Value Investor Insight Issue 298[1]


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ValueInvestor June 30, 2011 The Leading Authority on Value Investing INSIGHT F E AT U R E S Rational Optimist Distilling massive amounts of information down to what really matters is a key investing skill, one that Tom Gayner continues to apply with great success. Inside this Issue Investor Insight: Thomas Gayner Filtering ideas through four “North Star” investing principles and finding opportunity in Wal-Mart, Berkshire Hathaway, Nestlé and Intel. PAGE 1 » Investor Insight: Sheffield Partners Focusing on structurally changing industries and companies and finding value today in Carter’s, Prysmian, Greencore and C&C. PAGE 1 » Uncovering Value: Ocean Rig Making the case for a little-known player (for now) in a vibrant sector of the global energy market. PAGE 17 » H aving covered the company as an analyst for Davenport & Co., Tom Gayner jumped at the chance to join nearby Richmond, Va. insurance firm Markel Corp. in 1990 to help manage its investment portfolio. “They were smart, ambitious people with a permanent capital base,” he says. “What was not to like?” He now oversees the company’s $7.5 billion in equity and fixed income holdings with a deft touch that remains a key Markel asset. His equity portfolio has earned a net annualized 7.6% over the past decade, vs. 2.2% for the Russell 3000. With a portfolio mostly filled with stocks he wouldn’t have touched ten years ago, Gayner today sees opportunity in such areas as discount retail, insurance, food See page 2 and integrated circuits. INVESTOR INSIGHT Thomas Gayner Markel Corp. Investment Focus: Seeks proven companies with attractive reinvestment opportunities when they trade at earnings multiples that are unlikely to decline over time. Of Sound Mind Insight into fending off threats to one of the primary character traits PAGE 19 » of successful investors. Editors' Letter Why Scout Capital sold two core – and still highly regarded – positions in this year’s first quarter. PAGE 20 » INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS Berkshire Hathaway C&C Group Supply and Demand Markets particularly shun stocks with both company-specific and industry-wide problems – which is when Brian Feltzin and Craig Albert start to get interested. INVESTOR INSIGHT L Brian Feltzin (l), Craig Albert (r) Sheffield Asset Management Investment Focus: Seek beaten-up stocks of companies not earning up to their potential but poised – for clear reasons – to reach that potential in the not-distant future. ike many ex-lawyers turned investors, Craig Albert has a simple explanation for his own career switch: “I was far more interested in what our business clients were doing than arguing about whether word number 72 on page 133 of their prospectus was clear,” he says. Which is not to say that Albert and partner Brian Feltzin give any less detailed attention to their investing. Since the launch of Sheffield Asset Management in 2003 they have earned a net annualized 8.9%, vs. 7.7% for the S&P 500, while averaging a net long exposure of roughly 35%. Focused on industries and companies undergoing significant change, they’re finding mispriced value today in such areas as baby clothing, industrial cables, prepared foods and alcoholic beverages. See page 10 PAGE 6 15 12 14 8 7 17 13 5 Carter's Greencore Intel Nestlé Ocean Rig Prysmian Wal-Mart Other companies in this issue: Britvic, Brookfield Asset Management, CarMax, Coca-Cola Enterprises, Disney, DryShips, Home Depot, Microsoft, Sanderson Farms, UPS, Verisk Analytics I N V E S T O R I N S I G H T : Thomas Gayner Investor Insight: Thomas Gayner Thomas Gayner of Markel Corp. describes the attributes he puts before a cheap price when looking to buy, why his earnings models aren’t elaborate affairs, his “silver-medal” approach toward macroeconomic risks, why he chooses to be a rational optimist, and why he believes Wal-Mart, Berkshire Hathaway, Nestlé and Intel are mispriced. V You described the last time we spoke [VII, May 26, 2006] your four “North Star” investing principles. Have the past five years caused you to reassess any of those? Thomas Gayner: The four basic things I’m looking for in any investment haven’t changed. The first is that the business is profitable, which means generating good returns on capital without the excessive use of leverage. I was tempted in my youth by turnaround stories or betting on new product or service offers, where you could hit the ball out of the park if things got fixed or the new product took off. But I’ve had enough failures pursuing those types of ideas that I’ve for the most part lost the stomach for them. From a performance standpoint, I’m more focused on what something is than what it can be. I do care a lot about how sustainable that profitability is. One of the great episodes of profitable growth in U.S. corporate history started with DuPont’s creation of nylon. Rather than look to optimize profit at every moment, the company constantly cut nylon’s price in order to broaden the market. At the same time, they instilled a discipline in the organization that it needed to constantly come up with ways to produce the stuff for less. They were looking at the business as a long-running movie, not a photo snapshot – I try to do the same thing for the companies I’m looking to own. Our second key principle is to invest in management teams with equal measures of talent and integrity, because one without the other is worthless. The talent part largely speaks for itself through an objective look at performance, especially over time. Integrity is a bit harder to judge, but it’s one of those things that you know when you see. Think about how you decided whom you were going to marry. You spent lots of time together. You met her family. You met her friends. You June 30, 2011 learned what she cared about and her basic value structure. We do the same types of things to get to know management of the companies we invest in. It’s imperfect, but to our way of thinking nothing is more important. Our next North Star is good reinvestment opportunities. The ideal business earns a very good return on its capital and can then reinvest that capital with equally good or better returns over and over again. That’s a long-term compounding machine and it’s particularly important to us because, as an insurance company, we’re a full taxpayer on capital gains and dividends. We’d much rather have value compound within a company we own. I ask myself all the time what the “it” factor is in any business that will allow it to continue to compound value. For Disney [DIS], for example, even if I have no idea how entertainment content will be delivered in ten years, I’m quite confident that its basic business model of creating intellectual property that delights its customers and can be repackaged and sold in a wide variety of ways and with high incremental margins – what Disney has done very well for decades – will continue to generate excellent compound returns over time. For UPS [UPS], which we also own, the “it” factor is a distribution network built up over time that allows it to deliver packages more efficiently than anyone else. If you believe the amount of stuff that’s going to be sent in the U.S. – and especially outside the U.S. – is going to increase, it’s highly likely that UPS will be a key beneficiary of that. Rising living standards in places like India, China and Africa should sustain growth and reinvestment opportunities at the company for at least as long as I’m alive. To amplify that point, the great story in my investing lifetime has been and will Thomas Gayner Ever So Humble After graduating from the University of Virginia in 1983, Tom Gayner earned his CPA while working as an accountant in the Richmond office of what became PricewaterhouseCoopers. He quickly concluded, however, that his heart wasn't in it. “I was an accountant more interested in dollars than numbers,” he says. That interest led him to regional brokerage Davenport & Co., where he was a jack of all trades – analyst, retail broker and institutional salesman. It was while covering Markel Corp. as an analyst that he met Steve Markel, who hired him in 1990 to help run the company's growing investment portfolio. Today, Gayner is Markel’s Chief Investment Officer and a member of its three-person Office of the President. Ask him how the financial crisis made him a better investor and the calm and selfdeprecating Gayner offers a typically thoughtful, if somewhat surprising, response: “I would say that the humility that comes from going through something like that has made me a better businessman and even a better person. You're more connected to people and all that is going on and you listen better. That's so important to being a good investor.” Value Investor Insight 2 I N V E S T O R I N S I G H T : Thomas Gayner continue to be the increasing affluence of billions of people around the world and how that translates into increasing demand for goods and services. A central aspect of the long-term thesis for almost every company we’ll talk about is how they will benefit from that rising affluence. Compared to that, hand-wringing about whether Greece is going to default or what happens after QE2 ends is really just noise. Your final investing principle is to pay a fair price. How do you define that? TG: A fair price today is one that should allow us over time to realize on our investment the same level of compound annual growth we expect in per-share book value, earnings or cash flow – whichever is most appropriate for the company at hand. What that tries desperately to preclude is paying so much that the business can do extremely well but the stock price goes nowhere, which can happen as businesses inevitably mature and valuation multiples shrink. What that means practically to us is that if we find a business that meets all our criteria and we pay no more than 1415x trailing earnings, we’re not going to be wildly off on price. For any number of market, industry or company-specific reasons, it’s been my experience that we’ll episodically get opportunities to pay these kinds of prices. While price obviously matters, if we’re right on the big picture, I don’t need a screaming bargain to do well – compounding value can cover up a lot of sins. I’ve been criticized for the fact that my earnings models are not elaborate affairs and that I don’t have every relevant operating metric on the tip of my tongue for the companies I own. I tend to think in terms of allegories and stories and take gross, gist-of-it looks at where I see earnings going based on my understanding of the dynamics of the business. Different approaches work for different people and that’s what has worked for me. How would you characterize your ideageneration process? June 30, 2011 TG: I wouldn’t really characterize it as a process, but I’ve found no substitution for constant reading to immerse myself in the flow of information that eventually results in ideas. The perfect day for me, which doesn’t happen often enough, starts with two or three uninterrupted hours of reading newspapers, business magazines, investing publications like yours and anything else that can teach me something. I also get exposed to many good ideas from relationships I’ve built over the ON BLUE-CHIPS: I’m making a spread bet that this