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Graham & Doddsville

An investment newsletter from the students of Columbia Business School

Inside this issue: Issue XXXVII Fall 2019

2019 Pershing Square
Challenge p. 3 Paul Moroz, Mawer Investment Management
“From Graham to
Paul Moroz is Chief Investment Officer and a director at
Buffett and Beyond”
Mawer Investment Management Ltd., a Canadian firm
Omaha Dinner p. 4
with over CA$55bn AUM which he joined in 2004. He is
L.A. Alumni Event p. 4 also co-manager of the Mawer Global Equity Fund and the
Mawer Global Small Cap Fund. As Chief Investment
Value Investing Officer, he has broad responsibility for the research and
Welcome Reception p. 4 analysis of global equities and fixed income securities.
Paul Moroz p. 6 Mr. Moroz relocated to Singapore during 2016 to 2017
and served as CEO and Director of Mawer Investment
CBS Students’
Management Singapore Pte. Ltd.
Investment Ideas p. 16 In 2013, Mr. Moroz won the prestigious Morningstar
Mohnish Pabrai p. 22 Paul Moroz
(Continued on page 6)

Ellen Carr p. 30

Matthew Peterson p. 42 Mohnish Pabrai, Pabrai Funds

Editors: Mohnish Pabrai is the Managing Partner of the Pabrai
Frederic Dreyfuss Investment Funds. Since inception in 1999 with $1 million
MBA 2020 in AUM, Pabrai Investment Funds has grown to over
$580m AUM in the 2nd quarter of 2019.
Sophie Song, CFA
MBA 2020 The funds invest in public equities utilizing the Munger/
Buffett Focused Value investing approach. Since
John Szramiak inception, the funds have widely outperformed market
MBA 2020 indices and most investment managers. A $100,000
Rodrigo de Paula investment in Pabrai Funds at inception in 1999 would
MBA 2021 have been worth over $1.2 million as of June 30, 2019, an
annualized gain of 13.3% (versus 7.0% for the Dow).
Matt Habig Mohnish Pabrai
MBA 2021 (Continued on page 22)

Alison Tien Ellen Carr, Matthew Peterson,

MBA 2021
Weaver C. Barksdale Peterson Capital Management
Visit us at: Ellen Carr is a high Matthew yield bond portfolio Peterson is the manager at Weaver C. Managing Partner
Barksdale (WCB), a of Peterson
boutique institutional Capital
fixed income Management and
management firm. She he manages
has two decades of Peterson
leveraged credit Investment Fund
Ellen research, analysis, and Matthew I. Matthew has
Carr (Continued on page 30) Peterson (Continued on page 42)
Page 2

Welcome to Graham & Doddsville

We are pleased to bring you the We were also lucky to have a We continue to bring you
37th edition of Graham & conversation with Mohnish stock pitches from current CBS
Doddsville! This student-led Pabrai, founder of Pabrai Funds. students. In this issue, we fea-
investment publication of Co- He explained the difference ture finalist pitches from the
lumbia Business School (CBS) is between compounding a port- 2019 Pershing Square Chal-
co-sponsored by the Heilbrunn folio and investing in com- lenge. David Hao ’20, Eric Niu
Center for Graham & Dodd pounders, why he dislikes lev- ’20, and Freda Zhuo ’20 rec-
Investing and the Columbia Stu- erage and shorts, and his love- ommended a long position on
dent Investment Management hate relationship with levered Aramark (NYSE: ARMK), James
Association (CSIMA). Since our financial institutions stocks. He Shen ’20, Lauren Warsavsky
Spring 2019 issue, the Heilbrunn discussed his views on IPSCO ’19, and Mark Zager ’20 recom-
Meredith Trivedi, Managing
Center hosted the 2019 From and GrafTech, as well as invest- mended buying Servicemaster
Director of the Heilbrunn
Graham to Buffett and Beyond ing in South Korea. Global, Inc. (NYSE:SERV), and
Center. Meredith leads the
dinner in Omaha and the 2019 Edgardo Guttierez ’20, Yuri
Center, cultivating strong
Pershing Square Challenge. The Next, we had an in-depth dis- Rettore ’20, and Rodolfo Zeid-
relationships with some of
Heilbrunn Center also attended cussion on investing in high ler ’20 recommended to invest
the world´s most experi-
an alumni event hosted by Shel- yield bonds with Ellen Carr, a in US Foods, Inc. (NYSE:USFD).
enced value investors and
don Stone ’78 in L.A. portfolio manager at Weaver
creating numerous learning
C. Barksdale and an adjunct We thank our interviewees for
opportunities for students
Our first interview in this Fall professor at CBS. She dis- contributing their time and
interested in value investing.
Issue is with Paul Moroz, Chief cussed challenges specific to insights not only to us, but to
Investment Officer of Mawer, a the high yield bond market, the whole investing community.
Canadian investment fund. He from the pitfalls of investing in
discussed the value of having fallen angel bonds due to struc- - G&Dsville Editors
business operation experience tural differences between in-
early on, the importance of per- vestment grade and high yield
formance measurement, and the securities, to the evolving role
process of making repeatable of intangible assets as collateral.
value-added decisions. He dis-
cussed the benefit of holding a Finally, we spoke with Matthew
seemingly “boring” company like Peterson, managing partner of
Wolters Kluwer, the headwinds Peterson Capital Management.
Alphabet may face, and their He discussed the three main
longstanding position in Constel- criteria he uses to assess busi-
lation Software since its IPO in nesses, his unique approach to
Professor Tano Santos, the 2006. portfolio construction, and his
Faculty Director of the Heil- recent investment in DJCO.
brunn Center. The Center
sponsors the Value Investing
Program, a rigorous academ-
ic curriculum for particularly
committed students that is
taught by some of the indus-
try´s best practitioners. The
classes sponsored by the
Heilbrunn Center are among
the most heavily demanded
and highly rated classes at
Columbia Business School.

Value Investing Program Welcome Professor Tano Santos and Meredith

Reception Trivedi at the Value Investing Program
Welcome Reception
Volume I, Issue
Page 23 Page 3

Pershing Square Challenge - May 2019

1st Place Winners: Laurent Liu ’19, K.Y. Wong ’20, 2nd Place Winners: David Hao ’20, Eric Niu ’20, and
and Mingming Wu ’20 Freda Zhuo ’20

Audience looking on as teams present Laurent Liu ’19, K.Y. Wong ’20, and Mingming Wu
’20 pitching Dollarama, Inc. (DLMAF)

Applied Security Analysis Professor Ryan Israel, Pershing Square Capital The judges meet to discuss the
Anuroop Duggal delivers opening Management, addresses the pitches and select the winning teams
remarks audience
Page 4

“From Graham to Buffett and Beyond” Omaha Dinner - May 2019

Dinner panel featuring Professor Tano Santos, Audience members look on during the panel
Mario Gabelli ’67, Ashvin Chhabra, Ross
Glotzbach, Paul Hilal ’92, and Thomas Russo

Value Investing Program Welcome Reception - August 2019

Value Investing Program Class of 2019-2020 Students chat with Professor Santos at the
Student Orientation and Welcome Reception Welcome Reception

Alumni Event Hosted by Sheldon Stone ’78 in L.A. - September 2019

Sheldon Stone ’78 (Head of Oaktree High Yield Professor Tano Santos speaks during the event
Bond) with Professor Tano Santos
Volume I, Issue
Page 25 Page 5


23rd Annual
Columbia Student Investment Management
Association Conference
A full-day event featuring some of the most well-known investors in the industry,
including keynote speakers:

William von Mueffling ’95, President & CIO, Cantillon Capital Management

100 years of Value with Tweedy, Browne

Robert Shafir ’84, CEO, Sculptor Capital Management

Fireside chat with Michael Mauboussin, Blue Mountain Capital and

Baruch Lev (NYU), who will discuss his paper “Explaining the Demise of Value Investing”

Presented by:
The Heilbrunn Center for Graham & Dodd Investing and
Columbia Student Investment Management Association

Friday, February 7, 2020

8:00 a.m. to 5:30 p.m.

Columbia University
2920 Broadway (at 115th Street)
Alfred Lerner Hall
New York, New York
For inquiries, please contact:
Page 6

Paul Moroz, Mawer

Foreign Equity Fund understand what it was worth year, and we used some
Manager of the Year award to a buyer. leverage. I got to make so
at the 19th annual many mistakes in my career
Morningstar Awards. You learn so much about early on. The lessons were
Prior to joining Mawer, Mr. investing from a business massive. What was so neat
Moroz was employed by perspective. For example, we about that experience was I
Alberta Investment used to have a contract to cut had incorporated the company
Management and Merrill people's grass, and that was myself. I read through the
Lynch Canada Inc. great because it was recurring. Alberta Corporations Act,
Mr. Moroz is a Chartered I knew how much money we bought share certificates, and
Financial Analyst were going to make over the held shareholder meetings. It
charterholder. He earned course of the summer. That was like this crash course in
a Bachelor of Commerce was very different than thinking about the governance,
Paul Moroz degree from the Haskayne landscaping projects, because the company, and what it really
School of Business at the those were one and done. It was. These experiences of
University of Calgary. was a lot more cyclical. Those speculating, running a business,
Mr. Moroz is a member of concepts were important for a and thinking about governance
the CFA Institute and the businessperson as well as for all proved a tremendous
Calgary CFA Society. an investor. accidental education to
becoming an investor.
Graham & Doddsville I also started speculating
(G&D): Could you tell us how around that time, which is on I had an extremely clear idea
you got into investing? the opposite end of the that I wanted a career in
investing spectrum. For investment management, but
Paul Moroz (PM): I became example, in high school, I even beyond that: I just did it. I
a businessperson before I was raised $1,000 to invest in the skipped class to trade stocks
an investor. It started in junior Bulgarian lev, which had on the library computer. In
high school trying to find ways depreciated like 1,000 times one year, I worked at a local
to make money, so I sold against the U.S. dollar. I brokerage firm, which was
chewing tobacco brought back thought maybe currencies another great experience. It
from the U.S. In high school, I would mean revert, and if you was an entry-level position,
started a business with my invested $1,000 and this thing entering trade tickets into the
friend cutting grass and doing snaps back, well that's your system. Still, I had to skip a few
spring cleanup, before first million. I remember classes to take that job and get
expanding into landscaping. walking down to the local bank that experience. In my co-op
in a town just outside of term, I worked for Merrill
That was a fantastic Calgary, Canada, and trying to Lynch in research.
experience, because we buy $1,000 worth of Bulgarian
learned so much about all the levs. Of course, the bank didn’t Sometimes there are things in
aspects of running a business. have Bulgarian levs, and they life which can create a little bit
We wrote a business plan, got were perplexed. I didn't more motivation. The
a loan, and bought a truck. In understand the full economic University of Calgary had an
fact, the organization that lent picture at the time and how investment program with real
us money forced us to create a the economy produced that money that you could run, and
partnership, so we learned result. Still, it was a huge I applied for that. I'll always
about the legal aspect. We learning occasion. remember the interview. This
were also doing our own was right at the end of 1999
marketing. We hand-delivered In university, I incorporated an and I was talking about Nortel
flyers, hundreds of them. We investment company. That was Networks, how I thought it
also had to figure out how to neat, because it was a real-time was really a silly investment.
collect the money and deal experiment, like a little hedge The valuation didn't make
with receivables, invest capital, fund. We weren't dealing with sense. At one point, the
and manage the few employees a lot of money, maybe $50,000 person interviewing me asked:
we had. We later sold the in total at its peak, but we "How can you want to short
business, so I also had to turned the portfolio 20 times a this stock when there's so
(Continued on page 7)
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Harvey Sawikin
Paul Moroz, Mawer
much collective intelligence evaluate your mistakes in yourself, and where you stand
and people that believe in it." I order to be able to improve. on those issues.
had a probably inappropriate Finally, I had an experience in
response to that, something the Canadian Investments G&D: Do you use a
like “I don't need to follow the Group. I got to see how an benchmark?
crowd”. Needless to say, I institution manages money and
didn't get the job. But I had the the pressure of thinking about PM: Well, it's a unique
mild pleasure of watching things on a relative versus an situation, because today we
Nortel melt down, and absolute basis. I remember a manage close to CA$60 billion
knowing that independence decision was made to buy for our clients. Over 70% of
was worth something. Nortel on the way down. It our business is institutional. To
was still an important my earlier point about the
When I got out of school, an component of the Canadian need to have a proper
opportunity came up in the stock market after the tech measurement and keeping
investment arm of the Alberta bubble had been washed out, score properly, we have
government. Today, they look and the decision was meant to proper benchmarks for each of
after around CA$100 billion. reduce risk by moving the our investment strategies.
That was a rotational program, position closer to its
where I got to see how a large benchmark weight. I will always From a client's perspective,
institution managed money. remember thinking to myself you have to add value over a
that was such a backwards way cycle or there's not much
G&D: What was your role at of looking at risk. point in paying fees. So there's
the investment arm of the a relative component there.
Alberta government early in But what's unique about our
your career? firm is that when we started in
“If you're going to get 1974, we were focusing on
PM: I spent some time in managing money for high net
different groups, which was better at the sport of worth individuals. One of their
beneficial. I spent a little bit of goals is preserving capital. Risk
time in the asset allocation investing, you must is looked at in an absolute
group and gained a different sense. It's Warren Buffett's
perspective. I remember
keep scores properly. comment: "Rule number one,
learning about the concept of You have to be don't lose your client's money.
portable alpha, which I thought Rule number two, don't forget
was funny at the time, intellectually honest rule number one."
separating the value that you
can add, versus what the and evaluate your This gave us a unique
general stock market is going perspective that has shaped
to do and bucketing those into mistakes in order to be how we think about risk as a
two different groups. That's a firm. I'm not so concerned
pretty powerful mental model
able to improve.” about volatility, but what I
to have early on. don't want to do is impair
clients' capital. Still, we have to
Then I spent a little bit of time add value as an investment
in the analytical group. Even As an investor you really have management firm, so there's
though the work wasn't to think about the still a relative component.
terribly exciting, setting up a consequences of the ideology
systematic process for that you take. Looking at risk G&D: Do you use portable
benchmarking and measuring on an absolute or a relative alpha to filter out the noise of
performance, it still led me to basis is a huge philosophical the market?
realize that if you're going to decision that practically
get better at the sport of impacts your investment PM: I think the concept is
investing, you must keep decisions. I'm not saying either much more interesting in
scores properly. You have to side is right or wrong, but it's theory than in practice. You
be intellectually honest and important to understand can have all sorts of strange
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Harvey Sawikin
Paul Moroz, Mawer
things, even with the best laid- our fliers for the landscaping have a network affect, not
out plans, go wrong. Imagine if business right on top of require a lot of capital, and
we took our existing someone else's flier; there grow with the market. For all
philosophy and process to were really no barriers to these reasons, a stock
create a portfolio, and then entering that business. I joke exchange is a pretty good
short a given asset to net out that I started out with the best business. When I started
the difference. While I think education because it was also running our small cap portfolio
that tends to work over a long the worst business to be in. at Mawer, thinking about
period of time, you can get functional advantage became a
short-term challenges that real theme when sorting out
could last several years. My good businesses from the bad
approach is to never put on a first principle’s basis,
yourself in a position where before getting to competitive
even if you're fundamentally “There have been advantage or management.
right, the markets can dictate
your results. people in the I also read Ben Graham, who is
key for understanding the
When I was younger, I learned investment community concept of intrinsic value, and
it the hard way shorting stocks who are too focused on separating the company from
that got called and taken away. its stock. A point on which I
Even if you're fundamentally Ben Graham's differed immediately was the
right, you don’t have the importance of book ratios. It
capacity to stay solvent. That's philosophy, focusing on was based on my experience
the main issue I see with of selling that landscaping
portable alpha. I know you can book value instead of company. I think we had $700
create all sorts of interesting of equipment, and sold it for
products with derivatives, but I recognizing that it’s just $1,500. Beyond what’s marked
think as you increase a heuristic for the cash in the books, the success of
counterparty exposure and the business is what really
financial leverage, it gets flow that can be mattered: are those contracts
complicated fast, and it's not a going to be kept, will
place where I see much produced by those landscaping work be done
practical application for clients. under that brand, can you
assets.” manage your employees and
G&D: Were there any operate profitably. What
inflection points or mentors mattered was the cash flow
that influenced your stream and its longevity. There
investment strategy today? have been investors who are
Many people refer to too focused on Ben Graham's
PM: I went through a real competitive advantage as a philosophy, focusing on book
exploratory phase. The very moat, based on Warren value instead of recognizing
first book I ever read on Buffett's letters. I think that it’s just a heuristic for the
investing was on chart analysis, something else is just as cash flow that can be produced
explaining the Dow theory and important yet hasn't gotten as by those assets.
the different ideas around how much air time: functional
much information the market advantage, which is the very The way the world has
has. Later on, a big part of my nature of the business. The evolved, there are a lot more
investment philosophy came person who started me on this knowledge-based businesses
from my original business is Thomas Caldwell. At some where the competitive
experience: is the growth of a point, he was investing in stock advantage isn't based on the
company from recurring exchanges. He made the point assets. You have to make a
business, can it access capital that these are really good judgment on the people and
to finance its operations, even businesses by the very function the culture. Phil Fisher is
simple concepts like barriers of what they do. A stock another big influence. I still
to entry. I remember putting exchange naturally tends to refer to “able and honest”
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Harvey Sawikin
Paul Moroz, Mawer
management teams; those are from how a lot of other better chance that
his words. investors look at the market. management is going to do
It's the process and the what they say they will do, if
On another level, I'm also a fan culture, along with the modes they have established that
of George Soros. Beyond the of thinking and incentives, that track record in the past.
currency and speculation, I have enabled us to take that On capital allocation, it's not
think The Alchemy of Finance is simple investment philosophy just business models that
such a great book in which he and execute it very well. create wealth, managers can
talks about the concept of There's nothing secret or make decisions to use capital
reflexivity and the separation proprietary about our more effectively or not. There
between what makes a hard philosophy. These are all other is just a wild range, as you start
science and what makes a people's ideas that we've to interview management
social science. The market has stitched together. teams. When you go out to
this unique characteristic that their offices, you can see the
you can really influence the decisions. It's the little things,
outcome. That complicates whether they spent money on
things both to the upside and art in the board room, how
to the downside. This has much they are willing to pay
influenced not only the way I “The market has this people, or whether they have a
think about investing, but also process for thinking about
the way I think about managing unique characteristic acquisitions. All this relates to
a business. Just by injecting capital allocation. There's the
energy and leadership into an that you can really immediate thought about what
organization, you can change a stock is worth, but as you
influence the outcome.
the dynamics of that business, move out in time, as T tends
which then results in a That complicates things to infinity, those choices of
different economic outcome. capital allocation become a
The universe is very reflexive. both to the upside and prime driver of stock returns.

