull. "uilt out stores ?ith no ne? conce&ts9 (here are reasons it is chea& at that time9
!nd the ?hole idea o* doin, ?hat ?e have "een doin, is that i* .ou are ri,ht and .ou
sa. this could trade at 5#J to $##J more and than ?here it is and i* .ou are ?ron, and
.ou don2t lose mone., that is a &rett. ,ood ris1Cre?ard "ecause .ou reall. didn2t &a. u&
*or those o&&ortunities9 +t is almost ma1in, it seem harder than it is in a ?a. "ecause
?hen .ou miss .ou don2t lose much mone. "ecause .ou "ou,ht it chea&9 Nou don2t have
to "e ri,ht all the time9 So .ou are sa.in, it could "e ?ron, or it could "e ver. tou,h to
5,ure out ?hether the. can maintain this, "ut .ou don2t lose much mone. i* .ou are
?ron,9 !nd .ou could ma1e 5#J to $##J i* .ou are ri,ht and .ou are ri,ht more than
.ou are ?ron,, then the math ?or1s9
So + thin1these are di<cult questions to ans?er0inda is an e'&ert in this 5eld9 She
still is ?ron, sometimes, "ut she limits her losses and she 1no?s o&&ortunities ?hen
see sees them9 So ?hen she tal1s a"out Ann Talor Stores !A""# .ou ?ill see ?hat this
o&&ortunit. is and it ma. ?or1 or it ma. not9 @ut .ou can see the ris1 re?ard is
tremendous each time9 So + thin1 the ans?er is .ou ma1e a ,ood ,uess "ased on
ever.thin, .ou have seen: X+s the mana,ement ,oodQ /oes the "rand loo1 ,oodQ !re
their customers lo.alQ !nd thin,s o* that nature9 !nd i* .ou are ?ron, .ou don2t lose
3much4 mone.9 +* .ou are ri,ht .ou can do quite ?ell9 +t is not quite as hard as ,ettin, it
ri,ht ever. time9
The discussion above is similar to the di4erence between buin( 5ci(ar butts6 vs1
5)u4ett%tpe6 franchise companies1
!8< Bhen .ou ?ant to "u. somethin, chea&9 + &ut u& some o* A""2s closest
com&etitors ?hich are (al"ot2s 3T3)4 and @anana 6e&u"lic9
A))
TA*+&,
ST&,%S
(A)))
T!" C'S JI!!
2rie $25 $32943 $28 $$3927
-arBet Cap $$,79# $$,826 $5,#44 273
Cash (net) 255 3684 266 54
E"IT (!T-) $#5 $4$$ 224 $5
EP $858
EP/Sales !T- $ $93 592 #95
EP/E"IT 2009 $393 $$95 $695 -3293
2$K
EP/E"IT 200Q $$92 $#94 $395 $$97
Conepts
A"" 359
3oft 343
=act 36
738
Eisses 5$9
%ettit2s 286
!dd Stores
$$2
-utlets 24
$#49
Chico2s 5$$
BFC@E $67
Soma $67
688
Su&er lo.al
A9 Aill $5#
$5#
! cou&le o* others that cater to older ?omen are Chico2s and 71 7ill9
!t 5rst ,lance .ou ma. loo1 at )LC)@+( 3$3' or less than 795J &re-ta' return4 and thin1
that it is not chea&9 !nd &ro"a"l. i* .ou sto&&ed here .ou ?ould not "u. it9 @ut + thin1 it
is one o* these thin,s .ou have to delve a little *urther to understand ?h. it ma. "e
&otentiall. interestin,9 !,ain the num"ers don2t loo1 ver. chea&9 +* + said to .ou ?hich
one ?ould .ou "u.Q (he ans?er ?ould "e "ased on this ?ould "e 8-8) o* them
"ecause none o* them loo1 chea&9 Certainl. .ou mi,ht even loo1 at Chico2s and sa. .ou
?ould ?ant to short it9 (hat has "een, un*ortunatel., one o* the "est &er*ormin, stoc1s
over the &ast ten .ears9 0ots o* &eo&le have lost their shirt shortin, it9 A9 Aill ?ill lose
mone.9 A9 Aill ?ill lose mone. and this .ear is a turn around .ear *or them9 2##6 is reall.
a made u& num"er "ecause no"od. 1no?s i* the. turn it around, ?here the. ?ill land9
(hat could &otentiall. "e an interestin, stor. to loo1 at "ecause there is enou,h
o&&ortunit., "ut + don2t thin1 it is chea& enou,h9
Student< Bhat is the stor. ?ith Chico2s 8 Bh. has it &er*ormed so ?ellQ
!8: (he. are ,reat o&erators and the. have reall. *ound their niche9 !n."od. 1no?
an.thin, a"out Chico2s9
Student< (he. cater to [[[[[[[ and it is a ,ro?in, demo,ra&hic and it is an
underserved demo,ra&hic9
!8: (he. have done a ,reat :o" at creatin, a su&er lo.al customer "ase9 (he. have
,ro?n their core conce&t relativel. slo?l.9 (he. have honed in on their core customers
and created a ver. lo.al customer9 (here is some ,ro?th there9 BF@E is Bhite Fouse
@lac1 Ear1et ?hich is a ne? chain that the. have launched and there is ,ro?th le*t
there9 (hese &eo&le are ,ood o&erators9 Nou don2t ?ant to ,et in their ?a.9
(al1in, a"out A"" at 5rst ,lance it doesn2t loo1 chea&9 0oo1in, at the "ottom o* the
ta"le ?e are tal1in, a"out conce&ts H,ro?th o&&ortunit.-in their core conce&t the. are
at 359 stores9 (he. &ro"a"l. ,et to the 4## stores level "ecause the. ?ould ma' out
their store "ase "ecause the. have a hi,her &rice &oint9 -ne o* the nice thin,s there is
that the. launched 3oft a"out 5ve .ears a,o and it is almost matchin, the si;e o* A""
and the. could more than dou"le their 3oft store "ase *rom ?here the. are no? "ecause
the. are at a lo?er &rice &oint9 !nd the. have a lot o* street locations so the. are not
:ust limited to "ein, :ust in malls9 So des&ite A"" and T3) loo1in, similar, + could tell
.ou that A"" has a lot more square *oota,e ,ro?th &otential over the ne't 5ve .ears
than T3)9
22+
Bh. didn2t (al"ot launch a distinct conce&tQ (he truth is at $$5# stores the. ?ill ma'
out on their square *oota,e &otential a lot sooner than A"" is ,oin, to ma' out9
So ?h. do + li1e A""Q !nn is one o* those stories ?here ever.thin, the. could do ?ron,
in the &ast .ear in 2##4, the. did9 +n Christmas li1e 'a(le, a .ear a,o the. ?ere
"asicall. ,ivin, ever.thin, a?a.9 !nd ?hat has ha&&ened no? is that there have "een
some m,t chan,es that have ta1en &lace9 Eana,ement is tr.in, to ,et the A"" Talor
core chain "ac1 on trac19
Bhat + ?ill tell .ou is in this same time*rame 3+,T ?hich is a"out hal* o* their store "ase
has done e'tremel. ?ell9 8o? m,t9 ?on2t "rea1 out mar,ins *or .ou "et?een the t?o
conce&ts "ut + ?ill tell .ou that m. ,uess is that the. are at least in the $$J to $2J
o&eratin, mar,in ran,e9 !s .ou ?ill see *rom ?hat A"" did in 2##4 that means the
A"" Talor chain must reall. "e doin, lous. i* the. hal* the chain is doin, $2J mar,ins9
So .ou have lots o* o&&ortunit. !for improvement#9
+ onl. ?ent "ac1 to 2##2 here, "ut actuall. A""2s &ea1 )@+( mar,ins ?ere north o* $2J
and that is even lo? *or the industr.9 0i1e A)'*C*+M)I' !A",#: ?hich ?e loo1ed at
earlier, .ou can loo1 at this and sa. lots o* o&&ortunit. here "ased on ?hat the. have
done historicall.9 (he. did $2J o&eratin, mar,ins ?hen the. onl. had the core A""
Talor conce&t9 Bell the. ?ent *rom $2J to 6J mar,ins, "ut has there "een a
*undamental shi*t in the "usinessQ Bhat has ha&&enedQ
J8: 6i,ht no? this is li1e a s&ecial situation9 (he ,ood "usiness can dou"le in si;e 33+,T
conce&t4 and the "ad "usiness has done a lot "etter in the &ast so .ou can earn a lot
more *rom the "ad "usiness9 Nou can dou"le the si;e o* the ,ood "usiness9 (he "ad
"usiness is mas1in, the ,ood "usiness9 Nou have a lot o* &la.s9
!8: (he stoc1 has ,otten hammered9 +t has come "ac1 a little "it o> its lo?s9 Be ?ere
"u.in, it in the $2$2s9 +t is no? u& to $25, "ut + still thin1 there is tremendous u&side
"ecause i* .ou :ust ta1e a loo1 at ?hat Street )stimates are *or this .ear and ne't9 (he.
3Ball Street !nal.sts4 are assumin, ver. little ,ets 5'ed on the A"" Talor side9 (he
&oint "ein, is that ?hen .ou are loo1in, at those )LC)@+( num"ers that didn2t loo1 that
,reat--those anal.sts2 num"ers are reall. "ased on lo? estimates9 8o"od. is ,oin, out
on a lim"V no"od. is &uttin, "ac1 mar,ins to $#J to $2J in 2##69 @ut loo1 at the
num"ers, i* the. 3m,t94 do reach $#J to $2J9 0oo1 at ?hat ha&&ens to the stoc1 i* the.
can ,et their "usiness 5'ed9
(he. can ,o *rom the assum&tion o* earnin, $$95# &er share to north o* $2 to $3 the
*ollo?in, .ear assumin, i* the. can 5' these "usiness9 + thin1 $#J o&eratin, mar,in or
$2J o&eratin, mar,in one to t?o .ears out is realistic9 )ven 1no?in, nothin, a"out this
com&an. it is realistic "ased on ?hat the. have done in the &ast and ?hat their
com&etitors are doin,9 )ven i* .ou don2t 1no? much a"out their "usiness and ?ho this
ne? mana,ement team is that is comin, into &lace and ?hat their ne? merchandisin,
initiatives are, .ou can still loo1 at the historical record o* their com&an.9 Bhat .ou can
anal.;e is ?here has this com&an. "een and ?here does it have the &otential to ,o i*
the. do ,et it ri,ht9 +s it tradin, chea& enou,h so that i* the. don2t ,et it ri,ht ?ill + lose
m. shirtQ (he ans?er is in the mid 2#2s .ou have a cou&le o* &oints do?n here, "ut .ou
have a lot o* ,ood u&side--$3 or $4 do?nside *or $3# u&side9
Ann Ta"lor Stores (A))) 200Q 2006
(e?enues $2,482 $2,854
22$
E2S $29$7 $39##
2reEta> Inome $25397 $342
S!I$E /or 2rie proOetionG (missinA)
-ne o* the ?a.s to loo1 at it ?hen ?e loo1ed at A)'*C*+M)I' !A",# and 'a(le, is to
as1 ?here do these thin,s trade ?hen the. ,et it ri,htQ !nd as ?e said it trades at $7's
to 2#'s ?hen the. ,et it ri,ht9 Nou 1no? + don2t ?ant to assume a 2# multi&lethe
a"solute to&9 0et2s "e conservative and sa. that it trades at $5's, and &eo&le see in the
comin, .ear that the $3 in )%S is a realit., then there is a &ossi"ilit. *or a $45 stoc1
&rice *rom $25 ?ith $2 or $3 do?nside9 + thin1 that is a &rett. ,ood ris1Cre?ard9
!nother ?a. to loo1 at it is to loo1 out to *our or 5ve .ears and as1 ?hat &otential t.&e
o* "uild-out do the. haveQ !nd ?hat t.&e o* cash can the. ,enerateQ !nd ?hat ?ill
their earnin,s "e at the end o* that 5ve .earsQ So the. can still continue to ,ro? square
*oota,e in the $3J to $5J ran,e over the ne't 5ve .ears that :ust ". o&enin, 3oft
stores and a *e? A"" stores not to mention that the. tal1ed a"out o&enin, a
ne? conce&t9 (he. have not made that &u"lic .et, "ut that is sort o* a
*ree &la. so ?e are not even countin, the ne? conce&t9
200Q E 2006 E
Stores 938 $#38
A## 379 389
!o/t 493 568
So :ust *rom the 3oft and A"" conce&ts ?e have ,ot $3J to $5J sq9 *oota,e ,ro?th &er
.ear9 So i* ?e "uild it out to its &otential and ?e assume that the com&an. can ,et "ac1
on trac1 and o&erate in the $2J )@+( o&eratin, mar,in ran,e, the com&an. at the end
o* the 5ve .ears on the current store "ase--the. ?ould "e earnin, $$97# instead o* the
$$ the. earned last .ear9 So ?ith the current store "ase the )%S is $$97#, then ?ith the
additional "uild out in the $2J ran,e adds $29## so .ou ,et to $397# )%S9 (he.
currentl. have cash o* $395# and i* .ou "uild it out, the. ?ould ,enerate another $7 in
cash over that 5 .ear &eriod and that ,ets .ou to $$#95# in cash9 Nou ,et to a"out a
$6# stoc1 &rice9
J8: Bell, the "asis o* the e'ercise is .ou 1no? ho? anal.sts :ust stic1 a multi&le on it9
Bell it is ,ro?in, at ' &ercent so there*ore it deserves this multi&le9 +n retail i* .ou sort
o* 1no? the end ,amenot that the. couldn2t come u& ?ith ne? conce&ts?ith the
conce&t the. have, .ou sa. this conce&t has 34# stores and the. can ,o to 68#9 +* the.
have $2J mar,ins, ?hat ?ill the. earnQ Fo? lon, ?ill it ta1e them to "uild out to 68#
storesQ Bhat net cash "uild ?ill the. have in the interimQ (hen .ou can &ut a slo?er
,ro?th multi&le at the end9 Nou can ta1e a conservative num"er and .ou can &ut a $2'
at the end o* *our .ears9 Nou ,et $45, .ou have accumulated $$# in cash durin, that
time assumin, the. did not "u. "ac1 stoc1 or else .ou ?ould ,et a "i,,er "um& u&9 So
.ou are at $55 on a $25 stoc1 in *our .ears9 + thin1 0inda came u& ?ith a $6# stoc19
222
!8: +t is a com&ounded $7J annual return over the ne't 5 .ears !;<= to ;==#9
J8: !nd i* .ou remem"er our discussion last ?ee19 (his one is ver. eas. to see over the
hori;on9 +* the. ,et "ac1 to $2J mar,insit is not that the. &ro"a"l. ?on2t &a. more *or
this:ust "ecause that is the ?a. the. anal.;e this9 Nou have to do ?hat .ou thin1 is
reasona"le9 Bell that $7J annuali;ed ,ro?th assumin, the. 5,ure it out in t?o .ears,
then the. don2t discount "ac1 at $7J, the. discount "ac1 at $#J or 8J and .ou ?ill ,et
"ac1 a lot o* that income u&*ront9 So it is &ossi"le to ma1e 5#J to 7#J on this name in
the ne't .ear i* this &la.s out9 Dsuall., ?hat this &la.s out means is that it ?ill "e ver.
clear that the. ?ill "e a"le to "uild out the A"" Talor 3oft stores9 +* the. can 5' the
A"" stores and ,et "ac1 to $2J mar,ins ?hile the A"" Talor 3oft stores are alread.
there9 6i,htQ (hat is not so hard and .ou can 5,ure out these num"ers9 !nd &eo&le
mi,ht even tend to ,ive out hi,her multi&les thou,h ?e ?ouldn2t9 @ut .ou &ic1 a
reasona"le multi&le and discount "ac1 rather than tr. to ,uess at a multi&le9
!nal.sts ?ill sa. a com&an. ?ill ,ro? $5J a .earthe. ma. even "e endin, their
,ro?th 2 .ears *rom no? so it is cra;. to thin1 o* it as a $5J ,ro?er9 +t is reall. "etter to
sa., this is ho? *ar the. can e'&and out the conce&t, this is ?hat the. ?ill earn at the
end o* that, ma."e the. ?ill come u& ?ith a ne? conce&t and ?e ,et a *ree"iema. "e
the. ?on2t9
Student< (he. did ever.thin, ?ron,Q Fo? do .ou ,ain con5dence that the. have not
&ermanentl. dama,ed the "usinessQ
!8: (he "usiness *ell a&art in the second hal* o* the .ear9 (he. made some hu,e
merchandisin, mista1esit can ha&&en to an."od.9 (he. have no? ,otten rid o* the
,u. ?ho ?as doin, the merchandi;in,9 (he. "rou,ht in the ?oman ?ho no? has "een
runnin, 3oft *or the &ast 5ve .ears and ?ho has a ,reat trac1 record at that "rand to run
the A"" Talor "rand9 Fe 3*ormer merchandisin, mana,ers4 "rou,ht in the ?ron,
merchandise, and he also ?as ,oin, to "uild inventories to 2#J to 25J a sq *oot9 8ot
onl. did the merchandise not sell "ut it ?as acer"ated "ecause the mana,er "rou,ht in
?a. too much o* it 3overstoc1ed on &oorl. sellin, inventor.\49 Eerchandisin, and
inventor. issues ,oin, on9
(he nice &art a"out that ?as mana,ement too1 a ste& "ac1 and no? the. have &ut in a
much more disci&lined &lannin, and allocation &rocess9 So ?e ?ill ?atch inventories ,o
do?n9 (hat is a "i, red Pa, ?hen .ou see inventories ,o u& &articularl. in the *ace in
declinin, sales9 So certainl. .ou can certainl. ta1e the "et that the. ?ill mana,e their
inventories "etter9 (he "i,,er question is ?hether the. can ,et the merchandise ri,htV
that mi,ht ta1e lon,er9 @ut + am ?illin, to ma1e the "et ?ith some"od. ?ho has the
1ind o* e'&erience that this ?oman has ?ho is runnin, 3oft that the. ?ill re,ain their
*ootin,9
Be have done research on A"" Talor Stores 3A""4 ". ,oin, out to the malls and have
s&o1en to their customers9 (his com&an. has one o* the most lo.al customer "ases o*
an. conce&t9
J8: Fo? did .ou do thatQ Fo? did .ou intervie? customersQ
!8: Be s&o1e to those ?ho had A"" Talor "a,s and ?ho didn2t9 Be s&o1e also to
&eo&le ?ho ?al1ed into stores and ?ho did not "u. an.thin,9 Be sent &eo&le out
across the countr. to ,o to di>erent malls9 Bhat .ou ?ill 5nd out is that ?hat the. are
doin, in 8N ma. not "e ?hat the. are doin, in the Eid?est9
22(
Nou can also loo1 at the com&etitive landsca&e!lthou,h + mentioned @anana 6e&u"lic
and (al"ot2s--the nice thin, a"out A"" is that there is no one else doin, e'actl. ?hat
the. are doin, in the s&ecialt. store *ormat9 (here is no"od. else ?ho caters e'actl. to
these 1inds o* customers9 (al"ot is a much more conservative customer9 @anana is
more *ashioned *or?ard, .oun,er customer, so A"" sort o* has a reall. nice niche9 !nd
the "eaut. o* it is that their ustomers Beep ominA baB and Beep :aitinA /or
them to Aet it riAht beause the= ha?e no:here else to Ao reall= other than
$epartment stores and people /or the most part are not in lo?e :ith
department stores and department store shoppinA3 A"" has a lot o* lee?a. in
terms o* havin, the time and a"ilit. to ,et it ri,ht "ecause these customers ?ill 1ee&
comin, "ac19
(here are t?o*old ?a.s to ?in: im&rovement on their inventor. issues and their
customer "ase !will (ive them time and abilit to improve their situation#1
J8: @. the ?a., Be used to o?n $#J o* Chico2s a"out 8 .ears9 + don2t 1no? ho? man.
times the stoc1 has s&lit since ?e o?ned it at $4, so ?e have o?ned it at the equivalent
o* a $$ and no? it is at $289 Be ,ot out at even as o&&osed to ma1in, 28 times our
mone.9 (he one thin, ?e ?ere holdin, this thin, *or ?as that ?hen .ou tal1ed to their
customers the. ?ere the most lo.al &eo&lethin,s at the stores ?ere horri"lethe.
1e&t comin, "ac1 ho&in, it ?ould chan,e9 Be lived throu,h a *e? seasons9 + ?as
.oun, and stu&id, so ?e too1 a "i, "et on a retailer9 (he lo.alt. o* the customers ?as
?hat reall. came thou,h9 (he. 5nall. ,ot it ri,ht, the. "rou,ht in the ori,inal &eo&le
?ho had started the chain and the. turned the thin, around9 +t is the t.&e o* thin, that
can ha&&en here9 So i* .ou have lo.al customers li1e A"" and the. have their o?n niche
li1e Chico2s9 +* + had hun, on to Chico2sUU99
!8: + ?al1 in and thin1 that this stu> is u,l., "ut their customers love the store9 +* the.
do ,et it ri,ht, then there is hu,e o&eratin, levera,e9
Student< Fo? "ad did the. ,et it in their merchandisin,Q
!8: (he. ?ere over assorted9 (he. had one t.&e o* s?eater in 2# di>erent colors9 (he.
?ere &oorl. merchandise on the Poor9 (he. had a &in1 &air o* &ants to,ether ?ith a
&in1 s?eater9 (he. have had a revolvin, door o* merchandisin, mana,ers9
7oin, "ac1 to the canni"ali;ation question a"out this com&an.9 +* there is an."od. ?ho
1no?s ?ho this com&an. is tr.in, to cater to *or each o* their conce&ts it is this ?oman9
She ?ill do as much as she can to di>erentiate the t?o chains to ma1e sure the. are
dealin, ?ith se&arate customer "ases9
Student< Nou thin1 that there is limited do?nside to $2$9 Fo? do .ou ,et to that $2$
num"erQ
!8: + have to "elieve thin,s ?ill ,et a little "it "etter than the. did this .ear 32##449 !nd
certainl. ?ith their inventor. &ro"lem + am con5dent that the. ?ill not ma1e the same
mista1es there9 So + loo1 out a .ear or t?o and + sa. and i* the. are not doin, ,reat
thin,s ?ith the "usiness "ut 3oft continues to hold its o?n, then this at least deserves at
least a $# multi&le so the. have $395 &er share in cash so i* the. can continue to ,ro?
the store "ase, even i* the. don2t even do it ?ell, the. can still earn $$96# to $97# ran,e9
%ut a $# multi&le on that *or $$6 or $$7 and add in the $395# in cash *or a&&ro'imatel.
$$995# to $2#95#9 Bhat is nice a"out this is that there have "een ta1eover rumors so
that has held u& the "ottom *or the stoc19
22'
+* the. continue to do not such a ,reat :o", and + &ut a conservative multi&le on it, ?here
is m. do?nsideQ Bhere can it tradeQ +t could trade do?n to $2#9
Student< /o .ou shortQ
!8: + don2t short "ased on valuation9 (he s1. is the limit ?hen &eo&le are e'cited a"out
retail stoc1s9 +t has to "e a *undamental issue ?ith the com&an.9 0i1e a *undamental
shi*t in the com&etitive landsca&e9 (his com&an. has "een a"le to ,enerate the 1inds
o* returns that the. have "ecause no "od. else ?as doin, ?hat the. ?ere doin,9, "ut
then all o* a sudden ne? com&etitors start comin, into their niche9 Eean?hile the
com&an. is tradin, at 4# times, "ut it ma. ta1e a ?hile *or thin,s to &la. out *or the
short9
Student< Fo? so .ou tal1 to customersQ
!8: + send &eo&le out to tal1 to customers9 @ut &eo&le are ha&&. to tal1 a"out their
sho&&in, e'&erience9 Be have &eo&le ?ho ta1e surve.s?hat do &eo&le li1e and don2t
li1e9 %eo&le are ha&&. to tal1 es&eciall. lo.al customers9
Student< ho? did .ou ,et to $3J to $5J ,ro?th in storesQ
!8< (hat is ?hat the com&an. told me9 !nd + loo1 at ?here the. are toda.V ho? "i, the
stores are, ho? man. more the. can o&en, multi&l. that and + 1no? ho? man. stores
the. ?ill o&en9 So + can calculate ho? much ,ro?th the ne? amount o* sq9 *oota,e ?ill
"e on to& o* ?hat the. have no?9 (hat is an eas. num"er to 5,ure out "ecause the. ?ill
tell .ou and .ou can do the math9
Student< 0oo1 out ho? man. stores the. can o&en and assume some time scale *or
?hen the. o&en those stores9 (hen "ac1 out the rate9 Bhat is the nicheQ
!8: +t is ?omen2s ?ear *or &redominantl. 35 to 55 .ear old ?omen ?ho are not su&er
*ashion *or?ard9 ! lot o* it is ?ear to ?or1 *ashion "ut it is not su&er conservative9 %ant
suits9 (he. have Poundered on the casual side9 (here is an o&&ortunit. there9 Talbot2s
has a much more conservative customer, and it does not o>er a lot o* ?ear to ?or1
clothes9 @anana o>ers a cou&le o* suits "ut its customers are more interested in
trendier, more *ashion *or?ard merchandise9 (here is not much servin, the middle o*
the road customers9 !A"" has a uni>ue: underserved niche#1
E#$
EE
8reenblatt Class R 1<

%t3 24, 2003
A guest sister of Joel Greenblatt' 0inda runs a fund focused on retail stocks. Earning a return in the high 2+Ms.
2here are several hundred retail stocks to choose from.
It shows how well you can do if you focus on your niche by staying within your circle of com"etence.
Analysis of com"etition
225
Whole consumer sector
Jetail ? monthly flow of store sales. FreBuent information flow.
Same store sales com"arison
Store growth and JPID of stores.
Companies &B,?C?9+BI
, 1&./2
@5<S 1SD) .8S3@
Cash '++ 2+K C+ K+
52I8 (22 $2C CK 1A
5/452I8 <.< <.5 $$.C 1A
145 $(.' $5.C 2'.C 1A
5/4Sales $.) +.) $.2 +.5
;et Cash4Share '.+ 2.K +.<) (.+'
8otal Stores )<2 K$2 C55 )22
&,9S is going more into lower class malls than &B,?
What is growth "otential,
All these com"anies have a cash balance. When you look at 6;E you might want to take out cash and focus on
their earnings on o"erations.
Rnderstand conce"t customer base location know "rice "oint differential. For e#am"le a sweatshirt at
Abercrombie will sell for *(5 ? *'+ versus *25 at ,agle Putfitters.
&B,?C?9+BI, 1&./2 is at *2C.C+ Gas of Pct 2K 2++(I and it has *'.++ in cash so *2C.C+ minus *'.++ in
cash O *2'.C+ divided by earnings of *2.5+9$+# multi"le.
Where these conce"ts can go de"end on where the stores are located. 2he core Abercrombie conce"t has to be
at a better mall. <++ A Malls C++ D Malls.
Is conce"t maturing, What new conce"t is coming ne#t,
&B,?C?9+BI, 1&./2 will ma#. out about in about '++ more stores in A Malls. If &B,?C?9+BI, 1&./2
does not have growth "otential in its core "roduct what are they doing now to grow,
Bollinger?is there a new conce"t for &B,?C?9+BI, 1&./2. 2heir growth is slowing.
.autica; an a""arel com"any trying to be a retailer. A failure.
!ow to evaluate 0rand value, A good Buestion. &B,?C?9+BI, 1&./2 was once hot??they could sell
anything at full "rice. 2hat is not sustainable. ;ever tr to value a compan #our or #ive ears out based on
popularit.
Get an understanding of where these com"anies stand today. &B,?C?9+BI, 1&./2 is in the best "osition
today. 2heir core conce"t is old but they introduced Bollister which is very hot. Abercrombie Is more east
cost conce"t and Bollister is more of a West Doast Surf conce"t. Bollister has $5+ stores so it has good growth
"otential ahead of it.
Jetaliation, 6rice War, 5oes Bollister take business from ,agleN Is there room enough for everyone, ,agle
has been running negative com"s. ,agle was knocking off everything from Abercrombie. And selling it for
(+> off. 2hen that strategy sto""ed working.
,agle has tried unsuccessfully to buy into a new conce"t while &B,?C?9+BI, 1&./2Ms mgt. has successfully
introduced an organically conceived conce"t. ,agle bought an established name in Danada and has destroyed
it.
22)
Are they trying to go after their same customer base and cannibaliHe it, &.. Taylor has introduced &nn
Taylor 0ot and "eo"le can "ay less for the &.. Taylor brand??so "eo"le are confused.
What ha""ens if a brand is not as hot as it once was, &B,?C?9+BI, 1&./2 vs. ,agle mgt has marketed
well. &B,?C?9+BI, 1&./2 has done a good 4ob at maintaining margins.
&B,?C?9+BI, 1&./2 has been anti?"romotional. !igh standards of "ricing and have maintained the
integrity of the brand.
1Joel Greenblatt; & lot o the opportunity wor(s better with smaller stoc(s2$
&B,?C?9+BI, 1&./2&s Mgt. has im"roved their merchandise margins. 2hey manage it very scientifically.
&B,?C?9+BI, 1&./2 has maintained numbers very well.
A com"any wonMt "romote ha"haHardly.
It is tough to analyHe one store unless you go to the same store three times a month and you look at the
inventory and break out the inventory.
2his is the ty"ical analyst re"ort8 what is ha""ening to com"arable store sales. Is it relatively im"ortant that
they get back to their high com" store sales growth??no not to me if they are making good money on their
stores and there is growth and it is chea" enough. ;ollister is doin! well but comps are down. It doesn=t
thrill me, but it is not important in the bi! picture.
5o I care what they will do in Pctober if I am holding for three years or more.
Dom"s are down (> but they earn returns on ca"ital in the )+>??a good investment. Sure the JPID is not as
great but it is good enough de"ending on the "rice.
2ake advantage of Wall StreetMs fi#ation on same store sales. :ook like they have a lot of debt but what they
are on the hook for is the current market value of that store and the difference in what they owe. Anowing
where you are in the retail cycle. Also know the conce"t cycle.
2ake out rent e#"ense from income. 2here is a lot of debt. 1ote the current market value of real estate vs.
what the stores owe. ,,, Factor in lease e#"ense and make it "art of the debt.
A Buick and dirty on valuing &B,?C?9+BI, 1&./2. What is the "otential build?out in their conce"t,
&B,?C?9+BI, 1&./2 X *(5+;sB. ft. sB. ft. growth "otential *$++;A0EJ
5++ more stores for Bollister for a total of (.2 million sB. ft. total '.$ million sB. ft. X 2+> margin O *$.C+
E6S *2.5+ then *'.( with a $2 multi"le G$5 ? 2+ multi"le for com"arable stocks in retailI O *52 and with 2+#
O *C). 2hen add in e#"ected *$+ "er share in cash to grow in addition to current *5 "er share in cash??thus *$5
"er share in cash ?? *52 N *$5 O *)<.
I get the fourth conce"t for free. 2he stock is now at *2K and then take out 5 "er share in cash for *2' current
"rice for *2.5+ E6S or $+ #s.
*'.(+ E6S in ' years # $2 6;E multi"le N *$5 "er share in cash O *)< in five years so *2K to *)< is $<>
com"ounded growth over 5 years.
I ho"e they can continue what they are doing now. 2hey have 2+> margins. *'.(+ E6S??' years out.
Joel Greenblatt; At some "oint "eo"le Gthe mkt.I wakes u" and the stock goes u" more than $<> "er year. 2he
"rice does not go u" in a steady manner. $K> in one year
&B,?C?9+BI, 1&./28 *$.C+ they earn in this year.
22<
0ase case for &B,?C?9+BI, 1&./2 without growing the business is "aying *2K today with a $+ # multi"le
for *2.'+ E6S and G*2K ? *5;sh cashI. .ou have room for more than $++ &B,?C?9+BI, 1&./2 stores and
5++ more Bollister stores. Pn the additional stores &B,?C?9+BI, 1&./2 will earn more *2.5+. 1etting
after ca"e#. and new store ca"e#. you are netting *2.++ "er share and after five years you have an additional
*$+ "er share to add to the *5.++ "er share in cash. 2here are things you can do with the cash like buy back
stock Gadding value to this scenarioI.
