Value Investor Insight · he sees mispriced value in Penn West Energy, Saks Inc., Vinci and...

After several years pursuing in paral-lel his dual interests of medicineand investing, Ken Shubin Stein

hung up his stethoscope for good in 2000 tomanage money full-time. “I enjoyed medi-cine very much,” he says. “But I justenjoyed investing too much not to make acareer out of it.”

Investors in Shubin Stein’s SpencerCapital Management have reaped therewards of that career decision. SinceNovember 2000, they’ve earned a net24.1% compounded annually, vs. an annual2.1% loss for the S&P 500.

Shubin Stein’s rigorous research processis unearthing many opportunities today,including those in big-name corporateunderachievers as well as in companies hesees as potential hidden gems. See page 10

I N V E S T O R I N S I G H T

Ken Shubin SteinSpencer Capital Management

Investment Focus: Seeks companies forwhich temporary events obscure near-termprospects but do not materially affect long-term earnings power.

ValueInvestor February 28, 2006

Hating to LoseTo successfully buck the consensus you first have to fully understand what theconsensus is. That’s how Jon Jacobson and Highfields Capital excel.

After a successful run trading optionson Wall Street, Jon Jacobson got hisfirst portfolio to manage at Harvard

University’s investment company in 1990.“Back then you couldn't raise money with-out a track record,” he says. “But they werewilling to give me $100 million to managethe day I walked in the door.”

An excellent decision. When he leftHarvard in 1998 to start Highfields Capital,Jacobson had turned that initial stake andan added $200 million into $1.6 billion.Since starting Highfields, which now man-ages $8 billion, he and partner RichardGrubman have earned a compounded15.4% annually, vs. 4.4% for the S&P 500.

Valuation “dislocations” remain plenti-ful, says Jacobson, who’s finding opportuni-ty in Europe, energy and media. See page 2

Inside this IssueF E ATU R E S

Investor Insight: Jon JacobsonChallenging conventional wisdomon Penn West Energy, Saks Inc.,Vinci and Lagardere. PAGE 1 »

Investor Insight: Ken Shubin SteinLooking beyond the clouds at FootLocker, Tyco, Resource America andNewkirk Realty Trust. PAGE 1 »

Uncovering Value: SuperInvestorsRecent superstar-investor trades showthat finding value in brand-namestocks is catching on. PAGE 18 »

Behind the Numbers: Hedging IIWhy a one-time short-selling starthinks the deck is overly stackedagainst the practice today. PAGE 20 »

Of Sound Mind: Traits of the GreatWhat truly sets the great investorsapart from the crowd? PAGE 22 »

Editors’ LetterThe battle lines are drawn overshareholder activism. PAGE 23 »

I NVESTM E NT H IG H LIG HTS

Other companies in this issue:

Altria, Apollo Real Estate, Circuit City, CKE

Restaurants, Comcast, ConocoPhillips,

Corning, Covanta, Davita, DirecTV, General

Electric, International Coal, Knight-Ridder,

McDonald’s, Microsoft, Morgan Stanley,

Pfizer, Reliant Energy, Time Warner,

Vornado Realty, Wal-Mart, Winthrop Realty

Surgical PrecisionMaking smart subjective judgments first requires objective analysis of the infor-mation at hand – a particular strength of Spencer Capital’s Ken Shubin Stein.

I N V E S T O R I N S I G H T

Jon JacobsonHighfields Capital Management

Investment Focus: Seeks companiestrading at very low historical or competitivevaluations – for reasons that are both fullyunderstood and changeable.

The Leading Authority on Value Investing INSIGHT

www.valueinvestorinsight.com

INVESTMENT SNAPSHOTS PAGE

Foot Locker 12

Lagardere 8

Newkirk Realty 15

Penn West Energy 5

Resource America 14

Saks 6

Tyco 13

Vinci 7

http://www.valueinvestorinsight.com

Having started out as an options trader,describe how your value-investing stylehas evolved?

Jon Jacobson: I recognized that the mar-kets were divided between those doingfundamental analysis and applying itonly to buying stocks, and “quants”looking at mathematical relationshipsacross different securities with no senseof fundamentals. It seemed to me therewas an opportunity to combine the twoto create investments that had asymmet-ric risk-reward characteristics and prob-ability distributions with positiveexpected values.

We don’t have any discernible edgedetermining whether IBM’s earnings aregoing to beat the Street by a nickel, orwhether the multiple should be 16, 18 or20. We don’t know where the price of oilis going or whether small-cap stocks aregoing to outperform large caps. Thesethings are really unknowable and unpre-dictable. But there are a wide variety ofsituations in which there are dislocations– like mergers, spinoffs, short-term badnews, legal issues – where we think weunderstand why there might be a hugedisconnect between supply and demandfor a given security. Then if we can ana-lyze what the true value of the business isand look across all the different securitieson a company’s balance sheet, we may beable to find something that’s mispriced.

It’s analogous to going to Las Vegason Super Bowl weekend and betting onthe game. By definition, the line on theSuper Bowl is the most efficient on theboard. Every piece of information iscompletely disseminated and the line isset by all the buyers and sellers comingtogether, of which there are thousands.The best bet on the board in Las Vegas ismuch more likely to be on a gamebetween two college teams for whichmost people couldn’t name the coach,

any of the players, or even the team nick-names. But if you know one of the bestplayers on a team is hurt, or that oneteam got in at 4 o’clock in the morningbecause there was a snowstorm – and therest of the market doesn’t know that –you have an edge making that bet.

What other sources of pricing dislocationdo you tend to see?

JJ: We often see it in holding companies,where there are several disparate busi-nesses and a single earnings multipledoesn’t capture the true value. Or in com-panies that own a significant asset thatmay not currently be earning anythingbut is quite valuable.

Another is in companies – or evenindustries – that can trade at big dis-counts to their inherent growth ratesbecause of the perception that the earn-ings are highly cyclical.

A perfect example of that is the home-building stocks over the past five or sixyears. They’ve always traded at 8x earn-ings because the market views the busi-ness as highly cyclical. But homebuildershave been growing earnings at 25% peryear for as long as I can remember. At theslightest sign of softness, investors havedeclared the cycle to be over. At somepoint they will be right, but the reality isthat they’re running the businesses differ-ently and it’s more of a disciplined manu-facturing business than it was historically.

Another good example is gaming. Forquite a long time, the market valued gam-ing companies at 5-6x EBITDA, whilehotel companies traded at double that.That didn’t make sense. Gaming is a bet-ter business – you have profitable desti-ination hotels with lots of services com-bined with a casino, where the marginsare better than almost any business youcan think of other than money manage-ment. This fundamental disconnect has

I N V E S T O R I N S I G H T : Jon Jacobson

Investor Insight: Jon JacobsonJon Jacobson of Boston’s Highfields Capital explains why he thinks energy stocks today are like those of homebuildersfive years ago, why outsized private-equity-firm returns gall him, how hating to lose differs from loving to win and whyhe sees mispriced value in Penn West Energy, Saks Inc., Vinci and Lagardere.

Value Investor Insight 2February 28, 2006 www.valueinvestorinsight.com

Jon Jacobson

Aligning Interests

You couldn't ask for a better referral thanJon Jacobson received from HarvardManagement Co. upon leaving the firm in1998. Among the $1.5 billion he initiallyraised for Highfields Capital, $500 millioncame from Harvard. “Jack Meyer's style isthat if he trusts you, there's no furtherquestion,” says Jacobson of HarvardManagement's long-time CEO, who him-self left last year to start his own privateinvestment firm.

“Hooked” by Wall Street’s lure while work-ing at Philadelphia’s Options Exchangeduring his senior year at the Univeristy ofPennsylvania, Jacobson worked at MerrillLynch and Lehman Brothers before andafter earning a Harvard M.B.A. He joinedHarvard Management in 1990, attractedby its “cutting-edge” use of derivativesand its willingness to let him manage hisown portfolio.

“In Jack Meyer’s system, the interests ofthe organization and the people in it wereperfectly aligned,” says Jacobson. “That'sbeen a huge influence on me. It works inasset management, in parenting, in run-ning companies. Whenever we identify amanagement problem, almost 100% oftime it's because management interestsare not aligned with the interests ofshareholders.”


dissipated as both private and public mar-ket valuations for gaming assets haveincreased dramatically.

Are there any sectors currently exhibitingthese kinds of disconnects?

JJ: Near the end of 2004 we started see-ing a huge disconnect between the for-ward prices in oil and gas futures mar-kets and how the oil and gas companyequities were being priced. Given that,we came up with a methodology to valuethe companies, which basically consistedof comparing where they were tradingrelative to the net asset value you’d get ifyou assumed you put the whole companyin run-off and liquidated their provenreserves, hedging everything forward,and then assumed some terminal valuesix or seven years out. It was harder, butwe also tried to figure out how those val-uations compared to what they’d beenhistorically.

What we found was that, as a sector,the exploration and production compa-nies in particular where trading at thehighest discounts to net asset value sinceBoone Pickens made a run at Gulf Oil inthe early 1980s. Given the lack of explo-ration success most of the major oil com-panies have had, we were convinced thatthe magnitude of these discounts could-n’t persist. Either the market would rec-ognize it, or M&A activity would rectifyit as companies saw it made more senseto buy oil reserves on the floor of theNYSE than drill for it. We’ve actuallyhad a combination of both those thingsstart to happen.

How have you picked the specific compa-nies to bet on?

JJ: We started by visiting most of thecompanies to develop a clear point ofview on how good their assets are, whatkind of operators they are and, veryimportantly, how they think about capi-tal. For example, we’d ask managementwhere they thought prices were going andthey’d say, “Lower.” So then we’d askwhy they weren’t hedging forward alltheir production given the high prices

they could get at the back end of the for-ward market. Then they’d say, “Well, wecould be wrong. We’re risk averse.” Sowe’d say, “If you’re risk averse, youshould be hedging.” It made no sense.

Through all that we developed a pointof view in terms of the quality of theassets and management teams. We devel-oped the capability to track in real time

how each company is valued both in anabsolute sense and relative to each other.Over time, the ones we’ve owned haveshifted as valuation gaps have closed andothers relatively have opened.

Where do you see the opportunity now inenergy?

JJ: It’s shifted somewhat. The companieswe originally bought were the big explo-ration and production companies likeKerr-McGee, Pioneer Natural Resources,Devon Energy and Burlington Resources,which have all moved to much higher per-centages of their net asset values or beenacquired.

