VII_Russo

Run a red light in Camarillo,California and there's a chanceKevin Bernzott will pull you over.

The founder of Bernzott Capital Advisors isa sworn deputy sheriff, on patrol two nightsa week. “It's my way to give back to thecommunity,” he says. “They pay me $1 peryear and tell me I'm worth every penny.”

Bernzott has also more than earned hiskeep in his day job. Since his firm's found-ing in 1994, it has earned a net annualized13.1% for investors, vs. 9.7% for theRussell 2000 Value index.

Applying a quality-first approach tosmall-cap investing, he and fellow managersScott Larson and Thomas Derse see oppor-tunity in such varied areas as pet supply,vacation rentals, medical technology, creditscoring and consumer staples. See page 11

ValueInvestor November 29, 2011

Choose Wisely, and WaitWarren Buffett counseled Tom Russo's M.B.A. class in 1984 to invest in whatyou know and stand by your convictions. Russo has learned those lessons well.

Inside this IssueF E ATU R E S

Investor Insight: Thomas RussoSeeking companies with high capacityto invest and finding prime examplesin Pernod Ricard, A-B InBev, Nestle,Unilever and Wells Fargo. PAGE 1 »

Investor Insight: Bernzott CapitalFocused on competitive moats andrecurring revenues and finding themin PetSmart, Interval Leisure, Equifax,Teleflex and Energizer. PAGE 1 »

Strategy: James MontierApplying an “I don’t know” approachto finding scarce values in today’s less-than-hospitable markets. PAGE 19 »

Uncovering Value: Aspen InsuranceDo a bad year and a weak pricingcycle justify the pessimism built intothis insurer’s share price? PAGE 23 »

Editors' LetterRevisiting the origins of an increasing-ly questioned tenet of value-investingorthodoxy; Lions in wait. PAGE 24 »

INVESTMENT HIGHLIGHTS

Other companies in this issue:Altria, Ascent Capital, British American

Tobacco, Cintas, Coinstar, Comcast, Eni,

Jack Henry, Johnson & Johnson, Lexmark,

MasterCard, Microsoft, Nestle, PerkinElmer,

Philip Morris International, Procter &

Gamble, Richemont, Royal Dutch Shell,

SABMiller, Total, Valassis

Serve and ProtectIn life, paying up for quality is often a reasonable approach. In investing, as KevinBernzott's record would attest, buying quality at a bargain price is even better.

The Leading Authority on Value Investing INSIGHT

INVESTMENT SNAPSHOTS PAGE

Anheuser-Busch InBev 7

Aspen Insurance 23

Energizer 17

Equifax 15

Interval Leisure Group 14

Pernod Ricard 5

PetSmart 13

Teleflex 16

Unilever 8

Wells Fargo 9

Track Tom Russo's daily activitiesand you'll see a whirl of activity –visiting management, speaking with

investors, attending conferences. Track hisportfolio trading and the activity level fallsoff a cliff. “We tend to let management doa lot of our work for us,” he says.

Russo's hands-off approach has paid offhandsomely for investors. A partner atLancaster, Pennsylvania’s Gardner Russo& Gardner, he manages some $4 billionand the flagship Semper Vic Partners fundhe started in 1984 has earned a net annual-ized 14.6%, vs. 9.9% for the S&P 500.

Focused on companies with globalbrands and extensive reinvestment oppor-tunities, he sees upside today in such areasas wine and spirits, beer, consumer pack-aged goods and banking. See page 2

www.valueinvestorinsight.com

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

Thomas RussoGardner Russo & GardnerInvestment Focus: Seeks companieswith global brands and a high capacity forreinvestment, run by management with awell-developed “capacity to suffer.”

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

Bernzott Capital Advisors(l to r) Scott Larson, Kevin Bernzott, Thomas Derse

Investment Focus: Seek companies withunassailable business models when theirshare prices reflect temporary market,industry or company-specific stress.

http://www.valueinvestorinsight.com

I N V E S TO R I N S I G H T : Thomas Russo

Value Investor Insight 2November 29, 2011 www.valueinvestorinsight.com

Investor Insight: Thomas RussoThomas Russo of Gardner Russo & Gardner describes why he has no qualms about investing in multiple companies inthe same industry, what management trait he values above all others, how his “never sell anything ever” profile hasevolved, and why he sees unrecognized value in Pernod Ricard, Anheuser-Busch InBev, Unilever and Wells Fargo.

You’ve defined for yourself a rather nar-row circle of competence. Describe theideal business you typically pursue today.

Thomas Russo: My ideal business typi-cally owns strong brands which addressthe needs and wants of developing-mar-ket consumers who are growing rapidlyin number and in purchasing power.Those brands create the impression inconsumers that there is not an adequatesubstitute, which makes them aspira-tional and affords their owners valuablepricing power.

