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January 31, 2006

The Leading Authority on Value Investing

Carrying a Big Stick Inside this Issue
The barks of many activist investors are worse than their bites. Such is
not the case with Jeffrey Ubben of ValueAct Capital. Investor Insight: Jeffrey Ubben

Taking highly active interest in
he epiphany came to Jeffrey Ubben
I NVE STOR I N S IG HT Reynolds and Reynolds, Catalina
while managing the then $5 billion Marketing, Williams Scotsman,
Fidelity Value Fund in the mid-1990s: Gartner Group and Seitel. PAGE 1
I just didnt know what I owned. With so
much new money coming in, I was constantly Investor Insight: David Eigen
adding to 150 positions, which to me was a Seeing beyond the market's ongoing
recipe for mediocrity. skepticism of Molson Coors,
Spectrum Brands, Marsh &
Since leaving Fidelity to join merchant
McLennan and Neteller. PAGE 1
bank Blum Capital and then starting ValueAct
Capital in 2000, Ubbens results have been Behind the Numbers: Hedging
anything but mediocre. By making large bets Why Whitney Tilson believes theres
and working with management and boards to value in betting on the downside
increase shareholder value, ValueAct has and where hes doing so. PAGE 18
returned an annual 18.1% net of fees over the Jeffrey Ubben
ValueAct Capital Of Sound Mind: Playing the Odds
past five years, vs. 6.3% for the Russell 2000.
Investment Focus: Seeks companies In addressing uncertainty, investors
Ubben is finding his best value opportuni-
with recurring revenue streams in stable often fixate on only one possible out-
ties today in mature segments of growth industries and for which simple steps can come. Thats a bad idea. PAGE 20
industries, including technology, life sciences create incremental shareholder value.
and business services. See page 2 Editors Letter
Should value investing's current pop-

Navigating the Turns ularity concern you? Also: Bill

Miller's wei wu wei. PAGE 22
Every challenged company has some sort of turnaround story. David Eigen INVESTMENT HIGHLIGHTS
excels in determining in which ones to believe.

I NVE STOR I N S IG HT he key input for David Eigen in
Catalina Marketing 6
researching CKE Restaurants three
Gartner Group 9
years ago wasn't a detailed review of
Marsh & McLennan 16
its financials or meeting with its CEO, both of
Molson Coors 13
which he did. Most important were cold calls
Neteller 17
to Hardees assistant managers about how the
Reynolds and Reynolds 5
chains test menus were faring. Convincing
Seitel 10
yourself a broken business is going to stop
Spectrum Brands 15
being broken takes digging, he says.
Williams Scotsman 8
Such digging has served investors in
Eigens Post Road Capital well, earning a net Other companies in this issue:
11.1% compounded annually since the firm
Acxiom, Applied Biosystems, Avaya, CKE
opened in August 2001, vs. an annual 2.5%
David Eigen Restaurants, Del Monte Foods, General
Post Road Capital Management gain for the S&P 500.
Motors, Fairfax Financial, Farmer Mac,
Investment Focus: Seeks companies Eigen is finding plenty to buy in recent J. Jill, Martha Stewart, MBIA, McDonalds,
positioned to benefit from positive secular months. We havent ever been this comfort- Mentor Corp., News Corp., OmniVision,
trends but currently facing immediate prob- able with our portfolio, he says, adding that Palm, Inc., Planar Systems, Research In
lems that are being credibly addressed. it now trades at a 40-50% discount to his esti- Motion, Time Warner, Yum Brands
mate of intrinsic value. See page 11
I N V E S T O R I N S I G H T : Jeffrey Ubben

Investor Insight: Jeffrey Ubben

Jeffrey Ubben of San Francisos ValueAct Capital explains the two most important things he learned from Peter Lynch,
why technology companies are ripe targets for activism, what leads him to pick a fight with management and why he
sees great value in Reynolds and Reynolds, Catalina Marketing, Williams Scotsman, Gartner Group and Seitel.

You earned your value-investing stripes at was an originator of the idea of strategic-
Fidelity, which isnt known for its value block investing, which is sourcing ideas in
orientation. How did that come about? the public markets, committing to a long-
term time horizon, and working directly
Jeffrey Ubben: As the restaurant analyst in with the companies to fix things.
the early 1990s, I had to fight off growth Early in my time at Blum I saw the
portfolio managers who were beating me power of this type of investing through an
up for not participating in the restaurant- investment we made in Kinetic Concepts,
IPO boom at the time. The stocks were which makes high-end therapeutic beds
trading like they were the cure for cancer and wound-healing devices. The company
but so much of it was just a silly paper had a rental model, with very good unit Jeffrey Ubben
game. It was clear the industry had attract- economics and strong growth, but they
ed too much capital and there was no real were in the market with a secondary offer- Born to Invest
focus on the underlying supply/demand ing and nobody showed up. We bought
In an industry in which career paths often
dynamics over a longer period of time it 10% of the company, which was still 60%
meander, Jeff Ubbens road to founding
was just a total growth story, with owned by the founder, and got to know
ValueAct Capital stands out for its linear,
investors dropping ever increasing new them very well. In 1998, we took a plan to
blue-chip progression.
stores into their paper models. To me, go private to the CEO because the public
thats just guessing how long the paper market just wasnt recognizing the compa-
Ubbens father founded Lincoln Capital
game lasts, not really investing. nys value. We ended up doing a $900 mil-
Management, a growth-oriented invest-
lion LBO that just worked on all fronts.
ment firm in Chicago. I grew up doing
Did Peter Lynch influence how you think Making that work from beginning to end
about investing? was a real breakthrough for me. quarterly-earnings-change analysis in high
school, he says. After earning a
JU: Peters greatest influence, which still Does strategic-block investing describe Northwestern M.B.A., Ubben joined
pervades Fidelity, is that you pick up the what you do today? Fidelity Investments in 1987. By 1991 he
phone and call companies. At the end of was running the Fidelity Value Fund, which
the day, if you havent spoken to a few JU: Yes. We focus on a portfolio of grew from $500 million in assets to over
companies in existing positions or on new approximately 15 companies. In every $5 billion before he left in 1995.
ideas, you go home a failure. Thats a good company, we try to identify simple things
discipline you should spend your day that can be done with the business to cre- His next stop was San Francisos Blum
talking to operators, not to Wall Street. ate value independent of the market and Capital Partners, an early practitioner of
Another thing Peter does really well is then we take an active approach in work- the same style of strategic-block invest-
to figure out how else to make money on ing with management and the board. ing taking big stakes in challenged pub-
a good idea. Look right down the indus- lic companies and working closely with
try structure and figure out the other What types of companies attract your them to fix things that Ubben practices
ways that this particular information can attention? today in managing ValueActs $3.2 billion
generate an edge. In our portfolio today, in assets.
we identify a theme say consumer-driv- JU: We try to focus on businesses that are
en health care and then we try to figure so good that theyre hard to screw up, but Whats most fun is the intellectual chal-
out where all the opportunities are. many times when management seems to lenge of figuring out what the other guy is
be trying to do just that. Industry struc- missing from an investment-opportunity
What or who else has had a big influence ture is very important we favor relative- standpoint, says Ubben. But marrying
on your investing style? ly slowly evolving industries that are that with real-world stuff like moving a
duopolies or have three primary players. board to action or helping a new CEO
JU: I went to work with Dick Blum at Most of the time were picking up the lead a company thats where weve
Blum Capital Partners in 1995 because he pieces after a high-growth company hits added the most value.

January 31, 2006 Value Investor Insight 2

I N V E S T O R I N S I G H T : Jeffrey Ubben

the wall at 80 miles per hour, having made Given that, well take significant risk with We dont apologize for that because we
at least one too many investments to try to management because as activists we can love the current coupon and it protects us,
sustain an unsustainable growth rate. change that. I would say 80% of the time but the reason we have to look at 100
Public markets can actually conspire to were investing around a management ideas to find three or four to buy is
screw companies up. When youre grow- change initiated by the board on their because its hard to find enough growth.
ing fast, you get this big P/E and pretty own or at our urging. Leadership is every- We have compromised on the growth
soon you have all the wrong investors thing its fascinating how differently the rate if we can find more coupon. In the
with ridiculous expectations. You try to same business can perform with two dif- case of Catalina Marketing, which well
meet those ridiculous expectations and do ferent leaders. speak about later, it had a 15% coupon
things contrary to shareholder value. when we bought into it, but we were
challenged to see much more than 3-5%
That explains your many investments in ON GREAT LEADERS: growth. We still want a combination of
technology companies. the two that gives us a 20% return.
Intellectual honesty is the first
JU: Were focused on intellectual proper- thing I look for. I want the per- Given your willingness to bid for all of an
ty and service businesses technology, life undervalued company, do you look at
sciences and business services. The boards
son who is going to address some sort of take-out value?
of once-high-growth companies are usu- the elephant in the room.
ally still venture-capitalist driven and JU: Before we get heavily involved with a
often dont understand that you cant company, we do look specifically at an
grow your way out of problems any What do you look for in leadership? outcome that involves selling the compa-
more. Many technology-based industries ny. It isnt the primary driver, but we see
are mature, with recurring revenue mak- JU: Intellectual honesty is probably first. I it as a way to protect ourselves, especial-
ing up a higher percentage of sales. want the person who is going to address ly when we go on the board. You can get
Companies with more-predictable rev- the elephant in the room. It drives me quite illiquid when you join a board.
enue streams should be doing things like crazy when you meet with management I would add that were not after asset
leveraging their balance sheets, paying and there are real issues and they act like plays. To us an asset is only an asset if it
dividends and cutting costs rather than they arent there. generates free cash flow. Just because Level
chasing revenue growth. Also important is a contrarian bent, a 3 Communications put $15 billion of cap-
We dont like to take technology risk, confidence to go against the prevailing ital in the ground and its currently trading
which often leads us to software compa- trend. You generally dont want people at $5 billion doesnt mean squat unless its
nies or instrument companies that have a who are saying this is what we should do generating sustainable EBITDA and ulti-
significant service element to them. Our because this is what others are doing. You mately free cash flow. Im not saying that
biggest investment is Applied Biosystems want people who are spending when oth- using another style cant be a great way to
[ABI], which is a market leader in produc- ers are not, and taking chits off the table make money, but thats not what we do.
ing instruments used as tools for analyzing when everybody else is putting them on.
DNA, RNA, proteins and other mole- How do you manage risk in a concentrat-
cules. Its been around for a long time, has On what valuation metrics do you focus? ed portfolio?
great intellectual capital and a tremendous
installed base. But until two years ago JU: Were looking for a free-cash-flow JU: We think our way of investing lowers
they were run by scientists who were over- coupon of 10% EBITDA minus real risk dramatically. If you invest only in
investing in R&D and just werent focused capital spending minus incremental work- quality businesses that generally arent
on the bottom line. When they brought in ing capital, divided by enterprise value exposed to external shocks like union
a business person as CEO they stopped combined with a growth profile of 10%. actions or a lot of cyclicality that are
wasting R&D money, started taking We look three years out at what we think growing 8-10% per year and earning
advantage of their installed base and start- the balance sheet looks like, what the cash 10% current returns, you dont ever real-
ed caring about margins and cash flows. flows look like and what type of multiple ly dig yourself any big holes. We also keep
The upside from all that can be huge. we should expect out of that we want to reasonable diversity across industries in
see an annual 20% unlevered return. the portfolio. We can see markdowns in
Is management change often involved in The hardest piece to get is the growth. any one quarter, but over the course of a
the companies you target? To get really high-quality businesses that year we defend capital fairly well. If you
have recurring revenue streams and indus- cut me some slack for 2002, when we
JU: You dont find great businesses at try structures that are stable, you tend to were down 1%, we havent had a down
great prices with great management. end up in industries that are very mature. year in the past 10 years.

