· PDF fileDecember 30, 2017 Value Investor Insight 1 ValueInvestor INSIGHT December 30, 2017 The Leading Authority on Value Investing

December 30, 2017 www.valueinvestorinsight.com Value Investor Insight 1

ValueInvestorINSIGHT

December 30, 2017

The Leading Authority on Value Investing

Inside this IssueFEATURES

Investor Insight: Whitney George

Taking advantage of "moments of weakness" to find value in such stocks as Franklin Resources, Cirrus Logic and Pason Systems. PAGE 2 »

Investor Insight: Tom Olsen Covering all angles to unearth mis-priced opportunity today in recent spinoff Landis + Gyr, Ericsson and Salvatore Ferragamo. PAGE 7 »

Investor Insight: Richard CookSearching widely for a narrow opportunity set that today includes Anheuser-Busch InBev, Lindley and Coca-Cola Embonor. PAGE 13 »

A Fresh Look: Fiat/FerrariAssessing if these investment win-ners have room to run. PAGE 19 »

Strategy: Robert VinallChallenging once-sacred aspects of a value-investing strategy. PAGE 21 »

INVESTMENT HIGHLIGHTS

INVESTMENT SNAPSHOTS PAGE

Anheuser-Busch InBev 15

Cirrus Logic 6

Coca-Cola Embonor 16

Ericsson 11

Ferrari 19

Fiat Chrysler 19

Franklin Resources 4

Landis + Gyr 12

Lindley 17

Pason Systems 5

Salvatore Ferragamo 10

Other companies in this issue:Arca Continental, Cal-Maine Foods,

Coca-Cola, Franco-Nevada, Frank’s

International, GameStop, Hugo Boss,

Kennedy-Wilson, Microsoft, Publicis,

Randgold Resources, Sanderson Farms,

Viscofan, Wal-Mart

Liquid Assets

As he looks to expand the analyst corps at the firm he co-founded in 2001, Cook & Bynum Capital’s Richard Cook puts a premium on what he calls

intellectual honesty. “It’s very important in this business not to fool yourself into thinking you understand some-thing when you don’t,” he says. “If you know something for sure, tell me. If not, don’t pretend otherwise.”

Cook and partner Dowe Bynum have put their own clarity of thought to productive use, earning since 2001 a net annualized 8.4%, vs. 7.1% for the S&P 500. Finding much more to watch closely than buy at the moment, their eight-stock portfolio today includes bets on soft drinks, beer and regional bottlers. See page 13

Attention to Detail

Tom Olsen and his analysts at Swiss money manager Mensarius will make mistakes, of course, but after hearing him describe the firm’s seven-step due-dili-

gence process, it’s hard to imagine them resulting from re-search neglect. “We simply want to look at situations from all angles so we don’t miss anything important,” he says.

Such rigor has paid off nicely for Olsen’s investors. Mensarius manages €1.6 billion and its flagship European Value strategy has since the firm’s inception in 2008 out-earned its MSCI Europe benchmark by 260 basis points per year. In what he considers a rebounding Europe, Olsen today is finding opportunity in such areas as luxury goods, telecom equipment and electric meters. See page 7

Adversity to Advantage

Whitney GeorgeSprott Asset Management

Tom OlsenMensarius

Richard Cook Cook & Bynum Capital

Then co-CIO of Royce & Associates, Whitney George in early 2015 wanted a new challenge, ide-ally one taking advantage of his contrarian nature.

“I like situations where a leader in an out-of-favor sector turns adversity to its advantage,” he says. “Career-wise, that’s where I wanted my next step to be as well.”

He joined Sprott Inc., where he’s actively involved in managing the precious-metals-focused investment firm while continuing to run Sprott Focus Trust, which in his 15 years at the helm (starting at Royce) has earned a net annualized 11.2%, vs. 9.7% for the Russell 3000. Among contrarian bets today, he sees value in asset management, drilling equipment and semiconductors. See page 2

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You focused almost exclusively on small caps during your long tenure at Royce & Associates, but one fund you brought with you to Sprott invests in big and small alike. How did that come about?

Whitney George: That particular fund, now called the Sprott Focus Trust, always had a broad mandate, but we didn’t really take advantage of it until 2009 when very large, high-quality companies started to trade at absolute valuations that were too attractive to ignore. When you can buy Microsoft, Exxon Mobil or Apple at valu-ations that you’re only accustomed to see-ing in ignored and out-of-favor small- and micro-cap stocks, you should do it.

Also, as a long-term investor in smaller stocks, you can often see ideas grow from small, to mid-cap to even large over time. I generally don’t want to have to sell the companies I know best and where I have the longest relationships just because of the cap size.

You describe favoring high-quality com-panies, but don’t seem to have any prob-lem with very cyclical businesses. How do you define quality?

WG: High-quality companies have strong balance sheets, earn high returns on capi-tal through the cycle, and have people running them who allocate capital intel-ligently and whose incentives are fully aligned with shareholders.

But I’m also trying to buy at an attrac-tive absolute valuation, which means a cap rate – our estimate of a company’s nor-malized operating earnings divided by its enterprise value – in the low- to mid-teens. Those moments of weakness aren’t always a function of cycles, but basic cyclicality that you can understand is very often a source of mispricing. Cycles are difficult for many investors to deal with because they often create short-term disappoint-

ments that people hate. I’m basically doing time arbitrage – finding companies where economic, industry or company-specific disappointments prompt short-term inves-tors to sell me their shares at compelling absolute valuations based on what I con-sider normal longer-term earnings power.

Two of my larger holdings today are Cal-Maine Foods [CALM] and Sander-son Farms [SAFM], which produce eggs and poultry, respectively. I’ve known and invested in these companies for a long

time and they both have excellent track records, fortress balance sheets and scale advantages. They also fully understand they are in cyclical businesses and manage themselves accordingly, being opportunis-tic at low points in order to reap the ben-efits when times are good.

With respect to their businesses, both companies should benefit as global popu-lation growth and higher average income levels increase secular demand for afford-able protein like that from chicken and, even more so, eggs. But in terms of the market for the stocks, the sell side hates them because quarterly earnings are im-possible to predict, and investors gener-ally dislike the random things that can happen. Just earlier this month Sander-son’s stock was off 13% on the day it an-nounced missing earnings estimates by 20 cents a share. The principal reason was due to hurricanes in the U.S. that knocked out production long enough for the birds to get fatter, increasing supply on the mar-

ket, which knocked down prices. How can you predict something like that?

What we do with companies like this is arrive at what we believe the business is worth, say, on five-year average earn-ings or some other reasonable estimate of normal. If you keep your head while the quarterly earnings game drives people batty, these types of opportunities can be very attractive over time.

What other types of situations allow you to buy quality on the cheap?

WG: In addition to taking advantage of time arbitrage, there’s still something to be said as well for detailed, fundamental research. I’ve owned the real estate invest-ment company Kennedy-Wilson [KW] on and off for fifteen years and consider it one of the best real estate asset managers in the world, with a track record to back that up. But it’s also organized in a com-plex, not-easy-to-understand way, which exacerbates the difficulty of seeing how good they are unless they’re selling things and it becomes obvious. If you peel apart individual projects you can better under-stand the company's value and take ad-vantage when the market isn’t recognizing it. When they start selling more than they buy – which is starting to happen now – the underlying value tends to surface.

You own GameStop [GME], the video-game retailer, which has certainly had its share of naysayers. Has your patience been tested there?

WG: It has. This is also something I’ve owned on and off for a long time and to-day there is a well-articulated case that this will be in video games what Block-buster was in movies, which is kaput as everyone accesses games online.

I can’t make the case that the bears have it all wrong, but I do believe that

Investor Insight: Whitney GeorgeWhitney George of Sprott Asset Management describes his affinity for cyclical businesses, what he’s finding to be unusual after eight years of a bull market, how he’s applying his expertise in precious metals, what he prefers about managing a closed-end fund, and what he thinks the market is missing in Franklin Resources, Pason Systems and Cirrus Logic.

I N V E S T O R I N S I G H T : Whitney George

ON FINDING BARGAINS:

Cycles are difficult for many

investors, so basic cyclicality

that you can understand is

often a source of mispricing.




with the stock trading at 5.4x consensus earnings for this year and at an 8.4% dividend yield, there’s quite a bit more op-tionality on the upside than the downside. Management has been very clever in how they handle real estate and in building out complementary businesses in used games and equipment, in collectibles, and in sales and service outlets for Apple and AT&T products. The company’s loyalty program is first-rate, on par with something like Amazon Prime. I also don’t believe people understand how much content is in video games, making them a chore to download, and the loyalty that gamers show for tra-ditional gaming platforms and equipment.

One thing that worries me is why man-agement hasn’t taken the company pri-vate by now. I probably should be buying more, but I’m just finding it too hard to get the level of conviction that would re-quire. This is certainly not something for the faint of heart.

You’ve long been active in precious metals, probably even more so now that you’re at Sprott. Describe why.

WG: I’ve been using precious metals and mining stocks in the Focus Trust portfolio since 1999, and probably have 10% of my personal net worth in physical gold or re-lated investments. Physical gold in partic-ular I consider a great diversifier over the long term because it moves differently at different times from stocks and other as-sets. Think of it as a simple, less expensive alternative investment, providing a hedge against things not going as perfectly as ev-eryone expects.

There’s also a hard-assets angle to my interest. Developed countries have too much debt to ultimately service or pay back, but rather than default, the likely path will be to debase currencies. Gold is a way to protect against that and profit from it. There are other things going on with cryptocurrencies that are rather scary, but this same phenomenon is expressing itself today in the excitement over them.

Around 13% of Sprott Focus Trust's portfolio today is in miners, spread over nine or 10 stocks. (The fund can’t own

physical gold.) While I very much believe in having the hard-asset exposure, because of the unpredictability in the sector and the fact that extractive businesses aren’t that capital-efficient through the cycle, I generally don’t own more than 2% in any one name. I’m also highly unlikely to take the overall portfolio exposure past 15%.

What’s your take on the cycle in the gold-mining sector today?

WG: I actually think we’re in a bit of a sweet spot. The bear market in gold and precious metals exposed a great deal of malinvestment, resulting in a significant number of management teams being re-moved and replaced. There is capital discipline in the business now and prob-ably even some underinvestment in de-velopment. If interest in precious metals increases, mining companies’ leverage to higher prices is far greater than it would have been three years ago.

Most precious-metals investors have scars from ideas gone wrong. One of those for you was Allied Nevada Gold, which went under in 2015. Lessons?