category of stocks is cheap – I expect correlations among them to be quite high. years with wonderful investors. Nobody’s sharing hot tips, just talking about companies and businesses they consider interesting. I find that a good way to get exposed to ideas I might not otherwise pursue. Value investors often tend to buy on bad news they consider temporary. Is that your style? TG: We’re not at all averse to that, but there’s often no real “event” that triggers a purchase. That’s especially true today, when our portfolio is dominated by bluechips like Wal-Mart, Disney, Diageo, Johnson & Johnson and Nestlé. With Nestlé, as an example, I can’t say anything’s really changed for it over the last six months since we started buying, other than the business continues to build value as the stock price has gone nowhere. Given my nature, it’s very rare for us to buy a full position all at once. We take a long time to get to know companies and their managements and even then I’m always worried that I might have missed something, so we’re more comfortable building a position over time. We now have a core position in Brookfield Asset Management [BAM], but our original relationships with the people there go back decades. You may not know the history of the company, but it was once the unglamorous part of the Bronfman family empire, which owned many small stakes in the types of companies that dominate the Canadian exchanges, in industries like paper, energy and timber. Over time it has parlayed those holdings into bigger stakes in more companies around the world by essentially putting in capital when times are bad and taking money off the table when cycles improve. As we better understood that ethic and the results it generated, we gradually increased our position. How concentrated do your portfolio bets tend to be? TG: We’ve been holding 90 to 100 stocks, which may be a bit more than last time we spoke, but the concentration at the top is about the same, with the top 20 positions accounting for roughly 70% of the portfolio. Even though I have more positions, I’d argue that I’m more concentrated today than I was ten years ago when I owned few of the high-profile large caps I do today. I’m making a spread bet that this category of stocks is cheap, and I expect the correlations among them over the next five years to be quite high. Given that, I’m not spending a lot of time trying to figure out if Coke is less expensive than Pepsi – they’re both selling at low valuations so I just own them both. You’re responsible for Markel’s entire investment portfolio. How are you setting the allocations today between fixed income and equities? TG: The size of the fixed-income allocation is first and foremost driven by the need to over-collateralize the insurance liabilities of the corporation. Once that has been done, we invest the residual based largely on the relative opportunities we’re seeing, but also based on what’s going on in the insurance side of the business. Given the soft insurance-pricing Value Investor Insight 3 I N V E S T O R I N S I G H T : Thomas Gayner market today, I’m less aggressively weighted toward equities than I would be otherwise. As a practical matter, the highest allocation to equities of the residual has been about 80%, with the lowest closer to 40%. It’s been moving up for a couple of years now and is today in the mid-60s. With 10-year Treasuries yielding less than 3%, we’re finding plenty of equity ideas that are relatively attractive. What lessons did you take away from a very difficult 2008? TG: Be really, really, really careful about things that are leveraged, which is what went off the tracks in 2008. That includes companies in which the level of leverage is more apparent – I unfortunately had a relatively large position in banks going into 2008 – and other things where I didn’t fully appreciate the risk. GE, for example, was the perfect play on growing global affluence, with very broad geographic reach and exposure to industries like electricity generation and refrigeration and jet engines that the developing world increasingly needs. Next time I’ll look for all of that in a company that doesn’t have a levered beast within it like GE Capital. How did you handle your long-time position in used-car dealer CarMax [KMX] when its stock fell by two-thirds during the crisis? TG: We were criticized for it, but we didn’t sell any. The biggest issue was its autofinance business, but I didn’t think it threatened the company’s ultimate viability and I always believed the basic fundamentals of the business were intact. Being the best dealer of used cars is a good business, period, and CarMax was likely to be particularly well-positioned through a difficult economic environment. Given that, why sell? Did you buy more? TG: I bought a little more near the bottom, but not nearly as much as I should June 30, 2011 have. There was just too much uncertainty hanging over the system. I’m much more willing to be criticized for being too conservative than for being too aggressive. [Note: CarMax shares at a recent $32.80 have quadrupled from their crisis lows and are up more than 100% over five years ago.] Your private-equity division has stepped up its activity. How is that going? TG: The basic premise in setting up Markel Ventures was that the four princi- I mentioned the importance of being connected, and our ownership of these businesses has already paid great dividends from the diversity of people and industries we’ve gotten to know. From a Markel perspective, the Ventures unit is a nice source of non-regulated cash flow at the corporate level that can give us more flexibility. That could allow us to throw bigger punches when times are tough by making acquisitions, say, or buying in our own shares – things that would have been harder to do 10 years ago. Turning to your public-equity portfolio, describe why Wal-Mart [WMT] fits all your investment criteria today. TG: When I talk about Wal-Mart people tend to look at me like I’m hopelessly retrograde, but its record of financial performance remains superb. Very few companies earn the returns it does on such a giant capital base, which is a credit to the talent of its management and to what I consider its “it” factor, which is an extensive distribution system in the U.S. – and increasingly around the world – that delivers products to customers at the lowest cost. That’s competitively very difficult to displace and provides the company with a worldwide platform for continued growth. The knock on the company seems to be that it can’t grow as fast in absolute terms as it has in the past because it has saturated the U.S. market and because Internet competitors like are taking market share. I accept all that, but believe the market is exaggerating the concern, not giving Wal-Mart enough credit for its non-U.S. expansion opportunities, and not recognizing how aggressively it can buy back stock. So much of Wal-Mart’s business is in basic staples like toothpaste, underwear and milk that it’s hard for me to imagine an online competitor like Amazon figuring out a more efficient way to get those types of things to you than by Wal-Mart getting them to your nearby store and you dropping by to pick them up. The bigger competitive risk is in products like the $300 camera or $1,000 flat-screen TV, Value Investor Insight 4 ON MARKEL VENTURES: It’s a source of non-regulated cash flow that can give us flexibility to throw bigger punches when times are tough. ples we follow in making public investments apply just as well to private companies. Our first investment, in 2005, was AMF Bakery Systems, a company headquartered near us in Richmond and which has been the dominant manufacturer of high-speed baking equipment for 75 years. We now own full or controlling stakes in an eclectic bunch of businesses that make everything from mobile homes, to dredging equipment, to pickle-slicing machines, to dorm-room furniture. The common themes are that they’re durable businesses, run by talented and honest people, and they produce lots of cash. As in public equities, we steer clear of businesses, mostly technology-related, where something fundamental could change in the business and kill it and we might never see it coming. One company we looked at provided systems to deliver interactive educational products and services to classrooms. The numbers were great and the product demonstrations were impressive, but I couldn’t with any confidence say their technology wasn’t going to get overtaken by something else six months from now. That type of thing isn’t our cup of tea. I N V E S T O R I N S I G H T : Thomas Gayner but that’s not the lion’s share of WalMart’s business and there’s no reason why it can’t have a comparable online option for buying those types of products if that’s what people want. Earlier this month Wal-Mart’s board authorized another $15 billion in share repurchases, on top of the $14 billion or so they bought back last year. They’re not levering the balance sheet to do that, as they can fund those types of repurchases out of operations. As a thought exercise, what would happen if the company continued to buy back shares at that rate? In 12 to 13 years there would be one share left. If the equity value of the company INVESTMENT SNAPSHOT didn’t increase at all over that time, that share would be worth today’s market value of about $185 billion. Discount that back at 20% over even 15 years and the present value today is maybe $12 billion. Say that’s silly and cut it in half, you’re at $6 billion. You can keep cutting it in half for a long time and still come up with a share value significantly higher than today’s price [of around $53]. What I’ve described is never going to happen, but my point is that on a pershare basis this is still a company that can increase sales, earnings and cash flow at double-digit rates for some time. They get little credit for capital management. The current multiple certainly seems to be within your buying range. TG: I thought the stock was cheap at 1819x earnings when I first started buying it five years ago and now it’s going for less than 12x. The stock price is roughly the same because earnings have gone up 50% while the P/E has compressed 50%. Am I wrong, or am I just early? Sales keep going up, earnings keep going up, cash flow keeps going up, the dividend keeps going up – those are not typically the hallmarks of being wrong. As long as the value of the company keeps increasing, from this valuation level, I’m as confident as I can be that the stock price will eventually follow suit. You put a lot of emphasis on management integrity. How would you judge that for a company of this size? TG: I spend a lot of time going through the proxy statement to understand how people pay themselves and I find the compensation levels and plans here quite fair. There’s a lot of social criticism of Wal-Mart – that they run the local hardware store out of business, say – that I just think is unfair. How many of the people who worked at Jim’s Hardware or Bob’s Drugstore had health insurance, a 401(k) and career-advancement opportunities? I think there’s a false nostalgia around those types of displaced jobs that isn’t justified. I’m not saying working at Wal-Mart is any panacea, but it’s hardly the net negative that some people make it out to be. Turning to another company about which