:um"y returns8 year $ &B,?C?9+BI, 1&./2 goes u" $K> to *'C then K> annualiHed return for ( years.
!o"e for stellar faster returns.
Assum"tions8 growth and margin of safety.
For Margin of Safety8 :eaving out other good things that can ha""en to &B,?C?9+BI, 1&./28
&B,?C?9+BI, 1&./28 We get free??the fourth conce"t. 2he margin of safety8 we left out all these other
"ossibilities. We have room for error.
Im"ortant8 com" store sales. Further leverage their o"erations8 better sourcing etc.
Wall Street focuses on the wrong metrics. Dom" Store Sales and 6;E Multi"les vs. growth of the business
overall vs. com". Store sales. What is in total build out,
>or!et slappin! on multiples on !rowth rates.
%udge Buality of management
&B,?C?9+BI, 1&./2 focused on margins. 2hey take a strict anti?"romotional stance. 2hey havenMt slashed
"rices. Mgt. may "anic and slash "rices when a conce"t begins to age. 2hey may sell goods at a discount.
:inda8 :ook at total build?out of stores. What will they make, Study each of their ( different businesses. 5o a
sum of the "arts analysis. -,>P
An C.5> after?ta# yield??I am comfortable with that.
Sim"ler to do a total build?out for five years what are margins with additional stores, Get the methodology
instead of sla""ing a multi"le on it.
&B,?C?9+BI, 1&./2 is im"roving Gross Margins and Maintaining P"erating Margins.
P"en and closing stores. .
0reak?out the new store Da"e#. and old store ca"e#. &B,?C?9+BI, 1&./2 does a good 4ob allocating
resources.
&B,?C?9+BI, 1&./2 can im"rove sourcing "ull costs out and increase merchandiHing margins.
Aee" a close eye on mgt managing the com"any as a business, DEP has a big o"tions "ackage.
&B,?C?9+BI, 1&./2 rarely misses a number. 2hey buy goods on sale.
A hot conce"t is when goods sell at any "rice.
Analysts say com"s are down so stay away they donMt focus on the big "icture. 1ow the stock is a double.
Focus on how much cash is generated over the "eriod.
2here could be an o""ortunity for 3etseal. Why are margins down, P""ortunities with low margins??
turnarounds.
22C
2he guy running Gap came from %isney and he has identified "arts run "oorly. Function of a "oorly run
business.
Where are the "roblems to be fi#ed and are the "roblems fi#able,
2oday it is tough to find buys. :ittle value to be found in the market.
3oo" at absolute valuation.
&B,?C?9+BI, 1&./2 and ,agle show the same E7;E0I2 but normaliHed E0I2 is better for
&B,?C?9+BI, 1&./2 vs. AEM. &B,?C?9+BI, 1&./2 has better growth "otential and management.
0etter normaliHed earnings for &B,?C?9+BI, 1&./2 vs. trailing earnings.
:ook at normaliHed E0I2.
5;6
A"ril $( 2++5
Greenblatt Class #?
)8(+ 6M Donference Dall on Monday for Buestions to "re"are for the e#am.
In addition after our s"ecial desk8 we will have three short "resentation and we will talk about "ortfolio
management.
Introduction8 A to" "erforming hedge fund manager that my "artners who have gotten to know.
Matt Mar5 o# Bett Capital.
6istressed Investin!
!e started at risk arbitrage at Bear Stearns. !e is an e#ce"tional investor. !e does distress investing.
MA66 MARL%
I want to talk about three things.
$. 2he ty"e of analysis used in distress investing.
2. What distress is9there are different skills involved than value investing in general
(. 2hird we will talk about two situations.
I started Jett Capital with *2+ million three years ago in 2++2. We have a little over *(++ million now. We do
venture investing. :ook for value situations with some catalyst or some reason to think that the value will be
realiHed. Why the situation;investment might get better.
I li"e distress investin!, because I don&t thin" we are in an environment o# ver robust investor returns.
Where there is com"le#ity and it is hard to understand there tends to be more value all things being eBual.
3arren Buett G3,B2 has this saying that you don&t get "aid for the degree of difficulty in your investment. I
strongly agree with that. 0ut I find that if it isn&t difficult it is hard to find good investments in today&s
environment. 2hat is why we focus where we do.
:et us talk about distress in general.
A definition8 buying a fi#ed income instrument at a discount at "ar. What kind of skills do you need to be a
good distress investor,
22K
Anow the "rocedural and legal knowledge to understand the bankru"tcy "rocess in the distress market.
What else, Pther than the bank and legal "rocesses, 2he ability to value the business and you need to be able
to find value and be a good investor.
.hat is needed to be a distress investor% le!al and procedural "nowled!e o# the ban"ruptc process,
valuin! assets and companies and bein! a !ood investor.
Focus on different areas than what you have looked at. 5istressed investors focus in bonds9as an investor in
bonds my concern is8 will I get "aid back with an attractive return, Is this a credit "lay, 2hat is where we will
be focused. 2he other kind of distressed investing is receiving newly issued eBuity. 0onds will become a
stock in reorganiHation.
Some "eo"le think that is less interesting than buying stocks. 0onds can become eBuity in the new com"any.
We will talk of different rights and classes of stocks. In general the more senior your bond the greater your
chance of being "aid back. !owever in the event of a bankru"tcy where the liabilities are greater than the
assets it means you will have a higher likelihood of being "aid before the less senior securities.
What are the skills you want as a distressed investor, 2em"erament is a Buality that is an im"ortant "art of all
ty"es of investing. 0eing willing to act on the financial analysis and why every day is a struggle.
2here is a certain amount of negotiation involved. 2here is a real deal making element to being a distressed
investor.
When you have claims in a com"any that might not "ay you back then your interests may not be aligned with
other creditors or investors.
:ike a lot of investing distress investing is often cyclical. It is driven by Su""ly;5emand cycles. Sometimes
there is a lot if distress investing. Pther times the economy is weak and "eo"le are scared so demand for
distress goes down.
2hese are two different "oints in the cycle9the first is when distress was in big su""ly9shortly after World?
com Enron.
E#am"les of 5istress Investing9See !and?Put
T// is a Me#ican com"any run by a family. 2hey have a control "osition in the eBuity. 2FM is the largest
Jail Joad in Me#ico between RS and Me#ico. 2hey own 5$> and they have two minority shareholders9
Me#ican government and Aansas Dity Southern.
:et us talk a little about the situation at the start of the case. It is March 2++(9this is what the balance sheet
looks like.
A8 the Jail Joad9what is it worth,
Pther trans"ortation assets. I am using dollars because this is an A5J.
2hen there is cash.
0iabilities; there are two series of notes8 *'$+ million
9ther liabilities$ !ere is where seniority gets to be im"ortant
2rade claims and bank loans are senior to you as the note holder. 2he bonds are "ublicly traded. 2here is a
little bit of senior debt.
What is the "roblem here, .ou are the DFP and these notes8 *$<< and *2++ million notes are due in May 2++(
or one month. .ou don&t have sufficient cash. Why would the 2++( bonds trade higher than the notes to be
"aid later, 2hey get "aid back first. 2he 2++) notes have less chance of being "aid.
2(+
:et us think about the notes for 2++). 2hat *2++ million is now in the market trading at $C+ million. As a
bondholder you are asking8 Are they going to "ay you back and can they "ay you back,
2he DFP is asking what they can sell. *$++ million in assets that have a lot of small assets so it is tough to sell
it fast.
2hey decide to sell their interest in the Jail Joad for '<+ million dollars. *K'+ million worth in eBuity based
on ADS&s offer for "art of the eBuity. 2here is a billion in debt on to" of that so E7 is *$.K. Is that a good
"rice for its JJ, Is 2FM getting a good "rice, 2hey are getting <.5 # E0I25A. Is that a good "rice, Pther
transactions. If you really wanted to do a valuation the financials would hel".
Is this a !ood C> businessC 1o it is a JJ. It is a decent JJ. It is a mono"oly in its territory. 2ruck goods
can be com"etition. When I think of < to C # E0I25A (+ times trailing FDF??that is a good "rice considering
a DFP has looming liabilities.
Who else would buy this, If you own 5$> of this can you do whatever you want with it.
2he com"any announces that it will sell the JJ to ADS. 0ut it will take time for the "rocess to go through the
regulatory "rocess.
!ey you 2++( note holders we have the assets to "ay you but we need more time to get you the money. :et
the deal close. Give us more time. We will do a tender offer for your notes and give you new notes due in
2++) Gnot ( monthsI and more security. We will give you more interest.
Dhoice number $8 Give us your bonds.
Dhoice no 28 File for bankru"tcy. What does filing mean, 2he com"any files for bankru"tcy.
What are one of the "roblems of bankru"tcy, 2he 4udge is in charge of bankru"tcy. I as a bond?holder don&t
know what the 4udge will do.
2here are some technical influences too. .ou may not be able to own defaulted debt if you are a mutual fund
money manager. 0ankru"tcy is very disru"tive. Dustomers leaving and em"loyees leaving. Jeal value
destruction.
2he com"any can file for bankru"tcy. Stigma the com"any can be hurt by it.
Dhoice (8 2he threat of bankru"tcy9PA fine I will take my new bonds. 2he DFP could raise money from
other sources and re"ay the note holders.
:et&s say I run a hedge fund and I show u" May $C
th
and you show u" and say "ay me. As we got to May $5
then '+> to (+> note holders who held out. 2he "eo"le who were holding out was going u" and down.
It is in everybody&s interest to tender but in the individual&s favor not to tender. !olding out is unethical.
Je"utational effects for Jett Capital are im"ortant.
If everybody did it then we couldn&t manage the com"any. .ou don&t want to be known as someone who
"ushes com"anies into bankru"tcy.
2his is how it works8 read the com"any announcement. 2he com"any goes to a local 4udge to "revent the
re"ayment of debt.
2he com"any recogniHes the obligation but says it won&t "ay you back. Pn May $(
th
an in4unction "reventing
debt holders from forcing the com"any to "ay back its debt. 2he com"any added debt in a bubble
environment.
Pn May $(
th
the management is in my office saying to buy back our bonds so we will be fine. At the same
time they were in a local court trying not to "ay back the debt. So as an investor in "ublic markets that when
com"anies have material information they should tell me. 2hey did not tell their investment banker Salomon.
2($
When you read that you ask what else could be wrong, Mgt. s"ecifically lied to you.
8his is an important part o# the process. 8he bonds !o #rom ?0 cents to M0 cents. Scar. 8his is when I
bu.
0ut buying the bonds at )+ cents was a no?brainer. It may have been contrarianism. In a sense I will do
anything for a "rice.
0oth bonds default to the 5 cents difference between bonds go away.
I own the business at a value of *2'5 million dollars and there is asset value of *)($ million. At this "oint who
knows what will ha""en. ,e is buin! a N0 cent dollarSassumin! the assets are !ood.
0ased on the work that we had done buying a *)(+ million value seemed good.
What do you want to know now, .ou want to know about the asset values. Who would you talk to, 2alk to
the advisors to the transaction.
I could file Gto "ut the com"any into bankru"tcyI in Me#ico or the RS.
2alk to the RS Secretary of the 2reasury. We wanted to know if the financials were good. 2hey had minority
shareholders who had an active interest. 2he mid?level management was not ha""y. At )+ cents what I was
risking was fraud, 2here was cash on the balance sheet. I had no idea of when I would be "aid back.
I "itched this to other fund managers. <ne mone mana!er replied, O8here has to be somethin! better
than buin! )e+ican bonds.P 2hat thinking is why these o""ortunities e#ist. 0ut because "eo"le think that
way is why the bonds are so chea" des"ite having 2.5 times the assets values to cover the debt.
2o the e#tent we try to figure this u". Another "ress release -We grew our rail road.T 2he new 4udge on May
2(
rd
that nullified the "rior 4udgment. Irregularities could have taken "lace. 2here was concern that they might
have bribed the 4udge. It changed the dynamic.
1ow it was clear what our o"tions were. We have bought. We could sell our bonds or "ush the com"any into
bankru"tcy. Who can influence the outcome, Mgt. and the other minority shareholders9the Me#ican
government and -CS. And the senior claims holders and other bond holders. 8he bond holders can or!aniGe.
If the bond holders had organiHed "erha"s then this "roblem might not have ha""ened.
Why would you organiHe, :everage for being well re"resented before the com"any and;or a 4udge. 1obody
wanted to go before a 4udge.
:et us think about organiHing. T/+ decides not to do the deal with -SU. 2here was little talking going on
during this time.
So what do you want, .ou are the biggest bondholder and what do you want, !ow will we get our money
back,
2here are two ways to be "aid back8 $. cash and new "a"er or 2. Pwning the com"any.
Pwning the com"any.
I am buying at *2(+ million for the com"any. At my "rice then there is *$5+ in eBuity and all the debt is *K5+
mm for $.$ billion. *25+ mm in E0I25A and I am "aying ' times E0I25A and it trades for < to C times. So I
really have a 5+ cents dollar.
2his JJ is better than some of the com"arables. Why wouldn&t we want to own the JJ, Me#ico would not
want us as 1ew .ork !edge Fund managers to run the rail road and it is not what we do. So we can&t own it.
2(2
So how do we get "aid back, Dan we force them to sell it, Why do you think the com"any is reluctant to sell,
2he eBuity holders& stock is down K+>. 2he "ublic valuation is *'++ million. If the eBuity holder sells he
won&t get a good "rice. I would get "aid back though.
.hat tpe o# s"ills are needed hereC9the conflict between me and management and ADS is big here.
ADS&s DFP9what would he do, !e does not want to file bankru"tcy in Me#ico because they do business in
Me#ico. Dor"orate relations.
0ondholders e#"lored every avenue. We got new notes which were a lot better than the "rior offer of new
notes. We got higher interest rates and higher security and a guarantee to sell off the JJ and a warrant interest.
We "aid management to accom"lish the restructuring. 2he new "a"er traded at C+ cents on the dollar. $.2
times C+ cents eBuals K) cents. A double in two months.
6espite the paper #lin! bac" and #orth and the threat o# ban"ruptc, the asset values never reall
chan!ed and we bou!ht in at a reall, reall low price.
Figure out the motivations of the other "layers8
Money managers who work at Mutual Funds9their com"ensation goes u" if the bonds go u" that year. More
money on the assets they manage.
Pn the credit committee8 .ou can&t trade. A lawyer can tell me that I am fine but I am not fine. If the SED
calls would you mind telling the "erson from the SED what you did. Would I feel PA,
Most of the guys who held on where the high yield managers. Mutual Funds are a different business than
!edge Funds.
Pne "oint on ,lan Pharma$ 2heir big "roduct was recalled. Early to mid march the drug blew u". Model $
with the drug and Model 2 without the drug and burning through cash. It has $.5 billion dollars in debt and *2
billion in debt.
2he bonds were at "ar and fell to C5 cents. 2he biggest "oint I try to make9what is mgt incentiviHed to do,
When you think about the values you are buying at. 2his deal is not as good as the Me#. JJ. 0ecause the
market is so rich they are shooting for a $5> return. Is this worth it, 2his is not Me#ico and immoral
behavior but it is 0iotech and the reward is much smaller.
Boel Greenblatt ;otes
0ond .ield of )> Rsed as a Dom"arison
When I talk about the $+ year bond yield of )> I am talking about after?ta# yields. I am not com"aring that to
E7;E0I2 U it is almost like E6S here.
6;E ratio of $).)) that is what I am com"aring to a )> bond yield.
Dash Flow from P"erations8 DFP
DF from o"erations includes changes in working ca"ital. Sometimes they are a one?time change in working
ca"ital. What we have been using is 52I86@ minus )CR or E0I2 as a eu"hemism for E0I5A U MDL.
Dlearly each business is different but by 4ust taking DFP you don&t know if there is one?time liBuidation of
inventory or one time need for stuff. Sometimes it is accurate but sometimes not for figuring out normaliHed
earnings.
:ook at insider selling if they sold at higher levels.
2((
6resentations8 3orld 3restling /ederation
2heir sales are way below so their brands or other things are not hel"ing them e#"and. 2hey are s"ending
money to grow but not making much money. !ere your sales re (+> below normal or below your com"etitor
.eiman +arcus$
It is not easily fi#able. 2his is a value tra". 1o easy fi#es while they e#"and.
2heir E0I2 last years was *$++ and s"ending $) million on e#"ansion. .ou are not getting adeBuate returns on
ca"ital des"ite it being chea" on a multi"le basis. I need to look carefully at their business model.
Bohn 1etrie HBoel&s& 1artner at Gotha' Ca&ital$% 2his com"any doesn&t have a credible E0I2 margin
normaliHation story to it. If you look back at 2+++ they are at ).C> E0I2 margin when they were at half the
siHe. 2heir margins have gone down since then so there is no rationale for why the margins will 4um" back u"
with more com"etition. 2here is nothing e#"lainable and reversible.
What is E7;E0I2, It is <.$# for 3orld 3restling /ederation. What is the valuation if the voting stock was not
there, :et&s normaliHe E0I2, 1orm. E0I2 Glast was *)(.5I as a challenge to value it. %ust big "icture8 I want
to find out normaliHed earnings or E0I2. What is normaliHed E0I2 and E7;E0I2 and normaliHed E0I2;
G1WD N FAI. I would still do the valuation as if@@.
Wrestling is cyclical or not cyclical. 2wo sides to valuation8 what is the business worth, 2hen I can throw on
the e#traneous things like the mgt. will steal the E0I2 or I won&t have the E0I2.
>i!ure out normaliGed 52I8 and ;ormaliGed 7<IC. 8hen !o #rom there.
2here will always be moving "arts but that should be your base on every com"any. .ou can com"are
com"anies that way you can always ad4ust because each com"any is different. 2his analysis is sim"le but big
"icture it works. A lot of times you can&t figure it out either by s"ending more time on it or "assing.
5;6
Greenblatt Class #?
1ort#olio )ana!ement
We have s"ent the whole semester doing valuations and figuring out what something is worth.
2hen trying to buy it at a discount.
We are "assing on stuff we don&t understand.
I also take the 3,B a""roach to "ortfolio management. !ow much to buy of each thing, !ow much risk you
are taking in each one. 2here are all sorts of statistics in coming out with the best "ortfolio.
,ere is how I loo" at it%
.ou live in a small town and you sold your business for *$ million. !ow do you invest it, !ow many ways
should I divide the money, 2here are '+ different businesses in the town.
.ou would research the com"anies for the best businesses using the metrics we have learned and then I have
$5 businesses to "ut the money into. Pwning a "iece of a business in town. What would I look at,
$5 good businesses ranked by chea"ness JPID etc.
!ow many different businesses would you want to buy, !ow many is "rudent, 5 to K businesses.
2('
I could "ut 2+> into each stock. 6eo"le might say that such concentration is an unbelievable risk. I "ut a lot
of work into valuing those businesses. 2hink about it in the conte#t of a small town.
*$25+++ into C businesses. 2he way I look at9if I look at normaliHed earnings two to three years out unless it
is a s"ecial situation with a catalyst9I am doing sim"le value investing. Mr. Market will get it right within
two to three yearsI. I may only need to find 2 or ( businesses a year to kee" a 5 to C stock "ortfolio going over
time.
I# ou own a piece o# a business, then ou view thin!s di##erentl than traditional port#olio mana!ement.
I would rather have 5 to C "ositions in businesses that I understand well that I have valued and that are "riced
below value Gbig discountsI. I feel good that I have such a margin of safety that I won&t lose much.
I loo" #or investments that I thin" I will ma"e mone but i# I am wron! I won&t lose much because I have
such a mar!in o# sa#et. .ou can always lose money in the short run but if you get your valuations right you
are buying )+ cents dollars and you can wait two or three years then all those things have to be there. 2he
reason other "eo"le don&t look at it this way9Jich 6Hena was here9he buys chea" Ga logical strategy for meI.
!e started out and way under"erformed the market. Stick to your guns. !e now has one of the best records
on Wall Street. )an people can&t stic" it out. Most say they can under?"erform as long as everyone is
under"erforming.
,e stuc" it out and became success#ul.
It is very hard to do in real life. 2his is the one that makes sense. Most "eo"le can&t do this. &dam here in
class is thinking of having $+ "ositions because he is a conservative guy.
In a s"ecial situation there are o""ortunities where you can lose $++> of your money and then you do not "ut
2+> of your "ortfolio in it.
0uying a <+ cents dollar because it will grow over time. 2he reason I "ay a <+ cents for a dollar in the future is
if I have a strong conviction to earn a *$ in two years. I take a certain 2+> vs. a maybe '+>. 5valuate each
situation separatel. Pbviously your "osition siHe has to be ad4usted.
8hin" o# the bi! picture when ou thin" o# port#olio mana!ement
If you kee" the small town idea of dividing u" your "ortfolio and kee"ing a long?term horiHon then you will
concentrate on our best ideas. 2hat is not the only way to make money but it has sure worked well for us.
If you take half your money and use a 2+ "unch?hole card you will do the best in the class.
5nd
Greenblatt 7eview Class
@pril 15, 2005
Pn the E#am8 .ou will get financial statements and some com"arables??enough to come to a conclusion. 5o a
valuation. 5o ca"e# correctly. .ou will view subseBuent Buarters and see what ha""ens. !ow are things going
for the com"any.
0ring a calculator. A real world e#ercise. .ou might want to review my book !ow .ou Dan 0e A Stock
Market Genius and Thorton 9Gloves book =uality of Earnings. .ou will see telltale signs on the balance
sheet. 2hat is about half the test.
2here will be a Buestion on o"tions and risk arbitrage. Baugen reading. =uestions from my book.
2(5
.ou will have hardball and softball Buestions. 2his e#am is a very good test and learning e#"erience.
8he point o# the class is not to show how little I "now but what are the "e thin!s I have to "now.
Jeading a lot of the footnotes and all these things are im"ortant. What are you trying to do is boil it down to a
cou"le of conce"ts. Dan I answer this Buestion or not,
Is this a good business GE0I2;G1WD N1FAI, Jeturn on tangible invested ca"ital,
Dan I buy it at a good "rice assuming normaliHed earnings GE0I2;E7I, !igh Earnings .ield,
What are normal earnings going to be in a few years, 2hat means real cash flow
real earnings. Rnderstanding future growth through com"etitive advantages.
2hink about normal earnings in two to three years or whether those current earnings will continue to grow.
!ow confident are you are in those estimates, Rsing those estimates to figure JPID or E7 to E0I2. .our
earnings yield.
I hate to boil it down so simpl, but that is what I use. I# I don&t have enou!h in#ormation to !et there,
then I pass. @ll I am trin! to do is #erret out those answers.
.ou have to do a lot of research to get to normaliHed numbers. I made a lot of money doing s"ecial situations
looking for no?brainers. As time goes on I have found ways to make money in different ways. Rsually when
you find something at ) or C times earnings it is something horrible. Well the ne#t year or two will stink but
then normaliHed earnings will get better.
2here are a lot of tests they can do but taking your blood "ressure is the best indicator of your health or for
your risk of a heart attack. .hat can I boil it down to #or what I am loo"in! #orC
If it is so tough to figure out ne#t Buarter then why am I confident over the ne#t three years from now, 2hat is
what you are looking for.
Aou are trin! to #i!ure normaliGed earnin!s two ears out.
Well the market may fall or "eo"le worry about what ha""ens ne#t Btr, If you can cut through all the cra" and
focus on normaliHed earnings and whether the earnings will grow or shrink. Pr is this a good business, It too"
me a lot o# ears to !et here. It is not as sim"le as it sounds. I am sure you have learned a lot of so"histicated
stuff in other classes. 2here is a lot of information out there. 2he 3SJ has more information than the average
"erson had in a lifetime in the $'
th
century.
I# ou can reall pic" our spots, it is simple.
Pften times the guys running the business do not see the big "icture while you are looking at a lot of different
com"anies. .ou are looking at different com"anies in the industry. 2his kind of business will trade at higher
multi"les. I have seen a lot of businesses and JPE and growth streams deserve to get high multi"les but it is
not trading there. Aou have to be ri!ht more than ou are wron!.
+att +ar( he doubled his money in his "osition. 0ut it was really about gamesmanshi" rather than
valuation. So you have a good estimate of what this might be worth. If you do detailed work kee" the big
"icture in mind.
Why do you view E0I2 rather than FDF, E7 to E0I2. E0I25A U MDL or a "re?ta# cash flow,
E7 to E0I2 is a eu"hemism. Chan!es in wor"in! capital need to be ta"en into account Hi# ou use Cash
>low #rom <perations. .ou have to ad4ust those metrics to see if they are re"resentative to the com"any. If
there is a difference between earnings and cash I will use cash.
2()
0ased on assum"tions. If I grew earnings $5> a year then I grew the stock "rice at the same rate. GAnalyHing
stock buy backI. In 5uff S 6hel"s C> to $2> to 2+> DAGJ assum"tion.
A guy who ran a Dhemical Do. !e wanted to buy back stock in his com"any. A "icture of him "ointing to the
fence like 0abe Juth. 2hat is a scary guy. At the end of the day what was his game "lan, ,e was buin!
bac" stoc" even thou!h his stoc" was at a hu!e multiple on pea" earnin!s in a cclical business.
Sometimes when things don&t make sense they don&t make sense.
.hat we have been !ood at is avoidin! errors o# commission. We sold stuff too early we have missed stuff.
I thin" the "e is to pic" with con#idence and be selective. .ou understand the business well. 6eo"le
Buestion you on too short a time "eriod
2 "lus 2 is a "owerful idea. .ou know it is ' so no matter how many "eo"le tell you it is different. If you know
the valuation then these are the three things that are kee"ing earnings down but they won&t last. ) #avorite
thin!s are not ones that I am ri!ht on, but when I am wron!, I paid so cheapl that I don&t lose. I get a
decent amount right.
If you buy something and it only goes u" means you "icked the bottom tick.
Rse normaliHed earnings and it is trading at a 5+ cent dollar and then buys it. 5on&t wait. 2he school of hard
knocks teaches you things.
2he Short Side
2he short side??unless the thing is going to run out of money it is very hard to hang in there.
I was long and short stuff with bad business models 5 times overvalued and running out of money but it is
very hard to hang in there. 2here are guys who do well shorting stocks.
8he mar"et has an up bias and i# ou brea" even and the mar"et is up 7Q to KQ but ou are not addin!
value lon! term.
2he value stocks were going u" while the overvalued stocks colla"sed. 2here are some guys who can add
value but they are very rare.
Rnless you value volatility then shorting may not add much value. Make money in the long term. 1o matter
how you add u" all the numbers it won&t add value over the long term Glong;short fundI. If you look at small
"eriods of time then it is easy to draw the wrong conclusions. 2here is time when they both go against you.
2he notion you are only long 5+> when you are $++> long and 5+> short.
@nother thin! I have learned, the less levera!e, the better. 0ecause if you have the "hiloso"hy to be long
term you need to live to get there. .ou have to live to "lay another day if you take a long term horiHon.
If you know what the right thing is but your customers don&t then you have a "roblem.
Sometimes these outside forces can effect you.
Student% !ow did you move into starting your own firm,
BG8 I always knew I wanted to do what I wanted to do. I went to law school for a year because I didn&t want to
work. 2hen I went to work for a risk arbitrage firm where I was the flunky. I took that 4ob for *2++++ or a lot
less than what M0As are getting. I went to work for +ichael +il(en. I got interested in investing through
reading Ben Graham. I read an article in /orbes. Ben Graham is mathematically oriented so he finds chea"
things.
3harton Business School doesn&t teach value investing. 7alue investing hit home. Sometimes it clicks or it
doesn&t. 2here are "eo"le where it doesn&t click.
I was doing that and took a 4ob at a risk arbitrage firm. It was like the Wild West. 2he one offer for *5+ for
half your stock in the front end and *25 on the back end for the other half. A front end tender offer. It might
2(<
have made sense to tender the worse deal. 2he "rorate date was ten days after. Some didn&t know to tender
their stock. I traded o"tions at 0ear Stearns. 2here were some deals9*5+ front end and *25 back end or the
deal is worth *(< worth on average for the stock. .ou could buy the *(< "uts for a dollar3 the o"tions guys
didn&t understand the deal. So as long as the deal closed before the e#"iration of the o"tion then the *(5 "ut
then became worth *$+. .ou made $+ times your money.
I thought the Ben E Graham stuff could make you 25> "er year but the risk arbitrage business was $++> a
year in a bad year.
2hen I looked at things that fell off the back of the truck and s"in?offs. After doing this for three years I
thought I would go on my own if I could raise *2++ million dollars.
I met with +ichael +il(en. I wanted what I wanted. I figured I should stick to my guns. So I can&t say go
re"licate that.
@ lot o# it is bein! in the trenches #or a couple o# ears. Making mistakes seeing what can ha""en seeing
other "eo"le make mistakes. Seeing things you missed and you got.
8he bottom line is ou have to !o do it oursel#. Feel confident about getting going. %ust get going. If I
made (+> then I would "ay my overhead but at least I got going. If you run your own account say *$++++
run it like you are running a fund but don&t run it like you are running *5 billion dollars. Jun it like you are
running *$+ million.
I see guys who raise *$+ or *2+ million but they run it like they are running a huge fund. 8he invest in bi!
cap names. 2ake advantage of your siHe if you can. 8a"e advanta!e o# our abilit to !et into and out o#
thin!s. I started in $KC$ when the market bottom. I started in $KC5. When I went to Wall Street the market
had been flat from $K)) to $KC2 or $) years. .ou have a big leg u" having gone here. .ou have a value
"ers"ective.
I know it seems sim"le and obvious to you but the rest of the world doesn&t know what you have learned.
Student% What did those "eo"le have that you backed, Pr what makes them good investors,
%G8 It is different things. What I liked about him was that he disagreed with me. Independent thin"in! is
im"ortant. !e has a very reasoned argument. !e was willing to stick to his guns. A strong well thought out
o"inion and you are intellectually honest. 2hose are the "ersonal Bualities that I am looking for. Someone
who thin"s a little out o# the bo+ and the are not a#raid to do their own thin"in!.
%ust because I taught you certain ways there are many different ways to make money.
6ick what you are good at. Everyone is different. .ou have this value under"inning and then you overlay it
with your own thoughts. 0inda Greenblatt understands in her bones retailing. It is not what I do. She looks
for value retailers. She stays in one sector. Most of academia would say what she does is im"ossible.
6ortfolio Management8
I truly look at it the way I described. If I can "ut my money in 5 to C businesses that I understand well and I
can withstand the storm then why isn&t that a good strategy, :ooking at beta and volatility is a waste of time.
If my returns are (+> and they bounce around then so what.
If you look at ?ichard P8enas "ortfolio9he is a dee" value guy9his standard deviations in one year&s time is
more volatile but over three years time then it is lower.
8here is no relation between Hnear(term volatilit$ and bein! a !ood investor.
A "ension fund he sits on the board of9if the endowment has a long term horiHon@@.5;6
??
2(C
Greenblatt 7eview ;otes
52I8 ??? Earnings before interest and ta#es Goften called operating earningsI
2his is what the com"any earns before worrying about ca"italiHation Ghow much debt it hasI and ta#es.
5ebt levels differ among cor"orations and therefore E0I2 is a good thing to look at to determine the earning
"ower of the com"anyMs business. Dom"aring E0I2;Sales of com"anies in the same industry might tell you
how efficiently different com"anies turn sales into earnings.
1et income;Sales might not tell you this because net income is arrived at after subtracting interest and ta#es. A
com"any with a lot of debt will have a lot of interest e#"ense. So even if a com"any is o"erating very
efficiently net income may be low because of large interest e#"enses. 2a#es may differ because of the ta#
shielding effects of debt or s"ecial circumstances like ta# loss carry?forwards ta# credits etc. which may not
reflect o"erational efficiency.
.hat is 5nterprise /alue H5/$C
E7 is market ca"italiHation G6rice times shares;outI N 1et interest bearing debt G5ebt includes the current
"ortionI.
Why an investor should use Enter"rise 7alue, Donsider 2 com"anies??Do. A S Do. 0 which are the same
com"any. !owever Dom"any 0 has *5+ "er share in debt Gat a $+> interestI. Dom"any A has no debt.
Assume the going rate for the earnings stream re"resented by *$+ in E0I2 is *C+ GC # E0I2I for com"any A S
0Ms industry.