WG: This was a company pursuing diffi-cult but potentially lucrative development, with highly promotional management that seemed quite credible at the time. The problem very often turns out to be deceitful management, compounded by a balance sheet that can’t withstand it when the deceit results in too much cost and not enough revenue. That’s nothing new – if you’ve ever invested in gold miners, you know that’s what can go wrong. Unfor-tunately, knowing it doesn’t guarantee it can’t still happen.

Do any of your gold stocks stand out as particularly compelling today?

WG: Given my approach in holding a bas-ket, I wouldn’t put one or two over the rest. I would maybe point out, however, that Franco-Nevada [FNV] and Randgold Resources [GOLD] are unique in that their shares have outperformed the price of gold reasonably significantly going as far back as 2000. That’s rare, and would explain why their stocks are somewhat ex-pensive relative to peers at the moment. But that’s probably where I’d go first if there were a correction in metals prices.

In general, are you finding enough to do in today’s market?

WG: I would normally at this stage in a bull market have to be in the weeds with micro-cap stocks to find attractive-enough valuations. But the market seems more bifurcated, with values still showing up across the capitalization spectrum. The valuation of Apple [AAPL] is not chal-lenging. Western Digital [WDC] trades at 6x this year’s earnings. I can’t make sense of those valuations any more than I can at the other end with something like Tesla or Amazon.

I mentioned looking to buy when nor-malized operating-earnings yields are in the low- to mid-teens. On the other side, I’m looking to sell when those cap rates get closer to 8%, which is typically when a stock is attracting the kind of crowd that makes me want to be near the door. One advantage of having done this for a long time is that you already know a lot of companies, know where you’d buy and where you’d sell, and can just wait for Mr. Market to throw you opportunities from time to time. Even with overall valua-tions stretched, that usually happens often enough to keep me busy.

Another thing I’ve noticed that’s dif-ferent at this stage in the bull market is that the companies I own have tended to be investing rather than hoarding capital. At the margin they’re looking to enhance their businesses while others have been more focused on paying dividends and

ON GOLD:

Think of it as a less expen-

sive alternative investment

providing a hedge against

things not going perfectly.



buying back stock. I don’t know exactly how to read that, but I generally take it as a positive sign when well-run companies are investing rather than retreating.

You’ve said you typically average in and average out of positions. Why?

WG: It reflects the fact that I generally don’t believe I have enough clarity to make whole-position decisions all at once. For example, Westlake Chemical [WLK] is a long-term holding that has done very well and has been hitting valuation tar-gets. I’ll acknowledge when that happens and start selling in 5-10% intervals, but I will also go back and revisit if I’m miss-ing something the market seems to think it knows. I don’t kid myself that I can reli-ably bottom-tick or top-tick anything.

Explain your broader investment thesis for asset manager Franklin Resources [BEN].

WG: Asset management is an industry I understand well and have invested in throughout my career. I like that you get operating leverage without the financial leverage that’s typical of other businesses in the financial services industry such as banks and insurance companies. A well-managed company like Franklin generates high operating margins and high returns on capital because it requires little capital to operate.

The firm manages about $750 billion in mostly actively managed stock, bond and alternative-asset strategies. The Johnson family owns nearly 40% of the shares and manages the business responsibly for all owners, returning much of the company’s cash flow to shareholders through stock repurchases, quarterly dividends and the occasional special dividend.

The shares are cheap in my opinion be-cause assets under management have de-clined more than 15% since 2014, mostly due to the current popularity of compet-ing passive strategies but also the result of underperformance in some of its large funds. This trend has stabilized, and with the company enjoying strong performance across much of its product line, flows have

held steady through the fiscal year ending in September.

Is this mostly a bet that active money management has a brighter future than many expect?

WG: The passive story has been quite well told and has become a bit of a momentum trade. Growth of passively managed assets becomes self-fulfilling. Assets flowing into ETFs and index funds inflates stock prices and reinforces the perceived efficacy of passive vehicles, which begets more pas-sive flows.

I do believe, however, that the pen-dulum will swing back in favor of active strategies. The objective of most active managers is to reduce risk, and in bull markets reduced risk means reduced re-turns. The underperformance compounds with the length of the bull market, espe-cially when stocks are highly correlated as they have been in recent years. It’s a toxic recipe that has led to the most pronounced backlash against active managers in his-tory. The latest backlash has been partic-ularly acute, but this is not the first time active managers have come under fire. In the late 1990s when tech stocks were all


Franklin Resources (NYSE: BEN)

Business: One of the world’s largest invest-ment managers, with around $750 billion in assets invested primarily in actively managed stock, bond and alternative-asset funds.

Share Information (@12/29/17):

Price 43.3352-Week Range 39.32 – 47.65Dividend Yield 2.1%Market Cap $24.00 billion

Financials (TTM):

Revenue $6.39 billionOperating Profit Margin 35.4%Net Profit Margin 26.5%

Valuation Metrics(@12/29/17):

BEN S&P 500P/E (TTM) 14.4 21.8 Forward P/E (Est.) 14.3 20.0

Largest Institutional Owners(@9/30/17):

Company % OwnedVanguard Group 4.8%State Street 3.3%Massachusetts Fin Services 3.2%BlackRock 2.6%Highfields Capital 2.0%

Short Interest (as of 12/15/17):

Shares Short/Float 2.8%

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

THE BOTTOM LINEWhitney George believes the market is assuming the company's mostly actively managed assets "will be flat or down forever." If he's right that active managers return to favor and the company's diverse portfolio of funds again shows solid growth, the shares at an 8% cap rate on estimated operating earnings, plus net cash, would be worth around $68.

Sources: Company reports, other publicly available information

BEN PRICE HISTORY


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the rage and the market was very risky, active managers were similarly unpopu-lar. Redemption ultimately came with a bear market, as I believe it will again this time. When stock prices begin to decline, the poor performance of passive strategies will also become self-fulfilling. Investors will pile out of indexes the same way they piled in, but probably twice as fast.

Franklin’s diversity of assets, the de-risking nature of active management, and the relative outperformance of ac-tive strategies in our envisioned scenario should protect and ultimately enhance its business. We don’t believe the stock today adequately reflects that.

How inexpensive do you consider the stock at a recent $43.30?

WG: The shares currently trade at about 14.5x the $3 per share the company earned in its 2017 fiscal year, but if you net out $18 per share of cash on the bal-ance sheet, that earnings multiple falls to 8.4x. We think at these levels investors are ascribing a value to assets under manage-ment that they think will be flat or down forever. We don’t think that’s going to be the case and if we’re right, the company will grow again and investors will eventu-ally value it differently.

Franklin in rosier times has traded at an 8% cap rate on operating earnings, which is not far from where many peers that don’t have all the excess cash trade today. At an 8% cap rate, plus the cash, the shares would be worth closer to $68. It won’t be a straight line, especially if there’s a market break of some kind, but we believe the value will be there.

Oilfield specialist Pason Systems [Toron-to: PSI] is certainly not a household name. What attracted you to it?

WG: As a contrarian, I'm interested in the energy sector when it has just underper-formed. That is the case now, as it was in 2003 when I first invested in Pason. In en-ergy, I prefer the far better balance sheets of service companies over exploration and production firms. As I mentioned with

Franklin, Pason has operating leverage without the financial leverage.

The company isn’t that well known, trading in Canada with a market cap of about C$1.5 billion. But it’s the dominant market leader in what it does, which is provide technology and electronics that collect, manage and analyze oil and gas drilling data that is used to help opti-mize performance of drilling operations. For example, their primary product is an electronic recorder that monitors wear and tear on drills and pumps, collecting and transmitting data via satellite back to geophysicists who can monitor and man-

age multiple projects from their air-con-ditioned offices. Another product moni-tors gas levels from the drill bit in order to keep it in the sweet spot of long, hori-zontal resource formations. The company even installs electronics at the drill site so workers can e-mail their spouses and watch Netflix when they aren't working.

Pason has roughly 90% market share in Canada and has captured 65% of the U.S. market since entering it ten years ago. The hardware is installed on the rig by the original equipment manufacturer and generally remains in use over the rig’s life, providing a strong barrier to competi-


Pason Systems (Toronto: PSI)

Business: Develops and services technol-ogy systems that collect, manage and analyze oil and gas drilling data that is used to help optimize performance of drilling operations.


Price C$18.1952-Week Range C$16.65 – C$22.36Dividend Yield 3.7%Market Cap C$1.55 billion

Financials (TTM):

Revenue C$228.2 millionOperating Profit Margin 14.5%Net Profit Margin 5.0%


PSI S&P 500P/E (TTM) 133.7 21.8 Forward P/E (Est.) 33.1 20.0

Largest Institutional Owners(@9/30/17 or latest filing):

Company % OwnedBurgundy Asset Mgmt 10.0%Caisse de Depot du Quebec 8.4%Royce & Assoc 7.4%Neuberger Berman Inv Mgmt 6.3%Fidelity Mgmt & Research 4.2%


Shares Short/Float n/a


THE BOTTOM LINEA dominant market leader in a niche energy-services sector, the company should prosper as North American rig counts continue to rebound after a precipitous fall since 2014, says Whitney George. If the shares earn what he considers a warranted 8% cap rate on operating income that is 80% of its prior peak, the stock would trade at around C$30.


PSI PRICE HISTORY



tion. I also believe Pason's risk of techno-logical obsolescence is limited because of their commitment to R&D, on which they spend C$30 million annually and which occupies 25% of the workforce.

How has the company weathered the en-ergy recession?

WG: It’s actually quite resilient. Revenues fell nearly 70% from peak to trough in the latest cycle, but it has maintained positive cash flow due both to a flexible operat-ing model and the cushion of operating margins that in good times are as high as 50%. The balance sheet is also rock solid, with nearly C$160 million in net cash.

What do you think the shares, now C$18.20, are more reasonably worth?

WG: Revenues here are a function of the rig count and of the number of products per rig that clients use. The North Ameri-can rig count fell from about 2,300 in 2014 to less than 500 last year, and has re-covered to just over 1,100. That rebound in the rig count has had a nicely positive effect on Pason’s revenues and operating profits, but the shares have only modestly recovered.

If operating income gets back to 80% of the C$260 million the company earned at the peak of the last cycle, at an 8% cap rate that implies a per-share value of around C$30. I don’t think that valua-tion would be unreasonable at all, given the company’s market share, profitability and potential to grow in markets outside North America and by continuing to pro-vide additional services that increase rev-enue per rig.

Is this eventually an attractive takeover candidate?

WG: I think the size of the market – Pa-son’s revenues peaked at C$500 million – has kept it from attracting much com-petition and allowed it to gain a big head start. If its market does attract the interest of other big energy services firms, I would expect Pason to be acquired in pretty

short order. That would very likely have to be done at a premium to my C$30 price target.