I’m a value investor, which says I wantto buy 50-cent dollars, but given myfirm’s predilection for serving the needs oftaxable investors, I also want that dollarto tax-efficiently compound in value overlong periods of time. That means thebusinesses must have great capacity toreinvest, which is not all that common. Iown Nestle [NESN:VX] rather thanKraft, for example, because Nestle his-torically planted seeds for its brands inhundreds of countries that now canabsorb immense amounts of capitalspending to build infrastructure and toinvest in marketing to activate thosebrands. Kraft, with its much more U.S.-centric past, does not have the samecapacity for reinvestment. I want ourmoney to work for us – in essence, I ampassing through to our portfolio-compa-ny management much of my obligationto reinvest.

In addition to the capacity to investbehind growth, it’s equally vital that cor-porate leadership has the will to do soeven when such investments burden cur-rent reported profits. Jean-MarieEveillard used to talk about the impor-tance for investors to have the “capacityto suffer,” and I’d argue that same capac-ity to accept short-term pain for long-term gain is critical in management. Themarket often doesn’t like any burden on

reported profits, so adequate levels ofinvestment often invite scorn and ridiculethat leaders have to be able and willing toendure.

Do you find that willingness in short sup-ply today?

TR: It has never been particularly abun-dant. I often find it in family-controlledcompanies, where management is farmore likely to think generationally ratherthan focus on how to deliver results with-in some finite period to maximize thevalue of their stock options. It doesn’trequire family ownership to find man-agers who care about their company’sfuture beyond them, but it is even morerare without it.

I think about the efforts of spirits com-pany Pernod Ricard [RI:FP] in China. Inthe early 2000s competitors were pullingback in the country because the economywas going through a rough patch and themarkets for premium imported whiskeyand cognac were painfully slow to devel-op. Patrick Ricard saw it as an opportuni-ty to invest in developing both the market-ing profile and distribution of the compa-ny’s Chivas Regal and Martell brands, apath that proved very unprofitable in theearly years. Today China is Pernod’s third-largest market, accounting for some 15%of profits and growing 18-20% per year.There was nothing pre-ordained about thissuccess – the company made investmentsnecessary to build a category that tappedinto an increasing sensibility amongChinese with rising disposable incomes toshow standing and status through thebrands they consumed. If Pernod had notbeen there early, and endured the pain ofbeing early, they would not have the posi-tion they have today.

On a different note, during the depthsof the 2008 crisis, one of the mostextraordinary conference calls I heard

Thomas Russo

Who Says?

As an undergraduate history major atDartmouth in the 1970s Tom Russoremembers being particularly interested inhistoriography, which he describes as thestudy of how historians interpret history.“It's the study of 'Who says?’ – how differ-ent people interpret actual events basedon their knowledge, preferences and bias-es,” he says. “Sensitivity to that has beenvery valuable to me as an investor.”

Russo's own history sheds considerablelight on the development of his investingstrategy. His grandfather's travails invest-ing in energy stocks helped form an ongo-ing aversion to commodity-related bets.His first job as a bond analyst as interestrates rose in the mid-1970s made himhighly wary of inflation’s corrosive effects.A Warren Buffett talk to his Stanford busi-ness-school Investments class in 1984drove home the importance of focusing onwhat you know and stretching your invest-ing horizon to allow for companies to com-pound value. Those lessons were rein-forced after graduate school during fouryears as an analyst at the Sequoia Fund,where deep-dive primary research was allthat mattered. Says Russo today: “Youdon't have to rediscover lessons that havebeen well made by others before you.”




was that of Johann Rupert, the longtimechairman and large shareholder of anoth-er of my holdings, Swiss luxury-goodscompany Richemont [CFR:VX]. He start-ed talking directly to company operatingmanagers who were on the call, reassur-ing them that the reason the companyheld billions of euros in cash was to allowit to survive difficult periods and contin-ue to build its brand franchises throughthem. He went on to describe where thecompany was planning to invest heavily,such as China and Russia, as well aswhere it would stop investing, primarilyJapan. The tenor of the conversation wasmuch different than what you typicallyheard at the time. I found it all to be adramatic statement of how to prudentlyshepard assets.

When we last spoke [VII, June 30, 2006],you were almost exclusively focused onfour businesses: food, beverages, tobaccoand ad-supported media. Has thatchanged?

TR: Until I get more thoughtful aboutcompanies such as Google or Apple – thereplacements for the media businessesthat once had such a lock on consumercommunications – you can lop off thatlast leg.

One of the lessons I took from WarrenBuffett years ago was to define the areasyou’re comfortable with and stick tothem. Branded consumer businesses arethose for which I have a natural affinityand that I think I understand. While Iwould have a hard time on the weekendobserving what DRAM chip is in the cellphone of the person walking next to me,I pay a lot of attention to – and think Ilearn a lot from – what people are wear-ing, or eating, or smoking or drinking. Ofcourse these are also all businesses thatlend themselves to the types of globalgrowth opportunities I most value.

The share of your portfolio in U.S. com-panies continues to decline. Why?