January 31, 2006 Value Investor Insight 3

I N V E S T O R I N S I G H T : Jeffrey Ubben

Why do companies you invest in tend to Activists are going to need the capital Most boards are just guessing what share-
be mispriced? base, experience and credibility to follow holders really want and many directors
through by buying the company or havent ever written a check to be part of
JU: Usually for the typical reasons tem- going on the board to help fix it if steps the company. I feel a sense of urgency that
porary poor performance, perceived arent being taken to address their con- typical directors might not when I see a
unfavorable industry conditions, changes cerns. Youll need to be more than a yeller company being led poorly.
in management, accounting adjustments. and screamer whose biggest asset is that That said, its not necessary to be on
Wall Street doesnt closely follow most of you dont care what anybody thinks the board to have an impact. Most boards
the companies we invest in, which can about you. and management will listen to large
also lead to mispricing, especially during Our idea of activism is to get really shareholders, whether theyre on the
some sort of company transition. involved and help new or current manage- board or not.
We have three- to five-year time hori- ment lead the business and extend the run
zons and basically try to arbitrage the pub- of a successful investment. The more of our How did your investment in Acxiom
lic markets time horizon. Its still true that portfolio we can have in great assets with [ACXM] evolve or devolve into your
the big players in the public markets par- making a $25 per share offer for the
ticularly mutual funds and hedge funds entire company?
are not good at taking short-term pain for ON WHEN TO FIGHT:
long-term gain. The moneys very quick to JU: We went to them in 2003 with a plan
move if performance falls off over short When Acxioms board said they to realize equity value by getting out of
periods of time. As a result, too many big didnt think it was right to have a the high-growth game and focusing on
investors are asking what the market growing with their customers at 7-10%
wants, which is low volatility, rather than large shareholder on the board, I per year while emphasizing free cash flow
what drives long-term performance. We knew we were in trouble. and returns on assets. They responded
dont worry about headline risk once we initially and the stock went up quickly
believe in an asset, were buying more on from $16 to $25. We took money off the
any dips because were focused on the end table at the end of 2004, because we gen-
game three or four years out. great management where were helping erally like to sell 85-cent dollars to recy-
Im catching a falling sword in almost control the capital decisions thats nir- cle money back into 50-cent dollars.
every situation Im in, and Im trying to vana. Its obviously not always a lovefest In 2005, performance relative to the
figure out if its falling from the second were trying to generate 20% returns, so plan theyd laid out went off the tracks
floor or the 10th floor. But my capital base we have to challenge every company we when they returned to their old cap-
is big enough and my appetite to stay con- own with new ideas or theyre not going to spending ways. We still believed the com-
centrated strong enough that I can patient- stay on that 20% curve. pany was a great asset, so bought back in
ly over the course of three to six months One of our core holdings is Mentor at $20 and tried to work with them to get
make the price bottom by buying a little Corp. [MNT], the industry leader in back on track. But this time the more we
stock every day even as its going down. breast implants for aesthetic and recon- talked with management, the more disin-
structive purposes. The biggest value cre- genuous they were, saying one thing and
How does your brand of shareholder ation from our participation there has doing another.
activism differ from what you see out come from helping convince the founder I approached the board in the spring of
there today? to hand the business off to the next gen- 2005 with our concerns about manage-
eration of professional management. The ments ability to run the company and
JU: Much of what you see today is buy company is able now to do things like made a case for why it made sense to have
shares today and tomorrow throw a hissy selling its urology business, which was the a shareholder in the board room. They
fit. The focus is on shortening time companys heritage, to focus on growth in came back and said they didnt think it
horizons by being your own catalyst. the aesthetics business, which is one of was right ever to have a large sharehold-
Thats a problem for me, because that the all-time great businesses and in which er on the board. I knew then we were in
style is transparent and could discredit all Mentor has tremendous potential to trouble. It told me this was an
activists. Boards can say activists are just extend its reach for a long time to come. entrenched, founders board that was not
worried about making their quarterly or going to make the transition necessary to
monthly performance numbers, and Youre on Mentors board. Is that neces- avoid being a structural underperformer. I
theres something to that, frankly. Writing sary to be heard? had no recourse at that point but to offer
a nasty letter is going to lose the pop it a premium for control that would allow
has now the activism is going to have to JU: Its a very powerful situation when us to bring in a new management team
have more integrity than that. you get risk capital in the boardroom. and realize the potential of the business.

January 31, 2006 Value Investor Insight 4

I N V E S T O R I N S I G H T : Jeffrey Ubben

Weve made offers for entire compa- ers. Theres an incredible industry dynam- sales force. Then his fancy new system
nies in three cases where boards were ic: Reynolds and ADP split 80% of the didnt work and that was the end of him.
unresponsive. In one case, OneSource market and sell their services on a month- We met the new CEO, Fin ONeill, and
Information Services, we got outbid by a ly basis, so most of the revenues are came away thinking he was a leader who
strategic buyer. In the second, MSC recurring in nature. Auto dealers general- will make the hard decisions. We bought
Software, we eventually got three guys on ly arent technologists, so you dont tend some stock but didnt fully commit until
the board, including the new CEO. We to have competitive battles over the he wrote off $90 million of capitalized
really do want to own the businesses we fastest, newest thing. software related to the technology the old
make offers on and think we have the Ive followed the company for 15 CEO had bet the companys future on.
governance experience and CEO-recruit- years, since I was an analyst at Fidelity. Thats a hard decision they already had
ing experience to own them. Over the past five years we visited them 70 customers on the new system.
three times before investing at all. What
Whats the next step with Acxiom? became clear was that the company was Whats the new game plan?
being run by a technologist who was
JU: We have our board and management always betting on the new gee-whiz thing JU: The company makes 15% operating
slate lined up for a proxy fight. Were not and was gutting and demoralizing his margins with 75% of its revenue on auto-
going to back down because theres value
here. Companies can get run into the INVESTMENT SNAPSHOT
ground when investors just say to hell
with this and walk away. At the very Reynolds and Reynolds Co.
(NYSE: REY) Valuation Metrics
least, the pressure were putting on them (Current Price vs. TTM):
Business: Provider of information manage-
might result in their performing better REY S&P 500
ment systems and services to automotive
than they otherwise would. retailers and original-equipment manufac- P/E 20.8 22.0
turers in the U.S. and Canada. P/CF 13.3 14.7
Describe your concept of making farm-
Share Information Largest Institutional Owners
team investments. (@1/30/06): (@9/30/05):
Price 28.06 Company % Owned
JU: We like to live with smaller invest- 52-Week Range 24.72 29.20
ValueAct Capital 9.7%
ments in a company for three to six Dividend Yield 1.6%
Franklin Resources 5.9%
Market Cap $2.14 billion
months before making a full commitment. Kayne Anderson Rudnick Inv Mgmt 5.3%
It gives us an opportunity to even better Financials (TTM): Amvescap 4.7%
understand the company and its business Revenue $978.0 million LSV Asset Mgmt 4.4%
while getting to know management and Operating Profit Margin 15.6% Short Interest (As of 1/9/06):
whether were all on the same page. Net Profit Margin 9.0% Shares Short/Float 1.9%
Sometimes the stock pops quickly and
the valuation gets too high, or we lose REY PRICE HISTORY
35 35
some conviction on the attractiveness of
the business, or it becomes clear that
management and/or the board is not
30 30
interested in developing a positive rela-
tionship. We very infrequently purpose-
fully pick a fight, so well just move on.
25 25
Our goal is that by the time were
ready to commit to taking a 10%-plus
stake in a company we know the business 20 20
cold and have bonded with management 2004 2005 2006
so that were really in it together.
Tell us about Reynolds & Reynolds New CEO Fin O'Neill's back-to-basics sales and marketing strategy, coupled with a
[REY], a holding youve recently called broad cost-cutting effort, should result in strong gains in operating profitability, says
up to the big leagues. Jeffrey Ubben. He expects the company's earnings power as well as its stock price
to double within the next two to three years.
JU: Reynolds provides dealer-manage- Sources: Company reports, other publicly available information
ment software and services to auto retail-

