value investor insight issue 336[1]

One theoretical knock on investorswho specialize by industry is thatadvocacy can eventually taint their

objectivity. To Shawn Kravetz, however,that's much less of a problem for managersas willing to go short as long. “Focusing ona sector does not mean we're long in it, oreven that we're invested in it at any giventime,” he says.

Kravetz's discerning taste has served hisinvestors quite well since he foundedEsplanade Capital in 2000. His flagshipfund has earned a net annualized 8.1%since inception, vs. 1.3% for the S&P 500.

Gravitating often to turnarounds andoff-the-beaten-path small caps, he sees mis-pricing today in such areas such as solarenergy, footwear, casino gaming andJapanese convenience stores. See page 10

ValueInvestor March 30, 2012

Capital AppreciationOwning companies that are unlikely to generate headlines or set pulses racinghas paid off more than handsomely for Fiduciary Management’s Pat English.

Inside this IssueF E ATU R E S

Investor Insight: Pat English

Casting a wide net for high quality atlow prices and finding it today inHenkel, Sysco, Arrow Electronicsand Compass Group. PAGE 1 »

Investor Insight: Shawn Kravetz

Sticking to his knitting to identifymispriced securities such as Skechers,MEMC Electronic, Wacker, Ministopand Lakes Entertainment. PAGE 1 »

Uncovering Value: Poseidon

A low-profile player with a “disrup-tive” solution in a high-profile cornerof today’s energy market. PAGE 18 »

Uncovering Risk: Diamond Foods

Is this beleaguered food company acompelling contrarian bet ... or anongoing train wreck? PAGE 20 »

Strategy: Zeke Ashton

Centaur Capital’s founder outlinesthe essential elements of a built-to-last investment strategy. PAGE 21 »

INVESTMENT HIGHLIGHTS

Other companies in this issue:

Alliant Techsystems, Archon, Comerica,

Dentsply, Devon Energy, FamilyMart, First

Republic Bank, GlaxoSmithKline, Las

Vegas Sands, McGraw-Hill, Patterson

Companies, Sanderson Farms, Staples,

Tokuyama

Ins and OutsWhile his industry focus might be considered relatively limited, Shawn Kravetz'sability to recognize mispriced stocks has proven to be far more expansive.

The Leading Authority on Value Investing INSIGHT

INVESTMENT SNAPSHOTS PAGE

Arrow Electronics 5

Compass Group 8

Diamond Foods 20

Henkel 7

Lakes Entertainment 16

MEMC Electronic Materials 12

Ministop 15

Poseidon Concepts 18

Skechers 14

Sysco 6

Wacker Chemie 13

Pat English wasn't planning to be in itfor the long haul when he joinedMilwaukee's Fiduciary Management,

Inc. as an analyst in 1986. He'd moved tofollow his wife as she pursued a medicaldegree – “I wasn't expecting to make along-term investment,” he says.

Fiduciary investors can be glad he did.English, now CEO of the $12.5 billion(assets) firm, has been a driving forcebehind its flagship small-cap strategy earn-ing a net annualized 14.8% since 1980, vs.10.6% for the Russell 2000.

Focused on companies obsessed withtheir own returns on investment, English isfinding opportunity today in such variedareas as adhesives, consumer products,pharmaceuticals, technology distributionand food services. See page 2

www.valueinvestorinsight.com

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

Pat EnglishFiduciary Management, Inc.

Investment Focus: Seeks companieswhose under-pressure stock prices mostmisrepresent the underlying return-on-capital dynamics of their businesses.

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

Shawn KravetzEsplanade Capital

Investment Focus: Seeks “growth com-panies at value prices,” for which he's earlyin recognizing potential and believes mar-ginal economics will surprise on the upside.

http://www.valueinvestorinsight.com

I N V E S TO R I N S I G H T : Pat English

Value Investor Insight 2March 30, 2012 www.valueinvestorinsight.com

Investor Insight: Pat EnglishPat English and Andy Ramer of Milwaukee’s Fiduciary Management, Inc. describe what “quality” means to them inassessing a business, why they'll make exceptions to buy in industries they usually avoid, what golf lessons translate toinvesting, and what they think the market is missing in Henkel, Arrow Electronics, Sysco and Compass Group.

Your strategy focuses on assessing a com-pany’s business before its stock. Describethe primary elements of that.

Pat English: Our fundamental belief isthat top management and Wall Street areoverly optimistic, which leads to ineffi-ciency in how stocks get priced. For atime that may be to the upside, but itworks on the downside as well whenthere’s the inevitable disappointment.Our goal is to have identified a fullbullpen of companies that we believehave good businesses, so that we’re pre-pared to take advantage when disap-pointment hits and their shares becomeattractive.

These bullpen companies have certaintypical characteristics. They have highlevels of recurring revenue. They haveminimal financial risk – little to no netdebt for smaller-caps, and no more than30-40% debt to total capital for largecaps. Their businesses aren’t complicated,nor are the investment theses. We paycareful attention to our return on time, sowe’re not interested in tackling highlycomplex, time-consuming ideas.

Our most important focus is onunderstanding a business' return oninvested capital and, perhaps moreimportantly, its return on incrementalinvested capital, which I've learned toappreciate more and more over the past25 years. We scrub the financials to get areliable picture of the company’s histori-cal full-cycle ROIC and want to see it sig-nificantly ahead of its weighted averagecost of capital, which means the compa-ny is creating shareholder value. If a badacquisition has been written off, forexample, we’ll evaluate whether some orall of that writeoff should be added backto the capital base in assessing the returnon capital. We’re not just looking back-wards, but also want to see that prospec-tive returns – based on our estimates of

earnings and the investments necessaryto generate those earnings – are going tobe attractive.

Related to this emphasis on ROIC,we’re looking for management with aclear shareholder focus. What you havetoo often is a mentality that bigger isalways better: If an acquisition offers a5% ROI and cash is only earning 2%, doit. This doesn’t make sense – it adds riskand likely doesn’t cover the true cost ofcapital. If that’s all they can do with themoney, we’d rather they return it to usand we’ll reinvest it somewhere else. Tofoster our way of thinking, we want topmanagement paid on returns, not growth,and for them to own stock outright ratherthan through options. The only way tothink like an owner is to actually be one.

What puts pressure on share prices ofcompanies you admire?

PE: It’s often normal cyclical or company-specific pressure that Wall Street has nopatience to see through. We like it whenStreet research talks about waiting forindustry fundamentals to improve or forevidence that a turnaround is taking hold.Once those things happen the stock mayhave already moved 25% or more. If webelieve the pressure is temporary and thevaluation is compelling, we’ll take thattime risk.

Andy Ramer: To give an example, webought Sanderson Farms [SAFM], thefourth-largest producer of chickens in theU.S., in January 2011 when the stock fellinto the $30s because the industry waslosing money due to rising supply, fallingdemand and higher commodity feedcosts. We’d seen this before and werecomfortable that the industry and compa-ny were responding and that the imbal-ances would work out over 12 to 18months. We were surprised how quickly

Pat English

Of Course

By the end of his freshman year at

Stanford, Pat English started to reconsider

his dream of being a professional golfer. “I

was fifth on my college team. Given the

number of division-one programs and how

many players made it on tour, I didn't need

to be a genius to figure out that wasn't

going to happen,” he says.

His backup plan has proven to be a hole-

in-one. After graduation, English spent two

years as an analyst at Dodge & Cox and in

1986 joined Milwaukee's Fiduciary

Management, where by 1989 he was

Research Director and where he is now

CEO and Chief Investment Officer, over-

seeing $12.5 billion.

With a son starting out in the business,

English draws on his own time as a golfer

for lessons to impart. “I tell my son often

about this guy on our Stanford team we

called “Moon Man,” who seemed to be

operating in this lunar zone of some sort.

His swing wasn't great and he didn't strike

the ball that cleanly, but he always scored

well because he never blew himself up.

Investors forget that lesson all the time and

over-reach, over-concentrate and take on

too much risk – none of which is necessary

to score well.”




the market starting pricing in the recov-ery, so sold our stake at the end of lastyear when the stock was in the low $50s.

PE: It’s not always a cyclical issue. Onegood example that goes back to late2008 is McGraw-Hill [MHP], which webought when the stock traded downtoward $20 as the market feared that theStandard & Poor’s ratings business wasdoomed and that the educational busi-ness faced potential spending cutbacksand vulnerability to the digital distribu-tion of books. Our basic view was thatthese issues were manageable and thatboth franchises were sounder than themarket believed. On a sum-of-the-partsbasis we thought the stock was worth$45-50, which is close to where we soldit in the fourth quarter of last year. Thereis likely more value there, but we weredisappointed that despite the heavy pres-sure activist investor JANA Partners puton the company, the best it could do wasa spinoff of its education business. Atthe then-current price, we weren’t will-ing to accept the regulatory and litiga-tion risk that remained for the ratingsbusiness.

You’ve written about getting interestedagain in pharmaceutical stocks. What’sbehind that?

PE: It was our contention for some timethat the research efforts of the large phar-maceutical firms were not generating pos-itive economic value. The cost of new-drug development and the length anduncertainly of the regulatory approvalprocess had changed so significantly thatthe expected net present values of drugpipelines had in many cases turned nega-tive. Stocks that looked cheap reallyweren’t if you valued the drug pipelinescorrectly.

It has taken years, but this dynamichas been changing. Industry managementis taking a much more thoughtfulapproach toward how they’re spendingR&D money and we believe the net pres-ent value of drug pipelines is again turn-ing positive. The companies have alsobegun to trim bloated overhead struc-

tures. To the extent the market is slow torecognize this, there can be opportunityin select cases.

What’s a representative current example?

PE: GlaxoSmithKline [GSK] is one webelieve is well positioned because of itsless onerous patent-expiration issues, itsdiversified product mix across therapeu-tic classes, geography and molecular for-

mulations, and its new-product pipelinethat is showing improved productivityand has a number of meaningful, noveldrugs in phase-III development.

When we bought this in the third quar-ter of last year, the valuation to us impliedthat the market viewed the existing drugfranchises as almost a runoff-asset situa-tion and placed little to no value on thepipeline. On a sum-of-the-parts basis, westill believe the stock’s fair value is 60-75% higher than the current share price[of $45], while in the meantime we’reearning a better than 5% dividend yield.

You largely avoid both energy producersand banks. Why?

AR: In energy exploration and produc-tion, the commodity nature of the busi-ness makes companies struggle to earntheir cost of capital over time, but whatconcerns us as much is that managementteams too often don’t even focus on ROIand just want to grow. When we findexceptions to that, we will invest. Weown Devon Energy [DVN], for example,which has a production mix that is abouttwo-thirds natural gas and one-third oiland natural gas liquids. It has superioracreage positions with low entry costsand royalty burdens, a great balance

sheet, and its return on invested capitalover a cycle is in the top three in theindustry. The stock [at a recent $70.60] isunder pressure because of the severedowndraft in natural gas prices, but wethink the market is missing the deep port-folio of liquids-rich areas Devon can tar-get for development – over 90% of itscurrent capex is going into crude oil orwet gas – and on which it can earn verynice returns. The time to buy commodity-related businesses is when supply is fulland pricing is depressed, which is certain-ly the case with natural gas today. In thismanagement’s hands, we’re more thanwilling to ride out the cycle.