Now we see more opportunity in thebig integrateds, which have bothresources and refining businesses. Weinvested in ConocoPhillips [COP] in thefourth quarter of last year, taking advan-tage of the fact that the market hated itsagreement to buy Burlington Resources.One can argue whether the acquisition isthe best use of capital, but from a strate-gic perspective, Burlington gives Conocoa significant presence in U.S. onshorenatural gas and the combined company isexceptionally cheap – our model has it at67% of NAV and only 6x next year’searnings – particularly given the qualityof the assets. That’s a huge margin ofsafety. These companies have historically

traded near the market multiple – I’m notsaying they should trade at that rightnow, but there’s a lot of room between6x and 19x. I see this as analogous tobuying Toll Brothers, the homebuilder,five years ago.

What about the downside if oil pricesplunge?

JJ: We’re not making any bet on the priceof oil. If we had a legitimate view on that,we should just trade the commodity andnot complicate it by investing in stocks.There are deep, liquid energy futures mar-kets going out five or six years with pricesset by all the players in the market. Ourview about energy prices is not going tobe better than that. There is some art tohow we do it, but we hedge against pricesplunging by shorting the commodity.Our bet is that the inherent disconnectbetween the price of the stocks and theprice of oil will close, not that prices willgo up or down.

What does it take to be good at identifyingdislocations between price and value?

JJ: One of the biggest things we strugglewith in training people is driving homethe fact that you cannot have an opinionabout an investment unless you reallyunderstand what the consensus is and arethen able to articulate why the consensusis wrong. If you think what everybodyelse thinks, it’s already priced in. Back tobetting on the Super Bowl, why isPittsburgh being a 4-point favorite thewrong line if you want to bet on Seattle?You may not have to know if you’re bet-ting for fun on Sunday, but you sure bet-ter know if you’re making decisions with$8 billion of your clients’ money.

Warren Buffett has made the pointmany times that being contrarian reallyisn’t the full answer – it’s having convic-tion in your own opinion and filtering outthe noise. If the market happens to beright, being a contrarian for the sake ofbeing a contrarian isn’t a very good strat-egy. You have to have the discipline tostick to the situations where you have anedge and sit out the rest of them.



ON CONSENSUS OPINION:

You cannot have an opinion on

an investment unless you

understand the consensus and

can articulate why it’s wrong.


You also have to be able to swing thebat when the pitches are fat. We’re not asconcentrated as some of the investors forwhom I have the most respect, like SethKlarman at Baupost or Glenn Greenbergat Chieftain, but we generally only own40 to 50 positions at a time. Our topideas have to be better places for us to putan incremental dollar than our 51st-bestidea. That mutual fund managers runportfolios with 300-500 stocks justmakes no sense to me.

Where do you find good ideas?

JJ: Absolutely everywhere. We look at allthe usual valuation screens to identifystocks that are cheap relative to bookvalue, earnings and cash flow. We look atthe new-lows list for long ideas and thenew-highs list for short ideas. I’m inter-ested in companies whose margins aresignificantly higher or lower than they’vebeen historically. I look at the 13F filingsof 20-25 other investors I respect to seewhat they’re buying and selling. Also,Bloomberg on a monthly basis has thehighest-ranked and lowest-ranked stocksby sell-side analysts. I look at the lowest-ranked for buying opportunities and thehighest-ranked for selling opportunities.

Those are the types of places I look forideas, but everybody here has their ownsources and we have a meeting everydayto discuss them. In general, we’re lookingfor volatility – volatility creates ideas.

Once a potential idea has been identified,where do you focus your research?

JJ: Every industry has different relevantmetrics we look at, but at the end of theday we’re focused on a company’s abilityto generate cash flow and reinvest it.Every investor wants to find well-man-aged companies, with defendable marketpositions, that generate a lot of free cashflow that is reinvested intelligently. Theproblem is, those companies typicallydon’t have valuations we can accept asvalue investors.

So we look for businesses that qualifyon a few of the ideal characteristics andthat we think can improve on the others.

In most cases either the management islousy or the company has had a very badrecord in terms of capital allocation. Tous, those are the easiest things to fix.

Our goal is to generate 15-20% annu-al gross returns with bond-like volatility,which we believe is achievable over timegiven our appetite for risk. We don’tinvest in things that could be a coin flipbetween doubling or going to zero. Wewant the downside of every holding to beno more than 10-15% and the upside tobe at least 50%. The key for us is to notbe wrong about the downside.

Where does the margin of safety tend tocome from?

JJ: As many places as possible but prima-rily from the strength and sustainabilityof the business model, low valuations rel-ative to book value or cash-flow multiplesand undervalued hard assets or otherassets on the balance sheet.

You mentioned running a concentratedportfolio, describe the current breakdown.

JJ: Our top 10 positions today make up45% of our capital, all of which I’dcharacterize as the type of “strategic-block” investments Jeff Ubben describedin your last issue [VII, January 31,2006]. We have large positions and areworking closely with the companies torealize value.

We’re 125% gross long and 80%gross short. We have in the past held asmuch as 40% cash, but our long expo-sure is over 100% because we’ve found alot of opportunities. Shorting has been abit of challenge lately, so the logical ques-tion to ask is whether, if we’re going to

be 45% net long, why we don’t just hold55% cash.

Why don’t you?

JJ: I still believe we should be able tomake money at shorting. At the sametime, without being short, we just could-n’t sleep at night having the market expo-sure we have in owning the stocks wewant to own.

Our short experience has been some-what tainted by Enron. We nailed Enronand made more money shorting it thanwe’d made on any single investment,long or short, in a long time. We wereshort for about a year and a half beforethey finally went bust and endured a50% rise in the stock from where we firststarted shorting before it started tounravel. There’s something hugely emo-tionally gratifying to be right on some-thing like that.

You recently described corporate activismas a “structurally undervalued area of thecapital markets.” Explain that.

JJ: Most shareholders of undermanagedor poorly managed companies vote withtheir feet rather than push for changes inmanagement, board composition or strat-egy. So, poor management persistsbecause shareholders aren’t willing to doanything about it, which we think is anabdication of responsible ownership andfiduciary duty. But even if big sharehold-ers have a willingness to take on a publiccompany, most firms don’t have the expe-rience, resources or skill set to do so. Wethink the fact that we have that abilitywhen others don’t is a big opportunity.

The private-equity business is builtaround taking over companies and doingwhat shareholders should have gottendone, while they keep most of the moneyfor themselves. Most private-equityfirms do not possess secret sauce interms of management expertise – they’refinancial engineers. The amazing thing isthat the same shareholders who do noth-ing to effect change at a poorly managedcompany before a private-equity firmcomes in to take over line up to pay a



ON SHORTING:

It’s been a challenge lately, but

without being short we just

couldn’t sleep at night having

the market exposure we do.


stupid multiple for the company when itcomes public again.

You went so far as to make an offer tobuy Circuit City [CC]. How did thatposition evolve?

JJ: We invested in it originally because wethought it was cheap, that the industrywas in the early innings of a majorupgrade cycle in TVs that will benefitthem, and because there was a lot ofoptionality from correcting several yearsof bad management execution. We start-ed buying around $9, when they had $6per share in credit-card receivables andnet cash on the balance sheet. That $3 netprice was less than 10% of sales.

We filed a 13D because we wanted toupgrade the existing management, whichwe thought was badly misallocating capi-tal. It also became apparent that the fair-ly dramatic operational and financialsteps they needed to take could be easierto accomplish without the scrutiny thatcomes with being a public company.Finally, the market was persistentlyundervaluing the company’s futureprospects, in light of its past performance.

We got them to change the CEO,which was the most important thing. Ouroffer to buy the company [at $17 pershare] was conditioned on the participa-tion of the CFO and the incoming CEO.At the end of the day, they chickened out.

We would have loved to have boughtit, but they’ve been doing the rightthings. Sales are better. They have beenbuying back shares. They’ve closed a fairamount of underperforming stores. Ithink we played a huge role in the stockgoing from $9 when we started buying toaround $24 today.

Do you still see upside?

JJ: It’s a completely different investmenttoday. One Wall Street analyst upgradedit to a “buy” earlier this month, sayingthe company is in the first stages of aturnaround – which tells you somethingabout Wall Street research. We often sellway too early, so he may very well beright on the stock at today’s price, but

that’s not the type of investing we do. Wesold a lot of our stake as the shares gotinto the $20s.

Tell us about Penn West Energy Trust[Toronto: PWT.UN], one of your largestenergy holdings.

JJ: Penn West is the largest conventionaloil and natural gas trust in Canada. Itconverted to a Canadian unit trust struc-ture last May, which basically meansearnings are untaxed at the corporatelevel and have to be paid out. They pay amonthly distribution that works out toabout 10% annually.

The company produces 95,000 barrel-equivalents of oil per day and on a provenand probable basis has 370 million bar-rel-equivalents in reserves, two-thirds of

which is oil and the rest natural gas. Thefounding shareholder is an excellententrepreneur and investor named MurrayEdwards, who we met with roughly ayear ago when the stock was ridiculouslycheap, around C$23.

With the stock now around C$39, themarket appears to have caught on.

JJ: Unlike ConocoPhillips, which I men-tioned earlier, Penn West trades fairly closeon a proven-reserve basis to our estimateof net asset value. But in this case we’restill attracted by the high quality of thecompany’s assets, by the margin of safetyin the 10% cash yield and by what webelieve is huge optionality on the upside.

The primary option on the upsidecomes from Penn West’s 40% ownership



Penn West Energy Trust(Toronto: PWT.UN)

Business: Largest conventional oil andnatural gas income trust company in NorthAmerica, with production operations in fivecore areas throughout Western Canada.

Share Information(@2/27/06, Exchange Rate: $1 = C$1.1404):

Price C$39.36 ($44.89)52-Week Range C$25.43 – C$44.69Dividend Yield 10.4%Market Cap C$6.5 billion ($7.4 billion)

THE BOTTOM LINE

Jon Jacobson sees “optionality on the upside” from incremental oil recovery from thecompany's giant, 40%-owned Pembina oil field and the development of other undevel-oped acreage. With a margin of safety from a current dividend yield above 10%, hebelieves the shares are worth C$60, 50% above today's price.

I N V E S T M E N T S N A P S H O T

PWT.UN PRICE HISTORY

Sources: Company reports, other publicly available information

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Financials (TTM):

Revenue C$1.9 billion ($2.2 billion)Operating Profit Margin 35.2%Net Profit Margin 30.1%

Valuation Metrics(Current Price vs. TTM):

PWT.UN S&P/TSXP/E 11.3 20.4


of the Pembina oil field in Alberta,which is the largest conventional oldfield in Canada, with nearly 8 billionbarrels of light oil in place. They’ve ini-tiated a pilot project in Pembina toincrease the amount of oil recovery theycan get from the field by using new CO2technology they’ve successfully usedelsewhere. If the technology works, andwe believe it will, they can increase theirasset base by up to 40%. If we use con-servative operating-cost and capitalassumptions, we think Penn West’s inter-est in this field can be worth C$2.5 bil-lion, which is C$15 per share on top ofthe current price of C$39.