What do you think investors are missing in Apple supplier Cirrus Logic [CRUS]?

WG: Cirrus develops semiconductors that convert sound from analog to digital, and their chips have long been found in the highest-fidelity sound systems. The driver of their business in recent years has been Apple, which uses what’s called sound-vectoring technology developed by Cirrus that allows a microphone to capture a per-

son’s voice while canceling out surround-ing noise. For Apple to let the company earn 50% gross margins, it must be do-ing something special. Real estate in these phones comes at a premium and Cirrus has proved very good at adding capability while reducing power used and the space required.

We think the shares are discounted be-cause Apple accounts for about 75% of revenues and it doesn’t allow Cirrus to discuss the product or business pipeline, leaving analysts more or less in the dark about future earnings. As a result, the stock typically reflects little more than the


Cirrus Logic (Nasdaq: CRUS)

Business: Develops and sells semiconduc-tors for audio applications used in smart-phones, automotive entertainment systems, security devices and digital-assistant devices.



Financials (TTM):



CRUS S&P 500P/E (TTM) 12.7 21.8 Forward P/E (Est.) 10.7 20.0


Company % OwnedVanguard Group 10.4%BlackRock 9.8%Fidelity Mgmt & Research 5.4%LSV Asset Mgmt 5.0%AQR Capital 4.3%


Shares Short/Float 8.7%


THE BOTTOM LINEThe market's apparent concern about overreliance on large-customer Apple gives the company little credit for either continuing to expand its Apple business or for broaden-ing the market for its technology, says Whitney George. Applying a 12.5x multiple to estimated forward operating income, plus net cash, he values the shares at around $82.


CRUS PRICE HISTORY



I N V E S T O R I N S I G H T : Tom Olsen

quarter just reported and the concern that the company’s dramatic increase in earn-ings power over the last couple of years isn’t sustainable.

We disagree with that consensus view. Apple used around $5 of Cirrus’ content in the latest iPhone cycle, up from $2 in the previous one, and used another $1 of content in the latest AirPods. So it’s not pre-ordained that the Apple business is going to decline. At the same time, Cirrus continues to broaden its market beyond Apple. Through an acquisition, it now provides similar technology for Android-based phones, giving it content today in all of the top-five mobile devices. The company’s technology also enables voice interaction used in Internet of Things ap-plications that will increasingly be found in things like automobiles, security sys-tems and smart-home systems. Artificial intelligence should be another growth market – sound technology is necessary for Apple’s Siri and Amazon’s Alexa to recognize voices, and Cirrus’s chips are a premium option.

Walk through how you're assessing fair value for the stock, which now trades around $51.90.

WG: It’s quite straightforward. Excluding $5 per share in net cash, the stock trades at a 13% cap rate on the $400 million of operating income the company should earn in its fiscal year ending next March. Again, we’d argue both based on history and on the quality and prospects of the business that the stock will deserve an 8%

cap rate, which after adding the net cash would value the shares at around $82.

I’d add here that Cirrus, especially given the current valuation, would also make an attractive acquisition candidate. The engineering talent to develop this type of technology is a scarce commodity, so it would likely be cheaper and more effec-tive for a competitor or customer to buy Cirrus outright than to try to develop the same technology on its own.

Sprott Focus Trust [FUND] trades at a 12% discount to net asset value. Why, and are you trying to do anything about it?

WG: The premium or discount of the typi-cal closed-end fund, for better or worse, at least partly reflects the popularity of the underlying concept. When we acquired Focus Trust in 1996 it traded at a 20% discount. In June 2007 it was at a 12.5% premium. After I left Royce, it traded back down to an 18% discount. That’s come in a bit, but as you say, it’s still around 12%.

The closed-end fund is a great plat-form to manage money because the crowd doesn’t have to affect your investing. You have a stable capital base, so you’re not flooded with capital when you don’t need it or losing capital when you do. That’s a tremendous advantage over an open-end mutual fund, with which I also have sig-nificant experience.

That said, I don't intend to sit here with a large discount to NAV. Nearly 25% of the capital in the fund is my own, and it wouldn’t make sense to leave it chronical-ly undervalued. We can tell our story bet-ter, but in the end to shrink the discount I’m going to have to perform. That tends to heal all wounds in this business. VII

Investor Insight: Tom Olsen Tom Olsen of European money manager Mensarius explains the three types of situations that tend to attract his interest, his detailed research process meant “to identify and avoid the risks we are able to avoid,” his general view on the oppor-tunity set in Europe and the U.K., and why he sees mispriced value in Salvatore Ferragamo, Ericsson and Landis + Gyr.

You’ve said that your investments typi-cally fall into three general categories. De-scribe what they are and maybe provide a current example.

Tom Olsen: The first would be a com-pany that earns high returns on invested capital that we’re able to buy at an attrac-tive valuation relative to its own history. These may be in somewhat shorter supply today, but for a number of reasons even these companies can find their shares out of favor.

Not so long ago, for example, we bought Viscofan [Madrid: VIS], which is a Spanish company that is the world’s largest producer of artificial casings for processed meat production – in other words, sausage making. It also makes the machinery to process meat. The company over a long period of time has consistently built its global franchise, exploiting its scale and expertise in a way that com-petitors have been unable to do. It also benefits from growth in meat consump-tion as wealth levels increase in emerging

markets. But starting in 2015 and accel-erating in 2016 the shares took a hit for more macro reasons, including economic concerns in emerging markets and some foreign-currency issues. We saw that as a wonderful time to buy an interesting long-term franchise. [Note: As high as €60 in April 2015, Viscofan shares fell below €43 a year ago. They currently trade at €55.]

The second category of company we find interesting is the quality cyclical com-pany with a competitive edge that we try to buy close to the trough of the cycle.

ON PERMANENT CAPITAL:

The closed-end fund is a

great platform to manage

money; the crowd doesn't

have to affect your investing.



Here as a current example I’d use Frank’s International [FI], which is incorporated in Holland but is largely a U.S. operation. The company provides highly engineered well casings that keep oil and gas wells from collapsing after the hole is drilled. It’s the market leader in an oligopolistic market, and has an outstanding long-term track record under three or four genera-tions of family control.

The problem, of course, is that there’s so little drilling activity today in offshore environments, where most of the business is. We don’t believe that’s a permanent condition and that deepwater drilling will again provide a competitive – and neces-sary – source of oil to meet rising demand. Given the strength of its market position and its balance sheet, we expect Frank’s franchise and normalized profitability to be fully intact when demand returns. If we’re right, there should be considerable upside in the stock from today’s level. [Note: Frank’s went public in 2013 at $22 per share and the stock went above $30 later that year. It currently trades at around $6.75.]

Our third main category of investment would be restructuring companies that we believe are increasing their earnings power. We aren’t so interested in situa-tions where just the need for a turnaround is obvious, but rather when there is also a clear path defined to improve the business. We’ll talk later about the case of Salvatore Ferragamo [Milan: SFER], but another similar restructuring example we own is Hugo Boss [Xetra: BOSS]. The company in terms of returns had done quite well over time, but under the influence of a private equity investor in recent years the brand was stretched beyond its capability. They aggressively expanded retail stores. They expanded into new price points in men’s suits. They spent disproportionately on marketing a women’s line that made up only 10% of sales. All that led to dis-appointing results and the stock price fell 60% from its peak.

We got involved when the CEO was replaced, the Marzotto family that had owned 7% of the stock upped its stake to 10%, and the new management presented

a strategic plan that is meant to refocus and simplify the company and emphasize value creation over growth at all costs. The elements of the plan are clear and we can monitor carefully the results. If the earnings power is sustainably improv-ing as we believe, then the gap we see to fair value should continue to close. [Note: Having fallen below €50 in the summer of last year, Boss shares currently trade at just under €71.]

How do you tend to unearth these types of ideas?

TO: Our universe consists primarily of European stocks with market capitaliza-tions above €500 million and with daily trading volumes of at least €2 million. Out of that, we generate roughly two-thirds of our ideas from proprietary in-house screens that are designed to identify com-panies with returns on capital in excess of their costs of capital, good profit margins, low financial risk and with stocks priced at attractive valuations.

While our screens catch many of the high-return-on-invested-capital and cycli-cal-recovery cases, most of our restructur-ing cases and various other ideas generally come from external sources, including in-dustry contacts and referrals.

Our interest in Publicis [Paris: PUB], one of the top-four global advertising-agency companies, started with one of our analysts hearing company management at a conference talking about the global ad-vertising business and how the company was positioning itself in it. As we looked into it further, we found an industry that was out of favor due to concerns about the ongoing shift from analog to digital, but the company was still doing reason-

ably well and would have been doing much better if not for heavy and what we concluded were smart investments in its own digital capabilities. Our ultimate interpretation is that Publicis will actu-ally maintain its competitive moat and en-hance its earnings power due to its ability to offer broad-based, independent and ef-ficient marketing strategies for clients who are looking to get the most out of their spending. This has maybe some elements of each of the three types of ideas we typi-cally pursue.

Once you've identified something as inter-esting, describe your research process.

TO: We have defined a seven-step due diligence process which provides a struc-ture that is meant to insure we don’t miss anything important and which is appli-cable across industries and companies. I could go into considerable detail on each, but the first step is a background check, where we study the company’s history and current ownership structure with the goal to assess the risk of potential shareholder abuse and poor stewardship of capital.

The second step is analysis of the finan-cial statements, where we build a detailed financial model, making adjustments to the reported numbers as necessary to ar-rive at the true cash-generating ability of the company going forward, which drives our estimate of intrinsic value. Here also we assess how aggressive or conservative the accounting is – aggressive accounting to us is always a clear warning signal.

Informing our quantitative assessment of the business, our third through sixth due-diligence steps include assessments of the industry structure, value chain, product lifecycles and external operating environment. This would include a “Five Forces” analysis as described by Michael Porter to assess competitive advantage, which is obviously essential in evaluating the strength and sustainability of the fran-chise. I would highlight the importance of these particular steps. When I look at the mistakes that we've made, it has often been because we didn’t fully understand the competitive dynamics of the industry


ON TURNAROUNDS:

We're less interested if just

the need for a turnaround

is obvious, but rather when

there's also a path defined.



and the impact of external factors over which the company cannot exercise con-trol, or we didn’t anticipate how easily such things might change.

Finally, in the seventh step of our due diligence, we want to understand the mo-tivations of the management team. While experience and track record from previous positions are important, we also want to meet with management to gain any insight we can not only on strategy and execu-tion, but also on the extent of their focus on maximizing long-term shareholder re-turns. In the end, few franchises are viable long term and probably none will serve the best interests of shareholders if man-agement is incapable, untrustworthy or acting more in their own interest rather than in the interest of shareholders.