PE: The issue with banks is primarily thatit’s too difficult to see the assets and doour own underwriting of the loans andinvestments they make. They get theirROE from high leverage and low mar-gins, which is a risky premise from theget-go, and they go through loan boomsand busts that make returns over time notvery good. We’d much rather own amoney manager, say, which has high mar-gins and low leverage and has nice returnsthrough a cycle.

Comerica [CMA] looks like a Devon-likeexception in your portfolio. Why is it abank you’re willing to own?

PE: Comerica has an excellent long-termcredit track record, which makes us lessconcerned about the black-box nature ofthe business. We’re comfortable weunderstand what it does, which is basi-cally plain-vanilla lending with nothingexotic elsewhere on the balance sheet.The stock [now trading at $32.30] hasbeen under a cloud because the economyhas been weak and the interest-rate envi-ronment has been poor. We basicallyview this as an excellent call option onboth of those trends eventually returningto the mean.

On what do you primarily focus in yourresearch?

PE: We’ve developed over 25 years a com-prehensive research format we go

ON NATURAL GAS:

The time to buy is when sup-

ply is full and pricing is

depressed – certainly the

case with natural gas today.




through in vetting ideas, with a detailedlist of questions to answer about everyprospective investment. A big part of thatgoes toward understanding industrydynamics and trends, the competitiveenvironment, and how the companystands apart in any number of areas – itsproducts, distribution, cost structure, sell-ing effort, etc.

Also key is understanding how man-agement makes capital-allocation deci-sions – not surprisingly focused on theemphasis on return on capital – how theymeasure it and how they’re compensatedon it. This is often where we’ll hit road-blocks. For instance, Dentsply [XRAY] isin a business we love, an oligopoly pro-viding dental supplies that mostly aren’tsubject to reimbursement and that pro-duce stable, recurring revenues. We’d liketo own it, but management seems to havedecided the best path is to do acquisitionswe believe are value-destructive. We’llkeep it in our bullpen until that changes.

Our financial analysis centers onassessing margins, earnings power andreturns on capital over time. We set targetprices based on the valuation levels atwhich we believe companies with certainmargin structures and return profilesshould trade. If it’s a 10% EBIT-marginbusiness through a cycle, say, we’ll beinterested if it trades at less than 1x rev-enues on an enterprise-value basis. We’reoften counting on the business improvingfrom some level of under-earning today,which will also result in a revaluation –say from 0.7x EV/Revenues to 1.2x asthat happens over the ensuing few years.

We always ask before buying whetherwe’d be comfortable putting the stock ina lockbox for five years and not touchingit. If we’re not, we shouldn’t buy it. That’snot an argument for putting your head inthe sand, but we think you need that levelof confidence in the business to thinkmost clearly when things go temporarilyawry and clients are questioning you.

You run very concentrated portfoliosgiven your level of assets. Why?

PE: In small cap – which for our purpos-es is anything under about $4 billion in

market cap – we typically have about 45stocks. Our large-cap and internationalfunds each have about 25 positions.Given some overlap in large cap andinternational, that means we own rough-ly 85 unique names at a time.

Our basic goal is to hold enoughstocks to be well diversified acrossindustry sectors, while not holding somany that our investment team becomesdifficult to manage. We don’t mimic ourbenchmarks, but we do believe it’s pru-dent to have exposure to most majoreconomic sectors. In our large-cap port-folio, for instance, our 25 stocks areprobably going to represent 60 different

industries. We have an unwritten rulethat each of our investment profession-als essentially puts their entire net worthonly in our stocks. This focuses everyoneon what is best for clients and is also agood risk mitigator in that with your networth on the line, you will be sensitiveto diversification and prudence in allthat you do.

We have a total of seven analysts,including myself, and we believe wheninvestment teams have more than 10 peo-ple they start to break down. Egos get inthe way, people start to specialize and youjust can’t have the quality of collectivediscussion we think is necessary.

Do you follow any particular rules onposition sizes?

PE: It’s fairly rare for a position in any ofour portfolios to get higher than 5-6% ofthe portfolio, but we do make distinctionsbased on our level of conviction. One ofour biggest small-cap holdings, for exam-ple, is Patterson Companies [PDCO],which is in the dental-supply market I

described earlier in speaking aboutDentsply. Patterson is a high-ROI busi-ness, with lots of recurring revenue, secu-lar industry tailwinds, a great balancesheet and plenty of liquidity in the mar-ket. The negative investment issues areprimarily related to the stagnant econo-my. Given our conviction in the businesslong term, we’re happy to make it a larg-er position.

Describe why Arrow Electronics [ARW]is high on your conviction list today?

PE: We’re typically not attracted to mosttechnology businesses because of cut-throat competition, potential technologyobsolescence, short product cycles, andthe excessive use of stock options. Thereturn on time is also a problem – youspend so many hours analyzing newproducts and technology trends that 50%of your time gets spent on 5-10% of yourportfolio.

At the same time, technology is animportant driver of economic growth andgrows at above-GDP rates, so we want tohave exposure to it. We like to attack dif-ficult industries through the side door, soto speak. In Arrow, we have a leading dis-tributor of technology products – includ-ing semiconductors, software and elec-tronic components – that supplies mostlysmall and medium-sized companies. Thatallows it to benefit from the growth inhigh tech without the typical risks associ-ated with tech stocks.

How high-quality do you consider thisbusiness?

PE: It’s gotten much better in recent years.It’s more geographically diverse, with50% of Arrow’s revenues coming fromthe Americas, 30% from Europe and therest from Asia. The company has 1,200suppliers and more than 125,000 cus-tomers, so there’s no over-dependence oncertain products or vertical markets.Management recognized a number ofyears ago that growth for growth’s sakewas not conducive to shareholder value,so they re-focused on turning assets morerapidly and pursuing a better mix of busi-

ON TECHNOLOGY:

We like to attack difficult

industries that are important

drivers of growth through the

side door, so to speak.




nesses. Over a full cycle, we see this as a12-13% ROI business.

Isn’t there plenty of cutthroat competitionin this market?

PE: Avnet [AVT] is the primary competi-tor and has done battle with Arrow fordecades. But this is still a big and growingindustry, with over half of the marketmade up of smaller players that don’thave the economies of scale and supplierrelationships that Arrow and Avnet do.That leaves plenty of opportunity forboth of the leaders to take additionalshare. There are also ample growth

opportunities in new product categoriesand overseas.

How inexpensive do you considerArrow’s shares at a recent $42?

PE: We think there’s a real disconnectbetween the current valuation and theimproved quality of the business. It usedto be that when Arrow went through adown cycle it would be lucky to makemoney, but indicative of how the struc-ture of the business has changed, it madegood money through the last cycle andwas still earning its cost of capital even atthe cycle bottom.

Given its long-term return on equityprofile and assuming a normalized EBITmargin level of roughly 5% – it’s 4.5%today – we believe Arrow’s stock shouldtrade at 50-60% of revenues on an enter-prise-value basis. It’s traded in that rangemany times in the past – when it wasarguably a much inferior business – buttoday the stock trades at only 28% ofrevenues.

At 55% of $22 billion in revenues, theenterprise value today would be around$12.1 billion. Less $1.5 billion in net debtwould leave a market cap of $10.6 bil-lion, which on 112 million shares out-standing would translate into a shareprice of $95. Once the market stops treat-ing Arrow as some sort of pariah, there’sjust enormous upside in the stock.

Sticking with the “side-door” theme,describe your interest in Sysco [SYY].

PE: Sysco is the largest food distributorin North America, distributing 300,000products to roughly 400,000 restau-rants, schools, hotels, nursing homesand other food-service providers.Restaurants account for about two-thirds of the business.

Restaurants are by and large not verygood businesses – highly competitive,tough to manage and not particularlyprofitable over time. You’ll have the rarebreakout growth story like Chipotle, astalwart to invest in like McDonald’s andmaybe an occasional turnaround, but it’sa tough area for value investors.

That said, due to demographics andchanges in lifestyles, the restaurant busi-ness overall is secularly growing. Just aswe want to get at technology growththrough Arrow, we believe Sysco providessimilar access to restaurants.

And Sysco is an even better business.It’s the industry leader with 18% of theU.S. market, twice the size of the nextbiggest player, US Foods, and is muchmore profitable. It has very high recurringrevenue and a route-based model inwhich the incremental customer isextremely profitable. Even in a shaky eco-nomic climate and with some self-inflict-ed wounds, it’s earning almost 20%

Arrow Electronics(NYSE: ARW)

Business: Global distributor to OEMs and

commercial users of technology products,

including semiconductors, storage devices,

software and electrical components.

Share Information

(@3/29/12):

Price 42.0752-Week Range 25.71 – 47.50Dividend Yield 0.0%Market Cap $4.71 billion

Financials (TTM):

Revenue $21.39 billionOperating Profit Margin 4.4%Net Profit Margin 2.8%

THE BOTTOM LINE

Even though it has significantly improved the quality of its business and offers a “side-

door” way to play technology growth, the market treats the company as “some sort of

pariah,” says Pat English. At the EV/Revenues ratio at which he believes the shares

should trade – and at which they’ve traded in the past – the stock would be $95.

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

ARW PRICE HISTORY

Sources: Company reports, other publicly available information

50

40

30

20

10 2010 2011 2012

Valuation Metrics

(@3/29/12):

ARW S&P 500Trailing P/E 8.1 16.2Forward P/E Est. 8.4 13.6

Largest Institutional Owners

(@12/31/11):

Company % Owned

Fidelity Mgmt & Research 9.8%Wellington Mgmt 9.7%Artisan Partners 8.1%First Pacific Advisors 4.3%Vanguard Group 4.1%

Short Interest (as of 3/15/12):

Shares Short/Float 1.0%

50

40

30

20

10




returns on invested capital. This is onewhere if you think in terms of the lock-box analogy, you could put this away forfive years and be pretty confident uponopening the box that the challenges haveameliorated and that the core businesswas fundamentally sound.

What are the challenges you’re expectingto get better?

PE: One is high unemployment, whichtranslates into fewer out-of-home mealsand a shift in spending from the casual-dining outlets Sysco mostly serves towardquick-service restaurants like McDonald’s

and Chipotle. Some people think casualdining is now in secular decline, but wedon’t believe that. The changes inlifestyles and consumer habits that fueledthe casual-dining boom are unlikely tohave permanently disappeared.