G&D: What’s your investment to the downside. ” Like many people, we believe
process? the value of a company lies in
its discounted cash flows. A
PM: I came to Mawer in 2004. differentiating aspect of our
At that point, I had read so philosophy at Mawer lies in
much that I was able to clearly our probabilistic approach. I
differentiate between what I There are a number of factors actually wrote in my cover
believed in and what I didn't we look at when assessing letter, "This intrinsic value
believe in, based on what I saw management. I still feel like thing is great, but have you
in the market and the errors I we're in the dark ages in terms ever thought about looking at
made. Our investment of management evaluation, but intrinsic value in statistical
philosophy is very simple. We one of the benefits that we get terms, rather than just as an
invest in wealth-creating out of going back and reading absolute number?" It stemmed
companies, the ones able to public documents over time is from my observation and
earn a high return on their that you can understand what experience looking at oil and
capital by virtue of their management teams have said gas companies, where I
competitive advantage and able they are going to do and what thought "You don't know what
and honest management teams is their actual track record of the price of oil is going to be."
allocating capital to build a doing so. If a management One of the best ways to deal
resilient business. Our last team is consistent in thought, with that uncertainty is to
tenet is don't pay too much. deed, and word, that's our conduct a Monte Carlo
You can shortcut our definition of integrity. We analysis. If you were to just
investment philosophy to want to allocate capital toward estimate the intrinsic value and
Quality at a Reasonable Price, people with greater integrity, compare that to the stock
as opposed to value or growth. which really comes down to price, given the volatility
It's not going to be different trust and execution. There's a around your assumptions, your
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Harvey Sawikin
Paul Moroz, Mawer
discount to intrinsic value may very different from many stock with that number? The most
not be statistically significant. pickers out there. that you can say from first-
Intellectually, I was already principles basis is "Your return
heading down the path of should be above your
"Wait a minute, the world is perceived risk-free rate." It's
random." That's exactly the probably not going to be so
path Mawer was heading “We have some high or there will be
down, which I didn't know at competition that drives it
the time. They were prototypes of down. So, in a way, it's relative.
implementing these Monte It's based on inflation. It's
Carlo models that would be automated discount relative to your risk-free rate.
the big difference in how to It's relative to competition. It's
look at the world. cash flow models that relative to how much capital
there is. It has to be relative.
I have a tremendous amount of build out ranges, but
respect for the intelligence of what we need first is to What we require for
the market and I think that the companies to earn over a
goal in investing is often to do the work required to business cycle is always
avoid making behavioral dynamic. We recognize we
errors. While the concept of understand the quality don't know its true value.
intrinsic value is fantastic, one When analysts start building
of the errors you can make is of a company.” models, they have more of an
to get locked into thinking absolute idea on making
your opinion of value is the decisions, and we'll often say
correct one. To the contrary, "If you moved your discount
we build the models ourselves rate half a percentage point
and understand the key drivers It has served us well, because left, that's a 10% move,” and
of these businesses. We then another area where some that's a major change. We have
think about the world investors got caught out is on to be aware of that and be
probabilistically through where discount rates have flexible in how we look at the
scenarios and Monte Carlo gone. Imagine if you said, "I will world, or else we can make
analysis in order to understand only buy stocks that trade mistakes. So much of this
if, from a statistically below 10x earnings over the process aims at mitigating
standpoint, we actually have last decade." You would have behavioral errors
much of a discount at all. You most probably been left with a overconfidence, as we think
start to realize that it's not portfolio solely comprised of we know what will happen.
about getting a top stock pick companies facing problems. To
and being correct. What we the contrary, when it comes to G&D: Do you use the Monte
get with our Monte Carlo valuation, what we do is we Carlo simulation to screen
analysis is a fair value range, a randomize and iterate our ideas or to generate the
framework that imposes a level discount rates, which are log valuation? Do you seek out
of humility in our decision- normally distributed after investments where the range
making. As a security trades building our weighted average of outcomes displays a floored
further down in its fair value cost of capital up from spot downside and a right skew?
range, it doesn't mean it's bond yield curves, corporate
necessarily undervalued, but it bond premiums, and equity PM: It's mostly after we are
gives us a little bit more risk premiums. That allows for into the intensive analysis
statistical understanding of some flexibility and evolution process. We have some
how we should be reflecting in how we look at valuation. prototypes of automated
these odds. When stocks trade discount cash flow models that
to either the lower or higher I would say we're practicing build out ranges, but what we
end of the fair value range, we relative absolutism estimating need first is to do the work
adjust. We are very discount rates. The problem is, required to understand the
probabilistic as a research if you have an absolute quality of a company.
department and that can be number, how did you come up
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Harvey Sawikin
Paul Moroz, Mawer
One of the benefits of our G&D: Could you discuss how companies that really create
process is we can shift our you source ideas? wealth. You can narrow your
investment selection based on investment universe down in
themes, trends, or options that PM: That's the part of the fairly short order.
might relate to that skew. I'll process we've left the most Once you have a conversation
give you an example relating to open and creative. We are a with management, if you're not
the shape of a distribution. We process-focused firm. If you focused on next quarter’s
have been working on oil and were asking about due earnings but on how they
gas companies, particularly in diligence, there are a number think, how they build their
Canada, where a big issue is of specific steps. But there are business, and why they make
getting the oil and gas out to many ways ideas can come certain decisions, then the
the U.S. – we just don't have together and we want that, information becomes very rich.
the pipeline capacity. In because creativity's important. Brute force screening is the
reviewing valuations, among best way to do it. It's tough,
many risks are the The most creative ideas come because it takes a lot of time.
environmental ones. A about when we just get out But if it's tough to do, there's
company like Canadian Natural there and talk to people. Being also a better shot that there
Resources might be close to a in Calgary, Canada, there are will be an inefficiency.
CA$35 billion market cap, but not a lot of companies that
its tailing pond liabilities could come to us. We often go to We have also institutionalized
be anywhere from CA$2 companies in road trips or a lot of things. We have a
billion to CA$9 billion or research trips. We screen all database with over 8,000
more. It presents a more the companies in a country and companies and over 300,000
negative skew. then get out and talk to those entries, including everything
we are interested in. from management interview
On the contrary, one of our notes to independent sources
European companies is a of information, such as
testing, inspection, and conversations with suppliers,
certification company called “Brute force screening customers, or competitors, as
Intertek. They test and certify well as public documents,
all sorts of things to make sure is the best way to do it. releases, sell-side research,
they meet certain criteria and everything that we've been
It's tough, because it
standards. They also have an collecting for over 20 years.
assurance business to make takes a lot of time. But This is a platform that helps us
sure the standards are in place organize the world to focus on
at companies. It's a unique if it's tough to do, those companies that, at this
company, and they just time, meet our investment
announced today they would there's also a better criteria, and where we think
be developing a sustainability we can add a little more value
assurance service, enabling shot that there will be by investigating more. Even
companies to understand how when we’re looking at
an inefficiency.”
sustainable their products are. something for the first time,
If you have noticed the rising we already know a lot about it,
concern for the environment, and that helps tremendously.
it seems that Intertek would It’s more of a resource
be extremely well-positioned You might say, “There are an allocation problem than a
to benefit from that. awful lot of companies. How screening one.
can you parachute into India
As a portfolio manager, I and figure out which 40 G&D: Are there investments
would be adding incrementally companies to talk to over 2 you’re excited about?
to Intertek and trimming weeks?" Well, it's relatively
incrementally Canadian easy because we define what PM: We have a slogan, "Be
Natural Resources. It's not we are interested in and what boring. Make money." I think
black and white; it’s about we're not. My estimate is there people would be surprised but,
leaning to the right or the left. are only about a third of all over a long period of time, if
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Harvey Sawikin
Paul Moroz, Mawer
you're going to be a successful combination of non- long time. They are now at the
investor, it's not about the one discretionary services point where the print business
bang stock pick. Having a few representing a small cost has been declining for a while
of those helps, but it's more related to clients’ overall and revenue growth rate has
about not losing and staying on operations is extremely gone back up from 1% to 3-4%.
process, especially in large attractive from a business That's helped drive a little
caps. I have colleagues who model perspective. more interest in the security.
could talk all day long about At this point, it trades at 23x
unique, special small cap earnings. We consider it in the
stocks, but I don't think this middle of its fair value range,
illustrates what we're trying to between high €40s and €80 a
do in terms of consistently share. The internal rate of
tilting the odds in our clients' “I have colleagues who return stands only at 5% to 7%.
favor, and making value-added This is not something super
decisions for them on a could talk all day long attractive. Still, we recognize
repeatable basis. its unique characteristics as we
about unique, special
approach the end of the
A great example is a company small cap stocks, but I economic cycle.
called Wolters Kluwer. It’s
based in Europe, and I think don't think this This is where it helps to be
Peter Lynch would say, "It's a index agnostic. It's categorized
terribly boring name for a illustrates what we're as an industrial stock, but the
terribly boring company." They business model doesn't present
have a number of businesses trying to do in terms of the same level of industrial
that are just the most boring in cyclicality as most industrials.
consistently tilting the
the world: legal and regulatory, The doctors aren't canceling
tax and accounting, finance and odds in our clients' their subscriptions in a down
compliance, and health. The cycle. It's a nice recurring
company was originally a favor, and making value business and it might even have
publisher. A lot of the greater pricing integrity and
products they sell are -added decisions for stability during a downturn
reference materials and books than many consumer staple
sold to legal practitioners. All them on a repeatable stocks, whose barriers to
that used to be print, but now entry have declined with the
the business has been increasing ease to advertise
transitioning to digital. and distribute. That’s how it
fits into the portfolio.
One element of the thesis was
that print was struggling in Furthermore, the company has Management capital allocation
terms of pricing growth, but good market share positions. has also been pretty steady.
this was mitigated as the In tax and accounting, it holds What they have implemented
company transitioned to a the #1 or #2 position across is a target return on invested
digital, subscription-based Europe, with a 25% to 35% capital of over 9% and it has
business model. Today, print market share. In their health reached just a little bit over
accounts for less than 10% of division, they are #2. If you go 10% over the last five years,
the business, and you're only into your doctor’s office for a translating into an ROE of
left with these wonderful checkup, and your doctor is on almost 25%. It's not home run
niches where 80% of the the computer, they are not capital allocation, but they have
revenue is recurring. Of that just searching Wikipedia – acted with a lot of integrity not
80%, their retention rate they’re most likely looking at only on a return basis, but also
stands between 90% and 100%. Wolters Kluwer’s reference in terms of moving capital
This goes back to my history materials online. This towards segments that are
of first thinking about information is vetted, and we more recurring in nature and
businesses and the functional think these businesses are all more defensive.
advantages they hold. The going to be around for a very
(Continued on page 13)
Page 13

Paul Moroz, Mawer

In terms of risks, they do have a particular scenario that that you can have a lot higher
some debt, but at 1.8x debt-to would lead to that wonderful weight in Google. The highest
-EBITDA I think that's not a alpha will even occur. To us, weight that we allow ourselves
significant concern given the it's about shifting the odds and to have is 6%.
quality of the business. A grinding forward.
maybe more significant risk One of the reasons our
would be academic journals. position in Google has come
This segment has been facing “We've had so much down is because they are
some pressure, because the facing headwinds in the
industry’s been moving passive share gain in advertising market, along with
towards open-source journals. the U.S. and interest in Facebook and Amazon. Sure,
they built an amazing system
I’m not as concerned about technology firms. This around search, own the
relative risk. There's risk that Android platform, and display
interest rates or discount rates also calls for basic some pretty good optionality
go up and the stock de-rates. with their bets segment. But
By the same token, there's that diversification, for not think about the competition
same risk the other way. Right that could be unleashed if
now, we have $16 trillion of getting too far ahead of Netflix decided to monetize
negative yielding debt in ourselves, because if their business through
Europe, so you get an odd advertising and drop their
consequence in the event of a everyone runs for the subscription prices to compete
recession. The 10-year yield with Apple's or Disney’s
bond in North America could exit in the American content. This would be a huge
be negative 1% and your threat to what Google can
discount rate could be lower. stock market, and the charge. That's one of the risks
A stock like this could be that we see evolving. It's very
worth 30x or 40x earnings. It's tech companies really clear they're going through an
a possibility. get beat up, is it antitrust phase in their
business, similar to what
If the world doesn't fall apart, possible that Google Microsoft went through.
it'll still be okay. If the world There’s a reason to recognize
falls apart, we think it will act could trade at a much that this could be split apart.
more like a consumer staple. It We think the base case is that
has some resilient qualities to lower price?” there'll be minor restrictions,
it in the portfolio. but that’s still good reason for
basic diversification.
G&D: It seems the “valuation G&D: Similar to Wolters
at a discount” element is not Kluwer, you also hold a 3% Also, let's just separate stock
so important here? position in Google. from company for a moment.
Incidentally, they trade at We've had so much passive
PM: There are very few times similar multiples but have share gain in the U.S. and
when all the stars align with different growth profile. How interest in technology firms.
this philosophy and would you describe your This also calls for basic
everything's just perfect. There investment in Google? diversification, for not getting
are inherent trade-offs, and too far ahead of ourselves,
what we hope is that across PM: That's interesting to because if everyone runs for
the portfolio we arbitrage out approach Google from a the exit in the American stock
those facts and trade-offs to be valuation perspective. market, and the tech
consistently ahead. That's why Historically, Google has grown companies really get beat up, is
long-term investing is not what at a much higher rate, and if it possible that Google could
you think it is, in terms of each you were to compare those trade at a much lower price?
individual stock producing all stocks on some basic multiple
this wonderful alpha. In fact, principles, they might be fairly If you look at Baidu, the
you don't even know whether similar. There's an argument equivalent of Google in China,
(Continued on page 14)
Page 14

Paul Moroz, Mawer

it hasn't been doing that well. verticals had strong He operated with a high
Of course, Tencent and their competitive advantages. He degree of integrity. He really
WeChat platform has been went through Porter's five did that, and did that well.
wildly successful, and Alibaba is forces to establish this and said As we look back on the
pretty big. Yet the way the that there was an opportunity investments, what we didn't
Chinese market has developed in acquiring these. This was know at the time was how well
is that search has lost around 2005, and we were still they would be taking
relevance. I don't know the suffering in the market from businesses that weren't really
way the world's going to turn the tech bubble blow-up. Many making that money and turning
out, but maybe people will be people didn't want to touch them around. The businesses
doing their searches directly tech at all. That was part of the themselves had barriers to
on Amazon or Facebook. psychological opportunity, too. entry, but others wouldn't
Those are all risks. It's not that You have to be willing to have created the same results
we don't like Google, but understand things on a first in managing the turnaround.
there's been some heightened principles basis rather than just The other thing was the
risk more recently and that's saying "I'm not going to do culture. Mark had implemented
what that weighting reflects. tech." At the time, you had to a culture of measurement and
be thinking long-term to be was a thought leader in
G&D: Could you discuss your able to manage the volatility managing this business for the
investment in Constellation and take the position. long-term. When you can do
Software, and where you stand that and hold for so long,
on the company now? results are just outstanding.
“Around 2005, we were
PM: Constellation Software is Today, we are still invested in
in the business of buying niche still suffering from the Constellation Software, but the
software companies. It's been a risks are different. Despite the
very attractive company. The tech bubble blow-up. excellent capital allocation, it's
question always is, do people gotten tougher. They're
know about Constellation
Many people didn't looking at larger acquisitions.
Software now? Some of the want to touch tech at They have lowered their
price reflects that. Believe it or hurdle rates for acquiring
not, we bought it in our small all. That was part of companies and use debt to
cap fund, off the IPO. I was help meet the hurdle rates.
involved in the original the psychological They've been pragmatic about
analytical work on that. It's it. Investors waiting for the
amazing. I've gone back and opportunity in perfect 20%, 25% unlevered
looked at the investment IRR acquisition just haven’t
reports, and I don't think
Constellation Software.
done anything.
anyone recognized how You have to be willing
significant the opportunity was. The other thing that's probably
to understand things on changed is, there are questions
Constellation Software is a that remain around the legacy
great example of how people a first principles basis portfolio. How much technical
focus on different things. debt is there across their
There were many investors rather than just saying portfolio companies? Has there
who said, "Yeah, I think this is been underinvestment in the
a good company, but it's too
I'm not going to do transition to cloud? The thing
volatile and illiquid." They tech.” that investors really have to
didn't have the time horizon to watch closely is understanding
hold the position. When we how that organic growth is
met with Mark Leonard, who trending across the portfolio.
was the architect of the whole Another part of the appeal of
company, he outlined why Mark's business plan was that Finally, Mark was much more
these niche software he was very clear in terms of intimately involved in making
companies in these small how he would allocate capital. capital allocation decisions at
(Continued on page 15)
Page 15