there are plenty of disparate opinions, describe your investment case for Berkshire Hathaway [BRK-A]. TG: I find it rather absurd, but the market seems eager to second-guess just about anything Warren Buffett does and then marks down the stock as a result. He paid too much for Burlington Northern. Berkshire Hathaway owns too many businesses in the building-materials sector that aren’t doing well. The insurance marValue Investor Insight 5 Wal-Mart (NYSE: WMT) Valuation Metrics (@6/29/11): Business: World's largest retailer, with some 9,000 discount stores, supercenters and warehouse stores in 15 countries. Employs more than 2 million people. Share Information (@6/29/11): Trailing P/E Forward P/E Est. (@3/31/11): WMT 11.5 11.8 S&P 500 15.8 12.8 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 52.64 47.77 – 57.90 2.8% $182.80 billion $426.23 billion 6.0% 3.9% Company Vanguard Group State Street Wellcome Trust BlackRock Berkshire Hathaway Short Interest (as of 6/15/11): % Owned 2.3% 2.3% 1.5% 1.4% 1.1% 2.1% 80 70 60 50 40 Revenue Operating Profit Margin Net Profit Margin WMT PRICE HISTORY 80 70 60 50 40 2009 Shares Short/Float 2010 2011 THE BOTTOM LINE With its difficult-to-replicate distribution system, international growth opportunities and capacity to buy back stock, Tom Gayner believes the company will continue to grow per-share earnings at double-digit rates. With the shares trading today at less than 12x earnings, “I’m as confident as I can be that the stock price will follow suit,” he says. Sources: Company reports, other publicly available information June 30, 2011 I N V E S T O R I N S I G H T : Thomas Gayner ket is soft. The whole David Sokol affair highlights how difficult the succession issue is. There are always single data points people jump on to say Berkshire has lost it and I mostly consider it mindless noise that obscures the fact that Buffett has built an incredible capitalallocating machine and set of operating businesses that should prosper for a very long time. This is not a business that should trade for a modest premium to book value. How do you think through the succession issue, given Buffett’s unique talents and the fact that he’s 80 years old? INVESTMENT SNAPSHOT TG: Let’s talk about a couple other entities created by unique geniuses. I’m a huge fan of John Wooden, the UCLA basketball coach who retired in 1975 after a run of success that has never – and will never – be matched. I’m sure it’s been no picnic for all the coaches who have followed in his footsteps, but guess what, UCLA nearly 40 years later is still a pretty good basketball program. Since Wooden left they’ve won one national championship and have been fairly regular visitors to the Final Four. In the world of business, think about Exxon, the predecessor of which was started by John D. Rockefeller, another singular business genius of his age who stopped running Standard Oil before he was 50. I once asked a roomful of maybe 300 investment professionals if anyone could name four CEOs of Exxon, and no one could come close. My point is that over the next several decades there will be a series of top executives at Berkshire Hathaway whose names probably won’t be on the tips of everyone’s tongue, but that doesn’t mean the company won’t continue to thrive in the same way Exxon has. The assets and the capital discipline won’t go away when Warren Buffett is no longer in charge. How are you looking at valuation with the A shares trading at a recent $115,500, not far from a 52-week low? Berkshire Hathaway (NYSE: BRK-A) Valuation Metrics (@6/29/11): Business: Highly diversified conglomerate and investment holding company, with key operations in insurance, rail transportation, utilities and real estate brokerage. Share Information (@6/29/11): Trailing P/E Price/Book (@3/31/11): BRK-A 17.6 1.19 S&P 500 15.8 n/a Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 115,540.00 109,925.00 – 131,463.00 0.0% $190.87 billion $137.87 billion 11.9% 7.9% Company Fidelity Mgmt & Research First Manhattan Capital World Inv Ruane, Cunniff & Goldfarb Davis Selected Advisers Short Interest (as of 6/15/11): % Owned 2.6% 2.0% 1.1% 1.0% 1.0% 0.1% 150k Revenue Operating Profit Margin Net Profit Margin BRK-A PRICE HISTORY 150k Shares Short/Float 120k 120k 90k 90k 60k 2009 2010 2011 60k THE BOTTOM LINE The single data points the market appears to jump on to say the company has lost it obscure the fact that it’s “an incredible capital-allocating machine and set of operating businesses that should prosper for a very long time,” says Tom Gayner. Even the low end of his current fair value range is significantly higher than the current market price. Sources: Company reports, other publicly available information TG: I break the business into three parts, insurance, investments and the other operating companies. For the insurance business, which is currently relatively soft but is well-positioned and well-run, I look at the level of insurance premiums running through the business and assume at the low end that it breaks even on an underwriting basis, in the middle range makes 4-5 points of underwriting profit and at the high end makes 8-9 points. For the investment portfolio, I assume it earns from 3% at the low end up to 10-12% at the high end. For the operating businesses, I look at the actual cash flow produced over the past three years and overlay my expectations over the next few years to get a range of possible normalized earnings. On all of that, I apply 10x, 14x and 18x earnings multiples to arrive at a fairvalue range for the company overall. At even the low ends of the range, the resulting value is significantly higher than today’s share price. It’s a bit weird to say for such a highprofile company, but I really believe Berkshire is a stock that people by and large don’t think about. They seem to be either true believers whose analysis stops and ends with Warren Buffett’s presence, or they’re people who are dismissive without really taking a close look. On the sad day Buffett is no longer there, neither Value Investor Insight 6 June 30, 2011 I N V E S T O R I N S I G H T : Thomas Gayner of those default positions will apply. That may result in the market taking a much closer look at the company and appreciating what’s actually there. Is Nestlé [NESN:VX] a standardbearer for your global-affluence theme? TG: Yes. Rising standards of living don’t just mean people start buying more Rolexes or BMWs, a lot of it is about buying a better brand of coffee or chocolate, or buying baby formula for the first time. Over time that can’t help but benefit Nestlé, which is the largest and most geographically diversified food company in the world. I’m not sure I can name a more consistently profitable and durable business. Whether you look at the last year, the last INVESTMENT SNAPSHOT five years or the last 100 years, this is a company that generates mid-teens and better returns on equity with very conservative finances. Is that going to continue? Well, they’ve been at it successfully for more than 150 years, over a period in which a few things have happened – like the introduction of electricity, two World Wars, the advent of the jet engine, the creation of the Internet. I don’t spend a lot of time looking at whether the percentage of revenues they have coming from this sector or that is as high as I think it should be or whether gross margins in the ice cream business are going up or down. The record speaks for itself and I have every reason to believe management knows what it’s doing and the future looks as bright as the past. Have rising commodity prices been weighing on the stock? TG: Probably, but that’s the type of shortterm issue that really doesn’t concern me. These things go in cycles, but even if high commodities prices persist, I can make an argument that that eventually works to the long-term advantage of branded food companies like Nestlé. The only reason people buy generics is the price difference with branded products. Say a bag of Nestlé chocolate chips costs $2 and the store brand costs $1. If input costs go up such that each needs to increase price by 50 cents, the branded chips are still $1 more expensive, but now the price differential is 67% rather than 100%. I’m not saying absolute prices don’t matter, but at the margin I believe branded companies like Nestlé will benefit if or when the relative price premium goes down. At a recent 51.90 Swiss francs, what upside do you see in the shares? Nestlé (Swiss: NESN:VX) Business: Largest global food and beverage company. Key product categories include coffee and tea, water, dairy, chocolate, frozen foods and pet food. Share Information (@6/29/11): Financials (Full-year 2010) Sales EBIT Margin Net Profit Margin Valuation Metrics (Current Price vs. TTM): CHF 109.72 billion 14.8% 31.2% Price 52-Week Range Dividend Yield Market Cap CHF 51.90 CHF 48.92 – CHF 56.90 3.6% CHF 171.43 billion P/E NESN 20.0 S&P 500 15.8 NESN PRICE HISTORY 60 60 50 50 40 40 30 2009 2010 2011 30 THE BOTTOM LINE The company’s product mix, global reach and operating skill, overlaid with rising levels of global affluence, make it a “way-above-average” company, says Tom Gayner. But at 14-15x earnings (after accounting for its cash hoard), the stock trades at just an average price. He expects at least low double-digit annual returns on the shares over time. Sources: Company reports, other publicly available information TG: After accounting for the huge amount of cash on hand – much of it from the sale of the company’s stake in contactlens company Alcon – Nestlé’s shares have been stuck in the 14-15x earnings range for quite a while. To me, it’s a way-aboveaverage company trading at an average price. The price might even get below average, but what matters to me is that Nestlé persists as a way-above-average company. When I look at their mix of products, their global footprint, rising affluence and the skill with which they’ve conducted their operations, I think there’s a good chance that will persist. Even with no increase in the multiple, I’m earning a 3.6% dividend yield and should see earnings grow on a per-share basis in the high single-digits per year. That would produce a double-digit annual return on the stock. If you look at something like this against a Treasury bond, the risk/reward strikes me as highly favorable. Your portfolio is usually light on technology names. Why do you find Intel [INTC] interesting today? Value Investor Insight 7 June 30, 2011 I N V E S T O R I N S I G H T : Thomas Gayner TG: I certainly don’t consider myself a technology expert, but this is essentially a simple bet on a cash-generating machine that the market seems to think has a dismal future. I disagree. The primary knock on Intel today is that it hasn’t been at the forefront of chip technology for mobile devices. That’s a fair criticism, but the negative argument falls short in a couple key respects. For one, it makes it seem like Intel isn’t benefiting at all from the proliferation of mobile computing. In fact, all those mobile devices have to be connected with something, which happen to be the servers and network machines in which INVESTMENT SNAPSHOT Intel is still the dominant chip supplier. The company’s revenue growth of late would indicate the mobile craze isn’t just passing it by. Second, the company is so profitable that it can fund