Value investing to me provides a struc-tured and systematic framework for ap-proaching an investment. I personally don’t understand why not more people use such an approach. We’re trying in our research and analysis to do everything we can to identify and avoid the risks we are able to avoid. We think that goes a long way to having success as an investor.

How would you characterize today's in-vestment opportunity set in Europe?

TO: Valuations in Europe aren’t fantasti-cally low, but they are not overly stretched either. On a relative basis, certainly to the U.S., things look pretty okay.

I would say for the first time since the financial crisis we see a synchronized economic recovery, both in Europe and globally. Germany has been strong and re-mains the locomotive of Europe. Spain is improving. Even Italy, despite reforms not taking place as one might hope, is expe-riencing a recovery. One important thing to watch is France, where President Ma-cron is implementing reforms that people have talked about for decades but never accomplished. I would say that could be a positive surprise, if France can join Ger-many as a locomotive and help provide a broader foundation for economic growth. The jury is still out, but I would argue that’s not an unlikely possibility.

Are you optimistic or pessimistic about prospects for the U.K.?

TO: The country is dangerously divided over Brexit. The central problem seems to be that the hard Brexiters view it as an opportunity to be seized, while for those in charge of implementing Brexit it is a bomb that should be defused. Meanwhile, the Labour party has been taken over by the most leftist leadership since before the Thatcher era. This makes the Brexit nego-tiations very difficult and uncertain. All of that has been a drag on the economy, which is clearly slowing down.

I still have to believe that the Euro-pean Union and the U.K. actually have an interest in finding a reasonable resolu-tion to the problem, but no deal or a bad deal would clearly hurt the U.K. and its companies more than it would the EU. Is all the uncertainty creating investment opportunity? Maybe, but we believe it might be too early to pursue them. We’re strongly underweighted in U.K. stocks at the moment.

Describe in more detail the “restructur-ing” upside potential you see for Salvatore Ferragamo.

TO: The company, still 58% owned by the Ferragamo family, produces and sells luxury clothing, shoes, leather goods, watches, perfumes and jewelry. Its prod-ucts are sold in more than 90 countries through around 690 company-owned stores as well as high-end department stores. The brand remains well respected after nearly 100 years and the business has generally been highly profitable, earning 20% returns on invested capital.

After a decade of investing in its global retail footprint, the company is imple-menting a new strategic plan meant to rejuvenate the brand and improve retail-store productivity. That involves things like increasing marketing spending, spending money on store refurbishment, reducing the number of SKUs, investing in information technology, and bringing in a new generation of designers to ac-celerate new-product innovation. All that


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is currently weighing on revenue growth and margins, but is intended longer-term to drive annual revenues beyond €2 bil-lion and increase operating margins, now around 18%, into the low-20s.

Is there risk that Ferragamo experiences the same type of growth pains that hurt Hugo Boss?

TO: We think that risk is low. Hugo Boss opened too many new stores, lost focus and essentially diluted its brand. Ferraga-mo’s strategy is a more deliberate expan-sion and revitalization. The CEO since

August of 2016, Eraldo Poletto, consid-ers himself a retailer first, and comes to the company after an impressive tenure running handbag maker Furla. His track record and the fact that the controlling family is still actively involved gives us confidence that anything they do will be true to the brand and in the long-term in-terest of shareholders.

I’d argue that a better comparison would be between Ferragamo and LVMH. Each has key product lines, such as shoes and leather goods, which are less exposed to fashion risks and shifting consumer tastes. They both have long traditions,

unique brands and closely integrated manufacturing and distribution networks. As is the case with LVMH, Ferragamo is highly unlikely to jeopardize its brand eq-uity for short-term gain.

The shares, now at €22.15, are off more than 25% from earlier this year. What up-side do you see from here?

TO: As the strategic plan bears fruit, we expect a combination of overall GDP growth, increasing disposable incomes and improved market shares to drive 5% annual revenue growth over the next five years. With operating leverage, improved retail productivity and a more favorable sales mix, we expect operating margins over that time to reach 23%. Applying a 16.7x multiple to our five-year operating-profit estimate – effectively capitalizing at 6% – adjusting for options dilution and subtracting a small amount of net debt, we arrive at a five-year price target in the high 30’s.

From luxury goods to telecommunication equipment, describe your investment case for Ericsson [Stockholm: ERICB].

TO: Ericsson is the world’s largest manu-facturer, with a roughly 35% global mar-ket share, of telecommunications equip-ment. Its equipment carries 40% of the world’s mobile traffic and serves custom-ers in 180 countries. The business model is typically to sell the network equipment at cost and then make money on service contracts and software upgrades over the equipment’s lifecycle.

This became a fairly lousy business more than a decade ago when the network infrastructure industry was disrupted by the entrance of the Chinese company Hua-wei, which used its support by the Chinese government to aggressively undercut com-petitors on price. While Ericsson’s core business impacted by that has stabilized, the company has been very slow to re-structure itself as aggressively as it needs to, primarily due to political pressure in its home market of Sweden, where it is a major employer.


Salvatore Ferragamo (Milan: SFER)

Business: Global design, marketing and sale of luxury branded footwear, apparel, leather goods and other related products through company-owned and third-party retail stores.

Share Information (@12/29/17, Exchange Rate: $1 = €0.83):

Price €22.1552-Week Range €20.42 – €29.88Dividend Yield 1.8%Market Cap €3.74 billion

Financials (TTM):

Revenue €1.43 billionOperating Profit Margin 18.1%Net Profit Margin 14.1%


SFER S&P 500P/E (TTM) 21.7 21.8 Forward P/E (Est.) 24.9 20.0


Company % OwnedAllianz Global Inv 1.7%OppenheimerFunds 1.5%Norges Bank 1.2%Mensarius 1.0%Keva 0.8%




THE BOTTOM LINETom Olsen believes that the company's new focus on revitalizing its brand and improving retail-store productivity can over the next five years drive 5% annual revenue growth and an increase in operating margins to 23%. At 16.7x his five-year operating profit estimate, adjusted for options dilution and net debt, the stock would trade in the high-$30s.


SFER PRICE HISTORY



The impetus for our interest came in April, when the chief investment officer of one of the company's major shareholders, Industrivärden, publicly expressed deep dissatisfaction with the company's devel-opment. As we started to buy, so did Cevi-an Capital, one of Europe’s largest activist investors, which now has a 7.9% stake and has been agitating for change. The CEO was replaced earlier this year and the cur-rent chairman will be replaced early next year by Ronnie Leten, the former CEO of industrial-equipment manufacturer Atlas Copco. He will work with the new CEO, Börje Ekholm, to finally implement what

we think is a long-overdue and necessary cost-cutting and restructuring plan.

What are the key elements of the plan?

TO: It’s really a full overhaul of the busi-ness, focused not only on improving the profitability of the network-equipment and support businesses, but also on shut-ting down or selling big loss-making busi-nesses focused on the media, information-technology and cloud industries. The ultimate goal is to increase overall adjust-ed operating margins (excluding restruc-turing charges) from 6% to 12% by 2019.

Can Ericsson compete long term against Huawei?

TO: There are really only three large play-ers left in the industry, Ericsson, Huawei and Nokia, which bought Alcatel-Lucent last year. Huawei will continue to offer the lowest equipment prices, but upfront purchase cost is only one of many consid-erations that go into vendor selection. We believe Ericsson can compete on product quality, service and responsiveness, giv-ing wireless-service customers – who have a strong incentive to ensure that all three competitors stay in business – a perfectly viable option that is cost-effective over the life of the relationship.

Political issues will also continue to play a role, to the benefit of Ericsson. It’s highly unlikely, for example, that Huawei would set up large portions of the U.S. or European carrier networks, given the perceived exposure to Chinese espionage. That’s an additional reason we expect long-term industry market shares to re-main fairly stable.

Does the wireless upgrade cycle to 5G technology impact your thesis?

TO: Some analysts expect there to be a “land-grab” competition for 5G contracts that will depress margins for equipment providers. For the reasons already men-tioned, we don’t think that’s likely and that market shares in 5G won’t be mark-edly different.

There is, however, legitimate concern that 5G’s inherent modularity will allow wireless carriers to gradually upgrade their networks over an extended time pe-riod. This is why we’re actually modeling negative revenue growth for Ericsson over the next three years, followed by 2-3% annual growth thereafter. Management's forecasts are higher, but we prefer to be more conservative.

Ericsson shares at a recent 53.85 Swedish kronor have been cut in half from their highs of three years ago. If the restructur-ing succeeds, how could that impact the stock price?


Ericsson (Stockholm: ERICB)

Business: Manufacture and sale of network telecommunications equipment and related services to wireless and fixed network opera-tors located in more than 180 countries.

Share Information (@12/29/17, Exchange Rate: $1 = SEK 8.24):

Price SEK 53.8552-Week Range SEK 43.75 – SEK 64.95Dividend Yield 1.9%Market Cap SEK 176.56 billion

Financials (TTM):

Revenue SEK 209.32 billionOperating Profit Margin 3.0%Net Profit Margin (-8.6%)


ERICB S&P 500P/E (TTM) n/a 21.8 Forward P/E (Est.) 30.8 20.0


Company % OwnedCevian Capital 7.9%Swedbank AB 4.8%Dodge & Cox 3.8%BlackRock 3.5%AMF Fonder 2.9%




THE BOTTOM LINE"The time has come to believe that things can get better," says Tom Olsen, as the com-pany implements an overdue, broad-based overhaul of its business with the goal of dou-bling operating margins to 12% by 2019. If it gets halfway there, he believes the stock at 16.7x his earnings-power estimate of SEK 6 per share could be worth at least SEK 90.


ERICB PRICE HISTORY



TO: After years of disappointing results, it’s not surprising that the market is skep-tical about the company's prospects for improvement. But we think the time has come to believe that things can get better. Assuming operating margins get to 9%, halfway to management’s goal, we think the company’s earnings power three to five years out will be around 6 Swedish kronor per share. Capitalizing that at 6% – or as-suming a multiple of 16.7x – and adding back net cash, we believe the shares on that earnings power could be worth 90 to 95 kronor per share. As with any restruc-

turing, it will take time and will likely be a bumpy ride.

Tell us about your interest in electric-metering company Landis + Gyr [Switzer-land: LAND].

TO: The company, which has a 120-year history, was spun out of Toshiba and be-gan trading publicly in August of 2017. Based in Switzerland, it is the world leader in smart electric meters and integrated en-ergy-management systems, used by some 3,500 electric utilities worldwide to man-

age their power supply, production and distribution. It has the #1 position in the U.S. and Asia, and is #2 in Europe.

