Graham & Doddsville - Spring2016

8/16/2019 Graham & Doddsville - Spring2016

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Rolf Heitmeyer

Spring 2016Issue XXVII

Marc Cohodes is a former General Partner of Rocker Partners/Copper River from 1985-2009. He began his career at theNorthern Trust Company in 1982 after graduating BabsonCollege with a BS in Finance. He has been profiled in the books;Reckless Endangerment, Selling America Short ,The MostDangerous Trade. He was the subject of a Harvard BusinessSchool Case study on his efforts to expose Mortgage Fraud atNovastar. He resides in Cotati, California, where he runs AlderLane Farm.

(Continued on page 33)

Editors:

Brendan DawsonMBA 2016

Scott DeBenedettMBA 2016

Anthony PhilippMBA 2016

Brandon CheongMBA 2017

Eric Laidlow, CFAMBA 2017

Benjamin OstrowMBA 2017

Inside this issue:CSIMA Confer-ence & PershingSquare Challenge P. 3

John Phelan P. 4

Alex Magaro P. 14

Adam Wyden ’10 P. 25

Marc Cohodes P. 33

Pershing SquareChallenge Ideas P. 44

Visit us at:www.grahamanddodd.comwww.csima.info

Graham & DoddsvilleAn investment newsletter from the students of Columbia Business School

John Phelan of MSD Capital

Adam Wyden foundedADW Capital in January2011 and acts as soleportfolio manager tothe Fund. The Fund is

focused on maintaining a concentratedportfolio of high-quality and high-


Marc Cohodes

Marc Cohodes formerly of RockerPartners/Copper River

Mr. Phelan is Co-Managing Partner of MSD and Co-Founder of thefirm. Prior to forming MSD, he was a Principal from 1992 to 1997at ESL Investments, a Greenwich, Connecticut based investmentfirm. At ESL, Mr. Phelan was responsible for ESL’s SpecialSituation Investments and helped grow the firm from $50 millionto over $2.0 billion in assets under management. Prior to ESL, Mr.Phelan was Vice President in charge of Acquisitions (WesternRegion) for the Zell-Merrill Lynch Real Estate Opportunity Funds.Mr. Phelan began his career at Goldman, Sachs & Co. where he

(Continued on page 4) John Phelan

Alex Magaroof Meritage

Group

Adam Wyden ’10of ADW Capital

Adam Wyden

Alex Magaro is aCo-President ofMeritage Group, afundamentally-oriented

investment firm, managingapproximately $10B primarily on


Alex Magaro

http://www.grahamanddodd.com/http://www.csima.info/http://www.csima.info/http://www.csima.info/http://www.grahamanddodd.com/


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Welcome to Graham & Doddsville

ment horizons across assetclasses and the return potentialof businesses with durable

competitive advantages.

Adam Wyden ’10 of ADWCapital discusses the influenceof an entrepreneurial spirit onhis firm and investment pro-cess. Adam walks through pastideas such as IDT and ImvescorRestaurant Group (IRG.TO) aswell as current theses on Fer-rari (RACE) and Fiat (BIT:FCA).

Mark Cohodes shares hisexperiences from a lifetime ofshort-selling. He offers his per-spective on the discipline andtemperament required as wellas the intellectual rewards of acareer in short-selling. Marcdiscusses ideas such as HomeCapital Group (HCG) andTempur Sealy (TPX).

This issue also highlights pho-tos from the 19th annualCSIMA Conference as well asthe 9th annual Pershing SquareChallenge.

Lastly, we are proud to includein this issue finalist pitches fromcurrent students at CBS whocompeted in this year’s Per-shing Square Challenge.

When we inherited Graham &Doddsville as editors last year,we wanted to continue the

tradition of providing our read-ership with high quality inter-views and investment ideas.We sought to provide diversityof thought and experiences viaour interviews. We hope wehave lived up to those objec-tives.

We are honored and privilegedto have continued the Graham& Doddsville legacy, and welook forward to reading thenext generation of issues,helmed by three outstandingindividuals in Brandon Cheong’17, Eric Laidlow ’17, and BenOstrow ’17. We want to thankBrandon, Eric, and Ben fortheir commitment and dedica-tion to Graham & Doddsvilleover the last year.

As always, we thank ourinterviewees for contributingtheir time and insights not onlyto us, but also to the invest-ment community as a whole,and we thank you for reading.

- G&Dsville Editors

We are pleased to bring you the27th edition of Graham &Doddsville. This student-led in-

vestment publication of Colum-bia Business School (CBS) is co-sponsored by the HeilbrunnCenter for Graham & DoddInvesting and the Columbia Stu-dent Investment ManagementAssociation (CSIMA).

In this issue, we were fortunateto speak with four investorswho offer a range of perspec-tives based on their unique pathsto and careers in investing.

John Phelan of MSD Capitaldiscusses lessons learned overdecades of investing with men-tors such as Richard Rainwater,Sam Zell, Eddie Lampert, andMichael Dell. John offers insightsinto the development of MSDCapital as well as his own devel-opment as an investor and PM,while shedding light on challeng-es he sees today in the invest-ment management industry.

Alex Magaro of MeritageGroup discusses his many expe-riences, from running a businessas an owner-operator to invest-ing in early stage companies,which led him to co-manageMeritage Group . Alex talks toG&D about long-term invest-

Meredith Trivedi, theHeilbrunn Center Director.Meredith skillfully leads theCenter, cultivating strongrelationships with some ofthe world’s most experi-enced value investors, and

creating numerous learningopportunities for studentsinterested in value invest-ing. The classes sponsoredby the Heilbrunn Centerare among the most heavilydemanded and highly ratedclasses at Columbia Busi-ness School.

Columbia Business School students helpat registration for the 19th Annual

CSIMA Conference

Howard Marks from Oaktree, picturedhere giving the keynote talk at the CSIMA

Conference in January 2016

Professor Bruce Greenwald,the Faculty Co-Director ofthe Heilbrunn Center. TheCenter sponsors the ValueInvesting Program, a rigor-ous academic curriculum forparticularly committed stu-dents that is taught by someof the industry’s best practi-tioners.


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Page 3Volume I, Issue 2 Page 3

Columbia Business School Events:CSIMA Conference and Pershing Square Challenge

Howard Marks of Oaktree with Bruce Greenwald after

their keynote interview at the 19th Annual CSIMAConference

Keith Meister of Corvex Management LP delivers his

keynote address at the 19th Annual CSIMA Conference

Paul Hilal ’92 and Bill Ackman listen and judge studentpitches at the 9th Annual Pershing Square Challenge

1st Place Finalists Joanna Vu ’17, Melody Li ’17, and ThaisFernandes ’16 pitch Alimentation Couche -Tard at the 9th

Annual Pershing Square Challenge

Judges deliberate at the 9th Annual Pershing SquareChallenge

Bill Ackman and the winning team at the 9th AnnualPershing Square Challenge


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encouraged me to go find goodmentors. She said one of thethings about good mentors isyou can learn on someone

else's nickel. It's something youdon't realize when you’reyounger. But it struck me at avery early age to try to go findpeople that were the best intheir particular businesses, andI think my mother pushed metowards that.

In my real first job, I workedwith an uncle rehabbingapartments in New York. I wasdoing that during college. Thatwas an eye-opening experiencethat forced me to focus oncash flow every minute of theday. It was a very toughbusiness and I was doing anumber of different things. Thework ranged from running thenumbers to actually doingconstruction work. Thatteaches you a lot. I alsolearned I didn't want to breakmy back doing that for myentire career.

I was fortunate enough to get a job with Goldman Sachs, whichwas really the first bigcompany I worked for. At thetime, Goldman was still aprivate partnership. I learned aton and I had a number ofgreat mentors at GoldmanSachs. I worked with trulyexceptional people there.

As great as my experience atGoldman was, it did make merealize that I did not want acareer in investment banking.Instead of being the personwho is on call 24/7 to serve myclient I wanted to be the client.I preferred being a principal asopposed to an advisor. Idecided to attend businessschool and was accepted intoHarvard Business School. Thesummer between my first and

second years at businessschool I worked for RichardRainwater, and that's where Imet Eddie Lampert. Richard

introduced me to Eddie. Ofthose ten weeks that summer,I spent about three or fourwith Richard and the rest withEddie.

G&D: How did you connectwith Richard?

JP: I had been hoping to getback to Texas after businessschool and I wrote Richard aletter. In that letter I told him Iwould be willing to work forfree and one of my professorsat Southern MethodistUniversity had suggested Icontact him. I told him I justwanted to learn from one ofthe best and was willing toinvest in myself.

Richard called me on a Fridayat like 4:00pm. He said “Hey

John, this is RichardRainwater.” I thought it wasone of my classmates playing a

joke on me. I used a curseword I shouldn't have and justhung up the phone. A minutelater the phone rang again: “Ithink we got disconnected.”I'm thinking, “Oh my God, thisis Richard Rainwater. I cannotbelieve I just hung up on thisguy.” I said, “I'm really sorry,but my classmates have beenplaying jokes on each other,and I thought you were one ofthem.” “Oh that's a prettygood one,” he laughed— hewas very good about it.