Compan @ Compan 2
Sales *$++ *$++
52I8 *$+ *$+
Interest 5+pense + *5
8a+es *' *2
;et Income *) *(
Iuestion 18 If Dom"any A trades at *C+ "er share letMs figure out its 6;E 6rice;Sales ratio E7;Sales
E7;E0I2.
Iuestion 28 If Dom"any 0 trades at *(+ "er share letMs figure out its 6;E 6;S ratio E7;Sales E7;E0I2
Compan @ X EK0 per share Compan 2 X EF0 per share
145 *C+;*) O $(# *(+;*( O $+#
1rice4Sales *C+;*$++ O +.C# *(+;*$++ O +.(#
5/4Sales *C+;*$++ O +.C# *C+;*$++ O +.C#
5/452I8 *C+;*$+ O C# *C+;*$+ O C#
Dom"any 0Ms 6;E a""ears lower and its "rice;sales ratio a""ears incredibly low. Since Dom"any A and
Dom"any 0 have the same "re?ta# "re?interest earnings stream GE0I2 of *$+;ShI and since they are the same
com"any the different com"anies should really be worth the same thing to a buyer. Gi.e. whether you "ay *(
for the com"any and owe *5 or you "ay *C and owe nothing it is the same thing. GE.g. whether you "ay
*(+++++ for a house and assume a *5+++++ mortgage or "ay *C+++++ u" front. ItMs the same to you. .ou
can "ay the *C+++++ in cash or take out your own *5+++++ mortgage and be in the same sha"e as buying the
house with e#isting mortgageI.
2(K
2he different ca"italiHation skews 6;E and 6;S but E7 takes into account the different debt levels and lets you
com"are the true earnings stream that can be leveraged by a buyer or not.
.hat is 52I86@C
E0I25A is earnings before interest ta#es de"reciation and amortiHation. 2his is su""osedly the cash that the
com"any generates. Warren 0uffett dislikes this number. Investment 0ankers use this number to show how
much cash a com"any generates that can be used to "ay interest Gbecause de"reciation and amortiHation are
non?cash chargesI. !owever before you can use E0I25A to "ay interest e#"ense you must "ay those ca"ital
e#"enditures that are reBuired to kee" your business running at the current level. 2his is a cash e#"ense. I call
this maintenance ca";e#.
If instead of E0I25A you use GE0I25A minus DA6;ELI you will get a truer "icture of actual cash available
to "ay interest. 2his is closer to true cash earnings before ta#es. Pbviously some "ortion of ca";e# may not be
for maintenance Gsome may be for e#"ansionI so you can either subtract 4ust maintenance ca";e# Gif you can
find itI from E0I25A or total ca";e# to be conservative.
Instead of 6;E I like to use E7; GE0I25A ? DA6;ELI to com"are com"anies with different amounts of
leverage.
.hat is >755 C@S, >3<.C
G1et Income N 5e"reciation N AmortiHationI minus DA6;EL
1et income is accounting earnings after subtracting de"reciation amortiHation interest and ta#es. Since 5SA
are non?cash e#"enses we add them back to net income to figure out how much actual cash the com"any
generated. I subtract maintenance ca";e# Gor total ca";e# to be conservativeI to arrive at Free Dash Flow.
Da";EL is a cash e#"ense. Maintenance ca";e# must be s"ent. So free cash flow should re"resent the cash
available to "ay dividends buy back stock "ay down debt or make acBuisitions. 2hese are things that take
cash.
If you owned a business you would want to know how much real cash it was earning. Some com"anies s"end
so much on ca";e# to kee" u" with com"etitors that they never really earn as much cash as net income
indicates. GIn other words ca";e#"enditures are so large and continuing that 4ust to stay com"etitive
com"anies are s"ending all their re"orted income "lus more to 4ust kee" u" with com"etitorsI.
2e#tile com"anies and high tech com"anies may fall victim to this. Even a de"artment store may have to do
constant overhauls if com"etitors kee" fi#ing u" their stores every few years.
Pn the other hand a com"any may be earning more cash than re"orted earnings. Pften this ha""ens when
com"anies have large amounts of amortiHation resulting from acBuisitions made at substantial "remiums to
book value.
5;6
??
'o: Joel 8reenblatt uno?ers the seret hidinA plaes o/ stoB marBet proItsG
$eemberE30E2009 b= "rian Sen, %nlightened In-estor igest
A# !#1ight!#!3 ,-# t/"#s o# th! BLightB i# th! 3-"k hi33!# 81-c!s. Co!1 D"!!#5-1tt is s/ch - ,-#.
Discovering The Hidden Places
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Stock Market Genius (Even if you're not too sart!( Co!1 D"!!#51-tt g!#!"o/s12 8"o.i3!3 - 1ist o
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Spin-offs
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Merged Securities vs. Merger Arbitrages
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,/1ti81! go.!"#,!#t "!.i!ws( sh-"!ho13!" 3is-88"o.-1( -#3 ch-#g!s o ,-"k!t co#3itio#( !tc.
So,!ti,!s( th! ,!"g!" ,-2 #ot !.!# go th"o/gh. K c-11 this Bh-.i#g 2o/" i#g!"s 5/"#!3 whi1!
8icki#g th! 8ock!t o co"8o"-t! -c0/i"!"sB. *h! -c0/i"!" is 5/2i#g o" '20 - sh-"!. No/ t"2 to 5/2 -t
'19.5 - sh-"! -#3 3!1i.!" 2o/" sh-"!s to th! -c0/i"!" o" '20. Kt ot!# wo"ks( 5/t ,-#2 thi#gs
co/13 go w"o#g -#3 th! !#g-g!,!#t "!1-tio# co/13 t/"# so/"...-#3 2o/ s!! th! stock si#k 5-ck to
'15.
How!.!"( i# ,!"g!"s( th! -c0/i"!" so,!ti,!s 8-2s o" th! -c0/isitio# i# t!",s o s!c/"iti!s
oth!" th-# stock. *h! 8-2,!#t co/13 5! i# 5o#3s( 8"!!""!3 stock( w-""-#ts o" "ights. K#stit/tio#s
t28ic-112 sh/# th!s! i11i0/i3 -#3 co,81!4 s!c/"iti!s( -#3 i#3i.i3/-1s who "!c!i.! th! /#-,i1i-"
s!c/"iti!s ot!# 3is8os! th!, i# th! ,-"k!t -/to,-tic-112. *h! 8"ic!s -"! th/s 3"i.!# 3ow#(
,-ki#g th!, -tt"-cti.! 5-"g-i#s.
Bankruptcies
Fh-t is th! 5igg!st !-" o# F-11 St"!!tH $-#k"/8tc2J A#3 th-tGs wh!"! o88o"t/#iti!s 1ik!
A,!"ic-# E48"!ss( -#3 i# "!c!#t 2!-"s ;-cDo#-13Gs -#3 8!"h-8s ;!"ck( -"! hi3i#g.

A# /#co#.!#tio#-1 -#3 hi3i#g o88o"t/#it2 th-t D"!!#51-tt s/gg!sts is #ot th! stock( 5/t th!
5o#3s( 5-#k 3!5t -#3 t"-3! c1-i,s o co,8-#i!s th-t -"! 5"ok! -#3 5-#k"/8t.

Fh!# - co,8-#2 is 5-#k"/8t( th!"! -"! 81!#t2 o !-g!" -#3 -#4io/s s!11!"s -#3 th!
5/si#!ss!s -"! -1w-2s /#8o8/1-".
*h! "ight ti,! to 5/2 is th! t"ick2 thi#g h!"!. So,! s/gg!st 5/2i#g 3/"i#g th! 8"oc!ss wh!#
th! co,8-#2 ,-2 5! !,!"gi#g "o, 5-#k"/8tc2 8"oc!!3i#gs.
A#oth!" t"ick2 iss/! is th-t 2o/ #!!3 to 5! .!"2 c-"!/1 i# choosi#g th! G"ightG 5-#k"/8t
co,8-#i!s to i#.!st i#. No/ #!!3 to ,-k! s/"! th-t th! B"i!3 chick!#B o# F-11 St"!!t c-# o#! 3-2
12 -g-i#. A#3 how 3o 2o/ 3o th-tH 7F!11( ,-25! 2o/ sho/13 co#si3!" "!s!-"ch wo"ksho8s 1ik!
o/"s -t 9!#w-2.co,.:
orporate !estructuring
2'2
Fh!# - t"o/51!3 co,8-#2 go!s th"o/gh ,-Mo" co"8o"-t! "!st"/ct/"i#g( 5-"g-i# o88o"t/#iti!s
-"! ot!# c"!-t!3.
P!o81! sh2 -w-2 "o, ,-Mo" ch-#g!s -#3 /#c!"t-i#ti!s. F-11 St"!!t -#-12sts t!#3 to 3"o8
co.!"-g! o co,8-#i!s th-t -"! /#3!"goi#g ,-Mo" co"8o"-t! ch-#g!s( c"!-ti#g /"th!" 8"ic! 3i8s
o" th! stock.
No/ c-# !ith!" i#.!st -t!" "!st"/ct/"i#g h-s -1"!-32 5!!# -##o/#c!3 o" wh!# - co,8-#2 is
g!tti#g "!-32 o" "!st"/ct/"i#g. No/" Mo5 is to 8ick -#3 choos! to i#3 th! ,-Mo" co"8o"-t! ch-#g!s
o" th! 5!tt!" i#st!-3 o wo"s!.
C/st 1ik! $/!t -.oi3i#g 7-oot-5-"s wh!"! 2o/ ,/st 12 o.!" -#3 ,-2 5"!-k 2o/" #!ck wh!#
-11i#g 3ow# o# 2o/" 5-ck( D"!!#51-tt too sh/#s co,81!4 "!st"/ct/"i#gs wh!"! 2o/ c-#Gt
/#3!"st-#3 wh-t is "!-112 goi#g o#( o" 2o/ h-.! 8"o51!,s ,!-s/"i#g th! h!ight o th! 5-".
!ecapita"i#ation
D"!!#51-tt s!!s "!c-8it-1i9-tio# t"-#s-ctio#s -s -# i#.!st,!#t o88o"t/#it2( wh!"! - stock
5/25-ck is so,!ti,!s i#-#c!3 52 -33itio#-1 5o""owi#gs.
*h! "!-so# th-t ,-k!s 3!5t-!0/it2-"!c-8it-1i9-tio# i#t!"!sti#g is th-t 5/25-ck o !0/it2
i#c"!-s!s th! 1!.!"-g! i# th! 5-1-#c! sh!!t( th/s i#c"!-si#g th! t-4 s-.i#g which c-# th!# 5!
8-ss!3 o# to th! sh-"!ho13!"s.
K#.!sto"s -"! ot!# sc-"!3 o #!w 3!5t( th/s 8/shi#g 3ow# th! stock 8"ic!s to -tt"-cti.!
1!.!1s.
D"!!#51-tt 5!1i!.!s th-t( i# "!g-"3 to "!c-8it-1i9-tio#( Bth!"! is -1,ost #o oth!" -"!- o stock
,-"k!t wh!"! "!s!-"ch -#3 c-"!/1 -#-12sis c-# 5! "!w-"3!3 -s 0/ick12 -#3 g!#!"o/s12B.
&i#-112( *h! Disc1-i,!" K# &i#!8"i#t
N!s( 2o/ c-# 5!co,! - stock ,-"k!t g!#i/s !.!# i 2o/ -"! #ot too s,-"t. $/t( -s Co!1 D"!!#5-1tt
wo/13 w-"# 2o/ hi,s!1 th-t th!"! -"! to#s o 8-i#st-ki#g "!-3i#g( 1!-"#i#g -#3 "!s!-"ch i#.o1.!3 i#
i#3i#g th!s! hi33!# o88o"t/#iti!s.
KtGs M/st 1ik! th! co#.!#tio#-1 wis3o, -5o/t "!! 1/#ch( with which K h-3 so,! "-th!" 8!"so#-1
!48!"i!#c!. &i"st( w!G.! -11 h!-"3 th-t th!"! is #o "!! 1/#ch. $/t th!# w! wo/13 -11 i#3 o/t th-t( i 2o/
s!-"ch h-"3 !#o/gh( -#3 i 2o/ -"! Bh/#g"2B !#o/gh 7M/st -s K 1!3 to A,!"ic- with 8"-ctic-112 #othi#g
-#3 w-s -5o/t to 8-ss o/t i# ,2 -3.-#c!3 -cco/#ti#g c1-ss!s:( 2o/ wo/13 so,!ti,!s 8ick /8 - "!-1
"!! 1/#ch h!"! -#3 th!"!. A#3 ,-25!( 8-ck ho,! so,! #ic! git 5-gs. &o" !4-,81!( 3/! to 15 2!-"s
o h/#g"2 "!s!-"ch -#3 .o"-cio/s -cc/,/1-tio# o i#o",-tio# -#3 co#t-cts( K h-.! 3isco.!"!3 0/it!
- !w "!! 1/#ch!s wh!"! F-""!# $/!tt -#3 Co!1 D"!!#51-tt wo/13 h-.! #o ti,! to go to i# 81-c!s
1ik! H-".-"3 %1/5... H-.! w! ,!t 5!o"!HJ
An E?eninA :ith -r3 8reenblatt Januar=E00E200Q
Co!1 D"!!#51-tt by Shai Dardashti
2'(
;". D"!!#51-tt( -/tho" o *h! Litt1! $ook th-t $!-ts th! ;-"k!t( t"!-t!3 ,!,5!"s o th! ENSSA to -
s8!ci-1 !.!#i#g 8"og"-, o# B S8!ci-1 Sit/-tio#s K#.!sti#gB.
P"o.i3i#g - wo#3!"/1 g1i,8s! i#to th! !.o1/tio# o his i#.!st,!#t ,i#3s!t( ;". D"!!#51-tt o8!#!3
with -# -cco/#t o his co11!g! 2!-"s - wo"ki#g with >ich P9!#- to 3!co#st"/ct th! ,!tho3s o
$!#M-,i# D"-h-,. K# th! 1-t! 1970s( ;". D"!!#51-tt "!c-11s( h! B"!-3 - &o"5!s -"tic1! -5o/t D"-h-,B
th-t 3isc/ss!3 E!t-E!t St"-t!g2( th-t is - stocks t"-3i#g 5!1ow 1i0/i3-tio# .-1/!.
&"o, ,2 8!"so#-1 !481o"-tio#s i#to D"-h-,i-# t!ch#i0/!s( K 5!1i!.! this is th! -ct/-1 -"tic1! which
i#s8i"!3 ;". D"!!#51-ttGs .-1/! i#.!sti#g 8/"s/itsI
The "eturn of #en$ain Graha% &orbes 'ctober ()% (*+*
B*hi#k o - ti,! wh!# stocks o 191 i,8o"t-#t A,!"ic-# co"8o"-tio#s -"! s!11i#g o" 1!ss th-# #!t
wo"ki#g c-8it-1 8!" sh-"!. A"! w! t-1ki#g -5o/t 1932H Eo( 1979.B
%o#ti#/i#g his sto"2 o s!1 3isco.!"2( D"!!#51-tt "!c-11s th-t -t D"-3/-t! schoo1 -t Fh-"to#( h!
Bw"ot! - 8-8!" 8/51ish!3 i# th! Co/"#-1 o 8o"to1io ,-#-g!,!#t.B
K# his t28ic-112 h/,51! -#3 ,o3!st #-t/"!( ;". D"!!#51-tt chos! to 1!-.! o/t th! i#3i#gs o his !-"12
!481o"-tio#s - 8/51ish!3 i# - 1981 st/32. $!1ow -"! so,! #ot!s K co,8i1!3 "o, "!s!-"ch o# th!
-ct/-1 "!8o"tI
1981
=reen>latt- P:ena-
an8 ;e%>erg
?<% t#e &'all Investr "an Beat t#e
Mar!et
@urnal * Prt*li
Manage'ent
*h! D"!!#51-tt/P9!#-/E!w5!"g st/32 w-s i#t"ig/!3 52 D"-h-,Gs w"iti#gs i# S!c/"it2 A#-12sis i#
which Bh! o/t1i#!s i# 1itt1! ,o"! th-# - 8-g! th! o88o"t/#iti!s to 5! o/#3 i# stocks s!11i#g 5!1ow th!i"
1i0/i3-tio# .-1/!. K# st/3i!s 5!tw!!# 1923 -#3 1957( D"-h-, "!8o"t!3 s/8!"io" "!s/1ts wh!# ,-"k!t
1!.!1s !#-51!3 hi, to 5/2 - 3i.!"sii!3 1ist o th!s! 5-"g-i# stocks.B
*h! st/32 !4-,i#!3 th! 8!"o",-#c! o stocks ,!!ti#g D"-h-,Gs rough li,uidation value 7#!t-#!t:
!sti,-t!I
-ccounting Definition of "ough .i,uidation Estiate/
B%/""!#t Ass!tsB 7c-sh( -cco/#ts "!c!i.-51!( i#.!#to"2( !tc.:
L!ssI B%/""!#t Li-5i1iti!sB 7sho"t t!", 3!5t( -cco/#ts 8-2-51!( !tc.:
L!ssI BLo#g *!", Li-5i1iti!sB 71o#g t!", 3!5t( c-8it-1i9!3 1!-s!s( !tc.:
L!ssI BP"!!""!3 StockB 7c1-i, o# co"8o"-t! -ss!ts 5!o"! co,,o# stock:
Di.i3!3 52I *ot-1 Sh-"!s </tst-#3i#g
E01-.S 2.i,uidating 3alue Per Share2
*h! st/32 B3i3 #ot co#si3!" th! stocks th-t h-3 show# - 1oss o.!" th! 8"!c!3i#g 12 ,o#ths.B
2''
>!s!-"ch co.!"!3 B15 s!g,!#ts o 4 ,o#ths !-ch o.!" - si4-2!-" 8!"io3 i# which th! o.!"-th!-
co/#t!" 7EASDAO: -.!"-g!s h-1.!3 -#3 th!# 3o/51!3... *h! 8!"io3 /#3!" st/32 -# "o, A8"i1 1972
to A8"i1 1978.B
3#e 4rcess l!e8 e7clusivel6 at t#ree *actrsA
P"ic! i# "!1-tio# to 1i0/i3-tio# .-1/!
P"ic!/E-"#i#gs "-tio
Di.i3!#3 Ni!13
Stocks w!"! so13 -t!" - 100% g-i# o" -t!" 2 2!-"s( which!.!" c-,! i"st 7-s 8!" D"-h-,Gs
w"iti#gs:
3#e =ra#a' net-net >u6ing 4rcess %as a44lie8 %it#in *ur 8istinct 4rt*li 86na'ics- eac#
8escri>e8 >el% %it# its res4ective resultsA
Po"to1io 1I
# P"ic!/1i0/i3-tio# .-1/! P/Q 1.0L
# P"ic!/!-"#i#gsI 1o-ti#g with 5o#3 2i!13sL
R"!0/i"! - P/E co""!s8o#3i#g to twic! th! 8"!.-i1i#g t"i81! A 2i!13 i# !-ch
8!"io3S
# Di.i3!#3sI #o 3i.i3!#3 "!0/i"!,!#ts
"esults/
BD/"i#g th! 15 4-,o#th 8!"io3s o/" co#st"-i#ts 3ict-t!3 - 8ositio# i# th! ,-"k!t( w! -.!"-g!3 -#
-##/-1 co,8o/#3!3 "-t! o "!t/"# o 20.0% 5!o"! 3i.i3!#3s( co,,issio#s -#3 t-4!s. *h! <*%
i#3!4 -88"!ci-t!3 -t -# -##/-1 co,8o/#3!3 "-t! o 1.5% 3/"i#g th! s-,! 8!"io3.B
BF! wo/13 !48!ct high!" "!t/"#s to -cc"/! to "iski!" i#.!st,!#ts to co,8!#s-t! /s o" t-ki#g o# th!
-33itio#-1 "isk. *h!"!o"!( w! -1so st/3i!3 th! .o1-ti1it2 o th! "!t/"#s o o/" s!1!ct!3 stocks with th-t
o th! EASDAO ,-"k!t -.!"-g!. 7D/"i#g this 8!"io3( th! EASDAO -.!"-g!s sig#iic-#t12
o/t8!"o",!3 th! S6P i#3!4!s o 1-"g!" co,8-#i!s: A "!g"!ssio# o o/" Po"to1io 1 "!t/"# -#3 th!
<*% ,-"k!t "!t/"# o.!" th! 15 8!"io3s "!s/1t!3 i# th! o11owi#gI
Po"to1io 1 "!t/"# Q T6.14 T.836 7EASDAO "!t/"#:( 74 ,o#th 8!"io3:
Po"to1io 1 st-#3-"3 3!.i-tio# Q 14.15L
<*% 8o"to1io st-#3-"3 3!.i-tio# Q 12.75.B
Po"to1io 2
# P"ic!/1i0/i3-tio# .-1/! P/Q 0.85L
# P"ic!/!-"#i#gsI 1o-ti#g with 5o#3 2i!13sL
# Di.i3!#3sI #o 3i.i3!#3 "!0/i"!,!#ts
"esults/
BAt!" w! 1i,it!3 th! 8/"ch-s!s i# Po"to1io 1 to stocks s!11i#g 5!1ow 85% o 1i0/i3-tio# .-1/!( th!
"!t/"#s i#c"!-s!3 to - 27.1% -##/-1i9!3 "-t! 5!o"! 3i.i3!#3s( co,,issio#s( -#3 t-4!s 7co,8-"!3
2'5
with th! ,-"k!tGs 1.3% -##/-1 8!"o",-#c!:. At!" t-4!s -#3 co,,issio#s( this "!t/"# -88"o4i,-t!3
16.5% -##/-112.
*h! "!g"!ssio# wo"k!3 o/t toI
Po"to1io 2 "!t/"# Q T8.54 T.752 7EASDAO "!t/"#:( 74 ,o#th 8!"io3:
Po"to1io 2 st-#3-"3 3!.i-tio# Q 14.58L
<*% 8o"to1io st-#3-"3 3!.i-tio# Q 12.75.
A3M/st!3 5!t- Q 1.14B
Po"to1io 3
# P"ic!/1i0/i3-tio# .-1/! P/Q 1.0L
# P"ic!/!-"#i#gsI P/Q 5.0
# Di.i3!#3sI #o 3i.i3!#3 "!0/i"!,!#ts
"esults/
BFh!# w! /s!3 - 1ow co#st-#t P/E "-tio co/81!3 with - 3isco/#t to 1i0/i3-tio# .-1/!( o/" "!t/"#s
w!"! sig#iic-#t12 i,8"o.!3 to - 32.3% -##/-1i9!3 "-t! 5!o"! 3i.i3!#3s( co,,issio#s( -#3 t-4!s.
At!" t-4!s -#3 co,,issio#s( o/" "!t/"# -11s to 20.1% 8!" 2!-"( co,8-"!3 to th! <*% ,-"k!tGs
"!t/"# o 2.0% 3/"i#g th! 14 8!"io3s wh!# w! h-3 - 8ositio# i# th! ,-"k!t.
4o stocks 5ere 6urchased until -ugust (*+7 using the 6araeter of a PE belo5 )8 *h! 8o"to1io -1so
!#t!"!3 th! ,-"k!t c1os!" to th! to/gh -#3 with ,o"! co#s!".-ti.!12 .-1/!3 stocks. F!
o/t8!"o",!3 th! <*% i#3!4 52 5% o" ,o"! i# 9 o/"-,o#th 8!"io3s( whi1! w! /#3!"8!"o",!3 th!
,-"k!t 52 5% i# o#12 o#! 8!"io3. *h! "!g"!ssio# -#-12sis w-sI
*h! "!g"!ssio# -#-12sis w-sI
Po"to1io 3 "!t/"# Q T9.9 T .7537EASDAO "!t/"#:L
Po"to1io 3 st-#3-"3 3!.i-tio# Q 14.35L
<*% 8o"to1io st-#3-"3 3!.i-tio# Q 13.16L
A3M/st!3 5!t- Q 1.09.
Po"to1io 4
# P"ic!/1i0/i3-tio# .-1/! P/Q 0.85L
# P"ic!/!-"#i#gsI P/Q 5.0
# Di.i3!#3sI #o 3i.i3!#3 "!st"ictio#s
"esults/
B</" ,ost s/cc!ss/1 sc"!!#. K t "!s/1t!3 i# -# -##/-1i9!3 "-t! o o.!" 42.2% 5!o"! 3i.i3!#3s(
co,,issio#s -#3 t-4!s. *h! "!s/1t 5!o"! 3i.i3!#3 "!t/"#s -88"o4i,-t!3 29.2% o" th! 14 8!"io3s
st/3i!3( co,8-"!3 to th! 2.0% -##/-1 "!t/"#s o th! <*% ,-"k!ts. *h! "!g"!ssio# -#-12sis w-sI
2')
Po"to1io 4 "!t/"# Q T12.83 T .6717EASDAO "!t/"#:L 74 ,o#th 8!"io3:
Po"to1io 4 st-#3-"3 3!.i-tio# Q 14.94
<*% 8o"to1io st-#3-"3 3!.i-tio# Q 13.17
A3M/st!3 5!t- Q 1.13.
$ot bad, indeed.
Greenblatt discusses the study
*o 8"o3/c! th! 8-8!"( D"!!#51-tt !481-i#!3 to th! ENSSA( h! !481o"!3 th! S6P stock g/i3! - 52
h-#3 - -#3( tog!th!" with >ich P9!#-( ,-3! - /#i0/! 3-t-5-s! o stock i#o",-tio#. At th! ti,! o
th! st/32( th! -s8i"i#g s/8!" i#.!sto"s h-3 to c-1c/1-t! th!i" i#3i#gs o# U#i.!"sit2 o P!##s21.-#i-Gs
DE? 10 Digit-1 E0/i8,!#t %o,8/t!"( - -" st"!tch "o, th! ,o3!"# %o,8/st-t 3-t-5-s! -#3
co,8/ti#g 8ow!" o th! i#t!"#!t -g! th-t D"!!#51-tt !481-i#s w-s /s!3 to "!s!-"ch his ;-gic
&o",/1-(
*h! 3ow#si3! to th! B42.2% -##/-1i9!3 "-t!B o th! D"-h-, &o",/1-( D"!!#51-tt sh-"!3 with his
ENSSA -/3i!#c!( w-s th-t i#.!sto"s w!"! g!tti#g - 5-"g-i#( 5/t th! 5-"g-i#s 3is-88!-"!3 i# 1980s.
D"!!#51-tt c1!-"12 is -w-"! th-t( -s D"-h-, t!-ch!s( Bch!-8 wo"ksB - -#3 ;". D"!!#51-tt cit!3 -
.-"i!t2 o st/3i!s 3oc/,!#ti#g th! 8!"o",-#c! o 1ow 8"ic!-to-5ook( 1ow-8"ic!-to-!-"#i#gs( !tc. 7*h!
so/"c!s o which( K 8"!s/,!( -"! th! *w!!32 $"ow#! BFh-t h-s Fo"k!3B "!8o"t -#3 th! .-"io/s
!48!"i,!#ts 3oc/,!#ts i# H-/g!#Gs B*h! E!w &i#-#c!B:
K# -# -tt!,8t to -3-8t th! 0/-#tit-ti.! co#st"/ct to "!1!ct his -88"!ci-tio# o" F-""!# $/!ttGs
i#.!st,!#t t!ch#i0/!s( D"!!#51-tt co,,!#ti#g o# $/!ttGs 8"!s/,!3 tho/ght-P"oc!ssI B$/2i#g
ch!-8 wo"ks( K k#ow th-t... $/t wh-t i K 5/2 goo3 co,8-#i!s th-t -"! ch!-8H A#3 s!! how it wo/13
3o...B
9orking To5ards The Magic &orula
So( ;". D"!!#51-tt 5!g-# to st/32 th! 0/!stio# o Bwh-t is - goo3 co,8-#2HB *h! si,81! -#sw!"I A
5/si#!ss with - high "!t/"# o# c-8it-1.
$/si#!ss A:
'400(000 cost o sto"! to 5/i13.
'200(000 !-"#i#gs - 2!-".
50% ><K%
$/si#!ss $:
'400? to 5/i13.
10(000 !-"#i#gs - 2!-".
2.5% ><%
2'<
%1!-"12( i# this si,81ii!3 !4-,81!( $/si#!ss A is th! s/8!"io" 5/si#!ss.
As 8!" his wo#3!"/112 co#cis! s/,,-"2I
1: D"!!#51-tt "-#k!3 th! 5/si#!ss!s 52 ><K%.
2: A#3 th!# "-#k!3 th! sh-"!s 52 ch!-8#!ss.
B;o"! !-"#s "!1-ti.! to 8"ic!... K c-11 th-t Gch!-8.GB - i# "!!"!#c! to E-"#i#gs Ni!13.
)evel4ing t#e Magic $r'ula
Fo"ki#g with th! two .-"i-51!s( high !-"#i#gs 2i!13 -#3 high "!t/"# o# i#.!st!3 c-8it-1( ;".
D"!!#51-tt 3!ci3!3 si,812 to co,5i#! th! two "-#ki#gs to c"!-t! - 1ist o 5/si#!ss!s th-t h-.! th!
5!st o 5oth co,8o#!#ts.
Logic-112( - 5/si#!ss th-t "-#ks V100 o" ><K% -#3 "-#ks V50 "-#ki#g o" E-"#i#gs Ni!13 wo/13 "-#k
V150 i# *h! ;-gic &o",/1- hi!"-"ch2.
*o /"th!" "!s!-"ch th! !!cti.!#!ss o this ,!ch-#ic-1 8"oc!ss( ;". D"!!#51-tt took his "-#k!3 1ist
o ;-gic &o",/1- "!s/1ts -#3 3i.i3!3 th! hi!"-"ch2 i#to 3!ci1!s( -#3 si,812 8!"o",-#c! o !-ch
3!ci1!. *h! "!s/1tsI *h! to8 "-#k!3 3!ci1! o/t8!"o",!3 th! 2 #3 5!st( i# t/"# w-s 5!tt!" th-# th! 3
"3( !tc. So( th! 8!"o",-#c! o !-ch 3!ci1! w-s -5so1/t!12 i# 1i#! with th! "-#ki#gs "o, th! ;-gic
&o",/1-.
;". D"!!#51-tt( - .!t!"-# o F-11 St"!!tGs i#0/isiti.! -88"o-ch tow-"3s g"o/#3 5"!-ki#g c1-i,s(
o/t1i#!3 co,81ic-t!3 8ossi51! co#c!"#s with th! 8"oc!ss( -#3 si,81! co/#t!"--"g/,!#tsI
B$/t( th! ;-gic &o",/1- is s/5M!ct to !""o" 3/! to... B
.ook ahead bias
*h! st/32 /s!3 th! %o,8/st-t 8oi#t i# ti,! 3-t-5-s!. So th! 3-t- /s!3 w-s "!1!cti.! o
i#o",-tio# -.-i1-51! 8"!cis!12 -t th! ti,! 8!"io3
/#3!" !4-,i#-tio#.
Survivorshi6 bias
Ag-i#( th! st/32 /s!3 th! 8oi#t i# ti,! 3-t-5-s!
Sall co6anies couldn't be 6urchased% transaction costs 5ould kill you
*h! s-,! 8!"!ct12 -1ig#!3 3!ci1! "-#ki#gs -88!-"!3 wh!# o#12 !481o"i#g -t to8 1000
co,8-#i!s 52 ,-"k!t c-8it-1i9-tio#.
&aa frech arguent/ the forula is 6icking riskier stocks.
E!4t 0/!stio#.
This is data ining
2'C
*his w-s th! 1 st t!st -tt!,8t!3( -#3 th! w!ight o Bgoo3 co,8-#2B to Bch!-8 stockB w-s -
si,81! 50/50%
More -dvanced :onsiderations/ Piotroski and Haugen
;". D"!!#51-tt co,8-"!3 his ;-gic &o",/1- "!s/1ts to th! stock s!1!ctio# t!ch#i0/!s o Piot"oski.