Paul Moroz, Mawer

the beginning of the journey Another big thing was when G&D: Would you have any
with Constellation Software. Nadella took over. That advice for current students
Now there are other people transformation of culture will pursuing a career in the
that are more involved in that. be used as a business case investment management
Those capital allocation study for generations. They industry?
decisions have been pushed have created the culture
down throughout the necessary to win in this PM: You have to read as much
organization, but there's only environment, and they have as possible. You can't blindly
one Mark Leonard, like there's made a lot of tough decisions. latch on to any sort of
only one Warren Buffett. The big one was being a lot investment philosophy. As
more open than the company opposed to someone saying "I
G&D: Can you talk about ever was during the Gates and read a couple of Warren
your recent addition of Ballmer eras. They now look at Buffett’s letters, so I'm going to
Microsoft to the portfolio? other software companies and try to invest using his
think about win-win philosophy," I'd much rather
PM: Microsoft has a number partnerships, as opposed to a focus on discovering and
of really special characteristics. "we win, and you lose" type of understanding why I’m making
Of course, there’s the mentality. For the cloud, that's a decision, how I feel about
dominance of their operating a cultural and business strategy each principle. It's not only a
system. Additionally, they've shift that has really opened up lot of fun, it will also lead to a
done a good job of the potential of the market. much clearer understanding of
transitioning to the cloud. where you stand, as opposed
When we did our work on to getting lumped in with a
understanding that particular brand without even
opportunity, we looked at our having a core understanding of
cloud bill. That was so “When it comes to why you're there.
revealing, because it's broken
down by line items as if you're
investing, I believe My second thought builds on
buying auto parts or people have to Ben Franklin’s expression: "Tell
something. It will give you the me and I forget. Teach me and
quantity and the price. Often practice. It's not an I learn. Involve me and I will
these things are really small remember." When it comes to
when they are broken down, academic exercise. Use investing, I believe people have
so psychologically, it would to practice. It's not an
make it very difficult to your own money. Don't academic exercise. Use your
negotiate down the price of own money. Experiment with
cloud with Microsoft. More
wait. It doesn't matter shorting stocks. Experiment
than being a recurring and non if you're investing just with creating a process. Set up
-discretionary service, the a system for real time
software is woven into the $100 in the stock. Just experiments and coordinate it
fabric of the company. in such a way that you can
do it.” make errors that won't ruin
There is also extra code that's you, but from which you can
been written to port learn. Even looking back on my
applications to the cloud. This experience, I was just so lucky
makes it difficult to switch. It's For sure, there'll still be some falling into these experiments
a lot less of a commodity than cyclicality in the business and early on, which developed the
we certainly envisioned it to in the stock, notably because way I think and the decisions I
be. It means you have a long of how the stock trades. It's in made when investing. I
runway of opportunity and the technology basket. There's encourage people to actually
optionality with respect to all a lot of passive money that's do it. Don't wait. It doesn't
these different devices that will invested there. It's the U.S. matter if you're investing just
be connected to the cloud. stock market, which is $100 in the stock. Just do it.
Microsoft has a really nice extremely dynamic. I still think
position for it. the firm has a bright future. G&D: Thank you so much for
your time.
Page 16

Aramark (NYSE: ARMK) - Compelling Opportunity for Activism

2019 Pershing Square Challenge Finalist (May 2019)
Freda Zhuo, CFA Eric Niu, CFA David Hao, CFA

Trading Stats (Mlns except per share) Financials (mln) FY16 FY17 FY18 FY19E FY20E FY21E
Market Capitalization 7,655 Revenue 14,415.8 14,612.2 15,789.6 16,454.8 17,024.0 17,613.9
Enterprise Value 14,684 EBITDA 1,375.7 1,405.9 1,615.1 1,738.4 1,859.9 2,004.2
NTM P/E 12.8x Margins 9.5% 9.6% 10.2% 10.6% 10.9% 11.4%
David Hao ’20 Avg. 3M Daily Volume 2.32M Operating Profit 939.3 964.8 1,108.4 1,193.4 1,274.8 1,379.2
Float 98% Margins 6.5% 6.6% 7.0% 7.3% 7.5% 7.8%
David is a 2nd year student at
CBS and a member of the Value 52 Week High/Low 27.37/ 43.70 Net Profit 481.2 530.9 850.7 597.8 685.1 791.5
Investing Program. Before CBS, Current Price (05/02/2019) 31.08 Margins 3.3% 3.6% 5.4% 3.6% 4.0% 4.5%
he covered global energy, mate-
rial equities at TD Asset Man-
agement in Canada. David serves Recommendation
as the Co-President of Columbia We believe ARMK is a compelling LONG with a 23% 3-year IRR with a 4-to-1 upside/downside skew.
Student Investment Management Aramark is deeply undervalued with market sentiment obscuring the investment opportunity. What we see
Association (CSIMA). He in- today is two business segments that deserve more market recognition - the core catering business, which is
terned at Causeway Capital
during the summer.
more resilient in the midst of food/labor inflation, and the uniform business, which has margin enhancement
opportunities if scale is increased. All in, we see margin upside of 10% above consensus FY21 EBITDA. Addi-
tionally, recent share underperformance opened a window for activist involvement to accelerate value crea-
tion, with the bull case upside of 37% 3-year IRR. Consensus is focused on leverage, cost inflation, and a
lower multi-year outlook from the Investor Day in December 2018, though our in-depth primary research
with over 30 stakeholders unveiled opportunities for an activist to:

1) Realign senior & mid-level management incentives;

2) Address low-hanging fruit in operational improvements;
3) Potential spinoff of the Uniform segment or sale of entire business.

Aramark Overview
ARMK is a ~$15bn EV global leader of food catering and uniform rental services to education, healthcare,
Eric Niu ’20 business & industry, sports, leisure, and corrections clients. The company is the #3 player globally in Food and
Eric is a 2nd year student at CBS Support Services (“FSS”), behind Compass Group (LON: CPG) and Sodexo (SWX: SW), both based in Eu-
and a Private Equity Fellow. He rope. Additionally, the company is #2 in uniform rentals in North America, behind Cintas (NASDAQ: CTAS).
is also the Co-President of CBS’ Most of the company’s revenue comes from North America where contract catering penetration is lower
Private Equity Club. Prior to
business school he was a private than other developed countries. Since its IPO in 2013, the company has improved margins through a variety of
equity associate at Acasta Capi- cost cutting initiatives and increase in contract catering penetration. In 2017, ARMK purchased Avendra and
tal based in Toronto. Ameripride to bolster its scale and the uniform rentals business.

Investment Thesis
1. Food and Support Services is a higher quality business than currently perceived: 85% of ARMK’s
revenue is in FSS, which is primarily contract catering. Recent contract turnover garnered attention but ob-
scures the strong business characteristics of FSS: end-market client outsourcing remains a secular driver (in a
bid to save costs) and catering revenue is sticky with longer-term contracts. ARMK’s revenue coming from
business/industry (33%), which is cyclical, is also lower than that of its peers (45%+). In addition, ARMK has a
higher North American exposure, which is higher-margin and less penetrated than Europe. While rising costs
have been a concern, ARMK has multiple levers to offset cost inflation through investments in technology and
doubling the food purchase scale with its purchase of Avendra. Our primary research indicates that the initial
Freda Zhuo ’20 $40M synergy target with the Avendra acquisition is conservative.
Freda is a 2nd year student at
CBS and a member of the Value 2. Uniform becoming more competitive and essentially a “free option”: ARMK is the #2 player in
Investing Program. Prior to CBS, uniform rental in North America, but its acquisition of AmeriPride should make the Uniform segment more
Freda was a sell-side equity
research analyst at Goldman
competitive. Uniform economics are largely driven by per-route profitability, and AmeriPride enables higher
Sachs covering consumer staples revenue per route via larger contracts, as well as increased automation and efficiency vs. CTAS. Importantly,
companies. current valuation suggests inefficiency in market pricing. If we assume ARMK’s FSS segment trades at peer
level (11x EBITDA, at parity with Sodexo and a discount to Compass), investors are getting the Uniform busi-
ness for free.

3. Activism to address opportunities in operational improvement: We believe ARMK has significant

opportunities to catch up to best-in-class peer Compass Group. We propose that ARMK’s senior manage-
ment incentives to be restructured to include: 1) aligned peer group - current peer group includes megacap
staples like McDonalds, PepsiCo, and Starbucks, but excludes Compass Group, Sodexo, and Cintas, whom
ARMK competes with on a daily basis; 2) quantify ROIC targets and “individual” component of compensation;
Page 17

Aramark (NYSE: ARMK) - Compelling Opportunity for Activism

3) tie synergy targets to NEO compensation and have third-party auditor verification; and 4) for middle management, emphasize customer
service and collaboration to share best practices.

We believe these improvements can lead up to ~12% EPS enhancement. Finally, to the extent that the market does not appreciate the
value of the Uniform business (not part of ARMK’s operational enhancement opportunities), a spinoff can be pursued in a tax-advantaged
(Reverse Morris Trust) manner to accelerate value accretion.

Given our view that ARMK’s core operations are undervalued, our base case price target of $58 represents a 23% IRR and is based on
assumptions of conservative top line growth (+3.5%), margin expansion (+90bps to ~8% by 2022E), and 9x EV/EBITDA (close to the low
end of its historical range). The bear case of $25 represents a -7% IRR and would assume no sales growth as well as full cost inflation of
almost 4% along with a peer-low 7.5x multiple.

We believe that activist involvement in ARMK can accelerate value creation, and outline two bull scenarios. The first is through a tax-free
spinoff of the Uniform business (~$4bn EV), which enables both the FSS and Uniform businesses to trade closer to peer multiples and
generates a 32% IRR. The second bull scenario assumes operational involvement from an activist prior to spinoff, to realign incentives and
accelerate margin expansion (e.g. through retention-rate improvement and route-optimization). This could add up to ~10% to our base
case 2022E EBITDA and improve the IRR to 37%. All-in, we see close to a 4:1 bull/bear skew indicating favorable risk-reward.

Risks & Mitigants

1. Leverage/Economic Recession. While Aramark’s revenue/profit fell ~10%/~15% during the 2008 recession, the company’s end
market exposure is a lot less cyclical today with ~50% in non-cyclical segments. The company’s debt is comfortably termed out with
the first significant maturity in 2023.
2. Contract Losses. The company is well diversified across industries and contracts are long term (3-5 years) so losses can be mitigat-
ed through clear communication of expectations and middle management incentives that are tied to performance.
3. Cost Inflation. The company and industry has a demonstrated track record of passing through cost inflation to end customers—this
is contractually protected by the contract terms. Additionally, the company has opportunities to optimize labor spend.
4. Changes in Outsourcing Trends. Online food delivery and telecommuting may slow sales growth—but the TAM of outsourcing
in Healthcare and Education remains substantial.

Subsequent Events
This investment recommendation was presented at the 12th Annual Pershing Square Challenge on May 2, 2019. On August 16, 2019, Mantle Ridge
LP purchased a ~20% economic stake in ARMK and the investment firm expressed intention to discuss business strategies, operations, governance,
and composition of executives with the Board of ARMK. On August 26, 2019, then CEO of ARMK, Eric J. Foss, announced his retirement.
Page 18

ServiceMaster (NYSE: SERV) - Long with Constructivism

2019 Pershing Square Challenge (May 2019)
James Shen, CFA Lauren Warsavsky Mark Zager

Trading Stats (as of 5/2/2019) Financials ($MM) FY15 FY16 FY17 FY18 70 12

Share Price $49.00 Revenue 1676 1724 1754 1899 60 10

Market Cap ($MM) $6,659.10 Gross Profit 770 802 793 859 50

Volume (MM)
Enterprise Value ($MM) $7,674.77 Gross Margin 46% 47% 45% 45% 40

52 Week High/Low 62.70/ 34.28 Adjusted EBITDA 386 405 374 398 30
Short Interest 2.28% EBITDA Margin 23% 23% 21% 21% 20

James Shen ’20 EV/EBTIDA Fwd 17.6x FCF 308 355 283 315 10 2

James is a 2nd year MBA student P/E Fwd 34.5x FCF/Share 2.26 2.59 2.09 2.32 0 0

at CBS and a member of the

Value Investing Program. Prior
to CBS, he worked at HSBC in
the fixed income trading and Recommendation
balance sheet investing teams.
James interned at Cornerstone
We recommend a long in ServiceMaster (“SERV”) with a 3-year price target of $78, representing an upside of
Research this past summer. 59% on 5/2/2019 and an IRR of 20%. Our investment thesis is supported by ServiceMaster’s long growth run-
way, durable competitive position, and cash flow generation abilities. In addition, we see opportunities for a
constructivist to further maximize the value of the company.

Business Description
SERV provides: i) residential and commercial termite & pest control services through Terminix, and ii) clean-
ing, inspection, home repair, & disaster restoration services through ServiceMaster Brands. Terminix is the
second largest pest control company in the US with 21% share and accounts for 87% of ServiceMaster’s reve-

Lauren Warsavsky ’19 Investment Thesis

Lauren is a recent graduate of I) Pest control is a sustainable industry with a long growth runway
CBS and currently works as a
Director at N*GEN Partners, a
· The historical growth rate in the pest control industry has been both stable and sustainable. The $8.5bn
growth equity fund focused on US pest control market has grown at GDP+ for the past 10+ years and is recession proof, having grown
healthy living. Prior to CBS, 2.2% between 2008-2009.
Lauren was a generalist invest-
ment analyst at Focused Inves- · The penetration rate of do-it-for-me pest Industry Growth and Market Size
tors, a value-oriented invest- control services is still relatively low. Only 10 Recession-proof: Grew 2.2% 2008-2009 6.0%
ment management firm, and an 33% of the country has this service and it is
investment banker at Houlihan 9 5.2% 4.6%
4.7% 4.7% 4.6% 5.0%
Lokey in their Financial Restruc- growing as millennials become homeowners. 8 4.5%
· Pest control companies have been raising
Market Size ($Bn)

turing Group. 3.2% 4.0%

Growth Rate
6 2.8%
2.2% 2.2%
prices at 2%+ annually on average. 5 3.0%
· The industry is very fragmented. Although the 4 1.5%
top two players in the industry control ~37% 3
of the market, there are ~20,000 players in 1

the space and most have fewer than 100 em- 0 0.0%
ployees. Small firms and attractive route eco- 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

nomics provide enormous white space for Market Size Annual Growth Rate

tuck-in acquisitions.

II) Terminix is an attractive business that generates a lot of cash

· Terminix has strong recurring revenue. Contracts are structured to have upfront payment plus an annual
Mark Zager ’20 maintenance charge. The average customer life is between 4-8 years and retention rates run ~80%.
Mark is a 2nd year MBA student · Terminix has diverse revenue streams across geographies and product mix. The top branches are well-
at Columbia Business School and
a member of the Value Investing positioned in the fastest growing markets throughout the US.
Program. Prior to CBS, he was a
FCF Conversion (FCF/EBITDA)
· The business generates superior margins
generalist investment analyst at and free cash flow. With a 20% EBITDA margin
Terminix’s FCF conversion is
Anderson Growth Partners, a 90%

value-oriented investment 80%

highest among peers and 75% free cash flow conversion (FCF/
management firm. Mark interned 70% EBITDA), Terminix’s cash flow generation abil-
at First Manhattan Co. this past ity is higher than peers.
2014 2015 2016 2017 2018

Terminix Peers Avg

Page 19

ServiceMaster (NYSE: SERV) - Long with Constructive Activism

III) ServiceMaster’s recent struggles call for a focused strategy. We propose a three-fold constructivist plan.
i. Expand the board and align executive compensation with metrics that maximize value for shareholders.
· Current situation: Previous strategic inconsistencies reflect a lack of control and guidance from the board. Additionally,
named executives’ performance targets are relatively easy to achieve, which could result in a lack of incentive to achieve
better performance.
· We propose that ServiceMaster add a more pest control experienced cohort to the board.
· The board should also change executive incentive compensation targets to a blend of metrics (revenue, gross margin, dilut-
ed EPS, and operating cash flow) that drive value for shareholders.
ii. Close the gap with Rollins through training and technology.
· Current situation: Terminix’s retention rate trails the industry leader Rollins by 2% due to lags in training and technology.
·We propose that Terminix benchmark to Rollins and launch remote & field trainings for 1st year employees, provide mana-
gerial training to managers, restructure technician’s pay plan to an hourly pay plan, and adopt the BOSS & GPS tracking
systems to improve on-time delivery of services, optimize routes, and provide better customer service.
· Our analysis suggests that a 1% retention improvement would yield an incremental $0.20 to EPS.
ii. Spin off ServiceMaster Brands (SMB) to unlock additional value.
· Current situation: Terminix’s company owned model and SMB’s franchise segment have few synergies. Cross-selling on
national accounts has not worked well historically and cost synergies (if any) may only exist at the corporate level.
· A spin-off would increase managerial focus and ascribe a proper valuation to each independent segment. Moreover, Service-
Master historically has had success with spin-offs, including TruGreen’s spin-off before ServiceMaster’s IPO and FrontDoor
in October 2018.
· Based on our analysis, the current price suggests investors are getting a high-margin business like SMB for only 9x forward
EV/EBITDA. A tax-free spin would increase the IRR on the investment from 17% to 20% and unlock additional value for the
Variant View
· Wall Street does not give enough credit to Terminix’s restructuring potential. Under the new CEO’s leadership, Terminix is going
through a turnaround process and we believe top line growth will return to industry averages given management’s strategy.
· Consensus estimates understate Ter- IRR Bridge Constructivist Return
minix’s incremental margins. We believe 25% 3.1% 20.3%

that by focusing on improving employee/ 20% 2.8%

2.5% 17.2%
customer retention, Terminix can achieve 15% 2%

a higher incremental margin than consen- 10% 7.3%

sus. 5%

· The current multiples have room for 0%

EBITDA Growth Multiple Expansion Deleveraging Base Case IRR Incremental Sales from Margin Improvement Base & Operational
Retention & Customer from Retention Improvement
SMB Spin IRR with
expansion. Even at a discount to pure-play Acquisition Involvement

peer Rollins, ServiceMaster’s multiples

have ample room to expand as operations improve.

· Using a sum-of-the-parts approach, we arrive at a $78 target price by as- Terminix vs Rollins by 2021
suming a 20x 2021 EV/EBITDA for Terminix and 14x 2021 EV/EBITDA for Rollins
SMB. (Consensus)
· We use Rollins’ valuation as a benchmark for Terminix, and took a 30% Organic Growth(3y avg) 4.4% 5.1%
discount to reflect factors such as Rollins’ limited float, cult following
among the investment community, and its long history of delivering superi- Inorganic Growth(3y avg) 2.7% 2.2%
or organic growth. Gross Margin 43.5% 51.9%

EBITDA Margin 23.1% 21.7%*

Risks & Mitigants
· Company and shareholders are unreceptive to plan: our constructivist Leverage 0.8x 0x
approach does not call for removing management or board members and
should be viewed favorably by key constituents. Management is incentivized EV/EBITDA 20x 29x
to optimize ServiceMaster’s business portfolio under the new changes to
the ‘double trigger vesting’ program.
· Terminix and SMB may not reach expected valuations as independent companies: Both Terminix and ServiceMaster Brands generate
ample and stable free cash flow, which underpins the valuation. At present prices, we believe there is a large margin-of-safety.
Page 20

US FOODS (NYSE: USFD) - Long with Activist Value-added

2019 Pershing Square Challenge
Edgardo Gutierrez, CFA Yuri Rettore, CFA Rodolfo Zeidler, CFA

Trading Stats Financials ($ mn) 2016 2017 2018 2019E 2020E

Market Capitalization 7,954 Revenue 22,919 24,147 24,175 26,815 29,556
Enterprise Value 11,477 Gross Profit 4,053 4,218 4,306 4,819 5,360
P/E 2020E 13.9x Gross Margin 17.7% 17.5% 17.8% 18.0% 18.1%
EV/EBITDA 2020E 11.3x EBITDA 467 587 672 832 1,016
Edgardo Gutierrez ’20 Current Price ($/share) 36.6 EBITDA Margin 2.0% 2.4% 2.8% 3.1% 3.4%
Edgardo is a 2nd year MBA 52 Week High/Low 40.6/28.0 Net Income 210 444 407 489 572
student at CBS. Prior to CBS,
he worked at Moneda Asset Net Margin 0.9% 1.8% 1.7% 1.8% 1.9%
Management, a LATAM based
asset manager with $10 billion Opportunity Summary
AUM, covering telecom and
health care equities. He in-
We are recommending a LONG in USFD with an implied 23% 3-year IRR as a passive investment, which can be
terned last summer at Archegos improved to 33% with activist involvement. We think US Foods operates in a recession-resistant industry and the
Capital, a multi-billion long/ company presents strong and increasing competitive advantages. Recently the stock has declined more than 30%
short fund, based in New York. due to some operational challenges and misunderstandings over a capital allocation decision. These events have
opened a window of investment opportunity for an activist shareholder, who can help improve business decisions
and priorities and ease market anxiety.