I flew down to Fort Worth onmy own dime and met withRichard. He said, “Meet withthese different guys. You canwork with me for a bit and seeif one of them will take you aswell.” I met with Eddie and acouple of other guys who were


worked as an Analyst inthe Investment BankingDivision.

Mr. Phelan received hisM.B.A. from HarvardBusiness School andgraduated cum laude withdistinction and Phi BetaKappa from SouthernMethodist University witha B.A. in Economics andPolitical Science. Mr.Phelan also holds aGeneral Course degree

with an emphasis inEconomics andInternational Relationsfrom the London School ofEconomics.

Graham & Doddsville(G&D): To start off, talkabout your background andyour path to investing,including mentors andinfluences along the way.

John Phelan (JP): My motherwas a very big influence on mydevelopment as an investor.My father was a doctor and,like most doctorsunfortunately, not a very goodinvestor. My mother, on theother hand, came from a realestate background and focusedvery much on cash flow. Myparents gave me a Disneystock certificate for a birthdaypresent when I was five yearsold. That got me hooked — Iwas fascinated by numbers andseeing something trade everyday. That's what got me intostocks.

I initially went into real estate,where my mother taught mequite a bit, including twoprinciples: make sure you canalways pay your bills and debtservice and the importance offree cash flow for leveredassets like real estate. She also

John Phelan(Continued from page 1)

John Phelan


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investment fund and was oneof the few people who hadcapital. It was a good time tohave capital. The RTC was

formed after a number ofS&L’s failed, there were a lotof distressed loans, the tradingmarket for loans was juststarting to develop, and theilliquidity was incredible.Having capital at that time andbeing a liquidity provider tothe banks was a unique andgood place to be.

If you go back and study thegreat investors throughouthistory — the Medicis, theMorgans, the Rothschilds, andrecently Buffett — these greatinvestors with terrific recordsshare a common trait: theywere always in a position to beliquidity providers. Each waswilling to hold cash untilsomeone was in distress orunder duress, and they couldprovide liquidity at veryattractive prices. We have run

our firm without leverage andhave only been 100% investedonce in our 18 year history,the first quarter 2009. I

actually consider cash to be anasset class.

About nine months into the job, Zell through his Zell-Chilmark fund started taking ahard look at Executive Life,which had a large junk bondportfolio. I was asked to workon credits that had large realestate components: RiteAid(RAD), Carson Pirie Scott,Charter Medical — anycompany that had a big realestate component to it. Wewere trying to value both thereal estate and going concernvalue as that was what thedebt was secured by and thereal estate provided yourdownside protection. We lostthe Executive Life auction toApollo. It was a fascinatingexperience and I really learneda lot. I remember looking atCharter Medical debt whichwas secured by a large numberof hospitals. I called ChaseManhattan and said, “Hey, wesee you guys are the lead bankon this.” They said, “We've gotplenty of debt for sale, we cansell you at 20-30 cents on thedollar.” We came to theconclusion we could've soldfour or five hospitals andgotten all our money back atthat price. That's how bad andilliquid the market was.

Understanding where you arein terms of seniority in thecapital structure and identifyingthe fulcrum security wascritical, so I started auditing abankruptcy class at Universityof Chicago because I wantedto learn bankruptcy law. Ithought it was an importantaspect of the work I was doing.I put together a business plan


with Richard at the time. Ididn't know a lot about riskarbitrage, but I knew theywere analyzing stocks and that

was something I really wantedto do. It was a tremendouslearning experience. I reallyenjoyed working with Richardand Eddie that summer, and Ifell in love with the riskarbitrage business. One of thethings you have to be good atin the risk arbitrage business isvaluation: you need to be ableto understand your downside.

I graduated in 1990 — not avery good year to graduatefrom business school, as youcan imagine. The markets werebad, the RTC/bank crisis wasaccelerating and most moneymanagers were having a badyear. It was a rough year. Eddiesaid, “Listen, I don't know if I'mgoing to be in business muchless have a job for you. It's notclear. You should go findsomething.”

G&D: Did you end upworking with Eddie?

JP: I actually graduatedwithout a job. It wasdepressing because I didn'texpect to be jobless, in debt,and living at home with myparents after graduating fromHarvard Business School. Iknew I did not want to go backto banking, so I did not dothat. Luckily a couple of theguys I had worked with atGoldman in Chicago left thefirm to go work for Sam Zell.Bob Lurie had died and he wasreally Sam's right-hand man — they were partners. Sam hiredRandy Rowe, who was themain person I worked with atGoldman in Chicago. Randywas kind enough to offer me a

job. Sam had just raised hissecond distressed real estate

John Phelan

“...my mother taught

me quite a bit,

including two

principles: make sure

you can always pay

your bills and debt

service and the

importance of free

cash flow for leveredassets like real estate.

She also encouraged

me to go find good

mentors.”


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Glenn Fuhrman. All those guyshave been very influential forme. And they all have verydifferent approaches. They all

go about things verydifferently, but I've tried totake nuggets from each one ofthem and incorporate whatI’ve learned from each of theminto my thinking process.

G&D: Could you talk moreabout working with Sam Zellthrough the real estate cycle?How has he been able to avoidmistakes and be opportunisticwhen others can't?

JP: I think Sam is one of the

really great macro thinkers outthere. He's very good atlooking at excesses andthinking through the

implications of them beforethey happen, when theyhappen, and then after. He'sreally adept at connecting thedots. He's a much more top-down guy than someone likeEddie, who also has a greatnose for investments but ismore bottoms up.

I have a funny story with Sam.He spoke during my first yearat the Goldman real estateconference. He looked in theroom and said, “I want all youto know that, within threeyears, half of you will no longerbe working in this department.There is going to be a majorblow up.” This was in thesummer of 1987. He was deadon the money. Sam is verygood that way. He's also a verysmart deal structurer. Heunderstands leverage pointsand knows how to negotiatevery well particularly incomplex situations. He's aconsummate deal maker.

G&D: When did you startthinking about launching yourown fund? Why did youultimately decide to joinMichael Dell instead?

JP: In late 1997, I decided toleave ESL. It was a personaldecision. My mother hadpassed away veryunexpectedly. It was a verytough thing for me, and it wasespecially difficult on my dad. Idecided to take some time off.I'd been working like amachine with Eddie, thoseseven years were like dogyears. He was a demanding guyto work for but also a verysmart guy. I enjoyed it, andlearned an incredible amount,


on the side, while I was stillworking at Zell. I pitched Samon the idea of setting up a junkbond operation to buy the

debt of distressed companies.We had done a lot of work onover 100 companies. Exec Lifeowned only pieces of the debt,so there was a big opportunityto make a lot of money. Samgot up and slapped me on theback and said, “You knowwhat, congratulations. I wishyou a lot of luck — this is afantastic idea. I think this isgreat.” I asked, “Did I just getfired?” He said, “No, you don'thave to leave. But you're goingto leave. I already know it. Thisis a great idea. I don't want todo this because I want to ownand control companies. I'm notinterested in owning pieces ofcompanies anymore. I actuallywant to buy and control them.But you've got a great idea andI think you should go pursueit.”

I called Richard, but he hadalso taken a run at ExecutiveLife and already had a team inhouse. So I called Eddie. I satdown with Eddie and gave himmy business plan and pitch. Hesaid, “Well why don't youcome on in and do it.” I didthat with Eddie and ended upworking with him a little overseven years. I started offbasically doing distressed, riskarbitrage — all special situation-type of investing. Then I gotinvolved in the emergingmarkets debt crisis in 1994. Idid quite a bit in that area withEddie. That's how I earned mystripes.

I've been very fortunate tohave really great mentors atGoldman, as well as Sam,Eddie, and Michael Dell, whoseprivate investment firm I nowco-manage with my partner

“If you go back and

study the great

investors throughout

history — the Medicis,the Morgans, the

Rothschilds, and

recently Buffett —

these great investors

with terrific records

share a common trait:

they were always in a

position to be liquidity

providers. Each was

willing to hold cash

until someone was in

distress or under

duress, and they could

provide liquidity at

very attractive prices.”

John Phelan

Pershing Square Challengerunners-up with Paul Hilal’92 (from left to right:Chris Andreola ’16, Bran-don Cohen ’16, Paul Hilal’92, and Daniel Rudyak’17)


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build. I walked him through mybusiness plan and he said,“That's interesting. I'm tryingto hire a guy similar to Richard

to do something like that forme. Would that be of interestto you?” I said, “No, probablynot. I've got some goodinvestors and I am not sure Iwant another partner at thistime.” He said, “I got it, okayno problem.” I said, “By theway, I'm happy to give you mybusiness plan. It might help youthink through what you wantfor your investment office.”

I gave him my business plan.He called me about a weeklater and said, “You know, Iwas reading through yourbusiness plan, and I have aquestion for you. I'm justpuzzling on it. I'm curious howyou're better off under thethree Cs by yourself than youare with me. I have capital. I'mpretty connected. And you getto build the culture.” That

stopped me in my tracks and Isaid, “Now that's an interestingquestion. I didn't really thinkabout that.” He said, “I'd like

you to think about that.” I metwith Michael a few more times.At the end of the day it wastrust on both of our parts, andit worked. He's been aphenomenal partner. I'd makethe same decision againanytime. It's been a greatpartnership with him andGlenn.