The business generally has significant economies of scale and high customer switching costs. In markets like the U.S., where regulation is more homogenous and supportive of investment in new tech-nology, Landis + Gyr earns 20% or so on invested capital. The company does less well in Europe and Asia, where regula-tion differs from country to country and regulators have been slower to approve investments in the network-connected smart meters and systems the company sells. That’s improving somewhat in Eu-rope, but we’re only counting on around 14% ROICs there. Asia is further behind, which has dampened profitability, and for the purposes of our valuation we’re not assuming much improvement.

Is this a growth business?

TO: The rollout of smart meters to re-place traditional meter technology still has a long runway ahead. We don’t expect the U.S. market to show signs of satura-tion until around 2025, and it will be much later than that in Europe and Asia. As grids get “smarter,” the company also has considerable potential to grow its soft-ware and services businesses, which now account for 16% of sales.

How inexpensive do you consider the shares at a recent price of 77.50 Swiss francs?

TO: The key inputs in our model are or-ganic revenue growth of 5% annually over the next five years, 20% EBITDA margins in the U.S. and 8% EBITDA margins in Europe. This would result five years’ out in adjusted operating earnings per share of around 7.50 Swiss francs per share. Capi-talizing that at 6% – again, a multiple of 16.7x – and subtracting net debt, we think the shares can be worth 110 to 115 Swiss francs per share.

Are you a frequent investor in spinoffs?


Landis + Gyr Group (Switzerland: LAND)

Business: Develops, manufactures and sells smart electric meter technology and inte-grated energy-management systems used by some 3,500 electric utilities worldwide.

Share Information (@12/29/17, Exchange Rate: $1 = CHF 0.97):

Price CHF 77.6052-Week Range CHF 65.00 – CHF 79.50Dividend Yield 0.0%Market Cap CHF 2.29 billion

Financials (FY2017):

Revenue CHF 1.64 billionOperating Profit Margin 3.3%Net Profit Margin (-3.8%)


ERICB S&P 500P/E (TTM) n/a 21.8 Forward P/E (Est.) 17.7 20.0


Company % OwnedKirkbi A/S 3.4%Franklin Templeton 3.0%Norges Bank 2.8%BlackRock 2.7%UBS 2.3%




THE BOTTOM LINEThe company has a long runway of stable growth ahead as electric utilities slowly up-grade their infrastructures with its energy-saving technology, says Tom Olsen. Assuming organic annual revenue growth of 5%, improving margins in Europe and a 6% cap rate on operating earnings, he believes the shares five years' out can be worth at least CHF 110.


LAND PRICE HISTORY



I N V E S T O R I N S I G H T : Richard Cook

Investor Insight: Richard Cook Cook & Bynum Capital Management’s Richard Cook describes what’s behind the unusual composition of his portfolio, why he’s spending so much time in emerging markets, one key “error in psychological misjudgment” he guards against, and why he sees underappreciated potential in Anheuser-Busch InBev, Coca-Cola Embonor and Corporación Lindley.

You have a rather odd portfolio, with eight stocks and including both the bluest of blue chips and companies we’ve never heard of. How does that come together?

Richard Cook: We have a broad man-date, which is to find good businesses, anywhere, of any size and in any indus-try. But the ideas must be in our circle of competence, which for us means that we can see the prospects of the business far enough into the future to get our money back. If you pay 15x earnings for some-thing, you’re implicitly saying you know about enough years in the future that the investment will pay off. In addition to that we have an absolute-value orientation; we explicitly project cash flows in perpetu-ity and then use the current share price to solve for our expected annual rate of return. We don’t assume some greater fool will later buy the shares from us at a better valuation. In the current interest rate envi-ronment, our expected annualized return has to be at least 10%.

Only a few opportunities meet the crite-ria of investing in things we can know well enough and that meet our expected-return hurdle. As for the types of businesses that end up in the portfolio, our strategy gener-ally leads us to companies that are either unloved or undiscovered. That’s why we have positions in both well-known and not-so-well-known companies.

Give representative historical examples of both the “unloved” and “undiscovered.”

RC: Two in the unloved category would be Wal-Mart [WMT] and Microsoft [MSFT]. We paid 11x earnings for Wal-Mart in April of 2010 at a time when the market seemed to think it could do no right and Amazon could do no wrong. The obses-sion with Amazon was fair, but at 11x earnings we only had to expect that Wal-Mart could continue to get a few things right in order to grow earnings modestly over the next ten years and deliver us a better-than-10% return on our money.

We started buying Microsoft in 2011, when you could hardly pick up The Wall Street Journal without reading about how irrelevant it was becoming and how com-panies like Apple and Google were going to leave it in the dust. But the stock was at less than 8x earnings if you backed out cash, which basically meant they could put the business in runoff mode and we’d easily get our money back. We thought the Enterprise and Office businesses were stickier than the market recognized and had earnings power that warranted much better than a 7.5x multiple. Any upside from things like shipping better consumer products and building out the cloud busi-ness were tremendous free call options.

In the undiscovered category I’d put what you’ll see as our great interest in

emerging-market Coca-Cola bottlers. The first one we bought was Arca Continental [Mexico City: AC], the best-performing position we’ve ever had. Arca’s primary business is bottling Coke products in northern Mexico, Ecuador, Peru (through its controlling stake in Corporación Lind-ley), northern Argentina and, in a recent expansion to the U.S., Texas, Oklahoma, New Mexico and Arkansas.

We first got interested in the business more than ten years ago. Coca-Cola is the top-selling carbonated soft drink in nearly every market in the world, creating scale advantages for the company’s bottlers, each of whom have discrete territories. We found scale to be especially important in places like Latin America, where beverage distribution is very fragmented with infor-mal, mom-and-pop retailers accounting for well over half of the individual mar-kets. Bottlers who execute at the point of sale – and we think Arca is the best in the world on that front – can sell their prod-ucts at premium prices and still maintain over 70% market shares.

Even with those advantages, when we first invested in Arca in 2008 the company was growing earnings in the double-digits and had net debt of less than one year’s EBITDA, but the stock was trading at 7x earnings and a 9% dividend yield. That is not the profile of a well-understood stock. It’s still one of our largest positions.

TO: Investing in spinoff situations is not a theme we regularly play. In this case, the core of the investment thesis is that Lan-dis + Gyr is underearning its potential in Europe and we believe that will improve. What is probably more related to the spi-noff is that the company doesn’t appear very well known to investors. That could certainly help explain why the potential that we see isn’t being recognized by the market.

Wrapping up, how vibrant overall do you find Europe's value-investing community?

TO: There are certainly some of us, but I think as is the case everywhere that a dis-ciplined value investing approach can be counter-intuitive to human nature. “Inves-tors do not like uncertainty” seems to be the mantra among most financial experts and market participants. But, of course, we and most value investors would say

that the existence of uncertainty or risk is one of the fundamental ingredients for generating good investment returns. Suc-cessful value investors focus on managing risk, not avoiding it.

Humans also find comfort in consen-sus, providing confirmation for what they say and do. Value investors have to resist that, which is difficult. But it’s also neces-sary if you actually want to make money in the stock market. VII




What’s your current take on Coca-Cola [KO] itself, also one of your top holdings?

RC: We bought the shares in the depths of the 2008 crisis when they selling at only 12x earnings. We bought it well, but I would say we’ve been rather frustrated by the speed at which the company has taken advantage of the opportunities we think it has to improve the business.

The global growth story is still intact: In countries with between $5,000 and $20,000 in annual per-capita GDP, people start switching to ready-to-drink bever-ages, meaning anything pre-packaged in a can or bottle. A lot of the world isn’t yet to $5,000 in per-capita GDP and most of the world earns less than $20,000, so as that changes Coke should be in a good posi-tion to benefit for quite some time.

In developed markets, there is a clear need for the company to innovate beyond carbonated soft drinks sweetened with sugar. Management is aware of that, but we’d argue there needs to be a bigger cul-tural shift toward being a broad-based, marketing/distribution business with less bureaucracy. We hear terrific things from bottlers about new CEO James Quincy on this front, and we’ve seen some evidence that he is pushing management decision-making to local market experts and is willing to explore new product categories. At the current valuation we’re willing to see how things develop, but it’s fair to say our patience won’t be unlimited.

I’d add here that, unlike many inves-tors, we don’t tend to look at everything through the filter of what the Chief Finan-cial Officer would do to make things bet-ter. For Microsoft, it wasn’t about how to perfectly lever the balance sheet; the com-pany just needed to consistently provide better and more relevant products and services. The same thing is true of Coke. It’s not about what they do to the divi-dend or how they should save their way to prosperity. It’s about providing more and better products that meet the needs and wants of consumers. Whether they can do that or not is ultimately what’s going to matter, especially over our time frame in evaluating the company’s progress.

You're often on the road looking for op-portunity in emerging markets. Why are you taking that path?

RC: With respect first to getting out of the office, we believe in immersive research. If you want to authentically underwrite a business, you need to understand the ac-tual interactions that happen between that business and its customers. You have to know suppliers. You have to know com-petitors. You have to see how the company is set up to repeatedly satisfy its customers

and whether it’s doing so. That means you have to be out in the market.

This quarter we’ve been to the Philip-pines, Indonesia, Chile, Mexico and Bra-zil, in addition to traveling in the U.S. Part of our interest in emerging markets has to do with demographic tailwinds. It re-ally matters to the growth you can expect if you have a young working population and improving governance and financial systems that encourage capital formation and business enterprise.

Beyond that, Charlie Munger talks about a secret to success in life being weak competition. There are a lot of really smart people, including the entire private equity industry, trolling around every U.S. company. But if you do work in non-BRIC countries and you have value-investing skills, we think you can have a competitive advantage. It’s not easy, but there’s more mystery in developing markets, and where there’s mystery there’s potential profit.

Many global-minded investors have ar-gued that it’s better to capitalize on devel-oping-market growth through big Western companies with strong brands and unique expertise. Would you agree?

RC: It’s true that 10 or 15 years ago a Uni-lever, Procter & Gamble or Nestlé could plant a flag in a foreign country and take market share because people understood they had higher-quality products. I would argue that’s much less the case today, when we’re seeing more sophisticated local competitors make it much more difficult for Western brands to establish themselves in a market and take share. That’s inform-ing our views both on the challenges fac-ing some multinationals and on the local opportunities we uncover in our research outside the U.S.

On the subject of big multinationals, you appear to have concluded Anheuser-Busch InBev [BUD] is a long-term winner. Ex-plain why.