January 31, 2006 Value Investor Insight 5

I N V E S T O R I N S I G H T : Jeffrey Ubben

pilot, but its earnings and stock price tion in which the auditor resigned. The are installed in more than 85% of all U.S.
have done very little over the last five whole issue is arcane and usually has supermarkets. Consumer purchases trig-
years. The first critical thing is to rebuild more to say about auditors covering their ger coupons to be printed for products of
the sales organization, giving incentives backs than fundamental business issues. the companys consumer-packaged-goods
back and organizing to be more respon- In Catalinas case it was clear from the clients. Redemption rates are 8 to 10 times
sive to customer needs. 10-Qs and 10-Ks that the free cash being those of traditional coupons. The compet-
Auto dealers need help in talking to generated by the business was still there itive moat is substantial and protected by
their customers directly, so the company and in most cases growing. Cash doesnt the very powerful network effects of
is providing add-on customer-relation- lie. When people bail on a company reaching and having information on more
ship-management solutions that youre because of an arcane accounting issue than 200 million U.S. shoppers.
starting to see show up in top-line when the cash flow is there, we love it. What got us particularly interested
growth. If they can get revenues growing was that management seemed to be giving
even 5-7% per year, theres tremendous What attracts you to Catalinas business? up on the core business and was diwor-
profitability leverage, especially as they sifying, as they say. They were making
pursue broad-based cost cutting that was- JU: Catalina over more than 20 years has terrible capital-allocation decisions like
nt going to happen under the old CEO. built a network of coupon printers that buying up Japanese billboard companies.
The overall formula is pretty simple:
Get the margins to 20% by turning INVESTMENT SNAPSHOT

around an underperforming recurring rev-

Catalina Marketing Corp.
enue stream and cutting costs. Buy back (NYSE: POS) Valuation Metrics
stock with the significant amount of cash (Current Price vs. TTM):
Business: Delivers point-of-sale coupons
they have on their balance sheet. Watch and other marketing communications for POS S&P 500
earnings per share grow rapidly and then client packaged-goods and pharmaceutical P/E 16.4 22.0
get back to a historical multiple on a much manufacturers worldwide. P/CF 10.0 14.7
higher EPS. Its not rocket science. Share Information Largest Institutional Owners
(@1/30/06): (@9/30/05):
With the stock currently around $28, Price 22.25 Company % Owned
what do you see as the upside? 52-Week Range 21.71 27.90 ValueAct Capital 15.1%
Dividend Yield 1.3% Barclays Bank 11.2%
JU: Weve been thrown a curve ball on Market Cap $1.07 billion T. Rowe Price Assoc 8.6%
this. The company has had to stop buying Kayne Anderson Rudnick Inv Mgmt 5.2%
Financials (TTM):
Cooke & Bieler 3.7%
back stock because their auditors are Revenue $403.8 million
making them go back and look at some of Operating Profit Margin 25.1% Short Interest (As of 1/9/06):
their accounting for long-term software Net Profit Margin 15.6% Shares Short/Float 10.6%
contracts. Thats not affecting the stock
price because the market has figured out 35 35
theres no fundamental new information
in any of this. But its disappointing that 30 30
some of the buybacks have been delayed.
This doesnt change anything in how 25 25
we look at the business or stock. We think
20 20
the earnings power of the company is
$2.50 per share, almost double the $1.30
15 15
they make now. So even with no multiple
expansion, we think the stock can double 10 10
2004 2005 2006
within two to three years.

Didnt you buy another of your core hold- THE BOTTOM LINE
ings, Catalina Marketing [POS], during Greater marketer demand for accountability plays to the company's strength in provid-
some sort of accounting problem? ing targeted-marketing solutions with demonstrable results, says Jeffrey Ubben. He
expects 20% annual gains from the shares, without the optionality from what else they
might do with this asset of real-time information on 100 million transactions a day.
JU: Yes. We first bought Catalina two
years ago in the middle of an accounting Sources: Company reports, other publicly available information
issue about long-term revenue recogni-

January 31, 2006 Value Investor Insight 6

I N V E S T O R I N S I G H T : Jeffrey Ubben

You had to look through all the capital are vibrant businesses for them and Tell us about modular space rentals and
spending to realize the core business was growing at double-digit rates. Even if Williams Scotsman [WLSC].
still cranking out cash flow, and that in growth is challenged with U.S. super-
the right hands it was worth a lot more markets, 40% of the top line growing JU: Williams Scotsman is the largest
than the stock price reflected. quickly elsewhere can move the needle national provider of mobile and modular
pretty well. space rentals. We got to know the busi-
You played a role in the installation of a I also frankly think that Wal-Mart ness from owning McGrath RentCorp a
new CEO, so whats happening now? might be an opportunity. Whenever few years ago and understand how terrif-
theres an easy bear story, its always ic a business it is. Somebody else builds
JU: Previous management had given up smart to see how it might get turned on you a modular, you rent it to someone
on the core business because they stopped like a school district and they keep renew-
investing in the network and equipment. ing because it takes them longer to build
They stopped growing their footprint of permanent space then they thought, and
retail outlets. They didnt generate any If I can understand what the then you take it back, say, in ten years
new products. The coupons looked the and sell it for what you paid for it. Those
seller is afraid of and its either
same as they did 10 years ago. are the basic economics. There are
New management is changing all that. irrational or overdone, thats tremendous gains on sale because the
They just added two significant retail depreciation that runs through the finan-
partners in Walgreens and Kmart. Theyre
where you find opportunity. cial statements is not economic.
expanding their pharmacy channel, Scotsman is the only national player in
which places ads on the back of the the industry, with a diversified business
instruction sheet that patients receive its head. What if Catalina did something mix of roughly 30% education, 30%
when they pick up prescription drugs. with Wal-Mart? non-residential real estate, and smaller
Theyre adding color printing for the markets in health care, government
coupons. Theyve gotten out of peripher- Is understanding the bear story something Katrina has been huge for them and
al businesses. you pay close attention to? Canadian oil and gas companies that
The big picture here is the opportunity have seasonal operations. The national
in offering targeted-marketing solutions. JU: My father tells me the reason I gener- footprint should allow them to move
Marketers are seeing that the emperor has ate the returns I do is that I see things things around and run at a fairly high uti-
no clothes in broadcast media, so money other people dont see. But thats not lization rate.
is increasingly going into promotions for exactly the case. I spend my time trying to The company executed a leveraged
which you can look at the dollars spent figure out what the person selling stock to buyout in 1992 and then put a lot more
and figure out if theres a return. me is afraid of. If I can understand what debt on in 1997 even while they started to
Accountability is where the world is hes afraid of and its either irrational or overbuild along with the rest of the
going, which plays to Catalinas overdone, thats where you can find industry from 1997 to 2000. Utilization
strengths. opportunity. rates went down from around 88% to
80%, which is where they still are today.
Whats weighing on the stock, currently What upside potential do you see here? Because of all the excess supply, market
trading near $22? prices fell 10-15% and are just now start-
JU: We believe this is a solid 20% per ing to recover.
JU: Generating sustainable growth is an year return and thats without consid-
issue. We believe much of the problem is ering the optionality of what they might Do you see a catalyst turning things
prior managements not investing in the do with this tremendous asset of real- around?
core business. With new leadership only time information on 100 million trans-
in place for a year, much of the upside actions a day. Management is right to fix JU: Even with these challenges, EBITDA
from their investment spending is still to the core business first, but there will be a still stayed basically flat and the company
come. lot to build on. Catalina has never done was servicing $1 billion worth of debt
Theres also a headwind in the super- anything on the syndicated-research the business is that good.
market business from Wal-Mart, which side, for example. I also think there are The story now is relatively simple.
is taking more than 1% in market share some interesting business opportunities The industry has worked through its
each year from supermarkets. But 40% around their pharmacy business, say, as oversupply, and if you look at the
of Catalinas revenues are away from Medicare and the government are look- demand characteristics in Scotsmans
U.S. supermarkets altogether in phar- ing to better communicate with health- different markets, we think were basi-
macies and international both of which care consumers. cally at the bottom in terms of capacity

January 31, 2006 Value Investor Insight 7

I N V E S T O R I N S I G H T : Jeffrey Ubben

utilization and price. Demand is set to low level of risk given the high level of One of your longer-lived holdings,
grow at double-digit annual rates and visibility of the revenue stream. On a Gartner Group [IT], hasnt so far been
the utilization gains from that all drop to small share base, they can create a lot of earning your 20% per year target. Why?
the bottom line. Price gains from that all value going forward by paying down debt
drop to the bottom line as well. On top with the growing cash flow. Its great to JU: Sometimes our companies run off the
of that is an ability to profitably grow be able to buy a company with an LBO- rails and it takes some time for them to
the fleet now about 80,000 units like capital structure thats coming off the get back on track.
which generates about a 16% unlevered bottom fundamentally. Gartner is the leading subscription-
return based on current yields and a based research company focused on the
$12,000 cost per unit. Now around $19, where do you see the professional information-technology
We think those levers will result in share price two years out? industry. The research provides critical
EBITDA growing at double-digit rates, information for the IT executive making a
hitting $250 million within a couple of JU: With an 8.5x EBITDA multiple, rea- purchase decision or wanting to bench-
years. One of the reasons I love the com- sonable compared to industry peers, you mark current IT performance. Gartners
pany is its leveraged capital structure, get to a stock price of $30 on what I think independence is highly valued and renew-
which generates a low cost of capital at a theyll be earning in two years. al rates have historically been 75-80%,
even in downturns.
INVESTMENT SNAPSHOT We bought our first shares in mid-
2001 and had made a lot of money on
Williams Scotsman, Inc.
(Nasdaq: WLSC) Valuation Metrics them two years into the investment, but
(Current Price vs. TTM): the company was putting out guidance
Business: Provides rental mobile and
modular space solutions for education, WLSC S&P 500 calls that were flat to down while the
commercial, industrial and government mar- P/E n/a 22.0 economy and technology spending were
kets principally in North America. P/CF 12.3 14.7 recovering. Not unlike what had hap-
Share Information Largest Institutional Owners pened at Catalina, it was a CEO problem.
(@1/30/06): (@9/30/05): He was doing all this other sideshow stuff
Price 19.06 Company % Owned to try to grow away from the core tech-
52-Week Range 14.15 19.10 ValueAct Capital 7.3% nology-research business, which he
Dividend Yield 0.0% TimesSquare Capital Mgmt 2.7% thought was mature.
Market Cap $745.6 million Friess Assoc 2.5% This is another great example of a busi-
Barclays Bank 1.9%
Financials (TTM): ness so good it could withstand tremen-
Dawson-Herman Capital Mgmt 1.7%
Revenue $547.5 million dous amounts of turmoil and mismanage-
Operating Profit Margin 17.1% Short Interest (As of 1/9/06): ment. All we needed was the right CEO.
Net Profit Margin (-3.7%) Shares Short/Float 1.7% Gene Hall was hired from ADP and hes
been energizing the core research business,
20 20
which is where Gartner makes all its
money and where the incremental margins
are. I also was asked to join the board.
15 15

How is the business being energized?