Michael was the one thatintroduced me to my partner,Glenn Fuhrman. He was verygood at matching us up. It wasa hard thing for me to dobecause Michael waspartnering me up withsomebody I didn't know.Although we both came fromGoldman — and were there atthe same time — we didn'tknow each other. It becamevery apparent when Glenn andI first met that we had verycomplementary skill sets whichis really important to asuccessful partnership. Weboth came from the sameGoldman mold: teamwork,hard work, intelligent, humbleand ethical behavior. It justworked. I think, to his credit,Michael saw that it was goingto work and he knew,unbeknownst to us, that thiswas probably going to bebigger than what we thought itwas going to be when we firststarted. Glenn has been atremendous partner and friendand we owe this to Michael.

G&D: Could you talk aboutthe evolution of MSD as aninvestment firm as well as theevolution of your role?

JP: It definitely has evolved alot. I used to jokingly say thatwe'd never be more than 15


but I needed some balance andI needed to help my father.After a few months, I startedgetting itchy trying to figure

out what I was going to do. Atthe same time, I'd made adecent amount of money anddidn't feel rushed to have todo anything.

I decided I was going to write abusiness plan for a multi-strategy investment firm,similar to ESL. I met with anumber of different successfulinvestment people. Some ofthem I knew. Some of them Idid not. I said, “I just want 30minutes of your time, and Ihave just one simple question.Tell me why you've beensuccessful and how do yousustain it?” Richard as well asDavid Bonderman were two ofthe people kind enough toindulge me. I basicallyinterviewed different successfulhedge fund and private equitymanagers. From thoseinterviews I came away withwhat I call the three Cs, whichis what I thought were reallythe keys to success in theinvestment business: Capital,Connections, and Culture.

These were the drivers I wasable to identify. They'reprobably drivers in just aboutany business. I was out raisingmy own fund and had raised adecent amount of money.While I was raising the fundboth Dan Stern and RichardRainwater gave me a call andsaid, “You should go meet withMichael Dell.” I said, “Michael'san investor of Eddie's. I don'tknow that I really want to dothat.” Richard and Dan bothsaid, “Just shut up and go doit.”

I met with Michael and heasked me what I was trying to

John Phelan

“I came away with

what I call the three

Cs, which is what I

thought were really the

keys to success in the

investment business:

Capital, Connections,

and Culture. Thesewere the drivers I was

able to identify.

They're probably

drivers in just about

any business.”


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have to do is focus on theinvestment side. That's reallywhat we've tried to create atthe firm today. I would say our

roles have evolved to more ofa chief risk officer/chiefinvestment officer. Weoversee the portfolios, weoversee the teams, but they'rereally running independentbusinesses, and they're makingthe decisions to buy and sell. Ifthere's something in there wedon't like we will have a call.I'm happy to pick up the phoneand say, “Walk me throughthis and tell me why we've gotthis position and what's there,”because we're trying to riskmanage the firm, so we're kindof a second layer of riskmanagement to their own riskmanagement.

Today we have ten strategies.We sit on the investmentcommittees for our privateequity and real estatestrategies. Any illiquid-typeinvestments need to gothrough an investmentcommittee process. We spenda lot of time today on ourinvestment research processand how to improve it. Howdo we improve our decisionmaking? How do we do betterwith data management? What'sgoing on in the markets rightnow and how are wepositioned for it? Are we tooexposed in one sector? Are

there any hedge overlays weshould put on? What do wesee across our platform that isconcerning? We have a great

vantage point because we getto see everything across thefirm.

I'm not as deep in the weeds asI was when we started. That'spartly due to the fact that wehave highly capable peoplewho don't need my directoversight. We do still havevery robust conversationsaround investments andprocess. We focus a lot on ourprocess. I would say I probablyspend more time now onculture building and on tryingto develop the firm and ournext generation of talent. Inreality, for a firm to besuccessful you have to createthese virtuous circles. We'revery disciplined. We have agood team. We have goodculture. We have greatinvestors. We've beeninvesting for the long term. Allthis stuff has been built up overtime, and it's self-reinforcing.But you also have to adaptconstantly.

I look at the markets todayand I look at the sheer amountof information that's thrown atus. I look at all this algorithmictrading and the impact that hason the market. You better bevery aware of what's going onand how it's going to changeand what the implications arefor you and your business.Those are issues we talk abouta great deal.

G&D: One element of theMSD philosophy that comesthrough in a lot of yourinterviews and writings is acertain contrarian streak. Arethere sectors or areas of theinvestment world where you


people. Then when we got to20, and I’d said, “There's noway we're going to more than30 people.” Today we're 124

people. Initially, when it was just the two of us, Glenn and Iwere involved in everydecision. The firm evolved byus working closely with ourPMs before we really let themloose. Distinguishing a goodPM from a good analyst is notthat easy. We were on top ofthem in the beginning and overtime we established enoughconfidence in them that wecould step back. We knew thatthey were quite capable. Theydidn't need the same sort ofcontinued oversight, and wewanted them to focus onbuilding the business just as wewere.

We felt that creatingdiversification by strategy andhaving people who werefocused on their individualbusinesses was the right wayto build our overall business. Ifyou look at why mostmanagers get frustrated in theinvestment industry it'sbecause, as you get bigger andas you scale, you move frompicking securities to runningthe business. That can end uptaking 30% - 40% of your time.Guys like us, who like to lookat stocks and companies, don'tlike reviewing the HR policy,the vacation policy,compensation system, etc. Butthose are all things you have todeal with: your interviewingpolicy, your training policy, andall those operational issues.Today with all the regulationand compliance it can be a fulltime job in its own right.

We want to find really goodinvestors and remove thedistraction of running thebusiness from them, so all they

John Phelan

“It all depends on your

own DNA. Self-

awareness is a really

important quality to

have, as is humility.”


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real estate get hit. What willbe the flow through in office,multi-family, and industrial?You want to look into where

there's a lack of liquidity ormispricing. Is part of the recentequity market volatility due toMiddle East Sovereign WealthFunds taking their money outof equities?

G&D: On the topic of goodbusinesses, when Rainwaterasked you what was the bestbusiness you'd ever seen youanswered parking garages inNew York City. With thebenefit of 20-plus years ofinvesting now, would youchange your answer?

JP: Well at that time I didn'tknow a lot about companiesand businesses. I just hadn'tlooked at that many. But it'sreally not that hard of abusiness when you think aboutit. It's pretty defensible and youget the benefit of an increasedvalue in real estate over time,similar to car dealers, forexample. There's a lot ofinherent value in the realestate there. I would probablyanswer the same way again.I've seen some other greatbusinesses, but when you'reput on the spot like that youhave to think on your feetpretty quickly, and that's theone that occurred to me atthat time.

G&D: Could you talk aboutinvestments that you've beeninvolved with at MSD thatwould qualify?

JP: We've had a number ofinvestments that have goneextremely well. Because I am abig believer in patternrecognition and we have madeinvestments in the samecompany multiple times over

different years. Let me focuson a private deal we did.We're one of the big investorsin IndyMac Bank now called

OneWest which was recentlysold to CIT (CIT). In 1990,when I was with Zell, we werelooking at RTC banks, and Iremember the Basses made afortune on American Savings.IndyMac/OneWest was aninvestment we didphenomenally well on, and Ithink that was a combinationof good underwriting, goodmanagement, and a compellingrisk/reward. Buying a bank inthe first quarter of 2009 wasnot a really easy thing to do.We’re looking for very goodbusinesses with strongmanagement teams and verydefensible moats.

G&D: Eddie Lampert isfamous for using case studiesand studying historicallysuccessful investments todevelop pattern recognition.Were you part of this effort atESL and did any investmentsthat you made rely on thispattern recognition?

JP: Yes, I was. Patternrecognition can mean differentthings to different people. Thebottom line is this: goodcompanies, just like managers,have to experiment. You haveto constantly test new things.Sometimes that 30%probability case shows up andyou lose $0.25 of earnings oryou make a bad investmentand people just kill the stock. Itdoesn't mean your business orthe company is dead or thatit's a bad business. When I wasat ESL I can think of four orfive companies that we boughttwo or three times over theyears. Kmart was somethingthat originally came out of adistressed investment we


feel like you have a contrarianview currently?

JP: I like to call it independent

thinking as opposed tocontrarianism. We really try tobe as independent in ourthought as possible. I don'twant to get into a lot ofspecific investments and whatwe're doing right now — that isfor paying customers — but wetry to look for big dislocations.We try to look for places thatother people are running fromor people don't like. Zell usedto always say, “I like to lookfor trouble.” I think that'ssomething we try to do, aswell.