Another big issue for the company hasbeen its giant enterprise resource plan-ning [ERP] software implementation,which has been a beast. This year andnext are the maximum spending years,and the entire system will cost them over$1 billion before it’s fully operational.The goal is to dramatically improve sup-ply-chain efficiency and productivity,improving customer service while driving

down costs. It’s very difficult to say howSysco’s efforts will ultimately pay off, butwe have no reason to believe they won’t,and we’ve seen similar companies likeW.W. Grainger leverage their new ERPsystems to achieve significant marginimprovement. At the moment, the effortis costing them approximately 35 centsper share in earnings on top of the capi-talized costs and management distraction.That dynamic will obviously change asthe project winds down.

What upside do you see in the shares,now at $29.80?

PE: Without the ERP-system spendingand assuming modest improvement in theeconomy, we believe Sysco’s earningscould be pushing $3 per share within thenext two years, up from a run rate ofaround $2 per share today. As earningsrecover, we’d also expect some multipleexpansion. The company’s average P/Emultiple over the past ten years has been19x, but even at 16-17x our estimate ofnormalized earnings, we’d have a $50stock. On top of that we’re getting a3.6% dividend yield.

Does acquisition-related growth concernyou here?

PE: We do normally look askance atgrowth by acquisition, but in this case itcan make sense to do bolt-on acquisitionsthat can be integrated fairly quickly intothe existing distribution system.

More concerning today are the impactof higher gasoline prices on delivery costsand the potential for accelerating foodinflation hitting both end-user restaurantdemand and Sysco’s ability to pass oncost increases. Our assumption is thatneither issue becomes too acute, but theyare things to monitor.

Turning to a non-U.S. idea, what attractsyou to Germany’s Henkel [HEN:GR]?

AR: The company is interesting in that ithas a strong position in both industrialand consumer end markets. Roughly halfof the business is in adhesives, where

Sysco(NYSE: SYY)

Business: Food and related-product distri-

bution to restaurants, hospitals, nursing

homes, schools and other entities serving

out-of-home meals in North America.

Share Information

(@3/29/12):

Price 29.7852-Week Range 25.09 – 32.76Dividend Yield 3.6%Market Cap $17.41 billion

Financials (TTM):

Revenue $41.02 billionOperating Profit Margin 4.7%Net Profit Margin 2.8%

THE BOTTOM LINE

The sluggish economy and a massive software implementation project that is currently

all costs and no benefits is obscuring the enduring quality of the company’s business,

says Pat English. As those two challenges ameliorate, he believes the company can

earn $3 per share within two years, justifying a share price of closer to $50.


SYY PRICE HISTORY


35

30

25

20

152010 2011 2012

Valuation Metrics

(@3/29/12):

SYY S&P 500Trailing P/E 15.3 16.2Forward P/E Est. 15.4 13.6


(@12/31/11):

Company % Owned

State Street 4.9%Vanguard Group 3.9%First Eagle Inv Mgmt 3.6%Wellington Mgmt 3.4%Invesco 3.2%



35

30

25

20

15




Henkel is the global market leader sup-plying manufacturers in a broad range ofindustries, including mobile phones, cars,shoes, furniture and solar panels.Adhesives overall are taking global mar-ket share from fasteners, and Henkelbenefits in the business from economiesof scale and fairly high switching costs.We also like that while adhesives repre-sent a minimal share of the cost of agiven product, their contribution to itsefficacy is substantial. There are a fewcents' worth of adhesives in an AppleiPhone, for example, but the cost of fail-ure is very high.

On the consumer side, the company isa big player in laundry and personal care.Its better known brands include Dialsoap, Purex and Persil laundry detergentsand Schwarzkopf hair-care products.While not every part of this portfolio isfiring on all cylinders, we like that theseconsumer brands generally benefit fromgood brand loyalty and ongoing repeatconsumption.

The company has been through a fairlysignificant operational overhaul. Is thatprocess ongoing?

AR: Most of the heavy lifting has beendone since Kasper Rorsted took over asCEO in April 2008. He has discontinuedor sold some weaker brands, rationalizedthe manufacturing footprint and signifi-cantly reduced headcount, resulting inoperating margins increasing from 10%in 2007 to 13% last year. The target for2012 is 14%, and we see no reason thebusiness can’t earn 15-16% margins on anormal basis. That would still fall shortof what companies like 3M earn in adhe-sives or Procter & Gamble and Unileverearn in consumer products.

Is this a growth story?

AR: This is a typical name for us in thatyou’re not going to see off-the-chartsgrowth. The main drivers are the use ofadhesives in new applications and strongemerging-markets growth across productlines. Just over 40% of total revenuestoday come from emerging markets, and

the company expects that will be 45-50%relatively soon.

Over a cycle we expect the overallcompany to grow at a mid-single-digitannual rate, which it can leverage intolow-double-digit EPS growth as marginsexpand.

The company’s consumer-products busi-ness in North America has been strug-gling. Is that fixable?

PE: That is the part of the business thatWall Street is hung up on and it hasn’tdone well. They installed new manage-ment just over a year ago, which isfocused on improving the company’sproduct development and innovation,which has lagged. We’re watching itclosely and certainly don’t want it to

break down further, but in the end thisbusiness accounts for less than 10% oftotal revenues and our view is that theywill either turn it around or get rid of it,either of which would benefit overallmargins.

At a recent €€46.20, how cheap are theshares?

AR: The stock trades for 12.5x our 2012EPS estimate of €3.70, while theEuropean peer group trades at 18-20x.Given our view that this is an above-aver-age company, we don’t believe such a dis-count is warranted.

Looking at enterprise value to rev-enues, the current multiple is around1.4x, against the 1.8-2.0x at which webelieve a company with this margin struc-

Henkel(Xetra: HEN:GR)

Business: Producer of branded chemical-

based products focused on three primary

business lines: Adhesives, Laundry & Home

Care, and Cosmetics & Toiletries.

Share Information

(@3/29/12, Exchange Rate: $1 = €0.752):

Price €€46.1752-Week Range €30.22 – €47.32 Dividend Yield 1.5%Market Cap €21.61 billion

THE BOTTOM LINE

The market overemphasizes the company’s lagging North American consumer-prod-

ucts business and underemphasizes its strong potential in adhesives and in emerging

markets, says Andy Ramer. Based on peer comparisons and on where a company with

its margin structure should trade, he sees 40-50% upside from today’s share price.


HEN PRICE HISTORY


50

40

30

20

102010 2011 2012

Financials (TTM):

Revenue €15.60 billionOperating Margin 13.0%Net Profit Margin 8.0%

Valuation Metrics

(Current Price vs. TTM):

HEN S&P 500P/E 16.0 16.2

50

40

30

20

10




ture and return profile should trade.However we come at it, we believe there’s40-50% upside in the share price fromtoday’s level.

You own the “ordinary” rather than“preferred” shares. What’s the difference?

AR: The preferred shares are more liquidand there is a minor difference in the div-idend. The ordinary shares trade at a15% discount, which we don’t think iseconomically justified.

Describe the case for global food-servicescompany Compass Group [CPG:LN].

AR: Compass operates and staffs cafete-rias, restaurants and coffee shops on anoutsourced basis at corporate locations,

sports venues, universities and hospitalsworldwide. That accounts for around80% of revenues, with the rest comingfrom additional support services forthings like cleaning, landscaping andsecurity. Along with competitors Sodexo[SW] and Aramark, it is one of the fewfirms that can meet the needs of largerclients in multiple geographies and thatcan use its size for purchasing leveragewith suppliers.

This is a high-recurring-revenue busi-ness, with customer retention rates wellabove 90%. In addition, the outsourcingof food services is a global trend that stillhas plenty of room to run. Only 45% ofthe overall target market currently out-sources its food services, and in certainsectors like education and healthcare thatnumber is only 25-30%.

How does Compass distinguish itselfagainst Sodexo and Aramark?

AR: The breadth and quality of servicesare comparable, but what distinguishesCompass for us is the type of projectsthey bid on. It stays away from the high-profile project that might be very visiblebut doesn’t generate much profit. Theytry to avoid competing with the other bigplayers for deals, and are looking forprojects where the quality and value ofthe service can trump just a low price.This approach trades off some growth formargin, which is perfectly fine with us.

To give some historical perspective,Compass was an industry laggard for thefirst half of the 2000s, until RichardCousins took over as CEO in 2006 and ina disciplined way got out of over 40 coun-tries with sub-par profits, emphasizedorganic growth over acquisition, andinstilled a clear focus on ROI. Operatingmargins went from 4.4% to nearly 7%from 2006 to 2011 and now lead the com-petition. The target today is 8.5%.

The stock has done quite well over thepast few years. What is the market miss-ing with the share price at around £6.50?

AR: The P/E on next year’s earnings esti-mate of 47 pence per share is around 14x,which we don’t think adequately recog-nizes the quality of the business. Webelieve they can lever a top line growingat a mid-single-digit rate into high-single-digit EPS growth. With a better than 3%dividend yield, that would produce a 12-13% annual total return on the stock. Ifthe multiple expands to the 17x or so weconsider reasonable for an above-averagebusiness like this, our annual returnwould be in the mid-teens.

Speaking generally again, how well doyou recognize mistakes and move on?

PE: Any value investor needs to be highlysensitive to being on the wrong side of asecular issue. It’s one thing to be contrar-ian and another to be foolish.

A few years ago we owned Best Buy[BBY], which had a terrific track record

Compass Group(London: CPG:LN)

Business: Provider of food-related servic-

es for clients such as factories, hospitals,

schools and universities, sports venues, off-

shore oil platforms and military facilities.

Share Information

(@3/29/12, Exchange Rate: $1 = £0.627):

Price ££6.5352-Week Range £4.98 – £6.72 Dividend Yield 3.3%Market Cap £12.34 billion

THE BOTTOM LINE

Having significantly revamped its operations and refocused on returns on investment,

the company is poised to capitalize on global secular growth in the outsourcing of

enterprise food services, says Andy Ramer. He expects EPS growth, dividends and

some multiple expansion to translate into an annual mid-teens return on the stock.


CPG PRICE HISTORY


8

7

6

5

4

3

22010 2011 2012

Financials (FY ending 9/30/11):

Revenue £15.83 billionOperating Margin 6.4%Net Profit Margin 4.6%

Valuation Metrics


CPG S&P 500P/E 18.0 16.2

8

7

6

5

4

3

2




but whose stock was under pressure fromthe poor economy and concerns overheightened competition from Internetsellers like Amazon. At the time we basi-cally thought there was enough complex-ity around buying consumer electronicsthat Best Buy would hold its own againstAmazon, but in watching Amazon’s elec-tronic-product sales each quarter itbecome apparent that that basic premisewas flawed. Best Buy wasn’t doing terri-bly, but we almost couldn’t believe howfast Amazon was growing. We sold thestock in 2009 in the low $40s, so whileour original thesis was wrong, we did rec-ognize that earlier than others. [Note:BBY shares now trade around $25.]

More recently in small cap, we soldAlliant Techsystems [ATK] after conclud-ing we were underestimating the potentialseverity of defense-spending cuts. Thecurrent administration, Congress and theAmerican people don’t appear ready toaccept the kind of cuts that will be neces-sary in health and social spending, so

defense may be the whipping boy in thisequation. We didn’t want to be on thewrong side of that.