TR: We probably held 35-40% in non-U.S. stocks five years ago and that num-ber today – counting Philip Morris

International [PM] as non-U.S. becauseall of its operations are overseas – is clos-er to 70%. One practical reason is thatmy foreign investments have worked bet-ter than those in the U.S., but I have alsoactively swapped out of U.S. companiesthat didn’t have adequate global reinvest-ment opportunities and into Europeanholdings that did. Most of that is a resultof company-by-company assessment, butI will admit to casting an eye toward his-tory and wondering if today’s U.S.-cen-

tric investor isn’t like the similarly posi-tioned British investor in the early 1900swho would have left a lot of moneyunearned as a result of his nation losingeconomic relevance due to progress else-where while he or she stayed investedonly domestically.

Isn’t that sentiment a bit inconsistent withyour finding opportunity in old-worldEurope instead?

TR: The opportunity is less aboutEurope and more about European com-panies, that as a result of historical acci-dent or conscious effort have establishedprofound footholds in the fastest-grow-ing parts of the world for their celebrat-ed and long-nurtured brands. Unilever[UN], for example, has been imbedded inIndia through its Hindustan Lever sub-sidiary since long before India’s economybecame more open and hundreds of mil-lions of people started to enjoy incomesabove a subsistence level. The aspira-tional appeal of so many Europeanbrands – think Cartier watches, ChivasRegal scotch, even Heineken beer – hasbeen cemented in consumers’ minds andis a powerful driver of demand as risingincomes in many parts of the world take

those brands from unattainable toaffordable.

As a value investor, companies inEurope hold even greater appeal today.We have never really had to wrestle withexcessive valuations there because it hasalways been deemed a slow-movingregion, but investors are now activelyfrightened away. In addition, I thinkanother unrecognized result of the eco-nomic crisis has been that European com-panies are increasingly able to operatetheir businesses as dictated by competi-tion rather than regulatory fiat. Just oneexample: Nestle struggled for years afterbuying Perrier because the French govern-ment wouldn’t let it rationalize local pro-duction, which was orders of magnitudeless efficient than in Nestle’s comparableSan Pellegrino operation. That changedtwo years ago and Nestle has done whatit needed to do to make Perrier morecompetitive, while freeing up capital toinvest in growth. As a result, the Perrierbusiness has grown 30% over the pasttwo years. In general, while it has beenmasked by broader economic woes,Europe is becoming a more amenableplace to do business.

You mentioned swapping out of certainU.S. companies. Describe your thoughtprocess behind an example or two.

TR: I did a substantial amount of sellingin 2008 and redeployed capital intostocks I already owned, such as PernodRicard, Richemont and SABMiller[SAB:LN], that were down 50-60%because the global economy was sostressed and companies connected toemerging markets were particularly hardhit. Shares in Dr Pepper Snapple, adomestic soft drink company with littlehistorical ability to grow outside ourshores, were sold. Kraft Foods, domesticfocus, sold. International Speedway, theparent company of NASCAR which hadrun out of rope in expanding in the U.S.but was still attempting to do so, sold.H&R Block was cheap and trying towork through serious diversificationerrors, but its lack of reinvestment oppor-tunities kept it from making the cut.

ON EUROPE:

It has been masked by broad-

er economic woes, but Europe

is becoming a more amenable

place to do business.




What about newspaper companyMcClatchy, one of your last, painfulmedia holdouts?

TR: With every company I own there isalways the question of sustainability, thata transformation in its industry will leaveit behind. Five years from now you mayask me the same question about thetobacco companies I own and why I con-tinued to hold them in the face of chang-ing user preferences, regulatory hurdlesand litigation risks. You may ask me thesame question about Nestle and why Ididn’t see the extent of its vulnerability tocompetition from private-label brands.McClatchy was losing to the disruptiveforces of technology in its industry andmy mistake was in believing its franchisewould hold up better and longer than itdid. It’s that simple.

This process in 2008 was really quiteprofound for me as an investor. Itincreased my resolve to hold only compa-nies I deeply believe in because you neverquite know when forces outside of yourcontrol set off a tidal wave across marketsthat shakes everything to its foundation.During a crisis, the less conviction youhave about something, the more likelyyou are to handle it poorly and the morelikely the company in question is vulnera-ble. After 2008, I am more concentratedeven than usual, with nearly 75% of theportfolio in my top ten holdings.

Having sold as much as I did also putforever to rest my longstanding profile ofnever selling anything ever. I am overthat. One outcome of this exercise hasbeen to more pointedly question theenduring nature of the status quo and tonot hesitate in reducing portfolio hold-ings when the uncertainty is too high.

You mentioned tobacco stocks, of whichyou own Philip Morris, Altria [MO] andBritish American Tobacco [BTI]. What’sbehind your conviction about theirfuture?

TR: The world knows all of the vices oftobacco and the risks inherent in invest-ing in tobacco stocks, all of which isincorporated in their share prices. But we

also know the business has a high degreeof brand loyalty, is still growing in thedeveloping world, is enormously cash-generative and is increasingly controlledby fewer large competitors who are likelyto be sensible about the significant pricingpower their brands command.