We try to think about the longterm implications of things andhow they're going to turn out.That's something that wespend a lot of time on. Take,for example, the sustainabilityof a company or businessmodel. Today, competitivemoats are getting smaller andsmaller and competitiontougher and tougher. Trying tofind really good businesses thatcan continue to compound athigh levels is really hard. Youhave to really think through allthe risks out there and theirimplications. That's what Imean by independent thinking.Is there a company or businessimmune from technology risk?Maybe railroads, cement?Think about it.

I think there could be somepretty good opportunities inenergy as that is a space whichhas been decimated. We havebeen analyzing debt securitiesin a number of energy, metals,and mining companies. We'realso trying to understand theknock-on effects of the energydownturn. In energy-heavymarkets you're going to see

John Phelan


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G&D: What are yourthoughts on the broader hedgefund industry, what the futuremay hold, and whether or not

it's a good place to start acareer these days?

JP: If you applied Porter's FiveForces to the hedge fundindustry right now, I'm notsure that analysis wouldsuggest you should go runningin. You've got massive feepressure, so revenues are

coming down. You have hugeregulatory costs and burdensplus IT expenses which seemto go up every year, so yourcosts are going up. You couldargue the barriers have gottenbigger because of the expenseof starting, but when you lookat the number of hedge fundseach year that seem to startand go out of business, evenpost-2008, you would havethought there would be asignificant drop in the numberof firms and assets. But we didnot see that. When I comparethe number of firms today runby smart people compared to

when I started, it ismindboggling. I also think youhave a massive asset-liabilitymismatch caused by

institutional investors, makingit that much harder to succeedlong term. If you look at whatinvestors want today I call itthe Holy Grail: liquidity,transparency, high returns, lowvolatility, and group validation.The question is this: Is this goalachievable? Does it makesense? The only person I canthink of who consistently gaveyou this is Madoff.

Today it's hard to scale. Unlessyou become a large firm fast,you're not going to get properservice from any of the banks.Unless you're going to be a bigclient, it's going to be reallyhard for you. I could argue thatrunning less money may be anadvantage, candidly, but itdefinitely makes it harder rightnow. There are a lot of trendsgoing on now that make thebusiness very tough. You'vehad a lot of smart people comeinto it, making it much harderto find opportunities. Youneed to determine what yourreal competitive advantage is.When I look at the industry — and we look at it from a lot ofdifferent ways — I've not founda lot of people who makemoney shorting. I think long/short is to some extent just away to run leverage long. Ithink that it's a tough business.

With the advent of electronic,HFT, and algorithmic trading,many smart people believemachines are going to put guyslike me and firms like ours outof business. It's going to bemachine to machine. My ownview is the machines are goingto put the machines out ofbusiness. But the question iswhen. This may last for a very


made. We made a biginvestment in their mortgagebonds when they were inbankruptcy the first time. We

modeled out every single storeand even had a plan foralternative uses of the spaces.That was a company we did alot of work on before Eddieended up buying it.

When Dominos firstintroduced thin crust pizza themarket did not react wellwhich presented a goodopportunity as our researchindicated this would be verysuccessful. I think that historyand understanding whycompanies are successful isreally important. I think youcan learn different things aboutdifferent businesses and applythem really well to othersituations. That's something wewere able to do.

G&D: It seems like part ofbuilding your own moat as aninvestment firm, to build upyour own intellectual capitaland property.

JP: That's what you're tryingto do. We are very focused onprocess, as I believe youshould focus on process notoutcomes. Process is the keyto proper risk management.There is a big differencebetween a wrong decision anda bad decision. A wrongdecision is picking door #1when the prize is actuallybehind door #2. It’s a lousyresult but the fault lies withmethod. A bad decision islaunching the space shuttleChallenger when the engineerspredicted a nearly 100%chance of catastrophe. Thedistinction is importantbecause it separates outcomeswhich you can’t control fromprocess which you can.

“We are very focused

on process, as I believe

you should focus on

process not outcomes.

Process is the key to

proper risk

management. There is

a big difference

between a wrongdecision and a bad

decision.”

John Phelan


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Page 11

For a student, the amazingthing today is the number ofnew companies that arestarting up. The barriers to

starting a new company todayare so much lower. Google iswhat, a 15 year old company?It took Coca Cola over 100years to have the brandrecognition Google has. Thinkabout it. You can become aglobal brand in ten years orless. That's unbelievable. I thinkthat unless you're reallypassionate about this business,unless this is what you want todo every day, you're better offstarting a business today. Finda dislocation and start abusiness.

G&D: It seems like MSD isdoubling down in some wayson the hedge fund business byactually growing and takingoutside capital.

JP: I don't know that we'redoubling down. We don't thinkof ourselves as a hedge fund.We think of ourselves as aninvestment firm. For us, it's notdoubling down. We're notguys who run long/short. Wedon't use any of the Greekalphabet numbers thateveryone loves to bandy about.I still can't get anyone really toexplain to me what marketneutral means; yet, everybodyuses it. It's fascinating to me.One of the things I haveobserved during myinvestment career that I thinkis interesting is that the basicsof investing do not change onlythe terminology or lexiconseems to. VAR, sharpe ratio,Market Neutral — whateverthat means — tail risk, blackswans, Sortino ratio. To methere just seems to be someperverse human characteristicthat likes to make easy thingsdifficult.

There are a couple thingsdriving our decision to takeoutside capital. One was aquestion of whether we were

going to continue to get capitalfrom Michael. It was prettyclear that we had gotten to astage where that was probablynot going to occur anymoreSecond, we had a number ofpeople we had worked with oninvestments and they alwaysasked us if they could investwith us, but we declinedbecause we didn’t take outsidecapital. We started to find thatactually started botheringpeople. I remember we calledone person up whom weworked with on two differentsituations. He said, “You know

John, I'd love to work with youguys, but I can never investwith you. Obviously, I can gobuy the stock or whatever, butyou guys are really on top of it.I'd rather really be able to dothat.”

We started to realize that ournetwork was inhibited by thefact that we didn't take outsidemoney. The other thing wefound is when someone investsmoney with you, they help youout a lot more. One of thethings we did while I was atESL was to target a strategicgroup of investors. ESL had avery good group of investors.We're trying to build the samething at MSD. We want to findpeople who have got goodindustry experience and arelike minded. We have a lot ofex-CEOs, big families, and asmall group of sophisticatedinstitutions that are investors.They have great industryknowledge and expertise. Wewant to take advantage of that,be able to rely on thosepartnerships, and create ourown ecosystem. Look at whatBuffett has done with


long time. We're seeing a lotof interesting anomalies intrading. We're seeinginteresting things in stocks that

get beat up. I think this wholemovement to passive and ETFscombined with the electronictrading and the “Holy Grail” Imentioned earlier thatinvestors want today is makingit really hard to invest activelyon fundamentals. When youlook at stocks like we do asowners of a business asopposed to pieces of paper tobe traded, it’s a difficultenvironment today.

That doesn't mean youshouldn't go into the business,but the attractiveness of theindustry has declinedsignificantly from when Istarted. If you're an incumbentand you've got a lot of assets,you're in a pretty good place. Ifyou think about how much riska new manager needs to taketo really make it, it's quite high.They may make it, but eventhen all it takes is one badquarter or a bad year. If youdon't have five to ten yearsunder your belt, if you have abad quarter, the fund will seesignificant redemptions. Withpension funds and institutionalinvestors — the wholeecosystem, really — moving topassive, you're going to seethis big movement toquantitative trading, and, if thatlasts for a long time, I thinklong-biased guys like us aregoing to be very challenged inthat type of environment.You've got to make sureyou've got the capital, thewherewithal, the strategy, andthe ability to wait for that toend, because I do think it willend. I don't think it's going toend in a pleasant fashion. Buthopefully it'll be a goodopportunity.

John Phelan


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Page 12

resonates with yours at MSD?What should students be doingto prepare themselves for thiscompetitive environment to

create value? JP: I think it all depends onyour own DNA. Self-awareness is a really importantquality to have, as is humility. Ifyou're someone who iscomfortable being in a place

where you may only make afew investments each year andyou're not actively tradingevery day — it's not noisy andyou're not whipping stuffaround the trading floor — that's a value place. We're ashop like that. Baupost is ashop like that. I also have a tonof respect for AKO in Europe.They are a very good firm anddo a very similar thing. They'rea little more active but reallydisciplined, buy and hold typeinvestors.

If you're someone who wantsto focus on macro or you wantto trade or you want to dolong/short, that's a totally

different environment. Nothingwrong with it, but you're goingto be doing different things andconstructing different tradesand thinking about yourprocess differently. You've gotto decide as a student whatyou’re good at and whatyou’re not good at. I alwayssay to people who come in tosee me that you have to realizein our business a really, reallygood person is wrong 30% ofthe time. That's a world classinvestor. Are you comfortablebeing wrong 30% of the time?By the way, you can't be wrongin a massive way.

I think you have to besomeone who thinks in termsof probabilities. Finding theright environment for you issuper important. I came fromthe school of thought wherewe are all generalists. I thinkthat's a huge advantage. Withmany hedge funds today,you’re slotted into a sector:you're the tech guy, you're themedia guy, you're theindustrials guy, or you're thechemicals guy, and you're goingto learn everything about thecompanies in that industry.They've all specialized. Westill use a generalist model. Weneed to go figure out whatponds we're going to fish in. Ibelieve that 80% of the game isfiguring out what to work on.We've created our firm to bevery good at figuring out whatto work on.