They also have a significant amount ofundeveloped acreage – three million acresof which they don’t need to maintain pro-duction. They could joint venture withothers to develop that three million acres,not tying up a lot of capital, which weestimate would be worth another C$3-5per share.

So, overall, we see Penn West beingworth as much as C$60 per share. If oilprices go up or down, that’s obviously amoving target, but as I said, that’s notsomething we take a view on. To theextent we can, we’ve hedged the com-modity exposure.

We haven’t spoken yet about retailers.What interests you about Saks Inc. [SKS]?

JJ: Saks is a restructuring story. The histo-ry is that Proffitt’s, a mid-scale depart-ment store chain based in Tennessee, usedits wildly-inflated shares in the late 1990sto buy the parent of Saks Fifth Avenue. Ithasn’t worked out well and they’re nowin the process of splitting themselves up.When they’re done, they’ll end up withwhat was the old Saks Fifth Avenue busi-ness alone, which has been a huge under-performer.

In 1997, Saks Fifth Avenue had $2.1billion in sales, gross profit of $650 mil-lion and earnings before interest andtaxes of $153 million. In 2005, it’s esti-mated to have had $2.7 billion in sales,gross profit of $825 million and EBIT ofonly $100 million. So EBIT margins havegone from over 7% to about half that.

We see no reason why Saks, given itsbrand and locations, can’t earn operatingmargins comparable to the 7-11% thatcompetitors like Nordstrom and NeimanMarcus earn. Their gross margins areweak and their selling, general andadministrative costs are way high relativeto others. The key here is going to beblocking and tackling.

Do you have to believe the right people arein place to do the blocking and tackling?

JJ: Not at this price. They recently elevat-ed the COO to CEO, but the jury’s stillout on whether he’s a good operator.

They do have a new CFO who came fromAutoZone, where the stock rose five-foldduring his time there, who is excellent.The stock now is just so cheap that youcan afford to wait until they get it right.

With the stock trading at $19, how areyou thinking about valuation?

JJ: The company today has a total enter-prise value of $3.3 billion, which is anequity market value of $2.6 billion plusnet debt of $700 million. We believethey’ll get a total of $1.6 billion from sell-ing their northern department stores toBon-Ton – a deal that has already been



Saks Inc.(NYSE: SKS)

Business: National department storeretailer in the process of shedding diverseoperations to focus on its core Saks FifthAvenue luxury brand.

Share Information(@2/27/06)

Price 19.0052-Week Range 14.45 – 24.64Dividend Yield 0.0%Market Cap $2.64 billion

Financials (TTM):

Revenue $6.25 billionOperating Profit Margin 2.6%Net Profit Margin 1.9%

THE BOTTOM LINE

A return of operating margins to even the low range of what competitors earn wouldresult in significant upside for the company's shares, says Jon Jacobson, from bothhigher earnings and an increased multiple on those earnings. As a turnaround starts totake hold, he believes the shares could at least double.


SKS PRICE HISTORY


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SKS S&P 500P/E 22.6 22.2P/CF 11.1 14.9

Largest Institutional Owners(@12/31/05):

Company % OwnedSoutheastern Asset Mgmt 10.8%Deutsche Bank 5.3%Goldman Sachs 4.7%Barclays Bank 2.8%Oppenheimer Funds 2.6%

Short Interest (As of 2/8/06):

Shares Short/Float 3.9%


announced – and from the sale of theParisian specialty chain.

With that $1.6 billion from the sales ofthe businesses, you’ll have $900 millionof net cash, which gives you, at today’smarket price, an enterprise value of $1.7billion. On that basis, the company istrading at only 7x EBITDA, at a timewhen margins are as little as one-thirdwhat other big-box retailers earn.

Where do you see the margin of safety?

JJ: Primarily from the stock trading at adepressed multiple based on depressedearnings. If they get their margins any-where close to where the competitors are,the upside is very good because you’ll alsoprobably get a higher multiple.

The other margin of safety is that theyown four million square feet of retailspace, a quarter of which is in their threeflagship stores in New York, Chicago andBeverly Hills. The midpoint of the sell-side consensus on what the real estate isworth is $850 million – that’s a hugecushion relative to a $1.7 billion enter-prise value.

If they can turn things around, wethink the stock can pretty quickly at leastdouble from where it is today. The num-bers are going to be a mess this year andnext year, as they sell off businesses andreorganize. I see this as being like CircuitCity two years ago – now’s the time tobuy, when you’ve got a margin of safety.A year from now when the stock’s over$30 and the Wall Street analyst writes thereport that the turnaround has started, itwon’t be the same investment.

You’ve owned France’s Vinci [Paris: DG]for five years and have made a lot ofmoney on it. Why is it still interesting?

JJ: The short answer is because the earn-ings and cash flow have grown faster thanthe stock price. This is the best Europeanmanagement team we’ve ever met, interms of thinking about returns on capitaland how to reinvest in the business.They’re very disciplined.

Vinci is the largest construction andconcession company in the world, with

€21 billion in sales. They take on hugeconstruction projects and also run tollroads and parking lots – it’s a prettystraightforward business.

So what’s the market missing?

JJ: We think a few things. The companyjust agreed to acquire ASF, which is themajor toll-road concession business inFrance, for €9.2 billion. With this acquisi-tion, two-thirds of Vinci’s revenue will berecurring, concession income, which fun-damentally changes the profile of thecompany and, we think, the multiple itdeserves.

The market also seems concernedabout whether the construction backlogVinci has is going to hold up. But ourwork tells us that not only are the levels

of backlog real, but that the growth inconstruction spending is shifting to non-residential and public works – which iswhere Vinci is strong – and that there willbe a lot more put out to bid on such proj-ects in the next 18 months.

The company operates mostly inEurope, split roughly 50/50 betweenFrance and Western and Central Europe.Longer term, while we haven’t factoredthis into our estimates, we think there’s ahuge opportunity for them as EasternEuropean countries are accepted into theEuropean Union.

At around €78 per share, what do you seeas the upside?

JJ: With synergies from the merger andother operating upside, we think they’ll



Vinci SA(Paris: DG)

Business: Design, engineering, construc-tion and ongoing management of large-scale infrastructure projects and facilities.

Share Information(@2/27/06, Exchange Rate: $1 = €0.8440):

Price €78.50 ($93.01)52-Week Range €54.40 – €78.60Dividend Yield 2.4%Market Cap €15.6 billion ($18.5 billion)

THE BOTTOM LINE

The market underestimates Vinci’s earnings potential from merger synergies and agrowing project backlog, says Jon Jacobson. The P/E of 13x this year's earnings, hesays, also doesn’t appropriately reflect the recurring nature of two-thirds of total sales.With little downside, he believes the shares are worth at least €100.


DG PRICE HISTORY


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Financials (thru 6/30/05):

Revenue €20.5 billion ($24.3 billion)Operating Profit Margin 6.4%Net Profit Margin 3.9%


DG CACP/E 16.2 16.0


earn more than the market is expecting,or about €6.00 next year. So for only 13xearnings – significantly less than multiplesof competitors like Abertis and Ferrovialof Spain – we’re buying an excellent busi-ness with a management team that wetrust implicitly to do the right thing. Wethink the shares are worth at least €100,which is putting a 10x multiple on their€2.00 per share in construction earningsand a 20x multiple on their €4.00 earn-ings in concessions.

This is an inherently different type ofidea than Saks. This will be a GDP grow-er in terms of revenue, but should growearnings at 10-12% per year consistentlywith very stable cash flows. At 13x earn-ings, while the upside may not be as high,there’s very little downside.

Describe the opportunity in anotherFrench company, Lagardere [Paris: MMB].

JJ: This is a classic family-controlledholding company where there’s a percep-tion that the family is not that sharehold-er friendly. So there’s a discount for thaton top of a holding-company discount.Discounts in such companies tend to per-sist, but one advantage to being a long-term investor is the ability to hold whilethe companies are changing.

Lagardere is basically a media compa-ny that also owns 15% of EADS, the pub-licly traded Airbus commercial anddefense aerospace business. For everyshare of Lagardere, you get €29 of EADS,which is slightly less than half the currentstock price.

They’ve owned this stake forever, butthey’re able to dispose of it next year at0% capital gains tax. We’ve alwaysthought that when it isn’t onerous to doso, they would sell the EADS stake, whichwe expect to happen before the end ofnext year and possibly a lot sooner.

With the stock currently around €65, thatleaves the rest of Lagardere trading at €36per share. How do you value that?

JJ: Their media business has operatingearnings of roughly €500 million, whichconsists of €215 million from book pub-

lishing, €140 million from magazines, €80in distribution and retail, €50 millionfrom broadcasting and €13 million fromregional newspapers.

If we do a sum-of-the-parts valuation,using relevant comps in each of those busi-nesses, we get to around €58 per share.Essentially, all the media assets are valuedat way below market multiples, eventhough they have very high-quality assets.After buying Time Warner Books, they willbe the #3 book publisher in the world. Iftheir recently announced deal with CanalPlus goes through, they’ll own 20% of thesecond-largest pay-television group inEurope. The have great global magazinebrands like Elle and Car and Driver.

We also think the company is under-leveraged to the tune of about €3 billion.Over time, we expect them to put the

right amount of leverage on the company,which will result in an additional kickerto the share price.

Do you have to believe the cloud hangingover media stocks will lift for Lagardereshares to prosper?

JJ: I don’t think so. Our valuation isbased on looking at the comps – what themarket is valuing these businesses at now.To the extent multiples start to expandagain, that would clearly help us, and viceversa. The operating results of theLagardere media businesses have actuallybeen pretty good, beating expectations.

The risk versus the reward here is justvery low. There’s a huge margin of safetyin buying these type of brands at less than7x EBITDA.



Lagardere(Paris: MMB)

Business: Global media company with pri-mary operations in book publishing, maga-zine publishing and pay television. Alsoowns 15% of aerospace company EADS.

Share Information(@2/27/06, Exchange Rate: $1 = €0.8440):

Price €65.50 ($77.61)52-Week Range €55.30 – €68.90Dividend Yield 2.1%Market Cap €9.3 billion ($11.0 billion)

THE BOTTOM LINE

The company’s successful media businesses are trading at discounts even to alreadydepressed multiples of comparable companies, says Jon Jacobson. His sum-of-the-parts analysis shows the shares to be worth at least €87, including €29 for a 15%stake in aerospace company EADS that he expects soon to be sold or spun off.