So using Altria as an example, theypay out 80% of cash flow in dividends[providing a 6% yield at current prices]and still have plenty to invest in maintain-ing their brands’ strength and in making

selective acquisitions. They bought UST,the leading smokeless tobacco company,which also owned a domestic wine busi-ness. They also acquired the JohnMiddleton cigar company. Also impor-tant to me is that as a result of the sale ofMiller Brewing many years ago, the com-pany now owns $15 billion worth ofSABMiller shares, a global beer companywe find attractive and hold on its own.

How many new ideas do you add to yourportfolio in any given year?

TR: We’ve added two new portfoliocompanies over the past year, Anheuser-Busch InBev [BUD] and MasterCard[MA]. We wait for breaks in prices incompanies we would like to own, andboth of these came under pressure forU.S.-specific reasons at a time when theirappeal to me is almost entirely due totheir businesses outside the U.S.

MasterCard had intrigued me since itcame public in 2006, but it quicklybecame a darling of the investment worldand I missed the opportunity. It cameback to earth last year when increasingfears that post-crisis regulation in the U.S.would limit debit-card fees and profitabil-ity sent the shares below $200. At the

time it looked like the company wouldearn in 2012 something like $24 pershare, so we were able to pay 8x thatearnings number for a company that hadreally seen no change in its long-termopportunity set and whose new CEO,Ajay Banga, was to my mind one of themost impressive international financeexecutives in the world.

While it’s not a food, beverage ortobacco company, MasterCard fits all mycriteria: a heavily branded consumerproduct that has extraordinary potentialglobally due to the substitution of com-merce for subsistence, and the migrationwithin commerce toward payment sys-tems other than cash. This is also a casewhere I believe the business is enhancedrather than threatened by technology,resulting in innovative ways to pay bycredit that will hasten the shift away frompaying by cash. [Note: MA shares recent-ly closed at $359.]

I will talk later about A-B Inbev, butthere the break in the share price hadmore to do with a quarterly shortfall indomestic shipments of core U.S. brandslike Budweiser. In addition to being over-done, the market’s reaction was doublyill-considered because the shortfall inlarge part was due to a strategic decisionto raise prices on lower-end products, tolessen people’s incentive to trade down inprice. Steps to improve long-term brandequity over time caused short-term prob-lems – just the type of capacity to suffer Ilike to see.

How do you think about valuation?

TR: I wouldn’t say I’m overly precisewhen it comes to valuation. Most of thecompanies we’re speaking about todaytrade at around 13x earnings and I amcomfortable holding the right companieswith P/E multiples up to the mid-teens.Nestle, for example, trades at maybe 15xestimated earnings, but less than that ifyou back out the burden of $2.5 billion ininvestment spending on emerging mar-kets this year, up from $1 billion last year.Those transformative types of invest-ments impact earnings because you’redeveloping capacity that does not yet

ON SELLING:

After 2008 . . . I put forever to

rest my longstanding profile

of never selling anything ever.

I am over that.




have full scale advantages. But the com-pany will likely earn at least 20% on thatcommitted capital, adding on the order of$500 million in annual operating incomefive years out. Overall, I believe it cangrow earnings at least 7-10% annuallyover the next five to ten years, which withdividends should result in a double-digitannual return on my shareholding, whichis my general aspiration for the portfolio.

You mentioned selling in 2008, but whathave you sold more recently and why?

TR: In 2010 we started the year withRichemont at about 7.5% of the portfo-lio. The stock went up 75% and it endedthe year at about 7.5% of the portfoliobecause we sold shares as it became lessundervalued and the weighting becamehigher than I considered appropriate.That is just part of the ongoing process toadjust position sizes based on price move-ments, but I’m always mindful of WarrenBuffett’s caveat not to cut flowers andwater weeds. Some of the proceeds fromselling Richemont went to buy moreWells Fargo [WFC], to rebuild a positionsize after the stock had fallen in price.There is always the risk in such cases thatWells could be a value trap, whileRichemont’s great leap forward only pre-saged a great next few years’ of earningsgrowth. I am mindful of that, but I wouldnot have been comfortable withRichemont at 13% of the portfolio.

You appear to have materially cut yourComcast [CMCSA] stake recently. Why?

TR: My concern is over the impact oftechnology on its core business. The com-pany says that if everyone starts usingApple TV or Google TV, what they haveto pay extra as a result to Comcast forInternet access and using so much morebandwidth will compensate for whateverthey no longer pay on the cable side. Thatmay turn out to be true, but the outcomeis very uncertain. The government maylimit price increases. Consumers may balkat increases coming from monopolyproviders. I am not comfortable that cableproviders have done enough in managing

their governmental and consumer rela-tionships for the best outcomes to occur.

Describe your more detailed investmentcase for Pernod Ricard.