RC: This is a position we started building in March of this year. The company is the world’s largest brewer, with an estimat-ed 28% global market share and a wide range of brands, including Budweiser, Co-rona, Stella Artois, Brahma, Castle and Goose Island. It was formed by combining four major brewers – AmBev, Anheuser-Busch, Interbrew and SABMiller – and is controlled by a consortium of families led by the founders of 3G Capital.

The big story here for us is that we believe AB InBev has among the best de-mographic footprints in the world, and it is the best on-the-ground at execu-tion. Something on the order of 60% of revenues are now generated in emerging markets, and it’s not unusual in countries – particularly in South America and Africa – for AB InBev brands to have 80%-plus market shares. Even in a country like Chi-na, as difficult as it can be for foreigners, the company is the largest foreign brewer with a 19% market share.

We can talk about the craft-beer phe-nomenon in developed markets, but in developing markets craft brews have lim-ited opportunities. Small breweries simply cannot get distribution in the markets in which AB InBev has dominant share. In addition, high-end beers aren’t something consumers pay for in countries with low per-capita GDP. In Africa, for example,

ON EMERGING MARKETS:

We're seeing more sophisti-

cated local competitors make

it difficult for Western brands

to establish themselves.



40% of beer is still non-commercially produced. So AB InBev’s growth potential comes from attracting an emerging global middle class to its value-priced brands that come in a can or bottle. No other brewer comes close to benefitting as much from that shift over time.

Are the company’s market-share problems fixable in places like the U.S.?

RC: For decades consumers’ beer prefer-ences were very static, but now roughly one-third of U.S. beer drinkers say they want to try a different beer every time

they drink. Bud Light has been a primary casualty of that trend, and the inability of management to stem the decline in the brand led recently to the head of the U.S. business being replaced. Is it all fixable? I don’t know, but I do think the company has embraced the craft beer trend well, as-sembling a portfolio in the U.S. – including brands like Goose Island and Blue Point – that is growing faster than the craft cat-egory overall. That speaks to AB InBev’s distribution strength in the U.S., which I wouldn’t underestimate as an asset. I’d also mention that many craft brewers are not profitable, and we suspect that in ten

years many will have gone away and it will be a much more consolidated segment of the industry.

With the ADR trading at a recent $111.50, how are you looking at valuation?

RC: In general, we think the problems with the legacy brands are overshadowing the underlying strength in emerging mar-kets. Current earnings also don’t reflect the full $3.2 billion of annual cost syner-gies the company expects from the SAB-Miller deal over the next couple of years.

When we take into account revenue and cost synergies still available, normaliza-tion in depressed markets like Brazil and Argentina, and general emerging-markets volume and pricing growth, we believe earnings can grow at a mid- to high-sin-gle-digit annual rate. At the same time, at the current share price the yield on our estimate of normalized owner earnings – calculated as normalized operating cash flow less maintenance capex – is about 5%. The sum of the two approximates the low-double-digit annual return we expect on the stock over the long term.

There will also continue to be oppor-tunities for management to create value through acquisitions. To give just one ex-ample, the largest and third-largest brew-ers in Vietnam are state-owned and are slated to be privatized. AB InBev would be a natural buyer.

Do you think there’s any credibility to the rumors that AB InBev would try to merge with Coca-Cola?

RC: There would be many operational, financial, cultural and regulatory hurdles to overcome, but from a purely business perspective, the global distribution advan-tages of combining these businesses would be incredible. It would obviously depend on the price, but in theory the potential for value creation from such a deal would be pretty high.

Coming back to Coca-Cola bottlers, de-scribe your investment case for Coca-Cola Embonor [Santiago: EMBONOB].


Anheuser-Busch InBev (NYSE ADR: BUD)

Business: World’s largest beer producer, with 60% of sales generated in emerging markets. Brands include Budweiser, Bud Light, Michelob, Corona and Stella Artois.



Financials (TTM):



BUD S&P 500P/E (TTM) 41.6 21.8 Forward P/E (Est.) 21.8 20.0


Company % OwnedSoroban Capital 10.9%Franklin Resources 5.2%Fisher Asset Mgmt 4.8%ClearBridge Inv 4.2%Bank of America 4.1%




THE BOTTOM LINERichard Cook believes the challenges facing the company in developed markets inap-propriately overshadow its business strength in emerging markets. Adding his estimates of annual earnings growth and the stock's current earnings yield on normalized owner earnings, he expects to earn a low-double-digit annual return on the stock over time.


BUD PRICE HISTORY



RC: Based in Chile, this Coke bottler serves two primary markets, the country of Bolivia and most of Chile outside of the greater Santiago area. Chile is the wealthi-est and most business-friendly country in Latin America, which supports the stabil-ity of Embonor’s business there, but per-capita income is already relatively high at $14,000 per year so the volume growth potential isn’t that high. That’s not the case in Bolivia, which has per-capita in-come of about $3,000 per year and where the company’s business has been growing at double-digit rates. Bolivia is now the bigger market of the two for Embonor, which has a better than 80% market share in the country.

Are changing consumer tastes away from sweet, carbonated sodas an issue in coun-tries like these?

RC: The trend is far more pronounced in the U.S. This may sound strange, but consumers in low-income countries often think of Coke as a valuable part of their diet, a source of energy. That said, some Latin American governments are impos-ing sugar taxes, which has prompted the bottlers to test reformulated products. For example, Coca-Cola Embonor in Chile is testing formulations of Fanta and Sprite with 30-40% less sugar. If those work, margins would improve because sugar – the bottlers’ second-highest cost – is re-placed by cheaper artificial sweeteners. It would also improve sales volumes, as the cost to the consumer goes down without the sugar tax.

The company’s shares appear somewhat more volatile than the underlying busi-ness. How attractive are they at today’s 1,710 Chilean pesos?

RC: The shares rose 20% or so recently in response to what was perceived to be a positive outcome in the Chilean presiden-tial election, but we still think they offer an attractive return. Driven by long-term volume growth in Bolivia and the inherent pricing and operating leverage in the busi-ness, we think the company can increase

earnings annually at a high-single-digit rate for at least ten years. Add to that the current 4% yield on owner earnings and here too we’re expecting a low-double-digit annual return over the long term. That’s a more-than-fair return given what we believe is a narrow range of possible outcomes.

While we like the business as a stand-alone and wouldn’t anticipate a sale any time soon, Embonor is probably the most attractive acquisition candidate in the Lat-in American Coke system. Consolidation makes a lot of sense in a business like this, reinforcing scale advantages and acceler-

ating the proliferation of best practices. That’s potentially another way for share-holders to win.

Is the thesis similar for Peruvian Coca-Cola bottler Corporación Lindley [Lima: CORLINI1]?

RC: We started following Corporación Lindley four years ago and were interested both in the demographic backdrop in the Peruvian market and the opportunities we saw for a market-share leader to improve point-of-sale execution, capital allocation and corporate governance. What held us


Coca-Cola Embonor (Santiago: EMBONOR-B)

Business: Produces, distributes and markets carbonated soft drinks, bottled water, energy drinks and fruit juices in Chile and Bolivia under a license with The Coca-Cola Company.

Share Information (@12/29/17, Exchange Rate: $1 = 605 Chilean Pesos):

Price CLP 1,71052-Week Range CLP 1,300 – CLP 1,800Dividend Yield 1.4%Market Cap CLP 826.09 billion

Financials (TTM):

Revenue CLP 545.16 billionOperating Profit Margin 12.3%Net Profit Margin 6.5%


EMBONOR S&P 500P/E (TTM) 24.8 21.8 Forward P/E (Est.) 19.9 20.0


Company % OwnedCompass Group Chile 9.9%Moneda Administradora 8.9%BICE Inversiones 6.8%BTG Pactual Chile 5.1%Banchile Administradora 3.0%




THE BOTTOM LINEDriven by long-term volume growth in Bolivia and by the pricing and operating leverage enjoyed by Coca-Cola bottlers, Richard Cook believes the company can increase earn-ings at a high-single-digit rate for at least ten years. From the current share price he ex-pects that to translate into a low-double-digit annual investment return over that period.


EMBONOR-B PRICE HISTORY



back from investing was a lack of confi-dence that the controlling Lindley family could take advantage of the opportunities we saw.

That changed in late 2015 when Arca Continental announced that it was buy-ing the Lindley family’s controlling stake and planned to implement a series of op-erational improvements that promised to increase the sales and profitability of the business. To us it was a terrific match of a superior management team with great as-sets in a growth market. We were also able to buy in at less than half the valuation Arca paid because our shares, while hav-

ing the same economic interest and right to dividends as Arca’s shares, don’t have voting rights. Given our long relationship with Arca, that didn’t matter to us.

How’s it going so far?

RC: Arca is doing exactly what they said they’d do. They’re overhauling and in-vesting in point-of-sale execution to drive revenue gains. They have materially im-proved customer service and materially reduced delivery costs. They’ve also taken out costs by using Arca’s economies of scale to lower things like raw-materials

costs, insurance expenses and spending on information technology. Looking ahead, we think EBITDA can grow over the next three to five years by 50%, driven by an-nual volume growth of 4-5%, low-single-digit annual price increases, and per-unit cost improvement from better manage-ment and more-efficient production.

Is Lindley’s relatively leveraged balance sheet a concern?

RC: Net debt to EBITDA is nearly 4x, which is much higher than the 1x-or-less ratio Arca Continental would prefer. One reason for the elevated leverage is debt taken on from the recent construction of a state-of-the-art production facility located 50 kilometers south of Lima. With that major capital expense behind them, we would expect a steady pay down of debt through consistent cash-flow generation going forward.

The shares, recently trading at around 4.10 Peruvian soles, appear to be quite il-liquid. Is that a worry?

RC: We are the third-largest shareholder, behind Arca and Coca-Cola, and the next two largest owners are Chilean families with whom we have relationships. In general, we believe one of the other large owners would be a reliable source of li-quidity for us, but we think the shares sig-nificantly undervalue the earnings power of the assets in place and expect to hold on for a long time as the value is realized. As Warren Buffett has written, "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years." We feel that way about Lindley.

How are you assessing fair value?

RC: If we're right that owner earnings grow and debt is paid down as we expect, we believe the fair value is at least double the current share price.

Your portfolio doesn’t have a lot of posi-tions to sell, but have you sold anything recently and, if so, why?


Corporación Lindley (Lima: CORLINI1)

Business: Production, marketing and sale of Inca Kola, Peru’s top soft drink, and produc-tion and distribution of packaged beverages in Peru under a license with Coca-Cola.