Business Description
Food distribution is a simple
business that has a strong and
stable cash flow generation
pattern. In the US it is a highly
fragmented $290 billion industry,
with approximately 15,000 play-
Yuri Rettore ’20 ers. USFD is the second largest
Yuri is a 2nd year MBA student player with 8% market share,
at CBS. He started his career
with Safra Asset Management just behind Sysco (SYY) with
covering education and food & 16%. USFD and SYY are the only
beverage. He later moved to
Apex Capital, a $2B equity fund, players with national breadth.
where he became partner. The industry has been consolidating in the past several decades. USFD buys products from 5,000 suppliers and
During the summer, he interned delivers to 250,000 customers. Scale is extremely important in this business as it allow players to i) have bargain-
at T. Rowe Price in London.
ing power with suppliers; ii) run more efficient supply chain operations; and iii) dilute fixed costs. This combination
of scale advantage with a consolidating industry translates into high barriers to entry and a widening moat.

Recent Developments
USFD’s latest results came out with quarterly earnings of $0.64 per share, beating consensus estimates. This com-
pares to earnings of $0.57 per share a year ago (figures adjusted for non-recurring items). According to manage-
ment: “Total case growth also improved, thanks to strong performance with independent restaurants and im-
proved growth with healthcare and hospitality customers. Our service platform continues to get stronger and we
are confident in achieving our financial guidance for the year." Over the last four quarters, the company has
surpassed consensus EPS and topped revenue estimates three times.
Rodolfo Zeidler ’20
Variant View
Rodolfo is a 2nd year MBA
student at CBS. Prior to CBS, Based on our research, we believe that i) consensus today significantly underestimates the potential of the busi-
he worked at the equity invest- ness and ii) the current multiple gap (~18%) versus Sysco is not justified and can be narrowed. We disagree with
ment team of Votorantim S.A.,
the financial holding of one of the following market perceptions:
the largest Brazilian groups. He · Management lost some credibility after i) sequential negative sales guidance revisions and ii) delivery problems
interned last summer at T.
during the implementation phase of a new logistics system. We think current management has been im-
Rowe Price London.
proving the business since it took over and has the potential to continue doing so.
· The company announced the acquisition of SGA, which represents 13% of revenues on a pro-forma basis, while
the market expected cash distribution after years of deleveraging. The acquisition price was considered high,
raising concerns regarding capital allocation discipline. We believe the SGA acquisition was opportunis-
tic, strategic, and will ultimately be value accretive.
· SGA’s acquisition also raised questions as to whether the integration process would pose an additional chal-
lenge for a management team that was already facing some difficulties. In our opinion the integration is
facing normal implementation challenges with limited long-term effects. Moreover, we see plenty
of opportunities to reduce the margin gap vs SYY.
Page 21

US FOODS (NYSE: USFD) - Long with Activist Value-added

Investment Thesis
1) Independents and private labels will drive gross margin
·USFD’s economics differ depending on the size of the client. On
one end are large restaurant chains (1/3 of USFD's sales): these
customers buy large volumes and therefore have bargaining power
over distributors, which leads to very low margin deals. On the
other end are a large number of independent restaurants (1/3
of USFD's sales): these buy in low volumes, which therefore gives
distributors the power. The combination of this independent res-
taurant segment with the scale advantage of large distributors re-
sults in double the gross margins of national chains versus local
ones, and a return on invested capital that we estimate is >20% (compared to low single digits for large clients). Independ-
ents and private label are two correlated long-term secular trends that will make the business stronger and more profita-
ble with time. Evidence shows it is much easier to sell private label products to independents since customers save 10%-15% with the
same quality, which is an appealing value proposition.
·According to management, half of the EBITDA margin gap to Sysco comes from gross margins, specifically due to lower private label pene-
tration. Considering only the US Broadline business, Sysco makes 50% of their sales from independents, while US Foods makes only
33%, although it is growing at almost double the market rate of the segment. USFD’s share of private label currently is at 35%, but
is increasing at 100 basis points per year and accelerating. On an apples-to-apples comparison, our research suggests that the penetration
gap versus Sysco is around 8%-10%. We estimate that 100 basis points of private label penetration expands gross margins by at least 10
basis points. In conclusion, based on our research, 80% of the margin gap
can be narrowed, resulting in a potential 1.3% increase in gross margin.
2) Significant room for OPEX reduction
·During the years of private equity ownership, USFD underinvested in logistics,
favoring sales initiatives and quick-return projects. USFD also lost a lot of clients
after the announcement of a failed merger deal with SYY, as Sysco's sales reps
convinced customers to start switching long before the transaction was blocked
in 2015. Those problems, combined with talent turnover and low levels of en-
gagement, led to operational underperformance and widened the margin gap be-
tween the companies. After the IPO (May 2016), USFD started to get back on
track and results have improved significantly since then. We are confident that a
great portion of the margin gap with Sysco can be narrowed.
·According to management, the other half of the EBITDA margin gap comes from OPEX. We know that supply chain expenses are almost
double sales expenses, yet USFD is much more advanced in terms of sales initiatives and just recently started to focus on supply chain.
Therefore, we believe that management's plan to boost OPEX efficiency by $120 million between 2017 and 2020 is credible
and will likely come as flat real OPEX growth, with 50 basis points impact on margin. However, it is worth noting that the gap
is a moving target, with Sysco itself expecting an 80 basis points reduction from 2017 to 2020.
3) Activist shareholder can enhance value
·We know the market is worried about capital allocation discipline and we noticed there is no one with a strong investing background on
the board. We think that by getting a seat on the board, an activist can help ease the market anxiety by assuring the quality of future capital
allocation decisions. This can help close the valuation gap with Sysco (~18%). Our research suggests, for example, that management is not
pursuing private label penetration as aggressively as they could, and we know that private label is an important driver of EPS. With board
representation, an activist can i) assure that incentives and priorities are aligned with the key drivers of value creation and ii) focus on what
creates most value to shareholders, reduce chances of missteps, and facilitate communication with the market.
Under our Base Case, management steadily improves
the business at a sub-optimal rate and anxiety persists,
resulting in a non-ideal multiple. Sales grow 3.8%
CAGR, PL penetration increases 100 bps per year, and
EBIT margin reaches 4.1% in 2022, leading to $4.05/sh
EPS 22’. Using a 16.7x P/E multiple (USFD’s current
multiple) on expected EPS 22’, we obtain $68/sh, imply-
ing a 23% IRR. Activist involvement can enhance EPS by
6-7 p.p. and help expand the P/E multiple, therefore
reaching a 33% implied IRR.
Page 22

Mohnish Pabrai, Pabrai Funds

Pabrai founded TransTech, Mohnish Pabrai (MP): I'm Warren Buffett figured out
Inc., an IT Consulting and an engineer by training – my when he was a 10-year-old kid
Systems Integration undergraduate degree is in was the magic of compounding.
company, in his home in Computer Engineering. I He understood, even at that
1990 and bootstrapped the worked in hardware and very young age, what Einstein
company to over $20m in firmware design at first, then said: “Compounding is the
revenue when it was sold moved to international sales eighth wonder of the world.”
Mohnish Pabrai in 2000. and marketing in tech, before And the second thing he
He authored two books on starting my own IT Services/ understood was that if he
value investing, The System integration company. could compound at high rates,
Dhandho Investor and In 1994, I was vacationing with even starting with a very small
Mosaic: Perspectives on my wife in London and I was amount of capital, he would
Investing; with the former looking for something to read get incredibly wealthy.
translated in German, on the flight back, so I picked
Mandarin, Japanese, Thai, up one of Peter Lynch's books All the useless nonsense I got
Korean, and Spanish. at the airport. I had never taught in school, and they
actually read any investing never taught me this. I mean,
Pabrai won the 1999 books before and I found when we learn compounding in
KPMG Illinois High Tech Peter’s book very exciting to school it’s just for algebra or
Entrepreneur award read. Then I found out there fractions or geometry. No one
granted by KPMG, The was another Peter Lynch book tells you it’s the holy grail.
State of Illinois, and The and read that one, too. Nobody explains its magic.
City of Chicago. He is a In the second book he was So I was reading Buffett’s
member of the Young talking about a guy named biography by Lowenstein and I
President's Organization, Warren Buffett reverentially. said to myself, “Wow, this kid
and the Founder & just figured out two things.”
Chairman of the Dakshana One of those two things – the
Foundation, providing 1-2 magic of compounding – I’ve
years of coaching for even figured out now. I got it
Technological Institutes’ “The thing that Warren at age 30 and he got it at age
and Medical Schools’ 10, but that’s okay, I still have a
Entrance Exam to gifted
Buffett figured out
long runway. Then for the
but impoverished students, when he was a 10-year- second piece, how to
predominantly in rural compound at high rates, well
India. The Indian Institutes old kid was the magic Warren and Charlie are open
of Technology have books. They’ve freely shared
accepted 2,146 Dakshana of compounding.” how they do it.
Scholars in the last 12
years. Since 2017, medical At that time, I had just sold a
schools have accepted 296 small portion of my company
Dakshana Scholars, I had never heard of this guy and I had $1 million in my bank
including 55 at AIIMS, “Buffett” before. But I was account. It was actually the
India’s top medical school. lucky, because the first few first time in my professional life
He lives in Irvine, CA and books on Buffett came out in that I didn’t have any debt. I
enjoys spending time with the early 90s and Lowenstein's thought if I can compound that
his wife Harina and biography on him came out in money at 26% p.a. for 30 years
children Monsoon and 1995. I was just trying to find like Buffett, then through the
Momachi. He loves reading out who this guy Buffett was, magic of compounding the
and playing duplicate and that of course opened up a million becomes a billion – and
bridge. massive new world to me as I I thought the billion was a
went through the biographies, much better number than the
Graham & Doddsville the Letters to Shareholders; I million. Even if I missed it by
(G&D): What's your learned a lot from all of this 80% or even 90%, who cares?
background and how'd you get material and found it very Even $100 million or $200
into investing? exciting. The thing that million is still pretty good.
(Continued on page 23)
Page 23

Mohnish Pabrai, Pabrai Funds

So I decided to give MP: One mistake I made was I were to sum up all the
compounding a shot while still had several bets on levered Berkshire acquisitions, their
doing my day job running the financial institutions, and those record is actually not great.
boring IT company. I thought institutions that were levered But if you weight them by
26% should be a cakewalk at in 2008 and 2009 are not the actual capital deployed, their
that time, because I had never ones that went on to live record is unbelievable. He was
invested before. In the first five happily ever after. In fact, if you right with the banks – and I
years, the $1 million turned look at the returns of various think now he's given up on
into $12 million – a return of banks since 2007, there’s only retailers. So in some areas,
64% per year. From 1995 to one bank that actually had a Warren is just absolutely
1999, I made more money positive return since then: J.P. spectacular. That's the way for
from investing than my Morgan. Every other bank is all investors. We have some
declining IT business was negative, and some are areas we're really good at and
making, which had 200 people. negative by a lot. I wasn't we have other areas where we
Eventually my friends saw the invested in banks, but I had still have more to learn. I still
success I was having and some bets in sub-prime have a lot to learn. For
wanted me to manage their mortgage lenders, and they example, I still have one
money too. I thought it went straight to zero. To be levered financial institution in
wouldn’t be too much effort honest, I continued to struggle my portfolio. When you're an
for me to place one more with levered financial alcoholic, you just can't give it
trade for my friends after my institutions until very recently. up. So hopefully by talking to
own trades were done; but I you now the lesson is getting
didn’t want to lose their seared into my mind: don’t go
money. I looked at the Buffett “I still have one levered near levered financial
Partnership and modeled institutions.
Pabrai Funds after that. I financial institution in
started Pabrai Funds in 1999, G&D: Do you feel like you
really just as a hobby, with $1 my portfolio. When have certain circles of
million from eight friends and competence, maybe in
$100,000 of my own money.
you're an alcoholic, you technology companies, having
just can't give it up. So started out as an engineer?
In the first year we were up
70%, and this was during the hopefully by talking to MP: You know, one thing that
dot-com bubble while the has benefited me greatly in
NASDAQ was crashing and you now the lesson is investing was what I learned
burning. From 1999 to 2007, during my childhood. My father
the funds had returned about getting seared into my was an entrepreneur and he
37% p.a. before my ridiculous must have started, grown, and
fees. Then from 2007 to 2009 mind: don’t go near bankrupted at least 15
we dropped nearly 70%. I different companies in 15
levered financial
learned a lot in 2008 and 2009. different industries over his
Adversity is a great teacher. institutions.” career. He had a jewelry
Every time something negative manufacturing operation, he
happens to any of us, when we manufactured high-end audio
look back we usually recognize It’s interesting, as an investor speakers for Phillips, serviced
that time as one of great each of us will have certain and repaired high-end Japanese
learning and great growth. I’m things we’re very good at, and tape recorders, started a radio
very grateful for that. some things we have trouble station, made a movie, had a
with. For example, I have handyman services company,
G&D: What were your never seen Warren Buffett an insurance brokerage, on and
mistakes during this 2007-2009 make a dumb bet with levered on and on…
period and what did you learn financial institutions. I think his
from them? batting average is 100%. But He was really good at figuring
I've seen him make a ton of out opportunities, even in
mistakes on retailers. If you fields that were brand new to
(Continued on page 24)
Page 24

Mohnish Pabrai, Pabrai Funds

him. He was exceptional at to think fast and you need to G&D: Can you talk in more
starting and getting these think slow. On the thinking detail about your investment
businesses going, but he was slow, there are a lot of humans philosophy, which you said you
always overly optimistic and better than me. I have very modeled on Buffett’s and
highly levered. Then the first good skills on one side, but I Munger’s own investment
large storm would hit and the have to get a lot better on the strategy?
business would disappear. other side, and that's what
Then we’d be back to zero makes it fun. There's still a lot MP: I think investing is pretty
because my parents were very of learning for me to do on the basic. The core principles will
bad financial planners and we’d thinking slow side. never change. We’re putting
have no money for rent or out cash today with the goal of
groceries. Yet, somehow, he’d getting more cash in the
start another business again. future. Like Buffett said, it’s all
My father used to say you “Investing is about comparing one bird in
could put him naked on a rock the hand with two in the bush.
with nothing and he’d start a straightforward. It's So, you ask questions, “How
business. certain are we that there are
simple, but it's not easy. two in the bush? How long is it
Starting at the age of 11 or 12, going to take to get those two
my brother and I used to be It's simple because we’re in the bush?” That's really what
like my father’s Board of investing is.
Directors. Eventually whatever just trying to figure out
company he was running at the the future trajectory of a At the core, investing is
time would be in trouble. He’d straightforward. It's simple, but
sit down with us and we had given business. But it’s it's not easy. It's simple
to figure out how to make it because we’re just trying to
run for one more day. Then not easy, because figure out the future trajectory
the next night we’d figure out of a given business. But it’s not
how to make it run for one figuring out the future easy, because figuring out the
more day, and then for one future trajectory of any given
trajectory of any given business is really, really hard to
more day…
business is really, really do, even for the most simple
Around age 16, he started businesses. There are so many
taking me on sales calls with hard to do, even for the factors that can affect that
him. I am still amazed he did trajectory.
that. By the time I was 18, I most simple businesses.”
had finished many MBAs. I had To be honest, you cannot
learned plenty about business figure out the future trajectory
they’ll never teach you in of most companies. Most
business school. In general, it is really critical to businesses just don’t have that
be right in the center of your type of a dynamic. Capitalism is
One big advantage I gained circle of competence; you too brutal – most companies
from all this is I can understand don’t want to be near the won’t even be around in 20
businesses really well. I can edges or, God forbid, past the years. I don’t want to try to
crack business models. I can edge. If there are any things figure out the future trajectory
crack them on a wide range of that are fuzzy for you, move of companies like that. I want
industries, and I can do it really on. We’ve got 50,000 stocks to make bets that are as no-
fast. I can look at a business globally. Ideas are going to brainer as possible, with as few
and pretty quickly get my keep coming. If you don't buy variables involved as possible.
bearings on its basic economics one particular stock, you're So although figuring out the
and how it works and all that. still going to get rich. It doesn't future cash flows of a given
But I can still get some matter. There's an unlimited business is a difficult exercise,
investments wrong, because supply of ideas. we can do some hacks to
that's not where the investing simplify the problem for us.
results start and end. You need
(Continued on page 25)
Page 25