research and development spending that is unmatched in the industry. That’s obviously no guarantee that they blow everybody else out of the water in mobile computing, but I think it’s a mistake to assume a company with its capabilities is always a step or two behind in any important market in which it wants to compete. There’s a very high likelihood it will be a bigger and better player in mobile computing as the generations go by. Intel is also a company with every bit of the upside from increased developingmarket demand. Just as people will want to buy better toothpaste and put beer in the refrigerator, they’ll be increasingly using computers with Intel chips like they never have before. How have you gotten over your natural aversion to technology here? TG: Part of it is just trying to use some common sense about what areas of technology tend to be more durable than others, which has certainly been the case over time in Intel’s primary businesses. Leading box makers may come and go, but Intel has pretty consistently been inside each of them. Tech companies like Intel have also adopted more mature corporate behavior around capital allocation and compensation. I had little patience for most of the options-heavy compensation schemes of the past, which I considered excessive and also deceptive from an accounting standpoint. That’s changed in companies like Intel, which have shifted more toward cash-based compensation and the use of restricted stock. I do believe the odds that I’m flat-out wrong here are higher than in many of the other stocks I own, which I address by not having as big a position in it or in any one technology name. How inexpensive do you consider the shares, now around $21.40? TG: This is a real head-scratcher for me. This is the leading company in the world at what it does, with 35% operating margins and earnings that grew in the latest quarter by 30%. What it does is and is likely to remain in high demand. But the stock trades at 10x trailing earnings and has a 3.4% dividend yield. It’s hard for me to imagine ten years from now considering that as anything but an incredible bargain. You also own Microsoft. What do think of David Einhorn’s criticism of CEO Steve Ballmer? Value Investor Insight 8 Intel (Nasdaq: INTC) Valuation Metrics (@6/29/11): Business: Largest designer, manufacturer and seller of integrated circuits, used by makers of a wide array of computing and communications products worldwide. Share Information (@6/29/11): Trailing P/E Forward P/E Est. (@3/31/11): INTC 10.0 9.4 Nasdaq 12.1 14.0 Largest Institutional Owners Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 21.39 17.60 – 23.96 3.4% $113.41 billion $46.17 billion 35.3% 26.4% Company State Street Vanguard Group BlackRock Capital Research Global Inv Bank of NY Mellon Short Interest (as of 6/15/11): % Owned 3.9% 3.9% 2.6% 2.5% 1.9% 2.1% 25 Revenue Operating Profit Margin Net Profit Margin INTC PRICE HISTORY 25 Shares Short/Float 20 20 15 15 10 2009 2010 2011 10 THE BOTTOM LINE The leading company in the world at what it does, with 35% operating margins and earnings growth in its latest quarter of 30%, should not trade at 10x earnings with a 3.4% dividend yield, says Tom Gayner. Of the current valuation, he says: “It’s hard to imagine ten years from now considering that as anything but an incredible bargain.” Sources: Company reports, other publicly available information June 30, 2011 I N V E S T O R I N S I G H T : Thomas Gayner TG: If I believed that, I just wouldn’t own the stock. I would say that there’s a big difference between the success of the business and the success of the stock investment. Objectively speaking, it’s a bit harsh to say Steve Ballmer has been a bomb. He took over the top job when Microsoft stock was wildly overpriced and has had to live that down as the company’s earnings have probably tripled. Whoever is the CEO, it’s my view that if the value of the business continues to keep rising from here, the stock will eventually follow. What’s your biggest macroeconomic concern today and how are you dealing with it in your portfolio? TG: It seems to me that the current course of government action is unsustainable and that if something doesn’t change there is a real threat of inflation and a falling dollar. That said, I’m taking what I call a silver-medal approach that hedges my bets. If we continue to have a deflationary environment, which is the classic way debt bubbles unwind, the gold-medal idea is probably government bonds. Next best, in my opinion, are stocks of high-quality companies like those I mostly own, with the balance sheets and market positions to best navigate a tough economy. If inflation takes off, the gold-medal idea is probably going to be commodities, but the silver medal would likely go to high-quality companies with strong global brands and low-cost distribution systems that have a better chance of maintaining returns on capital even if the units of measurement change. Given the uncertainty over how things will play out, I’ll be happy to end up with the silver medal either way. We spoke last time about your finding investment inspiration in the writings of Mark Twain. Have you read anything recently that you recommend? TG: I really liked The Rational Optimist, by Matt Ridley. The general theme of the book is that while it may not feel like it all the time, things are getting better in the global economy and will continue to do so. Technology and the increasing interconnectedness of the world are causing good ideas and best practices to rise to the top more quickly and get disseminated more broadly. That makes all of us better off. Do you consider yourself to be a rational optimist? TG: I’ve been accused of being an irrational optimist, but as ugly as our system looks from time to time, it works. I continue to operate under the assumption that however bad our problems are, we’ll figure it out and be okay. I’ve always said you might as well assume the world is going to work, because if it doesn’t, it doesn’t really matter what your investment portfolio looks like. VII June 30, 2011 Value Investor Insight 9 I N V E S T O R I N S I G H T : Sheffield Asset Management Investor Insight: Sheffield Partners Craig Albert and Brian Feltzin of Sheffield Asset Management explain the evergreen idea source they consistently tap, why they’re currently far more apt to invest in Europe than the U.S., how their views on cotton inform several portfolio positions, and what they think the market is missing in Carter’s, Prysmian, Greencore and C&C Group. Your portfolio has both a European and a cyclical bent. How did that come about? Brian Feltzin: When I came into the business and even when I started Sheffield in 2003 there were more inefficiencies in classic special situations like spinoffs or distressed securities – things hedge funds typically pursue. While those opportunities can still exist, there are many more smart and aggressive people out there looking to exploit them. Recognizing that the game has changed somewhat, our sourcing process is focused primarily on identifying areas of the market which are the most out-offavor, and then looking for change that will drive material earnings improvement and thus a change in sentiment. From a geographic perspective, this approach for some time has frequently led us to Western Europe, and that’s certainly still the case today. In terms of the cyclical bent to our portfolio, cyclicals by their nature repeatedly experience boom and bust periods that create opportunities for investors like us who pay careful attention to supply/demand economics and believe in mean-reversion. If you look at the average equity holding period over the last 15 to 20 years, it’s clear that there are a lot of people out there just renting stocks. The primary inefficiency we’re trying to exploit is that investors don’t like it when things aren’t going well and a company is underearning its potential or what’s normal, so our focus on the long side is to identify overreactions in the stock when that happens. In Europe in particular, companies get put in the penalty box quite severely if they stumble. It doesn’t happen all the time, but reliably enough both there and in the U.S. that we’re rarely at a loss for ideas by focusing on cyclical but temporary issues in a company’s business. June 30, 2011 We see you’ve owned on and off over time shares in chicken producer Sanderson Farms [SAFM], a classically cyclical business. Describe why something like that plays to your strengths. Craig Albert: The chicken business is very cyclical and the cycles are very short. The current industry downturn, for example, is the fifth one since 2003. The time to own a chicken company is when bad news is everywhere and most participants in the industry are losing money. Bad news is good news because losses inevitably lead to the production cuts necessary to bring supply and demand into balance, starting the up-cycle anew. Recently, the industry has suffered from the double-whammy of weak restaurant demand and soaring corn and soybeanmeal prices. This caused Sanderson's stock price to decline from close to $60 a year ago to under $40 early this year, when it was trading at around 8x our estimate of normalized earnings and at a more than one standard deviation discount to its normal valuation on a priceto-book-value basis. Our investment thesis – and we’ve seen this movie before – is that this was and is a temporary problem that will meanrevert. Chicken supply will be reduced and prices will improve. Sanderson will be a major beneficiary of this improvement because it is the best-capitalized, lowest-cost producer in the industry and therefore can hold out while its highercost competitors are forced to reduce production. Some of these dynamics have started to play out, but we still see upside from here. [Note: Sanderson shares currently trade around $47.] You’ve done a tremendous amount of work on cotton. Describe what prompted it, what conclusions you’ve drawn and how you’ve acted on them. Brian Feltzin, Craig Albert Nice Complement After becoming friends on a study-abroad program in London between their junior and senior years of college, Brian Feltzin and Craig Albert stayed in touch as they each eventually embarked on investment careers. Albert earned a law degree from NYU but turned to investing through stints at Sanford C. Bernstein & Co. and hedge fund firm Ospraie. Feltzin spent three years at real estate firm JMB Realty and then seven years working at a go-anywhere investment partnership started by his mentor from JMB, David Richter. They reconnected in early 2004 when Albert joined Feltzin's year-old Sheffield Asset Management. As in many enduring partnerships, each describes the other's greatest strengths as complementary to his own. As Feltzin explains: “I like the relationship aspect of business, so if we're looking at solving a problem in dissecting a company, I might think about who we know or who we can get to in order to try to develop an information and analytical edge. To do the same thing, Craig might tear apart the 10-K, dive into 10 years of analyst reports and lay out a massive spreadsheet. We team tackle a problem from multiple angles and like to believe we come to better answers because of it.” Value Investor Insight 10 I N V E S T O R I N S I G H T : Sheffield Asset Management