D!#!"-112( Piot"oskiGs wo"k 8!"o",s .!"2 w!11( 5/t o#12 its /ti1it2 is !!cti.!12 1i,it!3 M/st to
co,8-#i!s with - ,-"k!t c-8it-1i9-tio# /8 to '700 ,i11io#. So( o" 1-"g! c-8 stocks( Piot"oskiGs wo"k
is#Gt -11 th-t !!cti.!.
>o5!"t H-/g!# i#t"o3/c!3 - 71 -cto" ,o3!1 o" s/8!"io" stock s!1!ctio#. Fith ,o#th12 8!"io3ic
t/"#o.!" o.!" th! 10 2!-" 8!"io3( H-/g!#Gs t!ch#i0/! 3!,o#st"-t!3 - 30% s/8!"io" 8!"o",-#c! o
his to8 "-#k!3 3!ci1! o.!" th! 1ow!st "-#k!3 c1-ss o stocks.
D"!!#51-tt o/#3 - 32% s8"!-3 wh!# "!s!-"chi#g th! 2 -cto" ;-gic &o",/1-. 7><K% -#3 E-"#i#gs
Ni!13:
*o -ss!ss th! 1o#g t!", .i-5i1it2 o th!i" "!s8!cti.! -88"o-ch!s( -#3 to "!3/c! th! t"-#s-ctio# costs(
D"!!#51-tt co,8-"!3 his "!s/1ts with thos! o H-/g!#Gs.
;n Search of The Magic &orula
Mr8 Greenblatt created an e<6erient in 5hich he held selections derived fro Haugen's +( factor
odel for a year% 5ith annual turn over% and develo6ed sa6le 6ortfolios every onth for the (=
years8 (So% he created 6ortfolios tracking (>= rolling one year 6eriods!
H-/g!#Gs to8 3!ci1! 5!-t th! 5otto, 3!ci1! 52 5.63%
D"!!#51-ttGs 2 -cto" ,o3!1 "!co"3!3 -# 18.5% s8"!-3 o o/t-8!"o",-#c!.
Greenblatt re6eated this e<6erient% looking at rolling 7 year 6eriods (there 5ere (?* such 6eriods
covered in the duration of his Magic &orula study!
H-/g!#Gs ;!tho3I *h! wo"st 3-2!-" 8!"io3 "!t/"# w-s B-35% o" - 45% B
D"!!#51-ttGs ;!tho3I *h! wo"st 3-2!-" 8!"io3 "!t/"# w-s -ct/-112 - 8ositi.! "!t/"#
B-"o/#3 10%B
WWWWWWWWWWWWWWWW
E1!.!#th A##/-1
*o,o""ows %hi13"!#Xs &/#3
K"- F. Soh#
+nvestment 6esearch Con*erence 6eca&
Sam Well ?? EBuity Grou" Investments
"eal Estate #ig Picture @
$!1i!.!s th!"! is !4c!ss c-8it-1 i# th! s2st!,
2'K
*hi#ks it wi11 t-k! 5 Y 7 2!-"s to 5/"# o
%ost o c-8it-1 is ,/ch 1ow!" -s -ss!ts h-.! 5!!# ,o#!ti9!3 "!c!#t12
A11 3"i.!# 52 -gi#g 5-52 5oo,!"s #!!3 o" i#co,!

:ee Ainslie ?? Maverick Da"ital
.e<ark (.AB!
- 51.34 -- 4.655 !#t!"8"is! .-1/!
- 950,, i# c-sh with 150,, i# 3!5t
Fh-tXs 5-k!3 i#I
05 w-s w!-k 5/t 06 !48!ct!3 to 5! 5!tt!"
%o,8!titio# i#c"!-s!3 "o, ,-#2 "o#ts i#c1/3i#g E8so#
P"ici#g !#.i"o#,!#t is 5"/t-1
K#.!#to"2 co""!ctio# sho"t!#!3 "o, 5 Z w!!ks 3ow# to 4 Z w!!ks
Low !#3 5i9 8"oits c"/sh!3

Fh-tXs #ot 5-k!3 i#I
2006 ch-#g!s co/13 1!-3 to 60 c!#ts i# !8s
K,8-ct o 10% Mo5 c/ts -c"oss th! 5o-"3
&%& "o, 02-04 "-#g!3 "o, 579,, to 685,, -#3 i# 05 it 5otto,!3 -t 300,,
$/2 5-ck o 20% co/13 -33 55 c!#ts 8!" sh-"!
06 1st c-11 -t 3.30 5/t co/13 -ct/-112 3o 4.00 to 4.25 5/c 1st c-11 /#3!"!sti,-t!s th!s! 2
it!,s -- !s8!ci-112 th! 5/2 5-ck i,8-ct

%hoic!8oi#t GD6SI
'44.07/sh-"! Y 4.0655 !#t!"8"is! .-1/! with 6% "!! c-sh 1ow 2i!13
L!-3!" i# !,81o2!! 3-t- s/881i!3 to i#s/"-#c! i#3/st"2 -#3 V2 s/881i!" o 3-t- to Ho,!1-#3
S!c/"it2 i#3/st"2
EPS g"owth "o, '1.33 to '1.90 -s "!st"/ct/"i#g occ/"s
At!" 1/""2 o 50 3!-1s i# "!c!#t 2!-"s th-t "!s/1t!3 i# ,i3 si#g1! ><K% Y ,g,t h-s 3!ci3!3
to sto8 5/2i#g s,-11 co,8-#i!s.
S!11 o so,! o th!s! 5/si#!ss!s to oc/s o# co"! 5/si#!ss
K#stit/t! ,-Mo" sh-"! 5/25-ck
>!i#.!st 8"oc!!3s i# i#s/"-#c! 5i9 wh!"! th!2 ho13 V1 s8ot -#3 90% ,-"k!t sh-"!
1
st
c-11 -t '2.20 5/t co/13 3o -t 1!-st '2.35 to '2.45 with 5/25-ck
5avid Matlin U Matlin 6atterson Global
Advisers
Polyer Grou6 (P'.G-CP'.G#! D>+
-;-k!s #o#-wo.!# t!4ti1!s.
-%/sto,!"s i#c1/3! - ?;$( PD 6 CEC
-P1-2 o# !,!"gi#g ,-"k!ts
-'528,, ,-"k!t c-8
-6.7 !./!5it3-
-115 !5it3-
25+
-'400,, i# 3!5t
-14% %AD> !5it3- t"-3i#g -t 6.74 !./!5it3-
-!5it3- - 04 -106
05 -115
06 -135 - 8"oM!ct!3
07 -150 Y 8"oM!ct!3
H/#ts,-# %h!,ic-1 7HUE: '18.31
221 ,, sh-"!s o/t.
4.55 i# 3!5t
*"-3!s -t 7.64 2006 EPS
%o,,o3it2 %h!,ic-1 5/si#!ss t"-3!s -t 8.14
Di!"!#ti-t!3 ch!,ic-1 5/si#!ss t"-3!s -t 16.84

S81it 5/si#!ssI
S!11 co,,o3it2 ch!,ic-1 5/si#!ss 4.5-5.5 !5it3- o 322,,Q1.5-1.85
S8!ci-1t2 7.84 - 9.54 Q 10.75
;i3 to high 20Xs .-1/!s
Ste?e Tananbaum D 8oldenTree Asset -anaAement
Li5!"t2 7L$*NA :
D1o5-1 8"o.i3!" o t"i81! 81-2 .i3!o
74 E@/E$K*DA
EA@I '34 i# 2007
'42 i# 2008
A5i1it2 to t!#3!" 1/3 o sh-"!s o/tst-#3i#g
>!c!#t $/25-ck
Fi11i-,s %o,8-#2 7F;$:
E-t/"-1 D-s( ;i3st"!-, -#3 EEP $/si#!ss
EA@I '29 i# 2006
'32 i# 2007
'34.75 i# 2008
D"!-t 5/si#!ss!s with w"o#g c-8it-1 st"/ct/"! th-t #!!3s to 5! s81it /8.
9.54 E5it3- Pi8!1i#! $/si#!ss
9.54 ;i3st"!-, $/si#!ss
8.54 EEP
S8i# o th! EEP 5/si#!ss "o, th! Pi8!1i#! -#3 ;i3st"!-, $/si#!ss( -51! to g"ow EA@
17%
James $inan D ,orB Capital -anaAement
At1-s Ai"
'65-'85 .-1/!
25$
Phi1i8s 7PHD:
25 E/"o #!t c-shL 0 3!5tL 4 o 5 5/si#!ss!s V1 o" V2
'10$ #o# co"! s!c/"iti!s
'6$ i# *-iw-# S!,i
'4$ i# LD Phi1i8s
K 2o/ .-1/! 7$ o" E/"o8!-# S!,is o" 1.44 "!.!#/!s( th!# th! "!st o th! co,8-#2 -tI
44 2006
34 2007
*h! Li,it!3 7L*D:
'28 with 4% <8!"-ti#g ;-"gi#s c-# g o to 8%( stock wo/13 5! wo"th '35
%o#s!#s/sI '1.60 i# 06 -#3 '1.80 i# 07
$!1i!.!sI '1.80 i# 06 -#3 '2.00 i# 07
>!t-i1 Y histo"ic-112 1ost ,o#!2
@icto"i- S!c"!t Y 70%
$-th $o32 Y 25%
A1c-# 7AL:
'17$ ,-"k!t c-8L '24$ E@
5.54 E@/E$K*DAL 94 EPS
H-1 -"! 3ow#st"!-, -ss!ts
K co,8-#2 is .-1/!3 -t 7.8 Y 84 8-ck-gi#g -#3 7.54 !#gi#!!"!3 8"o3/cts( th!# th-t c"!-t!s
- 44 E@/E$K*DA co"! 5/si#!ss
'9- '10$ i# .-1/! to s!8-"-t!
A3.-#c!3 ;!3ic-1 <8tics 7ENE:
'3$ ,-"k!t c-8
So1/tio#s -#3 1!#s 5/si#!ss 5/t th! ,/1tioc-1 K<L 5/si#!ss is g"owi#g "o, '200,, to '1$
2010
30-40% ,-"gi#s
'3 %-sh EPS
D!s!".!s 204 PE( #ot 154
20% %AD>
?-#s-s %it2 So/th!"# 7?SU:
>-i1"o-3 US to ;!4ico - 1-"g! co#t-i#!" -ci1it2 5!i#g 5/i1t i# ;!4ico
7.54 Y 8.04 E$K*DA
H/g! o8!"-ti#g 1!.!"-g!
10-144 o# t-k! o/t .-1/!
'36 - '57 .-1/!
7illiam "ro:der D 'ermitaAe Capital -anaAement !td
S/"g/t#!t!
4
th
L-"g!st <i1 %o,8-#2
U#"i!#312 ,-#-g!,!#t
&o"!#sic -cco/#ti#g Y i11!g-1 sh-"! 5/25-ck 60% o co,8-#2 #!.!" 3isc1os!3
S/i#g th! co,8-#2
'60$ ,-"k!t c-8
'28.25 stock "!8/"ch-s!s
'13$ c-sh
252
'14.4$ E!t
'1.60 8!" 5-""!1 o "!s!".!s
8a;prom
@-1/!3 -t '2.30 8!" 5-""!1
High g-s co#t"-cts i# th! Uk"-i#!
High!" g-s co#t"-cts 3o,!stic-112
$/i13 - D!",-# 8i8!1i#!
;!"i3!! ;oo"! - F-t!"sh!3 Ass!t
;-#-g!,!#t
A3.oc-t!s 5!i#g 1o#g th! -i" c-"go s!cto" 5/cI
6-7% to8 1i#! %AD>
H/g! o.!"c-8-cit2 iss/!s 5!i#g co""!ct!3
Li,it!3 #!w c-8-cit2 co,i#g o# st"!-,
High!" /!1 costs c/t 3ow# o# 8ossi51! co#.!"sio#s

At1-s Ai" Fo"13 Fi3! 7AAFF:
'49.00/sh-"! -- 975,, ,-"k!t c-8
&"!ight o"w-"3 8/"! 81-2
P"o.i3!s s!".ic!s to i#3/st"2 -- !.g. 8i1ots -#3 g"o/#3 s!".ic!s !tc
Sto"2 c-t-12sts i#c1/3!I
100,, i# cost c/ts
$!tt!" /ti1i9-tio# ,i4 o ,i1it-"2 -#3 co,,!"ci-1
High t!!#s "!! c-sh 1ow 2i!13 to !0/it2 ho13!"s
E!w %E< o# 5o-"3
7illiam ABman E 2ershinA SCuare
%-8it-1
%-#-3i-# *i"! 7%*%/A: '65
6.8 [ !./!5it3- 13.5[ 8/!
%-#-3i-# ti"! co with 4 5/si#!ss!s
1: *i"! 5/si#!ss
2: &i#-#ci-1 S!".ic!s
3: ;-"ks Fo"k F-"!ho/s! 7"!.s goi#g "o, '54 ,i11 to '84 ,i11 05 to 06:
4: %-#-3i-# P!t"o1!/, 7g-s st-tio#s '1.3 5i11 i# s-1!s -#3 '22 ,i11 E5it3-( co/13 s!11 "!-1
!st-t!:
10 % &%& 2i!13
<w# 75% o "!-1 !st-t!
KtXs - "-#chis! 5/si#!ss 1ik! *i, Ho"to#Xs with Z th! ,/1ti81!L th!2 -"! !48-#3i#g th! sto"!
5-s!( which is h/"ti#g co,8s.
K th!2 s!11 th! "!c!i.-51!s o th! c"!3it c-"3 8o"to1io th! stock is wo"th '84
K th! 3o - S-1! L!-s!5-ck o# "!-1 !st-t! th! stock is wo"th '96
K th!2 s!11 th! !4t"- "!-1 !st-t! th! stock is wo"th '100
K th!2 3o -# i#co,! t"/st co#.!"sio# th! stock is wo"th '129
*HE EEF ;AEADE;EE* *EA; KS >E%EP*K@E *< SHA>EH<LDE> @ALUE
25(
Joel 8reenblatt E 8otham 2artners
A,!"ic-# E48"!ss 7A[P: '52
High 0/-1it2 "-#chis! it is wo"th '75 to '80 t-"g!t
High ><K% -#3 o#12 #!!3s to "!i#.!st 25% o its !-"#i#gs
@!"2 8"!3ict-51! 5/si#!ss
D%& s/88o"ts '80 stock
H! 5!1i!.!s it sho/13 t"-3! -t 20-22[ !8s o '3.70 i# 2008
$a?id Einhorn E 8reenliAht Capital
&"!!sc-1! S!,ico#3/cto" 7&SL: '29.96
*h! st"!!ts !sti,-t!s o '1.95 -"! too 1ow 52 25 c!#ts.
*h! st"!!t is too wo""i!3 -5o/t sh-"! 1oss -t ;<* whi1! th!"! -"! h/g! o88o"t/#iti!s o"
3!sig# wi#s i# ?o"!- -#3 &i#1-#3
A11i!3 %-8it-1 7ALD: '29.82
;-#-g!,!#t h-s - stock o8tio# 81-# wh!"! th! co 5/2s 5-ck i# th! ,o#!2 o8tio#s whi1! th!
co,8-#2 is i# - 0/i!t 8!"io3.
Fith i#.!stig-tio#s o#goi#g this -11ows co i#si3!"s to 3o ,-ssi.! s!11 8"og"-,s with o/t
-!cti#g th! o8!# ,-"k!t t"-3i#g. A1so( "!g/1-to"s wo#t 5! -51! to -cc/s! th!, o i#si3!"
t"-3i#g.
;ic"osot 7;S&*: '22.79
9[ E5it 13.5 [ 8/! 2007
;S&* h-s 7 5/si#!ss!s -#3 4 o th!, -"! /#8"oit-51! which -11 tog!th!" 1oos! - co/81!
5i11io# 8!" 2!-". 1: ;o5i1! 2: ;SE 3: Ho,! !#t!"t-i#,!#t
;o5i1!- i th!2 got Z th! ,-"k!t sh-"! th!2 g!t "o, th! P% 5/si#!ss it wo/13 5! - co/81!
5i11io# i# "!.s
;SE- co/13 g!t - ,/1ti81! o co,8!ti#g 5/si#!ss!s which -"! 14-17 P"ic! to S-1!s
K th!2 c-# g!t "i3 o 1/3 o th! 8i"-c2 it co/13 !0/-1 '2 5i11io# i# o8!"-ti#g 8"oit
;S&* 8"o3/c!s '1 5i11io# i# &%&/ ;o#th
D"!-t co"! 5/si#!ss -#3 h! #!.!" tho/ght h! co/13 g!t s/ch - g"!-t co,8-#2 -t s/ch -
ch!-8 8"ic!
'35 5i11io# i# %-sh. *h!2 co/13 1!.!" /8 th! 5-1-#c! sh!!t with '40 5i11io# i# 3!5t -#3 5/2
5-ck 1/3 o stock
"arr= (osenstein D JA#A 2artners

%o,8-ss g"o/8 7%PD.LE: '231.25
%-t!"i#g/oo3 S!".ic! %o,8-#2
'65 E@
'125 S-1!s
'850, !5it3-
4.5% Ni!13
25'
7.34 .s. 8.84 8!!"s
144 EPS
18-20 P/E
Doo3 S!c/1-" Sto"2
</tso/"ci#g co#ti#/!s Y 95% "!. "!c/""i#g 5/si#!ss -s co#t"-cts g!t "!#!w!3
*h!"! is i#3/st"2 co#so1i3-tio# Y 2 co,8!tito"s -"! 5!i#g so13
*h! co ,-3! - s!"i!s o 5-3 co#t"-cts -#3 -c0/isitio#s so th! ,-"gi#s -"! #ow w-2 5!1ow
th! i#3/st"2
>!st"/ct/"i#gI
St-5i1i9! ,-"gi#s( s!11 -ss!ts( !4it 5!1ow ,-"gi# co#t"-cts( "!3/c! SD6A
<88o"t/#it2I
K th!"! is '250,, i# cost c/ts th!# 5.34 !./!5it3-
10.5% &%&
K it t"-3!s -t 7.5Q3908

Si4 &1-gs 7P?S: '8.65
'1.35 ,-"k!t c-8.
'2.25 3!5t
'3.55 E@
6.34 1!.!"!3
1.65 E!t o8!"-ti#g 1oss!s

<.!" 42"s !5it3- w!#t "o, '410, to '300, with 5-3 -c0/isitio#s -#3 8oo" c-8!4 s8!#3i#g. Low!"
,-"gi#s th-# co,8s !.!# tho/gh 24 th! si9!. E!w ch-i",-# D-# S#23!" -#3 %E< ;-"k Sh-8i"o
E!w 5"-#3!3/1ic!#s!/s8o#so"shi8 '20,, 8!" 2!-"
K#c"!-s! 8-"ki#g '10-20,, 8!" 2!-"
D-t! "!c!i8t i#c"!-s!s '15-20,, 8!" 2!-"
E1i,i#-t! 3isco/#t to S" citi9!# 3isco/#t '5-8,, 8!" 2!-"
'150,, i# "!.Q'100 i# i#c"!,!#t-1 !5it3-

%/t c-8!4 '30-50',,. >!-5"-#3( 1ow!" cost -tt"-ctio#s s!11 -ss!ts i#c1/3i#g !4c!ss 1-#3( '400,,
i# 18,o#ths 7"!c!#t12 so13 Ho/sto# 8"o8!"t2 o" '77,,:. 2007 &%& o '125,,. 9.34 !0/it2 .-1/!
o"w-"3 VXs Q '12 !0/it2 .-1/!. Eo t-4!s 8-i3 o" 2!-"s 3/! to #!t o8!"-ti#g 1oss!s.
??
Footlocker GF:I
Joel Greenblatt' Gotham Capital
!e s"ent entire time "lugging Foot Lo#5er (N//.,+).
25> "re?ta# JPID rising to (5> in the ne#t two years.
Market share is twice that of the ne#t two com"etitors combined
If things donMt go right you should make <5> on the stock in 2 years.
2heyMre in a big fight with their largest vendor .i(e. .i(e wants them
to carry their high?end line and not to discount. A front?"age story in
255
recent WS% said F: is losing this battle badly.
Must focus on facts8
? Even analysts who hate the com"any think it will earn *$.2+ this year.
5e"r and ca" e# are the same ?? cancel each other out.
2hey are doing high?return remodels for the ne#t two years that should
add *+.$2;year
Made disastrous foray into big bo# retailing3 shut this down3 getting
out of leases over the ne#t five years im"roving earnings by *+.(+3
assume *+.+);year
!ave *(5+M in cash and debt but "aying more on debt than earning on
cash so could use cash to "ay off debt take a one?time charge and
then save *+.+C.
Add it all u" and you get *$.)' in E6S in 2 years. Assume $2 multi"le
is *$K.)C if nothing good ha""ens.
6ossible u"side events8
? .i(e canMt re"lace them3 sees settlement in ne#t )?$2 months ?? a big
"lus?!ired guy who turned around Dham"s to head RS o"erations3 has good
relationshi" with .i(e
? Stores are doing great in Euro"e3 no com"etition3 high single digit
com"s3 no .i(e "roblem there
? *+.$C from last three years of getting out of big bo# leases
? economy could im"rove E?$
Greenblatt Class #N Sept. 2F, 200F
What are the "roblems with ?ich P8ena=s a""roach,
!e forecasts by e#tra"olating what are the "ro4ected normaliHed earnings over the ne#t ( to 5 years. !e will
take the bottom Buintile of com"aniesM lowest multi"les.
What he said?on average if he is looking at normaliHed earnings of $( times for the market as a whole his
universe is )?< times earnings. !e looks forward by looking backwards at historical normaliHed earnings.
Mkt. 2iming
Je :ini( went into a high "ercentage of cash of his "ortfolio and then was fired from +agellan. Investors did
not want him to market time but to "ick stocks.
Greenblatt com"laint8 So much work and sub4ectivity that goes into estimating normaliHed earnings. Why not
use a standard metric,
6rice to book8 !ow much you earn over time discounted back. !ow much you earn on book value, Co(e has
a great brand with much cash generating activity. Earnings "ower may indicate higher "rice to book. 1o
accounting for high returns to ca"ital. :ook at normal returns and "rice to book.
25)
Airline "assenger miles have grown 5> for the "ast 5+ years. 1ormaliHed earnings is what the com"any would
earn in an average year.
E#tra"olate naively and search in the bottom Buintile.
6roblem with a""roach G6rof. GreenblattI is that 7ich 1Gena is smarter than us. Some of the things are
sim"le to him??big "icture??Airbus is not going to grow. !ow he looks at the world. It is difficult to re"licate
that broad industry analysis and e#"ertise.
Joel doesnMt need to be that smart. 0e more selective and see" more disparit in price value relationships.
5isagree with8
Main assum"tion8 E0I2 Gw;o debtI # ). O 1et Income I assume de"reciation is roughly similar to ca"e#.
5e"reciation and maintenance ca"e# are similar. 3oo" out #or when ou have a cash(eatin! business and
depreciation eats up more than cape+. 6educt when cape+ e+ceeds depreciation.
1o catalyst
S"ecial situation8 always has a catalyst. Sometimes they are so chea" that eventually the market will get it
right. 0ecause I am not as diversified I can "ick and choose. ?ich P8ena would rather have (+ or '+ stocks
rather than concentrating. !o"efully I can give you tools to discern better choices from JichMs "ortfolio.
0oeing is going to earn *5.5+ "er share normaliHed in five years so it is trading 5?< times now.
2he C times com"any might be better than ) times com"any because it earns higher returns on ca"ital. I would
rather own the higher return business all things being eBual. !ow much assets are being used to generate your
returns.
*5.++ 1ormal Earnings
*5+ Da"ital 0asis vs. *<+
2hus $+> JPID <>
6roblems with E0I25A. 5A ??? ignores ca"e#.
E0I25A analysis is often used to 4ustify high "rice because money is chea". 7eview the ne!atives o#
52I86@.
!ow to determine a "urchase or value an investment
E0I2;Assets
E0I2;2angible Assets ? GWD "lus FA ??donMt care about historical assetsI.
!ow much money earned on the "re?ta# money on the net tangible assets Ge#clude GoodwillI
2he money you have to lay?out8 net avg. working ca"ital N fi#ed assets Gassume no debtI then e#clude net cash
Gsince it is not needed in businessI. 2he tangible assets because these are the assets I have to re"lace??e#clude
Goodwill G"rice over the net value of the businessI.
0e conservative on everything es"ecially return. Pn the margin how much ca"ital is needed to "ut in to earn
a return,
0orrow money at $+> and earn 25> "re?ta# yield??I would want to own that s"read8 *$.++ yields 25 cents. Pn
the margin when I o"en a new business8 I "ut out working ca"ital FA.
Jead 0uffettology??!ow to look at Jeturn on Da"ital. 0y using current return on investment ca"ital. 0eware
that this doesnMt necessarily mean incremental investment will earn the same rate of return. 2hink through
assum"tions.
25<
!igh returns on eBuity im"ly a strong franchise. 3arren found a few businesses that didn&t need to s"end their
retained earnings u"grading "lant and eBui"ment or on new?"roduct develo"ment but could s"end their
earnings either on acBuiring new businesses or e#"anding the o"erations of their already "rofitable core
enter"rises. Is growth financed internally or from additional infusions of ca"ital,
E7;GE0I2 ? maintenance Da"?e# is the "re?ta# owner&s return you get in the business.I
Study E0I25A and its weaknesses.
If Co(e is e#"anding its business then will Co(e get the same rate of returns. Co(e e#"ands. If I went into the
business the returns would be much lower. Will increased investment get you the same returns, 0e
conservative in your assum"tions.
Rse "re?ta# borrowing costs and "re?ta# returns??be consistent.
Rse a margin of safety in case you are wrong. Make assum"tions and only bet on the ones where there is a
huge dis"arity between "rice and value. If you had all the answers there wouldnMt be a game. 0ehavioral
0iases8 "eo"le get too emotional and dislike uncertainty.
If &etna doesnMt do well and earns *(.5+ instead of *5.++ in two years then the stock doesnMt go down much.
0e defensive in buying 5+ cents and )+ cents dollars.
?ich a man with a hammer he looks in the bo# for a turnaround.
Bill +iller who bought &ma8on is willing to make more uncertain assum"tions. A lot of "eo"le think they are
buying something chea" due to the future growth.
Rnderstand JPID.
=uick and dirty8 2ake a look at net tangible assets. Assets ? Goodwill O tangible assets
JPD. Jeturn on * invested in business.
E0I2;E78 Jeturn on money "ut into the business. E7 O G5ebt N Mkt. Da".I ? e#cess cash
G*5++ mkt. Da" N *2++ debtI ? cash O
Rse face value of debt. In distress situations you might want to use market value of the debt.
E0I2;E7 O $++ million;*5++ million O 2+> "re?ta# return or "re?ta# yield. Dhea", Is the *$++ million stable
and growing. 2hen it is chea".
*5++ million O *(++ million for eBuity ad *2++ million for debt.
:ook at real E0I2 which means de"reciation ? ca"e# Gadd or subtract from de"reciationI.
2+> "re?ta# or $2> after?ta# of C times earnings. 1ow $+ year bond is yielding '> but use )>.
6ay 2+ times or a yield of 5> G$;2+I I better be confident of growth. !igh Buality franchise in what content.
Above is a sim"le and im"ortant "oint.
I won a "ro#y fight and the com"any had K+++ em"loyees that were de"ending u"on me. I had to look at
acBuisition o""ortunities to make the com"any viable and "rofitable.
Investment bankers8 borrow at C> after ta# that is 5> and you "ay $C times earnings for this business and it
will be non?dilutive and it will add to your E6S.
6ay K # E0I2 for this business. Investing in an asset that yields K> and borrowing at C> so s"read is $>.
Earning *$ while "aying *K.++ or $$> and borrowing money at $+> so $> s"read or 2< cents "er share in
e#tra earnings. 0orrowing at $+> in money that is not locked in while earning $$> that could go to $'> or
C>. 1o margin for error9no +argin o Saety.
25C
2hey GInv. 0ankersI gave me a $++ "age book but when you boil it all down that is what I saw. A.I.S.S
We eventually bought something that yielded us *C+ million for *'++ million. E0I2 looked like *55 million
but the com"any had built a whole new "lant and it was o"erating at 2+> of ca"acity. A 5+ year life of "lant
so no new investment. So If I added back de"reciation I "icked u" another *25 million so *55 N *25 O C+
million. 2+> "reta# return.
*C+;*'++ "urchase "rice or 2+> yield. Start to look at the world in a sim"le direct way.
!ave them summariHe their bottom line8
Is the business growing,
What is your return on ca"ital,
Pur holding "eriod is ) months to 2 years??we will look at many stocks ? (+ stocks but only buy $ of them.
E0I2 multi"le instead of an E0I25A multi"le. E0I2 to be P"erating earnings before ta#es is a good
number. Donce"tually get back to the real E0I2. 5ecide the maintenance DA6?EL.
7alue Investors8
0ill Miller will buy AmaHon because he is willing to make "ro4ections under greater uncertainty.
Rnderstand 7<IC.
E0I2;E7 is the return on * invested in the business.
E7 O 1et 5ebt N Market Da"ital Minus E#cess Dash. E7 O G*5++ N *2++I ? *$++ O *)++
E0I2;E7O *$++;*5++ or G*2++ mil. for debt N *(++ mil for eBuity ca"italiHationI O 2+>Gis it stable or
growing,I.
2+> "reta# then multi"le of +.) G$ U '+> ta# rateI O $2> after?ta#??6;E is C#. 1ow $+ year bond is '> but
use )> for a more realistic hurdle rate.
2+ 6;E O 5> yield. Jarely would %oel buy such a multi"le but if the growth was strong and he was very
confident of growth. 2he com"any has a high Buality franchise in what conte#t.
Magna Auto ? a S"in?off
8o bu a business((loo" at the enterprise value #irst.
Some com"anies can carry huge leverage such as eBuity of *$.++ and debt of *K.++ or E7 of *$+
2hen E7 O $2 as eBuity goes to *(.++. EBuity tri"led.
Boeing=s unfunded 6ension Fund8 *(+ billion. With *$5 billion unfunded so at a 5+> ta# rate *+.<+ a year off
his "ro4ections.
%oel sees things from '++++ feet. !e is a generalist
5uff S 6hel"s8 An e#am"le of a strong franchise.
Growth but tangible assets not growing/ Earnings are used to buy back stock if the stock is chea" enough.
S"in?off in $KK' at *$(.++ "er share. Self?generated growth with high JPID.
In 2 years8 *2 million in e#"ense gone. So 1et income "lus *2 million to get normaliHed earnings.
Market Share8 SS6 with '+> Moody with '+> 5SF with $+> and others with $+>.
0A58 2 big com"etitors
GPP58 !igh JPID.
25K
*(.$) in earnings and *5+ stock O $) times.
E0I2
N 5e"r.
?Da"e#
N*2 million with no more e#"ense. Glook at notes to financial statementsI
*($.) million # +.) O *$C.2 in 1ormaliHed 1et Income;5.$ F5 Shares w;o buy?backs.
*(.)+ "er share or $(.2 #s
2+> ? 2'> E0I2 growth.
Margins
0uy 0acks of (<++++ shares net "er year,
*2C.' E0I2 in $KKC. 0ad good great. E0I2 is 2'>
(+> 1et Income ??Shares being bought back
C> ?? 5 years growth so *'$.< million "lus *2 million no longer "aid out O *'(.< "reta# # +.) O
*2).( # $( multi"le O *('$ million then divide by (.5 million shares O *KK stock in 5 years. 7EJ.
conservative assum"tions. *$ earned for *$( "aid O <.C> yield that is likely to grow ra"idly vs. <> yield on
$+ year bonds.
With $(> growth then *$22 "er share in 5 years at same multi"le
With 2+> growth then *$)' "er share in 5 years at same multi"le
6ick low multi"le to give yourself adeBuate margins of safety.
Greenblatt owns M to K positions held M months to 2 ears.
)ost o# m wor" time screenin! ideas(readin! the paper. 8he value investor club. .e wanted
to #ind !ood ideas. I# we !ot one or two ideas a ear, it would be a bi! home run #or us.
Screening ideas
Stock screens
A year later 5uff and 6hel"s was bought out by Fitch.
1otes8
Efficientfrontier.com A good scientist takes nothing for granted. Write about finance ? "eo"le ask you to
manage their money.
