Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/ 2011 Value Investing Congress Notes Day 1: Speaker #1: Seeing Value Through the Cloud Kian Ghazi- Hawkshaw Capital Management - Background (from Whitney Tilson) o Kian has been running this company for 10 years o Worked at Lehman brothers and is a Wharton MBA o Firm does some of the most extensive scuttlebutt research of anyone in this business - Understanding how a manger thinks through his ideas is the most valuable part of attending the conference o As such, he is going to go really deep into a single idea - Concentrated value portfolio with a focus on in-depth research - Long short portfolio o Extensive primary research: calling customers and former employees to get insights into the industry o Trying to confirm or refute their variant view o They do not use paid networks o The majority of what they do is cold calls to proprietary contacts who are unpaid - How do they invest? o They are value investors but their style goes beyond cheap business— Look for high quality, one of a kind business. Does the business have a dominant market share, barriers to entry? Shown by return on capital (ROC) Rock solid balance sheet with excess cash and monetizable assets o Do a deep dive to try to see land mines before they step on them o Perform a pre-mortem on an investment If there is a permanent impairment to the earnings power, what might cause that? If they can think of a lot of these they will avoid investing o Invest in a business and not a stock - Best Idea: Ingram Micro Inc. (IM) o Have talked to 25-30 industry contacts—employees, customers, competitors o World’s largest IT distributor— 1500 vendors and 180K value added resellers o $3B market cap, $35B in sales, trading .9x TBV and 10x EPS o Number one share worldwide
The following are my detailed notes from this year's Value Investing Congress in Pasadena. There were a number of great speakers at the event, including the legendary Howard Marks of Oaktree Capital.
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Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
2011 Value Investing Congress Notes
Day 1:
Speaker #1:
Seeing Value Through the Cloud
Kian Ghazi- Hawkshaw Capital Management
- Background (from Whitney Tilson)
o Kian has been running this company for 10 years
o Worked at Lehman brothers and is a Wharton MBA
o Firm does some of the most extensive scuttlebutt research of anyone in this business
- Understanding how a manger thinks through his ideas is the most valuable part of attending the
conference
o As such, he is going to go really deep into a single idea
- Concentrated value portfolio with a focus on in-depth research
- Long short portfolio
o Extensive primary research: calling customers and former employees to get insights into
the industry
o Trying to confirm or refute their variant view
o They do not use paid networks
o The majority of what they do is cold calls to proprietary contacts who are unpaid
- How do they invest?
o They are value investors but their style goes beyond cheap business—
Look for high quality, one of a kind business.
Does the business have a dominant market share, barriers to entry?
Shown by return on capital (ROC)
Rock solid balance sheet with excess cash and monetizable assets
o Do a deep dive to try to see land mines before they step on them
o Perform a pre-mortem on an investment
If there is a permanent impairment to the earnings power, what might cause that?
If they can think of a lot of these they will avoid investing
o Invest in a business and not a stock
- Best Idea: Ingram Micro Inc. (IM)
o Have talked to 25-30 industry
contacts—employees, customers,
competitors
o World’s largest IT distributor—
1500 vendors and 180K value added
resellers
o $3B market cap, $35B in sales,
trading .9x TBV and 10x EPS
o Number one share worldwide
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Number 1 in the US and number 2 in Europe
o Bear case:
Commoditized service in a highly competitive, low margin business
Mediocre returns on capital and thus the stock should trade at book value
Shift to the cloud is a major headwind
If Microsoft, Cisco and HP are trading at 10x earnings, then the middle man
should trade at a lower multiple than those companies
o Subtle industry tailwinds that the market does not understand
Offers a cost effective sales channel to small to medium sized businesses
(SMBs)
Industry competitive dynamic is shifting toward a better environment
Cloud fears are overblown
Oligopoly is developing
o Valuation
Book value is a floor to the value
Appraised the business at 100% upside over 2 years
- Why does this opportunity exist?
o Threat of the cloud
Uncertainty leads to an opportunity
o Large cap tech is out of favor
o Margins are at peak levels
o Change in the industry is subtle
- What is the value of 2 tier distribution
o Exists because they are the primary sales channel for selling tech into SMBs
8M SMBs
These firms purchase 40% of all tech products sold
o 30% are sold through 2 tier distribution
Other 70% is sold direct or through the 1st tier
o Cost effective sales channel
o What is the value to the distributor?
Cost effective sales channel—outsourced sales
Don’t need a large sales force—cost effective
Choose to use this to reach SMB than direct
Outsourced credit department
o All outside billing and collections
o One credit worthy company
Outsourced training
Distributor trains the value added reseller
Help with troubleshooting
o Industry Quotes
Comes down to efficiency, logistics and scale—many companies don’t want
to manage sales
o What is the value to the reseller?
One stop shop: one place and one bill
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
This very important and some customers are willing to pay more for
it
Source of financing—need credit extended by the distributor
Outsourced logistics and fulfillment
Resellers do not have to hold any inventory—no warehouses
If an order is placed by 5pm then the product is received the next day
with labeling that says it comes from the reseller
Support and expertise
Conferences to help them understand trends
o Realize that price is not everything—service is very important
- Why is a rational oligopoly in the making?
o 4 changes in the industry
Key geographies have consolidated—less competition
US: top 5 players have a 75% share
o Top 3 do the same thing
Mainly sell PCs, printers, and other computer
peripherals
o Next 2 are slightly different
High touch, low velocity
Ship to products directly to the data center
o Servers
Europe
o Top 5 have 62% share
o #2 and #4 in Germany have merged (# 1 market in Europe)
Synnex is no longer a price spoiler
No longer have to build share fast to achieve the scale they need to
compete
The CEO was the CEO at Ingram
He is focused on return on tangible capital (ROTC) and profits now
o Margins are trending up
Lifting the weight off of the shoulders of the industry
o This reduces pricing competition
Focus on ROC in the entire industry
Was previously focused on growth
Didn’t talk about ROC at all
o Synnex is now talking about ROC
o Same is true of Tech Data now
Company wants to achieve a ROC 500bps above the
cost of capital
o Ingram has a chart dedicated to ROC now
Targeting ROC 300-400bps above the cost of capital
Each company is pursuing growth adjacencies with little overlap
Better growth opportunities and better margins
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Ingram
o Data capture and point of sale—bar code scanners
Synnex and Tech Data are not in this market
o Logistics
3rd
party logistics
Have inventory but don’t own it—get a fee
for service
50% of all items distributed from Wal-
Mart.com come from an Ingram warehouse
o Apple and Amazon as well
Tech Data
o Mobility
Synnex
o Outsourcing
Call centers
The overlap between the 3 is in the data center market
o Higher margin business
o Really going after other firms’ markets
o These 4 changes can drive mid-teens returns on capital give the changes in the
industry
- Fears of the cloud
o A major headwind to this business in general is customers moving to the cloud
o Cloud computing- distribution of software applications over the internet
Characteristics
Shared servers rather than in-house servers
o Servers are in 3rd
party data centers
Virtualization
Cheaper and broader broadband pipes make the move easier
o Big growth expected
35% CAGR through 2013
o 2 impacts on the 2 tier distribution
Software—some companies will shift to the cloud
Others will leverage two tier distribution
Hardware
With the server not on premises anymore, they will not need certain
hardware
There will absolutely be an impact if companies to go to the cloud and
circumvent two tier distribution
However, just like not all IT services got offshored to India
o Not all software/hardware is going to be going to the cloud:
Bandwidth constraints
Mission critical apps
Service disruptions
Legal/compliance
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Customized software
o 68% of their sales will not be impacted by the cloud
Peripherals—monitors, printers
PCs
o At risk at to competition from the cloud is the remaining 32%
Mainly software
- Worst case
o 50% shift to the cloud n 5 years
Very draconian downside scenario
16% of revenue could go away if half of the 32% exposed goes away
Lose $1.1B in revenue
But the other 68% of the business will still grow
If it can still grow at historical growth levels, that would be $1.2B
annually
o Revenue would be about flat
o Company is priced for an Armageddon scenario
- Base Case
o 30% shift to the cloud in 5 years
$3.3B headwind over 5 years
Potential offsets
Cloud is going to need 2 tier distribution as well
o Value of 2 tier is not eliminated
o Cloud-based service providers will need to be able to tap the
SMB market
They will not build out their sales forces
There will be a land grab
First to market will be important
o The reseller will need 2 tier distribution
Will aggregate a 1 stop suite for cloud customers
o 50% of lost sales to the cloud could be offset
Higher end data center products—higher margins
POS bar codes and scanners
Base case is 3% growth per year
- Upside case- 10% shift to the cloud (20% is his actual guess)
o 5% growth projected by IDC for non-cloud IT spending
- None of the range of outcomes is horrible
o 0-5% annual growth even if 50% goes to the cloud
- Valuation
o Significant downside protection and 100% upside
o During a 5 month period in 2008 and 2009 the company traded below tangible book
value (TBV)
Is credit exposure an issue?