CA: We consistently look to commodity markets as signals for ideas. Our interest in cotton stemmed from our due diligence on Carter’s [CRI], the children’s clothing company whose business and stock has been greatly impacted by high cotton prices. Spot prices earlier this year went above $2.10 per pound, against 10-, 20-, 30- and 40-year averages of around 65 cents. As we dug into it, we concluded that cotton was massively mispriced, maybe even a bubble of historic proportions. [Note: Current spot prices for cotton are now around $1.60.] We could talk about this for hours, but our basic conclusions are as follows: High cotton prices will cause substantial declines in cotton consumption as users cut back or readily switch to alternatives such as polyester and rayon. The inventory build-up that occurred across the supply chain in the past year is now reversing itself, as industry participants move into inventory-liquidation mode. Weather permitting, farmers will harvest record cotton crops in 2011. The combination of increased supply and reduced demand will move the cotton market to a large surplus position that will rebuild inventories to above-normal levels. Finally, this large surplus and substantial inventory position will drive cotton prices back toward their historic norm of around 65 cents per pound. From an investment perspective, it’s important that we clearly have a variant view, as virtually everyone we talked to in our due diligence was convinced that cotton demand would increase in the 2011-12 crop year. In addition to our holding in Carter’s, which we’ll speak about later, we have established a cotton-related long equity position in U.K. soft-drink maker Britvic [BVIC:LN], a basket of short equity positions in mostly Asian chemical companies that have benefited materially from substitution away from cotton to polyester, and a long position in put options on cotton futures. All will benefit nicely if cotton prices fall. What’s the cotton connection to Britvic? BF: Britvic is the Pepsi bottler in the U.K. and Ireland and owns three of the top five June 30, 2011 on-premise soft-drink brands in the U.K. The company’s margins have been hurt by rising prices for PET resin. PET stands for polyethylene terephthalate and it is not only the primary resin used to make plastic bottles – a significant cost factor for Britvic – but the chemicals used to make it are the same ones used to make polyester staple fiber, which is the primary textile substitute for cotton. Because of switching from cotton to polyester fiber, producers along the entire polyester chain, including PET-resin makers, have enjoyed substantial pricing power, with prices up 30% in 2011. You have standardized your research process to a certain extent. Describe what’s behind that? CA: It all stems from our formula for what constitutes a great idea. To avoid wasting time researching ideas that can't get into the portfolio, we focus from the outset on teasing out whether the stock in question meets our criteria. That means answering a standard set of questions, including: What happened to make the stock hated or neglected? Is it a temporary or permanent problem? Have we identified a material change that will cause fundamentals to improve? How imminent is that improvement? How capable is management? How sound is the balance sheet? Do we have a differentiated view on earnings? BF: We believe sourcing is central to our ability to outperform. This industry attracts talented, hard-working people who when faced with the same set of facts are fairly likely to come up with similar conclusions. That makes it important for us to be looking where others aren’t or before they get there. We think our criteria for what makes a good idea fosters that, and helps us filter the excessive information we have coming at us every day. Can you generalize about how you look at valuation? CA: We try to buy businesses that are cheap based on what they should earn across an economic cycle. Valuation support alone isn’t enough, so having imminent catalysts is an important part of our formula. In arriving at our view of intrinsic value, we typically look out two years and apply what we consider to be a normal multiple to normal earnings. We’re only interested if we believe there is 50% upside from our entry price as the temporary problem goes away over that time. Walk us through your investment case for Carter’s. BF: The company is the largest U.S. marketer of apparel for babies and young Value Investor Insight 11 ON COTTON: As we dug into it, we concluded it was massively mispriced, maybe even a bubble of historic proportions. When Britvic announced it was going to miss its guidance largely as a result of this input-cost pressure, the stock fell from 500 pence to 380 or so – about where it is today – which is only 10x trough earnings. We believe that’s an attractive valuation for a high-quality, stable business and given our view that cotton prices will correct, this temporary cost problem for Britvic should go away and the stock can trade at a normal multiple of normal earnings, which in our view would result in a share price of at least 550 pence. Do you tend to look for ideas in a particular market-cap range? BF: Our sweet spot tends to be in companies with market caps from $1 billion to $5 billion. Illiquidity in smaller-cap companies is fine for a portion of your book, but it’s nice to have the ability to change your mind and more easily sell if things don’t develop as you hoped. The largest companies can certainly be mispriced, but our ability to create an analytical edge given the number of people looking at them is more limited. I N V E S T O R I N S I G H T : Sheffield Asset Management children, sold under two of the mosttrusted names in the industry, Carter’s and OshKosh. The products are sold primarily through department stores and discount retailers, as well as through some 320 Carter’s and 180 OshKosh retail stores. The Carter’s brand is by far the company’s best business. Its principal products are essentially consumer staples for newborns, including bodysuits, pajamas, towels, washcloths and blankets. The core brand has increased revenues by 12% and operating profit by 21% annually over the past ten years. Even through the downturn the company kept intact its string of 21 consecutive years of sales growth. It’s not surprising that the price of cotton has been weighing on the stock, as roughly 85% of the company’s products are made of cotton and the cost of cotton accounts for 15-20% of its total cost of goods sold. So is the thesis as simple as cotton prices reverting to the mean? BF: That’s an important part of it, but we also see other upside options that we don’t believe we’re paying for at the current market price. One is store growth, as they continue to expand the number of Carter’s branded stores at 7-10% annually. Competitors Gymboree and Children’s Place operate more than 1,000 and 600 stores, respectively, so we believe Carter’s has plenty of runway here. Another opportunity the company is just now capitalizing on is building its online sales channel. Management expects Internet sales to hit 5% of total revenues before long, or $100 million, which we think is conservative. New moms are especially busy and timestarved and Carter’s is the trusted brand in the space, so we see no reason why it can’t generate at least 10% of revenues online as its competitors do. That of course won’t all be incremental, but we believe a decent portion of it will be. In addition to raw-materials costs declining, we see opportunities for cost savings on the sourcing side. Carter’s has June 30, 2011 historically relied on a company called Li & Fung in Hong Kong to identify and manage its contract manufacturers in China. However, management is now considering whether it makes sense to go direct to its manufacturing partners rather than through a middleman. Even if this just forces Li & Fung to sharpen its pencil to keep the business, it should result in cost savings for Carter's. With the shares now around $30.60, how are you looking at valuation? BF: If we assume store growth of 50 new outlets or so per year and a normalization INVESTMENT SNAPSHOT of cotton prices, we expect earnings before interest and taxes in 2013 of approximately $245 million. On an EPS basis, that translates to about $2.75 per share. At a reasonable historical and peer multiple of 13x, plus the $4 per share of net cash we expect the company to have at the end of 2012, our fair-value price target is around $40. That assumes no savings elsewhere on the cost side, no improvement in OshKosh’s financial metrics – which have been lagging and are in focus – and no incremental upside from online sales. Is being wrong on cotton the biggest risk? Carter’s (NYSE: CRI) Valuation Metrics (@6/29/11): Business: Designs, sources and sells – through owned and independent outlets – baby and children's clothing under brand names such as Carter's and OshKosh. Share Information (@6/29/11): Trailing P/E Forward P/E Est. CRI 13.3 17.3 S&P 500 15.8 12.8 Largest Institutional Owners (@3/31/11): Price 52-Week Range Dividend Yield Market Cap Financials (TTM): 30.58 22.19 – 32.88 0.0% $1.77 billion $1.81 billion 12.5% 7.5% Company Berkshire Partners Royce & Assoc Vanguard Group T. Rowe Price BlackRock Short Interest (as of 6/15/11): % Owned 11.4% 5.6% 5.0% 4.7% 4.6% 10.1% 35 30 25 20 15 10 Revenue Operating Profit Margin Net Profit Margin CRI PRICE HISTORY 35 30 25 20 15 10 Shares Short/Float 2009 2010 2011 THE BOTTOM LINE The market has been fixated on the company’s exposure to high cotton prices and seems to be ignoring its solid growth prospects, says Brian Feltzin. Assuming store growth of 50 new units per year and a normalization of cotton prices, he pegs 2013 EPS at $2.75, resulting in a fair-value price target – including dividends – of $40. Sources: Company reports, other publicly available information Value Investor Insight 12 I N V E S T O R I N S I G H T : Sheffield Asset Management CA: We actually don’t believe persistently high cotton prices would materially impact the long-term earnings power of the company. Carter’s brand equity is very strong – evidenced by its meaningful market share gains over time – so the company is in a good position relative to its peers to offset the impact of raw-material inflation, even if it might take more than one season to do so. Our experience with commodities in general gives us confidence that sharp increases in an industry’s costs that affect all producers relatively equally – which is the case here – can ultimately be passed on to the end customer in the form of higher prices. BF: One last positive item I’d add is that Berkshire Partners, a well-respected private equity firm that had taken Carter’s private in 2001, is back in the stock and has been buying very recently. They originally filed as a passive owner, but have since increased their position and filed a 13D, indicating they may attempt to take a more active role. Regardless of how that plays out, we like that they must see some of the same latent value here that we do. Turning to some European ideas, describe your interest in Italian industrial-cable maker Prysmian [PRY:IM]. CA: Prysmian is one of the world’s leading manufacturers of power and telecom cables. Its power cables are used in a variety of different