TR: Pernod over the past 20 years hastaken its business from the sale of pastis,a declining liquor sold primarily inFrance, to marshaling a broad portfolioof iconic global spirits brands such asChivas Regal scotch, Martell cognac,Beefeater gin and Absolut vodka. Thebusiness model has been to add brandsthrough acquisition and integrate theminto direct local distribution systems thathave been built carefully over manyyears at great expense. As more brandsare directed through that dedicated dis-tribution, revenue synergies are realized,

cost efficiency goes up and the systemitself provides even greater competitiveadvantage.

The financial model has been to lever-age up to make the acquisitions, run thebusinesses better and then extract cashfrom them to pay down debt ratherquickly. That got derailed a bit by thepoorly timed purchase that brought themAbsolut in 2008, which ended up requir-ing some asset sales and a rights offeringto restore the balance sheet. To the com-pany’s credit, financing issues didn’t keepit from investing in the Absolut brand, an11-million-case-per-year brand when theybought it that they believe can sell 20 mil-lion cases annually. That will come fromselling it more forcefully in 25 marketswhere Absolut was already the leadingpremium vodka, but where the category

Pernod Ricard(Paris: RI:FP)

Business: Global marketer of spirits, wineand champagne, under brand namesincluding Absolut, Chivas Regal, Jameson,Beefeater, Martell and Perrier-Jouet.

Share Information (@11/28/11, Exchange Rate: $1 = !0.751):

Price !! 67.9752-Week Range ! 56.09 – ! 72.78 Dividend Yield 2.1%Market Cap ! 18.00 billion

THE BOTTOM LINE

Having long invested in local distribution, the company is well positioned to capitalizeon developing-market consumers’ increased appetite for its status-confirming brands,says Tom Russo. With further multiple compression unlikely, he believes share returnsshould at least match his expectation for low-double-digit annual net income growth.

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

RI PRICE HISTORY

Sources: Company reports, other publicly available information

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50

40

302009 2010 2011

Financials (FY2011):

Revenue ! 7.64 billionOperating Margin 25.0%Net Profit Margin 13.7%

Valuation Metrics(Current Price vs. TTM):

RI S&P 500P/E 17.1 13.4

80

70

60

50

40

30




was not fully developed because theagents representing the brand did notown it. That shows the power of the ded-icated global system Pernod has.

Is Pernod’s success in China typical of theupside you see for the company in emerg-ing markets?

TR: The scale obviously differs by coun-try, but another example would be India.Over the past decade Pernod has sownthe seeds of success by establishing a prof-itable niche for premium scotch whiskeyin the country, which commands a tinyshare of the market today. As that sharegrows along with disposable incomes, thegrowth potential for the company is dra-matic. To give you a sense of the scale,current worldwide annual demand forpremium scotch whiskey is 70 millioncases. The overall market for “scotchwhiskey” made in India – most of it todayfrom low-quality brands – is 125 millioncases per year.

Another engine fueling this type ofbusiness is that wealthy Chinese andIndians and Brazilians are increasinglytraveling the world, developing a taste forthe stature-confirming brands they findthere. One company we are close to ownsthe billboard concession in the Shanghaiairport. They contracted for the businesswhen it had 23 million passengers threeyears ago, but this year it will handle 70million passengers, the vast majority ofwhich are Chinese traveling the worldand potentially developing Western pref-erences. That’s a powerful force behindthe Pernod Ricard story.

How much of a problem will exposure toEurope and North America be?

TR: Developing and emerging marketsaccount for maybe 40% of the business,with Western Europe roughly one-thirdand North America around 25%. I don’tspend a lot of time trying to handicaphow the debt crisis plays out and its near-term effect on the economy, but I dobelieve Europeans and Americans willcontinue to indulge in small luxuries withrelatively small price points like those

Pernod sells. The risk is if retailers panicas they did in 2008 and pull sharply backon inventories. Barring that, any devel-oped-market sluggishness should be morethan offset by emerging-market growth.

With the shares trading at a recent !!68,how are you looking at valuation?

TR: The stock trades at about 14x nextyear’s estimated earnings, for a companyI believe can grow net income at low dou-

ble-digit rates for several years. Given theoverhang from concerns about Europe, Iwould argue that any further multiplecompression is unlikely and believe themultiple should actually expand if growthcomes in as I expect and as potential inplaces like India is better recognized.Even if the share price just rises withearnings growth, we expect to be perfect-ly happy.

Do you hedge currency exposure here?

TR: No, which is true as a general rule. Ilooked back at the impact currency hashad on my returns since 1991 and foundit has added an incremental 0.5% perannum. It has followed a volatile path,but over time the dollar has been declin-ing in value, a dynamic I would expect tocontinue given seismic movements inglobal economic power. Given that, I amhappy to maintain our natural exposureto currencies other than the dollar.

Moving along the adult-beverage spec-trum, describe the upside you see inAnheuser-Busch InBev.

TR: I have been a long-time investor inthe global beer market for many of the

same reasons I like the spirits business.Brands when properly handled conveystature and standing, making them aspi-rational. This creates vast opportunitywhen aspirational consumers are increas-ingly able to afford the product.