Write offs are 1% of gross profits over time
Only a small uptick in 2008 and 2009
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Concerns were unfounded
Is there inventory write down risk?
80-90% has contractual rights of returns or price protection
o Very little inventory risk
Gross margins actually improved during the downturn
Profitable every quarter during the downturn
$0 inventory write downs
Managed the downturn really well
o Trading at .9x TBV
Synnex (SNX): 1.5x TBV
Tech Data (TECD): 1.3x TBV
o Base case
3% revenue growth, some reasonable SG&A leverage
8% EPS growth
13% return on invested capital (ROIC)
o Apply a 12x forward multiple and add back cash they will
use for a sizable buyback and some tuck-in valuations
$35 price
Upside is 90%
o Thinks that ROIC will be better than before and the multiple
could expand to 13-14x
- Risks
o Severe downturn in global IT spending
But the stock only trades at .9x TBV
o Company is implementing an ERP system for the next 3 years
There Inevitably will be some hiccups
o HP is a huge customers and losing HP would really hurt
o Ingram straying from its ROIC focus
- Summary
o Had a bias at first and changed his mind after looking at it closer
o Book value sets a floor for the valuation
- Q&A
o How long do they propose to own Ingram?
3-5 years
Appraise intrinsic value over a pretty long time frame
Have a 2 year out price target
o What would inspire the company to sell?
He likes that it is not a play on one company’s technology
They are going to take part in the cloud boom
IM is an arms dealer to all vendors
What would cause him to sell
ROIC focus went away
HP changed how it was going for its distribution
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Not worried about a downturn in tech spending
o Why do the US-based companies in this sector not pay dividends? Why are the
models rated differently outside of the US? Does this make a case for the electronics
manufacturing services (EMS) industry as well?
Can’t comment on EMS—does not know that sector
Doesn’t know why Ingram trades at a discount to Synnex and Tech Data
He does not want to see them pay a dividend
Thinks they should buy back shares instead
o The best return on allocated capital is from share buybacks
Not going to get any value from paying a dividend
Tax inefficient
o How do they narrow down the investing field enough to do so much research on a
single name?
They used to pass on a company after 2-3 weeks of research
Implemented screening technology to find a more fertile hunting
ground
Narrow the universe to the cheapest stocks
Companies like Ingram Micro had been on his screen for a long time but he
liked a lot the more he dug in
o Did they analyze what TBV consists of?
Inventory is the biggest chunk
But, you could not get that carrying value if you were liquidating that
business
Price protection and ability to return reduce write down risk but you
can’t liquidate at the value on the balance sheet
Excess cash
Net PP&E—world-class distribution facilities
Accounts receivable
o Question from Whitney Tilson of T2 Partners: Is this like Costco (COST)—high
velocity but low margin business that actually is great?
Sales are a pass through and gross profits are like true revenue
Is more like a 25% margin business if you look at it this way
o 22% in 2008 and 2009
o Jumped back to 25% in 2010
Suggests a better business than it would at first glance
o Is there a franchise value to this business? Brand value?
Hard to argue for some enduring value for the brand
Don’t think much about the intangibles in this case
o Thinks about who will miss the company if they it is gone
o Companies only want to deal with 3-5 vendors
New company would find it hard to enter
Need customers to attract products and vice
versa
No good answer to what the price they would not buy more stock back
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
If it were trading a little above TBV he would still buy it
10% downside and 100% upside is a good tradeoff
o If .8x TBV is the floor
Speaker #2
The Human Side of Investing, or the Difference Between Theory and Practice
Howard Marks- Oaktree Capital Management
- Great quote from Yogi Berra
o ―In theory there is no difference between theory and practice. In practice there is.‖
This applies to investing
- It is important to realize that there is another side of investing not taught in schools and textbooks
o Professors provide a simple roadmap to investment success
There is no simple formula and it is the human side that screws it up
o Markets are objective, efficient and clinical and thus assets are priced accurately
But markets are made up of people who have emotions and swing between
extremes
o Riskier assets must provide higher returns to attract capital
If they could always be expected to produce higher returns then they wouldn’t be
riskier
o Appropriate risk premium is incorporated into returns
Sometimes the premium is appropriate
Other times it is inadequate or excessive
o Q3 2007 and Q4 2008 were on different extremes
o Since markets price asset fairly, if you buy at the market price you can expect fair returns
Buying at the market price cannot be counted on to produce a fair return
o People want more of something at a lower price and less as a higher price
Normal demand curve taught in Economics 101
Unfortunately, investors warm to investments when they rise and shun them
when they fall
Demand curve is actually the opposite in investing
- The swing of the pendulum
o Constantly going between greed and fear, risk tolerance and risk aversion, and optimism
and pessimism
o In theory, the pendulum should be at the happy medium
On average it is in the middle
But it spends little time there
Excesses constitute the errors of herd behavior
3 stages of a bull market
Few people feel things are getting better
Most people realize improvement is taking place
Everyone thinks things will get better forever
―What the wise man does in the beginning, the fool does in the end‖
o The last buyer pays the price
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
3 stages of a bear market
Few people realize that things are overpriced and dangerous
Most people see the decline is underway
Everyone believes that things will get worse forever
o Great opportunity to buy if we can behave counter-cyclically
- Importance of being a contrarian
o Quote from Mark Twain:
―Whenever you find yourself on the side of the majority, is it time to reform.‖
o A market top is coincident with extreme bullishness
How do we avoid getting caught up in the mania?
Approach has to be value-based and objective and we must be steadfast
in our attention to the swings in the pendulum
o What most people believe to be true in the investment world is often not true
It is very lonely being a contrarian and as value investors we have to be fine
straying from the herd
- Investor memory has to fail us for extremes to be reached
o According to John Kenneth Galbraith one of the main factors that contributes to euphoria
is the extreme brevity of the financial memory
We are less likely to repeat the past and go to extremes if we can bear these past
events in mind
1929 repeated in 2008—had to have been born in 1908 to have experienced both
events
o A man is willing to believe things that will make him rich if they are true
Greed can overwhelm caution
- Pro-cyclical behavior
o One of the most frequent mistakes investors make
o We were told to buy low and sell high
Instead we do the opposite
When the cycle is going well, media is positive, financing is available
o Coincident with rising cycles
o We need to be anti-cyclical when others are acting pro-cyclically
- Overstating knowledge of the future
o Value and growth investors are different
Value investors focus on the value here and now
Current assets, current cash, current cash flow
Growth investors are buying a piece of the dream
o But these are not that different
We need to understand the future in either case
At the same time, we should be cautious in what we expect of our prescience
o Another quote from Galbraith: ―There are two kinds of forecasters: those who don’t
know, and those who don’t know they don’t know.‖
o Amos Tversky said that it is frightening to realize that you might not know something
By in large the world is run by people who have faith that they know exactly
what is going on
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Very dangerous to act as if you know the future
o Quote from Mark Twain
―It ain't what you don't know that gets you into trouble. ... It's what you know for
sure that just ain't so.‖
o 2 schools of investing
The I know school
The I don’t know school
The I know school is the most prevalent school
o These people tell others what will happen in the future to
markets and economies
o Tend to invest based on the assumption that they are right
When they are proven wrong they try to invest again on
their predictions
o Make one outcome bets
o Have concentrated portfolios
o Target only maximum price gains
o Lever heavily
The best investors are in the I don’t know school when it comes to the macro
environment
o So, what do they do to limit risk?
