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CIGAR BUTTS
& MOATS
A"Phoenix"Capital"Research"Publica5on"

How To Make a
Fortune With
Value Investing

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How to Make a Fortune

With Value Investing

In This Report

Welcome Cigar Butts and Moats.

The purpose of this newsletter will be to help
you accumulate wealth through the careful
allocation of capital in high performing,
investments that well hold for months if not
years.

Our investment strategies will be heavy
influenced by the thinking of Benjamin
Graham and his legendary student, Warren
Buffett, with a focus on investments that are
either undervalued or which offer
tremendous compounding potential.

Before we get started, I want to lay out some
of the central principles of successful value
investing.

First and foremost, you need to know that few
if any investors actually beat the market in the
long-term. The reason for this is that most of
the investment strategies employed by
investors (professional or amateur) simply do
not make money in the long run.

I know this runs counter to the claims of the
entire financial services industry. But it is
factually correct.

In 2012, the S&P 500 roared up 16%
including dividends. During that period, less
than 40% of fund managers beat the market.
Most investors could have simply invested in
an index fund, paid less in fees, and done
better.

Two critical approaches to

value investing.
Benjamin Grahams Cigar
Butts or looking for just one
more puff.
Warren Buffets quest for
economic moats.
How to make a fortune in
long-term value investing.

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If you spread out performance over the last
two years (2011 and 2012) the results are
even worsen with only 10% of funds
beating the market.

If we stretch back even further, the results are
even more dismal. For the ten years ended 1Q
2013, a mere 0.4% of mutual funds have
beaten the market.

0.4%, as in less than half of one percent of
funds.

These are investment professionals, folks
whose jobs depend on producing gains, who
cannot beat the market for any significant
period.

The reason this fact is not better known is
because the mutual fund industry usually
closes its losing funds or merges them with
other, better performing funds.

As a result, the mutual fund industry in
general experiences a tremendous survivor
bias. But the cold hard fact what I told you
earlier: less than half of one percent of fund
managers outperform the market over a ten-
year period.

So how does one beat the market?

Cigar butts and moats.

Cigar butts was a term used by the father of
value investing, Benjamin Graham, to describe
investing in companies that trade at
significant discounts to their underlying
values. Graham likened these companies to

old, used cigar butts that had been discarded,

but which had just one more puff left in them.

Like discarded cigar butts, these investments
were essentially free: investors had
discarded them based on the perception that
they had no value.

However, many of these cigar butts do in fact
have on last puff in them. And for a shrewd
investor like Benjamin Graham, that last puff
was the profit potential obtained by acquiring
these companies at prices below their intrinsic
value (below the value of the companies
assets plus cash, minus its liabilities).

Graham used a lot of diversification, investing
in hundreds of cigar butts to produce
average annual gains of 20%, far outpacing
the S&P 500s 12.2% per year over the same
time period.

So when I say that you can amass a fortune by
investing in Cigar Butts, Im not being
facetious. For this reason, cigar butts, or
deeply undervalued companies, will be a focus
of this newsletter. And like Benjamin Graham,
well only be holding these companies in the
short-term: until they reach their intrinsic
value.

The other term, moats is in reference to the
investments Warren Buffett, a student of Ben
Graham and arguably the greatest living
investor, seeks out

Buffett amassed his enormous fortune
through a systematic investment philosophy
consisting of a few key ideas:

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1) Buy companies with moats around
them meaning that they have a
competitive advantage that stops
competitors from breaking into their
market share.

2) Stay within your circle of
competence: if something is outside
your knowledge or something you
dont really understand, avoid it no
matter how great it sounds.

(MCD).

For starters, MCD has a moat. MCD was
launched in 1940. Burger King was launched
in 1953. Wendys was launched in 1969.

Despite these competitors moving into its
space, MCD has thrived, growing to become
the largest hamburger based business in the
world: its 2012 revenues were $27 billion
compared to Burger Kings $1.9 billion and
Wendys $2.5 billion.

Today, MCD has over 34,000 restaurants
based in 199 countries employing 1.8 million
people. Obviously the company is able to
defend its market share from competitors.
Thats an economic moat.

MCDs core business, selling hamburgers and
sodas, is easily within most investors core
competencies. That is, its not hard to
understand the business of making and selling
burgers.

However, do not let the simplicity of the
concept (selling burgers) fool you. MCD is an
incredibly well run organization. The
McDonalds brothers who created the first
restaurants implemented an assembly line
approach to producing hamburgers and milk
shakes, systematizing the process until they
were producing a vastly superior product at a
faster pace than their competitors. The end
result was that they rapidly took market
share.

Ray Kroc who bought the business from the
McDonalds and built it into a global
powerhouse, took this approach even further.

3) Focus on companies that have

economic goodwill meaning they
have an intangible quality (such as a
brand) that permits them to raise
prices on their products without
driving consumers to a competitor.
4) Its better to buy a great business at a
fair price, rather than a fair business at
a great price.

5) If you can find a company that meets
these criteria, buy it and hold for the
long-term to allow it to compound as
much as possible (Buffett once said his
favorite holding period was forever).

Note the key differences between Benjamin
Grahams strategies (buy lots of undervalued
companies at cheap prices and hold them
until they meet their intrinsic value) and
Buffetts (buy a small number of companies at
decent prices as long as they have a unique
position in the market and then hold them
for the long-term).

To consider how moat investing works in
the real world, lets consider McDonalds

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Under his watch, every aspect of MCDs
business was quantified down to the smallest
detail.

For example, a MCD beef patty must have fat
content below 19%, weigh roughly 1.6
ounces, and be 3.875 inches in diameter.

This methodology was applied to every aspect
of MCDs business from how it prepared fries
(they only use #1 Idaho russet potatoes cut to
be 7/32 inches thick with at least 21%
minimum solids) to the training of franchise
owners (they have to attend a week long
training at McDonalds facility Hamburger
University where they learn management
skills, quality control and countless
performance metrics).

As a result of this systematization as well as

clever marketing, MCD has developed
tremendous economic goodwill that has
allowed it to become the #1 fast food
restaurant on the planet.

Between this and the companys focus on
producing returns to shareholders, those who
invested in MCD and held for the long-term
have dramatically outperformed the market
and built literal fortunes.

Indeed, had you in McDonalds in 1986, you
would have outperformed the S&P 500 by a
simply enormous margin (see Figure 1 below).
Not only that but you would have crushed
every asset manager on planet earth with very

Figure 1: MCD shares demonstrate the power of moat investing

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few exceptions.

Regarding returns to shareholders, MCD has
paid dividends every year for 37 years and
has increased its dividend at least once per
year.

Dividends per share have increased from
$0.11 in 1986 to $2.87 in 2012. Those who
invested in MCD shares in 1986 are receiving
a yield of nearly 30% per year on their initial
investment today just from dividends alone.

MCD is so focused on producing returns for
shareholders that the company has bought
back 23% of its shares outstanding in the last
ten years. So even investors who bought in
2000 have experienced a synthetic yield of
roughly 5% per year.

However, the most dramatic returns
produced by moat investing are evident
through the power of compounding as
illustrated by MCDs Dividend Re-Investment
Plan or DRIP (a plan through which cash
dividend payouts were automatically used to
buy more MCD shares).

If you had invested in MCDs DRIP program in
1988, you would have turned $1,000 into over
$23,000 by the end of 2012. This is not by
adding to your positions, this is the result of
one single $1000 purchase of MCD stock.

This example of moat investing is precisely
the kind of wealth generating investment that
has made Warren Buffett a billionaire.

Cigar Boats and Moats. Focus on these two
strategies, and you will produce literal fortune

in the long-term.