But I had never been a big fan of eitherAnheuser-Busch or the company thatbought it in 2008, InBev. With A-B, Iwasn’t convinced management was suffi-ciently focused on building long-termbrand and shareholder value. With InBev,my concern was that its famous penchantfor cost cutting risked hollowing out theinstitution and its brands over time.

I took a closer look as the integrationof the two businesses got underway. Thisis a scale business, in which high marketshares translate into marketing advan-tages, distribution advantages and oper-ating-cost savings. The merged companywas ideally suited to capitalize on itsscale, as it now controlled 20%-plus of aglobal market that has become far moreconsolidated.

I have since gained an appreciation formanagement as much more than merecost cutters. I saw it first in the way itcreatively re-positioned Stella Artoisfrom a bargain-basement brand to onecelebrating more of a high-end, fashion-setting image and competing head onworldwide with other European brandssuch as Heineken and Peroni. I heard itin how they talked about Anheuser-Busch’s legacy marketing focusing toomuch on the clever and cute and notenough on actually building long-termbrand loyalty. Their execution of large-scale and high-cost marketing partner-ships with soccer’s World Cup and theNational Football League has illustratedboth global marketing brawn and localmarketing sophistication.

Which is not to say they don’t knowhow to run a tight ship. For example, inNorth America since the acquisition man-agement has taken out costs across theboard, been more strategic with advertis-ing and marketing spending, and raisedprices on low-end brands. Operatingmargins for the North AmericanAnheuser-Busch business have gone fromthe mid-20s to now pushing 40%.

ON THE DOLLAR:

Over time the dollar has been

declining in value – I am

happy to maintain our natural

exposure to other currencies.




What are they doing to revitalize thefaded Budweiser brand?

TR: As much as we may have enjoyed the“What’s up?” commercials or those withchirping frogs, the reality was that thosetypes of campaigns had much more talkvalue than Budweiser brand value. Thatled over time to the hollowing out of thebrand and a big decline in market share,a void that luckily for the company wasmore than filled by the rise of Bud Light.

Management does not believeBudweiser should be allowed to languishfurther, so has relaunched the brand toearly success in the U.S. by celebrating its

American heritage and the notion that itis a beer that rewards hard work. They’vealso done something I would not havethought possible, which is turn Budweiserinto a premium growth brand outside theU.S. By playing up its iconic associationwith American values, Bud is expandingrapidly in places like China, Brazil andRussia, where the premium ends of themarket are small but growing rapidly.

In China, for example, Budweiseralready has 35% of the premium importmarket, which accounts for maybe 4% ofthe 550 million barrels of beer sold eachyear. Management believes over the nextdecade the overall Chinese market will hit

one billion barrels per year and that thepremium piece will go to 15%, compara-ble to most developed markets. Back-of-the-envelope math would indicate that ifBud can maintain its share of premiumbeer sales in China, its operating profit inthe market could go over the decade fromaround $200 million to $3 billion. That isjust one brand in one admittedly giantmarket, but shows the kind of globalopportunity the company has.

How cheap are the shares, now at $58.20?

TR: The valuation today is quite modestat just over 13x 2012 consensus earningsestimates. The market seems to be con-cerned in the near term about rising inputcosts and doesn’t yet grasp the potentialin developing markets. We believe there isa clear path through reinvestment andcontinued cost synergies from the A-Bacquisition for the company’s bottom lineto grow at a low- to mid-teens annualrate for some time – with the stock priceat least following suit. The market seemsleery of management’s ability to execute,a concern I find completely unfounded.

What’s behind your interest in consumer-products giant Unilever [UN]?

TR: The basic premise here is that thecompany has the highest relative expo-sure to fast-growing developing markets,while at the same time has been the leastwell-run of the large global consumer-goods companies. As it hits its full stride,the upside potential is quite high.

Unilever’s heritage has been a mixedblessing. It was early in building out itsglobal footprint, so that a relatively high55% of revenues today come from devel-oping and emerging markets. It has long-established and thriving businesses inplaces like India and Brazil, giving it a legup in the parts of the world that shouldgrow the fastest.

On the other hand, an overly complexand duplicative organizational structureleft it with excessive fixed costs, a lack ofdecentralized accountability for results,inconsistent brand-building efforts, inad-equate information systems and a muted

Anheuser-Busch InBev(NYSE: BUD)

Business: Largest global brewer with 14of its brands – including Stella Artois,Beck’s, Budweiser and Michelob – gener-ating annual sales in excess of $1 billion.

Share Information(@11/28/11):

Price 58.2252-Week Range 49.05 – 64.53Dividend Yield 1.7%Market Cap $92.82 billion

Financials (TTM):

Revenue $38.64 billionOperating Profit Margin 30.9%Net Profit Margin 12.9%

THE BOTTOM LINE

With unmatched global scale in a scale business and management that appears asadept at brand building as it is at cost cutting, Tom Russo believes the company’searnings can growth at a low- to mid-teens annual rate for some time – with the stockprice, now trading at a “modest” 13x forward earnings, at least following suit.