applications, including transmission and distribution of electricity as well as power distribution in homes, buildings and industrial equipment. On the telecom side, it produces traditional copper cables as well as optical fibers used to transmit video, data and voice. The company is widely regarded as the most profitable, best-run company in its industry, stemming from a large-scale restructuring led by the current management team in the early 2000s and from its strategic focus on the fastest-growing, highest-value-added industry segments. With lower costs and a favorable product mix, its return on capital has averaged more than 25% over the past five years June 30, 2011 and operating margins have exceeded those of peers by approximately 400 basis points over the cycle. Our basic thesis is that the market is ignoring major catalysts that will cause earnings to double or possibly triple over the next few years. The biggest catalyst is Prysmian’s acquisition earlier this year of Draka Holding, the #3 cable-market player in Europe. This deal marries the low-cost producer (Prysmian) with one of the highest-cost producers (Draka) at the bottom of the cycle, which should result in major synergies and, importantly, improved pricing discipline across the industry. Management has committed to € 100 million in annual cost savings from the combination, but has expressed confidence that number could reach € 150 million. If Prysmian were able to capture INVESTMENT SNAPSHOT € 125 million in synergies, it would add roughly 35 euro cents per share to the earnings of the pro-forma company. An investor today also is paying nothing for recovery in the more cyclical parts of the combined company’s business. At Prysmian alone, operating profit in the cyclical, lower-value-added areas of its portfolio declined by some 60% between 2007 and 2010. If they were to recover just 50% of that decline over the next two years it would add another 30 euro cents per share to EPS. Lastly, the company's entry into the flexible-pipe business – in which its cables move underwater oil and gas production to the surface – is potentially a significant source of value. Its market entry is secured by a multi-year contract with Brazil's Petrobras, which guarantees it Prysmian (Italy: PRY:IM) Business: Milan-based producer of highly engineered cable products used in the global power, energy, telecommunications and construction-related industries. Share Information (@6/29/11, Exchange Rate: $1 = €0.69): Financials (2010) Revenue Operating Profit Margin Net Profit Margin Valuation Metrics (Current Price vs. TTM): € 4.57 billion 8.5% 3.3% Price 52-Week Range Dividend Yield Market Cap PRY PRICE HISTORY 20 € 13.73 € 11.55 – € 16.25 1.2% € 2.94 billion P/E PRY 18.1 S&P 500 15.8 20 15 15 10 10 5 2009 2010 2011 5 THE BOTTOM LINE Craig Albert believes the market is ignoring three catalysts – merger synergies, a rebound in the low end of the market and a growing flexible-pipe business – that could double or triple the company’s earnings over the next few years. At 10-12x his 2013 EPS estimate of € 2.50, the stock would trade at roughly twice its current price. Sources: Company reports, other publicly available information Value Investor Insight 13 I N V E S T O R I N S I G H T : Sheffield Asset Management € 120-130 million in revenues, at high margins, when the plant is fully operational in 2012. How do you see all that translating into earnings and share-price upside? CA: The two companies’ combined operating profit was just over € 400 million in 2010. If we assume € 125 million of realized merger synergies and another € 125 million from market recovery in its cyclical businesses, our EBIT estimate for 2013 is € 650 million. Running that through the rest of the P&L, taking into account things like integration costs, tax savings from the use of Draka’s net-operating-loss tax carryforwards and an estimated payment to the EU Commission relating to an antitrust investigation, our 2013 EPS forecast is € 2.50 per share. At a not-aggressive 10-12x earnings, that would make the business worth € 25-30 per share, roughly twice today’s price [of € 13.75]. Tell us more about this potential EU Commission fine. CA: Since 2009 the EU has been investigating whether Prysmian and its peers colluded in the high-voltage transmission-cable market. The way these large high-voltage projects typically work – similar to what you sometimes see in deepwater offshore drilling – is that cable suppliers will jointly bid on a project because the projects are too large for a single company to accept the entire order. The EU alleges that industry participants improperly shared information regarding pricing in their preparation of bids for these projects. Under EU rules, the maximum fine that Prysmian could be assessed is € 450 million, or about € 2 per Prysmian share. While we've spent significant time and resources investigating the likely outcome of this investigation, we frankly don't have a strong opinion on the outcome. But given the current gap between our estimate of intrinsic value and the current share price, this issue doesn’t at all change our conviction on the investment. The June 30, 2011 market clearly doesn't like the financial overhang and we think the resolution of the investigation, however it turns out, will be a major catalyst for the stock. What do you think the market is missing in Irish food company Greencore [GNC:ID]? CA: Like a lot companies in Ireland, Greencore historically was a mini-conglomerate that in order to find growth in such a small country had expanded into many different businesses. It was the country’s monopoly sugar provider. It had a malt business. It had a water business. Those are all gone and what’s left is a convenience-food company that provides fresh food-on-the-go and prepared meals – things like salads, sushi, sandINVESTMENT SNAPSHOT wiches, lasagna, etc. – to supermarkets and convenience stores primarily in the United Kingdom. These types of products are very popular in the U.K., where people make more shopping trips per week and are less inclined to stock up on frozen foods. There appear to be two primary knocks on Greencore today. One is that it’s a small-cap company sitting in Ireland, which is nobody’s idea of an attractive market. Second, the market believes that the convenience-foods business is a lousy one, with low barriers to entry and little pricing power due to the highly concentrated nature of the U.K. supermarket industry. Our view is that the market fundamentally misunderstands the conveniencefoods business, which we believe is actu- Greencore Group (Ireland: GNC:ID) Business: Manufacture and distribution of prepared foods and related products sold to commercial vendors as well as through convenience and grocery stores. Share Information (@6/29/11, Exchange Rate: $1 = €0.69): Financials (2010) Revenue Operating Profit Margin Net Profit Margin Valuation Metrics (Current Price vs. 2010): € 856.0 million 7.0% 2.9% Price 52-Week Range Dividend Yield Market Cap GNC PRICE HISTORY 2.50 2.00 1.50 1.00 0.50 € 0.99 € 0.99 – € 1.48 7.6% € 207.1 million P/E GNC 8.5 S&P 500 15.8 2.50 2.00 1.50 1.00 0.50 2009 2010 2011 THE BOTTOM LINE The company’s prepared-foods franchise is a better business than the market seems to believe, says Craig Albert. As it takes share in a growing market at home and becomes profitable for the first time in the U.S., the company can earn 19 euro cents per share in 2012, he says. With a 10x multiple, that would result in a share price of € 1.90. Sources: Company reports, other publicly available information Value Investor Insight 14 I N V E S T O R I N S I G H T : Sheffield Asset Management ally a good business if one does it well, as Greencore does. There are many different skills required to produce and deliver high-quality, freshly prepared, good-tasting food consistently on a daily basis across the country – in sourcing, logistics, quality control and manufacturing efficiency. While it’s true that four supermarket chains in the U.K. dominate the market, they will pay for value-added services when provided. As the lowest-cost and best operator, Greencore earns around 7% operating margins. As for the competitive set, many of the other publicly traded players in the market have struggled. But over the past several years the supply/demand balance has improved and pricing has stabilized. Further, there has been recent consolidation in the industry and we expect more to come. As the low-cost market leader, Greencore should benefit from that consolidation whether it is an active participant in it or not. Are there organic growth opportunities? CA: Despite the negative perception of the industry, the prepared-foods market in the U.K. is actually growing in the mid to low single-digit range, as time-starved people turn to convenience foods. As competitors retrench, Greencore has also had some significant new-business wins and thus is gaining market share. Also interesting is the company’s investment in the U.S., built around its 2008 acquisition of a company called Home Made Brand Foods in Massachusetts. After roughly $50 million in total investment to-date, management expects the business to be breakeven in 2011 and to start earning comparable margins to the U.K. business in 2012. If that happens it would highlight the U.S. as a source of significant value within the company, something which we don't believe the market is pricing in at all today. At a recent €1, how cheap do you consider the shares? CA: Last year the business earned 16 euro cents per share in net income and we June 30, 2011 think with growth of the overall market, growth in market share, and improvement in the U.S., that number will be more like 19 euro cents by 2012. After making adjustments for unfunded pension liabilities, the stock trades at only 6x our 2012 earnings estimate. If we’re right on our estimate, a 10x multiple would be more appropriate, which would result in a stock price closer to € 1.90, 90% above today’s level. We believe Greencore is well-positioned to lead further industry consolidation. Last year it agreed to merge with competitor Northern Foods, but ultimately lost a bidding war for that asset. There are other opportunities on the horizon – including Uniq plc, which is for sale – so we’re optimistic this could be another source of value creation over the next INVESTMENT SNAPSHOT few years for the company. Our price target includes no value for that. Describe the potential you see in fellow Irish company C&C Group [GCC:ID]? BF: This is a company that attracted our attention in 2009 as a turnaround story when the board brought in new management from a much larger competitor and incented them with a private-equity-like compensation structure that aligns management’s interests with shareholders and encourages them to realize any value they create rather than empire-build. The primary business is alcoholic cider, under the Magners and Bulmers brands. They also have a beer business, the crown jewel of which is the Tennent's brand, which is the dominant lager in Scotland. C&C Group (Ireland: GCC:ID) Business: Manufacturer, marketer and distributor primarily in the United Kingdom of beer and alcoholic cider, the most popular of which is sold under the Magners brand. Share Information (@6/29/11, Exchange Rate: $1 = €0.69): Financials (FY2011) Revenue