Diversify
No leverage
Avoid losses
Is as important as generating gains
Hedge their bets
o Most people think in terms of norms and ignore outliers
The I know school thinks in terms of the average
Never forget about the 6 foot man who drowned in a lake that was 5 feet
deep on average
These people got into trouble in 2008
Leverage is what hurt people and didn’t let them survive the outlier
events
Single scenario investors cannot account for Black Swans
Believe that the event they see as most likely is the one that will happen
o There are still many other events that could happen that have a
higher cumulative probability
Quote from Elroy Dimson
―Risk means more things can happen than will happen‖
o It is important to recognize the twin imposters
Short term outperformance and underperformance
Neither says anything about skill
Events collide with an existing portfolio
Events can be unforeseeable and hurt a thoughtful portfolio
o Doesn’t not say anything about investment ability
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Remember the lessons of Nassim Taleb’s Fooled by Randomness
o Investors are right and wrong for all kinds of reasons
o Good decisions fail all the time; bad decisions work sometimes
o Randomness can produce just about any outcome in the short run
o Alternative histories
The other things that could have happened
Events are part of a range of probabilities
If we understand that then we reduce the
significance of what actually happened
Long term performance is what we should focus on
o If we think of the past as being as variable as the unknown future, it is very difficult to
get investment timing right
What should happen and what will happen are very different
Folly to bet your chips on what should happen
If you expect too much you get into trouble
o Hard to do the right thing in the investing business
Impossible to do the right thing at the right time
We are all going to be wrong
Being too far ahead is indistinguishable from being wrong
o We must avoid the pitfalls of investment bureaucracy
David Swenson of the Yale endowment says that ―active management strategies
demand uninstitutional behavior from institutions, creating a paradox that few
can unravel.‖
Over-diversification
Fear of embarrassment
It is better to fail conventionally than to fail unconventionally
Ultimate conundrum
o We must take the chance of doing a lot of something that fails
o Take the chance of being too early if we are going to be great
investors
o Investing in things with obvious appeal and that can be understood
Implies elevated prices and substantial risk
Real bargains come from areas in which the herd shuns
Focus on buying assets well rather than buying good assets
Inefficiencies are the superior investor’s reason for being
Mistakes of others lead smart investors to make vast sums
o Oaktree’s philosophy and approach
Understanding and controlling risk
Involved in less efficient markets
High degree of investment specialization—leads to expertise
Does not raise and lower cash levels to try to time the market
No reliance on economic projects
- Q&A
o How much are they holding in cash for future opportunities given the frothy markets?
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Oaktree has lots of different kinds of funds
Some are 90%+ invested
Some distressed debt and real estate funds are invested based on their
vintage
In most areas cash is high relative to normal times
o Challenging today to find exceptional bargains
Risk tolerance is too high
Time for great selectivity, caution and discipline
o Question from Guy Spier of Aquamarine Funds: Why does Oaktree still run institutional
money if it is so hard and the investors are so biased?
Swenson has worked it out how to handle institutional investors better than most
of his peers
He has outperformed his peers by about 3%a year for 25 years
In Oaktree’s case, some of it is an historic accident
Howard has been in the institutional business since he was 21
Believes Oaktree has added value to the institutional world
o Not many people bring this message to the institutional world
o Which area(s) are they finding the most interesting?
Does not know of any areas in which dollars are going for 50 cents
Very hard to answer that question
Oaktree is raising funds which keeps him from marketing outside the
institutional meetings
o Can’t say exactly where but they are raising money in some
areas
o How do you build the right temperament? How has he done it?
It helps a lot to be born with a reserved and steady temperament
Aloof, removed, analytical, skeptical
He didn’t do exercises to develop the right mentality
Reading is the most important thing
Read about the excesses of the market
o It should strike a chord with you
o If you read it and it you think it doesn’t apply to you—you are in
the wrong business
Galbraith book –A Short History of Financial Euphoria
o If you get this book then this business is right for you
The best investors are not artists
They are analytical, introspective and not emotional
Emotional investors may not be able to become value investors
Need serenity, consistency and stability
Many forces bear on us- envy, greed, benchmarking, fear
o Forces that cause bubbles, crises, and bear markets
Value investors see them for what they are and rise to
the occasion rather than succumb
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Hard to teach yourself how to do that
consciously
o People who read his new book and don’t get should probably be
in another business
o Question from VIC organizer John Schwartz- Does it help to be well self-analyzed in
order to counteract certain human emotions?
He once wrote that the most important science is not economics or financial
analyses or accounting
It is psychology
o People who have their psyches in control are in the best shape to
be great investors
A portfolio manager came to him in 1998 after LTCM crisis and was
worried that the world was going to end
o Howard said he understood why he was scared but told him to go
back to his desk and manage his portfolio
A battlefield hero is one who is afraid and does it
anyway
In 2008 they were impressed with the fact that they could be wrong
o Were not sure if they were going to fast or two slow
It was that tension that told them that they were doing
the right thing
But it was really hard to do at that time
o Were shown by the fact that very few
people didn’t jump back into the
markets that they were right
o If you couldn’t deploy money back then,
you were not alone
o It is often hard to buy something when prices are falling if you don’t own it. How do they
think about position sizing and how do they scale positions?
Within the areas they work, they are toward the more diversified end of the
spectrum
Have never had a position over 2%
o When things go right, they never have enough
o When you don’t have big positions, you can’t have big mistakes
o Graham and Dodd described fixed income as a negative art
What you don’t own is what is most important
Position sizing is forced upon them
When there aren’t attractive new investments available they may buy
more of things they already own
Will take large positions of 5-6% in certain distressed situations
Oaktree I still around after 30+ years because the focus has been on protecting
capital and managing risk
Many competitors are not around anymore
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
o There are old investors and bold investors. But there are not that
many old and bold investors
o Question from Marcelo Lima- If he likes inefficient markets, then why he is Oaktree not
more involved in the equity markets
They are not active in mainstream equity markets
But they do have funds for emerging market equities and Japanese
equities
Just don’t invest in developed world equities
o How does he think about dollar depreciation risk in the long term, especially when it
comes to illiquid investments?
Clients are looking to Oaktree for dollar-based returns
Don’t have superior knowledge about dollar depreciation
So, the best thing to do is try to generate high returns
Clients are fully equipped to do their own hedging
Oaktree offers dollar returns and they can hedge if they want
o Question from Ryan Morris of Meson Capital- Does he ever pay attention to external
issues that are not intrinsic to the market but can still affect the market?
The answer is no
His son is investing now
For years the 1st thing Howard says to him when he brings up an
investment idea is who doesn’t already know that?
o Meaning, why is this not priced into the market already?
For example, trade barriers are likely to go up around the world
But who doesn’t know that?
Is that priced in or not?
He doesn’t know anything about the future or exogenous events that
nobody else knows
o Can’t add value there
In high yield, the formula is simple:
o Buy ones that will not default and avoid those that will
o Will look at macro factors on individual investments when
assessing the level of risk but does not go beyond that
o He says Oaktree does not raise or lower cash based on market timing but has more cash
now? Is there a contradiction there?
Likes people to point out his contradictions
They never say: we are worried about the market and we are adding 10% cash
What they say is that there is a lot to sell and to little buy so cash levels
float up
o Their actions are the result of active portfolio management
Not a conscious decision to hold cash
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Speaker #3
Prospecting for Compounding Machines in a Minefield of Value Traps
Rahul Saraogi- Atyant Capital (from Chennai India)
- Has been investing in India for 11 years
o Long only, concentrated strategy
No shorting or leverage
$15M under management
- Ben Graham said that one of the mysteries of the business is how the price of a stock converges
to intrinsic value
o How do we deal with this mystery?