BUD PRICE HISTORY


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Valuation Metrics(@11/28/11):

BUD S&P 500Trailing P/E 18.9 13.4Forward P/E Est. 13.7 11.7

Largest Institutional Owners(@9/30/11):Company % Owned

Clearbridge Adv 0.3%KeyBank 0.3%Gardner Russo & Gardner 0.2%Wellington Mgmt 0.2%Brown Brothers Harriman 0.2%

Short Interest (as of 10/31/11):

Shares Short/Float n/a

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sense of urgency. Up against companieslike Procter & Gamble, Nestle, Colgate-Palmolive and Reckitt Benckiser, that putthem at a competitive disadvantage thathas been a challenge to overcome.

Much of our bet is that Paul Polman,who took over as CEO in 2009 fromNestle, will successfully complete the cul-tural transformation started under previ-ous CEO Patrick Cescau. It’s a monumen-tal task, but he is rooting out organiza-tional inefficiency and inefficient manu-facturing utilization. He is investing inmanagement information systems likethose he championed at Nestle, whichpromote localized decision-making sup-

ported by company-wide best practicesand information. He is more consistentlynourishing brands with the properamount of advertising and marketingsupport. All told, he still has 200 to 300operating-margin basis points to go to getto the minimum mid-teens level a busi-ness like this should have.

One concern I have is that the compa-ny may have moved too quickly on theacquisition front, buying the personal-care business of Sara Lee in 2009 andthen Alberto Culver about a year ago.Those businesses have been slow to inte-grate, complicating the broader transfor-mation and slowing it down.

What upside do you see in the U.S. ADR,now at $32.40?

TR: At a 14x forward multiple, theshares trade at a discount to peers. Thecompany owns publicly traded sub-sidiaries in India and Indonesia, whichtrade at much higher multiples and ifbacked out make the rest of the businessthat much cheaper. I could do cleverthings like short out the subsidiary expo-sures to isolate the core business, but I’mcontent to win from them delivering onrelatively modest expectations from anunchallenging valuation.

You have 55% of the business in mar-kets that are typically growing at anannual rate of 10-15%. With operatingleverage and the margin improvementscoming through, that should sustain bot-tom-line growth in excess of 10% peryear. If that happens and we get somemultiple expansion on top of that, we’lldo well.

This is still a show-me idea. But themodel of P&G under A.J Lafley andReckitt Benckiser under Bart Becht –when those firms delivered enormousshareholder value during similar periodsof transformation – leads me to believe thepayoff here could be well worth the wait.

Your position in Wells Fargo wouldappear to be a strategic departure. Is it?

TR: Wells is a company whose shares Ihave owned for almost 20 years. Whilenot a perfect match with the rest of myportfolio, it has a long and successful his-tory in nurturing and taking advantage ofits first-class consumer brand. It has evi-denced significant capacity to reinvest,and management has shown the willing-ness time and again to focus on buildinglong-term value at the expense of short-term criticism.

I consider the stock today a 50-centdollar, in large part because of the mar-ket’s profound concern about the bankingsector in general. Just a few weeks ago thestock fell 5-6% after an analyst reporthighlighted how American banks wereexposed to trouble in Europe. The realityis that Wells is not that exposed to

Unilever(NYSE: UN)

Business: Manufactures, markets and sellsconsumer packaged goods in more than180 countries; brands include Knorr,Lipton, Dove, Vaseline, Axe and Brylcreem.



Financials (TTM):


THE BOTTOM LINE

The company’s operational and cultural transformation under CEO Paul Polman is a“monumental task,” says Tom Russo, but he believes the resulting margin gains coupledwith strong developing-market growth will fuel 10%-plus bottom line growth. Multipleexpansion on top of that, he says, would make “the payoff well worth the wait.”


UN PRICE HISTORY


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UN S&P 500Trailing P/E 16.0 13.4Forward P/E Est. 14.0 11.7

Largest Institutional Owners(@9/30/11):

Company % Owned

Wellington Mgmt 1.5%Invesco 1.1%Fisher Inv 0.9%Capital World Inv 0.8%BlackRock 0.6%


Shares Short/Float n/a

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Europe’s problems, but its stock goesalong for the bumpy ride with the rest ofthe industry.

What sets Wells apart in your mind?

TR: It starts with a clear focus on retailbanking and a culture oriented towarddriving customer involvement with abroad range of products. They recognizethat just by staying close to home theycan leverage the returns that accrue fromincreasing the number of products andservices – from checking, to credit cards,to wealth management – sold per house-hold. That’s how employees in the branchare incented. This focus has kept Wellsfrom having to rely on wholesale money,derivatives and sophisticated financialinstruments to generate profits. They dothings the old-fashioned way, lendingmoney and offering financial services.