10 10
JU: The company bought Meta Group, its
5 5 number-two research competitor, in
December of 2004. The acquisition
0 0 brought 90 more salespeople that filled
2004 2005 2006
gaps in Gartners own sales force and
eliminated some competition. The com-
THE BOTTOM LINE pany now has about a 90% market share
Jeffrey Ubben believes the modular-space-rental business is at the bottom in terms of in syndicated research for senior technol-
capacity utilization and price. Strong earnings gains from increases in utilization rates ogy executives with an incremental
and prices flowing directly to the bottom line, he says, should result in a target stock margin in reselling content of 90%.
price of $30 within two years a nearly 60% premium to today's price.
Gene Hall has been investing in and
Sources: Company reports, other publicly available information reorganizing the sales force, which had
been through years of confused messages

January 31, 2006 Value Investor Insight 8

I N V E S T O R I N S I G H T : Jeffrey Ubben

and inconsistent bonuses. He also recog- Wont technology capital spending, which sion now and Gartners business would
nized that the sales effort should have hasnt been particularly robust, impact still be fine.
more of a user orientation than one Gartners potential growth?
focused on vendors. They used to have 20 The stock, at just under $14, has recov-
people selling to IBM but only two selling JU: The business world went through a ered nicely from its lows of last April. Is
to JPMorgan Chase, when it should be the pretty nasty recession in 2001, though the there still room to run?
opposite. overall economic numbers didnt look so
Another key piece of the puzzle has bad because consumers kept spending. I JU: Because Im on the board, I have to be
been to refocus on per-desktop pricing think the same thing is due to happen in careful about saying anything about
and away from some of the big enter- the inverse the consumer is going to hit future earnings. I think the company is
prise deals that had been done, which some real problems, but the commercial absolutely doing the right things and is
essentially were giving away a lot of eco- world is really quite healthy. Businesses well positioned for good things to happen.
nomics to customers. Thats going to have have more cash than they know what to
a positive impact on both revenues and do with and have some pent-up demand. Tell us about your investment in the ener-
renewal rates. You could have a consumer-driven reces- gy business, Seitel [SELA.OB].

JU: The story here is straight-forward.

Seitel has the largest library of North
American 3D seismic data an informa-
Gartner, Inc.
(NYSE: IT) Valuation Metrics tion set that they just sell over and over to
Business: Independent global provider of (Current Price vs. TTM): oil and gas companies to aid in their
research and analysis on information tech- IT S&P 500 exploration efforts. Its not unlike
nology, computer hardware, software, com- P/E n/a 22.0 Gartner in that its reselling syndicated
munications and related industries. P/CF 53.8 14.7 information.
Share Information Largest Institutional Owners Until less than a year ago, energy com-
(@1/30/06): (@9/30/05): pany exploration and development spend-
Price 13.94 Company % Owned ing was roughly 80% development and
52-Week Range 8.06 14.16 ValueAct Capital 16.2% 20% exploration. With rising oil and gas
Dividend Yield 0.0% David A. Rocker 4.4% prices, that mix is starting to shift dramati-
Market Cap $1.58 billion Sterling Capital Mgmt 3.0%
cally toward exploration, and Seitels busi-
Artisan Partners 2.9%
Financials (TTM):
Royce & Assoc 2.8% ness is driven by exploration. At the same
Revenue $955.1 million time, overall capital spending is going up,
Operating Profit Margin 7.0% Short Interest (As of 1/9/06): so the company benefits from both
Net Profit Margin (-1.3%) Shares Short/Float 9.6% absolute spending increases and changes in
the mix. That dynamic is only starting to
15 15 show up in Seitels revenue numbers.

The stock is up nearly 90% in the past

12 12 year, to around $2.50. Hasnt the market
already caught on?

9 9 JU: The company is still extremely cheap.

Their revenues, minus selling, general and
administrative costs and minus company-
6 6 funded capital spending, is about $60
2004 2005 2006
million. Thats only 1.2x enterprise value
of about $50 million.
THE BOTTOM LINE Seitel has more operational financial
CEO Gene Hall has been energizing Gartner's core research business, says Jeffrey leverage, because youre reselling a
Ubben, through acquisition, focusing sales efforts more on users than vendors, and library, than anything in the oil-services
more-profitable pricing strategies. The company, he says, is ideally positioned to bene-
business. In oil services youre lucky to
fit from pent-up capital spending demand by cash-rich corporations.
get 20-25% incremental margins here
Sources: Company reports, other publicly available information those margins are 70-80%.
The stock is up, but we think its still

January 31, 2006 Value Investor Insight 9

I N V E S T O R I N S I G H T : Jeffrey Ubben

very interesting and is going to make and energy prices is challenging in a glob- arent easy to find, but we think there are
investors a lot of money. al economy. I dont do commodities we ways for value guys to invest there.
like price-makers that set prices based on Take Avaya [AV]. In a lot of its markets
Are there industries you stay away from? value added, as opposed to price takers. it competes mostly just with Cisco, so its a
If you buy a high-quality business, you two-company horserace. Their product
JU: One thing about being an investor for only have to be right once buying at the sales are growing at double-digit rates as
20 years is that experience leads you to right price. The sale is fairly easy to exe- people transition off telephone land lines.
write off big chunks of the market. I dont cute. In cyclical or commodity areas, you Half of their revenue stream is services and
do retail because you have to recreate the have to be right twice, on the buy and the they under-earn on that, which is an execu-
demand every day. I dont do financial serv- sell. If you miss the exit, it might be awhile tion issue. Its trading at less than 1x sales.
ices because its a spread business with no before it comes back around. Were hoping to get to know management
real free cash in it you have to grow equi- better to understand their plan to maximize
ty to grow assets to make more spread. I What new areas you are exploring? value. All of this makes it the type of situa-
dont do much in industrials because the tion that attracts our attention.
capital demands are high and, long-term, JU: Were spending a lot of time on mobile
the cost structure particularly with labor computing and voice over Internet. They What recurring investment mistakes have
you found yourself making?

JU: Ive learned from experience to avoid

Seitel, Inc.
acquisition-driven stories during the actual
Valuation Metrics
(Current Price vs. TTM): acquisition-growth phase big problems
Business: Provider of seismic data and
related geophysical services to aid oil and SELA S&P 500 always come of that.
gas exploration, development and reserve P/E n/a 22.0 Ive also recently concluded is that if you
management in North America. P/CF 4.1 14.7 find yourself going back to the well with
Share Information Largest Institutional Owners
the same idea a third time, youre not gen-
(@1/30/06): (@9/30/05): erating enough ideas and are likely to get
Price 2.52 Company % Owned killed. Youre not as vigilant as you should
52-Week Range 1.22 2.63 ValueAct Capital 18.7% be because you think you know it already.
Dividend Yield 0.0% Paradigm Capital 1.9% When I find myself doing that, I tell myself
Market Cap $387.3 million Pinnacle Assoc 1.8% Im just not working hard enough.
Kennedy Capital Mgmt 1.5%
Financials (TTM):
American Capital Mgmt 0.7%
Revenue $141.7 million Your investment in Martha Stewart Living
Operating Profit Margin 5.3% Short Interest (As of 1/9/06): turned out okay, but certainly looked like a
Net Profit Margin (-6.2%) Shares Short/Float n/a big mistake for quite awhile.

SELA PRICE HISTORY JU: One thing activism can do is allow you
3.0 3.0
to really dive in and fix something to avoid
2.5 2.5 having to sell at the bottom. After Martha
2.0 2.0
was convicted, it would have been easy for
me to sell the stock at $6 and just admit I
1.5 1.5 made a mistake in betting on this person.
1.0 1.0 But I believed enough in the core brand
that I figured I could work to bring it back.
0.5 0.5 Activism in that sense was putting the train
0.0 0.0 back on the tracks.
2004 2005 2006
Did you ever imagine the market would
THE BOTTOM LINE bail you out and take the stock over $35
Seitel stock is going to make investors a lot of money, says Jeffrey Ubben, as the when Martha got out of jail?
company resells its library of North American 3D seismic data to oil and gas compa-
nies with growing exploration and development budgets. The company, he says, has JU: I never did understand that, but some-
more operational leverage than anything in the oil-services business. times its better to be lucky than smart.
Sources: Company reports, other publicly available information Sometimes you earn your luck from all the
pain youve had to endure. VII

January 31, 2006 Value Investor Insight 10

I N V E S T O R I N S I G H T : David Eigen

Investor Insight: David Eigen

David Eigen of Post Road Capital Management describes how vice and scandal create investment opportunity,
where hes finding his best short ideas and what he thinks the market is missing in Molson Coors, Spectrum
Brands, Marsh & McLennan and Neteller.