Operating Profit Margin Net Profit Margin Valuation Metrics (Current Price vs. TTM): € 529.6 million 19.0% 15.1% Price 52-Week Range Dividend Yield Market Cap GCC PRICE HISTORY 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 2009 € 3.53 € 3.00 – € 3.69 1.9% € 1.19 billion P/E GCC 13.9 S&P 500 15.8 4.00 3.50 3.00 2.50 2.00 1.50 1.00 2010 2011 0.50 THE BOTTOM LINE Obscured by a difficult economic environment, the company has made great strides in repositioning its products, expanding distribution, improving marketing, and pricing more effectively, says Brian Feltzin. He believes the endgame for the company is its sale to a large multinational – at a better-than 50% premium to today’s share price. Sources: Company reports, other publicly available information Value Investor Insight 15 I N V E S T O R I N S I G H T : Sheffield Asset Management Since we made our initial investment in the company, management has made substantial progress on several fronts. It has divested a non-core spirits business and completed two strategic acquisitions that broaden the portfolio and deepen the company’s trade relationships. It has also invested in sales and distribution, overhauled marketing with more segmented advertising, introduced new products like pear cider, and started pricing more strategically, which in some cases meant lowering selling prices. What exactly is alcoholic cider? CA: Cider across the U.K. was historically known as a drink for “youths and vagabonds,” but C&C and others were very successful in turning it into more of a premium category by lowering the alcohol content, improving the taste – which is basically like regular apple cider – improving the packaging and promoting it as something to drink “over ice” in a pint glass. It’s considered a more natural alternative to beer and is the rare alcoholic drink that seems to appeal equally to both men and women. Cider as a category is growing nicely in C&C’s home markets – 5% annually in the U.K., for example. The stock, at a recent €3.50, doesn’t appear to have been going gangbusters. BF: The economic environment certainly hasn’t helped, but we believe that is masking latent earnings power as the top line starts growing again. When over-ice cider sales were peaking in 2007, prior management doubled the size of the company’s Clonmel, Ireland manufacturing facility, which is now operating far below capacity. That fact plus other moves the company has made to better align costs with current revenues tells us that C&C’s incremental margins are much higher than what they’re earning today. Assuming overall growth in the market and modest market-share gains from the improved product mix and distribution, we believe the company this year can generate 30 euro cents in EPS. That June 30, 2011 means the shares trade at only 12x what is still a below-normal earnings level. Longer term – which we define as after management’s options-vesting period expires in December 2011 – we think the end game here is that C&C is sold to a large multinational alcoholic-beverage company. The cost synergies would be significant and every asset the company owns would benefit on the revenue side from being plugged into a more extensive distribution system. Given those synergies and prices paid for comparable acquisi- that same depth of macro analysis in a pre-financial-crisis letter? BF: We like a lot of people have been trained to be bottom-up stock pickers and not worry about the market. The fact is, however, that most of the risks we see today in our individual ideas are macro in nature, so as stewards of capital we ignore those risks at our peril. Summarize some of your conclusions. BF: This has already somewhat started to play out, but our main conclusion was that U.S. and global consumers could not absorb $110-per-barrel oil, $2-per-pound cotton, $7-per-bushel corn, $900-per-ton steel, etc. without reducing their consumption. At the same time, the expiration of the Fed’s QE2 program this month and its lack of viable policy alternatives was unlikely to result in a positive environment for equities. In response, we adjusted our portfolio positioning in an effort to profit substantially from our cautious view while trying to limit our losses if we were wrong. We reduced our gross exposure from 95% to 75% and our net exposure from around 35% to 25%, near the low end of our typical ranges. We reduced or fully exited our most U.S.-GDP-sensitive longs. We increased the position sizes of our highest-conviction longs. On the short side, in addition to our cotton-related shorts, we’ve sharply increased our positions in a variety of retail and restaurant stocks, representing the more discretionary areas of consumer spending. We’re curious how you’ve informed your broadened focus on all things macro. BF: It’s not really any different than the work you do to inform yourself about a company or an industry. You read. You talk to people. You learn from the companies you own. You subscribe to the best services in the field, such as ISI, GaveKal, Empirical and Bianco. It clearly takes time and energy to do it right, but to do otherwise today strikes us as a big mistake. VII Value Investor Insight 16 ON MACRO ISSUES: The fact is that most of the risks we see in our individual ideas are macro in nature, so we ignore them at our peril. tions in the past, we estimate the company’s private market value at around € 5.50 per share. You bought shares in Home Depot [HD] during the financial crisis, but have since sold. Does that say anything about your views on the U.S. housing market? CA: I wouldn’t say we have any particular insight on the timing of the housing recovery. When we bought Home Depot we liked the duopoly structure of its market and thought it had a lot of levers to pull in its restructuring under a new CEO. During the worst of the crisis, the market was pricing the stock as if there would be no recovery ever. When we sold it last summer, the recovery was priced in but we didn’t have an opinion on when it would actually arrive. Since we were no longer getting the improvement to a normal environment for free, we recycled the money into ideas we thought offered more upside. In your latest investor letter you described defensive portfolio moves you were making based on concerns about inflation and economic growth. Would we have seen U N C O V E R I N G V A L U E : Ocean Rig In Deep The little-known but well-positioned player in what is expected to be a dynamic and growing global market can be an investment gem – which is what Evan Claar is betting on with drilling contractor Ocean Rig. Operating an offshore drilling rig at water depths of several thousand feet and often in terrible weather is no simple task, as BP’s Deepwater Horizon disaster last year in the Gulf of Mexico made abundantly clear. Yet as complicated as the drilling is, the analysis involved in investing in companies that provide such rigs can be surprisingly straightforward. Not easy, mind you, but the key decision points are quite clear. Take the case of Ocean Rig, the Cyprus-based operator of giant, modern drillships used in deepwater and extremeweather drilling, four of which are currently operating and two more of which are planned for delivery by September. Taken private by then high-flying drybulk shipper DryShips [DRYS] in 2008, shares of Ocean Rig were refloated last December on Norway’s over-the-counter market, with DryShips retaining a 78% ownership stake. A U.S. Nasdaq listing is currently planned for August. With only six products “for sale,” the crux of the analysis on Ocean Rig centers on prospective supply and demand for deepwater rigs and how that will impact capacity utilization and rental day-rates. Once those assumptions have been made – often with high visibility due to longerterm contracts – it’s relatively easy to calculate the company’s resulting estimated profitability. Count Evan Claar of New York’s CBI Capital as bullish on both the industry’s and Ocean Rig’s prospects. Ultra-deepwater energy production today accounts for maybe 5 million of the 85 million barrels of oil equivalent [BOE] produced worldwide on average each day, he says, but the absolute and relative number of BOEs coming from it over the next decade is likely to increase sharply, as production in such relatively unexplored areas has to ramp up to meet increased overall demand and to offset natural declines in existing production. June 30, 2011 While demand for the sophisticated equipment required to deliver this new production increases, the supply is likely to remain somewhat constrained. It takes more than 30 months to produce the highest-end units and manufacturers such as Samsung Heavy Industries and Keppel FELS have the capacity today to produce a total of only 25-30 new units per year, many of which have already been contracted out before delivery is made. Next year, counting planned new deliveries that aren’t yet rented out and existing drillships that come off contract, Claar says INVESTMENT SNAPSHOT that, at most, 25 rigs will be available for rental. Against that, he counts 41 projects currently looking to procure rigs. “There’s simply not enough supply to go around right now,” he says. That translates into a very positive pricing market. All of Ocean Rig’s drillships have been contracted through at least 2012 at day-rates averaging around $500,000. Assuming $150,000 per day in operating expenses, 95% total capacity utilization for the company’s six rigs for the year, and $75 million in overhead costs, Claar says that should result in Ocean Rig (Oslo OTC: OCRG) Business: Cyprus-based owner and operator of state-of-the-art drilling rigs contracted out to oil majors for ultra-deepwater and extreme-weather energy exploration. Share Information (@6/29/11, Exchange Rate: $1 = NOK 5.45): Financials (Est. 2012): Revenue EBITDA Profit Margin Net Profit Margin Valuation Metrics (Current Price vs. 2012 Est.): $1.04 billion 62.5% 27.7% Price 52-Week Range Dividend Yield Market Cap NOK 99.00 NOK 99.00 – NOK 125.00 0.0% NOK 13.04 billion Forward Est. P/E OCRG 8.3 S&P 500 15.8 OCEAN RIG PRICE HISTORY 130 125 120 115 110 105 100 95 2009 2010 2011 130 125 120 115 110 105 100 95 THE BOTTOM LINE Once its full cash flows move from prospective to actual, its stock lists in the U.S. later this year and it starts paying a dividend next year, Evan Claar believes the company can earn the $950 million per-rig valuation currently accorded larger and more established peers. At that valuation level, the shares would trade for around NOK 185. Sources: CBI Capital, company reports, other publicly available information Value Investor Insight 17 U N C O V E R I N G V A L U E : Ocean Rig some $650 million in EBITDA for the company in 2012. How should that translate into share value? The company’s stock at a recent 99 Norwegian kroner currently trades at 6.5x that estimate of EBITDA on an enterprise value basis, which adds roughly $1.8 billion in projected year-end net debt to the current market capitalization. Claar believes it’s reasonable to assume the company – once its full cash flows move from prospective to actual, its stock lists in the U.S. and it starts paying a dividend next year – can earn the $950 million per-rig valuation currently accorded larger and more established competitors like Seadrill. At that level – assuming no change in the asset