MMB PRICE HISTORY


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Financials (Latest Available):

Revenue €13.0 billion ($15.4 billion)Operating Profit Margin 6.7%Net Profit Margin 4.3%

Valuation Metrics(Current Price vs. Latest Available):

MMB CACP/E 14.4 16.0


You have several other media-relatedholdings that have been less than robust.Are you still optimistic?

JJ: Our media, cable and satellite holdingsare completely out of favor, but we’re stillconfident they’ll pay off. What’s frustrat-ing is that the operating results have actu-ally been quite good. We think the compet-itive threat posed by the phone companies,Google, Yahoo and Apple – to nametoday’s favorites – is way overblown.

We bought a stake in Knight-Ridder[KRI] when the company agreed toexplore strategic alternatives under pres-sure from large shareholders. This is anexample of a company that probablyshouldn’t be public – the market’s con-vinced newspapers are lousy investments,but cash flow is plentiful, operating mar-gins are usually in excess of 20% andthere are limited reinvestment needs.

You’ve said private-equity firms willmake a fortune in the newspaper businessover the next 10 years. Why?

JJ: My point is that public investors areworn out by owning companies that areperceived to be going the way of the dodobird because of technological innovation.When that happens, there’s an opportunityfor the companies to be restructured andthe likely way that will happen is for pri-vate-equity guys to come in, cut costs andshrink the companies to make them looklike they can have growth going forward.Then they’ll repackage them and takethem public again at a higher multiple.

This process is not going to be easy. Ina lot of the companies in which we agitatefor change, the rank-and-file is rooting uson because they know the business is mis-managed. But in newspapers, the rank-and-file are often in it for altruistic rea-sons. This probably won’t be a fight we’lllead, but you can expect it to be fought.

Why aren’t you overly concerned by thecompetitive landscape for cable and satel-lite-TV companies?

JJ: We own Comcast, DirecTV and TimeWarner. The perception is that an arms

race with the phone companies to delivermultiple services will put pressure onprice and that everybody’s going to lose.That may be the case, but I think you’rebeing more than paid to take that risk attoday’s valuations. Also, from an operat-ing standpoint, I’d bet on the quality ofthe managements of the cable and satel-lite-TV companies over the RBOCs.

You were involved in the changes atMorgan Stanley [MS] – what originallyinterested you?

JJ: We looked at the company 12-18months ago and saw the stock trading at

10x or 11x earnings. They were dramati-cally underperforming their peers in keybusinesses. People were quitting in drovesand there was no succession plan. Thefact that Phil Purcell had been the CEOfor eight years and that most of the viablesuccessors had left was an embarrass-ment. It was incredible that in this dayand age you could have a Fortune 500company with a board that was this insu-lated from what was really going on atthe company.

Notwithstanding all the problems theyhad, many of their businesses were stillearning 20% ROEs and most of the onesthat weren’t should have been.

Are you happy with how things are work-ing out?

JJ: It’s been okay, but it’s one of thosecases that reminds me of one of myfavorite Warren Buffett sayings: you don’tget paid extra for degree of difficulty. Thereality is that if we’d bought GoldmanSachs at the same time we bought

Morgan Stanley, we would have madetwice as much money. It’s been the samething with our holding in Janus. Janus hasworked out all right over a long period oftime, but had we bought Legg Mason orBlackRock or T. Rowe Price at the sametime, we would have made two to threetimes as much.

But those types of investments – excellentcompanies doing relatively well – don’t fityour M.O.

JJ: You’re right. We generally can’t see themargin of safety in those types of things.

We have a column this issue (see page 22)that describes an obsession with “thegame” as a driving force for excellentinvestors. Is that important to you?

JJ: The competition aspect is very impor-tant to me. If you look at anybody who’sbeen doing this for a long time, there’s gotto be something to it other than money,because there are a lot of ancillary nega-tives as well. The biggest negative for meis that it’s very stressful to feel responsiblefor other people’s money. This is a busi-ness where at the end of the day you knowhow you did – you have to like keepingscore and wanting to come out on top.

I have no desire to stop doing this,but I have no desire to be mediocreeither. If we went through some extend-ed period where I was convinced we nolonger had a competitive edge as a firm,I’d give the money back. I care about ourlong-term record and having HighfieldsCapital be mentioned with all the greatfirms out there.

So fear of failure is a big motivator?

JJ: More than anything else. There’s a bigdifference between loving to win and hat-ing to lose, which has a lot to do withone’s approach to risk. Someone wholoves to win is willing to take a lot of risksbecause the euphoria of winning out-weighs the bad outcomes. If you hate tolose, though, any bad outcome is notacceptable. To be a great investor, I thinkyou really have to hate to lose. VII



ON MORGAN STANLEY:

It’s a case that reminds me of

one of my favorite Warren Buffett

sayings: you don’t get paid extra

for degree of difficulty.


I N V E S T O R I N S I G H T : Ken Shubin Stein

Your medical training put a lot emphasison research and data analysis. How hasthat informed your investing style?

Ken Shubin Stein: Given all the cognitivebiases that can affect investors, we thinkit’s very important to follow a well-defined research process. It has to be flex-ible enough to handle different types ofinvestment ideas, but it also has to beexplicit and reproducible so we can con-stantly try to improve it.

We use detailed checklists during dataanalysis, make a systematic effort to seekout data contrary to our beliefs and dofull “autopsies” of our mistakes. We tryto avoid broad-stroke generalizations oreven using inflammatory words. Themore we can focus on data-driven deci-sions, the less prone we’ll be to potentialbiases and careless errors.

This is particularly important with thetypes of stocks we tend to buy. When astock has disappointed a great number ofpeople, it tends to get a very negativebias, which then builds momentum. Wetry to be explicit about specifically whatthe problems are and to focus on collect-ing data that helps us analyze whether theproblem is temporary or permanent.

What types of things are at the top ofyour checklists?

KSS: One of the first things we do is acredit analysis. Often what drives ourinvestment decision is the credit qualityrelative to the sustainability of competi-tive advantage, stability of margins andneed for capital. Looking at the amountof debt – whether it’s fixed, long-term andwith few covenants or variable, short-term and with many covenants – is essen-tial to determining if the company has thewherewithal to fix its problems in thetime period you expect.

We also focus a great deal on under-standing the quality of management,which is best done by looking at theirprior actions. Have they made rationalcapital allocation decisions? We look atshare-repurchase decisions over time – arethey just buying back stock to offset dilu-tion from option grants or are they strate-gically buying back stock when it’s cheapand buying none when it’s not cheap?

The data you use will differ by industry.For example, with a property/casualtyinsurance company everything you see onthe balance sheet is largely fictional becausethe liabilities are based on guesswork aboutthe loss-development probabilities. But aconcrete way to tell if management hasbeen writing profitable policies that havebeen reserved correctly is to look over timeat the growth in tangible book value pershare. That will give you a very good senseof the quality of management.

We look at the shareholder base tounderstand the type of investors that cur-rently own the company. We also seek outcontrary data from people who are bear-ish on our idea and try to understandwhy. Sometimes we’ll assign the task toone of our analysts of looking only at thenegatives of an idea and nothing else –something we also do periodically forcompanies already in the portfolio.

Describe the typical opportunity you’lllook into.

KSS: Generally we see opportunity whereseveral events obscure a company’s 12-month earning power but don’t affect thecompany’s long-term economics.

For many companies we invest in, youcould bring the best investment mindstogether and get general agreement onwhat the problems are. There would beless consensus on whether the problemsare permanent or temporary, and even less

Investor Insight: Ken Shubin Stein

Ken Shubin Stein

Scientific Method

Ken Shubin Stein’s interest in medicinewas certainly no accident. His father is anacademic cardiologist, his mother an infer-tility specialist and his twin sister an ortho-pedic surgeon. His medical program atAlbert Einstein College of Medicine tookfive years, to allow for extensive clinicaland basic science research work – prima-rily in orthopedic medicine – on top of theregular medical school curriculum.

Wasted training for an investor? Not at all,he says: “How you go about the processof defining a working thesis, defining astrategy to collect data, collecting thedata, analyzing and testing the thesis andthen iterating is not materially differentbetween doing basic science researchand security analysis.”

Shubin Stein maintains a keen interest inhealthcare, both as an investor and a citi-zen. “Every year medical technologyadvances and we’re better able to treatvarious illnesses and diseases, whichobviously has enormous implications,” hesays. “I’d argue that how we as a countryaddress providing healthcare to our popu-lation is the number one domestic issue inour lifetime.”


Ken Shubin Stein of Spencer Capital Management describes what he’s learned from “autopsies” of his mistakes,how he’s prepared for inevitable market dislocations, why apparel companies and retailers are often mispricedand what he thinks the market is missing in Foot Locker, Tyco, Resource America and Newkirk Realty Trust.


agreement on the timing of the temporaryproblems being fixed. Lack of visibility ontiming is one of the best things you canhave as an investor with a long time hori-zon. We love situations where it’s very dif-ficult to model this year’s earnings.

Our investment ideas are generally oneof two types. The first are those withcharacteristics for which the high-caseoutcome would result in the shares dou-bling or tripling over three years, but ifthings go poorly we’ll still get our moneyback over the same period. The secondare quicker hits, ideas where we alsoexpect to get our money back, but thatmight go up 50% in the next 12 months.

We take a probabilistic approach, look-ing at the value of an opportunity as thepresent value of future weighted probableoutcomes. We define high-case, low-caseand middle-case outcomes for every invest-ment we look at. In particular, we want tomake sure we always look at the reason-able worst-case things that can happen.

How do you generate ideas?

KSS: We have four lists we use to gener-ate and track ideas. This helps us organ-ize our time, because I think time man-agement is one of the most importantthings to get right in our business.

The top list consists of ideas we cur-rently own, for which we track closely allnews on the company or industry. Listtwo is very short, consisting of the two orthree ideas we’re actively moving throughour research process. List number three isa long list of ideas that are interesting, butthat we don’t know a lot about. We pullideas off this list when we have someresearch capacity. Our last list is ourwatch list, usually with things we’velooked into but are waiting to revisit untilsome event happens or some price is hit.

How do ideas get on the lists?

KSS: We use qualitative and quantitativescreens. The qualitative screens consist ofdoing word searches across news and SECdatabases. The words might be someone’sname, say a famous investor, to see inwhat context his name comes up. We also

do searches on pairs of words or phrases,like “accounting scandal,” “plan of reor-ganization rejected,” “spinoff,” “bank-ruptcy,” or “recapitalization.”