Mohnish Pabrai, Pabrai Funds

For example, in 2003 I came G&D: Do you have any recent There are only three or four
across this steel company investments similar to IPSCO? other manufacturers of these
called IPSCO. IPSCO was electrodes in the world. It
interesting because the stock MP: There is a company called takes three to five years to
was about $ $45 a share. They GrafTech that recently showed construct a new ultra-high-
had $15 a share in cash, no up on my radar. It’s similar to performance electrode
debt, and they publicly stated IPSCO in many ways. We manufacturing facility for
that their free cash flow was don’t know the trajectory, but greenfield expansion, so supply
going to be $15 a year for the I think the odds of losing is very constrained. On top of
next two years. This cash flow money are pretty muted, while this, GrafTech is the only
was contractually locked in there’s a built-in element that manufacturer in the world that
from their customers. could give me a nice double or is backward-integrated. There
triple in not too long. What’s is a very critical raw material
Basically, if you looked at the not to like about that? required to make these
cash on hand and the next two electrodes called needle coke
years of cash coming in after and, again, there are just three
taxes, in two years you'd have or four manufacturers of
$45 a share on the balance needle coke in the world. It's a
sheet, and you were paying “I said Okay, I don't byproduct of refining
$45 a share. All the plants, petroleum; for example,
know what this ConocoPhillips is a big supplier
inventory, customer
relationships, know-how, company is worth. I'm of needle coke. GrafTech is
everything else, were free. the only electrode
just going to make a manufacturer which owns a
Now this was a widely cyclical large needle coke facility. It
industry, so it was possible that bet, keep it for two takes a long time to construct
after two years earnings would a new needle coke facility,
be negative. But it was more years, see what maybe five years or more. To
likely, that earnings would be sum up, there are number of
happens. That's a hack. factors in this industry that
positive. I said "Okay, I don't
know what this company is I never ever figured out make it challenging to
worth. I'm just going to make a instantaneously raise capacity.
bet, keep it for two years, and the intrinsic value of
see what happens." That's a In 2018, prices for these
hack. I never ever figured out IPSCO.” electrodes went crazy.
the intrinsic value of IPSCO. Historically, they were $2-
3,000, maybe $4,000, a ton.
A year goes by, then IPSCO Last year, they went all the
announces that they’ll have GrafTech makes ultra-high- way to $25,000 or $35,000 a
one more year of $15 per performance electrodes, which ton. They just went bonkers.
share in earnings. The stock is go into electric arc furnaces Of course, all the electrode
now trading around $90. Then that are used in mini-mills to manufacturers reaped
a few months later some make steel. Nucor, for incredible profits.
Swedish company came in and example, is a customer. There
offered to buy them for $160 are two ways to make steel: These electrodes represent
and the stock immediately you can either make it with only 3% to 5% of the total cost
jumped to $152. I didn't even iron in a blast furnace or you of making steel. It's a small
wait for five minutes after I can melt scrap in an electric part, but it's a critical one. The
heard that news. I was out of arc furnace. To melt the scrap, chemistry of these electrodes
there. It was a great outcome, you need these graphite is very important, and so is the
and all because Mr. Market electrodes able to withstand consistency of the supplier.
gives us these hacks. the 2,000- or 3,000-degree GrafTech went to their
heat in the furnace. GrafTech customers and said "Hey, these
makes these electrodes. electrode prices are going
crazy, it's hard to get supply.
(Continued on page 26)
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Mohnish Pabrai, Pabrai Funds

Do you want to sign a contract markets hate uncertainty. The MP: I depend on the readers
with us where we'll guarantee market, just like me, has no of Graham & Doddsville!
the supply and the price for idea what the other 30% of Hopefully they can Google me
the next three to five years?” production is worth. And Mr. and find my email address, and
All kinds of customers took Market has no idea what cash can you please put down that I
them up on that. flows look like for 100% of am in desperate need of their
As a result, 70% of their production after five years. But great ideas. There's a fan of
production for the next we've got the downside Mohnish in Canada who sent
several years is already sold, at covered, so we just sit on it. If me the full write-up and thesis
a known margin and a known at some point we get a deal on GrafTech. All I had to do
selling price. These are locked- done with China, we get a deal was to have mastery of the
in, take-or-pay contracts. done with the rest of the English language, and thankfully
Unless the customers go world, if the world starts the education system did teach
bankrupt, these are humming again, maybe things me that. I read it and I said
enforceable contracts. go crazy. But maybe none of "Okay, let's verify the facts."
Furthermore, they're spread that happens and we get our And the facts all checked out.
across hundreds of customers, money back. There’s a wide
so the revenue stream is very range of outcomes, but So, many people keep sending
diversified. If you look at that virtually all are acceptable. different ideas. I’m going
70% of revenue which is through Value Line every
locked-in over the next several week, too, and some stuff
years, it covers the market “Why do these comes in that way. I’ll read
cap. It’s IPSCO 2.0. Now it's Graham and Doddsville, I’ll look
not coming in two years opportunities exist in at Value Investor’s Club, Sum
because it's not 2004 – it's the first place? It’s Zero, the usual suspects. I’ll
coming in five years. But such look at DATAROMA to see
is life; that's still okay. because markets hate what other people are buying.
There are a lot of places to
The other 30% of production uncertainty. The find ideas.
is sold on the spot market.
This gives you a variation on market, just like me, G&D: You came to investing
what can happen. If electrode because you wanted to
prices go crazy again, they will has no idea what the compound, but it seems that in
make super profits. They've other 30% of your portfolio you don't tend
only sold the production to have a lot of compounders.
where they know what their production is worth. Is that a fair way of looking at
costs are. No other ultra-high- it?
performance electrode And Mr. Market has no
manufacturer can offer their MP: That's a really good
customers these types of idea what cash flows question. I am hoping that
contracts because they don't when I grow up, I can invest in
have control of the raw look like for 100% of the compounders. The
material, so they don't know production after five problem is that out of 100
what their cost of raw businesses, maybe two or
materials is going to be three years. But we've got the three of them are good. Most
years from now. GrafTech is of them are crap. When we
the only manufacturer that can downside covered, so look at these compounders,
offer this. especially the “obvious”
we just sit on it.” compounders, everyone else
From my point of view, it's the can see them too.
same thing as IPSCO. Who
knows what's going to happen G&D: How do you find Is MasterCard a compounder?
here? I certainly don't. But why opportunities such as IPSCO Yeah. But what's the multiple? I
do these opportunities exist in or GrafTech? What’ does your can't even look. Investing is not
the first place? It’s because process look like? about buying great businesses,
(Continued on page 27)
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Mohnish Pabrai, Pabrai Funds

it’s about making great Charlie would probably say 95%. Because auction-driven
investments. A great that if you were 1/3 Berkshire, markets are not rational, the
compounder may not be a 1/3 a compounder like Costco, lowest price a stock can trade
great investment. Look at and 1/3 GrafTech, that's at is one cent, regardless of
Coca-Cola. If you bought it in probably okay. the economics of the business.
2000 and you held it until Instantaneously, it can trade at
2015, you had a pathetic any price.
return because it went from
40-plus times earnings to 14 In 1974, Rick got margin calls,
times earnings. And 15 years is “I am hoping that when and Warren bought Rick’s
a long enough time to call I grow up, I can invest Berkshire holdings from him at
yourself a long-term investor. $40 a share. Each of those
At the end of the day, price in the compounders, ... shares is worth $300,000 right
matters. I wish I can get better now, but Rick was forced to
at this. I think many times [but] everyone else can sell them to Buffett at $40, and
companies that look expensive he didn’t get the chance to play
are actually cheap. It's all a see them too. out his hand. By the way, I
matter of the future cash have since gotten to know
flows. But I am such a Is MasterCard a Rick Guerin. He is a good
cheapskate, as you saw with compounder? Yeah. But friend and a fantastic human
IPSCO and GrafTech. Should I being and has done very well
buy GrafTech or should I take what's the multiple? I with his compounding
a flier on MasterCard? endeavors. A small capital
GrafTech or Amazon? can't even look. base, a long runway and a good
compounding rate can do
Every once in a while, you can Investing is not about wonders. And I should add
get a compounder that’s like a that Rick’s recollection of
diamond in the rough; people buying great businesses, these 1970s events differs
can't see that it's a diamond, it’s about making great from Warren.
but it is. Every once in a while,
that happens with me. Those investments.” When I look back at the
are the ones a cheapskate like Buffett lunch, if the only lesson
me can buy. I got from it was this
conversation, it was well
G&D: How do you think worth it. I was already not
about risk and portfolio G&D: Do you use any interested in leverage before I
concentration? leverage in your portfolio? went for the lunch. After God
himself told me this story, I
MP: My portfolio is very MP: No. Leverage is a very said "We're never going to do
concentrated. By the time you bad idea, and I’ll tell you why. that." So, Pabrai Funds doesn't
get to the sixth or seventh When I met Buffett for lunch use leverage, and I'm not going
name, we are talking about in 2008, I asked him a question: to take a stock like GrafTech
80% to 90% of our assets. Yet, "What ever happened to Rick and make some supposition
everything is probabilistic. Guerin?" Rick was one of the that auction-driven markets
There aren’t any sure bets in original Superinvestors of can act in a certain band. They
investing; the best we can do is Graham-and-Doddsville. can do whatever they want,
just put the odds very heavily Warren said that he and instantaneously. Just look at
in our favor. That’s one good Charlie always knew they were Long-Term Capital
reason not to make something going to get very rich, and they Management. There are a lot
like GrafTech 100% of your were not in a hurry. He said of history lessons out there.
portfolio. But I think if you had Rick was in a hurry. When the No leverage, please. I know
something like GrafTech, stock market crashed in 1973- that's blasphemy in private
someone like Charlie Munger 1974, it was down 60% and, if equity, but I think one can have
would say if you had two other the market is down 60%, there a very good and wealthy life
positions, you'll be fine. In fact, are stocks that are down 90%, without leverage.
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Mohnish Pabrai, Pabrai Funds

Same thing with shorting, it’s here because I’m still buying, index, you could do quite well.
just dumb. Maximum upside is but we have massive upside The entire market cap of the
a double. Maximum downside potential there with a pretty country is less than Microsoft
is bankruptcy. What kind of muted downside. or Google or Apple. You can
stupid bet is that? I look at the just buy the whole country for
Forbes 400 list and I don’t see less than Microsoft.
any short-sellers on it.
Someone like Jim Chanos, “No leverage, please. I G&D: One issue with South
who’s really good, will tell his know that's blasphemy Korea is corporate governance
clients “Listen, the market was and that not all shareholders
up 10% last year and I was in private equity, but I are treated equally. How do
down 6%.” And he's doing flips you get comfortable with that?
because he did so well, think one can have a
because he beat the market by MP: The companies we
four percent. That's how the very good and wealthy bought don’t have those issues.
scorecard is kept by short- I screened those out. We have
sellers. Market is up 15%, I'm life without leverage. rock-star governance. They
down 9%, you should be so Same thing with listen to me, what a concept! I
grateful; and that's actually a went to them and said, "Listen,
really good feat for short- shorting, it’s just dumb. you guys control the company
sellers. Shorting is one of the and it's your company. But
dumbest things you can do. Maximum upside is a how about doing X?" Guess
what? A few months later,
G&D: Can you talk about double. Maximum they're doing X. Hallelujah! I
your international exposure? didn't even twist their arm.
Recently, you were owning
downside is
only one US stock. bankruptcy.” G&D: How much does the
management team factor into
MP: Now we have three, but your decision making?
one of those is Chrysler, which
is technically European. The Unfortunately we aren’t able MP: I think management is
other two are GrafTech and to put much capital into it. incredibly important. I’ve been
Micron Technology. Yet, as South Korea is very interesting burned many times when I
Charlie says, go fish were the as well. Just look at the KOSPI didn't pay enough attention to
fish are. I feel like the U.S. index: 30 years ago, it was at that. Businesses, as I already
fishpond has been pretty 1,000, and now it’s at 2,000. told you, are very fragile. Most
depleted, so I’ve gone to It’s kind of like if the Dow was of them don't survive very
countries where I think the at 3,000 today. But in fact, 30 long. Leadership, both depth of
ponds are a little more well- years ago there wasn’t a South leadership as well as quality of
stocked with fish. Korean civilization like the one leadership, matters a huge
today. It’s been a miracle. The amount. The Fiat Chrysler bet
We have significant exposure other thing is that when I went I made was a very heavy bet on
in India. Recently, I’ve been to Seoul, I talked to South Sergio Marchionne. You could
making trips to South Korea Koreans and asked them: buy the whole thing for $5
and to Turkey. When the “Where do you put your billion. Most of Ferrari, which
Turkish Lira collapsed and the money? Do you buy stocks?” is now a $38 billion market cap
ship was going down, I booked They said, “Are you stupid? was buried inside Fiat
a flight to Istanbul. Just as No. Stocks only go down.” Chrysler. But even after we
everyone was exiting, I They buy apartments because got many times our money
decided, "Let's go take a look." prices have doubled in the last back, I kept it because I
By the way, the tea was really four years. We have some bets realized that, my God, there’s
good – and the bargains in the in South Korea, and I like an incredible capital allocator
stock market are awesome. those too. Yet honestly, with at the helm, who really
One of the best bets I have is the South Korean market, I understands how to create
in Turkey. I won’t talk about it think if you just bought the value. When you run into
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Mohnish Pabrai, Pabrai Funds

those kinds of people, you know who runs it, but it plan. They have great owners,
really want to hang on. Those doesn’t matter. I think the too. John Elkann and the
are very unusual. village idiot can run Moutai, Agnelli family are exceptional
and still mint money. All he has stewards and they've been
Then, on the other hand, I had to do is to jack up the price by very fair to outside
an investment in a company in 15% every January 1st. They shareholders. They've
China which I just completely can sell that stuff at any price conducted themselves with the
exited. During the entire time I they want, and it’ll all be gone. highest ethical standards. No
owned the company, I had no They come up with a special complaints. But I wish Sergio
idea who ran it. We put about edition at $40,000 a bottle, and was still running the place.
$21 million into it and got it’s gone in an hour.
$100+ million four years later, G&D: Do you have any
and still left a lot of money on parting advice for MBA
the table. I still don’t know “Take the job you students who are looking to
who ran the company. But it’s get into the investment world?
one of the widest moat would if you weren’t
companies one can ever think MP: I think all of you should
of. It’s called Kweichow getting paid. Work for have an investing account. You
Moutai, and they manufacture should have a three-stock
someone you like,
a branded Chinese liquor. portfolio, in honor of Charlie
None of us can drink it – we admire, and trust, don’t Munger. And those 3 stocks
can't handle it because it’s so should all have prospects of
strong. It'd be like drinking take the job with the compounding capital north of
gasoline. Still, it’s incredibly 30% annualized. Not the stupid
expensive and seen as a luxury. most prestigious firm or $10 worth $13 stuff. It's okay if
You've got a product that I one of the three is GrafTech,
can't imagine costs more than offering the most I'll give you a pass on that. But
$5 a bottle to produce, being the other two need to be solid
money. Those are both
sold for over $150 a bottle. compounders that no one
Globally, 50% of all the liquor very stupid things.” understands or can figure out,
sold at more than $150 a and they need to be squarely
bottle is Moutai. It has the in your circle of competence.
greatest market cap of any G&D: Did you trim your
liquor company on the planet. position with Fiat Chrysler at In terms of career, take the job
all after Sergio passed away? you would take if you weren’t
About four years ago, when I getting paid. As Buffett says, go
bought it, the Communist MP: No, I didn't. I recently work for someone you like,
Party was cracking down on started trimming. It was a admire, and trust. Those are
corruption… See, a lot of really sad thing that Sergio the jobs you want. Don’t take
Moutai was being consumed passed away. He was a one in a the job with the most
while government officials 100-year kind of manager. A prestigious firm or offering the
were meeting with private very unusual guy. He was quite most money. Those are both
people. What happened is confident about the future of very stupid things.
people would take pictures, the business. Still, he was going
and if you were a government to retire in a few months Lastly, remember that it’s all
guy and there was Moutai on anyway, and his hand-picked about length of runway and
the table when you were successor is running the place rate of return. Starting capital
meeting anybody for lunch, now. In fact, from then until is not that relevant. All of you
you just went straight to now, the execution has been will have plenty of income. The
prison, because they said great. I haven't seen Fiat key is to spend considerably
nothing good is happening in Chrysler do stupid things after less than you earn. There are
that conversation with the Sergio was gone. I think he two sides to getting rich. One
Moutai open. Yet, the gave them a game plan for the is spending less than you earn,
company just has an next four years, and they're the second is compounding.
unbelievable moat. I still don’t executing very well on that
G&D: Thank you very much.
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Ellen Carr, Weaver C. Barksdale

portfolio management Northwestern University. Stanley the best, so I thought
experience through several She is a Chartered this would be an interesting
cycles. Financial Analyst (CFA) place to try something out. It
Prior to joining WCB in Charterholder. was the summer of 1998,
2013, Ellen was a high yield when Long-Term Capital
analyst and portfolio Graham & Doddsville Management failed, a
manager at Capital Group (G&D): Thank you for taking predecessor to a lot of much
from 1999 to 2012, where the time to interview with bigger failures that happened in
Ellen Carr Graham & Doddsville. Can we later years. At the end of the
she was responsible for $4
billion AUM across start by discussing your summer, Russia defaulted,
Capital’s high yield background and how you got many emerging markets were
strategies, including a into the investment industry? having issues, and a crisis
sleeve of its flagship high started in Asia. It was a difficult
Ellen Carr (EC): I went to time for full-time employees at
yield fund (ticker AHITX). Morgan Stanley (I saw a lot of
Kellogg Business School a long
Additionally, Ellen is an time ago (I just had my 20-year traders with their heads down
adjunct professor at reunion, actually). Before that, on their desks), but it was a
I worked for a small consulting great time from an intern’s
Columbia Business School,
where she teaches courses firm in Los Angeles and had no perspective, experiencing all
on the credit cycle and background in investment these market events.
cash flow forecasting. She management. When I got to
has published articles in Kellogg, it was the lead-up to By the time I got an offer from
the Financial Times and is the dot-com bubble. Equity Morgan Stanley to go back, I
co-authoring a book about analysts were quoted all the figured out that my personality
the dearth of female time in the Wall Street Journal was more suited to the buy-
portfolio managers to be and it just seemed like an side. I liked an environment
published by Columbia attractive career, one where where I could take more time
people would care about your to dig into a company and
University Press. thoughts on a company. These adopt an entrepreneurial
were the days of Mary Meeker approach. On the sell-side,
Ellen splits her time
between Asheville, NC and (a Morgan Stanley tech equity everybody learns to do the
New York. She serves as a research analyst in the late- same model, which was
90s), who was known as “the valuable training. Yet, I wanted
board member of her local
NPR affiliate, the national internet queen” back then. Sell to spread my wings and
-side analysts had a lot of sway approach investing from a
NPR Foundation, the
and influence over companies, more creative perspective. I
Wilma Dykeman Legacy,
the Thomas Wolfe influencing which stocks went received an offer from Capital
up. I liked the fact that you Group thanks to a referral by a
Memorial, and is a
member of the finance could translate company Morgan Stanley colleague and
committee of the Western analysis into actionable ideas decided this was where I
for investors. wanted to go; it was also an
North Carolina
Community Foundation. opportunity to go back to
Ellen also manages a family While at Kellogg, I focused California.
foundation heavily on sell-side recruiting
( for the summer because this G&D: How did going through
which awards college was where most of the jobs the market volatility of the late
scholarships in rural were. Although I had never ‘90s influence your career and
thought about fixed income investing philosophy?
communities. before, I worked at Morgan
Ellen received a BA Stanley over the summer, EC: A lot of that filtered
(magna cum laude, Phi rotating across fixed income through my first 5 years in the
Beta Kappa) from Harvard sell-side research and the investing business. During my
College and an MBA from trading division. I liked the summer at Morgan Stanley in
the Kellogg School of people I met during the 1998, a lot of bad things
Management at interview process at Morgan happened. I then went to
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Ellen Carr, Weaver C. Barksdale