This is something that value investors are always trying to do
- Munger says, always invert
o So he thinks about what prevents a stock price from converging to intrinsic value
- Background on India
o India has been discovered by value investors
Some people have had good experiences and others have had bad experiences
o Tailwinds
Demographics
1.3B people- 3.5x the size of the US
600M people under the age of 25
85% of the people are under the age of 45
By 2020, 50% of the population will be in urban centers
o This is driving significant demand
14% nominal GDP growth
o 8% real growth
o This is in spite of the government
The government has done just about everything wrong
Demand is growing 25% each year for certain products
Has very deep markets
o T+2 settlement
o 6000 listed companies
o Every sector is represented
o Cost of going public is low
o Developed investor base
o Founded in 1875—one of the oldest exchanges in the world
Paradise for value investors
o Very short term and top down focused
Money waxes and wanes with risk on and risk off trade
80% of the total market cap of the index is made up of
15 companies
Market cap weighted indices
o Liquidity advantage
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
People often choose to invest or not invest based on
volume
ECN based market
Liquidity is very volatile
Risk off: $2B market cap company can trade
20K shares
Risk on: Same company then trades 2M shares
Investors refrain from trading in illiquid stocks
Because they can’t get out in 10 days
Very happy as value investors to be in these markets
o Information advantage
Useful universe is top 1500-1700 companies
$50M to $100B in market cap
o Not much research coverage outside of
the top-tier companies
If you can put your feet to the ground you can
have a huge advantage
- What prevents a stock from converging to intrinsic value?
o Hurdles
Eliminate companies that will never converge
Corporate governance
o Not just fraud and embezzlement
o Many companies have dominant shareholders
How do they treat minority shareholders?
Violations
Not securities fraud necessarily
Related party transactions
o Buying and selling to companies related
to the dominant shareholders
o Investments/loans to related companies
o Exposed to risks without upside
Skimming cash from the company
100% leverage in CAPEX
How do you identify it?
Related parties—past track record of
management
Fraud/syphoning
o Looking at the financials
Interest higher than net profits
Extremely low ROE
Are they paying taxes?
Stewardship of capital
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
o ExxonMobile (XOM)- has consistently managed to keep ROE
high and returns cash when there are no opportunities
o Can they generate $1 in PV for $1 in retained earnings
o Most companies see declines in ROE because the opportunities
disappear
Are they returning capital to shareholders
o Empire building or vanity?
Private jets, cricket teams, stadiums?
o Frequent equity dilutions?
o Are they raising money every opportunity they get in a bull
market?
Business fundamentals
o Domestic demand driven?
o Competition from imports?
o Pricing power?
o Distribution strength?
o Cost competitiveness
o Moats
o Great brands are overpriced in India
Can’t have an edge in franchise businesses
o Commodity businesses often have moats, but not in a way that
developed market investors usually think of them
Distribution
Entrenched position in a market for years
Financial strength
Relative opportunity
o Price history
o Major holders
o Insider transactions
o Valuation relative to market
o Valuation relative to industry and peers
Most people focus on the last 3 aspects
o 2 most important in India are the first 2
o They look for catalysts
Best catalyst is if the intrinsic value is compounding continuously
Framework helps them categorize firms as compounding machines
Not a lot of value in net-nets in India
- Case Studies
o Videocon Industries Ltd. (Bombay Exchange: VEDI.BO)
Well-recognized brand
30% compounded growth
Consumer durables
Washing machines, dishwashers, and other home appliances
Can compete with multinational brands
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Understands Indian consumer’s mindset
Rural Indians have different needs
Strong financial
position
Valuation
P/B: .74x
P/E: 7.4x
Bad corporate
governance and
stewardship of capital
Relative
valuation is not
attractive
Don’t get caught up in the brand of Videocon
o Just because the business fundamentals look good does not mean
that it is a good company
o Gujarat State Fertilizer and Chemicals (GSFC for short; Bombay Exchange:
GSFC.NS)
Large producer of complex fertilizers
Lowest cost producer
Advantageous port position
Entrenched distribution
Debt free
Most fertilizer
companies have a
lot of debt
Most of the market
cap is in cash
State-owned company
But has great
corporate
governance
Great steward of capital, fundamentals, financial strength and relative valuation
Looks like a commodity company but it is a great business
Earnings have tripled from 2007 to 2011
No earnings smoothing
Do not care about pleasing the street
Cash has grown substantially from $48M to $370M (2007-2011)
Why do they have so much cash?
o Really have a bazooka in a gun fight
Competitors don’t have the financial strength to compete
o Reinvestment opportunities have been and will be fantastic
Indian crop yields need to go up
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Complex fertilizers is a growth business in India
How much can they make?
Think that earnings can double in 3 years
o If that happens and the P/E ratio re-rates to an 8x, that would
lead the price being 4.4x times higher in 3 years
- Summary
o India has a lot of value traps so you have to be careful what you are invest in
o Sufficient universe of qualifying stocks
Market is infested but their idea pipeline is full
- Q&A
o How do they know earnings will double at GSFC?
The markets that the company are in are huge agrarian markets
Fertilizer growth is faster in their markets than in the rest of the country
Yields really need to go up so their suite of products will do very well
Natural growth and cost reductions will lead to a lot of earnings growth
o What is it that allows some companies to fly straighter than other? How are they
insulated from government and business?
The universe of those companies is very few
Not even they do it 100% straight
Lots of low level corruption
Public servants are not paid well
o Big companies are even involved in paying charges that are not
necessarily legitimate
Used the example of Hyundai
See this as a cost of doing business
o Who is corrupt?
The management – red flag
The company has to do things on the ground to run their
business—just the law of the land
o What returns are you expecting going forward?
Returns have been about 10% compounded
He hopes to be a better investor in 5 years
The last 5 years has been very interesting in India
Since 2006 the Sensex has outperformed everything else in India
o The gap between the largest and most visible companies
exploded when hot money flowed into India
As a result of this money going into the largest
companies, small companies did not outperform the
index
o How do they measure their alpha? What about India’s returns given inflation and interest
rates? What is his outlook for India?
Alpha: Manages money with a focus on low downside and high upside
opportunities
Opportunities that are growing- growing capital, moats and franchises
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Buy companies when they do not see permanent loss of capital, a margin
of safety and a potential upside greater than 0%
Inflation and interest rates.- Thinks that rates have overshot on the upside
Inflation is not driven by rapid growth of money or the general price
level
Change in relative prices is happening
o Food prices are going up—Indians are getting wealthy at a
phenomenal rate
Eating more meat and thus more grains
Increase in food prices is structural
Supply infrastructure is exploding due to the price
increases
A supply boom is 3 years away
Federal government is using a loose fiscal policy
o Due to democratic set up, reforms have been slow
Only thing that the bank can do is reign in demand
because supply response is slow
India will grow 7-8% in the next decade
o 13% nominal growth if there is 5-6% inflation
o Things are good in India and the outlook is good
o Tight money is not a bad thing
Prevents capital misallocations
Doesn’t want the Indian banking system to
become insolvent in a few years due to too loose
monetary policy
- Does GSFC export its fertilizer?
o Not, it does not export but they do import some goods
Speaker #4
Using Discipline, Patience and Cash to Realize Long-term Value
Steve Leonard- Pacifica Capital Investments
- Founded his fund in 1998
o 2 phases of his life
Commercial real estate (CRE) and then public equities
CRE
o Moved from LA to Denver and back to Southern California to
take advantage of distressed real estate properties
Moved along as the recovery became self-sufficient
Provided substantial returns to investors
Started his equity fund in 1998 after making money from his real estate
investments
o $250M in AUM now
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
- It’s not about beating the market every time
o Don’t actively trade
o Don’t short
o Don’t use leverage
- Decision making process
o Is the industry/business the type they have a chance of knowing deeply?
Can/will they know it better than the competition?
Is it the best company in the industry?
Does it have global growth opportunities?