JeBuirements8 Math !istory of markets 2oughness to do the right thing and Inde"endence of 2hought.
!SJ 0lock.
AIG
SP
Freddie ? Mac
.RM
Millea !olding A7L
6etsmart Dovance
6rioty !D
6LJE Do.
6etrocor"
Jich Electric
Joyce J.P2L
E?$
2)+
??
Greenblatt Dlass [5
Pctober +$ 2++(
1e#t week Special Situations. Dlass off Pct. $5
th
. 6resentations on Pct. 22
nd
.
Commodore International 1CBU2
"'4an6 B
In Millins
9/30/80 Incr./)ecr. 9/30/83 Incr./)ecr. 9/30/82
;et &ales 244.2 16.67% 209.3 102.61% 103.3
.ccunts/(ec. 254.7 34.12% 189.9 5.50% 180
Inventries 437.4 9.71% 398.7 22.00% 326.8
$ig S-1!s
Inventries
(a% Materials / CIP 243.2 -10.03% 270.3
$inis#e8 =8s 194.2 51.25% 128.4
S-1!s /8 5/t i#ish!3 Doo3s /8 5igg!" #ot s!11i#g -s w!11
"'4an6 B "''8re "'4uter
In Millins
12/31/80 Incr./)ecr. 12/31/83 Incr./)ecr. 12/31/82
;et &ales D6 's.E 582.9 -9.021 640.7 129.15% 279.6
.ccunts/(ec. divergence
Inventries 449.3 56.171 287.7 130.34% 124.9
Inventries At!" '30; F"it!-3ow#
Doo3s $-3
(a% Materials / CIP 204.7 33.62% 153.2 123.65% 68.5
$inis#e8 =8s 244.6 81.861 134.5 138.48% 56.4
A very "owerful tool to use to detect "roblems8 Study relationshi"s between Sales and A;J S Inventory.
Dom"are growth in Sales Inventory and A;J with each other. 5elve dee"er when you note a divergence.
Inventory is u" but not finished goods?so com"any is stocking u" on goods. 0ig dis"arities are bad.
1ote that in e#am"le above8 Sales down K> but finished goods u" C2>. Goods not selling. 0y kee"ing costs
in inventory and not writing down immediately??earnings are artificially high.
Thorton 9Glove8 Dha"ter C Two -ey ?atios; &I? and Inventories in =uality of Earnings.
2he best method I have ever discovered to "redict future downwards earnings revisions by Wall Street security
analysts9is a careful analysis of A;J and inventories.
2he analysis of Sales and A;J may "rovide a clue as to whether a com"any is merely shifting inventory from
the cor"orate level to its customers because of a -hard sellT sales cam"aign or costly incentives. In such
instances this ty"e of sales may constitute -borrowing from the future.T Within this conte#t it is im"ortant to
note that in most instances a sale is recorded by a com"any when the goods are shi""ed to the customer.
Also there is the added cost to the com"any in carrying an above?average amount of A;J.
2)$
E#am"le in table above Commodore International 1CBU2. 1ote that in +K;C2 sales advanced by $+2> while
A;J rose by only 5.5> an indication in a surge in demand. 0ut then in +K;C( and +K;C' D0R&s A;J rose 2# as
fast as sales. 2his is a clear sign that D0R&s retailers were moving out its "roducts at a slower than usually
"ace while the com"any was shoveling out its old "roducts in what looked like an attem"t to dum" them on
the market in advance of new introductions. In this regard inventories rose at a slower rate they were worthy
of a more detailed analysis.
What is known as a One!ative inventor diver!ence,P meaning that while the raw materials and work?in?
"rogress com"onents of inventories declined finished goods increased substantially. At CBU raw materials
in this case electronic com"onents were being assembled into microcom"uters and related gear which des"ite
an intense sales cam"aign were "iling u" as inventories of finished goods. Given the relationshi" between
these two sets of figures it isn&t difficult to see that the dollar figures for the finished goods com"onent of
inventories on Se"t (+ $KC' were too high.
2he si# months ended 5ec. ($ figures had been released by then showing earnings of *$.++ "er share against
*2.'$ for the same "eriod the "revious fiscal year.
What we see in the table above is a huge buildu" in inventories "robably older micros the market sim"ly
couldn&t or wouldn&t absorb. For the si# months ended 5ec. ($ $KC' the com"any&s sales declined by K
"ercent while inventories rose by 5).2 "ercent. 1ote that the finished goods inventory increased by C2
"ercent while raw materials and work?in?"rocess rose by only ('> indicating that D0R was still e#"eriencing
a backu" of finished goods inventory. E#"ect recurring and large inventory write?downs.
!igher trending inventories in relation to sales can lead to inventory markdowns write?offs etc. In addition it
is im"ortant to note that an e+cess o# inventories, time and time a!ain, is a !ood indicator o# #uture
slowdown in production. Within this conte#t it is im"ortant to analyHe the com"onents of inventories. If the
finished goods segment of inventories is rising much more ra"idly than raw materials and;or work?in?"rocess
it is likely that the com"any has an abundance of finished goods and will have to slow down "roduction. Akin
to A;J bulging inventories are costly to carry.
Dom"are with the same re"orting "eriod in "revious years. 0e es"ecially watchful in those industries sub4ect
to ra"id changes in "roducts and taste.9high fashions seasonal goods or high tech.
Fast growing industries are "laces to watch?out for. -1othing recedes like success.T
A;J and inventory analysis in relation to changes in sales is a great barometer for forecasting negative earnings
sur"rises.
LPositive inventory component divergence'M meaning sim"ly the reverse of some of the illustrations described
so far which were negative inventory divergences. 2he "ositive version trans"ires when the raw materials
com"onent of inventories is advancing much more ra"idly than the work?in?"rocess and finished goods
inventory Gwhich declinesI while ordering raw materials in larger amounts Gso this com"onent of inventories is
enlargedI. 2his of course is good news and would trigger bullish im"ulses.
8he 2est Short Ideas8 $. When the com"any is a Fraud
2. When the com"any will run out of money
0oth have catalysts.
Greenblatt was short Bally ,ntertainment at *$+ and it was at *2.++ 0onds were *$5 cents on the dollar.
Dlearly worthless in a static situation but smart money bought u" the bonds chea"ly and changed the
ca"italiHation of the com"any. !e covered at *5.++. 2hings change.
!1nbea' Cor&oration
6ec. 2K, 1??7 6ec. 2? 1??M
Sales $$)C$C2 u" $C> KC'2() G(.2>I
2)2
DGS C(<)C( 5own 5> K++5<(
Jestructuring Dosts ??? $5'C)K
A;J 2K555+ u" '+> 2$('(C G$.(>I
Inventories 25)$C+ u" 5C> $)2252
1et Earnings $+K'$5 ?22C2)2 0ig Jestructuring Dhg.
DFP (K,2N? 2i! 6iscrepanc w4 ;I $'$)(
Pften revenue that is recogniHed in a "remature or fictitious manner is not collected. Accordingly a balance
sheet account other than cash will increase as this revenue is recogniHed. 2y"ically that balance sheet account
is accounts receivable. Rnusual increases in accounts receivable commonly accom"any Buestionable revenue
whether due to uncertainties about the earnings "rocess or about collectibility. Sunbeam used aggressive
accounting tactics to boost revenue in $KK<. In a bill?and?hold arrangement while recogniHed revenue
collection is delayed. Accordingly one should see an accom"anying increase in A;J.
1ote the significant buildu" in A;J as the com"any became more aggressive in its revenue recognition
"olicies. An increase in A;J that is faster than revenue than an increase in revenue is not a "roblem if it is for
only a limited time and does not result in a collection "eriod for A;J that is significantly at odds with the credit
terms being offered.
Barrons Article in $KK<8
Sunbeam wrote down inventory to *+ from *K+ million for "roduct lines being discontinued and other "erfectly
good items so its future "rofits would grow. Even if Sunbeam realiHed 4ust 5+ cents on the dollar by selling
these goods in $KK< that would account for about a third of last year&s net income of *$+K.' million. 2hey
over?reserved to add to income. *25 million added from drawing down reserves.
6re?"aying e#"enses not a "roblem G0arron&s incorrectI. !owever note im"act of shifting e#"enses from the
future to the "resent.
2hey ca"italiHed current e#"enses to make an asset account on the balance sheet.
Sunbeam stuffed inventory. -0ill and !oldT sales and never even shi""ed.
Sunbeam re"orted -*$+K million in earningsT but had a ?*C.2 million cash drain.
Sunbeam also e#tended its Btr. From March 2C to March ($ to add ( more days of sales to its Btr. End.
When the 0arron&s story came out Sunbeam was trading at *22.++ or $)# -fakeT earnings.
2he Financial 1umbers Game Dharles W. Mulford.
Sunbeam intentionally overestimated the costs of its restructuring leading to understated results for $KK) and
higher results for future years.
0y recording unusually high restructuring costs the com"any was able to effectively move future?year
e#"enses into its $KK) results. For e#am"le among the costs included in the restructuring charge were reserves
or liabilities for future environmental and litigation costs. 2o the e#tent that these costs were normal o"erating
e#"enses of future years they should not have been included in a charge taken in $KK).
2hus by recording an overly large restructuring charge in $KK) the com"any was able to boost results for
$KK< and beyond.
Sunbeam boosted $KK< revenue through -bill and holdT "ractices where it sold "roducts to customers with an
agreement that it would deliver them later. 2he com"any recorded as revenue what were effectively
consignment sales given the liberal return "olicies that were instituted. Sales were contingent not final.
Bill4and4Bold Transactions. In some sales a valid order is received and the goods are com"lete and ready for
shi"ment. !owever for various reasons9for e#am"le a lack of available s"ace or sufficient inventory in
distribution channels9the customer may not be ready to take delivery. A bill?and?hold transaction is effected
when an invoice is issued but the goods in Buestion are sim"ly segregated outside of other inventory of the
selling com"any or shi""ed to a warehouse for storage awaiting customer instructions.
2)(
Sunbeam em"loyed e#tensive use of bill?and?hold "ractices as a sales "romotion cam"aign. 5uring $KK< the
com"any sold barbeBue grills to retailers at bargain "rices before the normal buying season for such "roducts.
Sunbeam was using the deals to recogniHe revenue "rematurely borrowing sales from the first and second
Buarters of $KKC.
Driteria for JecogniHing Jevenue in Advance of Shi"ment
$. 2he risks of ownershi" have "assed to the buyer.
2. 2he customer must have made a fi#ed commitment to "urchase the goods "referably in written
documentation.
(. 2he buyer not the seller must reBuest that the transaction be on a bill?and?hold basis. 2he buyers
must have a substantial business "ur"ose for ordering the goods on a bill and hold basis.
'. 2here must be a fi#ed schedule for delivery of the goods. 2he date for delivery must be reasonable
and must be consistent with the buyer&s business "ur"ose.
5. 2he seller must not have retained any s"ecific "erformance obligations such that the earnings "rocess
is not com"lete.
). 2he ordered goods must have been segregated from the seller&s inventory and not be sub4ect to being
used to fill other orders.
<. 2he goods must be com"lete and ready for shi"ment.
In $KK) including the effects of the restructuring charge Sunbeam re"orted a "reta# o"erating loss of *2C5.2
million. In $KK< before restatement the com"any re"orted "re?ta# o"erating income of *$KKK.' million.
Pnce results for the year were restated to remove the effects of the overly large restructuring charge and to
ad4ust for aggressive revenue recognition "ractices Sunbeam&s "reta# o"erating "rofit for $KK< was reduced
too *$+'.$ million.
3orldCom 4ust ca"italiHed all e#"enses.
.hen 7ecs. and Inventories !rowin! #aster than sales((a red #la!. :ook further to see what inventories are
made of.
Buett is now GPct. 2++(I borrowing in the bond market to buy Dlayton homes.
%u E Phelps has $++ JPID.
S,,=s Candy8 7alue a business within your circle of com"etence.
Get an idea of broad valuation thoughts how to think about the market and then how to find o""ortunities.
1e#t week s"ecial situations.
%u E Phelps had $++> JPID9a great business. A good business throws off cash while a bad business
consumes cash92e#tile business.
Buett could lock in the s"read between :2 and S2 Interest rates.
Buett uses E0I25A U Maintenance and Growth Da"?e#. )> yield gives you a *$.++ for each *$).)+ "aid.
!ow secure is the growth how secure is the dollar,
Buett likes high JPE return com"anies with "redictable growth.
Co(e had grown consum"tion for $$+ years. 6er ca"ita consum"tion going u". !e has confidence about what
Co(e and Gillette will do in $+ years. Aee" it sim"le. 0usiness 6eo"le 6rice
Franchise value9!ershey 0ar8 would "eo"le "ay 5 cents more for it.
See&s candy is "erceived as the best candy. A castle with a growing moat.
Wrigley&s8 tastes service and availability.
If you only had 2+ "unches you would think carefully about what you are doing.
2)'
Study Progressive Insurance
@n !ood investment idea can be phrased in a para!raph.
G<@3 o# this course8
1. -now how to value a business within our circle o# competence. Dnderstand particular
industries. Aou don&t have to "now a lot o# thin!s, "now a #ew thin!s.
2. ,ow to view the mar"et, )r. )ar"et.
I understand retailers. Dan they generate enough cash to grow internally, 5iscount the cash back.
Internet com"anies trading at *2.++ with *(.++ in cash "er share and below cash earning money.
6age (<8 E0I25A is a "oor yardstick it way overstates cash flow. Rse E0I2 minus maint. Da"e#..
``` Mental !ealth really earning *2.( in free cash due to amortiHation. AmortiHation a real non?cash e#"ense
but economic goodwill not declining.
8he hard part is to sit on m hands waitin! #or an opportunitSF to M months and the mar"et usuall
!ives ou opportunities. 1atience
0ad business8 must s"end Da"e# to kee" u" with the %ones. 1o com"etitive advantage. Must s"end money to
stay in "lace. 2ime is the friend of a good business the enemy of the bad.
0eta does not eBual risk. 0usiness and knowledge reduce risk.
C+> to 2+>????$+ better investments.
Greenblatt8 5on&t assume much. Dommon sense about what I understand.
Margin of safety8 *C to *$2 range of value *$+ with conservative assum"tions9buy at *5.++ to *).++.
Greenblatt8 I have looked at a lot of stuff. 25 years9seen industries before underlying work. Dheck the8
com"arables. Assum"tions remain correct ad4ust valuation. :ess margin for error more work.
I know my circle of com"etence8 what I can assume and can&t assume.
When to sell8 2hesis is correct. Selling9ta#es are :2 world of alternatives. 1ow C5> but other o""ortunities
are 5+> at a discount.
6eo"le are very emotional so the market will swing to e#tremes.
5uring the Internet bubble there were many bargains in "rosaic businesses. What would ha""en when the
bubble bursts, I am better at valuing com"anies than market timing or knowing the level of the market.
I don&t know a lot9a valid assum"tion. I do have common sense about what I can and can&t "redict. I don&t
know how much the com"any is going to grow its sales earnings over the ne#t five years. If I think it is worth
*$+ in broad brush strokes and I can buy it at *5 or *) "er share. I won&t get 4erked out of it at *'.++. Jight
more than you are wrong. 0ack of the envelo" calculations.
Greenblatt8 If there are Buestions I can&t answer I ski" it. If I buy $ that works it doesn&t really matter if I let
the other K go. I look at a lot of stuff but I only care about what I buy working out. I research the com"any
carefully. I have "retty good instincts and a short hand for what I am looking for. I know the metrics
underlying the business. Sometimes we do our work fast and then continue.
As long as you buy right the selling is easier. I am constantl loo"in! #or opportunities.
2)5
!ave we analyHed the industry correctly, Aee" re?evaluating. 2he rest of time is s"ent 4ustifying.
1e#t week we will look at s"ecial situations. Jead my 0ook .ou Dan 0e a Stock Market Genius. When the
s"read is so huge I feel comfortable looking at it.
__A1PW8 return on ca"ital JPE JPA.
JPD O JPE;$ N 52E or :2 debt to ca"ital. JPD O JPE # G$ U 52DI.
Pwner earnings8 12 N 5e"reciation U Maint. Da"e#.
www.sherloc"investin!.com4articles4capitalism.htm
Graham would buy 1et;1ets8 DA U all liabilities. Stock at *'.++ but :iBuidation 7alue is *).++9"rice is
below liBuidation value. A 2+> annualiHed return with Buick turnover by buying -cigar butts.T
Buett would say8 better to buy a fair "rice for a great business than a great "rice for a "oor business. 0uy
business at *5 in a business worth *$+ but *$+ is eroding to *<.++.
0uy a stock worth *<.++ at *5.++ but value is growing to *$+.++ then *$2.++.
E?$
Greenblatt Dlass [)
Pct. +C 2++(
1e#t week Special Situations. Dlass off Pct. $5
th
. 6resentations on Pct. 22
nd
.
2he "ur"ose of the assignment is to test your valuation skills. :ook at s"ecial situations. 2y"e single s"ace
with back?u" and com"arative analysis. *2+ million market ca" and RS based. Greenblatt wants to see your
reasoning needed to reach your conclusion9your thought "rocess.
1o 6;E or 6rice;Sales recommendations.
Rse 5/452I8 Analysis. Why is it chea", Jelative value analysis.
5iscounted cash flow "rocess and normaliHed earnings analysis.
Jisk free rate Jeturn on ca"ital em"loyed Working Da"ital and Fi#ed Assets.
Is it chea" U decent. %ustify it on an absolute basis.
!e "refers chea" stuff in good business9chea" and good.
Is it a value destroyer, A Da"ital destroyer.
5efine your terms U Free Dash Flow.
6re?ta# and after?ta# returns
G$I Is it chea" and
G2I a good business,
AnalyHe Dash Flow Statement
Insider Activity. Are they buying or selling stock,
Growth rates U why chosen, Why that rate.
6ick good com"arables??
6issing cash away9then what are they doing9convince me why they make sense.
2 different businesses?then must do sum of the "arts analysis.
Understand 0B9 modeling
2))
1ice cash earnings but they are doing bad things with the cash flow, 0uying stock at low "rices,
5o some :0P modeling. E#"lain your assum"tions.
Jest of semester U current.
2 weeks U Jisk Arbitrage and Activist Firm8 Eric Josen.
8he Spin(o## communit is small. Aou can ma"e 10 times our mone. 3i9uidit constrained.
Jelative and absolute returns with micro?ca" stocks. 7ery lucrative9get rich. :ess than *$5+ S *2++ million
market ca". Small grou" cycles with new "eo"le. 2he old "eo"le get rich and become liBuidity constrained.
3earn the trade. .or", patience and where to loo". @ C7@>8
2y"es of 5ivestitures8
Jestructuring Shareholders& Dlaims. 2he most common methods for creating new classes of stock include
cor"orate s"in?offs eBuity carve?outs and tracking stock.
In a "ure spin(o## the com"any distributes to its shareholders new shares of stock re"resenting $++> of
ownershi" of a com"any subsidiary. After the distribution the subsidiary trades as an inde"endent "ublic
com"any while the original "arent com"any shares become claims against the firm&s remaining assets. 2here
is a com"lete "hysical and legal se"aration of "arent and subsidiary o"erations. Small ca" s"in?offs have
higher returns than the market and larger ca" s"in?offs.
8rac"in! stoc" in contrast re"resents a -"ureT claim against the "rofits generated by a s"ecific segment of
the firm&s o"erations9but the segment continues to be "art of the consolidated business entity. 1ew shares are
distributed "ro rata to the shareholders. 2hese new shares re"resent a $++ "ercent claim on the "rofits of a
subsidiary3 the "arent com"any shares become a claim on the rest of the business. Alternatively the new
shares can be sold for cash in an initial underwriting or issued as "ayment in an acBuisition. 2racking stock
"roduces the same eBuity structure as a s"in?off but the firm&s cor"orate and organiHational structure remains
unchanged. Pne 0oard Pf 5irector one Dor". Dharter etc. 2he value of a tracking stock de"ends u"on cor".
overhead allocations9there must be large synergies between the firms.
In an e9uit carve(out the firm sells a "ortion of the stock in a subsidiary for cash usually in a "ublic
offering. 2he main difference from a s"in?off is that carve?outs bring in new ca"ital to the "arent com"any.
EBuity carve?outs increase shareholder wealth. Also it results in new shareholders. Darve?outs are more
e#"ensive to im"lement and sub4ect to more securities law disclosure reBuirements. Darve?outs also have
"ositive cash?flow effects vs. s"in?offs. Many firms look to eBuity carve?outs as a means of reducing their
e#"osure to a riskier line of business.
Jiskier and more highly leveraged firms choose to go the s"in?off route.
/oluntar li9uidations or bust(ups
If the market value of the firm&s assets e#ceeds the value of the firm&s eBuity a liBuidation may need to be
considered. 2his is more likely when the stocks "rices of other firms in the same industry are not also
de"ressed.
!EAR! C@S5 S8D6A HS1I;<>>$
6age $? SearsO%ean 3itter' sell &llstate. 2+> stake sold to the "ublic. Jaise money then C+> s"un off.
6arent gets no money.
Sell 2+> of &llstate?What does it mean for SSI.
2)<
5istribute 2+> so subtract C+> from Sears. S"in?off strengthens the ability to use stock com"ensation. 5oes
*2C make sense on a stand?alone basis, 6arent com"any wants to retain C+> of s"in?off so it can use the Dash
flow for consolidated ta# treatment.
2racking Stock? :egal entity U "artici"ating in income stream but not actual ownershi"
&llstate? s"in it off to showcase the value of Sears.
Rnderstand big "icture.
$ share of Sears O +.' %ean 3itter.
After sale of 2+> %ean 3itter
*(5 O *$'
*(K of Sears and *$' of %ean 3itter???Sears at *5(
1ot a "ublic market for &llstate right now but it has a "ublic market value. is at *2C and you own (C+ million
shares. 2hen subtract that from Sears and get where Sears is trading se"arate from &llstate.
6AJE128 Sears' ?oebuc( E Co$ GSI S6I1?PFF8 %ean 3itter' %iscover E Co$ 5A2E8 <;$(;K(
Sears wanted to turn itself into a "ure "lay in retailing.
%une (+ $KK5 s"un off the last of its big subsidiaries8 &llstate Dor".
Sears valued at *$< a share in %anuary $KK( now trades at *5' u" (++> in (.5 years.
Sears shareholders received .'+ shares of 5ean Witter for each share of Sears& common stock they held G5ean
Witter had com"leted an I6P on March $ $KK( at *2< a share.
&llstate was s"un?off in %une $KK( with the issuance of '(K million shares at *2< each. Sears s"un?off the
remaining C+> of &llstate Insurance in %une $KK5.
Sears was merely selling or distributing businesses it already owned. 0y taking Sears stock "rice and
subtracting the market value of its remaining stakes in 5ean Witter and &llstate a value for the rest of Sears
assets "rimarily the de"artment store could be calculated.
2+> stake in %3 at *2< "er share. 5W at *(< "er share3 &llstate&s stock was around *2K "er share3 Sears
stock stood at about *5' "er share but *2< "lus *(< O *)'. So $ share of Sears would get .'+ of 5W or *$5
worth of 5W stock. *5' ? *$5 O *(K for the remainder of Sears which owned C+> of &llstate. If you owned
$ share of Sears you owned $ share of &llstate 9both had ('+ million shares.
EF? o# total !ears minus E2? o# Allstate nets to E10.00 #or !ears& 7etailin!. 2ake out *2 or *( for Sears
Me#ico and *2?*( for Doldwell 0anker which leaves you a""ro#imately *5.++ "er share or *$.5 billion for the
retailer with *2< billion in sales. It is an almost debt?free retailer with huge real?estate o""ortunities.
E5.00 per share with E7? per share in sales and with no debt. @ la up:
Dom"arison with JC Penny showed sales of *<C "er share and a market "rice of *'' "er share or 5)> of sales
vs. )> for Sears. C# chea"er. @ ,DG5 disparit:
:ooking at what insiders are doing is a good way to find attractive s"in?off o""ortunities. Insiders may benefit
if a s"in?off trades at a low "rice. Shares of a s"in?off are distributed directly to "arent?com"any shareholders
and the s"in?off&s "rice is left to market forces. It may be in management&s interest to have the "rices trade
lower so as to get a lower "rice for incentive o"tions.
Internet stock?like &llstate?is the "rice sustainable,
-now dierences between trac(ing stoc( and spin4os$
2)C
1ot a natural buyer for this conglomerate here8 S,&?S. Weakness in &llstate is shielding the value in Sears,
What is the reason for the s"in?off,
Rsing the "rice of *5(.$25 for Sears After 2+> sale of 5ean Witter *(5.25 for 5W then Sears will dro" by
*$' to *(K "er share. Sears owns ('+ million shares of &llstate and Sears has ('+ million shares outstanding.
0arrons article mentions Sears analysis by Mike 6rice on %uly 5 $KK(.
*$.< 0illion market ca" for Sears with 2< billion in sales. 1P 5E02. ) cents for Sears& *$.++ in sales.
Sears is a cra""y retailer so com"are with JC Penny which has *$+ billion in :2 debt. *2.' billion market ca".
$2.' billion E7 for 6enny.
Compan Comparable Sales )ar"et Cap
!ears *$.++ *+.+)
JC enny *$.++ *+.)2 $+# more/
So if Sears was com"arable then it would trade at *5+.++9a ten bagger/
2IG G@1 between E5.00 and E50.00. Why did this occur if the market is efficient,
2hese things 4ust ha""en. Stuff ha""ens. Greenblatt sold Sears off at *(+ to *(5.
In the s"ecial situation world some things are slam dunks. 0e aware that this can ha""en9a slam dunk laid
out for me by Mike 6rice.
Stub stoc(s$
;<85S #rom C3@SS
6eo"le can be stu"id8 2his is an e#treme e#am"le. A4Com4444Palm. .ou could create the rest of A4Com for *$<
9Worth *$+.++ "aid *$<.++ for a *$+ value which had *<.++ in cash.
ACom at *)+ and Palm was at *$C+. ACom owned Palm. For every share of ACom you owned they owned
*<< of Palm. .ou could create the rest of ACom Gno debtI for ?*$< "er share G*)+?*<<I. I could buy that *$+
"er share of which *<.++ in cash while being "aid *$<.++. I am short Palm. Stuff could ha""en9the stock is
called in on you.
8Co'4al' 5+ample #rom 8he Intelli!ent Investor 1a!e N7?(NK0
Pn March 2 2+++ the data?networking com"any ACom Dor". sold 5> of Palm Inc. subsidiary to the "ublic;
2he remaining K5> of Palm&s stock would be s"un off to ACom&s shareholders in the ne#t few months3 for
each share of ACom they held investors would receive $.525 shares of Palm.
So there were two ways you could buy $++ shares of Palm8 0y trying to elbow your way into the I6P or by
buying )) shares of ACom and waiting until the "arent com"any distributed the rest of the Palm stock. Getting
one?and?a?half shares of Palm for each ACom share you&d end u" with $++ shares of the new com"any9and
you&d still have )) shares of ACom.
0ut who wanted to wait a few months, While ACom was struggling against giant rivals like Disco Palm was a
leader in the hot -s"aceT of handheld digital organiHers. So Palm&s stock shot u" from its offering "rice of *(C
to close at *K5.+) a $5+> first day return. 2hat valued Palm at more than $(5+ times its earnings over the
"revious $2 months.
2hat same day ACom&s share "rice dro""ed from *$+'.$( to *C$.C$. Where should have ACom have closed
that day given the "rice of Palm, 2he arithmetic is easy8
Each share of ACom share was entitled to receive $.525 shares of Palm
Each share of Palm closed at *K5.+)
$.525 # *K5.+) O *$''.K<
2)K
8hat is what each 8Co' share was worth based on its sta"e in al' alone. 8hus, at EK1.K1, traders were
sain! that all o# 8Co'&s other businesses combined were worth a ne!ative EMF.1M per share, or a total o#
minus E22 billion: 7arel in histor has an stoc" been priced more stupidl.
0ut there was a catch8 %ust as ACom wasn&t really worth minus *22 billion Palm wasn&t worth over $(5+
times earnings. 0y the end of 2++2 both stocks were hurting in the high?tech recession but it was Palm&s
shareholders who really got smacked9because they abandoned all common sense when they bought in the
first "lace.
Further discussion8 www.nber.or!4papers4wKF02
0e aware if the S"inoff creates a ta#able event. 0e aware of the ta# ramifications.
,ow to do stoc" screens9in another class. For' /+ 2or !&inIo22s. S"in?off Dalendar.
Announcements occur )?K months before for s"in?offs.
The intelligent investor eCcels by ma(ing decisions that are not dependent on the accuracy o anybodys
orecasts' including his or her own$
.esterday&s losers are often tomorrow&s winners. :ook at the list of new lows for the "ast 52 weeks.
S"in?offs have done very well and so have the "arents. S"in?offs beat the market by $+> a year. I ho"e you
can do better. S"in?offs are a ha""y hunting ground. After I wrote this s"in?offs did not do well. 6eo"le say
after ) months -Ph this doesn&t work well.T 2hey Buit.
I will mark the s"in?off dates on my calendar. 0ottom line I do valuation work. 2ottom(line I tr to do
valuation wor". I bu E1.00 #or E0.50 to E0.M0.
7is" @rbitra!e and )er!er Securities
ara'o1nt Co''1ni#ations* In#.G "ia#o' Case !t1dy
Se"t. $KK( :iacom wanted to "urchase 6aramount Dommunications. :iacom announced a merger with
0lockbuster Entertainment. :iacom "urchased 6aramount&s 5+.$> of stock. 2he method of "ayment for the
remaining 'K.K> of 6aramount,
0ack?end "ayment for each share of 6aramount consisted of :iacom common stock e#changeable
subordinated debentures of :iacom securities known as contingent value rights Gone for each share of :iacom
common stock received in the merger G'I three?year warrants to "urchase :iacom stock at *)+ "er share and
five?year warrants to "urchase :iacom stock at *<+ "er share.
Most of 6aramount shareholders were of interest in owning the shares of an entertainment conglomerate or the
stock of the takeover candidate so the other securities would have little interest.
What is all the stuff in the 6ro#y, ( "age section called -6aramount Merger Donsideration.T
P""ortunity8 combining the "urchase of one share of :iacom common stock with the "urchase of one
contingent right GC:?I created a uniBue investment o""ortunity.
Dontingent?value right was a security issued by :iacom to hel" guarantee the value of the back?end securities
that 6aramount shareholders were to receive in the merger.
If :iacom traded below *'C on year after the com"letion of the 6aramount merger :iacom would make u" the
difference through a "ayment to holders of the C:?s. If :iacom traded at *'' at the one year anniversary of
the merger&s close :iacom would "ay *' for each C:?. So buying on C:? with each share of :iacom an
investor would ensure that the combined value of the two securities would be at least *'C in one year.
2<+
If :iacom traded at *55 even better than the guaranteed *'C "rice. Since shortly after the merger was
com"leted one C:? and one share of :iacom stock could be "urchased for a combined "rice of *(< a
guaranteed "rice of *'C in one year looked "retty good9a (+> annual return with little risk and no u"side
limitation.
:iacom limited the "ayout on the C:?s to a ma#imum of *$23 :iacom could fall to *25 before an investor who
bought both the C:? and :iacom stock for a combined *(< would lose money. :iacom could e#tend the
"ayment date of the C:? but only in e#change for a "ayout larger than *$2.
It pas to chec" out mer!er securities: <nl invest in the ones that are attractive and that ou
understand.
Five year warrants at a "rice of *<+ for a share of :iacom that could be "aid with *<+ face value of one of the
other 6aramount merger securities.
Which merger security, 2he e#changeable subordinated debentures I mentioned earlier.
I could buy *<+ of face value of these securities for only *'2.++ G)+> of *<+I. I would have this right for five
years. :iacom was at *(2. 8he ri!ht to bu stoc" at EN2 #or #ive ears was a lot more valuable than the
ri!ht to bu stoc" at E70.
0uying both the warrants and debentures was a winning trade.
;otes% 2his is like a :0P. :iacom borrows a lot of money to buy 6aramount. Front?end is in stock and the
back end with 4unk securities.
Management incentiviHed with a lot of o"tions.
:iacom at *() and Warrants for ( years at *<+9but ( years is a long time and the situation is very leveraged.