You can look at the newspapertoday, or any day, and find fouror five things you might wantto look at. Which one youlook at and why is really


Berkshire and his shareholderbase.

I don't think a lot of managers

engage with their LPs much.It’s more “thanks for themoney, now let me do my

job.” We’re trying to includethem whenever we think theycan be helpful. We're trying tobuild an investment firm whichis different than a hedge fund.We will not just takeanybody's money. We're longterm, fundamental,concentrated guys. If you wantto start talking volatility equalsrisk, sharpe ratios, beta andgamma, the Greek alphabet,we're not a good match foryou.

It's funny, Buffett in his 2009annual report said, “Don't gettaken by formulas. Investorsshould be skeptical of historybased models instructed by anerdy sounding priesthood,using esoteric terms such asbeta, gamma, sigma, and thelike. These models tend tolook impressive. Too often,though, investors forget toexamine the assumptionbehind the symbol. Our adviceis to beware of geeks bearingformulas.” Same thing appliesfor investors. We're notformulaic. We're making betson things that we think aregoing to happen over time, andI think that's really, reallyimportant. When you thinkabout how you create goodrates of return and how youare going to make a successfulinvestment, the truth is that it'smade by positioning yourcapital where your view issubsequently adopted andacted upon by others. Youneed to be in front of them.

G&D: Are there funds whoseapproach to investing

John Phelan

9th Annual Pershing SquareChallenge judges.

“When you think

about how you create

good rates of returnand how you are going

to make a successful

investment, the truth

is that it's made by

positioning your

capital where your

view is subsequently

adopted and acted

upon by others. You

need to be in front of

them.”


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Page 13

important. You'remanufacturing ideas. You havea set amount of time each day,week, etc. and the market's

going to give you opportunitiesover certain periods of times.What stocks you follow andwhy, which ones you keep aneye on and why, which onesyou actually buy and why,which ones you pass on andwhy, that's really importantstuff. I think certain peoplehave the mental capacity to bedisciplined and do that and notneed action. Other peopleneed action. If you need action,that's a different firm.

I also believe that the morebusinesses you look at and cancompare the better investoryou will become. This is whywe like the generalist versusspecialist model. We areconfident we can get to 80% -85% of the knowledge base anyspecialist has. We can go buythe other 15%. We can go hirea consultant or whatever weneed to get up to speed. Ifwe're monitoring the wrongstocks, if we're not identifyingthe right things to work on,because we have small teams,it's going to be very difficult forus. We force our team to getgood at figuring out what towork on and how to spendour time well. That's what oursystem tries to do. That's oneof our views and one of ourcompetitive advantages.G&D: This was great. Thanksagain for your time andinsights. We really enjoyed it.

JP: Thank you, I really enjoyedit and hope you find mycomments useful.

John Phelan

“For a student, the

amazing thing today is

the number of new

companies that are

starting up […] I think

that unless you're

really passionate

about this business,

unless this is what you

want to do every day,

you're better off

starting a business

today. Find a

dislocation and start a

business.”


14/54

Page 14

Alex Magaro(Continued from page 1)

small private equity shop thatwas basically a fundlesssponsor — they would findcompanies and raise money for

each deal as they went. Idecided to work with themafter graduation, but we had anagreement that I could look forcompanies below a certain sizeto buy for my own account.

I gave myself two years to findsomething before going backto graduate school. I wentthrough hundreds ofbusinesses for sale and wentdown the road with a couple.On one, I pulled the plugbecause the sellers tried toextract an “n+1” at the lastminute. Almost at the end ofthe two years, I came across astaffing business. In the mid1990s, staffing had some prettygood tailwinds — and that reallysurprised me, so I ended upbuying it.

G&D: What was yourinvestment thesis at the time?

AM : In 1995, according to theindustry association, staffingwas the second fastest-growingindustry in the United States,between semiconductors andsoftware. It is a veryeconomically sensitivebusiness, and at that time itwas difficult to disaggregate

how much of the growth wascyclical and secular or even ifthere was a secular trend at all.My hypothesis was that we

were seeing the sameoutsourcing trend that hadstarted to take hold inmanufacturing in the 1980s,now moving into serviceindustries. Then, it was just-in-time inventory, now maybe itwas just-in-time people.

Companies tended to bestaffed for the peaks, and itwas clear that if you couldmake variable some fraction ofthat lower probability staffingneed, this would be a profitimproving decision. In addition,companies realized there werepotential working capitalbenefits as they transitioneddirect employees to temporaryworkers whose pay couldcome with as much as 90-dayterms through a staffingcompany. Over time, moreefficiencies became clear — things like workers’ comp,unemployment insurance, andnon-economic benefits likegiving frequent feedback toemployees, and so on.

It was basically this opinionthat outsourcing would widenthat led me to believe thatstaffing would have prettydecent tailwinds for at leastsome period of time.Obviously, there’s a price thatsolves almost any qualityconcern, and I was able to buythe business very cheaplybecause it was a smallcompany. I bought it for 3xEBITDA, of which one-thirdwas seller financing andanother third was in the formof an earn-out. Outside of thenegative working capitaldynamics on the labor, themirror image of the benefit thecustomer got, EBITDA was a


behalf of current andformer principals ofRenaissance Technologies.Prior to joining in 2003, he

spent ten years investing inprivate equity and runninga small company. Hegraduated from HarvardCollege in 1993. Alexcurrently lives in SanFrancisco, CA with his wifeand three children.

Graham & Doddsville(G&D): Can you discuss yourpath to investing?

Alex Magaro (AM): Irecognized early that I wouldbe a horrible employee forsomebody someday, for tworeasons. First, I really lackedany political skill to speak of,and second, I never really didwell with authority —if I didn’tagree with it. Those two thingsare almost certainly related.Working backwards from that,I started to ask myself, "Whatcan I do to make a living thatdoesn’t rely heavily on politicalability?"

I initially concluded that meantpursuing either an academic oran entrepreneurial career.While being an academicprobably suited my personalitya bit better, once I got tocollege, I realized that roadactually did require areasonable amount of politicalability.

In thinking about theentrepreneurial path I wantedto try to avoid the high deathrate of start-ups. If mostbusinesses fail in the first 5years, then avoid the first 5years, so it seemed to me thebetter move was to buy a smallbusiness and run it.

During college, I worked for a

Alex Magaro

“There’s a price that

solves almost anyquality concern, and I

was able to buy the

business very

cheaply...I bought it

for 3x EBITDA.”


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Page 15

Alex Magaro

kinds of value. You can make amaterial difference by going onsales calls or personallyspotting errors or otherwise

improving service. When wewere at $20 million and inmultiple locations, it startedbecoming much more difficultto effect that difference. Itbecomes an iterative exerciseof hiring and training salespeople, formalizing andcommoditizing an officeopening, etc., but maintainingquality is a significant gatingfactor to maintaining a highgrowth rate. We picked a lotof low-hanging fruit by virtueof approaching the business ina more professional andfinancially-oriented way thanour competition, but for us toscale to $200 million, wewould have had to competewith vastly better financed andstaffed companies.

I went to my partner and saidthat I thought it was the righttime to sell, but her preferencewas to continue with thebusiness. In the end, theleverage the business was ableto take on seemed to me a fairprice for my share of thecompany. Buying the companyhas worked out really well forher, although it was a toughten years.

Around that time, a closefriend from college, DavidZierk, now my partner, invitedme to have lunch with him anda friend of his. It was a socialoccasion, we had a nice lunch,and I never thought anything ofit. It turned out that David’sfriend was the son of JimSimons’ old MIT roommate.Out of the blue about sixmonths later, this fellow I’dhad lunch with called me to saythat Jim Simons was looking toseed a private equity fund and

that I should try to meet with Jim and Leo, Jim’s pick to runthe fund, to see about a job.

G&D: Was Jim Simons wellknown by that point?

AM: He was well known tome because David had been atrader on RenaissanceTechnologies’ execution desksince 1996. I was very aware ofMedallion’s performance up tothat point.

G&D : What was Simonsplanning with the privateequity firm?

AM : Jim’s hypothesis was thatthere might be someinteresting opportunitiesfollowing the dotcommeltdown, and he had beentrying to recruit his old collegefriend, Leo Guthart, for yearsto do something together. Leohad spent the last 35 yearsrunning a company whoseprincipal business was alarmmonitoring systems and theyhad just sold it to Honeywellfor something like $2 billion. IfI remember right, that businessbecame at least part of theplatform for what is nowHoneywell’s automationbusiness.

I met with Jim and Leo, and themeeting went well (whichreally surprised me), and I washired as one of the partners atthat firm. I was honest that Ididn’t have a lot of belief inventure-oriented investing, butI couldn’t argue with the factthat median returns in thespace over long time periodslooked pretty good — even ifyou considered that it had ahigh beta versus the market.That said, I pretty quicklyconcluded that this style ofinvesting wasn’t conducive to


good approximation of cashflows.