Are there competitive advantages and are the advantages sustainable?
o Does the management generate a high return?
How do they allocate excess cash?
o Is the price attractive?
Is there a margin of safety?
Is there the possibility of strong returns over time?
- 3 mantras
o Discipline
o Patience
o Concentration
When you find the right company you need to invest heavily
- Often have large cash balances
o Had 50% cash in their accounts in 2007
2 years later when the market was soft, cash was very low
Cash levels are building now
o Do best when the market is weakest
IRR since inception of about 12%
- Focus on the companies they own
o Don’t worry about the macro environment
Although they do pay attention to unsustainable trends
o Prefer to own American-based companies
But they want favorable growth opportunities as well
Developed world policies are not designed for growth
India, China, Brazil exposure
o Are careful regarding debt levels
Don’t like companies with large pension obligations
Entitlements and pension funds are a disaster than will occur down the
road
- Stocks/holdings
o Fairfax Financial (Toronto Stock Exchange: FFH)
Is their largest holding
Really likes the management team
Thought their experience with CRE helped them understand the P&C insurance
business
o Berkshire Hathaway (BRK)
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Is their 2nd
largest holding
Allows them to sleep well at night
o Starbuck’s (SBUX)
When the company was just becoming popular, they saw long lines for expensive
coffee
Could see that the returns they were making on each new store were high
Saw that the culture could translate well to other countries as well
Liked that the company did not have any debt
Was 15% of their portfolio for a time
Generated high return on new stores and the stock price went up
But then they started doing
things he was not comfortable
with
Lower returns on
stores
Aggressive stock
options
Bought back their
own shares using all
their free cash flow
(FCF) and debt
o At too high a price
Sold out by 2006
Still liked the characteristics on the company
But, results suffered from misallocation of capital
Price dropped a lot during 2008-2009 and they bought back in
Now the 3rd
largest position
o Now more focused on returns
o Now paying a dividend
Less cash lying around
o RG Barry (DFX)
Sells slippers that are sold at Macy’s and other retailers
Sold a low price item but had a manufacturing platform that was based on high
cost labor
Outsourced to China to cut costs
Are the largest shareholder of this company
o Goldman Sachs (GS)
Have always admired the culture
Were concerned about the aggressive culture
But crisis came and the competitors went away
This is a business they want to own, despite concerns over future returns as a
result of regulations
o American Express (AXP)
Great global brand with loyal customers
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
o Wells Fargo (WFC)
WFC came through the crisis better than ever
Best management team
o US Bank (USB)
#1 in the west
o Stacked (Private)
Take a store that would akin to the size of a California Pizza Kitchen (CPKI)
Menu that specializes in burgers, salads and pizzas
Get seated by the hostess and there is an iPad on the table that allows you to
customize your order
Hostess brings the food when it is done
Swipe credit card on iPad when you are done
Raised $10M to open 4 stores
LA, San Diego and Orange County
o All mall locations so far
Looking for a non-mall stores as
Looking to franchise it around the country
o FFH+ BRK+ SBUX+ Cash represents about 50% of the portfolio
- Q&A
o Given his real estate background, does he have plans to invest in CMBS? Can they take
advantage of future dislocations in that market?
Would not invest in companies that manage real estate
They can do that themselves
Saw how REITs managed their properties and do not want to run their
company that way
Thought that the financial crisis would create opportunities
o But it didn’t happen- too much capital and cap rates are too low
o Leverage is so prevalent these days
You need leverage to make great returns
o Can he give some examples of companies they invest in with exposure to Brazil?
Don’t invest in companies in Brazil
Most obvious company is Coca Cola (KO)
They wouldn’t look at KO because you can see a Coke sign everywhere
when you travel the world
But, AXP is a good example
Emerging countries will use more credit cards in the future
Do not do much in commodities
o Does he have opinions on the housing market?
Housing market—they were careful not to be anywhere near it in 2006 and 2007
Liked what Prem Watsa said would happen with housing
Liked what he did with CDS
Housing will bottom at some point
Then there will be the need to build some new houses
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
On his street all of his neighbors owned 5 houses
That was unsustainable
Not an industry that they are going to mess with
Like less cyclical and commodity-like opportunities
His friend who is a CEO of a homebuilder is not optimistic—although he was at
first more optimistic after the crash
There are too many houses in foreclosure
o They like companies that they are comfortable with. How can they invest in banks given
that? How can they trust management teams?
Tougher to know what is going on in insurance policies or bank loans
You can get to know management
When you listen to WFC talk, it is totally different from other banks
Knowing that these industries were not going away, they believed that
the ones who were not doing foolish things would come out ahead and
with a stronger market position
We’re willing to own Fairfax going into the crisis
Bought WFC too early
Think the management team is good—want the team to be their partner
o What was is about the valuation of SBUX in the 1990s that attracted them? Didn’t it have
a really high multiple?
SBUX sold at a large P/E but there was a lot of demand and room to grow
Almost didn’t care about the multiple they paid
Now they have 15,000 stores and the price really makes a difference
Have to think about international growth now
o How many stores can there be in China?
No brainer in 1998—could have paid 10% more or 10% less and it
would have not mattered
o What attracts them about preferreds during the crisis?
Have a lot of cash and wanted to park their cash somewhere that generated
returns
Look at preferreds with variable rate features from banks like GS
Not a buyer today because the 20% discount to par has closed
Looking for a future opportunities to buy more
o Don’t pay much attention to the macro data, but they have made good calls. What other
info or data do they look at?
They look at the market prices and valuations of the stocks in the same sector as
companies that they own
Are they higher or lower than the companies they own?
o Try to assess the state of the market with that framework
Don’t try to guess when the market is going to peak
o When they were buying SBUX during the lows, how did they size it?
The second time they he was thinking of buying SBUX, he remembered that he
had said he would never buy until they had a SSS decline
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
But he bought when it went below $20.
Bought under $20 and bought more around $10
o Knew the business was not going to go away
o The accounts owned about 10% SBUX
Today they are thinking about trimming their position and would not be a
buyer today
o What about the overlap between their holdings and those of BRK? Are they ever
concerned that the overlap makes them too concentrated since they own BRK as well?
Are other segments of the markets not represented?
When he was buying CRE in Denver, he put all of his net worth in there
He knew Denver real estate and knew he couldn’t lose
Would rather own more of what they are most comfortable with
Do not want to spread their risks into things they don’t understand
When you have good management, they are likely to not make mistakes
When they see that a market was going to change, they chose to get out—like in
the real estate markets
But good managers have the ability to avoid bad markets
Even if a company has a great brand, you have to pay attention to
management too
Speaker #5
Opportunities in a Complacent World
Steve Romick- First Pacific Advisors
- Now he has all of the time in the world after not having to present in years before
- He has no idea what the future holds and the present lacks clarity
o Looks to find something in the rubble that looks attractive
o Looking for cheap stocks is like trying to ski down Aspen in the summer
- We blew it after the crisis
o People are complacent
o People claim to look for safety but they are seeking risk
o People believe in the government to stop bubbles
Romick does not believe that people who didn’t see bubbles in the past will be
able to stop them this time
- Hard to have confidence in the US governments numbers
o GAO report said that the government’s financial statements have material weaknesses
If they say there isn’t inflation, that is only because they don’t eat or drive
Government is talking its book
Believe there is much more inflation than is being reported
o Government is increasingly hiring more people though
- We have a debt problem
o Mandatory spending keeps on increasing relative to GDP
o Only 16% of the budget was on the table to cut in the newest Obama budget
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
If we were really serious about cutting expenses, everything would be on the
table
Social security is morphing from benefit to an entitlement
Great deal for people as the collection age has not gone up with life
expectancy
Not saying that we should get rid of social security
o We just shouldn’t add to the obligations
o How does the government keep spending money when consumer cannot?