Capital Group in 1999 and that manifested in a lower which was absolutely the right
equity markets peaked before yielding portfolio than the way for companies such as
starting to unravel in 2000. I other portfolio managers. to fund themselves.
was in the High Yield bond However, I started managing However, during the 2002
market and it wasn’t a great money a couple of years High Yield bear market, the
time there either. Then 2002 before the credit crisis and my TMT sector had grown to
was an especially bad year. On results were the best during about a third of the market.
the equity side, Capital had just that time period because I The High Yield group at
been through a difficult tended to be more Capital was substantially
underperformance period conservatively positioned. To overweight those sectors
because we stayed away from anybody thinking about a because the analysts who
the internet bubble. None of career in investment, going followed them were very
the analysts could figure out through a cycle, and passionate about the
how to value these companies particularly a bear market, is companies. The High Yield
and it turned out they were an invaluable experience. TMT analysts were spending a
right to stay on the sidelines. lot of time talking to their
There were some very painful equity counterparts, yet
moments, especially on the “I don't know how to managed to blind themselves,
institutional side of the failing to realize that the same
business, an area where clients value any of the FANG things that equity analysts were
are looking at performance worried about were relevant
relative to a benchmark. stocks, but it can be to the companies that they
were looking at even though
I witnessed that, and with it helpful to sit on the
they were different companies.
the vindication that came from opposite side of the
sticking to your guns and It was an interesting lesson
demanding common sense capital structure table. about the need to look at all
valuation metrics for the the data points. A great
companies in which you invest. If I were to truly example is the paging industry.
That was also the era of Enron The paging industry financed a
and WorldCom, which was challenge myself, I lot of its capital requirements
another one of Capital's great in the high yield market from
“avoid” moments on both the would try to take an 1999 through 2001. The
equity and fixed income sides. equity perspective. analysts liked some of the
The analysts could not model paging companies, yet they
Enron; anybody who said she Conversely, if I were an didn't consider the fact that if
could was lying. Watching you liked the wireless sector,
some of the most senior equity equity analyst, I would which was nascent at that
analysts struggle with the point, then you probably
valuation and say "I don't probably take a fixed shouldn't like the paging sector
understand how the investing too because it would likely be
universe has gotten into a love income approach.” disintermediated. Connecting
affair with this company that the dots is certainly a lesson I
doesn't generate free cash learned and still spend a lot of
flow" was powerful. G&D: How did the internet time attempting to do today.
bubble impact the High Yield
The most important thing that market in the late ‘90s? An analogy today would be the
I learned during that time was FANG stocks. I don't know
to be cautious. That might EC: We had a very different how to value any of the FANG
have hurt my investing career experience on the debt side stocks, but it can be helpful to
sometimes, because I am a versus the equity side. On the sit on the opposite side of the
very conservative investor. debt side, those internet capital structure table. As an
When I was still at Capital companies didn’t come to the example, I don't own Netflix
Group, I was always the most High Yield market. They were bonds. They trade very well.
conservatively positioned and looking for equity capital, It's a BB-rated company and
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Ellen Carr, Weaver C. Barksdale

I've always been very skeptical that tremendous "issuance". because it has a pretty stable
of any company that doesn't Investment grade portfolio investor base. High Yield
generate free cash flow. If I managers are overweight investors don’t change that
were to truly challenge myself, BBBs. They tend to overweight much from cycle to cycle,
I would try to take an equity the highest risk part of the whereas there is often new
perspective and think about market because the default money flowing into and out of
why the equity market has so statistics on BBBs are virtually the Leveraged Loan market.
much comfort in a company’s nil, yet you get paid some The collateralized loan
ability to march towards free incremental spread over higher obligations, or CLOs, that we
cash flow, asking myself “what -rated corporate bonds. The saw in 2005 to 2007 are back.
is it I’m missing here?” fact that a lot of money has Most of these investors are
Conversely, if I were an equity been invested in that part of not sophisticated analytical
analyst, I would probably take the market makes me nervous buyers; they are buying
a fixed income approach to about what will happen if there primarily because something
Netflix and say "this company is either a recession or an has a certain rating, although in
doesn't generate cash flow. In exogenous shock. some cases what they’re
fact, its operating cash deficit buying isn't worth as much as
seems to be growing because what they think it is. Those
it's investing so much in “Fallen angels’ bonds buyers are also the ones who
content. How could that will probably be forced sellers
possibly translate into the are structurally inferior at the wrong point in the cycle.
valuation that it has in the
equity market?" to other bonds in the G&D: Could fallen angels be
attractive, given their relative
G&D: Do you see any bubbles High Yield market,
safety and liquidity?
in the market right now? Are
because High Yield
you cautious against any EC: I think they could be in
industries? bonds generally enjoy the long-term. During the
2005 fallen angels’ cycle, the
EC: I think the biggest bubble covenant protection auto companies got
right now is in the corporate downgraded to High Yield.
debt market. There are a and are issued at the Ford, GM, and Chrysler
couple of different aspects of it combined became 15% of the
that are particularly troubling. operating company High Yield issuances. The
The first one is the explosion level with subsidiary market wasn’t ready to absorb
of BBB-rated bonds. A certain all that volume. These issuers
percentage of BBBs get guarantees.” were downgraded to High
downgraded to junk within five Yield because they were
years of issuance based on deteriorating, so it took them
rating agencies’ seasoning a long time and, in the case of
models. Over the next five I’m also worried about the Chrysler and GM, a Chapter
years, there will be pressure Leveraged Loan market, which 11 process to get back to
on the High Yield market is exhibiting the same type of Investment Grade. I don't
because the capital structures underwriting behavior, anticipate a similar thing to
of Investment Grade exuberance, and frothiness happen in this cycle, but rather
companies are much larger. that it did in 2007. I think of that some companies will
Take GE for example: there High Yield bonds as a pretty gently slip from Investment
were concerns they would be stable asset class. There are Grade to High Yield. That will
downgraded to High Yield ups and downs in covenant give us a chance to buy better
earlier this year. If that had quality and deals underwritten issuers, which is positive.
happened, GE would’ve at this point in the cycle are
represented about 10% of the typically not great, but the However, even in the case of a
High Yield market value. It High Yield market doesn't perfectly good company that’s
would be really difficult for the boom and bust the way the become risky in terms of
High Yield market to absorb Leverage Loan market does leverage and gets downgraded
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Ellen Carr, Weaver C. Barksdale

to High Yield, there are two High Yield market dislocation, G&D: Do you usually hold
factors that will make an valuations usually overshoot to bonds to maturity, or is your
orderly transition difficult. become truly cheap before return coming more from
First, the sheer amount of High Yield managers get really spread compression?
supply will require some time excited and buy a fallen angel.
to be absorbed. When there is EC: By and large I'm not
massive selling pressure, with looking for capital appreciation
Investment Grade holders as much as I’m looking for
forced to sell bonds from something to mature at par. At
previously BBB issuers which
“Contrary to what my firm, the primary mandate
get downgraded to High Yield, happens in the Equity on the High Yield side is a
it creates a vacuum until High short duration one. We have a
Yield buyers have had a chance market, if you sell five-year maturity limit. Once I
to research the credit and get buy, unless the credit
to know the individual bonds something at a high deteriorates meaningfully, I
in the capital structure. intend to hold it to maturity,
price in the High Yield particularly due to the high
Secondly, the fallen angels’ trading costs in High Yield.
bonds are structurally inferior
market, then good luck
to other bonds in the High on ever buying it back Early in my years as a portfolio
Yield market, because High manager I made selling
Yield bonds generally enjoy below or finding mistakes. I would sell a
covenant protection and are company that was up four
issued at the operating something reasonable points because I knew it didn’t
company level with subsidiary deserve to trade at that
guarantees. To the contrary, to replace it with.” valuation. Yet contrary to what
Investment Grade bonds are happens in the Equity market,
for the most part lacking these if you sell something at a high
structural protections. Even if price in the High Yield market,
you like AT&T better than then good luck on ever buying
Sprint as a company, you still G&D: Are there any it back below or finding
might look at Sprint's secured industries in the BBB market something reasonable to
bonds and prefer the collateral that you are worried may be replace it with. Once I get
protection as opposed to a downgraded to High Yield? invested in a name it takes a
general unsecured obligation at pretty big change in my credit
the parent company level for EC: I don't think it would be opinion to sell it.
AT&T bonds. These may look an industry phenomenon. If
like technical differences, but in you take the 2000 to 2002 Having said that, I’m not afraid
the High Yield market they cycle, it was very industry to sell something if my credit
matter a lot. focused. It was Telecom, opinion has changed. I recently
Media, and Tech, the latter to sold Pitney Bowes, which
G&D: If an Investment Grade a lesser extent. This time became a fallen angel a couple
company gets downgraded to around, there's good of years ago. When it entered
High Yield, would the return diversification among the the High Yield market I liked
be attractive enough for High various BBB industries; same the bonds for two reasons.
Yield managers? thing in High Yield. Hence, I'm
not that concerned about any First, a number of bonds had
EC: It depends on the point in particular industry. Take coupon step-up protection,
the cycle. The spread between sectors like Energy or meaning that every time the
BBB and BB bonds is fairly Commodities: a lot of bond got downgraded by a
compressed now, but there's shakeout happened in 2015 notch, the coupon increased
still about 100 bps of spread and 2016. I think it will be by 25 bps to a maximum of
pickup. If the spread stands at bottom-up oriented, without 200 bps, meaning a holder of
100 bps between BBB and BB, any particular industry stress. the bond was protected from
with the wide bid-ask spread in spread widening as the
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Ellen Carr, Weaver C. Barksdale

downgrades occurred (i.e. the With some of the institutional paying 50 cents on the dollar.
increased coupon offset the clients who are more Of course, you have to
spread increase). benchmark-focused, I would be consider valuation and should
Second, I liked the company's more likely to sell something not pay too much for
free cash flow generation. So that gets upgraded. something. Yet what people
even though it had been tend to do at this point in the
downgraded and had several cycle is they don’t want to
businesses under assault from own things like HCA because
different internet business it looks too rich. Investors are
models, Pitney Bowes still had “I think that at this getting greedy and are only
a tremendous amount of free looking at valuation. They look
cash flow, and it was also point of the cycle the at spreads between wireless
investing in new business lines. telecom issuers going from a B
better trade is to to a CCC and say "I'm getting
I owned the bonds for about paid 100 bps to get the CCC,
18 months and, every quarter, increase the credit so I'd rather own that," while I
things didn't exactly go the way think that at this point of the
management said. There was
quality and give up a cycle the better trade is to
always some new story about little bit of yield. When increase the credit quality and
why this business line wasn't as give up a little bit of yield.
profitable as they had hoped the downturn comes, When the downturn comes,
or, even if the revenue trend that's when I want to buy the
was good, management had that's when I want to lower-rated, lower-quality
overestimated the margin issuers because the spread will
potential. Finally, after five or buy the lower-rated, become much greater.
six quarters, I decided to exit
the position because my initial
lower-quality issuers In Fixed Income people tend to
thesis that the company would because the spread will sell too early. What they do is
both continue to generate look at a spread or a yield
good free cash flow as well as become much greater.” target and sell once the bond
maintain its margins was hits that target. The problem is
gradually disproven. When that when that happens, it’s a
something goes against my classic example of selling your
thesis for more than a couple house because you thought the
of quarters, I sell. G&D: As a bond investor, do housing market was
you place more weight on the overvalued; but guess what,
G&D: When a company goes valuation or the fundamentals? you now have to go find
from High Yield to Investment another house and you may
Grade, do you usually sell? EC: I think valuation is more end up in a worse house. The
important in Equities than in High Yield market is very
EC: It depends on how I feel Bonds. People in my market much like that. Oftentimes the
about the market at the time. can make bad sell decisions house you're in is the best one,
Given the current based on valuation alone, but and even if you could get the
environment, I generally have they generally don't make the right price for it, it would be
not sold rising stars. In some wrong decision if it’s based on hard to replace it with
cases, that is because by the fundamentals. If a credit is something you liked as much.
time they get Investment deteriorating from a
Grade ratings, the maturity has fundamental point of view, you My view on this has evolved
become short. For example, I really want to get out of it. since the time I was at Capital.
held onto Constellation Brands Eventually you will feel really At Weaver, where I manage
when it got upgraded to good about having gotten out millions rather than billions, I
Investment Grade more than a of a bond that is down five have more opportunity to do
year ago as it is maturing later points from par when the transactional things. I can sell
this year. Still, you don't always company goes through something based on valuation
have the flexibility to do that. restructuring and ends up because the liquidity
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Ellen Carr, Weaver C. Barksdale

constraints aren't as material say: "that's mine if this In a bull market the market
as they were at Capital, and I company files." I think the doesn’t care about collateral.
can probably get reinvested degree of value we’ve placed Take HCA for example: the
more easily. Still, generally on hard collateral is going to spread between the secured
speaking, if my credit view on a decline over time because real and unsecured debt is around
company hasn't changed, I assets are becoming a 75 bps right now. I’m very
would continue to own it meaningless concept. happy to sacrifice 75 bps yield
unless I see something really for HCA’s secured paper. In a
exciting that I want to replace bear market, that discount
it with. would balloon to over 200 bps,
even for HCA, which is not a
G&D: How comfortable are “I'm wondering how the distressed issuer. Since the
you with counting on assets to market is not paying a lot for
mitigate risk when issuers market is going to that unsecured risk, you are
operate in a declining industry? better off in the secured part
evolve and if hard of the capital structure. When
EC: I always value collateral. If the market turns to a bear
there is a secured and an collateral will be less credit market, I expect to
unsecured option in the capital rotate out of some of the
structure, and if I can only buy
valuable… It may not secured structure to buy the
one, I will almost always buy be valuable to have as unsecured paper.
the secured position. Between
the OpCo position versus the collateral an old mall G&D: In addition to collateral,
HoldCo position, I’ll always what other fundamental
take the less risky position in that nobody goes to factors do you look at when
the capital structure. assessing an issue?
anymore or a factory
However, you still have to be EC: I always focus on free cash
comfortable with the
that's worthless flow and that takes many
collateral. For example, in the because production has different forms. I'm looking for
Chrysler 2007 leveraged companies that generate free
buyout, the second-lien was moved.” cash flow and are interested in
worth nothing because it was deploying that free cash flow
secured by the subsidiaries’ beyond giving it back to their
stock, and by the time the first shareholders. That might be
-lien holders got paid out at paying down debt, reinvesting
par there didn’t remain enough It's not as important any more in the businesses, or
collateral to go around. to own a factory or a building maintaining capex to keep the
in this age of more technology- businesses in good shape.
It will be interesting to see oriented business models.
how the High Yield market I'm wondering how the market The focus on free cash flow
evolves to evaluate the lack of is going to evolve and if allows me to think bottom-up
what High Yield investors security or “hard collateral” as opposed to taking an
would consider good will be less valuable. It might industry view. In top-down
collateral. A lot of the new become equally valuable to industries, such as the
tech business models like the have subsidiaries’ stock as Commodities sector, no
FAANGs don't really have collateral, whereas it has matter what the management
buildings, factories, or tangible previously been perceived to team does, the company's
assets; it's much more about be inferior collateral, since fortune will be dictated by
intellectual property. The today it may not be valuable to what's going on in the
Equity market has always been have as collateral an old mall Commodities market. If you go
cognizant of the value that nobody goes to anymore back to the Exploration &
embedded, whereas High Yield or a factory that's worthless Production (E&P) cycle,
investors usually want to be because production has Chesapeake had bad
able to point at something and moved. management before they
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Ellen Carr, Weaver C. Barksdale

booted the former CEO. The Energy issues when the don't own as much HCA as I
new management was good benchmark is 15% Energy. do. It is a 4% position in my
and did everything they could Because there is so much portfolio, and I own both the
to position the company for a variety in operating models secured and unsecured paper.
down market. But when the and capital structures, you can Most people would say all the
cycle hit, it overwhelmed even find something attractive. juice has been squeezed out of
the new management team's At the issuer level, we have a the HCA orange because it
best intentions. The company 5% limit. When I first invest in trades like Investment Grade,
was too levered and hit a a company, I usually take about even for the unsecured bonds.
rough patch. In these a 2% starter position and Howard Marks, who is the god
industries, you want to have a monitor it for a couple of of the High Yield market,
view on the industry and that’s quarters to make sure the always says "you don't have to
why I tend to avoid the more investment thesis plays out. My know exactly where you are,
commoditized sectors. average positions are usually in but you have to know if you're
the 3% range, with only a closer to the end or the
I like bottom-up industries couple of issuers at the 5% beginning of the credit cycle."
because even during an level. In all cases where I own Looking at every single
economic slowdown, if a position of more than 4%, I indicator, from corporate
management executes well, the have both the secured and the leverage to the duration of this
companies will do well. The unsecured positions in the bull market by way of
retail sector is a great example same capital structure. A great valuations, it should be clear
of that: if you have a great example of that is Tenet, that we are much closer to the
value proposition and sound which is a hospital company. end than to the beginning of
execution, even if there is a Tenet is not the best hospital the credit cycle. That's why
recession, customers will still company by any means, but it staying in HCA capital
come to you because you built is a 4.25% position in my structure and under-yielding
a better mouse trap. portfolio. Two-thirds of that is my benchmark still feels okay.
secured because secured
G&D: How do you put hospital bonds are bulletproof, The place where I would like
together a portfolio? unless there's fraud. The other to have a buy list, yet don't
third is unsecured. As Tenet have any at this point, is the
EC: We manage our had its share of issues and CCC part of the market. I am
portfolios to meet client there is some noise around the generally underweight CCCs
guidelines. My typical approach Healthcare sector, you get paid as I believe it’s not the right
when starting a portfolio is to to hold the unsecured part of time to invest in them. Still,
cap industry exposures at the capital structure: there is a from what I have seen in the
about 2x the benchmark level. 150 bps spread pick-up. last few market cycles, when
If an industry represents more the market turns you need to
than 10% of the High Yield G&D: When you add be ready to buy quickly
market, as the Energy sector positions to your portfolio, do because windows of
currently does, I’ll typically you use any metrics to gauge opportunity will close and
have an upper bound at index whether they are a good fit for shut. Some bonds get marked
plus 500 bps. My lower bound the overall portfolio or is it a down 20 points on a one-
stands at zero, meaning I’m not pure bottom-up exercise? million-dollar trade—that's just
afraid of not owning anything how illiquid the market can be
in an industry. EC: It's rare to uncover an when it turns. I think it would
investment that the market be worthwhile to come up
Having said that, most of the hasn't priced appropriately. Yet with a list of lower-quality
time you can find something to something can be priced issuers that are trading at lofty
invest in, especially in a large appropriately and still generate valuations. The market will
industry such as Energy. For a 6% return, with good punish them when it turns, and
institutional clients who are conviction on the company's those are the names I would
paying for exposure to the long-term commitment to its like to add in such a period.
High Yield market, I find it ratings. As an example, a lot of
irresponsible not owning any High Yield managers probably
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Ellen Carr, Weaver C. Barksdale