That was really why I bought it.

Staffing is not a great business.It's extremely competitive andhas very low barriers to entry.In fact, competitors actuallyused to go through ourgarbage looking for leads! Yet,I also needed to solve for abusiness I thought I could run.For example, I thought itwould be more difficult topurchase a manufacturingcompany with a largeworkforce, because I thoughtit would be pretty difficult for a24-year-old without politicalability to manage that workforce. With staffing, I wasbasically dealing with youngsales people, so I thought Iwould have a chance at beingable to do that.

We grew the business quickly.The business was generating$2 million in revenue when Ibought it and within 5 years,we were generating $20million in revenue.

G&D: Why did you eventuallysell?

AM: I decided to sell it fortwo reasons. First, we had hada really good run and itseemed to me that we couldeasily go sideways or evenbackwards for a long time; andsecond, I came to therealization that I wouldprobably have to spenddecades growing it before wehad enough scale to use it as aplatform to buy otherbusinesses and I needed tobelieve that was achievable inorder to want to spend mycareer at it.

When a business is small,individually, you can add all


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Alex Magaro

advance of that, it could be away for some of those insidersto continue to invest and insomething they trusted.

Further, because Meritage wasessentially captive toRenaissance employees, wewouldn’t have the traditionalprincipal/agent problems youfind between GPs and LPs. Allof this is to say we could havethe makings of a minimally-compromised investmentplatform.

However, I didn’t think that apure fund of funds could reallybe scalable. At that time itreally was a strong strategy forthat size, but the perversereality of investing in outsidemanagers is that if you aresuccessful in finding talentedmanagers, you can’t increaseyour position because theyclose. And given Medallion’sperformance it seemedpossible that we would needscale to be useful. In any case,my feeling was that if we coulddevelop a direct investingstrategy maybe that could giveus more scale. They didn’t

think the idea was wholly crazyand after about a year westarted this direct activity.

G&D: So the primary sellingpoint was that direct investingsolved the scalabilityconstraint?

AM: It was that, but it wasalso that Jim — rationally — prefers liquidity, and if youinvest directly, you are vastlymore liquid than if you investin funds. Also, we thought wecould be more rigorous on riskcontrol and hedging and thelast point was there was a feearbitrage. Paying 1.5 and 20 is alot of return to give up.Frankly, we didn’t have togenerate the sameperformance on a gross basisto outperform on a net basis.We were able to outperformon a gross basis, so it workedout better than ourunderwriting case.

G&D: How did you settle on astrategy?

AM: David and I spend thefirst year working together re-underwriting the fund of fundsportfolio. In addition to thefolks in our portfolio, weliterally met with hundreds ofmanagers raising capital. Myimpression was that most ofthe managers I met were short-term oriented and, in a way,that wasn't natural for me tounderstand. I couldn'tunderstand how someonecould even come up with anestimate of what a companymight print for this quarter’searnings with such precision,and, beyond that, how tohandicap what “the market”would think of that. It wastotally alien to me. Whatseemed clear, though, was thatinvestors’ attention would


the research-driven approach Iwas comfortable with and Iended up reverting to moretraditional fundamental

investing.During my time at Topspin, Ialso got to know Jim and hisson Nat better. Nat, who hadstarted Meritage in 1997 waslooking to take a step backeventually and asked if I wouldbe interested in joiningMeritage with a view to co-managing the portfolio withDavid, who had startedworking with Nat a couple ofyears earlier.

G&D: What was Meritage atthis point?

AM: Meritage was a fund ofhedge funds. Originally, it wasa P&L line item insideMedallion. The basic idea wasthat as Medallion grew, itstarted to accumulate someexcess capital. Renaissancebelieved that it could extendthe duration on some fractionof this capital and so Natstarted to invest it withoutside funds. These wereuncorrelated strategies andwere more profitable thanMedallion’s internal cashmanagement strategies. Itmade sense. Meritage was alsodirectly investible forRenaissance employees, and soit was also a way for people todiversify their own capital.

For context, Medallion closedto outside investors in 1993and started returning capital tooutside investors in 2002. Mythinking in joining Renaissancewas if Medallion continued toperform, not only could itreturn the outside capital, butyou could also arrive at a pointwhere inside investors werealso capped and if Meritagecould build a good platform in

“I couldn’t understand

how someone could

even come up with an

estimate of what a

company might print

for this quarter’s

earnings with precision,

and, beyond that, how

to handicap what ‘themarket’ would think of

that.”


17/54

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Alex Magaro

these cognitive biases as wecould.

As an aside, when we were still

affiliated with Renaissance, weused to get to attend theirmonthly colloquia where theywould invite an academic todiscuss their research. Most ofthe time, the topics were wayover our heads butoccasionally they would invitesomeone whose research a layperson could understand. Oneresearcher presented hisresearch which attempted todetermine something like an“internal discount rate” fordifferent animals. An example

of an experiment wassomething like this: you put arat in a cage and train him thatevery time he hits button Aand then B, he gets food. Thenyou train him that the longerhe waits to press B, the morefood he gets. By varying theamount of food payoff per unitof time waited, you can startto get an understanding of therat’s time preference— his“internal discount rate.”

I don’t recall the details, butthe rat’s discount rate wassomething crazy — like inexcess of 1,000%. You had togive him so much more food

just to wait a little while. Idon’t recall the other animalshe tried this on, but therewere many, and they all

exhibited the same kind ofbehavior. Next, he moved onto humans.

Humans are a little more trickybecause they can also reasonand if you actually want tounderstand a time scale thatmight be interesting, thesubject needs to believe you’regoing to make good on yourpromise. In any case, he spenta year setting himself up as areliable counterparty to agroup of NYU undergraduates.In this case, the experimentswere of this type: You canhave $20 today or some largeramount of money in a monthor six months or a year, etc.There were lots of clevertwists in his many iterations toferret out lots of little nuances,but you get the point. Theresults for his subject groupwere something like 100%discount rates. I wish I couldconvey how well he presentedthe concepts. It was like a LasVegas magician act. In his finalreveal he made the point thatthe subjects might notnecessarily understand financeand time value of money, so heran the same group ofexperiments on finance majorsfrom Stern. While the financemajors had lower discountrates, they were still absurdlyhigh. The final punch line — andI still can’t believe this— wasthat in all cases, human orlower animal, the subject’sdiscount rate increased withduration! I mean, you couldargue that in the human case,the dollars are so small thatthe actual quantities of dollarsmatter — why bother withhaving to remember to trackthis guy down in a year for $50


start to trail off after about sixmonths, and beyond a yearpeople really didn’t seem tocare much at all.

G&D: Were there any othertakeaways you came awaywith?

AM : The first observation wasthat if we were going tocompete on anything, it wasgoing to be in a fundamentalfield, and by this I mean deepanalytical research. This wasalso my background. Clearly,we weren’t going to competewith someone like a Citadel inmulti-strategy or a Medallion instat arb. We were mortals andwe had limited resources. Wethought we had an advantagein capital duration going for usand we thought most firmswere shorter-term orientedthan we were.

Another observation was thatif you looked at the embeddedincentives many funds had,these actually drove a short-term orientation. The feestructure of 1.5 and 20 is amodest incentive to generategains sooner. A related nuancewas that analysts tended to bepaid exclusively out of theincentive fee, which leveredthis behavior. Third, thecontractual terms of the fund(whether we’re talking aboutquarterly liquidity or evenmore modern gatedstructures) tend to make thefund favor more front-loadedreturn streams. Our thinkingwas that once you layer on anevolutionary time preferencefor now versus later, therewere lots of reasons to believethere could be inefficiency inthe medium to long term. As aguiding principle, we wantedour platform and investingphilosophy to resist as many of

“The final punch line

was that in all cases [of

the experiment],

human or lower animal,

the subject’s discount

rate increased withduration!”


18/54


19/54

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Alex Magaro

to disaggregate your returnsbetween stock selection andnet position. The goal is reallyto disaggregate luck from skill,

but given our slow moving andconcentrated strategy, we stillonly think that we probably have some skill. Track recordscan tell you something, but youneed a really long history ofoutperformance to have even amoderate belief. They’re justnoisy.

Another thing that has changedis we try to be more

opportunistic in cyclical assetclasses. For example, in 2008-2009, credit was a veryobvious asset class to invest inif you weathered the downturnin a reasonable way, and if youdidn't have all your investorsclamoring for their moneyback. It was a greatopportunity to buy credit andthen you could make high

teens returns investing incredits with very low defaultrisk. Further, if they diddefault, you wouldn’t have

minded owning the underlying.In 2012, we bought our firstprivate company, ColumbiaDistributing, the fourth largestbeer distributor in the US.They distribute about 60% ofthe beer in Oregon andWashington. It’s a veryinteresting and wide-moatedbusiness. I think buying privatecompanies is a key part of ourfuture and a very natural fit forour capital and its intent.

Because we don’t have adefined fund life, we don’t havea selling horizon and becausewe have a closer relationshipwith our investors, we have abetter idea about how andwhen they are likely to havecapital needs. What falls out ofthis is — just like when Meritagestarted — we think we havesome fraction of our portfoliothat can sensibly be “illiquid.”