Critique the handling of your Staples[SPLS] position so far?

PE: Our patience is certainly being tested.A few things have kept us from movingon. One, in contrast to Best Buy, Stapleshas been much more successful in com-peting online, where it now generatesroughly half of its revenue. Two, webelieve the company has an obvious leverto pull to increase profitability by gettingout of its European retail business. Three,we think it’s too early to call Staples sec-ularly challenged, given that the cyclicaloffice-products environment remainspoor and U.S. white-collar employmenthas yet to rebound. If white collaremployment rebounds and Staples doesnot, then we have a problem. It is amature business, but over the long runshould still grow modestly and the stock

is highly depressed, carrying a 10% freecash flow yield.

Pat, you were a scholarship golfer atStanford – how’s your game today?

PE: Not great. I need strokes from my 18-year-old, the 16-year-old regularly beatsme, and it won’t be long before my 13-year-old does as well.

I do think my time playing golf taughtme some useful lessons as an investor. Forone, you make mistakes all the time andyou try to learn from them, but it’s alwaysabout the next shot. It’s about properlypreparing and then executing to the bestof your ability. That’s an excellent mind-set for an investor to have.

Another thing tournament golf teachesyou is resolve. You can have a bad nineholes, or even a bad round, and still wina four-round tournament. If you hang inthere, keep your wits about you and don’ttake undue risks, the end result can turnout quite well. VII


http://valueinvestingcongress.com/landing/o12/partners/vii/april.php?utm_source=VII&utm_medium=A&utm_campaign=O12VIIE&ocode=O12VIIE

I N V E S TO R I N S I G H T : Shawn Kravetz


Investor Insight: Shawn KravetzEsplanade Capital's Shawn Kravetz explains his evolving views in areas of focus such as gaming and for-profit education,the types of small and “messy” situations that attract him, why he's added solar energy to his circle of competence, andwhy he sees upside in Skechers, MEMC, Ministop and Lakes Entertainment and downside in Wacker Chemie.

You spoke in our last interview [VII,December 30, 2005] about the impor-tance of sticking to one’s circle of compe-tence. Have your views evolved on that?

Shawn Kravetz: My basic view hasn’tchanged, which is that an extensiveknowledge of a business improves yourability to recognize patterns and drawuseful insights, a prerequisite to having aninvestment edge. Beyond that, I’d arguethat expertise is critical when thingsinevitably happen and you either need theconviction to stick with your thesis or thewisdom to recognize that it’s changed andreact accordingly. Stepping outside ofareas we know well just seems too muchlike dancing through a minefield.

What we’re essentially looking for aregrowth companies, trading at valueprices, in which we’re early in recogniz-ing the future potential and where webelieve the marginal economics are evenbetter than people think. We look forthose opportunities in industries in whichwe have deep experience, which areretail/consumer, gaming, education, busi-ness services and – new since we lastspoke – solar energy.

Last time you described secular growthpotential as a key rationale for thoseindustry choices. Is that as true as it oncewas, say, in for-profit education?

SK: Education was our largest sector onthe long side in the early years of the fund,was a source of both select long and shortopportunities preceding and following the2008 financial crisis, and is today virtual-ly absent from our portfolio. The industrysomewhat recklessly brought in too manystudents and charged them too much, allwith the help of government largesse.We’re now well into the retrenchmentperiod – which means we’re finding inter-esting things to again look at – but it’s

going to be a long unwind that will bemore secular headwind than tailwind.

In a similar context, what’s your updatedtake on gaming?

SK: Gaming, particularly for casinooperators, is a fabulous business withextremely high returns on invested capi-tal. The recession obviously hit theindustry hard, given the high leverage ofmany of its players and the business’overall sensitivity to consumer spending.But gaming’s fundamental growth driv-ers of increasing discretionary incomeand increasing spending on entertain-ment as incomes rise are very much stillintact worldwide. We never believed theindustry was immune to cycles, butwhile the U.S. was struggling, new mar-kets blossomed that have made LasVegas look almost quaint. There’s agood chance Las Vegas in 2012 will bethe third-largest gaming market in theworld, behind Macau and Singapore.The growth in Macau has been stagger-ing over the past five years – it now gen-erates five times the profits of Las Vegasas a gaming center.

Singapore may be even more interest-ing as a model. It methodically set out tobe in the gaming business and believed itcould thoughtfully manage and controlthe process while generating significantrevenues for the country. It sold two veryexpensive licenses – one to Las VegasSands [LVS], whose stock we own, andthe other to Malaysia’s Genting Group –creating a duopoly in a stable, highlyattractive market. Analysts were consid-ered incredibly optimistic in estimatingthat Las Vegas Sands’ casino there, whichopened in 2010, could generate $500 mil-lion in EBITDA annually, making it themost profitable casino in the world. Thatcasino today is earning at a run rate of$1.6 billion in annual EBITDA.

Shawn Kravetz

Hands On

Prior to founding Esplanade Capital in

1999, Shawn Kravetz put his Harvard

MBA to even more conventional use as a

strategic planner and strategy consultant.

As he described when last interviewed in

Value Investor Insight [December 30,

2005], this initial career training wasn't an

obvious plus: “This may sound heretical,

but consultants are generally not very good

investors. You're trained to find the 'right'

answer and tend not to acknowledge that

your analysis might have been wrong. As

an investor, when the market tells you

you're wrong, you have to acknowledge

that and try to understand why.”

Kravetz's experience has influenced his

hands-on approach to fundamental

research: “I can't say the extent to which

this is unique, but I want to talk directly to

people installing solar panels, or buying

and selling a certain kind of shoe, or tak-

ing classes at night. It's one thing to read

a sell-side report or go to a conference,

but it's another to understand first-hand

how decisions are really being made

about the products and services sold by

companies in which you want to invest. I

want to do that type of thing myself rather

than read notes from someone two years

out of business school.”


Other countries are looking atSingapore as the role model for what todo with integrated casino resorts. Weexpect over time to see similar develop-ments in South Korea, the Philippines,Vietnam, Japan, Spain and elsewhere, andwe’re investing in companies best posi-tioned to capitalize on that – Las VegasSands being at the very top of the list.

Describe what’s behind your focus onsolar energy.

SK: We started getting interested in solarseven years ago. There were dynamiccompanies, growing very quickly, withtremendous future market opportunity,but in the U.S. the industry was stillviewed as this futuristic, hippie, Berkeley,California type of lark. But in places likeGermany and Japan, solar was becominga way of life. The lack of a home biasmade it more compelling as an investmentopportunity if you believed the prevailingwisdom was going to be proven wrong.

On top of that, the business model wasstarting to be proven in other countries,companies along the value chain wereactually making money, and the prospec-tive market was almost unlimited. It was-n’t like in the late 1990s when if you didthe math on how many SunMicrosystems’ servers had to be sold tojustify its market cap, you had to believeeveryone in the world would have a Sunmachine on his desk. We were talkingabout electricity generation, which trulywas a $1 trillion global market, and solarat the time represented less than one-tenth of one percent of that. That wasseven years ago, when there was roughlyone gigawatt of solar-energy capacityinstalled each year. In 2011, that numberwas 27 gigawatts installed.

Today you have a much more compet-itive industry that has done what largegrowth industries tend to do in commod-ity-oriented markets – capacity expandsbeyond current demand and the profitpool shrinks even while the market con-tinues to grow. That hit home starting in2010 and accelerated in 2011. We believe2012 will remain very challenging, butcould be a turning-point year for theindustry, when prices fall to a level where

a lot of excesses get wrung out of thebusiness, solar’s cost-competitiveness getsstronger, and the industry grows moreprofitably worldwide while reducing itsdependence on overly generous govern-ment subsidies.

Global revenue for the solar industrylast year was on the order of $100 bil-lion, but plenty of investors still don’tbelieve it’s an actual business, or thatanything dependent on government sub-sidies is investable. That hasn’t botheredthem in aerospace, or healthcare, ordefense, but here it’s a deal-killer.Because of that disbelief and the fact thatthe industry is still so young, theextremes get amplified. That gives usmore chances to make money.

Your timing could have been better inlaunching a solar-focused fund in mid-2009. How has it fared so far?

SK: As I mentioned earlier with for-prof-it education, focusing on a sector doesn’tmean you have to be long. Through acombination of solid stock picking andsome well-placed shorts, the new fundthrough the end of last year was up acumulative 29% net, while representa-tive solar-energy ETFs were down 75%over the same period. In 2011, 58 of the59 stocks in our core solar coverage uni-verse declined. It’s come back somewhatthis year, but at the moment investorsseem to have largely capitulated on thesector. When people are throwing thebaby out with the bathwater, we’re look-ing to go long the baby and short thebathwater.

We’ll come back to that later, but return-ing to the subject of circle of competence,how does a holding like First RepublicBank [FRC] fit?

SK: We consider First Republic a retailbusiness with a superior franchise. It’s anupscale retail and commercial bank thatdoes good old-fashioned banking – it’s arelationship business to them, whereemployees make customers feel likethey’re being served by an exclusive pri-vate bank. How often do you feel likethat with your big dumb bank across thestreet, where no one knows who you areand doesn’t care?

This is a company with great econom-ics that is in only six markets in the U.S.It hasn’t come close to penetrating thosemarkets, and there are probably another10 to 20 in which it can expand. Webelieve it can increase earnings organical-ly at 15%-plus per year for many years. Ifyou looked at this as if it were a retailer, Ican assure you it would be deemed wortha lot more than its current 12x earningsmultiple. Because it’s a bank, people thinkthat’s expensive.

Describe your valuation discipline.

SK: The types of things that interest usare sufficiently dissimilar that it’s hard togeneralize. We invest in messy, small-capsituations where we think the net assetsare worth at least the current market cap,say, and we have free options on theupside. Lakes Entertainment [LACO] isan example of that we’ll talk about later.At the other end of the spectrum, we’llalso invest in high-quality, large-capnames trading at low multiples of freecash flow because they’re priced as if theywill never grow again. Lowe’s [LOW] andMicrosoft [MSFT] are examples webought last year that have worked outvery well.

If I had to say, we’re typically lookingfor companies that can grow earningsand/or cash flow at low double-digitrates, when their stocks trade at high sin-gle-digit or low double-digit P/E multiplesbased on what we believe they can earnon a forward basis.

How concentrated does your portfoliotend to be and why?

SK: We typically own around 15 stockson the long side and 5 or so shorts.



ON INVESTING IN SOLAR:

When people are throwing the

baby out with the bathwater,

we’re looking to go long the

baby and short the bathwater.


Maintaining that level of concentration ismostly a function of the depth of researchI and my colleague Paul Strigler want todo ourselves, which limits the number ofideas we can focus on at a given time.We’re only in our absolute best ideas, butaren’t so concentrated that if we make abig mistake or get hit by something out ofleft field that the fund will be devastated.A target full long position is about 7%,and we’re very sensitive to having any-thing at 10% or more of the portfolio.