Successively diminishing return on productivity of debt in the US
Government is supplementing Treasury demand by borrowing short
40% of debt maturing in the next 2 years
Have to convince lenders that we can pay off our debt and that the dollars will
be still be worth something then
Given that, he doesn’t know who is buying our debt
CBO has sanguine estimates—CPI inflation projected to average just 2% until
2021
These unrealistic numbers keep politicians complacent
Even so, they have interest expense getting so high in the future that it is
more than defense spending
5% increase in interest rates would cause interest expense as a percentage of
revenues to go from 6% to 21%
o Government spending spigot continues to be open
We are confusing medicine for narcotics
We haven’t taken the pain
We need assets to fall in value and prices to clear
We are in a recovery is between 2 crises
Children will pay for the sins of their fathers
o The New Monopoly game
Eliminated paper money—creating electronic money
o One path leads to inflation and that can be seen in commodity prices
It is hard to imagine that the increase in monetary base will not end up in
inflation down the road
o FPA’s returns will come from what they don’t own rather than what they own
Anxious about the returns on the US dollar
Cash is building in the portfolio
Looking for large business with foreign revenue sources
Not many opportunities
Margins are near all-time highs for US companies
o Wall Street said that there is always an opportunity
Analysts have a terrible track record
o Using a cyclically adjusted Shiller P/E, the S&P 500 trades as 23x
Small caps trade a 20% premium to large caps
Fewer analysts—less efficiently priced?
Easier to understand?
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Grow faster?
o This is a myth based on Russell 1000 and 2000 data
Large caps stocks have grown faster since 1995
Large caps have more exposure to foreign
revenue
More likely to be bought?
o FPA is basically short M&A
o FPA is positioned for inflation
Largest sector is energy
Have a big position in an insurance broker
Subprime whole loans at $.45 on the dollar
Private REIT in farmland
- CVS Caremark (CVS)
o Likes the trends in pharmacies
o Lots of growth in the old age
population
o Pharmacy utilization should be up
o Medicare market is growing fast
32M people will get
coverage in 2014 – if it
happens
Free option—
could be a 20%
bump to the number of prescriptions that CVS already writes
o Drugs are 10% of health care spending
Patient adherence to prescription regimens saves money
o CVS and Walgreens (WAG) are both best positioned
7100+ stores
Great footprint and opportunity to gain shares from independents
Independent share is down to 20% and has halved in the last decade
o Is mail order a real threat?
Small affect over time—only 19% of the market consistently
o Lots of drugs coming off of patents
Generics come on and it is beneficial to CVS
Better margins—peak in 2012 since they make better margins on
generics
Now self-distribute generics and can capture the margin there
o People care about private label versus branded when you can taste the product
But people don’t care as much when you can’t taste them
Production problems and JNJ recalls are helping private label sales
Higher gross margins but lower price on these products
Could increase operating income by 3.5%
Tesco has 50% private label products
CVS has a lot on runway on this front
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
o Pharmacy Benefit Management (PBM) business
Almost 50% of CVS’s sales and 1/3 of the profits
PBMs aggregate buying power to get lower prices
Induce pharmacists to switch from branded to generic
PBM and retail business allows them to offer mail order business as well
15% of Caremark’s customers use maintenance choice
o Could grow even more
Challenges
Lower future rebates
Legally mandated transparency of drug purchase costs
Decided to hedge out some of the PBM risk
o Management
Skilled operators and capital allocators
Retiring CEO has $300M in share exposure
CVS has been returning capital to shareholders
$3-4B in buybacks per year
Added to a dividend the yield jumps a lot
o CVS has the opportunity to reduce inventory
By 2013 their goal is to be on one platform
CVS estimate of $2B in inventory savings by yearend 2013
o Trading at 6.6x 2011 EV/EBITDA
Caremark can outperform its peers but they have still hedged out the PBM
exposure by shorting other PBM companies
o Could they spinoff Caremark?
Want to let the company execute on its plans regarding
Express Scripts and Medco could be likely buyers if CVS cannot improve the
PBM’s operations
o The stock is not a homerun and is not as cheap as it was when he started writing the
presentation
- Goldlion Holdings Limited (Hong Kong: 0533)
o Hong Kong based company that is a
wholesale clothing and apparel brand
o The company has $400M market cap
Float is about 1/3rd
of that
o It is like the Polo of Hong Kong but is
not as nice as Gucci
o Maintains quality above all else
Do not want cutthroat prices
o Market share slide shows 6% market
share in the fragmented Chinese apparel
market
Ranked 6th in a Credit Suisse brand survey in China
o Positives
Rapid growth
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
ROC: 49%
High margins
Optionality
Real estate assets
6.3% dividend yield
Has been public since 1992
Has a name brand auditor
Has lots of cash and some investment properties
Has not de-worsified in recent years
o Current market cap is 3.26B Hong Kong Dollars
Effective multiple of 2.6x trailing EBIT
Upside of 50-100% , supported by the dividend
- Value investing is the best means to preserve capital and provide adequate growth over the long
term
o Let thoughtfulness and patience be the driving philosophy
- Q&A
o When it comes to CVS, what is your the appraisal of the current management?
Acquisitions are not likely because they have already bought what they could buy
New systems are going to help the company drive inventory out
Can reduce the number of SKUs and stock outs
o You see out of stock positions at CVS and not at WAG
Very high marks for management
o What do you think of Goldlion’s corporate governance?
China is the wild west
There have never been insider dealings with this company
Has been public for 20 years
The paper trail and history give him comfort
o Inflation calculations have changed over time. Also, what does P/E 100 years ago have to
do with today’s?
There are appropriate changes to CPI that should be made overtime
Doesn’t buy that the high inflation numbers put out by John Williams of
ShadowStats are accurate
The problem with the Shiller P/E chart is that the data on the might not be great
going way back
o Isn’t it true that Goldlion has been leasing a lot over the last few years?
They are not a retailer
Even if you adjust ROC for leases, it is still very high
50% is ridiculous
o Very large ROC even if you incorporate leases
Only own the stock in small funds due to the small float and the inability to
accumulate shares
If you want to invest in China, there are no guarantees
But there is a margin of safety
He is trying to swing for a bigger hit; not just looking for a compounder
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
If you can buy the asset at a large enough discount, you can make money
o For Caremark, are there other headwinds?
Drug prices are going to be transparent
Corporate customers will see the price of drugs
o May demand lower prices
o He has no idea how to handicap that
Caremark had been losing share but the new management team looks set
up for success
o FPA is hedging out industry risk
Thinks they are going to stabilize and gain market share
o Winning lower margin but large accounts
Insurers will be getting into the business
Especially on the specialty pharmacy side
o In terms of rising interest rates, what would be the catalyst?
2 catalysts
If we actually get inflation
o Could be hard to see with high unemployment and low capacity
utilization
o We could also import inflation in commodities
o Bernanke mentioned inflation 86 times in his most recent
presentation and deflation only twice
o One day the inflation will be here without much warning
Lenders goes on a buyer’s strike
o Will lenders want to get paid in the same dollars they are lending
money in?
o Lenders may want a higher rate of interest, even without
inflation
Speaker #6
Hockey, Snow and Value: Uncovering Bargains North of the Border
Guy Gottfried- Rational Investment Group
- Guy is 29 years old
- His fund launched during 2009—40% returns per annum
o Average cash of 27% since inception
o Has not realized a loss yet on any investments
- Americans are concerned with US monetary and fiscal policy
o Canadian market offers an opportunity
Economy has been strong
11 years of budget surpluses before the recession
4th lowest corporate tax rate in OECD
Lowest debt to GDP of G7
Strongest banking system in the world for 3 straight years
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
No crazy mortgage products
No bailouts and not one bank even cut its dividend during the crisis
This is an inefficient market
Very few value investors
People are obsessed with Canadian resource stocks
o Mining and oil stocks comprise about 33% of all of the listed
companies in the TSX
o There is an entire economy that is overlooked
Small markets
o Morguard Corp (Toronto Stock Exchange: MRC)
Market cap: $780M
Has great business and is dirt cheap
Originally a distributor of auto parts
Controlling shareholder turned around the operations, sold them and had cash
to invest
Real estate stocks had a slump in the 1990s in Canada
o Bought stakes in 5 large real estate firms at this time
4 parts of the company
Wholly-owned
properties
Other investments
Investment in
Mortgage REIT
Management and
advisory business
Extremely cheap
4.8x FCF, net of
Morguard REIT
investment
Implied CAP rate of 13% on its portfolio
Valuing its owned portfolio below $0
o Getting paid to own those attractive assets
High quality assets
Outstanding capital allocation history
Several catalysts possible that can unlock shareholder value
o Why is it so cheap?