The experience we have hadwith Columbia has been great.It’s in our nature to giveautonomy to competent,passionate people. It’s how wetreat our analysts, it’s how wetreat our management teams,and it’s how our investorstreat us. The team runningColumbia is just first rate.Occasionally, we can helparound the edges or maybehelp lay out a way to thinkabout a problem, butotherwise it’s their business torun. We don’t meddle. Wethink they’d agree we’re easyto work with and so we thinkwe could be a good haven fora family or entrepreneur-owned business or amanagement team in search ofa capital partner.


sense.

So, we started small. Theinvesting world has evolved,

but I think a lot of what wastrue then is still true. Forexample, the average holdingperiod in US equities is now

just over 4 months. That’sactually down from when westarted, even though there aredefinitely more long-termoriented hedge funds in themarket today. Obviously,quantitative participation hasincreased too, and this willtend to reduce holdingperiods. I still believe thatmany fundamental funds areshorter-term.

G&D: It sounds like youstarted out with some realstructural advantages. How hasthe firm evolved over time?

AM: We haven’t changed ourinvestment focus or basicprocess since the beginning,but we have generalized ourinitial hypothesis. Originally,we were more focused on thistime preference, but now webelieve that there are hosts ofcognitive biases that can causemispricings and biases that candistort research itself, so wehave gradually tried tointegrate those into how weevaluate investments and theirvaluations.

In terms of performanceanalysis, from the beginning,we focused on evaluatingourselves in terms of alpha atthe position level. We pairevery position, long and short,with its beta to an appropriatemarket index. We think that ifyou don't understand the alphathat you're generating on aposition-by-position basis, itbecomes very difficult to assessyour performance. By that Imean it becomes very difficult

“In 2012, we bought

our first private com-

pany, Columbia Dis-

tributing, the fourth

largest beer distributor

in the US ... It’s a very

interesting and wide-

moated business. Ithink buying private

companies is a key

part of our future and

a very natural fit for

our capital and its in-

tent.”


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Alex Magaro

cash flow yield? I think youhave to be willing to assumethat it's going to grow at leasta little in perpetuity. If it grows

at around 2%, the 4.5% freecash flow yield delivers you anIRR of 6.5%, ignoring leverageand assuming you can exit atthe same 4.5% free cash flow

yield, which maybe isn’t a lock.

We think that a companygrowing in perpetuity is likelyto be a company of quality.We think that the whole ideaof a market multiple at thiskind of level presupposesquality. For example, youwould never pay 18x earningsfor a company shrinking 1%per year. That would be a 3.5%IRR if you could exit theposition at a 4.5% yield. I thinka lot of investors are ignoringthe terminal value when theypay certain multiples forbusinesses, because in theirrelatively shorter time horizon,the terminal value may not berelevant. I think that can be avalid strategy in the short-term, but I'm just notcomfortable with it becauseeventually the correct terminalvalue may become apparent toother people and then you're

in trouble.

Some investors might thinkthat the stock is in fact public

and liquid and that they don’thave to stick with theinvestment, so maybe theterminal value is lessimportant. I disagree becauseoccasionally market events willconspire against you and causeyou to “lose time.” Here’s anexample of what I’m talkingabout. If you look at 2014 and2015, we had a lot of centralbank activism and there werebig FX moves in lots of crossesversus the dollar. An FXdevaluation can come throughearnings and make it look likeit’s nothing more than adeceleration of growth. If weassume the valuation doesn’tchange, although there’s agood chance it would contract,the stock will be flat and thegrowth will again becomeapparent when the companyanniversaries the devaluation.But the point is, if the FXdoesn’t revert, you end uplosing a year of returns in theprocess. In investing, I find thatyou very often lose a year,sometimes several. The thingthat keeps me up at night is:what if you lose enough yearsthat people start to care aboutthe terminal value? Obviously,nothing is bulletproof forever,but my view is you want tohave a very clear opinion abouthow long that terminal value issecure —but that also doesn’tmean you’re right about it.

I don't know how you pick aquality company ex ante, but Ithink that most people know aquality company when they seeit and sometimes you have toget under the covers to seethat a company really is quality.The great investments are thecompanies that are quality but


G&D: When evaluatingMeritage’s holdings, it’s quiteobvious that business quality isvery important to you and

that’s not always the case withinvestment firms. Can youdiscuss why you feel businessquality is so important?

AM: We don’t have somenovel way of valuingcompanies. I think mostfundamental investors wouldagree with the view that thevalue of any company is thepresent discounted value ofthe future cash flows — whichincludes retiring debt. If you'veever played with an Excelspreadsheet, what youprobably noticed very quickly,is it’s all in the terminal value.

Public markets have generallytraded in the mid-teens on a P/E basis over the last 10 yearsor so, obviously ignoring therecent financial crisis and somemodest excursions here andthere. The market at themoment is trading about 18x. Ifyou take the inverse of 18,that’s a 5.5% earnings yield. Onaverage, free cash flow yieldstend to be lower than earningsyields. There are incentives tomake accounting earnings lookbetter, businesses often investmore in capex than theyexpense in depreciation, andcompanies generally consumeworking capital — just to namea few. So, maybe the market isat a 4.5% or 5.0% free cashflow yield. We are ignoringleverage in this example, butobviously the average companyhas leverage — which is to saythe unlevered free cash flowyield is probably lower.

What do you have to assumeabout the long-term growth ofthe average company in orderto be happy with a 4.5% free

“The great invest-

ments are the compa-

nies that are quality

but aren't yet obvious,

but those are rare.

When you find one of

those situations, they

can be extremely

profitable.”


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Alex Magaro

expensive. I can't rememberthe valuation that we sold it at,but we held it to a muchhigher valuation than we would

otherwise have imagined wewould have, and now I think itis quite expensive, or at leastthe last time I checked, whenyou consider they carry 5.5-6xin leverage.

G&D: How do you thinkabout leverage in a business?

AM: I think ignoring debt is a

little like ignoring terminalvalue and is another exampleof a short time preference. It’svery easy to ignore debt whenthe company is doing well andthe ratio of a company’smarket cap to its debt is high.It doesn't change the fact thatyou do eventually have to paythis off —you can’t refinanceforever. So, in the case of aTransDigm it would take thecompany about 12 years to pay

off its debt. It’s still growingnicely, so if it can keep that up,it might take more like eightyears. But the point is that you

have you have an eight to 12year view about somecombination of the company’sgrowth prospects and/or theavailability and price of credit.

In any case, at this price I thinkit’s hard to underwrite theduration of growth that youwould need to have in orderto make a good unleveredreturn. Again, no one may evercare that the company is highlylevered. We may miss out, butwe can't predict when otherpeople may care about the factthat the company is levered.The events of 2008 were aterrific example of people all ofa sudden getting religion onhow levered some companieswere and the reality that it’ssenior to you.

I think terminal value andleverage risk explains a lot ofthe undoing of Valeant’s equity.As the market cap shrank,investors increasingly focusedon this $31 billion bolus ofdebt and rather than thinkingabout it as a source of futureearnings accretion it became apayable with a due date. 5-5.5xEBITDA of debt (especiallywith a low tax rate) is by nomeans insurmountable, but ifthe company has begun toshrink, the equity will have towait. Obviously, with thecompany’s equity at somethinglike 4x earnings, people arequestioning its terminal value.

G&D: That brings up maybean interesting point. Manyinvestors who have studiedBuffett and Munger havedeveloped an appreciation forquality which means thesecompanies tend to trade at


aren't yet obvious, but thoseare rare. When you find one ofthose situations, they can beextremely profitable.

G&D: Do you have anyexamples of companies thatdidn’t appear to be greatbusinesses on the surface butsubsequent research showedthat they were?

AM: In our history, I think thebest example is TransDigm,which I'm sure you've seen andhave had any number of peoplediscuss. We first purchased thestock in 2007.

I was totally amazed that acompany could make returnslike this with airlines ultimatelydetermining their economicfate. This was totally shockingto me but only because of myown ignorance. The story isnow pretty well-known, butthere are enormous regulatorybarriers around themanufacture of aerospaceparts. However, the revenuecadence of any individual partmay not be terribly large orterribly stable. If you were asmall company with a smallportfolio, you would end uphaving a really erratic earningsstream. What the CEO, NickHowley, did was just beautiful.By putting a large number ofthese different parts together,whose cadences weren’tcorrelated, he ended up withthis totally predictable stream.That was like corporatealchemy. Because any individualpart is still erratic and thereare substantial regulatoryhurdles to producing the part,it doesn’t pay to compete. Theconsequence is thatTransDigm has real pricingpower across its portfolio.We sold our shares some timeago because we thought it was

“I think ignoring debtis a little like ignoring

terminal value and is

another example of a

short time preference.

It’s very easy to ignore

debt when the

company is doing

well ... It doesn't

change the fact that

you do eventually have

to pay this off — you

can’t refinance

forever.”