Turning to a specific solar-energy idea,describe your interest in MEMCElectronic Materials [WFR].

SK: The company was founded morethan 50 years ago and has been a pioneerin the manufacture of silicon wafers,which are the building blocks for semi-conductors and, in more recent years,solar panels.

The company consists of three mainparts. The traditional semiconductor-wafer business is currently in a tough partof its cycle and while I wouldn’t call it agreat business, the competitive environ-ment and MEMC’s position in it make ita decent business over the course of a fullcycle. It loses money at the bottom andmakes a lot of money at the top. On amid-cycle, normalized basis it earns on

the order of $150 million to $200 millionin annual EBITDA.

The second main business is sellingpolysilicon wafers to solar-panel manufac-turers. This drove massive profit andshare-price gains from 2005 to 2008, butthe business has collapsed under theweight of global overcapacity and remainsunder immense pressure. The company isrationalizing capacity, but in our opinionthis product line should be sold for what-ever they can get or shut down.

The third business is SunEdison, whichplans, constructs, manages and oftenowns part of large-scale solar installa-tions for corporations, independentpower generators and utilities. This is avery different business for MEMC,focused on long-lived assets with long-lived earnings streams, and we consider itan underappreciated jewel. It is a primebeneficiary of falling prices for solar pan-els and components – fueling robustdemand particularly in growing parts ofthe world – and it has a developmentpipeline that should produce more than$1.5 billion worth of projects this year.

Some of the projects SunEdison doesare comparable to the solar power plantsBerkshire Hathaway’s MidAmericanEnergy division invested $3 billion in afew months ago. These are high-qualityassets on which owners can make a goodreturn. That’s further confirmation to usof the long-term viability of solar as anindustry.

We take it you believe the sum-of-the-parts value here exceeds the current $3.70share price, which is at a 10-year low.

SK: The company has disappointed froman execution and stock-price standpointfor years now and overspends on corpo-rate overhead, so we do believe it’s worthconsiderably more apart than together.

There are two very good assets here(the solar-wafer business may have valueto an acquirer, but we’re valuing it at $0).The semiconductor business would be anattractive asset for another large player inthe industry and we believe is worth$2.75 to $3.50 per share, based both onreplacement value and by applying a rea-



MEMC Electronic Materials(NYSE: WFR)

Business: Development, manufacture and

sale of silicon wafers used to make semi-

conductors. Two primary business lines are

Semiconductor Materials and Solar Energy.

Share Information

(@3/29/12):

Price 3.6952-Week Range 3.50 – 13.18Dividend Yield 0.0%Market Cap $851.6 million

Financials (TTM):

Revenue $2.72 billionOperating Profit Margin (-0.9%)Net Profit Margin (-56.6%)

THE BOTTOM LINE

By focusing on the highly cyclical and currently depressed parts of the company’s

business, the market is missing the significant value in SunEdison, its “jewel” solar-

project development operation, says Shawn Kravetz. Arguing that the company should

be broken up, he puts a sum-of-the-parts value on its shares of around $8.


WFR PRICE HISTORY


25

20

15

10

5

02010 2011 2012

Valuation Metrics

(@3/29/12):

WFR Russell 2000Trailing P/E n/a 42.2Forward P/E Est. 21.7 20.2


(@12/31/11):

Company % Owned

Thornburg Inv Mgmt 10.9%Vanguard Group 4.7%Luminus Mgmt 4.4%Proxima Capital 2.7%Altai Capital 2.7%



25

20

15

10

5

0




sonable 3.7x to 4.7x multiple to normal-ized annual EBITDA of $175 million.

I’m not convinced SunEdison even as apure play should be publicly traded, givenits capital intensity and the lumpiness ofits results. But it would likely be highlycoveted by large energy companies look-ing to expand their downstream solarpipeline and capability. France’s Total, forexample, recently bought a majority stakein SunPower, one core asset of which is itsdevelopment business.

If you valued SunEdison at 7x our2012 EPS estimate for it, or at 3.2x our2012 EBITDA estimate, it’s worth around$5 or so per MEMC share.

That gets us to a base-case fair valuethat’s roughly twice today’s stock price.Given the size and growth of the solar-project development pipeline, we thinkthat’s potentially very conservative. Thisis the largest solar position we own today.

Has management shown any inkling thatthey’re on the same page?

SK: Unfortunately, no, but I don’t consid-er that a big negative. The market clearlyhasn’t embraced the status quo. Thatmessage is likely to get through eventual-ly, one way or another.

On the “bathwater” side of your portfo-lio, explain why you’re short WackerChemie [WCH:GR].

SK: Our shorts today are highly concen-trated in one part of the solar value chain,the makers of polysilicon used to manu-facture solar panels. For years this was agreat business dominated by a tight oli-gopoly including Wacker, Dow Corning’sHemlock, Tokuyama of Japan and, tosome extent, MEMC Electronics. But thegrowth of the industry has led to structur-al overcapacity that is so pronounced –China’s GCL-Poly and South Korea’s OCIwill in the next year overtake Hemlockand Wacker as the largest polysiliconmanufacturers in the world – that weexpect profits to fall well short of evenreduced expectations in 2012. Prices forpolysilicon, which costs $20-30 per kilo-gram to make, were around $80 per kilo

less than a year ago. Today they barelycover the cost and we think are more like-ly to go lower than higher.

How tied is Wacker to that business?

SK: In 2011 polysilicon accounted fortwo-thirds of the company’s €1.1 billionin EBITDA. Management has guided to“materially lower” EBITDA this year, butthe consensus estimate for the companyoverall is still around €900 million. Webelieve a shortfall in polysilicon will makethat come in closer to €600 million.Because of the huge fixed investments thecompany has made in recent years toexpand polysilicon capacity, net incomemay be close to breakeven. But consensus2012 analyst estimates for the companyare still for earnings of €4-5 per share.

The rest of Wacker’s business, also cur-rently struggling, may be able to offsetsome of the shortfall in 2013 and beyond,but we don’t consider this year to be aone-year hiccup on the polysilicon side.It’s more of a resetting of how this busi-ness is going to look for them in thefuture.

You’ve written about the importance ofcatalysts on the short side. Is this year’sexpected earnings shortfall a good exam-ple of one?

SK: We love to have catalysts in ourlongs, but if you own the right kind ofcompany, with the right kind of balancesheet and you paid the right price, youcan wait for the thesis to evolve. In shortsyou can get killed waiting for something

Wacker Chemie(Xetra: WCH:GR)

Business: Global producer of specialty

chemicals, including polysilicon for the

electronics and solar industries, silicones

and vinyl acetate-based polymers.

Share Information

(@3/29/12, Exchange Rate: $1 = €0.752):

Price €€66.0652-Week Range €56.87 – €175.50 Dividend Yield 4.8%Market Cap €3.45 billion

THE BOTTOM LINE

The “engine” of the company – the manufacture and sale of polysilicon to the solar-

energy industry – is more irreparably damaged than the market seems to realize, says

Shawn Kravetz. Using his estimates for this year, at what he considers a reasonable 5x

EV/EBITDA multiple, the company’s shares would trade at closer to €50.


WCH PRICE HISTORY


200

150

100

502010 2011 2012

Financials (TTM):

Revenue €4.91 billionEBIT Margin 12.3%Net Profit Margin 7.3%

Valuation Metrics


WCH S&P 500P/E 9.3 16.2

200

150

100

50


to happen, so we put much more empha-sis on having a catalyst.

Despite other decent assets, solar poly-silicon is the engine of this company. Ifprices stay where they are or go lower, theimpact on the reported numbers willforce people not only to take down esti-mates meaningfully for this year, but alsoto reset expectations for the future. That’sa clear catalyst.

The shares have already taken a signifi-cant drubbing over the past severalmonths. What downside do you see fromtoday’s price of €€66?

SK: A 5x EBITDA multiple is a reason-able valuation for a fine company whosecore business engine will continue tostruggle. On our estimates for this year,that translates into a share price ofaround €50.

I’d add that we’re also shortTokuyama [9946:JP] for all the same rea-sons. It’s smaller than Wacker, so is evenmore vulnerable because it lacks relativescale and diversification. Its stock is downsharply as well, but expectations are stillfar too high.

We – prematurely, as it turns out – cov-ered the turnaround case for Skechers[SKX] nearly a year ago [VII, May 27,2011]. What’s your take on it today?

SK: This is a solid footwear company thathas a knack every few years for identify-ing and milking a super-hot product.Unfortunately for them, the last time theydid it – with so-called toning sneakers –the market collapsed as quickly as it grewand caught them with far too muchinventory worldwide and more overheadthan necessary. Even as the stock got cutin half to the low $20s a year ago, weavoided it because the company was stilltoo far away from getting out from underthe problem. Now that the comparisonswith the toning-shoe boom times arerolling off, we think the timing and valu-ation are much more attractive.

While there’s clearly a faddish elementto what the company does, it’s built arecognizable brand in casual, affordable

footwear for the entire family, withexcellent distribution through its nearly330 company-operated stores as well asthrough many of the best departmentand specialty stores. It regularly developsnew products, including an emphasistoday on expanding its fitness offeringsunder the GOrun name.

Our basic premise is that the toning-related problems have obscured what isactually a strong and enduring consumerretail business, with high incrementalmargins as it grows through store expan-sion in the U.S. and increased distribu-tion outside the U.S. If we look out to2013, we’re estimating around $1.6 bil-

lion in revenue, with 7-8% EBITDA mar-gins, earnings per share of close to $1,and net cash on the balance sheet push-ing $5 per share.

How do you see that translating intoshare upside from today’s price of$12.80?

SK: If our 2013 numbers turn out to beright, the company will have objectivelystarted to turn the corner and should eas-ily command a 15x earnings multiple.Adding in the estimated level of net cash,that would result in a share price ofaround $20.

Value Investor Insight 14March 30, 2012



Skechers(NYSE: SKX)

Business: Designs, markets and sells

casual footwear for men, women and chil-

dren, sold primarily through independent

retailers and company-owned stores.

Share Information

(@3/29/12):


Financials (TTM):

Revenue $1.61 billionOperating Profit Margin (-5.4%)Net Profit Margin (-4.2%)

THE BOTTOM LINE

Getting out from under its overplayed bet on so-called toning shoes has proven more

painful than expected, but the company still has a “strong and enduring consumer

retail business,” says Shawn Kravetz. Adding in excess cash, at 15x the $1 per share

he believes the company can earn in 2013, the shares would be worth around $20.


SKX PRICE HISTORY


50

40

30

20

10

02010 2011 2012

Valuation Metrics

(@3/29/12):

SKX Russell 2000Trailing P/E n/a 42.2Forward P/E Est. n/a 20.2


(@12/31/11):

Company % Owned

Fidelity Mgmt & Research 15.7%Artisan Partners 8.0%Wellington Mgmt 7.0%Pzena Inv Mgmt 6.3%Vanguard Group 5.0%



50

40

30

20

10

0


And that would be before anythingparticularly good has happened. Thecompany made $2.80 per share in 2010during the toning boom and, more impor-tantly, had prior to last year been above$1 in EPS since 2005. It’s not as if our $1estimate for 2013 is pushing unchartedterritory.