You grew up with family in the real estate In this case the stock was so cheap
business. How has that influenced your because the companys Hardees business
investing style? was broken and the market was pricing
into the stock that it would never be
David Eigen: An ideal situation in real fixed. In fact, we thought the successful
estate is to buy a decent building in a good Carls Jr. piece of the business was worth
location that needs work, fix it up and more than the stock price, so Hardees
then eventually re-rent it from a B tenant appeared to be worth less than zero. If
at a B price to an A tenant at an A price. you could find value in Hardees if they
You buy at one capitalization rate and could make it perform more like Carls Jr.
then can re-finance at a lower one, taking there was a lot of upside in the stock. David Eigen
the cash from the additional leverage to On a visit to the company we heard
buy other buildings. Or you might sell about focus-group feedback on the new Seeing Irrationality Up Close
altogether at a much higher price. Thats a menu and format they were putting in at
good analogy for how we think about the Hardees. The reviews were excellent. But When David Eigen founded VitaSave, Inc.
turnaround companies in our portfolio focus groups are one thing and actual in 1996 to sell discounted nutritional sup-
we try to invest in what is perceived to be behavior can be another. So we asked for a plements and natural health and beauty
a B or C company that we believe can turn list of markets where theyd done the focus aids, the business plan was focused on a
into an A company. Those investments groups and started calling stores in those traditional catalog business, supported by
can make you a lot of money. markets. We talked to franchise owners, online retailing. Before long, however,
Real estate investing is also very but also called stores in the evenings to try well-heeled competitors were springing
focused on cash-on-cash returns always to get more assistant managers theyre up online, bidding customer-acquisition
thinking when you put a dollar in about less likely to know the corporate line, will- costs to unsustainable levels. Just doing
what you expect to get back. When I ing to speak with you, and definitely know the math, it was clear that playing the
started in college to read Warren Buffett if their stores are turning around. growth-at-any-cost game was not going to
and Benjamin Graham, their focus on We called three dozen restaurants and work, he says.
return on invested capital always made a found that the buy-in from customers and
lot of sense to me. franchise owners was tremendous. Thats Eigens plan to build the business more
The book that impacted me the most as usually your best endorsement, so I start- traditionally offline, however, fell on deaf
I was becoming an investor, though, was ed buying on the belief that Hardees was ears. The only thing that mattered to ven-
Philip Fishers Common Stocks and about to turn around, and it did. ture capitalists at the time was market
Uncommon Profits. You really only have Our sweet spot is the turnaround the share and how you were going to become
to read the first 50 pages to understand market isnt buying into yet. Where you the of your industry, he says.
how important it is for companies to get make a ton of money is not just buying Rather than pursue a strategy he didnt
all aspects of their business to work cheap stocks of broken businesses, but believe in, Eigen sold to one of the com-
together and also to see the benefit of cheap stocks of broken businesses where petitors in January 1999 and turned to
doing field research to support your ideas. you have conviction that its going to stop
investing full-time.
being broken. Thats what all those phone
Give an example of the type of field calls gave us about Hardees.
Not falling for the mania can be hard,
research you do.
especially when youre in the middle of it,
Does your process generally start with the
he says, But thats exactly what good
DE: Our best performing idea ever, CKE quantitative and move to the qualitative?
investors have to do. And how did his
Restaurants, originally came from me sit-
investing portfolio fare after the bubble
ting in my living room reading Value DE: We do all the traditional upfront
popped? Very well, he says. I never
Line. It caught my eye because it was analysis value investors do and also have
trading at only 4x cash flow. a simple point-system discipline to make bought a single

January 31, 2006 Value Investor Insight 11

I N V E S T O R I N S I G H T : David Eigen

sure were considering both risk and ly for the reasons Carl Icahn is giving, but ago, I bought shares of Universal Stainless
reward with some rigor. because they dont have a culture that can & Alloy, a specialty steel company that
The reward part is much more quanti- bring the businesses together for the com- does a lot of business with manufacturers
tative. We create an intrinsic value out of mon good. AOL should be the most for the utility industry. Soon after I
what we believe the normalized earnings amazing platform for Time Warner con- bought, I saw a press release from General
power of the company will be in two to tent, but its not. Time Warner Cable Electrics turbine business that they were
three years, based on free cash flow, times should be a great platform for launching taking a big gain from the cancellation of
whatever multiple we think the market new cable channels, but its not. Given orders from several utility customers. I
will award it. We then add to that the cash that, you might as well split it up and per- knew GE was Universals biggest cus-
we think the company will earn over those haps the market will give the independent tomer, so I called the company and want-
few years. We try to build a balanced port- parts a greater total valuation. News ed to go see them. They put me off
folio with both mature, stable-cash-flow Corp., by the way, has exactly the oppo- because they said they were in a quiet peri-
companies where we may accept a 30% site culture, which is why I think theyll od. The next week they came out with a
discount to intrinsic value, and higher- be so much more successful. release saying they were lowering earnings
risk turnarounds where we want to see guidance and the stock was cut in half.
40-60% discounts before we buy. The lesson Ive learned is that when
The risk analysis takes into account ON INVESTMENT THEMES: something spooks me, I should more
several things. We look at the long-term often take advantage of the liquidity of
On the long side, were spend-
competitive dynamics of the industry, the the market to get out and finish the work
positioning of the companys products or ing a lot of time on how trends on whatever the new issues are. If you
services, its proven historical track record determine the problem is a big one, you
in human behavior will translate
and how management is incented. On the can avoid a lot of pain. If you conclude
more qualitative side, we pay a lot of into business opportunity. the problem is only temporary, you can
attention to the quality of management always get back in at a lower price.
and the culture of the company.
Any other lessons youve come by the
Give an example of how company culture We keep hearing that about News Corp. hard way?
informed an investment thesis? [NWS-A], but it doesnt seem to be help-
ing the stock at all. DE: Like many value investors, we had no
DE: One of the reasons I shorted General material investments in energy last year.
Motors [GM] starting in the summer of DE: One reason the market is uneasy about We had invested considerable time in
2004 was because I just didnt believe the News Corp. is concern over the Internet researching several energy companies and
culture of the company could accommo- acquisitions theyve made. They bought the believed that the supply-demand charac-
date the extent of upheaval that was truly parent of last summer for teristics were positive and that they were
required by the reality of their financial roughly $580 million and I believe that will excellent hedges against the risks of rising
and market situation. I bought very inex- eventually be viewed as one of the great raw-material costs in a lot of our con-
pensive put options when the stock was steals of all time. MySpace is a social-net- sumer stocks. We just didnt pull the trig-
around $37, covered most of the position working phenomenon they did 12.5 bil- ger because we were uncomfortable bet-
at $25 and then closed out when the lion page views in December and the pace ting on commodity prices. Thats okay,
stock went above $30 after Kirk of sign-up is accelerating rather than decel- but in cases like this where we could
Kerkorian announced his involvement. erating. News Corp. has a global infra- hedge against risk in other long positions,
structure and culture that will take advan- thats something wed like to do.
That was a mistake, with GM stock now tage of that like almost no other company
under $25. could. I believe revenues from their Internet Youve said youre focusing more on
businesses will be $1 billion by 2008 and broader investment themes to help source
DE: Im still kicking myself over that. I then take off from that, which is a level no ideas. What themes do you currently find
had huge conviction, but gave in to all the one on Wall Street is expecting. interesting?
noise at the time that religion would be
forced upon them. Cultures that You mentioned bailing on your GM posi- DE: On the long side, were spending a
ingrained, as weve obviously seen, tion too soon, is that a common mistake lot of time on how trends in human
change extremely slowly. you make? behavior will translate into business
Another example of a dysfunctional opportunity. For example, the increasing
culture is Time Warner [TWX]. This com- DE: Ive actually at times had the opposite pace of peoples lives makes them more
pany should be broken up, not necessari- problem with long positions. Four years mobile, so theres going to be more need

January 31, 2006 Value Investor Insight 12

I N V E S T O R I N S I G H T : David Eigen

for mobile communications. People eat- and take profits more quickly now than Tell us about one of your vice bets,
ing more on the run globally provides we did even a year ago. Molson Coors Brewing [TAP].
opportunity for the best fast-food compa- We were short retailer J. Jill [JILL] in
nies and is a big reason we own the last half of last year and the stock was DE: We originally got interested in the
McDonalds [MCD] and Yum Brands going down because of a declining cata- beer space by watching Anheuser-Busch
[YUM]. One key reason we own Del log business and what we felt was a retail keep getting cheaper and then hearing
Monte Foods [DLM] is because theyre concept that had major competitive, mer- Warren Buffett talk about why he was
being smart about repackaging their chandising and inventory issues. Then in buying its stock at last years Berkshire
foods so theyre quick to eat. December Liz Claiborne expressed inter- Hathaway annual meeting. We still
Were also active in areas benefiting est in buying the company at 40% over thought Busch was too expensive, but
from both human and government addic- the market price at a 55x forward P/E were intrigued by the industry and start-
tion to vices, such as alcohol, tobacco and multiple. We think its a completely irra- ed looking at the other big players.
gambling. That people will succumb to tional offer, given that we believe J. Jill is With the merger of Coors and Molson,
such vices and that governments will look just going into crisis mode, but it killed which closed about a year ago, Molson
to the sale of them as a great source of tax what had been a very profitable short Coors is now the fifth-largest brewer by
dollars, we believe, is at least as inevitable position up to that point. volume in the world, with strong brands
as things like selling more Coca-Cola
around the world. INVESTMENT SNAPSHOT

Molson Coors Brewing Co.

What short themes are you pursuing? (NYSE: TAP) Valuation Metrics
Business: Fifth-largest global brewer with (Current Price vs. TTM):
DE: Were finding short opportunities primary operations in the U.S., U.K. and TAP S&P 500
right now in specialty retailers in over- Canada. Brands include Molson, Coors, P/E 21.7 22.0
crowded markets like womens apparel Keystone, Grolsch and Carling. P/CF 13.2 14.7
and consumer electronics that have Share Information Largest Institutional Owners
tough comparable sales to live up to. In (@ 1/30/05): (@9/30/05):
general, we think manufacturers and Price 62.36 Company % Owned
retailers of discretionary, nice to have 52-Week Range 57.37 79.99 Southeastern Asset Mgmt 7.2%
products in highly competitive markets Dividend Yield 2.0% Amvescap 6.9%
will take a hit in the slower consumer- Market Cap $5.32 billion Fidelity Mgmt & Res 4.1%
Barclays Bank 2.2%
spending environment we see coming. Financials (TTM):
Vanguard Group 2.1%
Im also expecting to be very active on Revenue $5.40 billion
the short side of companies deeply Operating Profit Margin 9.2% Short Interest (@ 1/9/06):
involved in adjustable-rate mortgages. All Net Profit Margin 3.1% Shares Short/Float 5.8%
of the infrastructure built in recent years
is becoming an increased burden as vol- 80 80
umes slow. Rising interest rates are result-
ing in more competition from fixed-rate
70 70
loans. We also think the government will
act to address some of the high-risk lend-
ing thats going on its just now that a 60 60
lot of adjustable-rate mortgages are start-
ing to roll over and by next year I think 50 50
youll start to see the rate adjustments
cause some real pain. 40 40
2004 2005 2006

With markets responding so quickly to

news these days, is shorting getting more THE BOTTOM LINE
difficult? The market is underestimating the newly merged company's ability to compete effec-
tively against industry giants and its ability to wring cost savings out of the combined
DE: We are being less patient with our operation, says David Eigen. He expects strong growth in free cash flow to result in a
share price of $103 by 2008, 40% above today's price.
shorts. Because of the amount of private-
equity and other money out there looking Sources: Company reports, other publicly available information
for bargains, we try to not be too greedy