On the quantitative side, we’re lookingfor companies that appear not to be doingwell relative to how they’ve done in thepast. For example, if you look for compa-nies that have a high enterprise value toEBITDA for the last 12 months, but a low

enterprise value to the EBITDA average ofthe past five years, you’d come up with alist of companies – good, bad or indifferent– that were making a lot more money inthe past than they are now. We don’t yetknow why, but that’s what further researchis for. These types of searches can be anearly guide to what the future earningpower might become.

This type of screen can be useful in sec-tors with short-term-oriented investorbases. For example, I look for retail andapparel companies that appear to be under-valued relative to historic levels. For some-one with a longer time horizon, you canfind excellent turnaround opportunities inthis area because so many people careabout short-term data points like monthlysame-store sales or what’s going to happenthe next season. Beyond that, I look forcompanies with overcapitalized balancesheets – you don’t want levered apparelcompanies or retailers – and those withmanagement that really understands thevolatile nature of the underlying business.

Are other screens bearing fruit today?

KSS: We’re looking a lot for overcapital-ized balance sheets or where earnings arebeing produced by a small amount of thebalance-sheet capital. These are candi-dates for restructuring which can involve

returning capital to shareholders andincreasing returns on invested capital.

That’s certainly relevant in today’sactivist environment.

KSS: It’s important to think about howyou’d capitalize a company if you coulddo it from scratch. You may not be able todo anything about it, but it’s likely some-one else who can is doing the same type ofresearch. McDonald’s is a great exampleof that. Bill Ackman [of Pershing SquareCapital] pushed forward the conversationon “should they own restaurants or sellthem off,” which has been an importantcontribution to the discussion aboutMcDonald’s balance sheet and business.

You’ve said that understanding history isimportant to investing success. Why?

KSS: I think it’s tremendously importantto understand the history of a companyand its industry. We regularly read biog-raphies and autobiographies about pio-neers in the industries we’re investing in.Without a sense of historical context, it’svery hard to think about probabilities ofparticular outcomes in the future.

Going back to McDonald’s, a fewyears ago it was one of our biggest posi-tions. We started buying around $15,buying all the way down to $12.75. I readeverything I could on the company andon the restaurant and franchising busi-nesses in the U.S. and how they developedin post-World War II America.

I learned that the problems McDonald’shad in 2002, such as kitchen process prob-lems and out-of-favor menu items, were inthe normal course of business for quick-service restaurants over decades – and wereall fixable. McDonald’s clearly wasn’t get-ting things right the first time, but thesewere all problems they could experimentwith, change and improve.

The stock’s over $35, so they seem tohave fixed at least some of the problems.Why were they slow to get things right?

KSS: Tremendous inertia can set in at vari-ous points for companies and even indus-



ON HISTORY:

Without a sense of historical

context, it’s very hard to think

about probabilities of particular

outcomes in the future.


tries, because there are many stakeholderswho defend the old processes. But most ofthese things are measurable and a dispas-sionate, rational observer can look at thedata and come to the right solution.Entrenched stakeholders are an addressableproblem. That can take time, especiallywhen you have several problems to addressat the same time, as McDonald’s did.

You described earlier your affinity forretailers. Tell us about Foot Locker [FL].

KSS: By a large margin, Foot Locker isthe largest seller of athletic sneakers in theworld. Two-thirds of their revenue isdomestic, 26% international and 7%direct-to-customer.

This is a case where there’s a structur-al expense built into the company that’sdecreasing slowly over time. In the late1990’s, they had pursued a strategy toincrease their store sizes, opening super-stores that turned out to be way too big.Sales per square foot plummeted. Theproblem with something like this is thatonce you’ve built out a new footprint, it’shard to reverse. You have to close stores,negotiate out of leases or wait until leasesroll off. That takes years and affects oper-ating margins all the way through.

This is a structural problem with clearand achievable solutions, but with a timeframe necessary for it to work out that islonger than most people on Wall Streetare willing to wait.

Are they having execution problems?

KSS: In fact, they’re executing quite well.Through renovating, relocating and resiz-ing underperforming stores, they’veincreased sales per square foot to $355,up from $316 in 2002. Trailing twelve-month EBITDA was more than $570 mil-lion, versus $425 million in 2002.They’ve paid down debt and now havenet cash on the balance sheet.

Is anything else weighing on the shares?

KSS: Profit margins in Europe are underpressure, as the market has become acute-ly promotional in the past year. We’re

always asking if problems like this aretemporary or permanent, and we believethis is temporary. Foot Locker has a realadvantage in being the market leader witha much better balance sheet. As competi-tors capitulate because they can’t affordthe excessive promotion, Foot Locker caneither grab market share or just benefitfrom a return to normal pricing.

People are also worried about thecompetitive threat of the Internet. If youthink about the shoe-buying process –especially for kids, but for adults as well– there’s good reason to expect that thehuman behavior of wanting to try shoeson first is not going to change quickly.

With the stock currently at $23.50, whatupside do you see?

KSS: Over the next three years, we’reassuming 1-2% annual expansion inretail square footage and 1-2% year-over-year growth in same-store sales anddirect-to-consumer revenue. As the store-renovation process winds down, weexpect operating margins to increasefrom around 7.5% now to 10% in threeyears. If that happens, they’ll be earning$2.40 in annual free cash flow in threeyears and will have produced over $900million in additional free cash from today.

If you assume they just hold the free



Foot Locker(NYSE: FL)

Business: Largest global retailer of athlet-ic footwear and apparel, operating approxi-mately 3,900 stores in 17 countries inNorth America, Europe and Australia.

Share Information(@ 2/27/06):


Financials (TTM):


THE BOTTOM LINE

An extensive and costly restructuring of Foot Locker’s U.S. retail footprint is on track,but with a time frame longer than Wall Street is generally comfortable with, says KenShubin Stein. If operating margins return to normal levels and the company steps upshare repurchases, he expects the stock to be worth up to $48 per share.


FL PRICE HISTORY


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FL S&P 500P/E 14.4 22.2P/CF 10.3 14.9


Company % OwnedLord, Abbett & Co 9.4%Sasco Capital 3.7%First Pacific Adv 3.6%Barclays Bank 3.3%Hotchkis & Wiley 3.2%

Short Interest (@ 2/8/06):



cash and put a 15x enterprise value to freecash flow multiple on the shares, you geta share value of $43. If they did the $500million share repurchase we think theyshould, the shares would be worth $48.

We see this as both safe and cheap. Thefree cash flow yield is over 8% and grow-ing, for a dominant specialty retailer witha strong balance sheet and shareholder-friendly management. They’re highly like-ly to improve operating margins over thenext three years and, while we don’t buildthis in, they have tremendous growthopportunities in Europe and, especially,Asia, where their footprint is small.

Your next idea, Tyco [TYC], has behavedlike a bit of a value trap in the past year.

KSS: It’s clearly out of favor and thestock’s been a disaster recently, but I see itas both an operational and balance sheetopportunity.

Tyco is a holding company with fourdivisions: fire/security, electronics, health-care and engineered products and servic-es. It’s the result of a rollup by a crook,who, to his credit, was good at identifyingexcellent businesses. The normalizedreturn on capital for the overall companyis over 20%. They are the dominantworldwide leader in every division. Onereason I have a preference for large distri-bution channels that are experiencingproblems is because of the real long-termsustainability such businesses have.

The fire and security business is show-ing great momentum and has great growthpotential. Just thinking about where theworld is and the services they provide, it’sclear they have real opportunity.

Overall, the company has invested agreat deal in research and development inrecent years, which we expect to startpaying off in terms of new products andrevenue growth. They’ve also hired a lotof salespeople, which you can safelyassume will result in incremental sales.

Aren’t the divisions other than fire andsecurity having operational problems?

KSS: Yes. These have tended to be manu-facturing and sales issues, which we view

as completely addressable. We believethey have capable management to addressthe big issues, but in companies like thiswith many problems, you just need a fewto be fixed for it to be a good investment.

What’s the “balance sheet opportunity”?

KSS: The company is dramatically under-leveraged. In two years, with the free cashflow they’re generating, they’ll have no netdebt. We think they should take advantageof the great credit environment and thefact that they’d get very favorable debtterms and buy back $25 billion in stock,which is half the current market cap.

I think the reason they haven’t donemuch on that front is because manage-ment, which has done a great job on cor-porate governance and generally in right-ing operations, was brought in during ascandal and is still in that mode. Theyneed to think about the business as itstands today, not where they were comingfrom three or four years ago.

How does the breakup plan Tyco is con-templating affect your thesis?

KSS: They haven’t given much detail, otherthan to say they plan to split into threeparts, all with scale and worldwide leader-



Tyco International(NYSE: TYC)

Business: Diversified manufacturing andservices company with primary operationsin electronics, fire and security, healthcareand engineered products.



Financials (TTM):


THE BOTTOM LINE

Operational problems are pinching margins but are “completely addressable,” saysKen Shubin Stein, who also expects new profit growth from investments made acrossmany business lines under new CEO Ed Breen. Coupling operating gains with mas-sive – and doable – share buybacks would make this “easily a $50-60 stock,” he says.


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Company % OwnedCapital Res & Mgmt 9.4%Davis Selected Advisers 5.1%Fidelity Mgmt & Res 2.5%State Street Corp 2.5%Barclays Bank 2.4%




ship positions. I agree this would createshareholder value and think it would onlyhighlight how underleveraged they are.

With the stock just above $26 per share,how are you thinking about valuation?

KSS: The stock is trading for only 12xthis year’s free cash flow of more than $4billion. With margin improvement fromfixing some of their operational problemsand incremental growth from the invest-ments they’ve made, we think the sharesare worth at least $40. If they also leveredthe balance sheet and bought back morestock, this could easily be a $50-60 stock.

Management is moving in the rightdirection, but there’s a clear financialrestructuring that should occur here and Ithink you’ll see some of the big value-ori-ented shareholders like Bill Miller andCarl Icahn start agitating for change.

Tell us about one of your much lower-profile ideas, Resource America [REXI].

KSS: This company that has been run formany years by the Cohen family, first Edand now his son Jonathan. They startbusinesses, grow them and sell them –and have proven that creating sharehold-er value is embedded in their DNA.

The last five public entities the Cohenshave spun off or IPO’d have annualizedreturns of 26%, 29%, 22%, 25% and129% since going solo. They usuallyretain interests in these companies to theongoing benefit of Resource America,while they build new businesses within it.

The investment thesis here is straight-forward. The market cap is $300 million.There are $150 million in excess assets onthe balance sheet – not needed to supportthe business – in the form of cash, invest-ments and income-producing real estate.