One open question is whether they’lldo anything with the balance sheet. Wedon’t expect a dividend anytime soon, butdo think a share buyback is possible oncelegal and regulatory contingencies areresolved over advertising claims for thetoning shoes. They’ve already reserved$45 million against such costs, but willlikely look for more clarity on the ulti-mate exposure before returning any cashto shareholders.

What attracted your attention in Japaneseconvenience-store operator Ministop[9946:JP]?

SK: In the aftermath of last year’s earth-quake and Fukushima nuclear disaster wespent a lot of time looking for potentialinvestment opportunities in Japan. We’ddone very little there, concerned that themarket’s reputation for cheap stocks thatstay that way forever was more or lessdeserved.

A fellow investor we respect told us hewas looking at the convenience-storemarket in Japan, which struck a chordbecause we were already looking for ideasthere and we know the convenience-storebusiness in general quite well. As it turnsout, we came upon three similar compa-nies in the industry – Ministop, Circle KSunkus [3337:JP] and FamilyMart[8028:JP] – which were just too cheap tooignore.

While we’ve made some money – par-ticularly in Circle K Sunkus, which hasaccepted a buyout offer from Uny, itsmajority owner – the crux of the storyhere is how inexpensive Ministop’s sharesare. At today’s share price [of ¥1,580],the stock trades at roughly 2x EBITDAon an enterprise value basis, and at 70%of what is a rock-solid book value. Nearly30% of the market cap is in cash. Thestock is so cheap you’d expect to find

financial risk or a business moving decid-edly in the wrong direction, neither ofwhich is at all the case.

Is the business growing?

SK: The Japanese market has little to nogrowth, but the company continues tobenefit from the economic recovery sincethe earthquake and tsunami – same-storesales, revenues, and profits in Japan arenow moving in the right direction.Roughly half of Ministop’s 4,200 storesare outside of Japan, mostly in SouthKorea but also with a small but growingpresence in China. For the company over-all, annual top-line growth is likely to bein the 3-5% range – nothing remarkable,but much better than what appears to bepriced into the shares.

What do you believe the shares are morereasonably worth?

SK: Ministop is in a strikingly similar sit-uation to Circle K Sunkus, with a major-ity stake held in it by a larger retailercalled Aeon. At the price Uny is payingfor Circle K Sunkus, 1.1x book value,Ministop shares would go for around¥2,200. We’re not counting on it becom-ing a takeover candidate, but it wouldn’tsurprise us – the industry is likely to con-tinue to consolidate as retailers try toincrease scale in a flattish market.

Absent any M&A, part of the joy inbuying dirt-cheap companies for whichthere are exceedingly low expectations isthat it doesn’t take much for things tolook up. If momentum turns even slightlybetter and the multiple moves from 2x



Ministop(Tokyo: 9946:JP)

Business: Owns and operates more than

4,000 combined convenience and fast-

food stores in Asia, the large majority of

which are in Japan and South Korea.

Share Information

(@3/29/12, Exchange Rate: $1 = ¥82.42):

Price ¥¥1,57852-Week Range ¥1,263 – ¥1,580 Dividend Yield 2.8%Market Cap ¥46.35 billion

THE BOTTOM LINE

Shawn Kravetz argues that while the bare-bones valuation on the company’s stock

would imply either severe financial distress or a business moving decidedly in the

wrong direction, neither is at all the case. At the still-low multiple of book value at

which a primary competitor is being taken private, the shares would trade at ¥2,200.


MINISTOP PRICE HISTORY


1750

1500

1250

1000

7502010 2011 2012

Financials (TTM):

Revenue ¥122.55 billionEBITDA Margin 12.2%Net Profit Margin 2.5%

Valuation Metrics


Ministop Russell 2000P/E 14.2 42.2

1750

1500

1250

1000

750


EBITDA to maybe 2.5x, we’ll make pret-ty good money.

Describe one of your most off-the-gridideas, Lakes Entertainment.

SK: This is one of the smaller-cap invest-ments we’ve made in a long time. Thecompany has been involved over the yearsin a motley crew of gaming-oriented busi-nesses, from owning the World PokerTour to developing and managing variousIndian-tribe casinos around the U.S. Ittends to throw a lot against the wall,some of which sticks and some of whichdoesn’t. That’s not exactly our typicalrecipe for developing long-term sustain-able value, but it is what it is.

The company at the moment has noreal operating assets, which is why thefinancials look terrible – overhead costsand not much else. The primary value wesee resides in an 8% economic interest inRock Ohio Ventures, a partnershipbetween Caesars Entertainment and DanGilbert, who founded Quicken Loans andowns the Cleveland Cavaliers. Rock Ohiohas been approved to open two new casi-nos in Ohio – in Cleveland and Cincinnati– with local monopolies. Cleveland’s isslated to open on May 15, withCincinnati’s not due until sometime inearly 2013.

While there’s no direct comp for eithernew casino, we can estimate run-rateEBITDA for each based on experienceselsewhere, corrected for the size of themarket, make-up of the casino, etc. ForCleveland, we estimate EBITDA reachingnearly $100 million, which at a 7.5xmultiple would translate into about $2per share of value in Lakes. TheCincinnati casino will be smaller, but weestimate the value of it to Lakes ataround $1 per share.

On top of that the company currentlyhas nearly $40 million in net cash, whichis 80% of the current market cap. Someof that will be drawn down to pay forLakes’ share of further investment inRock Ohio and to pay off some other pre-vious obligations, but we believe therewill be roughly $1 per share in cash leftwhen all is said and done.

You’re already ascribing value that is wellabove the current share price of $1.80.Are you finding any other options on theupside?

SK: This is even more speculative, butLakes should hear soon whether it’s beenapproved to operate a mostly gaming-machine operation at the Rocky GapLodge & Golf Resort in Cumberland,Maryland. The company is the lastremaining candidate in the running, butMaryland may still decide not to grantthis particular license. If it does, we thinkthis operation could be worth another 50cents to $1 per share.

Finally, Lakes also has notes receivablefrom previous contracts with variousIndian tribes for which payments havebeen suspended. These have mostly beenmarked down to zero, but there is a pos-sibility they could generate future pro-ceeds. If things went very well, that couldmean another $1 per share in value.

As risky as some of the payoffs mightbe, we like that we have multiple ways towin here. If Cleveland launches to evenmodest success, that asset and the cashshould allow us to at least get our moneyout. If just Cleveland does well, weshould be very happy as investors. Ifother things go right, we’ll be ecstatic.



Lakes Entertainment(Nasdaq: LACO)

Business: Develops, owns and manages –

typically with partners – casino or other

gaming-related properties. Primary asset

today is interest in two new Ohio casinos.

Share Information

(@3/29/12):


Financials (TTM):

Revenue $35.6 millionOperating Profit Margin 39.6%Net Profit Margin (-5.2%)

THE BOTTOM LINE

Ascribing value to the company’s assets – other than its large cash holding – is clearly

a speculative enterprise, but the risk/reward profile that results is quite compelling,

says Shawn Kravetz. Focusing just on its cash and an interest in two approved casino

projects in Ohio, he pegs the value of the company’s stock at roughly $4 per share.


LACO PRICE HISTORY


5

4

3

2

12010 2011 2012

Valuation Metrics

(@3/29/12):

LACO Russell 2000Trailing P/E n/a 42.2Forward P/E Est. n/a 20.2


(@12/31/11):

Company % Owned

Dimensional Fund Adv 6.4%Par Capital 5.0%Morgan Stanley 3.8%T. Rowe Price 3.6%Hotchkis & Wiley 2.5%



5

4

3

2

1


We spoke before [VII, October 31, 2007]about another small, quirky idea, ArchonCorp. [ARHN.PK], that probably hasn’tworked out so well. Any lessons there?

SK: We got involved when the stock wastrading at a meaningful discount to a sin-gle agreed-upon deal it had to sell 27acres of land on the Las Vegas Strip forapproximately $17 million per acre. Weknew there was real risk the deal would-n’t close, but thought the reward if it didwas worth the risk. After the 2008 crisishit, the deal fell apart and so did the stockprice. We have remained shareholders,however, because we’ve always felt theintrinsic value of the company’s assets –even after markdowns – far exceeded themarket value. Today it offers as good arisk/reward as we have in the portfolio.

Explain that.

SK: Other than the land on the Strip,there are three primary pieces to the puz-zle, all relatively easy to value: corporate

overhead, an office building inDorchester, Massachusetts and anotheroffice building in Gaithersburg,Maryland, which they’ve agreed to sell tothe current tenant. Quite simply, webelieve the value of those three itemsexceeds Archon’s current market value ofaround $64 million. That means the mar-ket is ascribing negative value to thevacant land on the Strip.

It’s difficult to value Las Vegas Stripreal estate today. I know it’s not worth the$15-20 million per acre being paid forcomparable land pre-crisis. I know it’s notworth less than $0. If the company offeredit to me for $0, I’d take it and – I’m total-ly serious – would create the world’s mostprofitable RV and trailer park. It would bea gold mine in the shadow of WynnEncore and the Fontainebleau Resort.That I could do that indicates it’s worthmore than nothing.

With just under six million shares,every $1 million per acre in value for theStrip land is worth roughly $3 per Archonshare. At $4 million per acre, you’re more

than doubling the current stock price [of$11]. As long as that kind of mathremains intact, we’ll be patient.

Do you have any general words of wis-dom to impart about mistakes?

SK: We do post-mortems on all of ourpositions – as well as regular positionreviews of what we own – to constantlyassess what we got right and what wedidn’t. That matters because we want tolearn from mistakes even if the invest-ment outcome turned out fine because wewere lucky. Luck is not a sustainable wayto make money as an investor. Avoidingmistakes that you’ve made before is.

One primary virtue of experience isthat you’re constantly learning the waysin which things can go wrong. If youinternalize that into your process, you’reidentifying more of what can go wrongand assessing how that changes yourinvestment case. Minimizing the numberof times you get blindsided is a very wor-thy goal. VII



What are the world’s best investorsbuying and selling?Gain insight from what superstar investorsown, what they’re buying and what they’re selling. Value Investor Insightsubscribers receive four quarterly issues of SuperInvestor Insight for only $149!

Subscribe Online »

Mail-in Form »

Fax-in Form »

Want to learn more?

Please visit www.valueinvestorinsight.com

Or call toll-free:

866-988-9060

Profit now from the research andinsights of today’s investing elite


http://www.valueinvestorinsight.com/superinvestorinsight

http://www.valueinvestorinsight.com/superinvestorinsight/subscribe

http://www.valueinvestorinsight.com/superinvestorinsight/download/SII_MailForm

http://www.valueinvestorinsight.com/superinvestorinsight/download/SII_FaxForm



There's an old saying that the betterbusiness in a gold-rush-type market is tosell pickaxes rather than to own mines.The analogy is apt in contemplating thepotential of Poseidon Concepts, aCalgary-based lessor of tanks used to col-lect and manage water and related fluidsat well sites where hydrofracturing, or“fracking,” is used to extract oil and nat-ural gas.