Most real estate stocks in Canada are REITs and pay dividends
Pays out less than 10% of FCF
o Likes to retain capital rather than pay it out
Illiquid due to CEO large ownership
Not big enough for large institutions
No sell side coverage
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Does not have a promotional management team
o Owned portfolio
Assortment of apartments, industrial, retail and office properties
Trailing NOI of $152M
10.3K apartments
Apartments are the most stable, lowest cap rate real estate asset class
97.5% occupied apartments located in Toronto, Canada’s biggest city
o Morguard REIT (Toronto Stock
Exchange: MRT-UN)
Owns 8.3M square feet of real estate
Morguard owns 45%
$35M in management fees and
dividends each year
Dividend is sustainable
Zero risk of losing MRT as client
Steady stream of growing fees
Capital source, exit strategy for fully
valued properties
o Advisory- Property Management Segment
Real estate management services to Morguard and other firms
Wholly owned subsidiary that provides $20M in NOI
One of largest property managers in Canada
Smaller NOI numbers than generated by the owned portfolio
So the market overlooks this segment
Low CAPEX business
30% pretax margins
Grew even during the recession
Stable cash flows and revenues
Want to grow this business and they have been successful
o Capital allocation and management
Have in a great capital allocator in a capital intensive industry is really important
Company has a strong balance sheet and discipline
o Can create opportunities by buying during the panic
Rai Sahi is an owner operator who owns 50% of the company
Has aggressively bought back the stock
Have not issued an option in a decade
Conservative balance sheet with a 50-55% loan to value (LVT) ratio on the owned
portfolio
This ratios is very low given that a lot of the properties are apartments, which
are highly leverageable
Conservative account
FFO includes PP&E deprecation on non-building items
o Peers inflate FFO by adding back all depreciation
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Very conservative company
Has bought back 38% of its diluted shares since 1996
The company is buying large blocks of stock
Has continued buying throughout its history
o 2006-201: 11.8% of shares bought back, all at a great price
This is what we look like as value investors
o Acquisitions
Sahi is a corporate raider and has performed takeovers at fire sale prices
Has done 5 major takeover recently
Goldlist Properties
o 17 multi-unit apartment buildings
o $335M price, including assumed debt
o Busted IPO
o Morguard bought 40% of the IPO at $9
Was able to cut the offer price of the IPO by 10% and
reduced the dividend the owner pulled out of the company
Revenue Properties
o Gained control of the company at an average cost of $1.48
o Privatized RPC in 2008 by buying the remaining 27% at $12 per
share
Advisor hired to provide a fairness opinion at $420M
o Implied cap rate of 35%
MIL
o Bought from Mutual Life Assurance
o Generates $20M in per tax income now and was bought by $33M
o Valuation
7.1x FCF (14% FCF yield)
High quality business
If you back out MRT, the core business free cash flow multiple is 4.8X
Owns MRT for strategic reasons; not for operating reasons
o Instructive to see how the market is valuing the rest of the company,
ex-MRT
Cap rate calculation
NOI/Market Cap implies a cap rate of 12.8%
o For the owned portfolio alone
o These are Toronto apartment buildings that usually sell at a 5.5% cap
rate
Even commercial and industrial properties in Canadian
command a 6-7.5% cap rate
If you subtract out the value of the other segments, the owned portfolio is
valued at less than $0—actually negative $79M
o Guy is being paid to own 10.3K residential units and 6.9M square
feet in commercial space that are generating $150M in NOI
o Catalysts
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Create a new REIT to hold investment properties—could sell properties to a REIT at
current market prices
Cap rates on apartments are in the 5.5% to 6.5% range
o Implied cap rate on the portfolio is currently about 13%
New stream of income
o Would become property manager and advisor to those buildings
Could sell properties to MRT
Morguard investors are clamoring for the company to expand
o Analysts want the firm to grow its portfolio
US expansion
Valuations are rich so there is little to do in Canada
o Undervalued acquisitions are likely on the horizon in the US
Could profit from compression of the difference between price and intrinsic
value
Also get growth in intrinsic value
o Q&A
Any concern that the supply of apartments is going to increase?
There are a lot of cranes there, but there are 10x as many in Israel
Residential construction in Toronto is on the condo side
o There are few apartments
o Condos are hotter because more can be squeezed out
Cap rates are extremely rich in general
o Company knows this and hinted that it might try to monetize some
the assets at those rates
Takes a long time to do so though
o Are the controlling partner’s incentives aligned with shareholders?
He doesn’t think Sahi plans to buy out the company—the stock fell to $13 in the
crisis and he could have bought it out
Now it is at $60
Does not that that Sahi wants the price to stay low so that he can buy it
o He could have bought it over the last 20 years are much lower prices
Thinks he wants to grow the business instead
o But you never know 100%
Even a margin of safety can protect you from something like
that
The market has a mind of its own—the price can go up no matter what the
CEO wants
o How do you differentiate between skill and being in the right place at the right time (referring
so Sahi’s ability to buy low and sell high)? Does the skill move abroad—to the US?
Company already has been active in the US
Great management can create value in any environment
Most companies operate with the herd
o Make acquisitions when times are good and do not buy during panics
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Morguard has been able to maintain its results in good times and bad
o Can operate better in down markets
Cheap price with a management that knows how to deploy capital
o Question from Peter Brotchie of Union Trust Mortgage Corporation: If they do not spin the
properties off, is there a lot of maintenance CAPEX in the pipeline, based on the age of the
properties?
No, they have a normal CAPEX program and Guy does not expect a large ramp in
CAPEX in the coming years
o How accessible has the management team? Can they be influenced?
Not amenable to activism
Management has been buying back stock at the right times and making deals at the
right price
Has already been selling properties to MRT without pressure
Slowly embarking on this strategy
When you are aligned with good owner-operators, you don’t need to be an activist
o Alex Rubalcava of Rubalcava Capital Management: How did he value the asset management
business? Has the CEO sold or bought shares?
There is no exact science to valuing a business
Pretax income multiplied by 12x
o Did not look that closely at comps because the company is so cheap
CEO has bought shares in 2008 and 2009 in the $30 range
Has never sold a share
Through the company buying back shares and buying shares on his own, he
has taken his stake from 20% to 50%
o How old is the CEO and does he have kids in the business?
Daughter works for the company in the US
He is in his mid-60s
No kid who is an executive or who is highly paid
No evidence of nepotism
o What is the variant perception here? Why is the stock being ignored?