They also own a small-equipment leas-ing company, which will do over $500million in loan originations by the end ofthis year. They lease things like telephonesystems and high-end copiers for smallbusinesses. In an interesting twist,Resource America built and sold the sametype of business with the exact same man-agement team in the 1990s. It was eventu-

ally owned by Citigroup, which releasedthe management from their non-competesand they went back to REXI and startedthe same business all over again.

The leasing company alone is worth$200-250 million if they sold it, whichthey could do easily. They’ve already hadpeople approach them to buy it.

So you’re already seeing asset value abovethe current market price.

KSS: And that doesn’t include their asset-management business, which I estimate isworth another $300 million. The compa-ny manages over $8 billion in a host of

different types of funds – in things like pri-vate equity, real estate and collateralizeddebt obligations – that are sold throughseveral channels, including independentfinancial planners and brokers. The busi-ness is growing nicely and should reach$10 billion in assets within two years.

The stock trades at $16.50 and you esti-mate the assets at more than twice that.Why the disconnect?

KSS: I think there are a few things. First,the businesses are a bit complicated.Some of the funds invest in pretty unusu-al stuff. One makes leveraged investments

Value Investor Insight 14February 28, 2006


Resource America(Nasdaq: REXI)

Business: Specialized investment holdingcompany with primary operations in U.S.money management, real estate and small-equipment leasing.


Price 16.5152-Week Range 13.36 – 19.75Dividend Yield 1.4%Market Cap $291.70 million

Financials (TTM):

Revenue $62.96 millionOperating Profit Margin 27.8%Net Profit Margin 22.6%

THE BOTTOM LINE

Ken Shubin Stein believes the market is dramatically mispricing Resource America’scurrent assets as well as the wealth-generation track record of the founding companymanagement. He estimates the company’s assets today are worth as much $700 mil-lion, a 140% premium to its current market value of less $300 million.


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Company % OwnedCobalt Capital Mgmt 8.9%Fidelity Mgmt & Res 7.0%Omega Advisors 6.3%Dimensional Fund Advisors 5.5%Rockbay Capital 3.1%



in savings and loans through securitiescalled trust preferreds. To value those,you have to understand some arcaneaspects of S&L regulation and alsounderstand what trust preferreds are.

In addition, the company is obscureand nobody follows it. On the last earn-ings call there were two people, LeonCooperman [of Omega Advisors] and me.

There are also related-party transac-tions with the Cohens that make somepeople uncomfortable. We’ve put hun-dreds of hours into analyzing the dataand we see nothing but a long and distin-guished history of shareholder focus andvalue creation on their part.

This is just tremendously undervalued.It’s an asset play you could break up andsell for a lot more than the market value.You also have great management, whichprovides call options on their continuingability to create value and start new busi-nesses we don’t even know about yet.

Another rather obscure pick is NewkirkRealty Trust [NKT], where management’srecord is also a central part of the thesis.

KSS: Newkirk is a net-lease real estateinvestment trust run by Michael Ashner.He’s an extremely smart and successfulreal estate investor with a fantastic long-term record of creating shareholder value.He started out doing private real-estatedeals, buying distressed assets and operat-ing them very well. He then startedinvesting through a public vehicle, nowcalled Winthrop Realty Trust [FUR],which he also runs and which owns near-ly 7% of Newkirk.

What’s Newkirk’s strategy?

KSS: The historic portfolio of Newkirk ismostly plain-vanilla triple net leases, withover 80% investment-grade tenants.Triple-net-lease contracts are for tenantslike Barnes & Noble, who don’t want tosubject their customer shopping experienceto the speed or quality with which theirlandlord fixes problems that come up.Tenants have almost all the responsibilityfor the property – for taxes, maintenance,upgrades. For the property owner, it’s like

having a bond with the tenant’s creditquality – all you do is collect the rent.

What they’re going to do going forwardare more special-situation triple-nets thatare unusual, complicated or hairy, say, inleases where it’s harder to get comfortablewith the tenant’s credit or the propertyneeds redevelopment work. MichaelAshner is a proven expert at sourcing andstructuring these types of deals.

So is it just another bet on management?

KSS: It’s more than that. We believe theNewkirk portfolio has a liquidationvalue of around $20 per share. With the

shares currently trading below at $17.50,you already have a margin of safety onan asset basis.

The other people involved are thecream of the crop when it comes to realestate. The two largest shareholders areApollo Real Estate Advisors, which ownsaround 36%, and Vornado Realty Trust,which owns 16%.

So I see this as having very little down-side, with a free call option on MichaelAshner creating value – and he has amulti-decade history of creating tremen-dous value in real estate. You can buyhim at a discount to liquidation value.He’s highly incentivized to make the



Newkirk Realty Trust(NYSE: NKT)

Business: Real estate investment trustinvesting in traditional and special-situationtriple net leases. Run by well-known realestate investor Michael Ashner.


Price 17.4552-Week Range 15.00 – 17.61Dividend Yield 9.2%Market Cap $338.09 million

Financials (TTM):

Revenue $249.62 millionOperating Profit Margin 76.9%Net Profit Margin 9.2%

THE BOTTOM LINE

Newkirk shares currently trade at a 13% discount to Ken Shubin Stein’s estimate of itsportfolio liquidation value. That and a dividend yield of more than 9% provides a sig-nificant margin of safety, he says, and a “free call option” on the talents of accom-plished real estate investor and Newkirk CEO Michael Ashner.


NKT PRICE HISTORY

Sources: Company reports, Spencer Capital Management, other publicly available information

20

15

10

5

0

20

15

10

5

02004 2005 2006


NKT S&P 500P/E n/a 22.2P/Book 1.3 4.1


Company % OwnedApollo Real Estate Inv Fund III 36.3%Vornado Realty Trust (and affiliates) 15.8%Limited Partners of Newkirk MLP 14.7%Winthrop Realty Trust 6.8%Security Capital Mgmt Group 5.9%




company grow, because he gets a veryhigh promote on profits above a certainlevel. It has to do very well for him to getpaid, but if it does very well, he gets paida fortune.

We also like that Ashner has been inthe public markets recently buying a lotof stock around today’s prices.

What are you seeing that the market isn’t?

KSS: The main reason the stock trades ata discount is the concern that the divi-dend will decline over the next severalyears. To sustain the current $1.60 pershare annual dividend – equal to a morethan 9% yield at today’s stock price – weestimate they need to do $1.2 billion intriple-net-lease deals over the next fiveyears. Figuring that out involves estimat-ing not only the amount of deals they do,but also what spread they earn – the costof capital vs. the cap rate [the ratio ofyearly net income to the property value] –on doing them.

The market is essentially waiting forthem to do some deals. Once they doand people get more confident that thedividend will be supported by the newdeals, the stock will go up. The companyis going to do deals opportunistically,which is what you want from manage-ment – to only do deals when there aregreat values.

Risks?

KSS: The biggest risk would probably beif interest rates rose sharply, which wouldmake the current yield less attractive.

We’re comfortable they can sustain thecurrent $1.60 per share dividend and thatit will even grow. So at today’s price,you’re collecting a better than 9% yieldfor something trading at 13% below liq-uidation value. If the stock just gets to liq-uidation value, you have a greater than20% return in one year.

Given your background, are you lookingfor opportunities in healthcare?

KSS: Given ongoing advances in medicaltechnology and demographics, the per-

centage of the population over the age of60 is going to increase significantly.Healthcare services, technology anddrugs are obviously going to be in highdemand and very expensive.

The drug companies today are every-one’s favorite villain. But beyond public-health initiatives like the provision ofpotable water, I’d argue nothing has donemore in the history of humanity toimprove our overall condition than thedevelopment of pharmaceutical compa-nies. It takes $500 million to $1 billion –and 10 to 15 years – to discover, develop

and distribute an important drug. Thecapital employed in that endeavordeserves a high return.

That said, the drug companies wenttoo far in taking advantage of their priv-ileged position, so you’ll continue to seemargin pressure on them. But I dobelieve they’re in a unique position. Inmy lifetime we’re not going to see manymore global pharmaceutical companies –scale in doing what they do is veryimportant. And what they do is so fun-damentally important to global health-care that I think they’ll have to continueto be paid well to take the risks of drugdevelopment.

We pay particular attention in lookingat healthcare companies to the profitmargins for their products or services,who’s paying for them and whether, overtime, the benefits justify the costs. Wealso think the “processors” of healthcare,which includes insurance companies, arelikely to do very well.

Biotech?

KSS: The biotech industry was basically away to take basic research off the balance

sheets of global pharmaceutical compa-nies and have public shareholders under-write the research. That’s often benefitedthe big pharmaceutical companies, whoend up doing joint-venture developmentand marketing deals on the drugs thatshow the most promise.

You’ve spoken of the importance ofpreparing for inevitable market disloca-tions. How do you do so?

KSS: Every couple of years there’s a cri-sis, in one industry or across markets.When those happen, a lot of cognitivebiases come into play – as markets fall,there’s social proof that something iswrong, people overweight near-term dataand, in general, fall victim to uncertaintyand doubt.

We think it’s very important to havebuying power going into something likethat, which we always have eitherthrough holding cash or having signifi-cant borrowing power. Without the abil-ity to buy in the middle of a crisis, you’llsuffer the volatility of it but won’t beable to buy the cheap assets that resultfrom it.

It’s also important in a crisis to have alibrary of ideas on which you’ve alreadydone careful asset-valuation work thatyou can quickly update. It’s very difficultto do de novo research in a crisis.

The toughest part is having the emo-tional constitution to buy during a crisis.Even if you have the emotional where-withal, you might have career risk fromyour boss or clients thinking you’recrazy. This is when it’s very important tostay focused on the expected values ofwhat you believe something is worth,regardless of what’s just happened to thestock price.

You mentioned earlier the “autopsies”you do on mistakes. Describe the processand what you’ve learned from them.

KSS: People naturally try to discount theirmistakes and forget about them as soonas possible. I actually modeled thisprocess on the morbidity and mortalityreviews that hospitals do after serious,



ON DRUG COMPANIES:

They are so important to global

healthcare that I think they’ll still

have to be paid well to take the

development risks they do.


unexpected adverse events occur. We for-mally analyze the mistake, including theresearch and theses that led to the invest-ment, what occurred to reveal the mis-take, how we dealt with the problem andwhat lessons can be learned.

One reason why examining credit is atthe top of our research checklist is the les-son I learned from investing a coupleyears ago in Adelphia, after the scandalcame out.

I had analyzed the known asset andliability values and concluded the com-pany was undervalued, even with thescandal overhang. What I didn’t accountfor adequately was both the size andmakeup of the debt the company had,which was a particular problem as thevery creative types of fraud they commit-ted were further exposed. It gave me ahealthier appreciation for the margin ofsafety required when you’re looking atany highly-leveraged situation.