Relative to the incumbent methods formanaging water at non-conventionalwells – lined open pits and linked “tankfarms” using 400-barrel capacity tanks –Poseidon's modular tanks, with capacitiesranging from 4,500 to 41,000 barrels,offer drillers “superior economic andenvironmental attributes,” says LongbowCapital's Terry Fitzgerald. A convention-al tank farm may require 100 to 150tanks, each needing one 18-wheeler pertank for transport, causing the set-up andtake-down processes to each take roughlyfour days. Even the largest Poseidon tankcan be installed or removed in one day,transported by two 18-wheelers. Theextent of the cost savings? In a recentinvestor presentation, Sand Ridge Energyput the total savings of using a newPoseidon system at one of its seven-wellMississippi Line sites at $58,000 per well.Sand Ridge expects to drill at least 200wells in that area this year, suggestingannual savings of more than $10 millionfrom using Poseidon tanks.

While the cost savings versus lined pitsare smaller, the environmental advantagesof the company's systems are pro-nounced. It says its tanks have so far sup-ported more than 1,000 “fractures” with-out an environmental or safety incident,and Poseidon tanks make it easier to treatwater on-premises prior to reintroducingit into ground water or recycling it forfurther use. Lined ponds have provenmore prone to leakage and are particular-ly vulnerable in floods. Citing such con-cerns, the North Dakota legislature earli-

er this month sharply restricted the use ofsuch pits at most drilling sites in the state.

While fracking as a method for oil andgas extraction is growing, Longbow'sFitzgerald ties Poseidon's near-termupside primarily to taking share fromexisting water-management methods. Hesays roughly 50% of the fracking donetoday in North America relies on linedponds to hold water, and in most casesPoseidon can offer a better alternative. Oftank-based storage currently in place, hesays the company now has only about7% of the addressable market. “We are

not basing our thesis on an extrapolationof growth in hydrofracturing,” he says.“We expect fracking will continue togrow and that represents an incrementalpositive, but the real story is thatPoseidon provides a superior disruptivesolution that is disintermediating the cur-rent alternatives.”

Poseidon's rental business model is assimple as it is lucrative. The companyoutsources nearly everything and current-ly has less than 50 employees. As demandfor its systems takes off, Fitzgeraldexpects a very high percentage of the

Full TankA recent spinoff that has yet to publish its first quarterly financials, Poseidon Concepts sports a decidedly lowprofile with investors. Based on its growth potential in a booming market, that is likely to change.

U N C O V E R I N G VA L U E : Poseidon Concepts


Poseidon Concepts (Toronto: PSN:CN)

Business: Leases modular tank systems

used to manage water and related fluids

that are used in the hydrofracturing method

for extracting natural gas and oil.

Share Information

(@3/29/12, Exchange Rate: $1 = C$0.997):

Price C$13.8852-Week Range C$10.05 – C$16.90Dividend Yield 7.8%Market Cap C$1.13 billion

THE BOTTOM LINE

The company’s “superior disruptive solution” for managing water and other fluids used

in non-conventional oil and natural gas drilling positions it exceedingly well to take

market share at North American wells, says Terry Fitzgerald. At a 6.5x EV/EBITDA mul-

tiple on his 2013 estimates, his one-year price target for the shares is C$22.50.


PSN PRICE HISTORY


20

15

102010 2011 2012

Financials (Est. 2012):

Revenue C$248.0 millionOperating Margin 83.1%Net Profit Margin 58.5%

Valuation Metrics

(Current Price vs. TTM est.):

PSN Russell 2000P/E n/a 42.2

20

15

10



spoils to fall to the bottom line. Assumingan average 400-tank fleet in place, aver-age $2,400-per-day rental rates and uti-lization levels of around 70%, he believesthe company can generate nearly C$250million in revenue in 2012, earn an 80%EBITDA margin and generate C$145 mil-lion in net income, roughly C$1.80 pershare. Even as inevitable competitionbrings day rates and margins down, he'sstill expecting high volume growth toresult in some C$340 million in 2013 rev-enue and C$2.30 per share in earnings.

What's that worth to equity holders?The company's stock remains well offmost investors' radar screens. Poseidonwas spun off in November by explorationand production company Open RangeEnergy, so has yet to publish its own inde-pendent quarterly financials and is fol-lowed in the U.S. by only one boutiqueresearch firm. On Fitzgerald’s 2013 num-bers, at the current price of C$13.90, thestock trades at an EV/EBITDA multipleof 4.2x. That's at the very low end of thevaluation range for companies in themore generic and highly competitive oil-field-services sector, he says, and a signif-

icant discount to more comparable spe-cialized oil-services firms, which trade at7-9x EV/EBITDA. At the 6.5x multiple hethinks is reasonable for Poseidon, theshares would trade at C$22.50. In themeantime, the company is debt-free andis able to fund its projected growth from

internally generated cash flows whileretaining the ability to pay a healthyC$1.08-per-share annual dividend, result-ing in a current 7.8% yield.

The biggest risk to that rosy outlook iscompetition. Firms don't make 80%EBITDA margins without attracting com-petitive notice, and while Poseidon enjoyscertain first-mover advantages – includ-ing hard-won existing relationships with

more than 100 customers and a highlyvalued environmental and safety record –its systems are not so sophisticated froman engineering standpoint that they can'tbe replicated. Due to new competition,Fitzgerald expects rental day rates for thecompany to fall 20% in 2013, crimpingEBITDA margins but still leaving them ata sky-high 77%. That's largely because hebelieves new entrants will be morefocused on taking advantage of frackinggrowth and on taking share from incum-bent water-management alternatives thanon pounding Poseidon on price.

Offsetting some of that risk is incre-mental upside if utilization rates ofPoseidon's tanks come in better thanexpected. Fitzgerald is modeling around70% usage rates for 2012 and 2013, butbelieves there's potential for those to bemuch higher, which would have a signifi-cant positive impact on earnings. If uti-lization rates came in at 80% in 2013, forexample, his EPS estimate would be morethan 25% higher, pushing C$3. “Ourbase-case twelve-month target price ofC$22.50 is not the limit of the opportuni-ty here,” he says. VII


U N C O V E R I N G VA L U E : Poseidon Concepts

Subscribe now and receive a full year of Value Investor Insight – including weekly e-mail bonus content and access to all back issues – for only $349. That’s less than $30 per month!

Subscribe Online »Mail-in Form »Fax-in Form »Want to learn more? Please visit www.valueinvestorinsight.com

Your Guide Through Perilous Seas

ON COMPETITION:

New entrants will likely focus

more on industry growth and

taking share from incumbents

than pounding on price.



https://secure.valueinvestorinsight.com/subscribe/

https://secure.valueinvestorinsight.com/subscribe/

http://www.valueinvestorinsight.com/download/SubscribeMailForm/

http://www.valueinvestorinsight.com/download/SubscribeMailForm/

http://www.valueinvestorinsight.com/download/SubscribeFaxForm

http://www.valueinvestorinsight.com/download/SubscribeFaxForm


Committed investment contrarianscould find Diamond Foods worth a look.The seller of branded snack foods such asEmerald nuts, Pop Secret popcorn andKettle potato chips has seen its share pricefall 76% in the past six months, to arecent $23.20. Disclosed accountingirregularities around payments made tonut growers scuttled what would havebeen a crowning-achievement deal – thepurchase of P&G's Pringles – led to theFebruary ouster of the company's CEO,prompted SEC and Justice Departmentinvestigations, and have left the companyscrambling to repair its over-extendedbalance sheet. After announcing a deallast week with certain creditors thatincreased Diamond's interest costs andrequired it to eliminate its dividend, thestock fell more than 7% the next day.

A case in which things look darkestbefore the dawn? In a word, no, saysSolas Capital's Tucker Golden. He andpartner Anand Atre have a long andsometimes painful history with the com-pany's stock, having made the short casefor it two years ago in Value InvestorInsight [January 29, 2010] at around$37. Diamond then seemingly proceededto go from strength to strength, buyingKettle in February 2010, regularly report-ing earnings surprises, and then in April2011 announcing the proposed $2.35 bil-lion Pringles buy, a deal to be paid formostly by selling ever-more-valuable newequity. In September 2011 Diamondshares hit an all-time high of $96.

Then the roof caved in. The companylast November announced an internalaudit investigation, a board member onthe audit committee died by suicide, andthe market priced into the stock that thePringles deal was likely dead. Golden andAtre, having stuck with their short posi-tion – even selectively adding to it on theway up – closed out their position ataround $27. “Painful as it was, at everystep of the way our fundamental analysis

had implied a value far below the stockprice,” says Golden. “With a chance thePringles deal still might close, at $27 thatwas no longer the case.”

What is Diamond worth today?Golden pegs the value of the profitableKettle business at up to 10x EBITDA, or$700 million. Pop Secret has done fairlywell since being purchased for $190 mil-lion in 2008, but because he believesDiamond “egregiously overpaid” for it,he'd be surprised if it could fetch morethan $200 million. He ascribes no value

to the nut franchise because he believesit’s burning cash and fighting to retain itssuppliers. After some $610 million in esti-mated net debt, that leaves roughly $13per share in equity value, 45% below thecurrent price. That takes no account of anestimated $100 million final payment duethis summer to walnut growers for lastyear's crop, potential fines, lawsuit settle-ments, increased advisory fees, or the pos-sibility of a dilutive capital raise, saysGolden. His fund is again betting againstDiamond’s stock. VII

Value Investor Insight 20March 30, 2012

U N C O V E R I N G R I S K : Diamond Foods


In the RoughInvestment cases could be made that Diamond Foods is: 1) An ongoing train wreck, or 2) A compellingcontrarian bet. Solas Capital’s Tucker Golden explains why he suggests bargain hunters steer far and wide.

Diamond Foods(Nasdaq: DMND)

Business: Markets nuts and packaged

snack foods under the Kettle, Pop Secret,

Diamond of California and Emerald brands.

Share Information (@3/29/12):


Financials (TTM):

Revenue $965.9 millionOperating Profit Margin 11.4%Net Profit Margin 5.2%

THE BOTTOM LINE

Faced with unhappy suppliers, an over-extended balance sheet and the overhang of

SEC and Justice Department investigations, the company is not one on which to take

an investment flier, says Tucker Golden. His estimate of fair value per share: $13.