January 31, 2006 Value Investor Insight 13

I N V E S T O R I N S I G H T : David Eigen

primarily in the U.S., Canada and the Is there more to the story than cutting? As a backstop, if Anheuser-Busch,
U.K. The stock has been held back for a SABMiller and AmBev turn out to be just
couple main reasons: fear of a price war DE: Sales volumes have been pretty flat, too big to compete against, Im sure well
theyd lose against bigger competitors like but were optimistic. They brought in a see further consolidation in the beer
Anheuser-Busch and SABMiller, and new president of North American opera- industry. In particular, SABMiller or
skepticism about the realization of bene- tions from Nike and have already been Heineken would be ideal buyers for
fits from the merger. more innovative and consumer-oriented Molson Coors. Based on acquisition mul-
on the product side. They had a great tiples paid in the past, Id expect the com-
Whats the market missing? product launch last year with a 12-pack pany to be worth a minimum 50% premi-
um to todays market price to a buyer.
DE: First, we think the threat of a pro-
longed domestic price war is less likely
ON THE FICKLE MARKET: One of your turnarounds the market
and would be less harmful to Molson One surprising thing is how doesnt seem to be buying yet is Spectrum
Coors than is typically perceived. The Brands [SPC].
company has excellent core brands glob-
quickly the market has turned
ally that can withstand aggressive price on [Spectrum] management. DE: Spectrum is a company that has been
competition. Our experience with price built up essentially from the leveraged
wars in other industries leads us to believe They didnt get stupid overnight. buyout of the Rayovac battery business in
some of the competitive price pressures 1996. In recent years they started to
will continue to dissipate. Why would diversify, buying the Remington shaving
Budweiser and Miller destroy their that came in an actual cooler and we business in 2003 and last year acquiring
brands by forcing consumers to think of expect to see more innovation like that. lawn and garden, insect control and pet-
their products as cheap junk, which Given their product mix, theyll also related products in an effort to better
McDonalds and Burger King almost did benefit significantly in the U.K. from an leverage their global distribution capabil-
and, by the way, General Motors and ongoing shift in consumer tastes from ales ities and diversify away from batteries.
Ford did? to lagers and from the move to more Just as the company was significantly
drinking at home. And while this is only levering its balance sheet last year, it got
Has Anheuser-Busch stopped cutting a one-time pick-up, the return of profes- hit with several operating challenges.
prices? sional hockey after last seasons strike Rising commodity prices impacted mar-
will benefit them in Canada. gins. Their European battery business
DE: Theyve actually announced price was hurt by a continued increase in pri-
increases and a desire to stop the price With the stock at around $62, how are vate-label competition. In North
wars, which will benefit all beer produc- you looking at valuation? America, excess battery inventories
ers in the U.S. industry-wide resulted in significant price
DE: With the merger and operational sav- cutting in the fourth quarter. The compa-
How is the merger integration going? ings, we expect operating profits to grow ny had to adjust earnings guidance three
strongly, even assuming only GDP-type times last year after July.
DE: The company identified $175 mil- growth in revenue. We expect free cash
lion of pre-tax annual cost savings from flow to be $675 million by 2008, up from All of which would explain why the share
the merger from combining facilities, an estimated $500 million last year. At price, at around $21.50, is down nearly
better procurement and cuts in informa- the 13x multiple we think theyll deserve 55% from its 52-week high of $46.
tion technology and overhead which on that vs. an 11x multiple today we
by all indications they are on track to have a target price of $103. DE: One surprising thing here is how
meet. Management has also proven to be quickly the market has turned on man-
very smart in finding operating efficien- Risks? agement. Top management has basically
cies related to logistics. Coors in the U.S. been in place since the LBO ten years ago
had been doing almost everything by DE: The price wars could start again, but and has not only done an excellent job
truck, but the company is now more I just dont see how that makes sense for but has been perceived by the market to
aggressively using rail transport, which anyone. Also concerning would be a con- have done an excellent job until just last
we think alone can improve gross mar- tinued shift in alcohol consumption away summer. We dont believe management
gins by 5% over the next few years. from beer toward spirits. But given how got stupid overnight.
Theyve also just agreed to sell their little growth Ive already built into my With all the noise, we think the market
Brazilian operation, which was a disas- numbers, the shift would actually have to is missing the significant free-cash-flow
ter and losing $60 million a year. accelerate to be much of a problem. growth coming for the company. They are

January 31, 2006 Value Investor Insight 14

I N V E S T O R I N S I G H T : David Eigen

going to take a tremendous amount of ment at Wal-Mart. Theyve also been suc- half times where the stock is today. Even
cost out of the business over the next cou- cessful in expanding Remington brands in if cash flow stayed flat at $180 million,
ple of years, not only from further inte- the U.K. and Latin America, which will the stock still only trades for 6x that fig-
gration synergies but also from restruc- continue, and have big opportunity in ure, which gives us a great margin of
turing businesses that need it, like the continental Europe as well. safety.
European battery business. Theyre mov- We just think the market has severely
ing manufacturing to lower-cost coun- What upside do you see for the stock? over-reacted to the challenges here and
tries. They have pricing leverage in specif- that management is more than up to
ic categories of the lawn-and-garden and DE: If management executes as we meeting them.
battery businesses, which will help recoup believe they will, free cash flow should
increased commodity costs. grow from the current pro-forma level of The market seems similarly skeptical of
At the same time, theres upside from $180 million to at least $240 million by your next turnaround idea, Marsh &
the remaking of the Rayovac business in 2008. Thats assuming only 1-2% annual McLennan [MMC].
the U.S., focusing its marketing more on revenue growth. Put a reasonable 12x
improved product performance than multiple on that and we get a target price DE: One theme were paying attention to
price and getting improved retail place- of $56, which is more than two-and-a- is the increasing globalization of business
and we like the mix of services Marsh
INVESTMENT SNAPSHOT provides to growing businesses in a wide
range of markets. Their four main divi-
Spectrum Brands, Inc. sions are in insurance brokerage, risk
(NYSE: SPC) Valuation Metrics
(Current Price vs. TTM):
consulting and services, management
Business: Global branded consumer-
SPC S&P 500 consulting, and investment management.
products company with primary operations
in batteries (Rayovac), electric shaving P/E 18.7 22.0 All of these businesses have very low costs
(Remington) and pet supplies (Tetra). P/CF 4.3 14.7 of capital and little need for capital
spending, so returns on invested capital
Share Information Largest Institutional Owners
(@ 1/30/05): (@9/30/05):
are generally quite high.
Price 21.47 Company % Owned The story, of course, is that two of the
52-Week Range 16.00 46.11 Thomas H. Lee Partners 23.7% businesses, the Marsh insurance broker-
Dividend Yield 0.0% American Express Financial 9.2% age and the Putnam Investments division,
Market Cap $1.09 billion Wachovia Corp 5.7% were caught in scandals Marsh in the
Nominingue Asset Mgmt 4.2% contingency-fee scandal and Putnam
Financials (TTM):
Glenview Capital 4.1% from allowing after-market trading. As a
Revenue $2.36 billion
Operating Profit Margin 11.4% Short Interest (@ 1/9/06): result, margins in these divisions are at
Net Profit Margin 2.0% Shares Short/Float 11.0% historic lows. The question then is
whether you believe these businesses will
SPC PRICE HISTORY turn around.
50 50

What gives you conviction they will?

40 40
DE: From the chairmanship down
30 30 through the top management of these two
divisions there are new people in charge.
20 20 Weve done a lot of work on these people
and believe theyre top-notch and have
unquestionable integrity. The insurance
10 10
2004 2005 2006 group is moving fast to rebuild client rela-
tionships and increase employee-retention
THE BOTTOM LINE rates, which are now approaching his-
Investments in the U.S. battery and European shaving-products businesses, coupled toric levels. Putnam has changed its
with aggressive cost cutting following acquisitions in the past year, will drive strong incentive structures and now the overall
growth in Spectrum's free cash flow, says David Eigen. He believes the shares should investment performance so critical in
be worth $56 by 2008, a 160% premium to today's price. that business is improving.
Sources: Company reports, other publicly available information
Both of these businesses have great
economics. The insurance brokerage

January 31, 2006 Value Investor Insight 15

I N V E S T O R I N S I G H T : David Eigen

business benefits from secular global regained and theyre presented with a Since tanking 15 months ago, the stocks
growth in demand for insurance prod- solid, competitive product or offer. done little and now trades at $30.60.
ucts, without the risk of catastrophic What potential do you see?
losses that the insurers have to bear. In So is this mostly a question of regaining
fact, when disasters happen, pricing whats been lost? DE: Given the quality of these businesses,
tends to firm and broker dollar margins they should be worth a 15-17x multiple
go up. In money management, Putnam DE: Thats a major part of the case in bro- of free cash flow. We estimate free cash
traditionally has earned 20-25% operat- kerage and money-management. Were flow jumping to $1.85 billion in 2008,
ing margins even with all the problems also excited about the Kroll security busi- primarily from improving margins at
it still earns 15%. ness, which does everything from providing Putnam and the Marsh insurance broker-
In both of these businesses the margins corporate security guards, to doing back- age business. Put a 15x multiple on that,
are still well below those of competitors ground checks, to providing global risk plus the cash we estimate theyll have by
and we see no reason why over time they assessment and management services. This then, and youve got a $59 stock.
cant return to competitive levels of prof- business is well situated to prosper in a Theres also a nice margin of safety in
itability. Customers generally have pretty more complex, inter-connected world and a current breakup value we calculate in
short memories when a level of trust is should continue to grow 20% annually. the mid-$40s. Management is committed
to fixing the businesses, but if thats prov-
INVESTMENT SNAPSHOT ing difficult were confident theyll create
value by breaking up the company.
Marsh & McLennan Companies, Inc. I understand the market wants to see
(NYSE: MMC) Valuation Metrics
(Current Price vs. TTM):
more proof. But if you wait until a turn-
Business: Global professional-services
MMC S&P 500
around is obvious to everyone, you can
firm with primary operations in insurance
brokerage, security and risk management, P/E n/a 22.0 leave a lot of money on the table.
consulting, and investment management. P/CF 82.13 14.7
From scandals to gambling, tell us about
Share Information Largest Institutional Owners
(@ 1/30/05): (@9/30/05):
Neteller [NLR.L].
Price 30.60 Company % Owned
52-Week Range 26.67 34.25 Capital Res & Mgmt 8.5% DE: Neteller is an Isle of Man-based com-
Dividend Yield 2.2% T. Rowe Price Assoc 7.5% pany that essentially is to online gambling
Market Cap $16.67 billion Pacific Financial Res 6.0% what PayPal is to online retail an alter-
Barclays Bank 3.3% native payment system. The company pro-
Financials (TTM):
Davis Selected Adv 3.2% vides a secure online funds-transfer service
Revenue $12.16 billion
Operating Profit Margin 7.7% Short Interest (@ 1/9/06): that enables gamblers to load, withdraw
Net Profit Margin (-2.6%) Shares Short/Float 1.8% and transfer funds to and from an elec-
tronic wallet for use at any gambling
MMC PRICE HISTORY site that supports Netellers online pay-
60 60
ment system. More than 90% of online
gaming sites support the Neteller system.
50 50 Neteller earns money from users when
they add to their e-wallet and from host
40 40 sites when gamblers move from site to site
with their Neteller e-wallet in tow.
30 30 Merchants love Neteller because it guaran-
tees the funds its users gamble with and
because it has expertise in dealing with
20 20
2004 2005 2006 things like proving if a user is old enough.
Neteller also can settle in multiple curren-
THE BOTTOM LINE cies, which allows broader marketing
David Eigen believes the market has yet to recognize the turnarounds underway at the opportunities for the gambling sites.
company's scandal-plagued insurance-brokerage and investment-management busi-
nesses. He expects strong earnings growth as those businesses return to historical What is Netellers market position?
profitability, resulting in a share price by 2008 of $59 nearly double today's price.