G&D: How do you screen for long-term, yet it could still you don't always have to have
opportunities? Do you source have a bank revolver available, a constructive long-term view
your own ideas or do analysts cash on the balance sheet, and about a company to get
bring ideas to you? assets that it can sell, all of comfortable with its short-
which would make it investable term maturities.
EC: I work with another under a two-year maturity, but
portfolio manager and an much less so with a five-year G&D: Do you usually buy
analyst. That's been helpful, but or eight-year maturity. companies that you have
I do not invest in any company The poster child for that is J. known for a long time?
unless I build a model from
scratch and go through the EC: At least two-thirds of my
10Ks, financial statements, and portfolio is comprised of
the earnings’ transcripts. I companies that I have known
think doing the foundation “20 years in the fixed for over five years, even for
work on a firm sets you up for the very short-term holdings.
income market is a
a good investment decision. An example is Nielsen, which I
lifetime… You don't have known for a long time. It
I tend to start with companies became private equity-backed
displaying a stable or improving always have to have a during the 2005-2007 LBO
ratings trajectory. I also have a cycle. I like the company and
couple of industry biases. First, constructive long-term its underlying cash flow
I don't like financials because generation, but there have
High Yield financials are a view about a company been many questions about the
contradiction: financial sustainability of its business
to get comfortable with
companies should be model. Nielsen has a clear
Investment Grade since its short-term pathway to paying down debt,
accessing capital is so but there is the risk that if it is
important to their business maturities.” acquired it will be levered up,
model. I tend to be so I have only been
underweight the Commodities comfortable owning a short
and Energy sectors, simply maturity bond.
because leveraging a highly C. Penney. Retail was my first
volatile company eventually sector; I started covering it in As another example, Sprint is a
leads to ruin, which we saw in 2000. It was when everybody company with which probably
2015 and 2016. started talking about the every High Yield investor has a
internet and its impact on the love-hate relationship. Yet you
I had good success in some mall sector. Everybody decided would still be hard-pressed to
melting ice cube industries, for that the mall was dead and no find a High Yield portfolio
example with an incumbent one was ever going to shop at manager not owning any of its
wireline company or some Macy's again. It turns out it was bonds. There are many
retail issuers that have found a true, but it took 20 years for investment theses on Sprint.
home in the High Yield market. that to come home to roost. J. Some hold it because of the
Those companies are under C. Penney is on the verge of M&A thesis: they assume that
assault from changing business filing for bankruptcy and under the Trump
models and evolving Macy's is still BBB, albeit administration, there is going
technology, but they take a lot trading more like a BB. We are to be a way to get the T-
longer to die than they might finally seeing Amazon and the Mobile/Sprint merger done
appear to. I wouldn’t touch the other internet alternatives take that didn’t exist in the Obama
equity of these companies, but a bite out of the cash flow of administration. That is not my
firms like Frontier or these companies… But 20 investment thesis. My
CenturyLink can offer years in the fixed income investment thesis is spectrum
attractive Fixed Income market is a lifetime. There value, which covers the bonds
opportunities in the very short might have been five new easily. There is a whole class of
end of the maturity curve. A issues and bond maturities in High Yield investors who have
company may not be viable that timeframe, which means known Sprint over the many
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Ellen Carr, Weaver C. Barksdale

troubled iterations of its the DNA of how their analysts to address, and I think it’s
history. The company still analyze companies, similar to rippling through the market. If
burns cash and is one of the what Al Gore’s firm it's having this much of an
only companies I own that Generation Investment impact today, just think about
doesn’t generate free cash Management does? what it's going to look like in
flow, but I'm still comfortable 50 years, when this generation
with it, because the spectrum oversees all the wealth.
Sprint owns would be very The evidence to date on the
valuable in somebody else's performance of ESG mandates
hands. Although they’re not “There are firms such as is mixed at best. Nobody is
managing the spectrum well, making a ton of money in ESG
bond holders take comfort Generation Investment versus non-ESG mandates.
from the underlying asset value There are firms such as
of the wireless spectrum.
Management that have Generation Investment
Management that have done a
G&D: ESG mandates are
done a good job of good job of generating
witnessing rising popularity. generating superior superior results under an ESG
What’s your experience on framework, but I think that is
that and what do you think is results under an ESG the exception rather than the
driving this rising demand? rule. To gain real traction, it’s
framework, but I think going to take a lot more in
EC: We received a lot of terms of specific criteria and
interest in ESG mandates that is the exception transparency into the way
recently and I think this is an firms define ESG; but I think
rather than the rule. To
area with a lot of growing ESG will get there.
pains right now. We currently gain real traction, it’s
don't do anything labelled as That being said, I think returns
SRI or ESG because that means going to take a lot more should still be an important
such different things to factor. I get excited about the
different firms. For example, if in terms of specific prospect of combining a focus
you look at PIMCO's total on returns with an attention to
return fund that calls itself criteria and things you want to see
ESG, it owns Exxon. You can companies do. But as an
argue that Exxon is doing
transparency into the analyst who models companies
some things about the climate, way firms define ESG.” all day, I don't have a
but I think a lot of investors framework for incorporating
who buy an ESG fund do not that. Bloomberg now has a
want to invest in big oil firms. function that gives companies
an ESG score, and it’s very
The investment management I think what has been driving quantitative. It goes through
business faces long-term issues, the popularity of ESG is the everything from board
which is illustrated by fee millennial generation. My son, composition, diversity by
compression and a shift to who is only seven, is already gender/race, to employee
passive. One area that I think having conversations with me practices. Still, it can
will continue to grow and on this. One of his favorite sometimes generate
thrive is ESG. But we should shows is The Lorax, and it’s counterintuitive results. There
take a step back and think basically about climate change. is still a lot of work to really
about what we are trying to My son and I had this understand how to translate
achieve with ESG and who philosophical debate about corporate culture and
should be proposing the ESG what we are doing to the practices into a set of
criteria. Should clients come Earth, and he talks about how quantitative metrics. This is a
up with a list of companies? Or if he had land, he would never real opportunity; right now,
should asset managers create cut down any trees. The there is no substitute for
ESG buckets, exclusions, younger generation picks bottom-up research.
approved lists, and work it into things they want corporations
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Ellen Carr, Weaver C. Barksdale

G&D: On the topic of passive issues that I think passive its leverage trajectory it’s a
vs. active, what do you think players just can't address in rising star candidate, meaning it
will be the key value-add factor Fixed Income. has the potential to be
for active going forward? upgraded to Investment Grade.
Some of the biggest winners in
EC: Weaver’s CIO wrote a “There is a big High Yield are companies that
white paper titled “The Top have Investment Grade ratings
Ten Reasons Against Fixed difference between potential but are still priced
Income Indexation and Why and rated as BB. Because of
Passive Fixed Income buying the stock of an the 100+ bps spread
Management Doesn’t Exist.” In compression that occurs when
line with him, I think it’s much overvalued company a company goes from High
more difficult to adopt a Yield to Investment Grade,
and investing in the
passive approach in the Fixed these firms’ bonds offer a lot
Income space. bonds of a company of upside potential.

The first reason comes from which is so levered that Another example is Penske
the lack of liquidity: since Automotive, an auto retailer.
Bonds are not exchange- it's a potential distress I'm concerned about the auto
traded, it’s difficult for ETFs to cycle long-term, but Penske
move around and get invested. candidate. These are and its peers generate a lot of
Until the liquidity challenges free cash flow from their parts,
structural issues that I
are fixed it will be difficult for service, and repair operations.
passive to take the kind of think passive players That’s a sticky, more stable
share it has taken in Equities. part of their business that does
just can't address in not fluctuate a lot over time.
The second reason is that They have a BB/B split rating
passive represents maybe 5% Fixed Income.” and management is
of the High Yield market but comfortable with that rating.
tends to be a big marginal Unlike Olin, they don't have
contributor to volatility. On G&D: What are some of the Investment Grade potential,
down days, ETFs investments you are most but they are a steady company
programmatically sell bonds as excited about these days? that I think should hold up well
retail investors pull out, and in a down cycle. Given the
the opposite thing happens on EC: I'm not super excited performance of the auto
the flip side. As a small nimble about anything right now sector and the potential
active manager, you can pick because valuations are downturn, looking back to
up good bargains on days like stretched. Occasionally, I'll 2008 can provide the worst-
that. Another big problem with stumble across a good case scenario and, in 2008,
passive in Fixed Income is that company while reading a sell- Penske still generated free cash
it does not discriminate side research report or flow and managed to take a lot
between big issuers, which are hearing something from a of costs out. It makes me feel
usually more levered and thus trader, and then dig in. confident that the firm should
poorer credit, and good hold up well, even in an
issuers. It’s a similar structural A great example is a chemical Armageddon scenario.
issue to the one you have in company called Olin. Its 2022
Equities, when you are buying bond is BB-rated. The G&D: What was the most
overvalued companies, but management team has been unexpected investment in your
there is a big difference stable and the founder is still career?
between buying the stock of an involved in the company. It has
overvalued company and always managed its capital EC: Some of my worst
investing in the bonds of a structure conservatively, with mistakes were two companies
company which is so levered an eye on the BB rating, and it that defaulted in 2015. The
that it's a potential distress generates a fair amount of free first one was Peabody. I now
candidate. These are structural cash flow after dividend. Given focus more on the industry
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Ellen Carr, Weaver C. Barksdale

and if it’s a terrible industry I G&D: Can you discuss the and at Capital it would have
don’t care how good the differences between working been too small for it to have
management team is. At the for a large fund like Capital made a difference in my
time, I got coal completely Group versus your current portfolio. At Capital, positions
wrong. It was during the firm, Weaver C. Barksdale? less than $50 million wouldn't
Obama administration, which really impact a portfolio, but at
declared war on the coal EC: It’s been a delight to go Weaver even $1 million
industry. It’s difficult to price from managing billions of positions make a big difference.
political risk in, but that was dollars to millions of dollars,
one of the factors that because it opens my investing In terms of portfolio
contributed to the default. I universe while also narrowing construction, when I was at
also underestimated how it in a very positive way. When Capital, I would sometimes
quickly the cycle would turn. I I worked at Capital, we struggle to get something to a
was not taking a skeptical managed about $25 billion in 2% position because I just
enough view of the coal sector High Yield and I was directly couldn't find the bonds, while
and focused on the large responsible for about $4 today I can. Being able to focus
component of the world that billion. That meant I had to on a smaller group of higher-
uses coal, not realizing how own at least 100 issues in the conviction names has been one
quickly it can turn for an portfolios, which translated of the joys of working at my
individual company. I ended up into 80 issuers. A lot of times I new firm.
owning Peabody’s equity, found myself owning low or
mostly for option value, even weak conviction names simply G&D: Do you have any advice
though it was trading at to get invested. for students going into the
something that represented 10 investment management
cents on the dollar. Today, I own between 30 to industry?
40 issues in my portfolio,
During the same cycle I also which translates into 30 to 35 EC: Make sure to thoroughly
owned Linn Energy, a natural issuers. I love being able to interview the company before
gas company that was a darling invest in a much smaller you start working there. I think
of the High Yield market. number of companies. When it’s a great career, but more
There, I made a different you are only investing millions than ever your professional
mistake. In the years leading up of dollars, you can get invested path is going to be highly
to the Commodities crash of in the bonds and the issuers dependent on who you work
2015, Linn had done all the that you are excited about. for. In the next decade, there
right things from a balance is going to be a tremendous
sheet perspective. It made a A great example is Ingles amount of shakeout,
big acquisition in 2014, Markets, a supermarket consolidation, and fee
financed with equity, and de- company which happens to be pressure. Think critically about
levered as a result. Linn headquartered in Asheville, the industry and the company,
wanted to further de-lever, but NC, where I live. I have taking an analyst perspective.
it hit the Exploration & followed this company for There is a lot of political
Production cycle at the wrong years and watched it deal with pressure to invest in passive
time. I then made the mistake new entrants, from Whole alternatives, and a lot of
of placing more emphasis on Foods to Kroger by way of investment committees are
what the management wanted Trader Joe's. There are now all blindly switching from active to
to do and not enough on what kinds of competitors that passive management to satisfy
the company was actually didn't exist when the company their boards.
capable of doing. In a good was founded many years ago,
environment, the fact that the and yet it has continued to do Different funds have different
management wants to de-lever well. This is a company that ways of dealing with this. Some
is important. Yet when the makes a big difference in my are rolling out no-fee
cycle turns, as was the case for portfolio today, and which alternatives, experimenting
Linn then, management is not would not have worked at with novel ideas, while trying
capable of de-levering before it Capital. The bonds outstanding to protect core active
gets hit by the cycle. represent around $500 million, management by positioning
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Ellen Carr, Weaver C. Barksdale

themselves for an environment individual decisions become multiple perspectives it allows
where active management more collaborative, this could for. Valuing diversity and
continues to witness fee probably lead to better putting it in action is going to
compression. Others are outcomes. The investment be very important in the years
doubling down on active management industry can to come for the industry.
management, making a definitely increase diversity by
conscious choice to not having more women, more G&D: Thank you very much
deviate from it and to continue people from different ethnic for your time.
investing the way they have. It backgrounds, and more people
helps if they have lower fees who went to different schools.
than their peers, making them One of the equity analysts who
more competitive with the covered retail at Capital had
passive universe. You need to actually worked on a Macy's
understand the mentality of a floor for years before he
company and figure out what ascended the ranks and
their competitive advantage is. eventually went to work at
Capital. He had a great
The whole industry is still knowledge base.
trying to figure out how to
evolve from here. The most
knee-jerk way to evolve is to
cut fees. Probably every firm “More diverse teams
has been in a position of fee-
cutting for the last decade or make better decisions.
more, ever since the passive
revolution took hold. The Most portfolio
firms that are thoughtful are
thinking not just about cutting managers make
their expenses in response to individual decisions, yet
fee pressure but also about
investing in technology and if teams of people
exploring other areas of
improvement, such as making individual
diversity, in order to come up
with other sources of decisions become more
competitive advantage. collaborative, this could
Investing, especially portfolio
management, is one of the probably lead to better
least diverse industries. This is
also an industry that has outcomes.”
consistently charged high fees
while not being able to justify
them. The passive providers
came in, provided the same
thing at lower fees, and it One of my mentors at Capital,
worked. But I think what will who was the CIO of the
prove active management balanced funds, started her
works is more diversity in career as the head of investor
investing teams. relations at International Paper
and then moved to the sell-
More diverse teams make side—a transition which would
better decisions. Most be much less likely today. I
portfolio managers make think having people like that
individual decisions, yet if would contribute to results
teams of people making over time because of the
Page 42