DMND PRICE HISTORY


100

80

60

40

202010 2011 2012

Valuation Metrics

(@3/29/12):

DMND Russell 2000Trailing P/E 10.4 42.2Forward P/E Est. 7.2 20.2


(@12/31/11):

Company % Owned

Fidelity Mgmt & Research 14.0%Wellington Mgmt 12.3%Columbia Wanger Asset Mgmt 6.1%



100

80

60

40

20


Value Investor Insight 21March 30, 2012 www.valueinvestorinsight.comwww.valueinvestorinsight.com

Editors’ Note: In addition to deliveringmarket-trouncing returns since foundingCentaur Capital in 2002, Zeke Ashton[VII, April 30, 2010] has also establishedhimself through his investor letters andthe occasional essay as an introspectiveand articulate student of the craft ofinvesting. In these excerpts from a recentCentaur Value Fund [CVF] letter, he out-lines the essential elements of a “built-to-last” investing strategy.

One of the realities of investing thatwe need to acknowledge is that we arelimited in our ability to predict the future,and therefore we cannot reasonably hopeto be perfectly positioned for whateverthe prevailing environment may be in agiven time horizon. Each year bringsunforeseen events, some positive andsome negative, and even companies thatwe have come to understand well canoften surprise us.

If we can’t know in advance with anyprecision what kind of investing scenariowe may face in any given year, it makessense to develop a strategy that can beexpected to do reasonably well across thewidest possible number of potential sce-narios – what a game theorist might call a“robust” strategy. This requires that thestrategy be able to overcome not onlyoccasional bear markets and dislocations,but all of the other hurdles that areendemic to active management. The listincludes bad luck, bad timing, and occa-sional mistakes in judgment or execution.Most importantly, any truly robust long-term investing strategy must be built tosurvive the worst possible scenarios themarket can throw at us and live to playanother day. The only major drawbackfor the truly robust strategy is that it ishighly unlikely to be the best performer inany given scenario or environment. Infact, one of the hallmarks of a robustinvesting strategy is that it must activelywork to eliminate extreme results – both

positive and negative. While it is notalways easy to endure those periodswhere more aggressive strategies appearto be making money hand over fist, itseems a reasonable trade-off given thelong-term benefits offered by the moreresilient strategy.

Avoiding Common Pitfalls

Charlie Munger, who is best knownfor his role in collaborating with WarrenBuffett to build the exceptional long-term track record at BerkshireHathaway, offers a useful mental exercisefor accomplishing any complex task. Histechnique is to first invert the problem byidentifying the common pitfalls that onewishes to avoid and then building inplans specifically to prevent the classiccauses of failure. It is for this reason thatwe have made a practice of studying thereasons that investment funds or strate-gies fail, looking for lessons that we canincorporate to make our own strategymore robust. In almost every case of cat-astrophic failure that we’ve observed, webelieve the root cause can ultimately beboiled down to one or a combination ofjust five factors. The five factors are 1)leverage; 2) excessive concentration; 3)excessive correlation; 4) illiquidity; and5) capital flight. Having identified thesefive factors most commonly implicated ininvesting strategy failure, we haveworked to address each of them to helpus to avoid these common pitfalls or oth-erwise minimize their impact.

Leverage

Excess leverage is one of the classiccauses of investment failure. WarrenBuffett once observed that “leverage isthe only way a smart guy can go broke.You do smart things, you eventually getvery rich. If you do smart things and useleverage and you do one wrong thing

along the way, it could wipe you out,because anything times zero is zero.”

While we occasionally use instrumentsthat offer us the benefits of leverage, theseinstruments are chosen because they offerus leverage to good outcomes but limitour exposure to bad outcomes. We willnever use excess leverage to try toenhance our returns in the Fund. Ourmaximum long exposure is 125% ofFund assets, which takes into account theleverage embedded in any options orother derivative instruments. While theFund is likely to carry long exposure inexcess of 100% of assets for extendedperiods, the true net exposure to the mar-ket is rarely much higher than 75-80%when taking short positions and hedgesinto account. The highest month-endlevel of recorded net market exposure forthe Fund was a bit higher than 86% ofassets, which occurred in late 2008.

Excess Concentration

Excess concentration is another com-mon factor in investment failures. Wehave seen many talented managers suffersignificant and permanent capital loss dueto overconfidence in one or two ideas.While we manage a fairly concentratedportfolio by conventional standards, wealso limit individual position sizes in orderto prevent a single bad outcome from wip-ing out our capital. Centaur Value Fund[CVF] often has as much as 40% of itsassets invested in the Fund’s ten largestpositions. We believe this level of concen-tration represents a reasonable compro-mise between ensuring our capital residesin our best ideas without risking a loss toolarge to recover from if we suffer a badoutcome in one or two of our top ideas.

Correlation

While this factor has some similaritiesto excess concentration, correlation is a

Building a “Robust” Investing StrategyHaving identified the five key factors that traditionally lead to “catastrophic” investor failure, Centaur Capital’sZeke Ashton in this essay details how he addresses each in managing his highly successful investment partnership.

S T R AT E GY: Zeke Ashton



Value Investor Insight 22March 30, 2012 www.valueinvestorinsight.comwww.valueinvestorinsight.com

S T R AT E GY: Zeke Ashton

factor that can sneak up on a manager.This is particularly the case with so-called“specialist” or “sector” strategies limitedto a narrow universe of potential invest-ments. Such strategies tend to be quiteattractive theoretically, as they offer theinvesting “edge” of having specializedknowledge, but they are also highly sus-ceptible to systemic shocks impacting thearea of specialty. Whether it be theInternet funds that proliferated in the late1990’s before being wiped out by the techcrash in 2000, or master limited partner-ship funds that suffered terrible losses inthe wake of the Lehman Brothers bank-ruptcy in 2008, owning an entire portfo-lio of securities that react in a highly cor-related fashion to any given risk factor issimply not consistent with a truly robuststrategy.

This is why we prefer to be generalistsand prefer to invest across industries,market caps, and geographies in oursearch for undervalued securities. Thiswide-ranging approach generally resultsin our owning a portfolio of highly idio-syncratic ideas, and also ensures that wecan migrate to whatever areas of the cap-ital markets appear to offer the mostvalue at any given time. It is also why ourstrategy includes the use of short-sellingand hedges in the portfolio, as those posi-tions should be negatively correlated toour long portfolio. Finally, we use sectorlimits as a way to reduce the negativeimpact of any industry-specific or themat-ic risk factor.

Illiquidity

The inability to sell when one wishesto or needs to can often lead to significantlosses when an external event requires thesudden need for cash. Given that we dealalmost exclusively in publicly tradedsecurities for which there is an active mar-ket, CVF is not at great risk from illiquid-ity. However, we do limit the securities wehold that have limited trading volumethat would likely move the stock againstus if we were motivated to sell quickly.For our purposes, any security that wouldlikely require more than ten trading daysfor us to liquidate our entire position

(assuming we represented no more than20% of average daily trading volume) isdesignated as “low liquidity.” We limitsuch investments as a whole to no morethan 30% of the fund’s assets.Theoretically, this would allow us to beable to exit the vast majority of our posi-tions with minimal price disruption overthe course of a single calendar month. Welimit the holdings of securities that aretotally illiquid, such as restricted securi-

ties or private placements, to a maximumof 10% of Fund assets, and this group isincluded under the 30% rule notedabove. As of this writing, securities meet-ing the “limited liquidity” definition com-prised approximately 25% of Fundassets, of which approximately 3% arecurrently restricted from re-sale or areotherwise illiquid. Overall, whether driv-en by opportunity or necessity, the Fund’sinvestments are highly liquid and weremain well guarded against liquidityrisks even in an extreme scenario.

Capital Flight

The final common cause of fund orstrategy failure is capital flight, whichalmost always happens in concert withone of the risk factors noted above.Sometimes the capital flight causes orexposes one of the other risk factors, andsometimes one of the other risk factorscauses the capital flight. Either way, theflight of capital will inevitably exacerbatewhatever other problems there might bein times of stress. Often, the strategy itselfwould eventually have fully recovered butfor the need to liquidate positions duringa time of market dislocation. As notedinvestor Howard Marks has said, man-agers need to ensure they build their port-

folios and funds to survive the worst pos-sible day, otherwise they will “end up likethe 6-foot-man who drowned crossing ariver that was five feet deep on average.You have to be able to get through thelow points.”

Regardless of the strategy, it isinevitable and universal that periods ofpoor performance will result in somecapital-base declines. Given that everystrategy will occasionally suffer suchperiods, modest turnover in the capitalbase should be expected and planned for.One of the ways to reduce capital flightrisk is make every effort to qualifyinvestors who understand the Fund’sstrategy, have realistic expectations, andshare a long-term investing horizon.Another method is to avoid excessiveconcentration of the capital base suchthat a handful of large investors do notrepresent the majority of the capital. Inthe Centaur Value Fund, we are limitedto 99 investors by SEC regulations. Mostof our investors have been with us formany years, and have participated in theFund’s historical track record. No singleinvestor in the Fund comprises greaterthan 10% of the Fund’s assets. In addi-tion, approximately 13% of the Fund’sassets belong to minority owners of theFund’s management company.

A Strategy for the Long Run

As the saying goes, investing is amarathon and not a sprint. And like amarathon course, there are downhillstretches where the going is easy anduphill stretches where the going is hard.Unlike a marathon, however, there isn’t adefined finish line, and we must remaindiligent as long as we have capital at risk.We hope that this letter has demonstrat-ed that we have given much considera-tion to building a strategy that can with-stand the toughest stretches the coursehas to offer in order to experience thesatisfaction that comes with achievinglong-term success.

Note: Zeke Ashton is also the manager of the

Tilson Dividend Fund [TILDX], in which co-

Editor Whitney Tilson has an ownership interest.

VII

ON SPECIALIZATION:

Such strategies tend to be

quite attractive theoretically,

but are also highly susceptible

to systematic shocks.



Value Investor Insight March 30, 2012

Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the “Site”) by Value Investor Media, Inc. Useof this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse. Foryour convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way tolimit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

No Investment AdviceThis newsletter is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solic-itation would be illegal. This newsletter is distributed for informational purposes only and should not be construed as investment adviceor a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a gen-eral or personal recommendation or take into account the particular investment objectives, financ ial situations, or needs of individualinvestors. The price and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this newslet-ter may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and arenot suitable for all investors.

DisclaimersThere are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth inthis newsletter. Value Investor Media will not be liable to you or anyone else for any loss or injury resulting directly or indirectly fromthe use of the information contained in this newsletter, caused in whole or in part by its negligence in compiling, interpreting, reportingor delivering the content in this newsletter.

Related PersonsValue Investor Media’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may,from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter.

Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, a registered investment adviser.T2Partners Management, LP may purchase or sell securities and financial instruments discussed in this newsletter on behalf of certainaccounts it manages.

It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of thisnewsletter before purchases or sales are made of any securities or financial instruments discussed herein as Investment Snapshots.

CompensationValue Investor Media, Inc. receives compensation in connection with the publication of this newsletter only in the form of subscriptionfees charged to subscribers and reproduction or re-dissemination fees charged to subscribers or others interested in the newsletter content.

General Publication Information and Terms of Use



http://www.valueinvestorinsight.com/misc/termsofuse


value investor insight issue 336[1]

Documents