He is not aware of what he is missing
Market is looking at:
Illiquidity- can buy a few millions of dollars in it
Business is a bit obscure
o Owned portfolio dwarfs the numbers of those of the property
management business
Shares a conference call with the REIT—95% of questions go to the REIT
o Very low profile company
Does not need to be promotional
Pays a low dividend
Speaker # 7
Global Value Investing: Guidelines Opportunities, Pitfalls and Actionable Ideas
Ori Eyal- Emerging Value Capital Management
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
- Has been running this firm since 2008
- Learning experience
o Had the opportunity when he was working at Deutsche Bank to participate in a Russian
power plant IPO
The ultimate decision was based on his meeting with the CEO
The CEO said he was issuing equity and said he was doing so because
equity was free and debt had to be paid back
o He didn’t do the deal and he was lucky because it performed
very poorly
- Lack of concern for the rights of minority shareholders is prevalent outside of the US
o In the US companies at least pretend to care
o Do not even pretend to care in some other countries
- Strategy is to take the principles of value investing and apply them all over the world
o Guidelines
You have to do detailed research on the company and the country you are
investing in
Some countries are more attractive than others and you can’t just invest
in every country
Don’t chase GDP growth
No correlation between GDP growth and stock market returns
Why not?
o Expected GDP is priced into the stocks you are buying
o Benefits of growth may accrue to new firms not in the basket of
stocks you purchased
o Benefits of the return could get stolen, inflated away or
expropriated
Why is his cash in US dollars?
o Emergency market and commodity currencies are likely to
appreciate versus the dollar over time
Not going to be a straight line though
o When they can invest in country like these, they can get an
additional tailwind
o But, they need cash when there is a crisis
Flight to safety occurs as people move from risky assets
to US dollars
Dollars are likely to be up in times of crisis, exactly
when they need their cash
One billion new capitalists in emerging markets
o People are moving to the cities and they embrace capitalism
more
o They become an emerging middle class
o Look for businesses that have good management, trade at a
reasonable price and that are selling more to emerging markets
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
o Promoter De Informaciones SA (NYSE:PRIS)
PRISA is a levered media company
Share class arbitrage opportunity
Merged with a US SPAC (Liberty Acquisition) at the end of last year
Created new shares
o PRISA A and PRISA B
B shares are a lot better
Yet, they trade at almost the same price
Strategy is to short the A shares and go long the B shares
B shares eventually become A shares
Mandatorily convert in 3 years
o Shareholders can convert at any point
A shares cannot trade at a higher price than the B shares
because people would just convert
The spread cannot turn negative
B Shares pay a mandatory dividend while the A shares do not
1.6 euros per share
is the NPV of that
stream
o This is not
the whole
story
though
B Shares offer downside
protection
As long as A shares
trade above 8 euros,
you get a 1 to 1
conversion
But, if they trade below 8 euros, you get extra A shares
o Do not lose money until the A shares fall below 6 euros
o At very least he thinks the B shares are worth 2.6 euros more than the A shares
Price could be about 4.2 euros higher than the A shares
o This is a lot considering that the A shares trade at 8 euros
About 50% upside and little downside
o Catalysts
Dividends are going to start to be paid
Hasn’t been paid yet—we don’t know when it is going to be paid
o Likely between now and September
Bad news from PRISA group or macro bad news from Spain
Would highlight the value of the downside protection
o Larger funds have not been able to borrow the A shares
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
If you can’t borrow them (exchange A shares for B shares), just go long the B
shares
This is a good opportunity even if you can short the A shares
- Research the country: Israel
o Often finds very interesting opportunities there
o Israel has a well-managed economy and barely felt the economic crisis
Has the most NASDAQ listed companies and start-up companies outside of the
US
o Shareholder protection and rule of law are present
o Favorable business environment
o Highest rates of entrepreneurship among women
o Higher life expectancy than that of the UK, Germany and US
o Discovered a huge offshore natural gas field
Will wean Israel off of foreign energy sources
o Most well regarded research universities in the world
- G. Willi Food International (NASDAQ: WILC)
o NASDAQ listed company
o One of Israel’s largest food
importers
Search the world for
successful food
products and work
with the maker to
create kosher
products
Specializes
in Kosher
foods
Appeals to Muslims and other non-Jews
o Viewed as healthier due to less animal fat
80% of sales are into Israel
o 20% rest of the world- mostly US
Expanding rapidly internationally
Growing 15% each year
o Divisions
Gold Foods
Shamir Salads
51% interest
o Financials
$100M in sales
9.5% operating margin in 2010
$8M in net income
$51M in cash and essentially no debt
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Market cap is $100M
EV equals $50M
Should earn $10M in 2011
Net of cash, the company is trading at 5x this year’s earnings
Looking to acquire a distributor in the US
They are not going to overpay
Want to get their food on the shelves of US stores
If they can’t acquire one, they will pay a dividend
Are in talks with private equity firms
If it gets sold, he only get a onetime bump
o Hopes they don’t get bought out
This is a compounding machine
o Well managed, recession resistant business
Literally trade on the NASDAQ—not an ADR
- Q&A
o Regarding PRISA, would you consider writing a covered call on the As if you can’t
borrow the A shares?
Does not think they have listed options
Would love to create a synthetic short or buy a put
o Does he have any thoughts on the turmoil in the Middle East? How does it affect this
company?
Doesn’t affect Willis Food in any way
In fact it could benefit because other foods get rationed in the event of a
war
The main issue is that Iran is building a nuclear bomb and a mechanism to
deliver it
Egypt and Libya situations are not as important as what is going on in
Iran
o What exactly does the company hope to achieve with a US distributor? US market for
kosher foods is well developed already.
Willi Foods already has products on shelves in US
Believes that there is a shortage of strong kosher brands
Third party distributors eat up profit and control of shelf space
Company thinks it could distribute much better if it owned its own
distributor
Has not disclosed any names of who the company is interested in buying
o Can you elaborate on the 2.6 euros and 4.2 euros upside on PRISA group?
Equation: Dividend stream+ Downside Protection (3 year at-the-money put
option)= 2.8 euros
Extra value comes at the expense of the A shares
o 2 A shares for every B shares
o If the B shares gain 2.8 euros then the A shares lose 1.4 euros
o 1.4 euros + 2.8 euros= 4.2 euros
How did this opportunity come about?
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
Merged with Liberty Acquisition and the merger was complex
Brokers can’t even find the B shares
Market is just not recognizing what is going on
o The company will pay a dividend of at close to an 8% yield
o How is Willi Foods positioned to handle rising food costs?
Rising food costs are a negative for every food producer in the world
Company is fully aware of it and have hedged in the past
Got it wrong and stopped hedging
They do try to match currencies though
May depress margins in the short run
In the long run the costs have to be passed on
o Question from Michael Kao of Akanthos Capital: Could the company increase the float
or add A shares?
It is possible to issue more A shares
May also be able to issue more B shares
The SPAC was mostly cash and the result of the merger was a de-levering
So, the company is not that levered and has little reason to issue equity
Speaker # 8:
Lessons from 15 years in Micro-Cap Land
David Nierenberg- D3 Funds
- D3 Funds
o Concentrated portfolio
o Large block stakes
o Look for undervalued growth micro caps
o Private equity- like model
o Take 10% stakes
o Busted growth companies
o Not activism—constructive engagement
Want to be partners in unlocking value
o Almost all of the money in D3 comes from individuals and families
Have a multiyear lock up but investors stick around after it expires
o Avoid leverage
o Most of his own net worth is in the funds
o During the 12 years beginning in 1999, the firm has compounded after fees at 11.4%
- The macro backdrop matters
o Painful lessons learned in the recent crisis
o Sailed through the 2000-2002 correction
Actually gained over the 3 year period
o The 2008-09 period was payback time
Had to rethink how to preserve capital
Cheap stocks got cheaper
Ben Claremon: The Inoculated Investor http://inoculatedinvestor.blogspot.com/
40% of companies in the portfolio were trading at less than net
cash/share
Smallest companies were illiquid and the stocks went down more
o Average market cap: $400M
Needed to figure out how to profit from the pain
o Report by Ed Easterling of Crestmont Research
Market likely remains in a bear market
Multiples may trough at 8-10x P/E multiple
Increasing inflation and slowing growth are likely to compress P/E multiples
Market is likely to remain volatile
Slow growth
Reinhardt and Rogoff’s rule of 90% debt to GDP
o When countries go through that threshold growth starts to slow
Aging population in the US will hamper growth
Need to have a point of view and focus on preservation of capital
Even if they are wrong, their strategy will not hurt them
o Strategic changes
Will now sell at fair market valuation as opposed to target valuation
Unless they have proprietary insight that the company could be worth far
more than it is
Cash is not trash
Now focusing on what appropriate purchase levels are for future purchases
Defensive valuations
Started returning to public board service
Shift portfolio to higher growth businesses and higher margin geographies
Emerging markets
Natural resources
Mobile computing
Seek companies that pay regular and special cash dividends
45% of returns came from dividends in the last century