Sources: Company reports, other publicly available information

DE: They handle about 20% of total
global online gambling payments.

January 31, 2006 Value Investor Insight 16

I N V E S T O R I N S I G H T : David Eigen

Theyre most established with U.S. gam- We assume the regulatory issues are not $1.7 billion, for a company that will gen-
blers, have a good-sized operation in the insubstantial. erate a minimum of $140 million in free
U.K. and are prepared to grow rapidly in cash flow this year. So it trades at less than
Asia after making acquisitions in Japan DE: Regulatory risk will always be an 13x 2006 free cash and they have lots of
and China. issue with a stock like this. There has cash and no debt on the balance sheet.
A head start means a lot here. They been legislation introduced in the Senate With companies growing this quickly
already have a global infrastructure that by Senator Kyle of Arizona that has strict its hard to model a price target. This one
works across many languages and in a prohibitions on Internet gambling. But isnt for the faint of heart the stock is
wide variety of regulatory environments. since Katrina hit, theres been no move- volatile and there is U.S. regulatory risk
Thats not at all easy for new players to ment on the bill. My basic feeling is that that wont go away. But if things keep
replicate. it will be something legislated by states in going as they are and if Asia really takes
Our bet then is on their being very the U.S., and as long as the economic off for them as we think it will, this could
well positioned to prosper from an over- interests of the states are met, I dont real- have incredible upside.
all growth in online gambling poker, ly believe this will be legislated away.
sports betting and all types of casino-type You take to heart the advice of people like
gaming that we just think is unstop- At 795 pence on the London exchange, Charlie Munger and Bill Miller to cast a
pable. Neteller revenue was $83 million the shares have quadrupled in less than wide net for insight on investing. What
in 2004, was more than $170 million in two years. Has it gotten too pricey? have you come across recently that has
2005 and should be well over $240 mil- had an influence.
lion this year. DE: The current market cap is around
DE: The book thats had the most impact
INVESTMENT SNAPSHOT on me recently is The Wisdom of Crowds
by James Surowiecki. One of the many
Neteller plc anecdotes he recounts is from long ago at
(London: NLR)
a country fair where people were asked to
Business: Provider of secure online funds- Financials (TTM):
guess the weight of a cow. Hundreds of
transfer services for primary use by cus- Revenue $146.0 million
tomers at poker, sports-betting and other people guessed and nobody got that close,
Operating Profit Margin 56.8%
gambling websites. Net Profit Margin 50.7% but if you took an average of all the guess-
es it was within a few pounds of the cows
Share Information
(@1/30/06, Exchange Rate: $1 = 56.6 pence): Valuation Metrics actual weight. The idea is that if you have
(Current Price vs. TTM): a diverse set of inputs you can come to
Price (in British pence) 795.00 ($14.05)
NLR FTSE 100 more accurate conclusions.
52-Week Range (in pence) 435.50 919.50
P/E 22.9 19.2
Dividend Yield 0.0% One of my mistakes historically has
Market Cap $1.69 billion been to anchor on my traditional sources
of information and ideas. When I looked
NLR PRICE HISTORY at the things I tended to read and people
0 1000
I tended to listen to, I realized they were
8000 800 all too similar in how they viewed the
world. I didnt have nearly enough diver-
6000 600 sity of input, something which Im funda-
mentally changing.
4000 400 In almost every field, from medicine to
finance to science, you see the collective
2000 200
opinion upended by new information. But
0 0 0 the level of group-think by even the best
2004 2005 2006
and the brightest is amazing. This is why I
think youll always find opportunities in
THE BOTTOM LINE value investing. There will be legions of
Its established global presence in providing funds-transfer services for online gamblers experts who all believe the same things
positions Neteller well to prosper from an overall growth in online gambling that David and who will influence the masses, but
Eigen calls unstoppable. At only 13x his estimate of 2006 free cash flow, Eigen will often be wrong. If you do your own
believes the share price significantly underestimates the company's growth potential.
work and seek new angles from which to
Sources: Post Road Capital Management, company reports, other publicly available information approach problems, youll continue to
find things to make money on. VII

January 31, 2006 Value Investor Insight 17

B E H I N D T H E N U M B E R S : Hedging

Bear Necessities
Given how our bearish bets have performed in the past couple of years, weve asked ourselves why we bother
betting on the downside at all. Heres why. By Whitney Tilson and Glenn Tongue

Given the long-term upward trend in Initially, our investment worked well as ish bets on baskets as a way to make
equity prices and frequent bouts of exces- the Nasdaq-100 and SMH were down money, we still use puts on such indicies
sive investor optimism Markets can more than 12% and 30%, respectively, as the S&P 500 and Russell 2000 for
remain irrational longer than you can over the first seven-and-a-half months we hedging because: 1) It reduces risk,
remain solvent, John Maynard Keynes held them. Alas, we werent clever enough defined as the permanent loss of capital;
once warned one might ask why make to take our profits and instead held as both 2) In the event of a major correction, it
bearish bets at all. This question is par- indicies rallied through the end of 2005. will provide us with substantial cash to
ticularly relevant to us given the money Of course, the passage of time was also invest at bargain prices, thereby enhanc-
weve lost in this area over the past cou- eroding the value of the puts. We sold ing returns; and 3) It allows us to remain
ple of years. these positions at a loss late last year and invested in certain stocks we otherwise
After carefully studying our experi- dont plan to reinitiate them. might sell prematurely, which also should
ence, were not swearing off negative bets We made two mistakes here: First, we enhance returns.
for two main reasons: First, we still think strayed outside our circle of competence
we can make money on them. In addi- always a bad idea and tried to com- Hedging 80-cent dollars
tion, they remain a great tool for hedging pensate by buying a basket of stocks.
against risk. That said, some refinements Second, for us, a basket is a poor way to The last point warrants further dis-
in our strategy are in order as we learn express an investment opinion, bullish cussion. Like many value investors, we
from our mistakes. or bearish. Our advantage as investors is tend to sell our winners much too early.
detailed, bottom-up stock research, and Because were so conservative, our esti-
Be Specific we give up much of that advantage when mates of intrinsic value are usually low
we invest in a basket. Assuming we suf- and, even if they arent, the market often
Two years ago we became convinced ficiently understand at least certain com- tends to push our winners far above
that the technology sector in general panies within a sector, we will almost intrinsic value at least for a time. There
and semiconductor stocks in particular certainly be better off buying or shorting are few things more annoying than buy-
had become significantly overvalued. the most undervalued or overvalued ing a stock at $10, selling it from $15 to
Following its nearly 80% decline from stocks in the sector rather than investing $20 and then watching it go to $50.
March 10, 2000 through October 9, in a basket (see box). Heres an example of how weve
2002, the Nasdaq had rallied dramati- While weve abandoned making bear- hedged one of our favorite positions to
cally, rising 80% from its 2002 low
through the end of 2003. We were
Getting More Specific
amazed to see the froth returning to the
Making a bet on a basket of stocks or an index either bullish or bearish can be a poor way for bottom-up
very stocks that had obliterated
investors to express an investment opinion. So rather than making bearish bets on baskets of technology or
investors only a couple of years earlier financial stocks two areas in which we currently see pockets of significant overvaluation weve taken
and believed that, across the technology negative positions on the following individual stocks. Whitney Tilson and Glenn Tongue
sector, the fundamentals did not remote-
Price 52-Week
ly support the stock prices. Company Ticker Industry
@1/30/06 Low High
Rather than shorting or buying puts
on individual tech stocks, we felt the Fairfax Financial FFH Insurance 151.10 126.73 179.90
best way to profit from the perceived Farmer Mac AGM Agricultural/Rural Mortgages 28.50 15.53 32.47
overvaluation was to buy puts on two
baskets of stocks: the Nasdaq-100 Trust MBIA MBI Financial-Guarantee Insurance 62.68 49.07 64.00
[QQQQ] and Semiconductor HOLDRS
OmniVision OVTI Imaging Semiconductors 25.22 11.74 25.58
[SMH]. While we might not understand
many of the companies that make up Palm, Inc. PALM Mobile Computing 37.47 20.75 37.95
these baskets well enough to make a
Planar Systems PLNR Flat-Panel Displays 13.25 7.19 13.25
bearish investment, we believed, in
aggregate, that these indices were sure to Research In Motion RIMM Wireless Communications 66.82 51.90 84.55
decline materially.