base – Ocean Rig shares within the next two or three years would trade for around 185 kroner. The key risks? One is another large BP-type disaster that either directly affects Ocean Rig or causes temporary or permanent changes in the oil majors’ ability to hunt for oil offshore. While clearly a risk, says Claar, he argues that height- ON THE BP SPILL’S IMPACT: Oil majors don’t want to be seen as more cost-conscious than safety-conscious. That increases new-rig demand. ened sensitivity after the BP spill has worked somewhat in Ocean Rig’s favor. “Oil companies don’t want to be seen as more cost-conscious than safety-conscious,” he says. “That increases the demand for new, safer rigs and the price they’re willing to pay.” The second big risk is that the company’s fortunes are closely tied to the price of oil, although he believes oil prices would need to stay below $80 for an extended period of time for the day-rates Ocean Rig is earning to materially decline. One back-door way to own the company’s shares would be through publicly traded DryShips, whose CEO, George Economou, also calls the shots at Ocean Rig. DryShips’ 78% stake in Ocean Rig is currently worth some $2 billion, while its own market cap – after a vertigo-inducing fall in its share price from as high as $120 pre-crises to around $4 today – is only $1.4 billion. That seeming bargain brings with it a leveraged-to-the-hilt company operating in a terrible competitive environment in drybulk shipping. “It’s technically a cheaper way in,” says Claar, “but you have to have a very strong stomach for what’s happening in that market.” VII Your Guide Through Perilous Seas Subscribe now and receive a full year of Value Investor Insight – including weekly e-mail bonus content and access to all back issues – for only $349. That’s less than $30 per month! Subscribe Online » Fax-in Form » Mail-in Form » Want to learn more? Please visit June 30, 2011 Value Investor Insight 18 O F S O U N D M I N D : Self-Control Good Things Come ... Value investors know all about the importance of self-control and its corollaries of patience, perseverance and long-term thinking. Right? But the temptations to behave differently are always out there. In a landmark Stanford University study started more than 40 years ago, psychologist Walter Mischel devised a deceptively simple test of four-year-olds' self-control. Each child was escorted into a small gameroom and allowed to pick one treat from a tray of marshmallows, cookies and pretzel sticks. The researcher then offered the child a choice: eat the treat right away, or don't eat it and wait until the adult returned, at which point they could have another treat and eat them both. Video footage of the experiments is fascinating, as the children visibly struggle with the decision. In the end, only about 30% held out for the delayed, extra gratification of an additional treat. When the 650 study participants were in high school, Mischel sent out detailed questionnaires to their parents, teachers and academic advisors. From the responses, he found clear evidence that the subjects who as four-year-olds had been able to delay gratification had fewer behavioral problems and were higher academic achievers. Their SAT scores, for example, were an average of 210 points higher. Similar research efforts have produced comparable results: One Duke University study of more than 1,000 subjects tracked over 30 years – after controlling for IQ and socioeconomic status – showed that children with the least self-control at a young age had more frequent health issues, more financial problems and were more likely to have trouble with the law. The patient children in the studies ultimately were more successful in using reason to control their impulses. Rather than focusing on the “hot stimulus” of eating a marshmallow now, they were able to focus on the longer-term goal of getting two marshmallows and devised various strategies to resist immediate temptation. Some sat on their hands. Others pretended to play hide-and-seek under the desk. Still others paced the room singing their favorite songs from Sesame Street. As June 30, 2011 Mischel, now a Columbia University professor, recently recounted in an interview in The New Yorker: “If you can deal with hot emotions, then you can study for the SAT instead of watching television. You can save more money for retirement. It's not just about marshmallows.” In adults, this ability to manage emotions successfully and remain focused on longer-term goals often comes down to being aware that those emotions are at work. Here's how author Jonah Lehrer explains it in his first-rate book on decision-making, How We Decide: “How do we regulate our emotions? The answer is surprisingly simple: by thinking about them. The prefrontal cortex allows each of us to contemplate his or her own mind, a talent psychologists call metacognition. We know when we are angry; every emotional state comes with self-awareness attached, so that an individual can try to figure out why he's feeling what he's feeling. If the particular feeling makes no sense, then it can be discounted – the prefrontal cortex can deliberately choose to ignore the emotional brain.” Overt defensive strategies can also blunt emotions’ impact. In Greek ogy, Ulysses knew the sirens' song would entice him to follow them, which he also knew was a bad idea. Recognizing his weakness, he instructed his sailors to tie him to the mast when they starting singing. In an investment context, such defensive strategies might mean committing never to make an emotionally charged buy-or-sell decision without sleeping on it first or going through a checklist of critical questions to always answer. A further check on emotions unduly affecting decisions is to foster a decisionmaking environment in which a diversity of viewpoints is freely shared. In How We Decide, Lehrer describes how the advent of “Cockpit Resource Management” [CRM] principles have contributed to a significant decline in pilot error in airplane emergencies. Rather than defer to the pilot in all circumstances, CRM calls for constant communication among flight-crew members, shared responsibility for catching errors and the obligation of all to make dissenting opinions known. “Bad decisions happen when the mental debate is cut short,” writes Lehrer, “when an artificial consensus is imposed on the neural quarrel.” Value investors, of course, know all about the importance of self-control and its corollaries of patience, perseverance and long-term thinking. But the temptations to behave differently are always out there – keeping the population of traditional value investors in check. As Joel Greenblatt once put it: “Value investing strategies have worked for years and everyone's known about them. They continue to work because it's hard for people to do, for two main reasons. First, the companies that show up on the screens can be scary and not doing so well, so people find them difficult to buy. Second, there can be one-, two- or three-year periods when a strategy like this doesn't work. Most people aren't capable of sticking it out through that.” VII Value Investor Insight 19 EDITORS’ LETTER Hitting Refresh We’re asked from time to time how the stocks featured in Value Investor Insight by specific investors have fared since appearing in the newsletter. It's a legitimate question and we meticulously track it as best we can. We know, for example, that had one bought an equally weighted portfolio of the four stocks recommended by James Crichton and Adam Weiss of Scout Capital at then-current prices in our December 2, 2010 issue – Verisk Analytics, Coca-Cola Enterprises, Sensata Technologies and QR National – the portfolio would be up 23.6%, not counting dividends. The comparable rise over that time in the Russell 3000: 8.1%. As satisfying as it is to report such performance, the big flaw in any such analysis is that it requires an assumption about whether or when the recommended stocks are sold. Whether the analysis of intrinsic value turns out to be right or wrong, it may take years for that to become clear or it may happen in three months. Making a call on that is obviously of comparable importance to the buy decision in determining the success of any investment. If after doing your own work you end up buying something an investor Value Investor Insight™ is published monthly at (the “Site”), by Value Investor Media, Inc. Chairman and Co-Editor-in-Chief, Whitney Tilson; President and Co-Editor-in-Chief, John Heins. Annual subscription price: $349. ©2011 by Value Investor Media, Inc. All rights reserved. All Site content is protected by U.S. and international copyright laws and is the property of VIM and any third-party providers of such content. The U.S. Copyright Act imposes liability of up to $150,000 for each act of willful infringement of a copyright. has recommended in VII, that sell call necessarily has to be your own. We bring all this up because in reviewing Scout Capital's 13F filing for 2011's first quarter we noticed that Weiss and Crichton had sold their entire stakes in two of the stocks they'd highlighted in VII, Verisk Analytics and Coca-Cola Enterprises. They had owned each stock for a year or less and made well-reasoned, in-depth arguments for their continued long-term upside. The share price of each was up, but not markedly since the issue date. What had changed? In this case, not much, as Adam Weiss explains: “There is nothing negative we'd say about either company. Sometimes we sell when we've been right, sometimes we sell when we've been wrong, and sometimes we sell because there are four more things that became more compelling. That is what happened here. There's a common expectation that people who do primary research in the depth we do to arrive at their own fundamental view of what value is over a three- to five-year time horizon should hold the stocks for that long. That can happen, but the reality is it often doesn't work out that way.” In other words, timing can be everything: “When we first bought Coca-Cola Enterprises [in February 2010 when it announced a dramatic restructuring in a transaction with parent Coca-Cola] we believed it was at a special moment in its history. Same thing with Verisk, which we first bought when its property/casualty insurer owners took the company public in an IPO. I would stress that we could get back into either of them at any time, but when we looked at our portfolio during the first quarter, we felt we had other, fresher ideas more in the early innings of the market's misunderstanding than the middle innings, and we will consistently make that swap.” Brilliant reporters that we are, we asked Weiss if he'd share one or two of the new ideas with us. Scout is still assessing and accumulating those positions, he says, “so call me back in two weeks.” Will do. VII John Heins Co-Editor-in-Chief Whitney Tilson Co-Editor-in-Chief Always on the lookout for better investment ideas? Subscribe now and receive a full year of Value Investor Insight – including weekly e-mail bonus content and access to all back issues – for only $349. That’s less than $30 per month! Subscribe Online Mail-in Form Fax-in Form Subscribers may download Site content to their computer and store and print Site materials for their individual use only. 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