We’ve also looked carefully at why weso often sell investments too early. Peopletend to give you a pass on that, saying

you invested in the safest part of the prof-it cycle. But I have to say, people havemade a lot of money buying stocks fromme. Over an investment career, that’s nota good thing.

What I discovered is that the invest-ments that have done much better than Iexpected – after I sold – are consistentlythose in superior businesses or with supe-rior managements. That’s why we nowspend so much time analyzing manage-ment’s prior actions and their results increating shareholder value. If you’re along-term investor, how well retainedearnings are managed and existing capital

deployed mean everything to what youreventual return is going to be.

Investing provides plenty of mistakes fromwhich to learn – if you pay attention.

KSS: The nice thing about security analy-sis – and medical research, for that matter– is that there’s an accretive nature to theeffort. As you learn, you start to ask bet-ter questions and develop faster and bet-ter insights about risks and opportunitiesin the future.

I once read a quote saying how portfo-lio managers make every mistake possiblein their first five years and then spend therest of their careers trying to avoid mak-ing the same mistakes. There’s a lot oftruth to that.

Funds managed by Co-Editor Whitney Tilson

own Foot Locker, Tyco, Resource America and

Winthrop Realty, which owns a stake in

Newkirk Realty Trust. A partner in Tilson’s

money-management business is an investor

with Spencer Capital.

VII



ON SELLING TOO SOON:

Investments that do better than

expected after I’ve sold are con-

sistently in superior businesses

or with superior managements.

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Co-Editor Whitney Tilson and partnerGlenn Tongue last summer made theinvestment case for Microsoft, notingthat “in today’s shockingly complacentmarket, our favorite investments continueto be mega-cap, blue-chip stocks” –which, according to a study by GMO,were then trading at their lowest relativevaluations ever (VII, July 29, 2005).

This quarter’s VII SuperInvestorReport, in which we analyze the portfoliosof more than 25 of the most successfulvalue-oriented hedge-fund managers weknow of (plus Berkshire Hathaway),shows that finding value in brand-namestocks is clearly catching on. As shown inthe table below, at least three superin-vestors made significant new bets – definedas establishing a new position or addingmore than 20% to existing share positions


U N C O V E R I N G VA L U E : VII SuperInvestor Report

Brand-Name PreferenceBased on last quarter’s trades by superstar investors, big appears to be better for findingtoday’s compelling market opportunities.


Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of December 31, 2005.

Company Ticker Industry Price@2/27/06

Q4 2005 % Change In TotalShares HeldLow High

Advanced Medical Optics EYE Medical Devices and Products 44.41 32.04 44.00 36.60%

Altria Group MO Tobacco and Consumer Products 72.72 68.60 75.20 123.74%

CKE Restaurants CKR Fast-Food Restaurants 17.18 11.57 14.13 204.88%

Corning GLW Diversified Technology 24.91 16.61 21.62 78.41%

Covanta Holding CVA Waste and Energy Services/ Insurance 17.98 10.41 15.06 1,200.18%

DaVita DVA Dialysis Services 59.07 45.87 53.90 68.41%

General Electric GE Diversified Industry 33.32 32.67 36.34 44.04%

International Coal ICO Coal 8.84 9.16 13.10 All new positions

McDonald's MCD Fast-Food Restaurants 35.25 31.48 35.69 169.86%

Microsoft MSFT Computer Software/Services 27.05 24.25 27.73 52.78%

Pfizer PFE Pharmaceuticals 26.60 20.27 25.18 72.90%

Reliant Energy RRI Wholesale Energy 10.19 8.65 15.65 47.07%

Wal-Mart WMT Retail 45.76 43.30 50.87 38,098.28%

VII SuperInvestor Report:“Big” Appetite

VII SuperInvestor Report tracks the portfolios of many of the best money managers in the business. Below are stocks in which at least three superinvestors established new positions or increased existing sharepositions by more than 20% during 2005's fourth quarter. Unlike in previous quarters, big-cap stocks rule.

ABOUT VII SuperInvestor ReportInstitutional money managers with discretion over $100 million or more must file a

Form 13F with the SEC listing all publicly-traded U.S. equities held – including the

number of shares owned and the fair market value – no later than 45 days after the

end of each calendar quarter. From these filings, we track and seek insight from the

holdings of an elite cadre of hedge-fund managers (plus Berkshire Hathaway), rang-

ing from better-known investors such as Omega Advisors’ Leon Cooperman and

Baupost Group’s Seth Klarman to those less well-known like Stephen Mandel of

Lone Pine Capital. The list of investors tracked evolves as we add names of those

we believe bear watching. This quarter, new superstars added include past VII inter-

viewees Larry Robbins of Glenview Capital, Jeffrey Ubben of ValueAct Capital and

Lisa Rapuano and Jeff Berg of Matador Capital.


– in each of 13 stocks in last year’s finalquarter. In a departure from previousquarters, more than half the list consists of“mega-cap, blue-chip” stocks: Altria,Corning, General Electric, McDonald’s,Microsoft, Pfizer and Wal-Mart.

As is often the case, adversity appearsto have also attracted superstar investors,in particular to two flagging energystocks, International Coal and wholesaleenergy provider Reliant Energy.

International Coal is the latest roll-upvehicle of savvy investor Wilbur Ross,who has made similar successful forays inboth the textile and steel industries.Company shares retreated steadily after alarge $11-per-share secondary offeringand their listing on the New York StockExchange in November. (Shares were hitfurther in January after a fatal accident atthe company’s Sago Mine in WestVirginia.) Reliant Energy shares per-formed even more poorly in the fourthquarter, falling 34% as the companystruggled with high debt, regulatory sanc-tions and heavy operating losses.

Healthcare has also attracted quite abit of smart-money investment – in Pfizer,

dialysis-services company DaVita andeye-care-product company AdvancedMedical Optics. DaVita shares are upfive-fold in the past five years, driven byaverage annual growth in revenue and netincome of 15% and 65%, respectively.Valued for the company’s strong position

in the burgeoning market for renal care,DaVita shares continue to rise sharply, up17% so far in 2006.

The story is less rosy for AdvancedMedical Optics, which announced anextensive reorganization and reposition-ing plan in last year’s fourth quarter at thesame time net profit fell 77% year-over-year. At a recent $44.41, the shares havebarely budged over the past 18 months.

Wal-Mart’s appeal to superstarinvestors should come as no surprise toValue Investor Insight readers. Last yearWhitney Tilson and Glenn Tongue arguedthat the giant retailer’s growth potentialand operating leverage were not beingappropriately valued by the market (VII,April 27, 2005). In addition, theyexplained why they believed WarrenBuffett’s Berkshire Hathaway was likelyto be a big buyer of Wal-Mart shares, cit-ing Buffett’s admiration for the companyand Wal-Mart’s fitting of Buffett’s defini-tion of an “inevitable” that could beexpected to dominate its field for aninvestment lifetime.

Wal-Mart shares remain depressed,which perhaps explains increased invest-ment from three of our superinvestors lastquarter. The 38,000% increase in sharesheld was skewed by one giant new invest-ment of nearly 20 million shares. Thebuyer? None other than BerkshireHathaway. Funds managed by Co-Editor Whitney Tilson

own Berkshire Hathaway, CKE Restaurants,

International Coal Group, McDonald’s,

Microsoft and Wal-Mart.

VII


U N C O V E R I N G VA L U E : VII SuperInvestor Report

TYPICAL ATTRACTION:

As is often the case, adversity

appears to have attracted

superstar investors, in particular

to two flagging energy stocks.

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Your offer code is VICVIIA1

• Bill Miller, Legg Mason • John Rogers, Ariel Capital • Jeff Ubben, ValueAct Capital• Tom Brown, Second Curve Capital• Steve Romick, First Pacific Advisors

• Dan Loeb, Third Point • Mohnish Pabrai, Pabrai Funds• J. Carlo Cannell, Cannell Capital• Mitch Julis, Canyon Capital Advisors

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You’ll master the concepts these investing legends use to make millions for their clients (andthemselves!) and be among the first to know what they’re buying now when you actively participatein this unique investing summit in Los Angeles May 10-11.

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Editors’ Note: In our last issue (VII,January 31, 2006), Whitney Tilson andGlenn Tongue argued that bearish betsthrough short sales and put options arepotentially viable money makers and asound way to hedge risk. This prompteda response from Joseph Feshbach, whosees short-selling as a loser’s game. Giventhat Joe, along with brothers Kurt andMatt, ran the largest short-only invest-ment fund in the 1980s, we were eager tohear this counter argument.

“Investing is most intelligent when itis most businesslike,” wrote BenjaminGraham, a sentiment that WarrenBuffett has described as containingamong the nine most important wordsever uttered about investing. Given that,how would you judge an investing strat-

egy with the following fundamental eco-nomic characteristics:

1) Limited potential returns, but unlimited potential losses

2) Skyrocketing competition3) Tax inefficiency4) Aggregate net losses over its history5) The elimination of a significant

source of income in recent years6) Risk of asset repossession at

creditors’ whim

Having spent 15 years of my careerdoing nothing but short selling – withperiods of great prosperity and other peri-ods of fast, painful losses – I can arguewith some authority that, as an invest-ment strategy, shorting suffers from eachof these characteristics of a bad business.

Nothing in my investing career hasbeen more satisfying than identifying andprofiting from the emperor-has-no-clothes opportunities we repeatedlyfound in the 1980s. But I’ve come tobelieve that the game has become sostacked against the short seller that it’sjust not worth the periodic emotional andmonetary high that comes from beingright with a bearish bet.

The business of shorting has only got-ten tougher since my brothers and I left itin the early 1990s. Rebates on the shortcredit – a share of the interest earned onthe short-sale proceeds – used to be a sig-nificant source of income for short sellers,but have all but disappeared due to lowinterest rates and even “negative rebates”on hard-to-borrow stocks. There are nowa few thousand hedge funds looking atthe same short opportunities, versus afew dozen 20 years ago. The tax ineffi-ciency is more pronounced than ever:short-sale profits are taxed at a short-term capital-gains rate that is approxi-mately 2.5 times the rate for long-termgains. The landscape is littered with thecarcasses of short-only funds that nevermade money, while long-term winnersare about as numerous as those in the air-line industry.