January 31, 2006 Value Investor Insight 18

B E H I N D T H E N U M B E R S : Hedging

avoid selling too soon and why we dont So what has happened? The S&P 500 from renewing our policy.
regret losing money on the hedging so far: has risen, volatility has fallen and time Capital preservation is far more
We think McDonalds [MCD, $35.78] is has elapsed, all of which have caused the important to us than keeping up with the
easily worth $40 per share, based on a S&P 500 put position to decline. S&P 500 over short time periods. We do
16x multiple of the $2.50 per share of Multiply this across a number of posi- believe, however, that we erred somewhat
free cash flow we think the company can tions and its easy to see how this strategy in how we sized our insurance policies
earn in the not-too-distant future. When lost us a lot of money. in essence, we took a good idea and
the stock hit $32 in late 2004 having Is hedging 80-cent dollars when the overdid it. All of our index put positions
risen steadily from a low of around $12 tended to move together, so we effectively
in March 2003, when we last purchased it had more insurance than we needed. This
it was, in our opinion, the proverbial HEDGING AS INSURANCE: served us well during the down months of
80-cent dollar. 2005, but cost us for the year as a whole.
The fact our home didnt burn
In the past we might have sold and In addition, our buying of at-the-money
locked in our gains, but this would have down doesnt mean were upset puts was, in hindsight, a mistake. Were
triggered big taxes and, more important- not trying to hedge against modest 5-
ly, denied us the healthy long-term com-
we lost 100% of our invest- 10% declines, but against a much larger
pounding we expect from this stock over ment in home insurance. correction, so weve recently been buying
many years to come. Instead we bought 10% out-of-the-money puts. Finally, our
long-dated puts on the S&P 500, which macro concerns lessened our confidence
we felt were very attractively priced, with cost of hedging is at or near all-time lows in our long stock positions more than
a notional value proportional to our the wrong strategy? We dont believe they should have. Were still hedging our
holdings in McDonalds. In this way, we so. Buying insurance always looks wrong 80-cent dollars, but at what we now think
could hedge our McDonalds position in hindsight when the event you insured are more appropriate levels. VII
against the possibility of a substantial against doesnt happen. But the fact that Funds managed by Whitney Tilson and
market decline, yet still benefit from the our home didnt burn down last year Glenn Tongue own puts on the S&P 500, Russell
upside of an undervalued stock that we doesnt mean were upset that we lost 2000 and MBIA, and are short Fairfax Financial,
believed was highly likely to outperform 100% of our investment in our home- Farmer Mac, MBIA, OmniVision, Palm, Inc.,
the S&P 500 over time. insurance policy and it doesnt keep us Planar Systems and Research In Motion.

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January 31, 2006 Value Investor Insight 19


Anythings Possible
Most investors know that investing is an exercise in probability. But knowing it
and actually living by it can be two separate things.

Games of chance must be distin- name on Wall Street as an arbitrage trad- short a couple years ago,
guished from games in which skill makes er, warns against this excessive certain- for example, after taking into considera-
a difference, writes Peter Bernstein in ty in his book In an Uncertain World: tion what he considered to be the unlike-
Against the Gods, his historic review of [It] seems to me to misunderstand the ly event that Amazons scale would start
risk taking. With one group the outcome very nature of reality its complexity and translating into the profitability gains the
is determined by fate, with the other ambiguity and thereby provides a rather market was expecting. In fact, that is the
group, choice comes into play. There are poor basis for working through decisions scenario that began to play out, and the
card players and racetrack bettors who in a way that is likely to lead to the best stock rose 180% in the following year.
are genuine professionals, but no one results. An added benefit to thinking in terms
makes a successful profession out of The first basic step in incorporating of probabilities is that it helps make
shooting craps. probabilities into investment decisions is explicit the actual risks under considera-
Like playing poker and betting on to explicitly consider several potential tion. If given the choice between purchas-
horses, investing is a game of skill similar- outcomes. Abingdon Capitals Jacoboski ing a $350 non-refundable plane ticket to
ly focused on assessing the odds of uncer- looks at each of his holdings business attend a future event that could possibly
tain future events. At the end of the day, fundamentals under four to six distinct be cancelled vs. waiting to buy a last-
investing is inherently a probability exer- scenarios, calculating an intrinsic value minute ticket for $1,200, many people
cise, says Legg Mason strategist Michael under each scenario and applying a sub- would choose to wait. Nobody wants to
Mauboussin. Most investors acknowl- jective probability to each. The final esti- blow $350. But in pure expected-value
edge this point but very few live by it. mate of intrinsic value is the intrinsic terms, it pays to buy the ticket now unless
Why is it difficult for investors to think value of each scenario weighted by its you believe the risk of cancellation is
in terms of probabilities when assessing a probability of occurring. A key is to cap- above 71%. Framing the question in this
companys future performance and stock ture low-probability but high-impact sce- way may not change the decision, but can
price? It isnt human nature to view the narios, primarily to see where the vulner- increase the chances that a more informed
future in terms of a wide range of possi- abilities are, he says. He decided not to decision is made.
bilities, says Abingdon Capitals Bryan
Jacoboski, who was featured last summer
in Value Investor Insight (August 29,
2005). We naturally think in terms of
what is most likely to occur and implicit-
ly assess the probability of that scenario
occurring at 100%. That may sound
reckless, but its what most people do and
isnt a bad way to think as long as less
likely, but still plausible, scenarios dont
have vastly different outcomes. In the
investment world, however, they often
do, so making decisions solely on the
most likely outcome can cause severe
Anchoring on the most likely outcome
is a natural attempt to reduce the com-
plexity involved in making investment
decisions, but also can reflect the danger-
ous overconfidence with which many
investors ply their trade. Former Treasury
Secretary and Goldman Sachs Co-
Chairman Robert Rubin, who made his

January 31, 2006 Value Investor Insight 20


In studying the common traits of you were right or wrong. The only true expectations and your own.
those most successful at games of skill way to know is by tracking the same or Perhaps the single greatest error in
across disciplines researchers have similar events to see if they, over time, the investment business is a failure to dis-
found a clear tendency to focus more on happen 60% of the time. Weather fore- tinguish between knowledge of a compa-
process than individual outcomes. Poker casters and bookmakers keep track of nys fundamentals and the expectations
legend Amarillo Slim has described it such things to refine their ability to judge implied by the stock price, says
this way: The result of one particular probabilities. Investors should do the Mauboussin. Driving home this point is
game doesnt mean a damn thing, and same even if its with much less preci- Steven Crist, chairman of the Daily
thats why one of my mantras has always Racing Form: The issue is not which
been Decisions, not results. Do the horse in the race is the most likely winner,
right thing enough times and the results
ON PLAYING THE ODDS: but which horse or horses are offering
will take care of themselves in the long The issue is not which horse is odds that exceed their actual chances of
run. Adds Legg Masons Mauboussin: victory. There is no such thing as liking
By definition, poor decisions will peri- the likely winner, but which a horse to win a race, only an attractive
odically result in good outcomes and horse offers odds that exceed discrepancy between his chances and his
good decisions will lead to poor out- price.
comes. The best in their class focus on their actual chances of victory. Even with a framework to assess ambi-
establishing a superior process, with the guity, the right decision in the face of
understanding that outcomes will follow great uncertainty is often just to pass.
over time. sion to calibrate their probability-set- Warren Buffett refers to it as placing
Thats not to say that process cant be ting skills. something in the too-hard pile. Writes
improved. Making explicit and writing While necessary, skillfully assessing the Peter Bernstein: Once we act, we forfeit
down the probabilities used in making probabilities of various outcomes for a the option of waiting until new informa-
investment decisions can provide valuable company is not sufficient to making a tion comes along. As a result, not acting
learning. After all, if you judge an event sound investment. Stock prices have has value. The more uncertain the out-
to have had a 60% chance of occurring future expectations already built in the come, the greater may be the value of
and it doesnt occur you dont know if trick is to find the gaps between those procrastination. VII

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January 31, 2006 Value Investor Insight 21


When the Road Less Traveled Gets Congested

Value investors, rightfully so, pride While we don't at all question the this isn't relevant. Which is, of course,
themselves on following the road less trav- validity of these recommendations in the the point. Portfolios are built one stock at
eled. After all, it's tough to have much of aggregate, does this mean individual a time, and in each case the value investor
an edge in an investment when every- value investors should move to the side- is looking to buy something for less than
bodys in agreement on it. As legendary lines and wait for the current cycle of it's worth. Some are better at it than oth-
Wall Street investor Bernard Baruch suc- popularity to pass? We think not. ers, of course, but that's not something
cinctly put it: Never follow the crowd. For starters, there is really no typi- that can go out of style.
Investment manager Evergreen Capital cal value investment to avoid. We've
Management has quantified the virtue of been consistently impressed in our con- Creative Inaction
this sentiment by analyzing past data on versations with the best value investors by Bill Miller's latest quarterly commentary
mutual-fund inflows and outflows. It the breadth of their ideas and of the was typically filled with wit and wisdom,
found that when relative flows into a strategies they employ. Recommendations including this on trading: We practice
given fund sector or style exceeded one in these pages have come from nearly the Taoist wei wu wei, the doing not
standard deviation above historic norms every industry from steel to semicon- doing as regards our portfolio. We are
at the same time the P/E ratios relative to ductors, from newspapers to videogames, mostly inert when it comes to shuffling
the S&P 500 were above historic aver- from trucking to wireless Internet. the portfolio around, with turnover that
ages, the odds are overwhelming that Great value investors are also adaptable, has averaged in the 15-20% range. Many
over the next two years that sector will or, as Legg Mason's Bill Miller describes it, funds have turnover in excess of 100%
underperform, says David Hay, willing to take what the market gives us. per year, as they constantly react to events
Evergreen's Chief Investment Officer. That many value investors are finding plen- or try to take advantage of short-term
On the surface, that isn't great news for ty to buy among what have traditionally price moves. We usually do neither. We
value investors. With money flowing freely been considered large-cap growth compa- believe successful investing involves antic-
into value funds after years of strong per- nies is testament to this adaptability. ipating change, not reacting to it. VII
formance, Evergreen's analysis suggests the In the middle of describing the relative
party is over. Value investing is too popu- values he's currently seeing based on mar-
lar, says Hay. In fact, small-cap-value and ket capitalization, Jeffrey Ubben of
mid-cap-value are two fund categories ValueAct Capital during his interview for
Evergreen now recommends avoiding alto- this issue stopped himself and said: You John Heins Whitney Tilson
gether. (The third such category is REITs.) know, we're so bottoms-up that a lot of Co-Editor-in-Chief Co-Editor-in-Chief

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January 31, 2006 Value Investor Insight 22

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January 31, 2006 Value Investor Insight