:iacom ? *2 billion mkt. ca" and *C billion of debt so E7 of *$+ billion. 2he value of assets goes u" 2+> over
( years but the eBuity has been doubled. :everaged eBuity. 0ut risks reBuire a smaller "osition.
.arrants are a "rice to buy stock at a certain "rice for a certain time. When you e#ercise these warrants you
give the com"any *<+.++. P"tions are among shareholders. 6age $) use 4unk in ( to "ay for :iacom. 2ake
merger securities9debentures )+ cents on the dollar and "ut them in at face value for the stock. 6ay )+ cents
for debentures but I get *$ of :iacom stock.
)+ cents bonds for five year warrants at *<+ so )+> of *<+ O *'2.++
.hen ou see some weird securities #allin! o## the bac" o# the truc", 8@-5 @ 3<<-:
1ow not as many merger securities. 1ow there are many Bostile mergers. 2here are tons of s"in?offs. 7alue
stock at low "rices and absurdly high "rices for Internet com"anies9inefficient markets. 2here are "lenty of
o""ortunities all over the "lace.
In March there were many o""ortunities. :ast Pct. 2++2 the "rices were very low.
2here is so much emotions. .ou usually only have to wait about ) months for o""ortunities. %ust sit on your
hands and wait. :ook for weird securities who is in charge, :ook at the conte#t. Follow the money.
*(+ million of the (?yr. warrants.
*C+ million of the 5?year warrants.
A fallacy in risk arbitrage8 no analysis of worse case scenario.
S$+ take over trading at *K.5 so 5+ cents;*K.5 in ' months so a 5+> return annualiHed. :ook at true
risk;reward. Make 5+ cents minus cost of carry of $< cents so (( cents "rofit. Stock goes to *'.5+ if deal does
not go through.
2<$
Bostile deals are fun.
6ay *C+ "er share in cash for 6aramount on *'5 in cash and the rest in eBuity shares.
2ed 2urner "aid Q cash and Q in securities. Everyone hated the deal but 2urner saw value in the film library.
*'+ in cash and *'+ "a"er trading at *2+ so "urchase an *C+ asset at *)+.++.
Greenblatt shoots for a (5> to '+> annual return.
;ost MarriotGMarriot International
E#. From 0ook8
2he cream of the business was charging management fees for managing hotels9+arriot International$ We
will s"in off the assets that are loaded with debt9Bost +arriot.
S"in?off the management fee business. $++ million shares outstanding. Stock trading at *' or *'++ million
market ca". Mkt. bad for real estate.
+arriot International will back a *)++ million line of credit to Bost +arriot.
1o one would want the new Bost +arriot because of real estate and loads of debt. 2he selling "ressure would
be enormous so values would be interesting.
1on?recourse debt so I would have *) of value after subtracting all the debt.
W!A2 I look for8
Institutuions don&t want it Gand their reasons don&t involve the investment meritsI. Many thought that Bost
+arriot was loaded with unsaleable real estate and crushing debt. Also the siHe of the com"any was small9
accounting for only $5> of the total value being distributed to shareholders.
Insiders want it?Aey/ Are the managers of the new s"in?off incentiviHed along the same lines as the
shareholders,
Stephen Bollenbac( would become Bost&s chief e#ecutive. Marriot family would still own 25> after the s"in?
off.
Investors were interested in hotel management not owning hotels therefore the sales of stock solely for this
reason would not be based on the s"ecific investment merits and therefore might create a buying o""ortunity.
@ previousl hidden opportunit is created or revealed.
Bost had tremendous leverage. Bost would trade at *(?*5 "er share but it would also have *2+ to *25 in debt
"er share. Say assets worth *(+ "er share so a $5> rise in value of the assets would double the stock G+.$5 L
*(+ O *'.5+I. For every dollar of debt transferred to the new s"in?off com"any adds a dollar of value to the
"arent.
+arriot International the -goodT com"any was on the hook to lend Bost u" to *)++ million.
Say what you will about highly leveraged com"anies the rewards of sound investing and good research are
vastly multi"lied when a""lied in these leverage situations.
Bost could be a good "ick because8
2<2
Most institutions were going t sell their Bost +arriot stock 0efore looking at it thus creating a
bargain "rice
Aey insiders a""eared to have a vested interest in Bost&s success and
2remendous leverage would magnify our returns if Bost turned out for some reason to be more
attractive than its initial a""earance indicated.
Identify where you think the treasure lies.
Bost +arriot 6age (+ last column on the right. *2.) billion of debt and convertible "referred stocks ahead of
the eBuity.
$++ million outstanding shares outstanding. Say *'.++ "rice or *'++ million so *( billion valuation.
Most of debt will be in !MA holding G*2 billion of debtI. Still *)++ million of debt on the "arent of Marriot.
2his debt is only recourse to !MA !olding.
Pne hotel is the San Fran Marriot??*25+ million of debt was non?recourse. 1ow get worth of that debt.
*) of value after subtracting all the debt. Anything in !MA !olding is worth over *2 billion. My *) is in the
debt free in "arent. 2he value is "robably worth *$2 "er share if I was right. 2he key was that the debt was
non?recourse.
0uying *'.++ where it is worth *).++ in the "arent with a call on the other stuff "erha"s worth *$2. I could
buy a lot of it because it seemed very low risk.
=uestion8 When to sell. 0ought F: at *$+ and now it is *$<. 2hink it is going to *2< in two years. I usually
sell based on valuation. I "ick my valuation as to how long I wish to wait.
If what I buy works out is PA even if I let another $( go buy. It doesn&t hurt me not to invest. Jemember U
don&t lose money/ 6atience. Swing at your "itch.
5o my valuation work and if the stock gets chea" enough es"ecially for a business I like I will buy if the "rice
gets chea" enough.
Form $+?$2 for s"in?offs. 10(- .iGard is e+cellent. :ook for s"in offs. Aey words?s"inoff distribution etc.
Jights Pfferings8 a "arent com"any may give its shareholders the right to buy stock in one of its subs or
divisions.
When a rights offering is used to effect a s"in?off it is worthwhile to "ay close attention. Pften used to raise
additional ca"ital.
Jights that are not e#ercised or sold e#"ire worthless after a set time "eriod.
Jights offerings are obscure and often confusing. 2hrow in the neglect and disinterest dis"layed by most instit.
Investors towards s"inoffs and you have an e#"losive combination.
A "arent will generally distribute to its shareholders rights to buy shares in a s"in?off.
At the time of the offering it is not known whether the s"in?off will trade above or below the "urchase "rice
set in the rights offering. 1o need to seek the highest "ossible "rice. In a rights offering since all shareholders
of the "arent have an eBual o""ortunity to "urchase stock in the s"in?off9shareholders have been treated fairly
and eBually.
0AJGAI1 6RJD!ASE8 the inclusion of oversubscri"tion "rivileges in a rights offering. 2he right to buy
additional shares if the rights offering is not fully subscribed.
2<(
FP::PW 2!E MP1E./ 1o matter how a transaction is structured if you can figure out what is in it for the
insiders you will have discovered one of the most im"ortant keys to selecting the best s"in?off o""ortunities.
Shares of a s"in?off are distributed directly to "arent?com"any shareholders and the s"in?off "rice is left to
market forces. Pften management&s incentive?stock?o"tion "lan is based on this initial trading "rice. It "ays
to check out when the "ricing of management&s stock o"tions is to be set.
2here are few investment areas where insiders have such one?sided control in creating a new "ublicly?traded
com"any. @nalGe the motives o# insiders in spin(o## situations.
0iberty +ediaITele4Communications
2his was a $+ bagger in less than 2 years. A right is somewhat like a short?term warrant.
2his situation was artfully designed to create the most u"side "otential for those who "artici"ated while
simultaneously discouraging most investors from taking advantage of the o""ortunity.
0egan %an. $KK+. Tele4Communications the country&s largest cable o"erator announced its "reliminary
intention to s"in off its "rogramming assets like =7D and the Family Dhannel9assets est. to be worth nearly
*( billion. 2here was "ressure to limit the ability of cable?system o"erators to own interests in "rogram
"roviders. 2he goal of the s"in?off was to alleviate some of that govt. "ressure by se"arating the com"any&s
"rogramming assets from its controlled cable systems.
In March $KK+ Shareholders were to receive rights that would entitle them to e#change some of their TCI
stock for shares in the new com"any. If a rights offering is structured "ro"erly shareholders are only ta#ed
based on the value of the rights received.
*)++ million value of entity to be s"un off. TCI had a total ca"italiHation of *$5 billion G*) billion of eBuity
value and *K billion in debtI. 2he siHe of the 0iberty s"in?off was going to be an unim"ortant sideshow as far
as most institutional investors were concerned. GDlassic o""ortunityI.
2 million shares to be issued in the s"in off vs. '$5 million F5 in TCI.
0iberty considered unattractive by the media.
Tele4Communications shareholders were to receive one transferable right for every 2++ shares they owned.
Each right together with si#teen shares of 2ele?Dommunications could then be e#changed for one share of
0iberty Media. At a "rice for TCI of *$) the "rice was *25) "er share of 0iberty. For '$5 million shares of
TCI9for every 2++ TCI shares held translated into the a""ro#. 2.$ million shares of 0iberty to be issued.
Institutions would consider the stock too illiBuid. A "rice over *25+ would be considered awkward.
2he amount of 0iberty shares issued would be eBual to the amount of rights e#ercised. If only $ million rights
were e#ercised to "urchase 0iberty stock only $ million shares of 0iberty would be issued9not the theoretical
ma#imum of 2 million shares.
A sale of $ million shares in e#ch. for *25) worth of TCI stock would eBual a "urchase "rice of *25) million
for all of the common eBuity in 0iberty Media Ginstead of a "otential *5$2 million cost if all 2 million shares
were "urchasedI. Since 0iberty would own the same assets regardless of whether $ million shares of common
stock were issued or 2 million shares anyone interested in 0iberty&s u"side would much "refer to s"lit that
"otential among fewer shares.
Any stock not sold in the rights offering would be re"laced by "referred stock to be owned by 2ele?
Dommunications. Any shortfall was to be made u" through the issuance of *25+ million of 0iberty "referred
stock to TCI9terms very favorable to TCI.
2he FEWEJ shareholders that "artici"ated in the 0iberty offering the more leveraged the u"side "otential for
0iberty&s stock. 0etter this leveraged u"side would be achieved not through the issuance of debt but through
the issuance of low?cost "referred stock.
2<'
2he success of 0iberty would be of material im"ortance to Malone. !e had an o"tion on 5> to $+> of the
com"any.
2he loss of *K.<< wasn&t as bad as first a""earances since other assets were not consolidated9the stakes in
eBuity of other com"anies.
0iberty set u" as a vehicle for TCI&s "rogramming ventures. TCI&s "rogramming muscle would benefit little
0iberty. !el" in the u"side.
0iberty&s "roblems include an illiBuid stock a terribly com"licated asset and ca"ital structure and a lack of
initial cash flow from its investments.
2he owner of 2++ shares of TCI G*(+++ of TCI stock at *25) "er shareI received a right worth less than *$.++.
+alone was able to kee" nearly 2+ "ercent of 0iberty&s u"side for himself com"ared with his "artici"ation in
less than 2 "ercent of TCI&s u"side. Malone would use TCI&s clout to hel" 0iberty.
Dlass 1otes8
$ share O $;2++ of a right. Ggo through the hand?outI. 7ery unattractive to do.
Donsolidated statements looked horrible. *(2+ million.
2.$ million common at *25+ "er share. Why own illiBuid stock when you own (2+ million shares of the "arent
stock. Many rights e#"ired worthless so less PS issued for 0iberty. 2he *25+ stock went to *(+++ in two
years.
'++ "age "ros"ectus. Every shareholder had the same right as Malone. 2his is a multi?billion dollar
o""ortunity. 2here are many other smaller o""ortunities in smaller deals.
Institutional Framework.
2hinking of how to think.
:earning curve of a few years in finding S"in?offs. 2he world evolves. I am not the most so"histicated
analyst but I do have a very good conte#t to evaluate what I am looking at. 8hin"in! about how to thin". It
is sim"ler than you think. It is not going to be based on a '+ "age analysis but it is on finding a big o""ortunity
and acting on it. 2he s"ecial situation world has lots of o""ortunity.
GPP5 :RDA on your "ro4ect.
E?$
Greenblatt Dlass [<
Pct. 22 2++(.
:ook at +arshield &ssociates
Companies to research
DI !DA SMJ2
A:P. F: FMD
JDI M!S F2S
0AS 6PS S
2<5
APD 6SS !!G6
:AF 6SS
S :A0 !PF5 GScreenI
A0S FD1 D2GI GScreenI
S:E 20D 5FS GScreenI
2MA A1F 1:S GScreenI
Eri# Rosen2eld is a benevolent Carl Icahn. !e started in Jisk Arbitrage. !e now focuses on activist investing
in Danada where the laws are friendlier shareholder laws. With 5> share holding you can reBuisition a
shareholder meeting.
Danada is a good "lace for activist investor. :aws more favorable for investors. Also there is less com"etition
in Danada from RS investors. If you own 5> of a com"any you can reBuisition a shareholder meeting and
com"any must have a meeting within <$ days.
0y serving as our own catalyst9trying to bring out that value whatever that value9you can hel" control the
"rocess. .ou want the "rice mis?"riced for some reason9there is some e#traneous event that has caused such
an event.
Spar &erospace
Dhairman in $KKC. 2hen sold com"any in 2++$ to a large RS defense com"any. 2he com"any had *C.5+ "er
share in cash trading at *K.++ and no debt.9a sur"lus. Enter"rise;E0I2 of ( #s. 2he maintenance "art of
com"any was the most attractive "art of com"any. 2he "rice of the stock declined all through the $KK+&s. 2he
com"any had a market ca" of *$(+ million vs. *$'+ million of "otential liabilities GAMD lawsuit before a
4udgeI in legal costs in DA. Settled for *$( million. 2here was an insurance ca" but not there if fraud. Rsually
you should discount this.
We "aid cash to shareholders with a return of ca"ital3 we "ut in a stock buyback3 we offered a dividend3 we
closed down under"erforming divisions.
Stock trading at *K with *C.5+ in cash. $5 million in PS. *2+ million in E0I25A with *(?*' million in yearly
ca"e#. So $ times greater # E0I25A. Enter"rise value was *+.5+ # $5 PS O *<.5 million E7 over *$) million
in E0I25A but lawsuit greater than market value of the com"any.
2he analysts thought the trail was before a 4ury in DA so they 4ust threw u" their hands and did not do further
work. 2here was an insurance ca" as well. Either an analyst doesn&t cover a com"any or there are other issues
that they can&t research or understand.
2he deal took three years.
Wild Wetman
25 million PS. 2' million non?voting. 2 families own $ million in voting shares. *$C "rice. 6ut a resale to
liBuidate the com"any?message to the 0oard. 2he com"any&s board had little res"ect for the minority
shareholders. 5<> vote for liBuidation.
$ year later sold at *'5 vs. *$C "rice then. 2he assets were there.
Call.et in Pct. $KKK. Sprint in Danada. Puster of management. *2 billion on debt.
What is the P""ortunity Set for Danada today, Answer8 It is still very good. I am on the 0oard of three
com"anies
&toc( 1adoc(2 Technologies in Montreal. Work?force "lanning software??scheduling. Scheduling aircrews.
2<)
Stock at *(.++ with *2 "er share in cash??mis"riced by events. ( # E0I25A. 1ow at *'.++
Pivotal Corporation C+ cents with no debt but losing money. Most of assets in cash. 1ow at *$.<) "er share
9sold. 2he deal should close ne#t month.
Sierra Systems 8 in 7ancouver Danada $'+ million in sales. A system Integrator no debt E0I25A margins
way below Industry. Jun for the benefit for em"loyees instead of shareholders.
5utch Auction8 We try to determine the highest "rice for buying. We will buy '+> of the com"any in a set
"rice range. 2he market dictates the "rice.
5utch Auction U offer to shareholder. Set *).)+ to *<.<5. 0uy u" to 25> market dictated system.
6ay attention to debt. 1ote all the ramifications of debt. !e serves as his own catalyst to bring out the value.
C1I aero(structures on AMEL. A liBuid business but has much debt. 0ot $<> from com"any at *'.++.
*$+.2+. *(.25;Share in Ebitda. Electronics masked the great returns in the defense business. :iBuidate one
business "ay off debt. E7;E0I25A about (.5L with E0I25A growing at 5+>. Good investment.
Bollinger?a disaster. Dontrolled by Donrad 0lack. Dor"orate governance issues.
Are buy backs accretive to cash flow, 1ot based on book value.
!olding "eriod is from ( months to 5 years.
.ou must be "re"ared to carry the fight to the end.
!ow do you source investments8 %ust in Danada and RS. Jeading "a"ers in Danada RS Investment bankers
coming to us screens.
I work towards consensus and by showing the other "arties that my way is best for all. (+> to 5+> return in a
short "eriod of time. A longer "eriod would reBuire a higher return9$++>.
7IS- L @72I87@G5%
S"reads have been (# the risk free rate. 1ot worth it. 2he risk is in the deals not going through.
S"read from today to where the "rice would be if deal consummated.
Merger
2ender Pffer9a buyer offers to buy shares from the shareholders.
:iBuidation
:0P&s in the $KC+s "ut u" $+> to $5> of the eBuity but now the reBuirement is (5> of the eBuity.
Jeca"s
Self 2ender? 5utch auction
S"in?offs
2here is a lot of ca"ital and few deals.
*$+5 cash merger trading at *$++ to *5;*$++ O 5> with ' months to close O $5> cash deal.
2he brokerage firm has the shares in a de"ository. :etter reBuesting a shareholder meeting and the "ur"ose.
Stock for Stock deal
Stoc" @ Stoc" 2
$ share of A O Q share of 0
2<<
*2+ *'2
5ividends8 if long you get dividend and if short you "ay dividend.
Q of 0 O *2$.
$ dividend of 25cents with A while losing Q of (+ cents with 0 or 25 cents U Q of (+ cents O 25 cents U $5
cents O $+ cents. *2$.$+;*2+ O 5.5> s"read or 22> Jate of Jeturn
If deal 0:PWS R6 you lose *$+. What could go wrong, F2D %ustice 5e"t. time delay.
$5> for :2 holding vs. (5> for short term holding. Stock declines Se"t. $$ other deals break GRA: in $KCKI.
1ow /irst %ata Corp buys Concord ,/S owns )'> of G$+> of EFS marketI of 1ice 1etwork. EFS has )+>
market share so with combo it would own )'> of check market. 2o avoid %ustice 5e"t. s"in off 1ice,
<C cents s"read with F2D at *().+( and EFS at *$(.)(95.<> differential. :ose *5.++ but make 25>. 1ot
worth it. A game of chicken.
Stoc" Screenin! is a valuable toolSBoel Greenblatt.
@2R@ Spin(<>>. 5!: offered to buy Airborne E#"ress. but a foreign com"any G5!:I can&t own a RS
airline. So "rior to the Merger Airborne E#"ress would s"inoff its airfleet. Pne of those weird things that
ha""ens as a result of a merger. Where 5!: offered to "ay 2$.25 and a half. In addition you would get a s"in
off at a "rice of *+.5+ to *$.++ in a com"any that was e#"ected to make from *+.(+ to a half 5ollar/ EBuity in
A0LA would continue to do Airborne&s air e#"ress business. Stuff likes this ha""ens all the time.

2here is room to get other air business at higher margin. S"in?offs are ha""y hunting grounds. .ou have a *2$
stock and a *$.++ s"in?off.
Issue8 Is this really an inde"endent airline or was 5!: controlling it, If the s"in?off doesn&t go through all
the trades are cancelled. If the merger structure doesn&t go through the s"in?off is cancelled. All trades
cancelled and no funds transferred.
Joel Greenblatt is not a specialist, but I "now where to loo" and how to thin". Jetail9everyone looks at
same store sales but (+> JPID so that is good enough for me. I look for 1PJMA:IWE5 E0I2 2!JEE
.EAJS PR2. If there is something I can&t figure out I don&t do it. :ow E7;E0I2 and high JPID then a
"lace to look. Jeturn on tangible ca"ital. E0I2;Working Da"ital and fi#ed assets.
What is the balance sheet made u" of,
Screens8 out of $+ names you will "robably have $ or 2 good names.
Factor Models8 5.5 E0I2 but show with a JPA. Jeview author of inefficient markets. Dom"anies may be a
good buy that don&t fit all the criteria. 2he combination of two factors is very high thus you can find good
com"anies. Screened com"anies that are trading with net cash minus :2 debt. (# E0I2. S6AJ had a lot of
cash and 2 #s E0I23 the "roblem is a big lawsuit9then do your research.
:ook for low "rice;07 com"anies3 look for high cash "er share com"anies. Screenin! is an art.
Small Da"8 greater than *5+ million and less than *5++ million. .ou can always find names. 6eo"le over
react.
Rnfortunately you have to do some amount of work.
1ound into our head% where to loo" and how to thin". .here I loo".
1. I loo" at 8railin! 12 month 52I8 and then tr to come out with a normaliGed 52I8 a #ew ears
out.
2. Is the price cheap enou!h to ta"e out the uncertaintC
2<C
F. 3ow normaliGed 5/452I8 and
N. Good returns on capital:
@m I buin! it at a low enou!h price relative to normaliGe 52I8 a #ew ears out in a compan with
!ood returns to capital so as to have a mar!in o# sa#et in case I am wron!C
I use a broad brush screens. 6ower screen. Market Guide from multe#. Much chea"er. Dom"ustat is
e#"ensive.
:ook at the balance sheet and see what the balance sheet is made u". Some businesses don&t need much
inventory so don&t be so concerned with dro""ing ratios etc. What is a material "art of their business,
.ou look for certain clues. .ou "ursue one "oint. 6aramount deal9the interesting securities9I "ursued.
1ote that Jeturn on Assets is tougher than return on tangible assets because you need a return on intangible
assets.
Ask if the screen is too cheap.
Screens% Assoc. of Individual Investors 6ower Investors Dom"ustat.
:ook at +erc(I+edco S"inoff.
Rse 5"- 3i8ard. 0ad news8 easy to find things but "eo"le still need to do the work.
Word Search8 ma#imiHe shareholder value s"in off rights offerings.
2here is a learning curve of a few years. .ou can make a living "ursuing this strategy. I do have a good
conte#t of what I am looking at and I am disci"lined.
2hink about how to think. 2hink about what conte#t to "ut things on9then things are sim"ler than you think.
.ou can '+ "ages of analysis. It is more like8 !ey it is worth *$+ but it is trading at *(/ It should be obvious.
E?$
??
Greenblatt Class # K
<ct. 2?, 200F
A Guest the sister of Joel Greenblatt' 0inda runs a fund focused on retail stocks. Earning in the high 2+Ms
return. 2here are several hundred retail stocks to choose from.
It shows how well you can do if you focus on your niche by staying within your circle of com"etence.
1Son(in runs a much smaller class so there is more interaction and student individual presentations in micro4
cap stoc(s2$

Analysis of com"etition
Whole consumer sector
Jetail ? monthly flow of store sales. FreBuent information flow.
Same store sales com"arison
Store growth and JPID of stores.
Companies A?F @5<S 1SD) .8S3@
Cash '++ 2+K C+ K+
52I8 (22 $2C CK 1A
2<K
5/452I8 <.< <.5 $$.C 1A
1C5 $(.' $5.C 2'.C 1A
5/4Sales $.) +.) $.2 +.5
;et Cash4Share '.+ 2.K +.<) (.+'
8otal Stores )<2 K$2 C55 )22
&,9S is going more into lower class malls than &B,?$ What is growth "otential,
All these com"anies have a cash balance. When you look at 6;E you might want to take out cash and focus on
their earnings on o"erations.
Rnderstand conce"t customer base location know "rice "oint differential. For e#am"le a sweatshirt at
Abercrombie will sell for *(5 ? *'+ versus *25 at ,agle Putfitters.
&./ is at *2C.C+ Gas of Pct 2K 2++(I and it has *'.++ in cash so *2C.C+ minus *'.++ in cash O *2'.C+ divided
by earnings of *2.5+9$+# multi"le.
Where these conce"ts can go de"end on where the stores are located. 2he core Abercrombie conce"t has to be
at a better mall. <++ A Malls C++ D Malls.
Is conce"t maturing, What new conce"t is coming ne#t,
&./ will ma#. out about in about '++ more stores in A Malls. If &./ does not have growth "otential in its
core "roduct what are they doing now to grow,
Bollinger?is there a new conce"t for &./. 2heir growth is slowing.
.autica; an a""arel com"any trying to be a retailer. A failure.
!ow to evaluate 0rand value, A good Buestion. &./ was once hot??they could sell anything at full "rice.
2hat is not sustainable. ;ever tr to value a compan #our or #ive ears out based on popularit.
Get an understanding of where these com"anies stand today. &./ is in the best "osition today. 2heir core
conce"t is old but they introduced Bollister which is very hot. Aber. Is more east cost conce"t and Bollister is
more of a West Doast Surf conce"t. Bollister has $5+ stores so it has good growth "otential ahead of it.
Jetaliation, 6rice War, 5oes Bollister take business from ,agleN Is there room enough for everyone, ,agle
has been running negative com"s. ,agle was knocking off everything from Aber. And selling it for (+> off.
2hen that strategy sto""ed working.
,agle has tried unsuccessfully to buy into a new conce"t while &./Ms mgt. has successfully introduced an
organically conceived conce"t. ,agle bought an established name in Danada and has destroyed it.
Are they trying to go after their same customer base and cannibaliHe it, Ann 2aylor has introduced &nn Taylor
0ot and "eo"le can "ay less for the Ann 2aylor brand??so "eo"le are confused.
What ha""ens if a brand is not as hot as it once was, &./ vs. ,agle mgt has marketed well. &./ has done a
good 4ob at maintaining margins.
&./ has been anti?"romotional. !igh standards of "ricing and have maintained the integrity of the brand.
1Joel Greenblatt; & lot o the opportunity wor(s better with smaller stoc(s2$
&./&s Mgt. has im"roved their merchandise margins. 2hey manage it very scientifically. &./ has maintained
numbers very well.
2C+
A com"any wonMt "romote ha"haHardly.
It is tough to analyHe one store unless you go to the same store three times a month and you look at the
inventory and break out the inventory.
2his is the ty"ical analyst re"ort8 what is ha""ening to com"arable store sales. Is it relatively im"ortant that
they get back to their high com" store sales growth??no not to me if they are making good money on their
stores and there is growth and it is chea" enough. ;ollister is doin! well but comps are down. It doesn=t
thrill me, but it is not important in the bi! picture.
5o I care what they will do in Pctober if I am holding for three years or more.
Dom"s are down (> but they earn returns on ca"ital in the )+>??a good investment. Sure the JPID is not as
great but it is good enough de"ending on the "rice.
2ake advantage of Wall StreetMs fi#ation on same store sales. :ook like they have a lot of debt but what they
are on the hook for is the current market value of that store and the difference in what they owe. Anowing
where you are in the retail cycle. Also know the conce"t cycle.
2ake out rent e#"ense from income. 2here is a lot of debt. 1ote the current market value of real estate vs.
what the stores owe. ,,, Factor in lease e#"ense and make it "art of the debt.
A Buick and dirty on valuing &./. What is the "otential build?out in their conce"t,
&./ X *(5+;sB. ft. sB. ft. growth "otential
*$++;A0EJ
5++ more stores for Bollister for a total of (.2 million sB. ft. total '.$ million sB. ft. X 2+> margin O *$.C+
E6S *2.5+ then *'.( with a $2 multi"le G$5 ? 2+ multi"le for com"arable stocks in retailI O *52 and with 2+#
O *C). 2hen add in e#"ected *$+ "er share in cash to grow in addition to current *5 "er share in cash??thus *$5
"er share in cash ?? *52 N *$5 O *)<.
I get the fourth conce"t for free. Stock is now at *2K then take out 5 "er share in cash for *2' current "rice for
*2.5+ E6S or $+#.
*'.(+ E6S in ' years # $2 6;E multi"le N *$5 "er share in cash O *)< in five years so *2K to *)< is $<>
com"ounded growth over 5 years.
I ho"e they can continue what they are doing now. 2hey have 2+> margins. *'.(+ E6S??' years out.
Joel Greenblatt; At some "oint "eo"le Gthe mkt.I wakes u" and the stock goes u" more than $<> "er year. 2he
"rice does not go u" in a steady manner. $K> in one year
&./8 *$.C+ they earn in this year.
0ase case for &./ without growing the business is "aying *2K today with a $+ # multi"le for *2.'+ E6S and
G*2K ? *5;sh cashI. .ou have room for more than $++ &./ stores and 5++ more Bollister stores. Pn the
additional stores &./ will earn more *2.5+. 1etting after ca"e#. and new store ca"e#. you are netting *2.++
"er share and after five years you have an additional *$+ "er share to add to the *5.++ "er share in cash. 2here
are things you can do with the cash like buy back stock Gadding value to this scenarioI.
:um"y returns8 year $ &./ goes u" $K> to *'C then K> annualiHed return for ( years.
!o"e for stellar faster returns.
Assum"tions8 growth and margin of safety.
For Margin of Safety8 :eaving out other good things that can ha""en to &./8
2C$
&./8 We get free??the fourth conce"t.
2he margin of safety8 we left out all these other "ossibilities. We have room for error.
Im"ortant8 com" store sales. Further leverage their o"erations8 better sourcing etc.
Wall Street focuses on the wrong metrics. Dom" Store Sales and 6;E Multi"les vs. growth of the business
overall vs. com". Store sales.
What is in total build out,
>or!et slappin! on multiples on !rowth rates.
%udge Buality of management
&./ focused on margins. 2hey take a strict anti?"romotional stance. 2hey havenMt slashed "rices. Mgt. may
"anic and slash "rices when a conce"t begins to age. 2hey may sell goods at a discount.
:inda8 :ook at total build?out of stores. What will they make, Study each of their ( different businesses. 5o a
sum of the "arts analysis. -,>P
An C.5> after?ta# yield??I am comfortable with that.
Sim"ler to do a total build?out for five years what are margins with additional stores, Get the methodology
instead of sla""ing a multi"le on it.
&./ is im"roving Gross Margins and Maintaining P"erating Margins.
P"en and closing stores. .
0reak?out the new store Da"e#. and old store ca"e#. &./ does a good 4ob allocating resources.
&./ can im"rove sourcing "ull costs out and increase merchandiHing margins.
Aee" a close eye on mgt managing the com"any as a business, DEP has a big o"tions "ackage.
&./ rarely misses a number. 2hey buy goods on sale.
A hot conce"t is when goods sell at any "rice.
Analysts say com"s are down so stay away they donMt focus on the big "icture. 1ow the stock is a double.
Focus on how much cash is generated over the "eriod.
2here could be an o""ortunity for 3etseal. Why are margins are down, P""ortunities with low margins??
turnarounds.
2he guy running Gap came from %isney and he has identified "arts run "oorly. F#n of a "oorly run business.
Where are the "roblems to be fi#ed and are the "roblems fi#able,
2oday it is tough to find buys. :ittle value to be found in the market.
3oo" at absolute valuation.
&./ and ,agle show the same E7;E0I2 but normaliHed E0I2 is better for &./ vs. AEM. &./ has better
growth "otential and management. 0etter normaliHed earnings for &./ vs. trailing earnings.
:ook at normaliHed E0I2.
E15 of :inda Greenblatt 6resentation
2C2
???????????????????????
Cable /ision Spin(o##. 6eo"le are down on Dable7ision because of the money thrown at the Satellite venture.
2he Satellite venture is losing money. 2hey will "ut in three of their channels with the Satellite. Dharles 1olan
will run Satellite. Donfusing is good. P""ortunity in %unk. !e doubts the business will drain ca"ital. *(
billion for Dable Dhannels. 7PPM is considered 4ust throwing money away. Dable channels very chea" but
that logic takes over ad he dro"s 7PPM.. Dombined and a lot of debt.
0y !e might cut and run. Pr the stock might get chea" enough. 2he stub is chea". Aee" it sim"le.