The ongoing opportunity – and chal-lenge – for Wells today is to successfullytransmit its culture to the Wachovia busi-ness it purchased at the height of thefinancial crisis. Wachovia had essentiallythe same footprint as Wells in terms ofbranches and total assets, but it sold farfewer products per customer, relied muchless on core retail deposits, was moreinvolved in reckless mortgage lending andhad gone further afield in investment andcorporate banking. That cost it its inde-pendence and allowed Wells to buy it – ina splendid capacity-to-reinvest moment –at roughly 10% of what Wells was worthat the time.

The process of making acquiredWachovia more Wells-like has burdenedthe income statement since the merger, ashave crisis-related expenses that will notlast forever. Duplicate integration expens-es have run at well over $1 billion peryear since the acquisition. There are alsosignificant costs attached to managingthrough troubled real estate loan portfo-lios and in dealing with unprecedentedrefinancing activity. As these costs contin-ue to go away and the Wachovia businessstarts to operate according to new metricsmore consistent with those of Wells, youshould see a dramatic increase in the com-pany’s earnings power.

On top of that is the earnings benefitthat will come from the eventual return ofa more normal yield curve. I cannot tellyou when the world becomes safe enoughfor capital that we will once again have ayield curve that makes sense, but I amquite confident it will happen, and it willrelieve some of the massive pressure onnet interest margin that comes frominvesting non-loaned money at ratespainfully close to what’s being paid forcore deposits.

What does “normal” look like here andhow do you see it impacting the shareprice, now at $24.15?

TR: I have a high degree of comfort thatprofits should approach $4-plus per shareby 2014. If that happens, I don’t knowwhat the multiple will be, but it will like-ly be significantly higher than today’s 6xthat normal earnings level. In the mean-time I am comforted by a balance sheetthat isn’t pledged with instruments I can’tunderstand and by a retail franchise thatis secure and offers enormous value toconsumers who use it.

What could go wrong?

TR: The world remains troubled from acapital standpoint, so it’s likely that Wells

Wells Fargo(NYSE: WFC)

Business: With $1.3 trillion in total assets,provides banking, insurance, investmentsand mortgage products and servicesthrough 9,000 offices primarily in the U.S.



Financials (TTM):


THE BOTTOM LINE

As integration expenses from its acquisition of Wachovia go away and the acquiredbusiness achieves metrics more consistent with its own, the company’s earnings powershould increase sharply, says Tom Russo. That, he says, would warrant a “significantlyhigher” multiple than the current 6x his $4-plus estimate of normal per-share earnings.


WFC PRICE HISTORY


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WFC S&P 500Trailing P/E 8.9 13.4Forward P/E Est. 7.4 11.7

Largest Institutional Owners(@9/30/11):

Company % Owned

Berkshire Hathaway 6.8%Fidelity Mgmt & Research 3.8%Vanguard Group 3.7%State Street 3.6%Capital World Inv 2.9%


Shares Short/Float 1.0%

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will be required to tie up more capitalthan it needs. That may limit its flexibili-ty in buying back shares, which at today’sprices would likely be highly accretive toshareholder value.

There is also always a risk that thecompany is no longer content with beingthe best retail bank and deploys capitalelsewhere, say into the investment-bankand brokerage businesses acquired fromWachovia that can have a way of siphon-ing off investment. I do not believe thatwill happen, but it’s worth watching.

While Wells is your only bank, you obvi-ously have no hesitation owning multiplecompanies in the same industry. Why?

TR: There are not that many great busi-nesses in the world, so to the extent I canhave multiple exposures in them, I amlucky. Pernod is one of three spirits com-panies I currently own, the others beingBrown-Forman [BF-B] and Diageo[DEO]. In addition to AB-InBev in beer, I

have owned Heineken [HEIO:NA] since1989 and SABMiller since 2008. We alsospoke about tobacco. In general, it seemsartificial to me to force myself to buy thebest steel mill, for example, because I

have already filled my one allotment for aglobal spirits company. Where it gets a bitawkward is when I’m expecting compa-nies in the same industry to expand sharein the same key countries, but given theoverall growth potential in those coun-tries and the admiration I have for thecompanies’ franchises and management, I

don’t consider that an overly risky posi-tion to take.

You seem more or less unperturbed by themarket turbulence we’ve experienced inrecent years. Any secret to that?

TR: I’ve been lucky enough to havetrained at the Sequoia Fund and to haveinvested in Berkshire Hathaway for thepast 28 years, so I’ve tried to learn fromthose who take a patient posture andhave had such robust success.

Recent commentary around BillMiller’s retirement suggested that invest-ing today is a new game requiring a newset of tools. I believe pronouncements of anew era will prove to be as misplacedgoing forward as they have been in thepast. The work Bill did over his career –identifying great businesses trading at fairprices and lengthening out the time hori-zon to investors’ profit – should remain arewarding game going forward. That isthe game I attempt to play as well. VII

ON SECTOR INVESTING:

It seems artificial to force

myself to buy a steel mill

because I have filled my allot-

ment for spirits companies.


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