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Harvey Sawikin

What does that mean? Thatmeans that, one-sixth of thetime, assuming a roughlynormal distribution, it will

trade more than 30% lowerthan here, ignoring the driftfrom its expected return(which maybe is just themarket if it’s fairly valued orzero which is a commonassumption for the short run).My casual observation is, givenenough time, it will be 10% or20% cheaper than fair. You justhave to have an opinion at thatmoment. I think it’s mucheasier to have an opinionabout strong companies whenthey are dislocated than weakones.

Moody’s is trading a little lessthan 20x 2016E earnings.Earlier this year it was $83, so15% cheaper. In February,when there were concernsover debt issuance, youcould’ve bought at 17xearnings or a 5.8% free cashflow yield (in this case freecash flow and earnings areabout the same) and thecompany has de minimisleverage.

The company has pricingpower. They would say theyraise prices 3%-4% a year.While issuance may besomewhat elevated now, we’repretty confident that over longperiods of time issuance willcontinue to rise on average. Inany case, between volume andprice it’s not heroic to get to5% revenue growth. Thecompany has about 50%operating margins. If you inflatethe cost base at 3%, you get7% income growth. If thecompany maintains its verymodest leverage and buysstock, the effect to EPS shouldbe a bit better – and could bebetter still if you believe a

company of this stability couldresponsibly manage more. Ithink you can get that for awhile, but for sure there will

be bumps. If you can sell thestock at a 6% yield – which Idon’t think is optimistic in thecontext of today’s valuations,you’ll end up with about a 13%IRR unhedged and it wouldn’tsurprise me if you could endup holding the position for 10or more years.

A big part of when we buysomething is that we have anex ante view about the qualityof the business and we canreact to a price. Often there'salso an accounting component,or there's something that isotherwise obscuring thenumbers a little bit for aperiod of time. Perhaps there'smore earnings power availablethan is currently evident. If youget those things together, thenthat produces an even betterresult.

G&D: How do you generatepotential investment ideas?

AM: We don't have any kindof magic screen. In that firstyear when I met a lot ofmanagers, one of my favoritequestions was “how do yougenerate ideas?” and everyonealways wants to provide ananswer that demonstratedsome kind of systematiccapability. I always thought that

— unless you're someone likeRenaissance — that was unlikelyto be what was actually goingon.

I think idea generation is veryserendipitous. We call itcontrived serendipity. We have14 analysts who are all lookingat companies and one companyleads to the next, leads to thenext, leads to the next, and


rich valuations. What happensto enable Meritage to buythese quality businesses atvaluations that provide

attractive go-forward IRRs?AM: The first question is whatis an attractive IRR? Mostpeople are familiar with theMungerism of preferring thelumpy 15% to the steady 12%

— I think there are issues withthat, by the way. I’d rather12%’s that are 10 -yearinvestments than 15%’s thatare 5’s. Obviously, even withtaxes, if you can string two 5’sat 15% together, that’s better,but I find that our most limitedresource is analytical time. Ithink ultimately we willgenerate more return indollars for our investors thisway.

Other than this opinion, by farthe most common one is timearbitrage. I would also say thatI don't think that the numberof great companies in theworld that is investible for us isvery big. It’s probably in themiddle hundreds. Over time,as you research morecompanies, you learn a little bitabout how they work. Youlearn a little bit about theirdurability. Some stick out tous, and if you just try to stayaware of their valuations, themarket will provide you withopportunities from time totime.

We can take Moody’s as anexample. The volatility of thisstock measured over a 50- to100-day period is about 30%.

Just in February, the volatilityon a 10-day basis was near50%. The point is that a highquality company like this has avolatility of about 30%, even ifmeasured over longer termtime periods.

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Harvey Sawikin

theoretically not as illiquid as itseems.

The opportunity we saw with

beer distribution was theopportunity to buy a companyin a very well-protectedindustry. Beer distributionworks like a franchise. Youacquire the right to distribute abeer in a particular territoryand that right is more or lessperpetual. It is similar to buyinga Dunkin' Donuts franchise.You have the right to operateyour business with exclusiverights in whatever territoryyou agree on with thefranchisor under certain terms.

Essentially, that franchise is atoll road on beer consumptionin a given geography for thebrands that are in yourportfolio. That's a very stable,predictable thing. Anotherreason that these kinds ofassets are particularlyattractive to us is a very largefraction of Meritage’s capitalwill ultimately be given away,but probably over a very longtime horizon.

We think that being able togenerate some of Meritage’sincome through operatingearnings is a good way todefease that rate of giving. Ifwe thought we could doexactly the same thing in publicequities, then we would alwaysdo that. If you could generatethe same return, with exactlythe same shape plus haveliquidity then clearly that’ssuperior. Actually, in manyways that’s Medallion. We feltfor Meritage to have thatreturn profile, we needed toown the asset.

G&D: Do you have any advicefor students interested inentering the investment

management industry?

AM: I spend a really largefraction of my time

interviewing people. We arealways looking for greatpeople. Most of the people weinterview are early in theircareers, and they have typicallyspent the previous two to sixyears in some combination ofbanking, private equity, and/orbusiness school. We generallyfocus on hiring folks thathaven't been trained by otherfunds. We think our approachis a little bit different and weare hoping to hire folks beforethe preceding firm’sinvestment approach is toofirmly entrenched in them.

When I first got into investing,the people going into the fieldwere attracted by the work.They just thought it was fun.What has happened in theintervening years is that it'sbecome clear that investingcan be a lucrative career andincreasingly we are seeingpeople pursue investing-relatedcareers because it's lucrativeand not because the worklights up their brains.

Investing is obviously verycompetitive and markets areefficient to the first order. I’mconvinced we spend really allof our time deep in the land ofdiminishing marginal returns. Itry to tell the folks weinterview that we will probablythrow out 80-90% of the workthey ever do if they work here

—because it’s true— and howdo they feel about that. If theydon’t really have an interest ininvesting and don’t have a timepreference that matches ours,this will defuse their interest.My point really is this: if youdon’t really enjoy the day today of investing, it’s going to


just by covering enough of arelatively small universe, youtend to find opportunities andhopefully add to the universe.

We keep trying to come upwith ideas to organize it moreformally, but I think goodanalysts enjoy the freedom andthe variety. It goes back tobelieving in backingcompetence and passion withcapital and autonomy.

G&D: Could we briefly touchon beer distribution? GivenMeritage’s prioritization ofliquidity, it must be a reallyexceptional business in orderto get you over that liquidityhurdle.

AM: Jim has a strongpreference for liquidity. I don'tfeel quite as strongly, but I dohave a deep respect for it. Ithink that ultimately you haveliquidity for a reason. I don'tthink liquidity is an end untoitself and I would argue thatyou have liquidity in order totake an illiquid position — whether that’s funding medicalresearch or buying a privatecompany.

I think the first question is howilliquid is the position really? Ifyou own the whole companyyou would think it’s illiquid.However, if it's very cashgenerative, which is the case inbeer distribution, you getsubstantial dividends.

I would also ask the question:how long does it take to sell acompany? Maybe it takes 12 or18 months, so the position isnot as illiquid as it might seem.Of course, we don't want tosell it and we don't have theneed to sell it, and it’s veryhard to imagine thecircumstances that would driveus to sell it, but it is

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Harvey Sawikin

G&D: Thank you, Alex. That'sgreat advice. Thank you forsharing your thoughts and timewith us.

wear you out and make youmiserable. Even if you’re ableto retrain yourself to be purelymotivated by money, that

motivation will in fact wear offand sooner than you think andthen you will hate it. You willbe vastly happier in a field thatnaturally lights up your brain.

The second thing I would say isto pursue an investment firmthat has a style and culturethat matches your own. If youhave to work too hard toadapt the way you think to theway the organization thinks,you’re unlikely to be successfulin any case.

I realize figuring this out isn’teasy. But, instead of trying tofigure out the firm’s culture orstyle, I’d recommend firsttrying to figure out your own.Start with something like: whatis it you like about investing?Do you like solving puzzles?Do you have more stamina todo research than most people?Do you have a psychoticallyhigh level of persistence? Doyou perform better in and likea low or high stressenvironment? What is yournatural time preference? Areyou comfortable with volatility?Are you relationship-driven?Do you prefer to think aboutthe big picture? Hopefully,thinking about this will offersome clues about your wiring.Once you have a view aboutthat, then you’ll know whatquestions to ask of firms toassess the fit from yourperspective.

The point of going oninterviews isn’t to get the job,it’s to figure out which job youwant. The point of interviewingpeople is not to fill an opening,but to find the person that willimprove the organization.

Alex Magaro

“[I]f you don’t really

enjoy the day to day

of investing, it’s going

to wear you out and

make you miserable.

Even if you’re able to

retrain yourself to be

purely motivated by

money, that

motivation will in fact

wear off and sooner

than you think andthen you will hate it.

You will be vastly

happier in a field that

naturally lights up

your brain.”


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Price Club and others thatwent public, and made otherpublic investments while sittingon public company boards. My

great-uncle was a visionarywho had a nose for good dealsand was unafraid of reasonablerisk when he had conviction.More importantly, he stressedinvesting in t

Graham & Doddsville - Spring2016

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