Share Information (@12/29/17, Exchange Rate: $1 = 3.2 Peruvian Soles):

Price 4.08 Soles52-Week Range 2.85 Soles – 4.10 SolesDividend Yield 0.0%Market Cap 2.67 billion Soles

Financials (TTM):

Revenue 2.76 billion SolesOperating Profit Margin 10.8%Net Profit Margin 5.8%


COROLINI1 S&P 500P/E (TTM) 16.6 21.8 Forward P/E (Est.) 14.0 20.0

Largest Owners(@9/30/17 or latest filing):

Company % OwnedArca Continental 57.0%Coca-Cola Co. 34.0%Cook & Bynum 2.5% Short Interest (as of 12/15/17):



THE BOTTOM LINENow under the control of much-larger and better-run Latin American Coca-Cola bottler Arca Continental, the company is improving its point-of-sale execution, customer service and operating efficiency, says Richard Cook. He believes EBITDA can grow over the next three to five years by 50%, and that that can translate into a doubling of the share price.

Sources: Cook & Bynum, company reports, other publicly available information

CORLINI1 PRICE HISTORY




RC: We’ve been reducing our position in Microsoft, which is a function of valua-tion. Today you can hardly pick up the Journal without reading about how great its Enterprise business is, or how it’s mak-ing wonderful inroads in the cloud, or how smart Satya Nadella is. As Buffett says, “You pay a high price for a cheery consensus.”

We also in our private partnership very recently sold our entire position in Wal-Mart. I talked earlier about how in 2010 we thought the market’s expectations were overly negative, but while it’s taken a while, the strength in the share price has made that no longer the case. Especially given the ongoing challenges facing retail-ers, we just didn’t think we had enough margin of safety to hold it.

You’ve written in the context of selling about the importance for investors to bat-tle “consistency bias.” Describe what you mean by that.

RC: Even highly accomplished value in-vestors struggle with the tendency to ig-

nore or misinterpret information that con-tradicts what they have come to believe. That’s obviously dangerous for investors, so we try to be as explicit up front as we can about identifying the things that if they went wrong we would rethink why we own the stock.

I’ll give you an example. We like a lot of value investors five or six years ago bought Tesco, the British retailer that was losing market share and margin in its home market because it had ill prepared for new competition, primarily from dis-count grocery chains Aldi and Lidl from Germany. Our thesis was that if it could improve the in-store experience, that would stabilize the ship enough for us to make money on shares for which we only had to pay 8x earnings.

In this case the keys were, first, that they could improve the in-store experi-ence, and second, that it would make a difference. So we knew exactly what to look for that would confirm or disprove our thesis. After 18 months it was be-coming clear that the in-store experience wasn’t really getting better, so we got out.

We actually made a little money, but had we fallen in love with the original thesis and pooh-poohed the contrary evidence, it would have been a big mistake.

You’ve been adding to your analyst team. What are some of things you're looking for in people to hire?

RC: The primary thing is we want people with integrity both in how they conduct themselves and in how they understand information and data. We want analysts who are willing to say “I don’t know” whenever that is true. Intellectual dishon-esty is quite detrimental to successful in-vestment research.

Curiosity and a love of learning are also important to us. Investing has been called the last liberal art, which I really believe. In that spirit, we want people who are thinking about a broad range of things and how they all work together, and they need to be willing to work really hard to figure things out. Hopefully every now and then all that helps us predict the fu-ture a little bit better than average. VII

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As the bull market continues to run, many value investors find their portfolios filled with highly appreciated stocks that present a bit of a dilemma. The compa-nies and their shares are likely hitting or exceeding expectations, so it’s difficult to jump out now, especially when table-pounding alternatives may be scarce. On the other hand, value investors – always worrying about what can go wrong – can get edgy sitting on large gains and feel compelled to take at least some money off the table. What to do? Admittedly, it’s a high-class problem to have.

Adam Wyden of ADW Capital faces just such a happy dilemma with each of the four “focus” ideas he discussed in his interview earlier this year [VII, March 31, 2017]. The shares of laundry-equipment company EnviroStar are up nearly 110% since the issue appeared. Fiat Chrysler stock is up 63%, while its newly public spinoff, Ferrari, has increased 41%. Ca-nadian restaurateur Imvescor Restaurant Group just this month received a takeover offer that Wyden has publicly argued is too low, but the stock is still 33% higher than it was nine months ago.

Prompted for an update on his think-ing about Fiat Chrysler and Ferrari, Wyden first offered some deeper perspec-tive on his approach to selling: “As I’ve gained experience, I’d say I’m increasingly trying to get into assets that I don’t have to sell,” he says. “It’s much better to buy something that’s growing, run by people who allocate capital effectively and make decisions in real-time that are fully aligned with all shareholders. If you overpay by two multiple turns but the assets are grow-ing and there are people allocating capital effectively, it’s just a timing issue around when you get paid. As Charlie Munger says, it’s not about the timing, it’s about getting it right. What kills you is not miss-ing something by a year or two, it’s miss-ing something completely and suffering a permanent capital loss.”

Having obviously tapped into some-thing he’s been thinking a lot about, he continues: “If you’re an investor in my fund would you want me to tell you I’m selling something like Fiat Chrysler that I know extremely well, that has best-in-class insider ownership and that has a stock I think can still at least double from here, because I want to take money off the table so I can invest in something else?

You’re at such a structural disadvantage as an investor every time you sell some-thing you know very well to go and buy something that you don’t know as well. If you think you can continue to compound your pre-tax dollar with people who are well aligned with you and your interests, the bar is extraordinarily high to sell.”

With respect to Fiat Chrysler, whose stock now trades around $17.85, Wyden

A F R E S H L O O K : Fiat Chrysler/Ferrari

A High-Class ProblemValue investors are very often not as adept as they would like at letting their winners run. ADW Capital’s Adam Wyden explains why he’s not planning to let that happen with portfolio holdings Fiat Chrysler and Ferrari.

Fiat Chrysler (NYSE: FCAU)

Business: Global vehicle and component manufacturer; brands include Jeep, RAM, Chrysler, Fiat, Alfa Romeo and Maserati.



Valuation Metrics (@12/29/17):

FCAU S&P 500P/E (TTM) 7.5 21.8 Forward P/E (Est.) 5.6 20.0


THE BOTTOM LINEBecause the impact of its transformation and the value-unlocking levers it still has to pull have yet to be fully recognized by the market, Adam Wyden has maintained his position in the company's shares.


Ferrari (NYSE: RACE)

Business: Designs, develops, manufactures and sells luxury performance sports cars and engines under the Ferrari brand name.



Valuation Metrics (@12/29/17):

RACE S&P 500P/E (TTM) 32.8 21.8 Forward P/E (Est.) 29.1 20.0

THE BOTTOM LINEWere the market to better underwrite the company's still-robust profit growth poten-tial from here, on his 2018 earnings esti-mates Adam Wyden believes the shares would more reasonably trade around $180.

VII, March 31, 2017VII, March 31, 2017



A F R E S H L O O K : Fiat Chrysler/Ferrari

"In this treasure chest of quotes by proven money managers, it is the love of the game and

the joy of meeting the challenges put forth by a very demanding business that captivated

me. The lessons are like scars and they are revealed here firsthand.”

Jeff Ubben, ValueAct Capital

“A must-read for any serious investor. John and Whitney have produced a veritable bible

that reveals the secrets of some of the greatest contemporary investment minds in the

world.”

Jonathon Jacobson, Highfields Capital Management

“I often judge a book by how many times I get my highlighter out and dog-ear pages. On

that metric, this book is wonderful – simply packed with insight from some of the best

long-term investors. Everyone will learn something from this book.”

James Montier, GMO

contends that the impact of the company’s transformation has yet to be fully recog-nized by the market. Its five-year strategic plan announced in 2014 has revamped the product mix away from low-margin small cars toward more lucrative sales of Jeep SUVs, Chrysler minivans and RAM trucks. With much of the transformation-related manufacturing and product-devel-opment investments behind it, he says, the company in 2018 is poised to deliver on its plan, which calls for the generation of $5 to $6 in earnings per share and free cash flow that would translate into a 30%-plus free-cash-flow yield on today’s equity.

Beyond that, the company has addi-tional value levers to pull. Fiat manage-ment has made clear its intention to spin off its Magneti Marelli automotive-com-ponents business, which generates around €8.5 billion in annual sales, and is also likely to spin or merge its Maserati and Alfa Romeo units after their own strate-gic transformations are complete. Doing “caveman math,” Wyden believes those

actions alone could unlock value worth the current market value of the entire company, leaving the Jeep, RAM, Chrys-ler and Dodge businesses as pure upside. While he doesn’t see the logic in Fiat re-sponding to the expressed interest by China’s Great Wall Motor in buying only the Jeep brand – I can see why they would want Jeep," he says, "but not why [CEO] Sergio Marchionne would be interested in selling it to them" – he does see additional upside optionality from a potential play for the entire company by a larger global competitor like Volkswagen or GM.

With Ferrari, his thesis that the com-pany has erred too far on the side of limit-ing supply relative to burgeoning demand remains intact, and he expects it going forward to respond by raising production levels, increasing prices and broadening the product line to include SUVs and addi-tional “supercars” – all without the need for heavy incremental capital spending. Based on the prices and volumes at which other ultra-luxury brands like Bentley and

Lamborghini are selling their SUVs, for example, he thinks a Ferrari SUV could generate $1.2 billion in annual revenue and close to $1 billion in annual EBITDA relatively soon after launch. He also sees considerable potential in increasing sales of Ferrari-made engines to sister brands Maserati and Alfa Romeo.

Even before some of those longer-term upsides kick in, at the luxury-brand 20x multiple of EBITDA on an enterprise value basis Wyden believes the company deserves on the above-consensus $1.7 bil-lion in EBITDA he thinks it can earn in 2018, the shares would trade at around $180. That’s still a cool 70% premium to today’s stock price. Bolstering his long-term case for the company is his belief that while Sergio Marchionne plans to step aside from Fiat Chrysler at the end of next year, he would expect Marchionne to remain very actively involved with Ferrari. “I think it’s his swan song,” says Wyden, “and that’s likely to be a truly wonderful thing for shareholders.” VII


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S T R AT E GY: Robert Vinall

What I Am Doing DifferentlyEuropean investment manager Robert Vinall in this recent memo describes how even as a tried-and-true value inves-tor he has had to consistently challenge once-fundamental aspects of his strategy to avoid being left behind.