*( billion of cable channels going over to 7PPM. Everyone to a man who covers cablevision says this will be
a disaster. My thinking8 these two will be combined so they will be sold for a lot less than *( billion because
they have this money drain. 2here is a lot of debt on this thing too. 2hey buy the cable channels for $.5 billion
vs. *( billion and "erha"s 1olan wakes u" Buickly and sto"s draining the money. !e closes the thing down
early. I can hold for a year waiting for 1olan to make a better decision. 2he market takes over at some "oint.
1olan bought the WiH and has made some stu"id decisions but they were small. !ere he is "laying with *(
billion dollars.
6eo"le view this negatively.
5onMt short com"arables.
,and(out is the 2u##ett @rticle in 2arron=s.
!e seeks $'> "reta# return. < # E0I2??de"ends on the business and its growth "ros"ects.
6ut money in treasuries 2?0ills which earns less than $> a year after ta#. Pccasionally successful investing
reBuires inactivity. We are trying to buy com"anies at *5+ worth *$++. In the short term the stock could go to
*25.++. 2he more confident you are donMt be afraid of short term "rice movement.
5rug com"anies are better businesses than tech com"anies. Dom"anies with mystery are worth more than
those without?A 0en Graham saying.
Inactivity 8 wait for your s"ots.
!e "refers a lum"y $5> return vs. a smooth $2> return.
!e erred by not selling Co(e and Gillette at 6eak 5+ # E6S. 2here is a downside to being on 0oards and
having huge "ositions??it is difficult to sell or liBuefy your "ositions. 2he downside of being on cor"orate
boards and huge "ositions.
!e wants investors for the long term. 5onMt "ay attention to what the market is doing. If you saw a chart of the
1ekki in $KCC and saw it dro" for $5 years. 0ut in the meantime it rallied u" (+> to '+>. If you are trying to
inter"ret the economy by moves in the market. It is a waste of time. Focus on valuation of com"anies. 1o
logic in that '+>. :ook at your stocks as businesses. 7alue them.
A threat of a terrorist attack on Manhattan.
6ick com"anies on good valuation.
A student of Wharton asked 0RFFE22 to visit. A grou" of '+ students went out to meet 0uffett for several
hours.
???????????????????????
Dhart of 1EAAII from $KCC going from '++++ to $++++ in 2++(. Focus on com"any valuation and not on
"redicting the market.
Allete In#. ( @ Spin(o## #or )a 200N. C to K months from now. 5oes the auto auction seem interesting,
0uy s"in?off or buy combined.
2C(
.
AISS8 anytime I get com"licated I lose. 5onMt short com"arables. 2u E1 that is worth EN.00. 0ig enough
difference for a margin of safety.
Se"arate out the two businesses. Easy to value and the auction business looks interesting.
Palm S"in?off ? software then hardware com"any
)IS8@-5S I; S8D65;8 1@157S
5+. 1%
Dom"any8 5avid 0usters Analysis8
E7;E0I2 ? Maint. Da"e#. O ).C vs. Industry multi"le of 2C.$ so it is chea". 2E7;SA:ES is +.5) vs. $.$5 # of
industry.
0ut no mention of the reason why the com"any was chea"8 JPID is )> and JPD and JPA is '>. Metrics are
low because the business stinks that is why it is low. 6ut *$ in com"any and then the com"any loses money.
An :0P deal fell through. 2he com"any is earning money at such a low rate that is why the com"any is
chea".
5+. 2%
2he com"any can cover their debt8
$.' # E0I25A Gstudent left out ca"e#.I. *+ free cash. Who "ays for ca"e#.??0uffett8 the tooth fairy. $KC) ?
$KCC 5onMt leave out Da"e#8 Seven ,leven failed8 the 2e#as Dhain Store Massacre. 5eals got done but they
cratered.
5+. F%
7aluation8 C.25 # E0I2. In three years 1ormaliHed earnings O *(.++. *(.++ # C.25 E0I2 O *2'.++.
2ake normaliHed C.2' # de"ressed earnings. 1ormaliHed is higher. Dom"etitors have de"ressed E0I2. If you
use that for a 4ustification for using C.25 your multi"le is inflated. 2hey "ay lower multi"le of normal earnings.
At C.25 of 5E6JESSE5 EAJ1I1GS they are actually "aying a :PWEJ multi"le of 1PJMA:IWE5
EAJ1I1GS. 1ormaliHed earnings at C.25 may be aggressive.
5+. N%
Jeturn on tangible assets. JPA vs. Jeturn on 2angible Assets. 7<@ can be loaded with !oodwill. In the
future what return on this business without acBuisition. Goodwill may mean you over"aid for business.
Jeturn on tangible assets. JPA can be de"ressed due to high goodwill amounts due to over"aying for
acBuisitions. Good returns on *2 million in tangible assets vs. the *$+ million that the com"any "aid for in
acBuisition Ggoodwill of *C millionI. :ook at the underlying returns on that business so look at tangible assets.
Study the difference between JPA vs. Jeturn on tangible assets. JPA is an annual e#"ense.
5+. 5%
+.< # 0ook 7alue is chea", 5e"ends on tangible book. Pn return on assets. !ave an earnings 4ustification.
Sales growing but credit is used to grow sales.
Sears has an incentive to use credit to grow sales due to its credit arm.
5+. M
The 0imited !8 the < to $' year?old grou". 1o com"etition in that s"ace. 1o analysis of stores could be
o"ened how long to take them to o"en new stores how much they will make on each store. 6ick another
retailer. C # E0I2 vs. others. 1o com"arables. :ook at com"anies below the < year old market in retail and
com"anies o"erating in the market above $' year old.
2C'
See logic. Go to G&P$
5+. 7%
Dom"any chea" but it is a highly cyclical com"any. 7ery difficult to estimate normaliHed E0I2 so either walk
away or take a very low number.
5+. K%
5e"reciation ? Da"e#. So much higher 5e"reciation vs. Da"e#8 is this "ermanent or not, 0e ske"tical.
2ake a more conservative basis and do not take 5e"reciation over DA6EL.
3i9uidatin! /alue8
Dash 1eed to make ad4ustments by discounting the assets other than cash based on industry
com"arables.
Inventories GC+ cents on the dollarI
A;J
66SE G$+ cents on the dollarI
Minus debt Ginclude liabilitiesI
Also what are the liabilities to em"loyees, Dosts to e#it and liBuidate,
5+. ?%
E0I2;1et WD and Fi#ed Assets?came out with returns of (5>.
:ow valuation is not valid to re4ect based on low JPA.
5+. 10%
( year average for E0I2 for normaliHed. 0e careful using a "ast average. 5o not use trailing three years.
Many folks using trailing. Rse your head when you "ro4ect out into the three years.
5+. 11%
2ech com"any 2 # sales $+ # E0I2 above below market multi"les. Even if sales donMt grow then if it trades at
these multi"les then I will make 2 # my money. At least use 5DF to check or 4ustify relative value.
Jelative 7alue8 Rses 5DF8 "ay for this "rice growth.
5onMt use stu"id nose bleed valuation as com"arables. Dome to a 4ustification with 5DF analysis. :ook at
debt.
5+. 12%
Dom"any has *' in cash and *$$ in receivables and stock is trading at *$5 but the student left out *$5 in debt
"er share.
5+. 1F%
2elecom8 Pther com"any&s trade at *2C++;subscriber and this com"any here "ays *2+++;subsriber therefore
it is chea"er. 6eo"le do this with hos"ital beds. 6C> is a realit chec". 2his is good to know the metrics.
In a normaliHed environment will this earn *2.++ "er share, 5o my assum"tions make sense, !ow secure I
am in making my assum"tions. What are my other alternatives,
2C5
5+. 1N%
Jetailer ? 5e"t. 5) is chea".
Sales down $+> Inventories u" 5+> Buarter over Buarter. Gthey o"ened new stores so they had to hold more
inventoryI. Is this something bad, =uest.
:ook at some things first.
$. 0ig inventory business, Inventory turns )+#, not a big deal. :ook behind the figures.
2. P"en retail stores needed to hold more inventory. Wholesalers had sale channel down 22> and
overall sales down $$>
Is there a good reason a good e#"lanation for the numbers changing.
5+. 15%
Wholesale channels down 22> and overall sales down $$>. 1ot a good result.
5+. 1M%
Market Da".;E0I2 Jatio8 WJP1G/ A""les to oranges com"arison. E0I2 has debt Gbefore "aying for debtI
and Mkt Da" is net of debt.
5+. 17%
Pwens Illinois. AAJ holds 25> so it is a risk. It may be a "ositive. AAJ ma#imiHe value thus they could
be a catalyst.
0est "erforming com"any in the industry on a E0I2;E7 basis. E0I2 is what you "aid for the assets etc. 1ot
what is in the business. E7 is what you "aid not what is in the business.
5+. 1K%
0ook 7alue is *$$.5+ "aid for the com"any but this doesnMt include *(.5+ in Asbestos and environmental
reserves. If they are reserves the reserves are included in the *$$.5+.
5+. 1?%
5over 5owns has race track slots. In C years you will have to s"end a huge amount of DA6EL. *$+ to *$2
for maint. Da"e#. ).5 million a year in additional DA6EL. Pr ) # E0I2. .ou are thrown off by *'+ million.
.our cash flow will look higher than it really is.
5+. 20%
E7;E0I2 vs. industry average but no break?out.
1et Income;E7. AGAI1 A""les to oranges. E7 is after debt service and 1I includes debt.
E0I2
N5SA
?2ALES
?Increase in Working Da"ital
?Da"e#.
```````````````````````
Free Dash Flow.
2C)
If you have to constantly increase working ca"ital. 0ecause you are sticking multi"les on these numbers you
need a one time increase in WD and it doesnMt ha""en every year you will have a very skewed number. :ook
as they grow how much additional working ca"ital will they need,
I)1<78@;8
:ook at o"tions for management and the com"ensation "lan for mgt. Dom"are o"tion "lan to salary.
A manager who has *$ million salary vs. $+++++ o"tions at *5.++ then his bread is buttered through his
salary.
3oo" at how mana!ement is compensated. @li!ned with shareholdersC
Greenblatt "ut in a hostile motion to force management to earn more shares.
When you do "ro4ections and it is a cash earnings com"any. So what will the com"any do with the cash,
AnalyHe how they will s"end the cash8
AcBuisitions
5ividends
Stock 0uy?0acks
Account for that cash generated into the future. Include cash generation and action in your assum"tions.
Ad4ust your share count due to buy backs.
5+. 21
A student suggested to Short a com"any because it was trading at a 2C 6;E but was earning $$> JPE. 0ut that
$$> JPE included intangibles and if you included the cash "er share the returns went u" to 25> JPE on
tangible eBuity.
??????????
2hen he handed back studentMs "a"ers.
?????????????
$+A WiHard *$5+ "er year. *$5+ more8 lay out many years of data.
5o word searches such as Vover?subscri"tion "rivileges.
6ower Investor.com
AAII.com ? screening "ackages
Jead e#tensively to find ideas.
5;6
Greenblatt Class #?
1ovember +5 2++(
Always do a thorough 4ob on valuation.
In a break?u" analysis be aware of ta#es if the break u" is not ta# free.
2C<
S2R5E12 6JESE12A2IP1S
?6L! 6iscussion
1autilus?0owfle# was once hot. A direct sales com"any. 0owfle# has (+> "reta# DF yield. In =( sales dried
u". Sales were inflated due to the nesting instinct. Dom"etitors are selling at Q the "rice at *5++.
(2 million PS and *2.++ "er share in cash. Durrent "rice is *$).++. A short with current margins and sales
declining. Dosts are sticky. :ook at E"inions.com. 1autilus will go after the cardio market which is greater
than the weight market. $ million shares in o"tions.
DF8 5SP '5 5ils <).') 56P )<.5)
1ordic 2rack had fast cumulative sales that saturated the market Buickly then there is no where else to go.
Sales are like a bell curve. A very Buick deceleration of sales.
Dybe# has (> margin while .T0S has margins tri"le that. E#"ect margin erosion.
BC& U S"in off of Triad Bospitals.
Industry has significant regulatory costs.
5iscretionary s"ending from "atients.
Dhange cost "lus "ricing to fi#ed costs for Medicare reimbursement.
Facilities and "hysicians sent "atients to su""liers.
6rivate insurers are the gateway.
0ad economics8 bad debt and elective "rocess.
!istorical low for industry ).5. 2otal ca"e#
2ake out the $ time hit for fines so really at $2 6;E not $< to 2+. *25 billion E7 Jevs at 2$ bil. E0I2 is 2.C
billion. E0I2 to tangible is $5>. K# E7;E0I2. 0ad debts and A;J is u". Good mgt.
:egal Gnon?recurring e#"ensesI e#"enses. Ad4ust E0I2 and legal. 1I N I N 2a# N min. interest.
Ad4usted E0I2;2angible Assets O $2> is a truer reflection
$2# E7;E0I2 but $+# now $5 #s at "eak. *5+ share E7. FDF U re"ay debt and shares
'.5> growth8 $Q> from demogra"hics and (> cost;"rice increases.
*2.C E0I2 U o"erating income minus Interest. :egal settlement and ad4ust E0I2 legal.
Jisks and Datalysts8
Increase in co?"ay
Jegulation
:imited e#"enses
Increase in fraud
Datalyst8 fraud is behind us. !ealtBC&re South
6ro4ect 2++< of *'.C+ in E0I2 historical $2 # O *5C or $$.)> annual return.
*';share is a steady grower. $5> for "rofit. 1on?"rofit. 1on?"rofit is less efficient and C5> of the market.
So Medicare has to su""ort.
2CC
$) multi"le vs. $+> bond yield. *)'.++ com"ounded is ).)<> G$;$) 6;E multi"leI com"ounded over 5 years.
*(.5+ to *'.5+ in E6S.
S"ortsman 7ID
If these sim"le metrics hit you over the head then I have done my 4ob. Sm?ca" stock.
0uy on what info you can get. 0uy an office building.
*2+++++ "ut in eBuity *C+++++ in mortgage *$2++++ in DF Mortgage is C> cost
$2++++;G2+++++ N C+++++I $2;$++ O $2> return on assets
C> of annual mortgage costs # *C+++++ mortgage O *)'+++. 2hen *$2++++ cash flow minus *)'+++ O
*5)+++ left for eBuity holders. *5)+++;*2+++++ in eBuity O 2C> JPE. $2> return on assets. Jeturn on
eBuity is 2C>
I need to know both to value.
*5);*2++ or 2C> O return on stock. Es"ecially if yield locked in.
Jeturn on e#". Da"e# 1ormaliHe E0I2 E7;E0I2
0ig analyst interviewed by Greenblatt. 2he analyst was "ushing a stock that was at $'#E6S and 22> growth
so the analyst sla"s on a 2+ multi"le. When does the "atent run off,
A thorough more in de"th 4ob on your "a"ers.
A1A:.SIS8 5DF analysis is 4ust a checking analysis. Dom"arables. 0reak?u" analysis. 1ormaliHed E0I2
I will hand out four e#cellent situations that worked out well for the 7ID.
Student 1resentation 1
.autilus; .T0S$ E7 of *'(+ million. (+> of float is short. A direct marketing com"any that includes health
and fitness com"anies. 0owfle#.
0owfle# has a (+> FDF yield. A very "rofitable business. A big sales boom on the back of 0owfle#.
2heir business crashed. .r. Pver .r. Growth dro""ed (+>. Sales boosted by K;$$?the nesting instinct.
*5++ "er unit dro" would cause the math to change on "rofit margins.
Sales for these "roducts ty"ically flame out Buickly due to the small market for the "roduct. Pnce you hit
saturation in the market there is no where else to go.
What "ro4ections are needed to 4ustify the market "rice,
2he direct business has a 5+> gross margin
Indirect business has a (+> gross margin
Sales and marketing e#"enses
$5> growth of the branded "roducts such as Stairmaster' bow leC' schwinn.
CybeC has been down '> but .T0S says they can grow at $5>.
Sto" loss of all sales des"ite com"etition at $;2 the "rice. Assum"tions are too aggressive by mgt. We do not
think it likely that .T0S will not lose sales and maintain gross margins com"eting against com"etition with
"roducts "riced $;2 as low.
2CK
(2 million PS.
Pn Cross4bow they have maintained margins but lost sales.
1ew "roduct introductions do not seem to be successful. Mgt. is saying they will kee" the GM. We know the
cardio market is bigger than the fitness market.
Mgt. has been shady. After "re?announcing bad news the mkt. went from *$5 to *C and then mgt. issued
themselves o"tions.
Sales going down 25> "er year. Either they lower "rice or kee" margins and lose sales margins.
Pur "rice target is *5.++ "er share. Rsing $2> cost of ca"ital.
2hey have been acBuiring businesses with $;2 the gross margins. 2hey brought in a new management.
Rse an o"tion to short. $$> margin in the indirect business so they might be able to sell.
Dybe# o"erating margins are (.5> so if they turn themselves into commercial;retail business it will be much
less attractive business.
Jisk to *5+ if they turned sales around.
Who will win this game of attrition,
????????????????
Student 1resentation 2
BC& 6resentation by students
A com"licated value chain in the industry. 2he govt. insurers "rovide "ayment to the healtBC&re "rovider
who is referring the "atient to the facility.
2here has been a shift in "ricing from cost "lus to fi#ed "ricing.
2he industry as a whole is attractive. Mgt. has been value creators and not destroyers.
WE0 "urchased some stock at *(<.
Mid ? )s E7;E0I25A for the industry.
2ake out the $ time hit for "enalties for BC& so then it is really trading at $2 times. *25 billion market ca".
Jolling trailing $2 month data. E0I2 has not been Buite as steady at 2.K bil.
K E7 to E0I2 multi"le. $( # when you take out all ca"e#, All multi"les have declined. What is going on
underneath the com"any to e#"lain this, 5ebt hasnMt changed. Why the missed their earnings because of their
bad debt??donMt think this is a significant issue for the com"any. It has not started to sky?rocket.
We do an ad4usted E0I2 to account for the $ time legal settlements and "ayments.
Good free cash flow. $2 times multi"le averaged $5 6;E multi"le
*(<.5 mkt value "er share value and *$<.5+ in debt ? *5.++ in cash for E7 of *5+ "er share.
All FDF to "ay down debt and buy back shares. Rse all that FDF or *' "er share each year for ' years is *('
"er share in E7 by 2++<. 5uring this time the base business has grown by '.5> which is made u" of $.5>
demogra"hic growth and (> of "rice growth??below the average that "eo"le are e#"ecting for the industry.
5++ mil. PS. *2.C million re"orted E0I28 1I N 2a#es N Int. e#cluding ca"e#.
2K+
P"erating income which is *2.C then you have minority allocations Gbig neg. numberI asset losses and legal
settlements. We take all those numbers e#ce"t for legal settlements and calling that our ad4usted number??it is
about *2 billion.
We did our FDF to E7 for a C> and increasing to year ' to $'>. What are the risk to C> and the risks to get
to $'>. 0ig risk is "ricing "ressure from govt. and increasing costs from regulations. 2here could be
additional fraud.
Datalysts8 the fraud is behind us and the industry will return to normal earnings. 2he industry fraud should
eventually clear.
7aluation Summary
Pur Ad4usted E0I2 is *'.C+ in year ' and using a historical $2 6;E beings us to a *5C "er share and it is also an
E7 since all debt is "aid down.
Durrent share "rice of *(<.5+ and E7 of *5+ so the annual return is $$>. It is an attractive risk ad4usted return
but it is not a clearly a 5+ cent dollar.
??????
In three years they will earn *' "er share. An industry could grow. 2he hos"ital business has C5> non?"rofit
business while BC& is in the $5> that is for?"rofit hos"itals. Medicare canMt cut out for?"rofit without hurting
the non?"rofit hos"itals.
Greenblatt8 2he way I would look at this in the big "icture8 if they do earn *' in three years you "ut a $)
multi"le??using )> $+ year bond yield??and IMm say a ).)< "ercent return that is growing. Would I rather have
this ).)<> growing vs. )> GBC& has best "ro"erties and mgt. businessI?so you get *)' "er share. .ou could
get this in ( years. IMm looking long?term. 2he govt. canMt run these guys out of business. :2 you have to have
the non?"rofit hos"itals in business therefore the for "rofits hos"itals which are more efficient must survive.
*(.5+ to *'.5+ range in earnings. 2he downside is not big at these "rices.
S"ecial Situation Write?u"s from the /alue Investors Club H/IC$
*5) "er share value and you have a *$+ share "rice. What is a reasonable multi"le with conservative
numbers??he came out with *5).++. !e looked at a "lace that was very inefficient. !is analysis was very
sim"le??the key is that the numbers are there.
1ov. $2
th
"ublished and the write?u" came out on 1ov 2<
th
. .ou could have bought this coming out of
bankru"tcy. 2hey donMt have to "ut out much ca"?e#. 2hey already have their network built out.
2his got one of the highest ratings.
Pverhanging stock, I couldnMt care less. I focus on valuation work.
2his stock ran from *2 to *K.<+ GS"ortsman StoresI before recommendation??so the writer received criticism.
2his is su"er chea". 6art of it is that this is a small ca" com"any so not many "eo"le are looking at it.
If I have to hit you over the head??you have a 2+> "reta# yield a scenario where it could do much better??the
shift to the Internet. It was very chea". .ou have a big margin of safety. Management gave the numbers.
.ou may know some things or you may not but you donMt have to buy all the stocks. Walk away if unsure.
5valuation o# 7<C and 7<5
*'+++++ in a building.
$2++++ cash flow and mortgage is C> "er year.
$2> unlevered return.
2K$
JPE8 take the *2+++++ of eBuity ? GC> of *C+++++I O *2+++++ ? *)'+++ O *5)+++ then *5) left for eBuity
holders;*2++ eBuity base O 2C> JPE
Should I look at both??yes. Asset yield and eBuity yield. Jeturn on stock in the JPE. $2>??if cost of funds
goes u". !ow you can leverage your return if the yield is locked in.
Are you looking at all the right factors, I wish I could "ay a lower "rice but I am willing to "ay a higher "rice
for a great business like the %u and Phelps e#am"le.
.ou have to s"end some time understanding the business. 2here is work involved in figuring out if it is worth
*'.++??normaliHed E0I2. 2he more confidence I have in the business the more likely I am to invest.
I "ass on those situations where the "rice is too high or my confidence level is too low.
I like the sim"licity of the thought??the research idea on 7ID.
BCI coming out of bankru"tcy. 2he hard "art is finding out what the numbers are. 2he hard "art is the
digging.
!ome manufacturer?17J
!uge returns of ca"ital G25> "re?ta#I. =uestion8 how close are these numbers to normaliHed earnings, 2he
business model is relatively low risk. 2here is not much ca"e# or ca"ital at risk.
2hey are buying back their stock at very reasonable "rices. Where is the o"tion "rice??I donMt mind as long as
they Gmgt.I arenMt stealing. 2hese guys have been good she"herds of investor&s ca"ital. 2his was *$'( when it
was written u" and it is now above *5++ "er share.
It really is the big ideas the numbers look great then try to understand the business??what are normaliHed
earnings and will this get better or worse.
Even if there are only C million shares at *$5+ "er share. 0arriers to entry8 not having the connections and
resources. 2here is scale to this business.
Greenblatt8 my worries about the business and the stock are different at higher "rices for the stock. I would be
worried but not at this valuation. I will worry at )+> to <+> higher
$. Is this an oil com"any with limited wells??the life is (+ years. 5o they have a "lan to re"lenish the
wells. A building "lan
2. 2he valuation and risk that you are taking are very low at these "rices. !ere they have a great model.
At a conservative case what are normaliHed earnings, Forget about recession ty"e earnings. If a normaliHed
environment they will make very good returns to ca"ital es"ecially to the "rice I am "aying today. A good
business with reasonable barriers.
I am still buying it at ) # E0I2.
?????????????????????
S"ecial Guest. DEP with 6i"e GGreenblatt "retending to be a DEP being interviewed by the class on how to
restructure or fi# his com"any??a declining a""arel com"any with a manufacturing business and a licensing
businessI.
Solution8 shut down the manufacturing business and 4ust use the licensing business. Always se"arate out the
two businesses in your analysis.
?????????
An investment analyst that I interviewed so I asked the standard Buestions such as what returns they get on
ca"e# and all the usual ty"es of Buestions.
2K2
2his com"any will ratchet u" sales they have huge margins and everything else. At $'# earnings and it will
grow at 22> "er year for the ne#t few years. I have been in the business for $+ years and those things get like
a 2+ multi"le.
So I asked a sim"le Buestion8 when will the patent run(o##C !ow can you "ut a 2+ multi"le on a stock that
will grow at 22 "ercent for ( years and then it will fall off a cliff. .PR DA1V2 5P 2!A2. I got a <+ "age
write?u" on this com"any. SP W!A2/ Aee" it sim"le stu"id GAISSI.
5id you do a 5DF analysis for three years for what they will earn before the drug goes off "atent then what
ty"e of "ros"ects do they have in the "i"eline, Well they donMt have anything great in the "i"eline. 2hen "ut
some low value on what they have in the "i"eline. 0e very conservative since you are saying that they donMt
have much in the "i"eline or many drugs far along in the F5A a""roval "rocess. 2his is an analyst who makes
*$ million a year and is a "artner in his firm. I am trying to get very sim"le facts.
Anow all the Buestions should you ask. 2hese sim"le metrics matter. .ou may not be able to8
Figure out normaliHed E0I2
1ormaliHed returns to ca"ital
What ty"es of returns to the industry and what ty"es of barrier are there,
2hen "ass on the idea.
2hese were stocks that had huge margins of safety and the facts checked out. 2hey were chea".
.ou had com"etitors who had less of a franchise than the e#am"le. So "ut a low multi"le on it. .ou do your
5DF and com"arable analysis. A"art from 5DF analysis??do a reality check with low assum"tions such as low
growth rate and high ca"ital costsI. 2est out your thinking that your numbers are in line.
!ey I am getting a ).))> earnings stream with BC&. !ow do I feel about that??many of my choices are
Bualitative assessments. Is it a good business can it grow with low risk??many Bualitative assessment.
2he holding "eriod for most of these stocks is two to three years. 0uy $ or 2 stocks every ( to 5 months
E?$
Greenblatt Dlass [$+
1ovember $2 2++(
Joel Greenblatt8 I will s"eak about o"tions this afternoon.
If ca"e# is greater than depreciation and amortiHation then this is growth ca"e#.
1e#t week a review session for the final and I will tell you what is on the final GA1FI.
Med#o 1resentation b Students.
0reak?out maintenance ca"e# from growth ca"e#. Is the Dom"any earning adeBuate returns on each additional
*$ invested, Dom"anies o"en first in the best locations then move into secondary locations in the retail
industry for e#am"le. JPID.
Medco8
# E0I2;2angible Assets
# P6EJA2I1G FDF;E7
# E7;E0I2
# E7;E0I25A
2K(
With E0I2 the amortiHation is deducted from E0I2 so in this case Ga com"any making many acBuisitionsI
E0I25A is a better metric.
2he students estimated a *'5 "rice target for +edco4??(+> above +edco=s current "rice. *2< is the downside
case.
Jisks8 !MP&s will take this in?house. *$5+ million ca"e#;yr. $2 6;E multi"le. E7 *$+.5 0il.;*C5+ mil. E0I2
or $2# E7,E0I2. :ook at the risks. What are the risks,
E7;E0I25A U DA6EL Dash return on what you are laying out. <> FDF FDF;E7. Growth
assum"tion is C.5>
=uestion8 !ow much to weight your trade or how wide your margin of safety,
)5 cents to *$ in a year with catalyst. :evel for certainty. 2ime horiHon.
Jisks8 Dom"etitive. 0ig customers. Dash "ick u" of *+.(+ "er share from AmortiHation charge. .ou don&t
have to amortiHe Goodwill anymore. Dash earnings greater than re"orted earnings. Add back amortiHation.
E7;E0I25A a better measure than E7;E0I2 Gsince 5SA e#"ensedI.
E7;E0I25A U maint. Da"e# to arrive at "re?ta# owner earnings.
:ook at how mgt is com"ensated. Are they aligned with shareholders,
Mgt. Stock o"tions.
Mgt. Incentives.
????????????
Albertson E1?.75 L @2S second Student 1resentation. *$$?*$( "er share valuation.
&lbertson=s is in a "oor market condition. It doesnMt dominate its market. A very ca"ital intensive business
with economies of scale. 1o. ' in market share.
1ot growing the business but remodeling key stores. 2hey own '$> of their real estate??it doesnMt seem to be
worth that much. 2hey have a restructuring "rogram. 1o FDF. A change in their ca"e# s"ending.
Earnings Buality is "oor. *() million u"wards by 2> and im"roved returns from restructuring. Earning "ower
of *$.5 billion. 1ormaliHed Da"e#, Are they overs"ending ca"e# now, ?%oel Greenblatt Buestion. 2heir
earnings are overstated??less than the cash earnings number. If you "ut a multi"le on that earnings "ower that
increases your error if you are wrong. 0e sure to ad4ust for VnormaliHed ca"e#V
Je"lacement value. 2angible eBuity and took out o"erating leases and added back brand value. 2angible
book and added the cost of ca"ital. A range of brand value??a "ortion of the Greenwald book. I G%oel
Greenblatt find evaluating brand value is difficult to doI. Even if they have a great deal on real estate??
undervalued on the books their rents may be subsidiHed due to an under?market rent. find it very difficult to
do. .ou canMt double count. Aes, real estate is undervalued on the boo"s, but the earnin!s are overstated
due to under mar"et rents. 6on&t double count in our valuation.
1egative FDF. Even if generous margins and (> growth you get negative DF. !ow much left do they have
for dividends??add back dividends. *'++ billion in sales limited DF Wal?Mart about to come in. 2his is ugly.
All numbers are deteriorating.
2hey are somewhat chea"er to their com"s. 0reak?u" valuation.
%oel Greenblatt8 If I was an Investment banker for these guys. Is it worth more broken u", Some businesses
are worth more in some markets. 2hey are "rofitable in some markets and less in others. 2hey might be a
more "rofitable enter"rise by being smaller and broken u". 6erha"s they have a big amount of value in their
real estate.
:abor cost is a big issue. Dom"etitive landsca"e8 1ot 1o. $ in local markets e#ce"t in a few local areas.
2K'
Dom"etes against Wal?Mart and Dlub Warehouses.
2rading with 6eers U no catalyst for short. 0ut their business is weak.
).2> JPID??).2> stinks. 2hey own their own real estate.
*(+ billion in revenue. $+ basis "oints means a big change. :abor costs are key. 2heir labor is union. :ocal
market share is key. 0ut they are only $ to 2 in only ) of their $5 markets.
6ost ta# JPID $KCC U 2++' is going down. 5eclining returns on assets eBuity and ca"ital.
5/5;8D@33A 8,5 )@7-58 G58S I8 7IG,8.
1eg. FDF less than +. Mgt. has been selling. Stake in Dom"any vs. their salaries for mgt. is im"ortant to focus
on for com"ensation.
P"erating leases may need to be ca"italiHed for com"arison "ur"oses. :iBuidating inventory so net income
artificially boosted. 1o "ension "lan listed?under funded. 1o e#"ensing of o"tions in the income statement.
1et income artificially high. 5SA is *K'C mil. 1o o"ening stores. Pvers"ending on ca"e#, Rndercounting
5SA,
2heir earnings should deduct more for 5SA.
Multi"le on Earnings 6ower. Figure out normal ca"e# is key. $.5# ca"e# greater than 5SA.
0alance sheet re"lacement value. 0rand value U tangible book # cost of ca"ital9intangible value. 1et asset
value is *'.<+. 6er share value is *$2.++.
Rnderstand J;E. :ow rent GsubsidiHed storesI??shows more "rofit9don&t double count.
E0I25A8 Earnings from P"erations before8
? Interest
? 2a#es
? Increase in WD
? 5ividends
? Da"e#
:ower com"s8
A0S E7;E0I28 C 6;E com"arables.
:ousy market conditions worth less. :ook at com"any in "ieces. Some market "rofit others have "oor "rofit.
0reak it out/.
So shift in ca"e#. Jemodeling vs. o"ening new stores. 5ivest Jeal Estate.
:ook at "arts. If there is a huge sales and low margin com"any it could be worth more at Q siHe.
:ook at management com"ensation for s"in?offs and all investments.
?????????????????????????????????