Whitney Tilson and Glenn Tongue arein good company with the poor perform-ance of their bearish bets. According tothe investor presentation Carl Icahn usedin launching his activist hedge fund lastyear, his returns from a mere 15 longpositions from 1996 to 2004 generated$1.5 billion in profits. Conversely, his 24short positions produced a comparativelysmall $150 million in profits, 85% ofwhich came from a single position,Conseco (a stock, by the way, that Ishorted about ten years too early!). Giventhat this period included three years of agut-wrenching bear market, even Icahnhimself must be questioning the real ben-efit of shorting.


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

Coming Up ShortShort selling shares two key traits with the airline industry: New players keep coming into the business … and net industry profits over time are below zero. By Joseph Feshbach


“I thought buying the boat would make him more optimistic about the future but apparently not...”



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

Whitney and Glenn offer a key argu-ment for making bearish bets: hedging.Specifically, they see such bets as “insur-ance” against their portfolio of “80-centdollars,” and take comfort in the analogythat “The fact our home didn’t burndown doesn’t mean we’re upset that welost 100% of our ‘investment’ in homeinsurance.”

But any insurance only makes sense ata given cost, which I’d argue is too highwhen it comes to short-selling. Greatshort-sellers like Michael Steinhardt andEdward “Rusty” Rose have made signifi-cant profits over the course of theircareers from shorting, but from my inter-actions with each, it was always clear thattheir motives in shorting were not as“insurance,” but as a vehicle to createhigh absolute profits in every single posi-tion, in up markets or down.

Are put options a better alternativethan shorting for making bearish bets?They do take away the risk of unlimitedloss and aren’t susceptible to shortsqueezes, but they suffer from two addi-tional major flaws. First, other than dur-ing the Internet bubble, I’ve found that

the most overvalued and hyped stocks aresmall- or mid-caps, for which puts usual-ly aren’t available or are extremely expen-sive. Second, puts require that you beright not only on the fundamentals, butalso on timing. Payday may arrive, butyour options may already have expired.

So if making bearish bets is the costlygame I think it is, how should valueinvestors address issues of risk manage-ment, preservation of capital and periodsof underperformance? I like Icahn’sdescription of his risk-managementapproach as “fundamentally driven bythe underlying value of the companyrather than prevailing market condi-tions.” In other words, nothing beats get-ting the value proposition right on astock-by-stock basis as your best protec-tion from permanent capital loss. I amstill looking for and finding 50-cent dol-lars and would argue that the 80-cent dol-lar offers both inadequate downside pro-tection as well as insufficient upsidepotential. I also insist on growth as a keycomponent of the investment thesis –value accreting over time furtherenhances the risk-reward equation.

Don’t worry about short-term swingsin performance. Contrary to modernportfolio theory – and as legendary valueinvestors such as Buffett and JoelGreenblatt have well articulated – portfo-lio volatility and risk are not remotelysynonymous. Tweedy, Browne’s ChrisBrowne studied the long-term perform-ance of seven of the greatest valueinvestors in history and found that theyunder-performed market averagesbetween 28% and 40% of the time –sometimes accompanied by hair-raisingasset drawdowns – while still trouncingthe averages over long periods. My unso-licited advice: Embrace volatility – you’llmake more money in the long run.

There will, of course, be many marketswoons to come and short selling mayhelp mitigate losses during the toughesttimes. But for my and my investors’money, the structural disadvantages ofshorting make it too un-businesslike topursue.

Joe Feshbach runs Joe Feshbach Partners,

which invests primarily in companies facing

some type of crisis – from accounting scandals

to government investigations.

VII


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You wouldn’t know it from the breath-less mutual-fund advertising selectivelytouting stellar performance, but themajority of professional investors, overreasonable periods of time, underperformthe market. Based on screens I’ve runrecently using Morningstar data, 58% ofall large-cap equity mutual funds –excluding sector and other “specialty”funds – underperformed the S&P 500,after expenses, over the past five years.Over ten years, 63% of such funds laggedthe market. Among small-cap funds therelative performance is even worse, with65% below the Russell 2000 index overthe past five years.

It’s a safe bet that managers of thesefunds have advanced degrees, above-aver-age IQs, a team of research analysts attheir disposal and professional traders toefficiently buy and sell. Yet, in the end,only a minority of them do better than adart-throwing monkey.

This state of affairs highlights theunique nature of investors who do man-age to outperform the markets consistent-ly over long periods of time. As a long-time student of such great investors,allow me to highlight four common traitsI believe they share:

Trait #1: The willingness to go againstconsensus opinion

Social psychologist Solomon Asch per-formed a series of fascinating experimentsin the 1950’s to test the effects of socialpressure on individual perceptions. Manystudy participants gave obviously incor-rect answers to simple questions onlybecause other members of the groups –who were planted by Asch – first gave thesame incorrect answers. Subjects assumedthat the consensus answers must be cor-rect and they wanted to “fit in” by goingalong with the crowd.

Maintaining one’s conviction in the faceof conventional wisdom isn’t easy. Humans

are social creatures and are often rewardedsocially for going along with others.Money managers face serious negative con-sequences for going against consensus andbeing wrong, including investor redemp-tions and even job loss. As a result, fewmanagers are willing to maintain strongconviction in the face of adverse opinion.Even harder is to stand firm when markets,as they often will, initially go against you.

Yet the ability to maintain convictionin the face of adversity is a clear trait ofthe Warren Buffetts and Bill Millers of theinvesting world. A simple test of your ownpositions can shed insight on your crowd-following propensity: For each of thestocks you own or want to buy, check theconsensus analyst opinion. If virtually allanalyst ratings are “buy” or “strong buy,”you may want to reconsider the position.

Trait #2: An open, skeptical mindThe strong convictions of great

investors don’t mean they’re blindly con-trarian. In fact, the best investors con-stantly keep an open mind and look toseparate fact from spin. They’re informa-tion sponges, but distinguish themselvesfrom the pack by constantly assessingwhat they read and hear against the factsand their own judgment. They do notignore new, conflicting informationbecause they want to “believe.” If theyconclude they’re wrong, they correct mis-takes and move on.

Dispassionate humility, openness tocontrary opinions and the ability to admita mistake and correct it are remarkablyrare traits in investors. I worked as an ana-lyst at Morningstar near the end of the dot-com bubble and was amazed by the num-ber of angry responses – even death threats– that the technology analysts receivedwhen they put a sell rating on a stock.While it’s easy to dismiss such people ascrackpots, I’ve found that some form ofthis self-delusion afflicts many investors.

Trait #3: A well-developed sense ofwhen to bet – and when not to

Their ability to learn from investingexperience gives outstanding investors aunique ability to recognize patterns. Thisis critical when information is incomplete– or unknowable – which is always thecase in trying to predict future events. Butonce great investors recognize a pattern,they form opinions about the probabili-ties of various outcomes and make betsaccordingly. For example, many veteranvalue investors knew how the dot-combubble would ultimately end – becausethey had lived through previous manias –even if they didn’t know exactly when.

When no pattern is recognized, thegreat investor declines to make any bet atall. Buffett calls this staying within one’s“circle of competence” – a simple conceptthat can take years for investors to trulyinternalize, if they ever do.

Trait #4: An obsession with “the game” In my experience, superior investors

view investing first as a high-stakes com-petition, and only secondarily as a job orcareer. Even if they made little moneydoing it, they would play the gamebecause they enjoy the challenge and liketo win. It’s no coincidence that this typeof person is attracted to an endeavor inwhich you’re judged by a “score” thatcan be measured at the end of each day.

When I was a teenager, I was obsessedwith playing video games and even madeit to the finals of the North AmericanVideo Game Olympics. I ate, drank andslept video games. Investing is now thesame way for me. This is one trait I canconfidently say I share with greatinvestors – as for the others, I’m stillworking on them.

Mark Sellers is a former equities strategist

at Morningstar and now manages Chicago-

based hedge fund Sellers Capital, in which Co-

Editor Whitney Tilson owns a stake.

VII


O F S O U N D M I N D

Common Traits of Uncommon InvestorsGiven that investing skill is part nature and part nurture, what is it that truly sets the great investors apart? By Mark Sellers



The subject of shareholder activismis clearly top-of-mind on Wall Streettoday. Nearly all of the investors we’vefeatured in interviews over the past sixmonths are either increasingly activistthemselves in dealing with company man-agement or boards, or are basing manyinvestment decisions on the potentialupside from others’ activism.

We'd argue that the rise of sharehold-er activism is a natural – and long over-due – product of the times. Shareholdersblissfully slumbered through the boomyears of the late 1990s while a not-insignificant number of companiesfudged their numbers, leveraged their bal-ance sheets pursuing pie-in-the-skygrowth – often via ill-conceived acquisi-tions – and compensated their top execu-tives to a nauseating degree. When thebubble popped, corporate managementsand boards, for the most part responsibly,de-levered their balance sheets and start-ed piling up cash.

The result today is that corporateAmerica, as a whole, is overcapitalizedrelative to the stable economic conditionsof the day. A high-class problem, to besure, but a vitally important issue

nonetheless. How this capital is allocatedis understandably front and center ininvestors' minds and much of today’sactivism stems from fundamental dis-agreements between large shareholdersand company management over how thisabundance of capital should be deployed.

The battle lines over increased share-holder activism are sharply drawn.Highfields Capital’s Jonathan Jacobson,whose interview is featured in this issue,states the investor case plainly: “Poormanagement is able to persist becauseshareholders aren't willing to do anythingabout it,” he says. “To us, that’s an abdi-cation of both responsible ownership andfiduciary duty.”

New York law firm Wachtell, Lipton,Rosen & Katz, on the other hand, pullsno punches in stating the anti-activistposition: “(Do) not allow the attackers toachieve the moral high ground by wrap-ping themselves in the cloak of good gov-ernance,” it wrote in a recent memo tocorporate clients. “Expose the attackersfor what they are, self-seeking, short-termspeculators looking for a quick profit atthe expense of the company and its long-term value.”

We’re not so naive as to believe allshareholder activism will be productive.As ValueAct Capital's Jeffrey Ubbendescribed to us recently (VII, January 31,2006): “Much of what you see today is‘buy shares today and tomorrow throw ahissy fit.’ You’ll need to be more than ayeller and screamer whose biggest asset isthat you don’t care what anybody thinksabout you.” But shareholder activism isnot a passing fad. As investors learned inthe early years of this decade, the stakesare too high to stand idly by while com-panies fritter away billions of dollars.

Well-managed companies with inde-pendent boards will have nothing to fearfrom increasingly activist shareholders. Inthose many cases, however, of poor man-agement and/or passive, entrenchedboards, expect to hear a lot more fromthe owners whose money is at stake.Which, for our money, is exactly as itshould be. VII


E D I T O R S ’ L E T T E R

Pro-Activism


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Value Investor Insight February 28, 2006

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