Editor's Note: Switzerland-based invest-ment manager Robert Vinall has trounced the market since launching his Business Owner TGV hedge fund in 2008, but like all successful investors he aggressively fights the temptation to rest on his laurels. The most recent evidence of that comes from a memo he prepared for a mid-No-vember meeting of the Munich Value In-vestors Group, in which he thoughtfully describes “Five Things I Am Doing Differ-ently Today vs. Five Years Ago,” and why. The full memo below is shared with his permission.

At Amazon, employees must present their ideas in prose (PowerPoint is

banned!). Jeff Bezos thinks prose enforces greater intellectual discipline than string-ing together bullet points in a presenta-tion. Far be it from me to contradict the great man, so I wrote this memo and cir-culated it prior to the meeting. After the meeting, I refined the memo to reflect some of the great points that came up in the discussion.

Be more open-minded about what constitutes a value investment

All businesses are worth the cash that they generate between now and eternity, discounted at an appropriate rate. An ex-pensive business is one that trades at a pre-mium to the present value of its cash flow, and a cheap business is one that trades at a discount. This is an a priori propo-sition that presumably all value investors can agree upon. For a long time though, I thought that only a company whose stock traded on a low multiple of next year's earnings was consistent with a value in-vesting approach.

This is absurd. The path that differ-ent companies' cash generation takes can vary enormously. Some businesses may have outlived their useful purpose and be in liquidation. Others may have reached

maturity and the current level of cash flow might be expected to continue indefinitely. Still others may have negative cash flow today as they invest to build growing cash flows in the future.

At an appropriate price, each of these companies can be considered value invest-ments. Whilst an undervaluation of the former two will likely go hand-in-hand

with a low multiple, the multiple of the latter will probably be high and even nega-tive. This has no bearing on whether it is cheap or not – only the size and the du-ration of future cash flows relative to the price can tell you that.

In recent years, I have come to appreci-ate that the latter type of company pro-vides a far more fertile ground for finding undervalued investments. This was a dif-ficult transition for me to make, as clearly some value investors believe that member-ship of the guild is contingent upon only ever paying low multiples. Having made the transition, I think it is obvious why it makes sense.

First, companies in investment mode have historically been ignored by value investors, by far the most thoughtful co-hort of capital market participants. As discussed, this is most likely due to the above-average multiples such companies command.

Second, investing in this type of com-pany requires a longer time horizon as it only becomes apparent after a few years whether investment in new products, ex-panded salesforces, etc. bears fruit. This

makes them unattractive to capital market participants with shorter time horizons and "catalyst-driven" investment strate-gies (the majority).

Third, it requires thoughtful analysis and thorough due diligence to figure out which companies are positioning them-selves correctly for an uncertain future, versus simply looking up on Bloomberg what the current multiple of next year's earnings is.

My aim as a value investor is to put capital to work in whichever type of com-pany offers the most value, i.e. the highest present value of future cash flow. Admit-tedly, I derive more satisfaction from own-ing stakes in businesses that invest in fu-ture growth. Also, it is difficult to envisage a scenario where mature businesses are the most mispriced given the prevalence of short-term thinking and the ubiquity of market data. But if this is where the value is, I stand ready to pivot.

Invest in "Technology"

I started investing in technology stocks in 2012 when I took the plunge and bought a stake in Google (now Alphabet). This too was a difficult transition to make. My investing hero, Warren Buffett, is famous for only "investing in what he under-stands." Historically, this meant avoid-ing the "tech" sector. The wisdom of this approach was spectacularly vindicated in the dot-com crash in the early 2000s. I sometimes allow myself a wry smile when people ask why they should pay me to in-vest in Alphabet when they can just do it themselves. Trust me, it was not an easy decision at the time.

From today's perspective, the invest-ment decision was correct, not because Alphabet's share price subsequently went up, but because it is now clear that Alpha-bet and many other tech companies were moving into the thoughtful generalist's circle of competence.

ON "VALUE":

I thought only a stock trading

on a low multiple of earnings

was consistent with a value

approach. This is absurd.



Historically, value investors eschewed the tech sector because it was too fast-moving. Today's hot, new technology was likely to be replaced by something better a few years down the line. It was the invest-ing equivalent of a teeny fashion brand. For the long-term investor basing an in-vestment decision on cash generation 20 or more years into the future, the sector was un-investable.

Clearly, companies like Alphabet or Amazon or Apple are far too entrenched in our modern, Internet-driven economy to be considered un-investable for the above reason. In fact, I would argue that it is the traditional media companies and re-tailers that seem to be moving outside the generalist's circle of competence. Anyone who claims to have a better understanding of the future of a traditional department store than of Amazon is, in my view, being disingenuous.

I frequently hear some members of the value investing community complain that "value investing no longer seems to work." In my view, paying less than some-thing is worth – the essence of value in-vesting – will always work until the laws of mathematics are repealed. I guess what these investors may mean is that pay-ing low multiples for mature, apparently "easy-to-understand" businesses no lon-ger seems to work.

Is it any wonder? The change brought about by the Internet, mobile and, soon, AI (just to name three major technologi-cal shifts) is fundamentally changing the economic basis of nearly every established business (just ask the owner of a taxi me-dallion). A refusal to engage intellectually with these changes not only means that you miss out on the investment opportuni-ties they throw up, but it blinds you to the fundamental changes taking place at every "easy-to-understand" business.

To his enormous credit, Buffett ac-knowledged at this year's shareholder meeting that Google was well within his circle of competence. He too has made his first investments in the tech sector, most notably in Apple. Interestingly, he views Apple more as the modern-day incarna-tion of a branded consumer goods com-

pany than a tech company, and as such not so different from some of his famous investments of yore.

The conclusion is clear: Our interpreta-tion of what is within and what is beyond our circle of competence must continue to evolve over time. Nobody demonstrates this better than Buffett. I wonder which

previously taboo sectors will soon fall un-der the purview of the value investor. Bio-tech, perhaps?

Pay more attention to the direction, not the width of the moat

For a long time, I thought the wider the moat the better. All things being equal, what is there not to like about a wide moat? I have changed my mind on this in at least three respects.

First, it strikes me that the direction of a moat is, broadly speaking, more impor-tant than the width of a moat. If you are planning on investing in a business for a long time, then it is far more important to know whether the competition is clos-ing in on you as opposed to the absolute width of the moat. Companies with wide moats are insulated to a considerable ex-tent from competition and this tends to make them less responsive to potential competitive threats. A wide moat com-pany is like a soccer team that only gets to play friendlies.

Second, the problem with wide moat businesses is that market shares are not up for grabs. The whole point of a wide moat is that market entry is exceedingly difficult. This, of course, has certain ad-vantages, but the big disadvantage is that a great management has only limited op-portunity to demonstrate its worth. When

you have a company that can crush the competition, it is desirable to have a com-petition to, well, crush.

Third, it strikes me that the best time to invest in businesses is before the moat is fully formed, provided of course there is sufficient evidence available that the moat will one day be formed. This is the period when the market's reassessment of the company's cash-flow-generating abil-ity will be most dramatic.

This decision to focus more on the di-rection than the absolute width of a moat was closely connected to my growing interest in the tech sector. Clearly, many mature businesses that have historically been considered wide moat – fast-moving, branded consumer goods companies, for example – are seeing their moats steadily eroded. Parallel to this, many tech compa-nies' moats are growing – especially those that benefit from a network effect. No prizes for guessing which ones have been and will continue to be the better invest-ments for the long-term investor!

Make management the criterion, not a criterion

Partnering with the right management has always been central to how I manage Busi-ness Owner. One of just four questions I ask of every investment is "Does the man-agement possess honesty and integrity?", a question which was recently reformulat-ed to "Does the management set the right example?" Despite this, even I underesti-mated the importance of management.

Whilst I have always been enthusiastic about finding a great management, the main thrust of my research was uncovering and subsequently avoiding the dishonest managers. Having convinced myself I had done this, other factors took centre stage in the investment process, in particular the strength of the competitive advantage and the near-term valuation. Today, I will hap-pily trade a higher multiple of short-term earnings or a narrower moat for managers that I feel a genuine enthusiasm for.

I do this not because I am looking to sacrifice returns for a better social life, but because I expect this approach to result

ON TECHNOLOGY:

Change brought by techno-

logical shifts is fundamentally

changing the economic basis

of nearly every business.





in greater long-term cash generation and hence performance. It is difficult to quan-tify how much, but that does not make the value creation any less real.

For example, in the last financial crisis, Wolfgang Grenke and his then CFO, Uwe Hack, bought a bank at a fire-sale price. It was a great deal as Grenke gained a deposit-taking capability and could sub-sequently lower its cost of capital and diversify into new product lines. It was impossible to predict this exact transac-tion before the financial crisis, but it was easy to anticipate this type of transaction should there be a financial crisis.

How on earth do you put a value on the unquantifiable? You cannot, but it would not be conservative to ignore it. It would be plain stupid.

For more detail on how I try to iden-tify managers who set the right example, I recommend the talk I gave at Bob Miles' Value Investing Conference in Omaha ear-lier this year. (Here is the link.)

Engage with Management

Before I started RV Capital, I worked with an activist investor. From this period, I gained an appreciation for the activ-ist strategy. If a management is wasteful

and dishonest, it is rational for the capital market to take a pessimistic view of the size and timing of the business' future cash flows. If the activist replaces the manage-ment with a better one, it is rational for the capital market to raise its estimate of future cash flows, leaving the activist with a handsome and deserved return.

My only problem with activism was that my personality was not particularly well suited to it. The activist is permanent-ly in confrontation with managers who are either dishonest, incompetent, or, in a best-case scenario, both. As should be abundantly clear, I much prefer partnering with managers I admire and (hopefully) getting rich alongside them as the value of their farsighted investments crystallises over time.

For this reason, I have generally es-chewed activism since I started Business Owner. However, I strongly believe that engaging with management should not be left solely to the activists. For this reason, I have increasingly tried not just to be a pas-sive recipient of information when I meet with managers, but to create a genuine two-way flow of information.

I strongly believe that positive feed-back from owners when managers are doing the right thing is just as important

as negative feedback from activists when they drift off-piste. If a manager decides to sacrifice near-term earnings to capture a larger opportunity further down the road, it is vital that the long-term owners are more vociferous in their approval than holders with shorter time horizons are in their opprobrium.

The only investor I am aware of who publicly and frequently praises his manag-ers is Warren Buffett. Here, as in so many other instances, I see him as a role model. As the capital base of Business Owner grows and with it the stakes in our compa-nies, this is an area where I hope to posi-tively impact our investments.

In a nutshell:

1. Keep an open mind on what constitutes value

2. Be alive to the business opportunities cre-ated by technological progress

3. Prefer widening moats to wide moats

4. Make finding the right managers the most important criterion

5. Use the growing capital base to promote the right behaviours in managers

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