Matthew Peterson, Peterson Capital Management

two decades of experience interest rates were much was by studying great
with global financial higher in the ‘80s. investors, but I also think it has
markets and financial evolved organically through
services firms including I went to the University of experience as well.
Goldman Sachs, Morgan Puget Sound, a liberal arts
Stanley, Merrill Lynch, school on the West Coast, There are three things I want
American Express, and where I studied economics and to see when I analyze an
Ameriprise Financial. math. From there, following a investment: a superior business
short stint in Beijing, I went to model, a superior
Prior to forming Peterson Wall Street and, again management, and
Capital Management and somewhat unconventionally, I extraordinary value. For a
Matthew Peterson launching Peterson took the consulting route. This superior business model, I'm
Investment Fund I, put me at Goldman Sachs often looking for something
Matthew split time working with some of the top that can scale and that has a
between Wall Street and managing directors in the risk dominant invariant strategy.
London as Capital Markets management space. I spent This could be a win-win
Manager in the Financial almost seven years between relationship with customers,
Services Vertical at New York and London doing employees, shareholders, and
Diamond Management and market risk management and society, so that the company
Technology Consultants. credit risk management at can become a very strong and
Matthew worked as a Goldman Sachs as well as at a sustainable business. If it’s a
member of both the U.S. couple other institutions, of mature business, I'm looking
and U.K. offices, with which Morgan Stanley. for something that has very
expertise spanning from high cash flows, with a natural
risk management to During that time, I also was moat that will protect it from
derivative processing. In earning my CFA designation, competition for a long period
2010, Diamond was and with that in 2010 I of time. Capital-light
purchased by PWC, and determined that it was the companies, or even negative
became Diamond Advisory appropriate time for me to working capital firms such as
Services. launch my own firm. I could SaaS firms, are examples of
live anywhere, and so from a superior business models.
Before Diamond, Matthew quality of life perspective, I
worked with Merrill Lynch, decided to come out to the In terms of superior
and founded M. Peterson West Coast again. We management, the first question
Financial Services, a launched our fund in 2011 and is: do they have high integrity?
financial planning firm that have returned about 15% per Then there are nuanced
offered client planning year since inception. details, like: do they have an
services to American owner mindset? You can
Express Financial Advisors. G&D: Coming from risk recognize if they do or do not
management and consulting, by the way they talk. If they
Graham & Doddsville how did you develop your have a shareholder mindset,
(G&D): What’s your investment philosophy? they’ll talk about things in
background and how did you terms of “cash flow per share ”
get started in investment MP: I start by reading and or even “return on equity”; if
management? educating myself based on the they don’t have a shareholder
vast amount of information mindset, they’re probably
Matthew Peterson (MP): that's available. The issue is exclusively talking about
I’ve been working in finance that people tend to stray from revenue growth. This is
professionally for two decades, these key principles – important, because I think
but I actually started at 10 or especially if you're paid based management’s main
11 doing pretty unconventional on an annual review and bonus responsibility is capital
things, like recycling soda cans cycle. It’s much easier to allocation. If you have a
out of my father’s law firm and maintain discipline if you superior business model and
then using the cash to trade operate independently. The there's a ton of cash flow that
bank certificate of deposits; way I developed my philosophy comes into the business,
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Matthew Peterson, Peterson Capital Management

management determines what pursue the process, and you superior business models, and
to do with that cash flow. have a superior process, superior value. Our third step
There are only five main things ultimately your outcome will is a little unique. Once an
they can do with cash flow: be superior. exceptionally mispriced
make acquisitions, reinvest in opportunity is identified, I do
operations, pay a dividend, pay not buy its stock outright.
down debt, or repurchase Instead, I search for a method
shares; but the choices they “You should always to obtain the shares for below-
make matter significantly. A lot market prices. Often, I write
of times, people who rise to focus on the process, cash secured long-dated puts
management positions may not on the securities; we are paid a
have capital allocation and not the outcomes, premium to buy the securities
knowledge or experience. we want to own. It becomes
when investing.” more difficult when you start
If you have an exceptional running billions of dollars, but
business model and superior even Warren Buffett sells puts.
management, usually the price There are four stages in our
is very high. Finding investment process. The first I’m looking for the optimal way
extraordinary value is the most one is a very thorough 13F to accumulate the shares we
challenging part. As an filter and analysis. I look desire. There is oftentimes an
investor, you really need to be through hundreds of 13Fs each inefficiently-priced product
doing something different to quarter to evaluate what other affiliated with the equity, so
find an opportunity that will fit managers are buying and you can take advantage of that,
all three criteria. selling. If you have the ability to and get a better price than
identify superior value- what’s offered on the NYSE.
If you’re just screening for oriented managers, look
value, for example, it won’t through their 13Fs, and take a I’ll give you an example from
work; you’ll get too many false superset of the stock our portfolio. In 2011, Buffett
positives. Instead, I tend to ownership across these announced very publicly
look for hidden assets and managers, you ultimately end Berkshire’s new policy to buy
hidden value, whether it is up with only a few hundred back stock at 1.2 time book
companies that are operating unique firms – which means value. Immediately the price of
with a specific strategy or in a you just eliminated 95% of the the security rose to 1.2 time
specific niche that protects the US market. Charlie Munger book, but the price of the puts
business model, or subsidiaries likes to say “fish where the fish and calls did not incorporate
that are not on the financial are.” Well this is where the this qualitative detail. At the
statements. I think the easiest fish are. Our portfolio is very time, the B share price was
way to find value – once concentrated; we only have 14 $80 and we were able to sell
you’ve identified the other two positions and five of them 15-month puts with a strike
criteria – is to find assets that make up over 50% of the price of $80 for $20. This left
do not show up on the portfolio. This means we only us with a binomial outcome - If
financial statements. need one or two ideas every the shares dipped below $80,
year. We are really searching our counterparty will put their
G&D: How do you uncover for needles in a haystack. For stock to us, costing us $60
this hidden value? me to deviate from this instead of $80. Alternatively, if
universe of stocks, I need to the prices rise, we keep their
MP: I think that when you understand very clearly why $20 on our $60 collateral and
invest, you should always focus none of the hundred value earn 33% over 15 months. If
on the process, not on the funds that I admire have put a we think the shares are worth
outcomes. In a probabilistic penny into it. $200, and we’re happy to buy
distribution of the future, you at $80, then we’re much
can make exceptional The second step is happier to buy at $60. I'm
investment decisions and still fundamental analysis. You take giving that example on
have a bad outcome every the 200 businesses and look Berkshire because it’s
once in a while; but if you for superior managers, something so obvious: you can
(Continued on page 44)
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Matthew Peterson, Peterson Capital Management

get a 25% discount simply by allocation that’s as objective as Graham stocks, you have to
selling puts rather than buying possible. Most of the managers constantly find new ideas. If a
on the NYSE. I know have a very subjective company doesn’t have the best
approach to the allocation business model and doesn’t
Finally, the fourth step in our process, because it’s very hard have exceptional management,
process is about portfolio to identify the factors that then once it becomes fairly
management. For that, we use make it objective. I’ve studied a valued you have to get out and
things like the Kelly criterion, lot of behavioral finance and find a new place for your
which was created by John recognize how much our capital. I prefer to allocate to
Kelly in the ‘40s. Originally, it environment can impact our the Fisher opportunities than
was a way to avoid the emotions, and how much that the Graham opportunities.
transmission of noise through can have an impact on an We're eight years in and we
telephone lines. It turned out allocation decision. The Kelly have a lot of Fisher
that some of the concepts criterion isn’t perfect, but I just opportunities; but we're happy
could be applied to poker, as want to make these decisions to hear about more from any
well as in finance. The Kelly as objective as possible. of your readers.
criterion says that, if you have
a fixed pool of capital, and you If you use the Kelly criterion, G&D: What’s a recent
know the probability of you’ll find that the optimal investment you’re excited
winning if you make a correct allocation you should give to about, and what’s your process
bet and the probability of any opportunity is between for analyzing that opportunity?
losing if you make an incorrect 10% and 50% of your portfolio.
bet, then there's an objective In other words, the optimal MP: I typically don't talk about
allocation you should have to number of securities you our holdings publicly, but at
that opportunity. Most should have in your portfolio is least one position in our
managers significantly over- between two and ten; we have portfolio is a long-term
diversify, and correlations tend fourteen, because if you have compounder that I expect us
to move toward one during a two securities with the same to hold for decades, so I don't
crisis anyway. If you're adding a potential outcome, then you mind speaking about it. It's
15th or 16th or 17th position to can split their allocation. such an obvious situation, yet
your portfolio, you are not nobody's getting involved. It's
getting any of the G&D: What discount-to-price hidden in plain sight.
diversification benefits. In do you normally look for?
addition to that, your 17th best When we do our 13F analysis,
idea is presumably not as good MP: It depends on the we can follow the
as your 1st best idea. In business model. I classify things breadcrumbs to other
essence, you are reducing your internally as to whether opportunities. Many people are
return, but not your volatility. they're a Ben Graham familiar with Charlie Munger,
The Kelly criterion guides opportunity or a Phil Fisher but what many people might
toward smarter portfolio opportunity. A Graham not know that, for over 40
allocation decisions. opportunity is something years, Munger has been
where the business, earnings, running another company
G&D: How do you come up or management are not as high called Daily Journal. It’s a
with the appropriate of quality and intrinsic value publishing company, but it’s
probabilities in order to use isn’t necessarily growing but also a technology company.
the Kelly criterion accurately? you can buy at a very, very Daily Journal has a hidden
deep discount. A Fisher business model, and it's not at
MP: The reality is that you opportunity would be a all about newspapers. It’s very
don't know the probability of superior business model with misunderstood and there are
being right and you don't know intrinsic value growing at high zero analysts, zero investor
the outcome when you're double-digit rates, that you’d relations. They have significant
right. So the inputs are still be willing to pay more for, off-financial statements value,
subjective. I use the Kelly maybe even a fair price. they have deferred revenue,
criterion because I want to Ideally, I prefer Fisher and they have accelerated
have a framework for portfolio opportunities; with Ben costs. I think it’s undervalued
(Continued on page 45)
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Matthew Peterson, Peterson Capital Management

from both a Ben Graham and a different forms. Daily Journal learned that they don't bill
Phil Fisher perspective. It’s a has the best debt I've ever until implementation is
micro-cap compounder in an seen. It’s primarily deferred complete, three or four years
enormous space, and it has an capital gains tax: zero interest, after they've won an RFP. This
extraordinary board and non-callable liabilities owed to makes their income statement
management team – perhaps the government if and when void of much deferred
among the best management they sell their securities. It's revenue. I also learned that
teams in history. 100% their decision. They also they have these tenure
have a $30 million loan that contracts with automatic price
Charlie Munger bought this they used to build their increases that will still push
company for $2 million in 1977 technology business. That’s a right through even during a
with Rick Guerin, who was margin loan against their very recession. I learned how much
one of the original large equity portfolio; it is their customers love the
“Superinvestors of Graham- below 3% interest rate, non- products they're providing. It
and-Doddsville”. Both Rick and callable, and the dividends was very eye-opening. I also
Charlie remain on the board from their equity portfolio realized that, to really
to this day. Peter Kaufman, service the payments. That's understand what they were
author of “Poor Charlie’s very different than a revolving doing I needed to understand
Almanac” and an incredible liability at 7% or 8% that has an who was using their software,
CEO in his own right at expiration date and potentially because the financial
Glenair, also sits on the board. high interest rate. statements were so incorrect.
The board is exceptional.
The most important thing, The company has an ethos of
Daily Journal has 10 very however, is the new deferred gratification. They
specific niche papers that technology business. This is look for opportunities to
operate in the legal space and something that very few provide services today and get
are very resilient. For example, people know about. I've been paid tomorrow. When they go
they have an internal public going to these Daily Journal into an RFP process against
disclosure notification annual shareholder meetings their main competitor, the
business; so when there are for eight years, and they say behemoth Tyler Technologies,
foreclosures or estate plans very little about Journal they are able to present
that need to go out publicly, Technologies. The lack of customers with an opportunity
they broker that business. information about this where they will not be billed
technology group intrigued me. until the implementation is
People think this is a Last year, I found a training complete and the court
newspaper company, and that’s conference Daily Journal was approves the software; many
what people are missing. We holding in Utah for users of times that goes out three to
basically value the newspapers their technology, which turned four years. When you're up
at zero. During the Great out to be a case management against a strong competitor
Recession, the newspapers software solution for court who would like customers to
brought in some cash and Rick houses and municipalities. I pay $100,000 a month, it's very
Guerin and Charlie, being the couldn't attend the conference valuable to defer the billing to
great investors that they are, because I didn't have the right the end. At Daily Journal, they
invested that cash in the stock courthouse credentials. do not report revenue until it
market and built a $220 million Instead, I booked a room in is billed and received, despite
equity portfolio inside of Daily the hotel, sat in the lobby, and the fact that they are already
Journal. The company has a interviewed their customers as performing significant work
$300 million market cap, with they got coffee for three days, today. There’s a ton of off-
$220 million in real estate, before being politely asked to financial statements’ value and
equity, and cash. leave by the COO, Jon Peek. you need to do work to find it.

Interestingly there's debt, and When I left the conference I I brought in an intern and we
in finance and accounting we had learned an enormous went county by county across
tend to treat all debt as equal. amount and had tools to America, digging through the
Still, debt can take very continue my research. I tax reports and meeting
(Continued on page 46)
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Matthew Peterson, Peterson Capital Management

minutes to find Journal $1 billion business in less than G&D: Do you invest
Technologies or Daily Journal 10 years. internationally as well?
being discussed. If we found
something, we’d then search G&D: How did you come MP: We are very much
for contracts in that county. across this idea? At what point diversified globally. Two years
What we found was incredible. did you realize that this was ago we launched a Turkish-
Los Angeles owes them $5 something worth digging into? focused fund named Talas
million. Austin, Texas owes Capital, which serves as a
them $1 million. Surprise, MP: I've been going to the capital pipe to some of the
Arizona, owes them $25,000. Berkshire Hathaway annual most undervalued companies
Australia owes them at least shareholder meetings in in the world. It’s a zero
$16 million, and potentially a Omaha since 2004. The Daily management fee fund, based
whole lot more as of last Journal meetings are held in on the original Buffett
week. We found over $40 Los Angeles and I started partnership. Through that fund
million in revenue that has not attending those, too. It was a we’ve been able to capture a
been captured on their very small, intimate group, just basket of eight Turkish
financial statements . We a few hundred people, and we securities that trade for three
found over a hundred got to sit and talk to Charlie times earnings. We held most
contracts that are being for a couple hours. It has of the eight positions through
implemented across the nation. grown over time and now the entire crisis which
These contracts have recurring more than a thousand people occurred over the last years.
license agreements. It's a SaaS attend, but it's still quite small The market declined by about
business model, with automatic compared to the 40,000 plus at 40% but we are basically flat.
price increases and 10-year Berkshire Hathaway. We intend to hold these
lock ups. We believe that positions for a very long time.
within the next 10 years, It was through eight years of We think of ourselves as
there'll be at least $150 million watching these conversations owners, and we go and meet
in recurring revenue from the and reading the annual reports with management to discuss
technology business. that I started to recognize that their long-term strategies.
the technology piece seemed Fluctuations in currency or
SaaS is one of the best business to be gaining traction. politics doesn't bother us; it's
models out there today. You Originally, Charlie referred to actually expected. Over the
create software and it scales it as a group of "five ninety- long-term, I think we have a
around the world. You've year-olds with one eye who very high probability of
probably seen margins of 60%, can't walk, trying to climb significantly not only
70%, 80% in this space. But if Mount Everest; it's never going outperforming the Turkish
you used a simple, very low to work." A few years later, he market, but also the S&P 500.
margin of like 25%, you'd started saying things like "Well,
realize they're going to have we've jumped from flow to We’ve also been able to
close to $40 million of EBIDTA flow and crossed the river, but purchase about 3% of Mohnish
in the not too distant future. just because we did it once, Pabrai’s Dhandho Holdings
This whole company is a $300 doesn't mean we'll ever do it through private transactions.
million market cap business. again." That's quite a different We’re not an investor in the
We're taking the whole statement. It suggests that fund, we are owners of it;
newspaper business and saying they've accomplished the initial through it we get some
it’s worth nothing; we're taking objective. That encouraged me indirect exposure to the Indian
the equity portfolio of $220 to start wondering what the stock market.
million and subtracting the software actually is, and the
“fake” debt of $70 million, so more I discovered that nobody G&D: Are there other
we’re left with $150 million knew, the more intriguing it investments that you are
net; and now we need to figure became. Frankly, most people excited about?
out if Journal Technologies is didn't even knew that they
worth $150 million to cover have built a case management MP: I will share a position that
the current market cap. Well, software for courthouses. we have created. Over a
our models show that this is a number of years, we’ve
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Matthew Peterson, Peterson Capital Management

constructed a very asymmetric 2017 and we were able to business works. I think that
payout hedge that we hold in implement it again in 2018. when launching a firm, focusing
our portfolio. I noticed that We’ve been trying to get the on the three legs of the stool –
overpriced puts were shrinking same prices through all of 2019 portfolio management,
considerably over the last few and are yet to put on the operations, and marketing –
years, particularly as volatility hedge because the prices have will help the company be
was very low. This made it less been too high. Should the successful. I have seen many
valuable to sell the puts, prices decline a bit more, we firms with an exceptional
because the return no longer will create it again for the third portfolio manager who can't
compensated for the risk. I year. This will cost us 1% a write an investor letter on
started wondering if I should year for protection in flat or time, or who has no ability to
be buying some underpriced up markets; but a 40% drop in raise capital; those businesses
puts rather than selling the the market will deliver us a ultimately don't last.
overpriced puts. I eventually large gain in the portfolio.
recognized that, if sized One of the greatest things
appropriately, it could be a about this business is that
very advantageous position in you're on an intellectual
for our portfolio, particularly treadmill. You're constantly
in the event of a major learning, growing, and evolving.
correction or recession. In general, people should
expect launching to take a little
It would be unnecessary to “One of the greatest bit longer than they would
hedge to zero, because we're expect; but if they do it wisely,
value investors. At some point,
things about this they may be able to launch
we become net buyers. With business is that you're with less operating expenses
1% of our portfolio, we buy than they assume.
puts slightly out of the money, on an intellectual
because 10% or 15% volatility G&D: Thank you very much
is not going to hurt us. Then treadmill and you're for your time.
we go down 30% or 40% and
sell a put there to help pay for constantly learning,
the put we're buying, and then
we go down even further and
growing, and evolving. ”
sell a second put where we
would ultimately like to buy
again. These are three-year put
contracts. By doing this, we’re
able to take an already low
premium and reduce it further
by picking up far out-of-the- G&D: Do you have any advice
money options to finance it. for students pursuing a career
For example, with 1% of capital in investment management or
we were able to buy $5 worth those looking to launch their
of protection in case the S&P own fund?
500 falls below 2,750 and that
turns into $75 (or 15x) if the MP: The first thing to
market falls through 2,000. recognize, assuming that you
have the education and IQ, is
As the markets fall, we have that it's nice to have
this embedded contrarian experience. I encourage people
asymmetric position that will to spend a year, maybe two,
explode upward in price. I working either on Wall Street
think it's a very nice hedge to or under a prominent
have on at this point. We were manager, in order to try
able to implement it first in understanding how the whole
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Contact Us: Graham & Doddsville Editors 2019-2020 Frederic Dreyfuss ’20
Fred is a second-year MBA sponsored by Columbia (Columbia Fellow).
He spent the summer working in the Equity Investment Group at Capital Group.
Prior to Columbia, he was an Investment Manager in the Principal Investments de-
partment of BNP Paribas, where he invested across the capital structure of unlisted
companies active in various industries all over Europe.
Fred graduated from Sciences Po Paris with a Corporate Strategy concentration.
He can be reached at

Sophie Song, CFA ’20

Sophie is a second-year MBA student and a member of Columbia Business School’s
Value Investing Program. During the summer, Sophie worked in the Fixed Income
group at Capital Group. Prior to Columbia, she worked at the Royal Bank of Canada
and the Office of the Superintendent of Financial Institutions in liquidity and market
risk management in Toronto. Sophie graduated from the University of Toronto with
an Accounting and Economics concentration.
She can be reached at

John Szramiak ’20

John is a second-year MBA and is a Columbia Fellow.
Prior to Columbia, he worked in the Private Credit group at First Eagle Investment
Management. He also built and ran a value investing website, which he sold earlier
this year. He spent the summer working at a leading e-commerce company in India,
where he built a new credit scoring engine for the company’s lending platform.
John graduated from Boston University with a concentration in Finance and a minor
in Economics.
He can be reached at

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