Second Student 6resentation
```````
Sprin!house Capital 1resentation((2rian
!e focuses on small ca" s"in?offs. S3B% which is in the s"ace of >ahoo su"er "ages J0PDs.
Dash screen came u" with this one. ,P?, sence.com8 ,P?,. It owns 52> of switchboard K.C million shares
,P?, has cash se"arate from S3B%.
2K5
2++$;2++2. Dash "lay screen for solid business. Is the Internet for real,
1et cash. *5+ mil cash??below cash. 2his com"any was at a discount to cash because of fears that the
com"anies would burn through their cash.
$ ,P?, share owned +.'2 S3B% so Q share. ,P?, was a back door to S3B%. Dash and Engin. 0usiness.
EIAI.com
S3B% $C MM shares??*5< mm mkt ca". 1et cash of *2.C+ "er share. $2;2$;+$ It had an *C) mm 1ols.
,P?, had big GM of <5>. Slash and burn costs. *5C million loss9losing more than revenues.
E0I25A U ca"e# eBuals ?*'.( MM.
,P?, burning cash. 2he service business sucks. Switchboard.
!e let the com"any "ass for two more Buarters. Pn Aug. +2 the cash situation had stabiliHed.
:onger than e#"ected transition. AP: sells directly so time is needed.
If revs gone for good then stock will decline. 1o change in cash so deterioration stabiliHed. !e focuses on
cash.
Jevs 2++$ is *2.< million.
2hen S0W5 delisted ????S0W5E *2.5+ ? *2.<5 with *( in cash so you had a free o"tion on the business. 2
million shares at *$.'+ from *2.5+ due to delisting. !uge trading volumes. Why, Who is in the stock,
!arvard MFS and !arborvest. 5FS GInde# FundI U selling to get rid of the stock due to delisting.
,P?, had *'< MM in cash N *$5 for S3B% O *)2 MM 6er share value of *2.C+
While "rice of ,P?, is *$.2+. R"side to value is $((.<>
Pverloaded Sales staff cut but sales were u". 2he stock went from *$.'+ to *'.++. 2he core business is
better. Donsulting has negative value due to labor liabilities. *<+ MM E7 over *'.' MM E0I2. $5> grow and
grow GM no ca"e# com"etition alliance with "ortal acBuisition candidate level of revenue for other "layers.
$<> of market who cares, Grow 2# as fast. Dontract runs out in a year. A big "lus?sell to local "a"ers. 7alue
in traffic advertising. Pther "eo"le are selling services.
!e bought during the delisting since there were uneconomic sellers G5FS?inde# funds who needed to e#it
S0W5I. 6eo"le dum" for no economic reason. An o""ortunity
Im"ute cash burn. 5educt from cash. !e works in the micro?ca" world.
<ptions
@ hu!e advanta!e i# ou have a stron! opinion on a stoc". Create our own ris"4reward trade(o## or
levera!ed situation.
$. 0uying Intrinsic 7alue *(.)+ and 5 months in the life of the o"tion. *(.)+ minus ) cents dividend O *(.5'
"aid for the call.
*'.(+ minus *(.5' O *+.<) "remium above intrinsic value.
0uying time value and right not to lose.
*+.<) ? *+.)+ O *+.$)
1ot loss of time value 7alue of 6ut
2K)
*$) cents ; *$5 stock "rice O $.$> cost of *.
Make * on o"inion. %oel Greenblatt uses o"tions further out in time??$ or 2 years. *2<;*$C O '5>
*).25 for %an +) calls. Stock at *2<.++. *$5 call so o"tion would be worth *$2
*$5 N *).25 O *2$.25 ? *2< O *5.<5 different risk;reward. 6ut out *).25 to gain *5.<5.
%an. +) *$2.5+ call buy
*$<.5+ call sell *2+ ??????????*$2.5+ O *<.5+ ? *2.5+ O *5.++ greater *$<.5+.
today *C *$2.5+ call for *'.C+ *$5 for *2.5+
6ay *C.++ get *'.C+ so "ay net *(.2+ for s"read. If *$5.<+ or better get money back if stock *$2.5+.
*5.++ get so "rofit of *$.C+ so 55> return.
*(5 "rice target. 1ow *$< for F: so over *$++>. Dreate a situation to earn 5+>. 6ay s"read U do it at *(.2+
Jisk arb. If you know "rice and time then you have an edge.
0uy *C<. 0uy C+ "ut. After tender *)C "ay *$ for C+ "ut. 2hen *(K.K5. *C++ million dis"arity in value.
*'.++ in ( years and Buality
$)# O *)' in ( years.
(+ calls X *5C O *2C. 6ay *$(.$+ O $$(>. *2).25 less. *(.<5 for interest $'> or ).25> "aid.
:end me X*).25. 1on recourse lending.
:end me *2) for *).25> interest by buying this call.
(+ Dall allows one to borrow money on a non recourse basis. 6ay *) to make *$+. ) # .) O )+> return.
P"tions to change risk reward. Focus on great risk;reward situation.
Greenblatt Class #11
1ovember $K 2++(
2oday8 ?obert Goldstein my "artner will discuss an investment in +oodys and why we were willing to "ay
the highest multi"le ever for a com"any??2$ 6E for +oodys. Job gets to the "oint Buickly.
2K<
;ote% CapitaliGation vs. 5+penses% CapitaliGed leases vs. ownin! stores((7etail Industr.
:ease vs. "urchase.
Donsider two firms in the same line of business. Pne buys the reBuired assets and the other leases GrentsI the same assets. Pnly
the former has made a ca"ital investment and from the creditor "ers"ective owns the assets. 2he other firm only owns the lease
rights.
In economic terms however the firms are using the same mi# of ca"ital and labor. In this sense the firms are identical and
measurement of their return on assets and the efficiency of o"erations should be made on a com"arable basis regardless of the
differing form of ownershi". 2he ownershi" costs should be similar with total lease "ayments over the lease term a""ro#. the
acBuisition and financing costs. 2he form of ownershi" of an asset can greatly affect financial statement "resentation even
through o"erationally the firms are essentially identical.
Firms that ca"italiHe costs and de"reciate them over time will show VsmootherV "atterns of re"orted income. Firms that e#"ense
costs as incurred will tend to have greater variance in re"orted income.
Firms that ca"italiHe always shows higher cash from o"erations3 the difference increases and does not reverse over the life of the
asset.
2he ratio of cash from o"erations;ca"ital e#"enditures measures the degree to which internally generated funds of the firm
finance the re"lacement of "roductive ca"acity and e#"ansion. FJEE DAS! F:PW the e#cess cash from o"erations would be
identical for both firms and would eBual the DFP for the e#"ensing firm assuming that de"reciation is also eBual to the cost of
re"lacing Vused u"V ca"acity that is eBual to ca"ital e#"enditures. G2his eBuality also assumes that as the firm is not growing no
investment in working ca"ital is reBuiredI.
1ote that non?cancelable leases constitute Goff?balance sheet debtI.
Secondly Joel Greenblatt will discuss 1ort#olio )ana!ement. !ow he thinks about it.
A lot of the good things we find are so good that we donMt need to use financial models to figure it out. 2he
value is clear. We find '+ to 5+ cent dollars. It is not that we are not thoughtful about our investments but it is
4ust that when they are good we donMt need fancy models to figure them out.
+oodys was com"ared to Co(e since it was "riced at 2$# forward earnings. Is +oodys as good a business as
Co(e. Buett could "ay a high "rice and still make a fortune doing so. Buett bought Co(e and then $2 years
later he made $+ times his original investment.
!e bought in $KC). .ou should "ay *5 and $+ years later the stock was *5C. What is that com"ound rate of
return??22>.
Buett "aid $'# for Co(e in $KC). $2 years later Buett made $+ # his money. !e "aid *5.22 in $KCC?in %une
2+++ it was *5C.
+oodys is a credit rating agency since customers must use their service and their market is growing very
ra"idly. 2here is little "ricing "ressure. $<> o"erating earnings growth for $K years. An incredible business
with no margin deterioration. +oodys and 5S0 were the two main com"etitors.
$ share of 5S0 eBuals *2<.<5 which would eBual $;2 share of 5S0 and $ share of +oodys. 2his creates8
5S0 s"inoff eBuals *< $;2 and 2+ $;' for +oodys. Earning K5 cents "er share "er year.
);(+;CC Dom"arison8 What Buett "aid for Co(e. What Greenblatt "aid for +oodys
*'.5 to *5.5
6rior (( cents $5# 2'#
.ear (K cents $(# 2$#
2he stock for Buett went from *5 to *5C and Co(e "aid out *'.<5 in dividends. )> ????*) dividend "ay?out.
*5C N *) O *)'. 2(.<> DGJ.
We thought +oodys is a great business but the "rice was high, 2hey com"ared it to Co(e.
0IG 6ID2RJE8 An Pligo"oly.
+oodys had '+> of the business
'+> to SS6
$+> for 5uff and 6hel"s.
And it doesnMt cost customers much as a "ro"ortion of the value for them to get a credit rating.
P"erating Income u" $2>. What focus here,
0uy back stock S "ayout dividends with cash. JPD for Co(e was )+>.
$2> o"erating earnings in $2 years for +oodys
$. !istorical financials?certain conclusion.
2. 2. Growth ? :ow double digit growth o"tion set to tell you any less.
Dom"etitive analysis.
__Always look at mgt. alignment in a s"inoff.
Co(e at $2> for $+ years. +oodys doesnMt need ca"ital to grow. GFI1SEJ7I/
:ook at JPD. 2hey could grow o"erating earnings at $2> annually. 2wo assum"tions they had been growing
at $C> management told us that growth rate would slow. We took them at their word.
2KC
Student8 5id you do any growth analysis for +oodys in its different markets, 2o us it didnMt matter as long as
they grew a lot.
+oodys doesnMt have to reinvest so how to evaluate.
Earn *$ no e#tra ca"ital. 25>. Co(e *$ invested eBuals 25cents. C+ cents to *$. 25> more.
JPD "ay $5> more for +oodys vs. what Buett "aid for Co(e. $5# forward earnings to "ay vs. 2$ # forward
earnings for what we "aid for +oodys. !ow 4ustified,
Buett "aid *< for Co(e and C # "lus dividends O *)'.
*5 $5#
*< 2+# :ower rate of return&s
5id I leave anything out of my analysis, Always ask the Buestion.
Joel Greenblatt8 Rsually shareholders are so ha""y that mgt. is doing a s"inoff to unlock value that they are
often lenient with mgt. on com"ensation.
+oody does not need to invest ca"ital in its business to grow. Why is that, 2hey 4ust need em"loyees with
minimal ca"ital eBui"ment. 2he strength of the business allows for that??ca"tive customers who "ay fees.
!ow to Buantify their e#cess ca"ital8 For every dollar they earn +oodys invests nothing G*+I to grow $2>.
.ou are getting a *$ from +oodys and only C+ cents from Co(e so you are earning 25> more from +oodys.
Co(e will have to reinvest C> to $+> of their earnings to grow.
5ifference in JPD we are willing to "ay C+> more than Buett would "ay for Co(e. $(# $.25 you get $5
times forward earnings but how can you 4ustify 2$ times forward earnings, We are willing to take a lower
return. If you "ay $5 times earnings then you "ay *5 or you "ay 2$ # earnings you "ay < dollars you take a
lower rate of return.
Interest rates were higher in $KCC than in 2+++. (+ year 0onds were at K> you "ay $$ # earnings.
In 2+++ the bonds were at )>??5+> less in interest rate cost than in $KCC. At )> of $) and change or almost
5+> more.
2o get a 2+> com"ounded annual return for C years then how much of a multi"le to "ay for +oodys,
$( # earnings but with a higher JPD it was worth 25> more then '+> more for the lower interest rates so we
could "ay 2$ # earnings. Earnings grow by $2> a year and the com"any uses all its earnings to re"urchase
stock. 2he com"any had no debt.
2hey could actually grow earnings about $<> a year. 2++( they have earnings of *$.'K and a 2$ 6E multi"le
you *(< "er share. (.(2> yield for a great business and growing revenue so we thought the business was
worth (+ times earnings for *$.<5 at the end of 2++' so a "rice over *5+. It was difficult to lose money at *2+
which was our initial "rice "aid for +oodys. We might be aggressive using high multi"les here but growth
had been higher and the downside was limited. Pur best conservative guess. Even if we screwed u" some of
the numbers we wouldnMt have lost much money. We took a shot.
In addition we knew Buett owned $5> of +oodys at the time and you could still do this analysis. 2his was
so obvious that this was a great business and you were "aying the same "rice as Buett.
A great e#ercise we com"ared to Co(e and we thought +oodys was better. 0y looking backwards at Co(e
+oodys was "ros"ectively a much better business. Dombined the stock was 2$ times combined but if the bad
business was sold then we were only "aying 2$ times.
2KK
/alue investin! is not 'ust buin! low 145 multiples. In value investin!, ou are buin! somethin! at a
discount to what ou thin" it is worth.
.ou had to make a 4udgment about 5S0 due to this s"ecial situation. 2he mgt was Buestionable. Some
investors were afraid that mgt. was going to flush the +oodys "rofits down the toilet.
%oel Greenblatt8 we sold it in the mid (+Ms and our cost was *$< and change. We should have ke"t it. Rsually
if you are looking for stuff you can find better stuff. .ou don&t feel it e#ce"t for the ta#es "aid. 2he easier
money was the first year we held it. Dom"are the investment to your other alternatives are at the time. We
were more comfortable in an alternative investment vs. being Buett?like and holding on.
;ow that I am older, patience would have been rewarded. I started out in the arbitrage business because
that was where the money was made. 1ow I look three years out. 0ut with +oodys the returns came very fast
in the first year. !ow fast do you turn over your money, What are your alternatives. 1et of ta#es we would
have been better off holding on but we were more comfortable moving on to other 5+ cent dollars.
2here might be a flaw in our analysis. 6art of Co(eMs "rice rise was due to a dro" in interest rates. Factoring
Interest rates??how does this effect +oody share "rice and our analysis,
2?0onds 8 u" in 7alue. '+> "remium for $5 #. so "ay 2$#?22#. 2ighten u" your e#"ectation. Earnings u"
$2>. All earnings to re"urchase stock.
Stock at 2+# then share buy backs with the e#cess ca"ital. So earnings growth would go from $2> to $<>
with declining share base. In 2++( *$.'K # 2$ O *(< "er share.
Jeal value (+ # earnings. Earnings yield (.((> for a great business. (+ # $.<5 O *5+.25
!ard to lose money at *2+ by owning a great business. 2here are not many o""ortunities like this. Buett
owned $5> of +oodys at one time. It was obviously a great business.
+oodys business is better than Co(e because it needs no ca"ital to grow.
:ook backwards at Co(e ? +oodys would do better going forward. 7alue investment ? not 4ust buying low.
6;E and book value.
0uy at discount to what you think its worth is??Intrinsic value. Investors when they looked at +oodys were
worried that Mgt. was Buestionable at +oodys,
0ot F: and it is now at *$< but we think it can be worth *(5. Dom"are alternatives.
2he older I get the more "atience is rewarded. My time horiHon has e#"anded. 2hat is life sell winners later.
!e focuses on a certain niche.
So much analysis is wasted time. 2he hard "art is the knowledge of where to look and the "atience to find the
right o""ortunity.
!ost;Marriott e#am"le8 the hotels were 4ust being finished?so earnings will start going u".
????????
1ort#olio )!t.
$. Doncentrate ? $?2+ "ositions. 2+ things ? which ones you like most. :ive and learn. Buett "aid
high multi"le for a Co(e so %oel learned to find o""ortunity in +oodys. :ook for the fat "itch wait
for what you are comfortable with. Put of 2+ situations you usually find $ or 2 that you are
comfortable with. Doncentrate on your best "ositions.
(++
2. 7olatility ? Washington 6ost. E7 was *$++ million and subseBuently it went to *5+ million in $K<(?
<' market. Any analyst at the time or "rivate buyer would "ay *'++ million for the 6ost. 0ut near
term uncertainty was bad.
6ick $?( stocks or $?< stocks or $?$+ a diversification "ortfolio of businesses. .ou would want to own ( ? $+
businesses. .ou would rather own ( to 5 good businesses in a town rather than 5+ businesses. ( ? C business
you would feel well?diversified. I would have an o"inion of what those cash flows are worth.
Stop analGin! stoc"s as data 0 statistics and start analGin! businesses. In 2 or ( years the market gets it
right??I guarantee it G%oel GreenblattI. 2he catch is your accurate analysis. .ou can combine you valuation
skills with "icking your s"ots. VI know this is worth between *2+ to *(+ but IMll "ay only *$2.
Move your time horiHon out 2?(?' years and think of stocks as businesses.
:ook for a catalyst. It can ha""en over the ne#t year or two. 2hey will have "ositive earnings growth or they
can fi# that division. 2here are other s"ecial o""ortunities beside 4ust s"in?offs. We own ) to C securities held
)?$C months.
Jisk O volatility is strange.
$++> stock "ortfolio would have $C> std. 5ev. 2hen $+ years it moves to '>. 2he efficient frontier is
worthless. If your horiHon is $+ years then why lower return to lower std. devs. It doesnMt make sense to lower
returns.
If you are good at "icking stocks then as time increases your returns go u" while your volatility goes down. If
you view these stocks as businesses then donMt be frightened by fluctuating businesses. 5oes it make sense
focus on statistical analysis vs. evaluating the Buality and ongoing condition of the business.
1ote8 in the Intelligent Investor by 0en Graham8 :ike it or not8 market "rices fluctuate but that does not
eBuate with risk.
.ou are taking a risk on your valuation work or future deterioration of that business. If you doubt that it is
worth a dollar and now it is worth 5+ cents then you sell.
:ast fall was a great time to be buying stocks. Stocks were being given away. Jight now there arenMt a great
amount of o""ortunities.
What would you say to a money manager now, 0e "atient. 0uy what you think is very chea" and;or sit on
your money. We are bottoms u" investors. If we can&t find things chea" enough we wait9"robably ' to )
months. 5on&t "ress. .ou will have "lenty to buy but usually in clum"s.
$ to ' years time horiHon out.
$. discount to value
2. some catalyst
(. *)+ to *<+ million s"inouts a year. 0ut I might only buy $ or 2. I own ) to C securities.
Jisk does 1P2 eBual volatility.
$C> Std. 5ev. 6er year. '> Std. 5ev in $+ years.
Why lower returns for less volatility,
Std. 5ev. $ year (?5 $+ yrs.
6Hena 2+.< 5.) '.5
(+$
Jussell $).K $+.$ ).$
If you are good at valuing stocks then your volatility will go down over time.
Act as if you own the business.
Jisk that valuation is wrong. Pr there is a large deterioration in business.
6atience.
Wait for ( to ) months for o""ortunities to arrive. 5onMt "ress when you canMt find o""ortunities . 2he
o""ortunities will come in clum"s.
2rying to "redict the market8 2he average o"inion of the average o"inion in trying to "redict the market.
6ointless/
In 2+++ %oel thought that the $5++ to 2+++ SS6 market too high. Internet boom to bust. 0ut tons of
o""ortunities ? good com"anies are steady growers at chea" "rices. '+ cent to 5+ cent dollars.
5own 5> in $KKK then u" $++> in 2+++.
Why do many "ortfolio managers fail, 5o it a little different.
Mistakes8
2hey lack a circle of com"etence3 too many stocks3 less focus
Inde#ing and momentum
Se#y businesses vs. unattractive
;< .<7-: In %oelMs mind the main issue.
Emotions8 More "ainful to lose than win.
2he less you know the worse your emotions. 2he more stocks you have the less knowledge for each holding.
Rnder"erformance;lose. :iBuidity. 0enefits to concentration8 it is easier to under"erform. A loserMs game of
5+ to $++ names.
2o really out?"erform8 focus.
Work to "ick s"ots. Investors not always rational.
6iversi#ication
2 stocks reduce risk by ')>
' <2>
C C$>
$) K(>
$+ stocks in a "ortfolio then risk reduced C5>.
*$+++ then $+> in each "osition??lose $;2 so now 5> loss of the "ortfolio. After ta# assuming other "rofits
then )+> # 5> O (> after?ta# loss.
So out of *$+++ you have a *(+ loss leaving *K<+ in your "ortfolio.
%oel Greenblatt has ) to K names in his "ortfolio. Some leveraged calls.
With a leveraged security his weighting would go down from $+> to 5>??5 to $ or +. !e would take a $;2
"osition limit.
If he really likes an idea then $+> to 2+> of "ortfolio. 2he "ortfolio is built from the bottom u".
(+2
!edge with market inde#.
!e made a big investment in a SS: with a com"licated ca"ital structure but a clear 5+ cents dollar.
WAI2 for o""ortunities. 2ake worse case situation. :arger "osition with higher "robability events.
3ells /argo8 *+ or *$5+?*2++. Pr *5+ investment goes to + or *$++. Rse Dalls to make a risk;reward bet of
*$5 for *$$+ "ayoff or +. 0etter risk reward.
Rsually he will not have more than (.5> bet in :ea"s.
Pro$ Greenblatt then hands out to each student??their 2+ hole "unch?card. If you could adhere to this you
would become rich.
5ecember ( is the final??2 weeks from today. 2his coming 2uesday at 2 6M will be a review class.
A Buestion on risk arbitrage. Jead financials do a com"arative analysis.
-e to outper#orm%
Concentrate and #ocus on our best ideas within our circle o# competence.
Focus on undervalued com"anies not the market. 0ack in 2+++ %oel was worried about the Internet bubble
and what would ha""en to the market when it burst yet he was finding '+ cent and 5+ cent dollars. What
should he have done, 0ought undervalued stock and ignore the market.
Find chea" com"anies relative to what they are worth.
.hat mista"es do Institutional Investors ma"eC
Stay within your circle of com"etence. If you own a lot of stocks it is very difficult to stay within your circle
of com"etence.
1o work9that is a big one. Many lack the time or inclination to do inde"endent "ro"er valuation.
6ersonal needs to remove money out of the market can mess u" your results.
6ick your s"ots and stay around those s"ots.
6eo"le hate losing money twice as much as when they make money. It is "ainful to lose.
I am guaranteeing you that the market will get it right if you hang in there long enough. 8he catch is our
valuation wor".
I# ou own too man stoc"s, ou will dissipate our e##orts and "nowled!e. 2he less your knowledge the
more emotional you will be. 2he further you get away from what the com"anies are worth the more emotional
you will be. Jisks of concentration you are more likely to under"erform.
:ack of liBuidity is a risk.
A loser&s game is owning too many stocks9take your out "erformance way down. FPDRS on the best ideas.
2he more at bats you have the less chance you have of being better than a '++ hitter.
Modern 6ortfolio 2heory GM62I will teach you how to do average. Investors do not "rocess information
correctly.
2ake the o""ortunities as they come. !e will take the worse case scenario such as lose Q to entire investments.
!e takes large "osition with high "robability events.
(+(
E?$
Greenblatt Class #12 H7eview$
;ovember 2N, 2002
Saddleroc" 1artners ? 5iane Greenblatt 2$2?($K?'$++ Stock8 Salton SDF
7anaud @'dler 212(F7N(1F51. 0elgium Dlassmate who audited GreenblattMs class.
0ankru"tcy Investing by 0en 0ranch;!ugh Jay suggested by :inda Dhen.
7eview Class ;ov. 2N, 200F
I ho"e you read my book .ou Dan 0e A Stock Market Genius and the !augen 0ook.
Make assum"tions and tell me why you make those assum"tions.
JPD is im"ortant. 0alance sheet interests that we s"oke about GInventories growing faster than salesI.
E0I2 to E0I25A. Rse E0I25A for com"arative analysis. For absolute analysis you have to deduct for
Da"e#.
Shorthand which is PA to use is E0I2 or E0I25A ? Maint. Da"e#. 2he difference is between E0I2 and
5SA.E0I2 and amortiHation. When there is a dis"arity between ca"e# and de"reciation you have to take that
into account. Was ca"e# for maint. or growth,
Was the Da"e# for maint. Pr maint. And growth, .ou use 6;E when you com"are unleveraged com"anies.
Jemember the first e#am"le in the class. When you have cash and no leverage then it is all the better to use
E7 rather than 6;Es. Figure out normaliHed E0I2.
We are using E7;E0I2 as a shorthand for what is the return for the ca"ital you have invested. Some times the
trailing is a good "ro#y and other times it isnMt.
E7 is the amount you "ay for the com"any. E0I2 is the "re?ta# earnings.
!ow good a business it is. JPA and JPE and Jeturn on tangible assets. Jeturn on Da"ital. WD N Fi#ed
Assets for tangible assets.
)> 2?0ond Jate. Dom"any has a return of $+> "reta#. I either have to borrow the money or have an
alternative use for the money. $+> "reta# return and growth for 2+> a year??that might be good.
Alternative investment8 risk and set Ir with a %unk 0ond.
Jetail8 cost of o"ening stores8 E0I2;1et Working Da"ital and Fi#ed Assets.
E0I2;1et WD N FA O *2+;*$++ O 2+>. 2he marginal return on each store will be at least 2+>. If it is $+> to
build the ne#t store then there are alternatives like %unk 0onds.
What will be my normaliHed returns,
0uy a "ile of assets then reinvest in assets. What are they earning on them,
5avid 0usterMs8 *' million each store around for a few years. *$C++++ E0I2 O '.5> "re?ta#. :ousy return.
2he investment is *' million which is the fi#ed assets and Working Da"ital for each store??that is a ca"ital
destroyer8 '.5> is less than reBuired return of $+>. 2here is risk involved.
I would like to see at least 2+> "re?ta# in a business. 0ut after ta# I am left with $2> return de"ending u"on
ta# shields having debt etc.
5ifferent retail chains have other returns.
(+'
E7 Gmkt. 7alue N debt ? net cashI is the market "rice you "aid. E0I2 is what you get on those assets.
E0I2 is the return on the business. E7;E0I2 at '.5> is a mi# of the two. 2he '.5> de"ends on the return on
assets A15 the "rice "aid.
A value trap8 A com"any looks chea" but it earns lousy returns on ca"ital.
I donM like the DA6M method because it is based on a number without logic. What I do8 I use the 2?0ond rate
at )>. Pr buy a business at $) # 6;E. I feel very secure about their franchise.
What are my other investment o""ortunities or ) months from now relative to my e#"erience.
If I could buy something at ' times E0I2 then it is not clear. 2hey have two businesses8 $ earns *) and the
other loses *'.++. If they shut the loser down then they can earn *'.
What multi"le it is trading at,
0reak?u" analysis. Footlo#5er took a little work. We s"oke with management. *$.++ trading at *$+ with no
leverage and they had a build?out. 1o growth so it might be "riced PA. Mgt. tried the Su"er store conce"t
but it failed. 2he sneaker mkt got overbuilt. A lot of stores closed down. 2oo much su""ly. I felt good about
the store base. 2hey had o"ened a ton of Su"erconce"ts and they were losing money. Each time a lease came
u" they closed the stores.
2hey were losing )+ cents after ta# on those stores. Each year they would earn 2+ cents "er share more each
year9overlooked by many analysts. So if they did nothing and stayed flat they could earn an additional )+
cents. :ess maint. Da"e# GMDLI and more DF. So from *$.++ to *$.)+. 1o leverage and do nothing they can
earn *$.)+ so a *$< to *2< stock at a $+;$$ 6;E to $) 6;E. 1ow I have a number over *2.++ so $) multi"le
could be *(2. All those things doable by the com"any without "redicting the future of sneaker sales.
I donMt have to look for hard ones. ;CA; What is normaliHed E0I2, In three years would be *' "er share.
What ty"e of multi"le that deserved. Given the nature of the business the demogra"hics and the "rotection of
medicare. 2hey go in cycles. 2ake a normaliHed number. I will do better on this *' growing at 5> ? )> so a
$) 6;E was reasonable so *)'.++ and the stock was at *() or more than double. I know institutions do not
have many alternatives for their money so the multi"le may even be low. Pr I could be wrong and the
multi"le should be $'. I could be wrong on the business and the multi"lier and still not lose money.
I do think of my cost of borrowing not my cost of eBuity. '.5> is a ca"ital destroyer. )> and growing is PA.
2his business will earn $+.5> and the borrowing cost is K> with half of that not fi#ed. .ou have a com"le#
business and you get a thin s"read. 1ot worth it. !is e#am"le when he ran that com"any.
What is this business going to earn, If I have to borrow to buy this business and the s"read is only $.5> then
"ass. It is that sim"le.
1o one who looks at it that way would take that bet.
<18I<;S%
Stock is at *'$ with a (5 call and a (5 "ut trading at *$.25 and cost of carry is )> and ' months to e#"iration
and no dividend. Where does the call trade,
*'$stock "rice ?(5D O *).++ intrinsic value "lus *$.25 6ut value N 2> G)> for ';$2 of yearI on *(5 O <+ cents
for a total of *) N *$.25 N *+.<+ O *<.K5
8he Intrinsic /alue, the 1rotection )one Hor ri!ht not to lose mone$ and the time value o# mone.
2he value of the call is the Jight not to "ut u" money and the right not to lose money and intrinsic value.
.ou can create interesting risk;rewards with this. 5onM think of this as volatility etc.
(+5
Sometimes you may have 0inary events where the stock could go to *2+ or *<+. :everage and time
constraints then go to use :ea"s G:2 P"tionsI??borrow money for long "eriods of time. 0uy Dall but you buy
the 6ut as well. 2he cost of money could be as low as what it costs Goldman Sachs to borrow money by
buying that call. Jeview his Dha"ter in his book. Even if you include the cost of this "ut "art of my
borrowing cost i;o "aying 2> you are "aying <> ? C>.
Dall8 Intrinsic value cost of "ut and cost of money.
:EA6S are like non?recourse loans.
!ow to assess management, :ook at the numbers. :isten to them to their game "lan. 5o they make sense,
If you canMt assess the situation then "ass on it. !ow does management "ut incremental to work. E#"ertise.
Money managers lose on disci"line. 1ote -oda" and their "lan to s"end money is very risky. Instead of
taking their cash cow and "aying back to shareholders. Milk the business before s"ending that *(5 "er share
and losing "art of it. My assessment is that their "lan is riskier. I have less of a sense of how well they will
com"ete in the digital world. .ou "ay your money and you take your chances. MgtMs "lan may be right I 4ust
wouldnMt bet on it.
I donMt know where sneaker trends are going??but that was not im"ortant for >ootloc"er. 2he market is not
changing overnight.
If you are going from 5+> returns on ca"ital to '+> that is good but if it is + that is bad. Rse common sense.
1ic" somethin! that ou can assess and come up with a valuation based on our e+pertise, then pa 142
that. 1eople bu lots o# thin!s and !et out o# their circle o# competence.
2he bottom line is that you guys are Dolumbia M0As and are all smart. Wall Street is smart. 0ut not many do
well. Small com"licated "ortfolio. .ou canMt measure risk by volatility. Special Situation Investin! is value
investin! with a catalst.
I didnMt give you com"licated formulas to beat Wall Street.
I am !ivin! ou a wa to loo" at the world.
A way you look at the world. Everyone reads the same things. !e focuses on S"ecial Situations which are
value investments with a catalyst. Success is not I= "oints or a '+ "age re"ort. It does or can take a lot of
work to get to normaliHed earnings.
)IS8@-5%
P4A +edia$ I bought it out of a s"in?off from a merger. 6?( media in 2+++ for *2.++ and raised an I6P at
*).++. It was running trade shows at Domde#. Mismanged. 2hey rent s"ace for *2;SB ft. and sell for *)2 "er
sB. ft. !uge *2 to *)2 s"read. A negative working ca"ital business. 6ay ahead of time e#"enses low. :ittle
ca"ital for the business. In 2+++ the had $ million sB. ft. 0ut o"erating leverage works both ways. As
business started to decline they lost money. Pther trade shows took "arts of the audience. SB. ft. were lost.
2he stock went from *2 to *$2. I decided to wait out the storm. I owned too much of an illiBuid stock and I
was not aggressive enough to get out when I was clearly wrong when the stock traded at *).++.
E#am on Wed. 5ec ( 2++( about 2 hours
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E?$
(+<

Complete Notes On Special Sit Class Joel Greenblatt

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Special Situation Investing Classes at Columbia University Business School

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