VII Giverny Capital August 2010

ValueInvestor August 27, 2010

Keeping It SimpleEven the best companies – or their industries – go out of favor from time to time.That's when Francois Rochon's “capitalist antennae” are their most receptive.

Inside this IssueF E ATU R E S

Investor Insight: Mason Hawkins

Playing off “widespread angst” tofind global opportunities in such firmsas Carrefour, Dell, Hochtief, Gentingand Shanda Interactive. PAGE 1 »

Investor Insight: Francois Rochon

On alert when quality firms trade atcheap prices, the case he finds todayin Medtronic, Disney, MTY Foodand Lumber Liquidators. PAGE 1 »

Uncovering Value: Accelrys

Intrinsic value can be hidden for manyreasons, a few of which appear at playin this software provider. PAGE 17 »

Of Sound Mind

We're hard-wired to filter out “noise”in making decisions, a trait that canget investors into trouble. PAGE 18 »

Editors' Letter

Forgive the hyperbole, but this is thestrangest market ever. PAGE 19 »

I NVESTM E NT H IG H LIG HTS

Other companies in this issue:

Aaron's, Bank of the Ozarks, Campbell

Soup, Chesapeake Energy, Daiwa

Securities, Dell, DirecTV, Hennes & Mauritz,

Johnson & Johnson, Leighton Group,

Olympus, Omnicom, Rent-A-Center,

Ruddick, Shanda Games, Visa, Wells Fargo,

Worthington Industries, Yum Brands

The Leading Authority on Value Investing INSIGHT

INVESTMENT SNAPSHOTS PAGE

Accelrys 17

Carrefour 5

Disney 12

Genting Berhad 7

Hochtief 6

Lumber Liquidators 14

Medtronic 13

MTY Food Group 15

Shanda Interactive 8

Though interested in the stock marketfrom an early age, Francois Rochondidn't put investing high on his early

list of career choices. “I saw the market as abig casino populated by shady characters –not the place for a serious career,” he says.

After three years as an engineer, his pas-sion for stocks proved too strong to resist.He joined a large Montreal investment firmin 1996 and two years later started his ownfirm, Giverny Capital. Since the beginning of1999, investing mostly in U.S. stocks, he'searned a net annualized 7.6% for hisinvestors, vs. a 0.8% gain for the S&P 500.

Finding plenty of what he considershigh-end companies trading at pedestrianprices, Rochon sees opportunity today inareas such as restaurants, flooring, enter-tainment and medical devices. See page 2

www.valueinvestorinsight.com

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

Francois RochonGiverny Capital

Investment Focus: Seeks companieswith what he considers premium prospectsfor earnings growth at times when they’retrading at discount-to-the-market prices.

Giverny US ($US) 1993-2010$100 000 invested on July 1st 1993

984,096 $

342,349 $

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1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Giverny US

S&P 500

This reprint provided courtesy of:

For more information about Giverny Capital, please visit:www.givernycapital.com *See disclaimer on last page

http://www.valueinvestorinsight.com

I N V E S TO R I N S I G H T : Francois Rochon

Value Investor Insight 2August 27, 2010 www.valueinvestorinsight.com

Investor Insight: Francois Rochon Francois Rochon of Montreal's Giverny Capital explains why he believes buy-and-hold investing is far from dead, whyhe puts so much emphasis on finding outstanding managers, why it's rare that he's not fully invested, and why he seessignificant upside potential in Medtronic, Walt Disney, Lumber Liquidators, Omnicom and MTY Food Group.

You’ve said complication scares youwhen it comes to investing. How doesthat manifest itself in your strategy?

Francois Rochon: I look for great compa-nies in businesses I understand and whichI believe have competitive advantages.Warren Buffett had a wonderful quote,that if a company has a bad past and agreat future, he’ll miss it as an investmentopportunity. We want companies thathave had great pasts and then focus ouranalytical attention on whether and whythe future should be great as well.

The complications that scare me arethings like overburdened balance sheets,regulation and less-than-transparentaccounting. The fewer liability items onthe balance sheet the better, and I’ll typi-cally filter out companies that can’t atleast pay off their debt, including anynegative working capital, with fouryears’ of current net income.

One classic mistake I made in notkeeping things simple was owning forsome time the shares of HealthManagement Associates, a hospital chain.Fighting through all the regulatory issues,dealing with public and private insurers,the complicated accounting for uninsuredpatients, all that made the businessextremely difficult. Those are not thetypes of businesses we favor.

How would you define your investableuniverse?

FR: I say we’ll look at anything, but inreality we have several filters that narrowthe universe pretty quickly. One is thatthe company has to be profitable, whichremoves roughly 50% of the stocks trad-ed worldwide. Our filters on debt levelsscreen out a great number of companiesand I also take out just about everythingcommodity-related – like oil and gas,gold, steel, copper or timber – where it’s

almost impossible for companies to havea competitive advantage. There are somerare steel companies I admire like Nucorand Posco, but only when I don't thinkinvestment success rests primarily on theprice of the commodity, which I don'tbelieve I have any edge in predicting.

Most of our initial research is on find-ing the true standouts in any given busi-ness. That’s largely a numbers-drivenexercise, focusing on returns on equity,margins, and growth in key sales andprofitability metrics – all in comparisonwith the competition. We’ve identifiedmore than 400 companies – primarily inthe U.S., but not exclusively – that wecould imagine owning and that we try tokeep fairly close track of.

Does cap size matter?

FR: The quality of a business is not neces-sarily linked to size, so market cap isn’t acriterion for us. We have owned very bignames such as Microsoft or Procter &Gamble, but we’re also happy to invest insmall gems as well. One good examplewe’ve owned for a few years is Bank ofthe Ozarks [OZRK], a small regionalbank based in Little Rock, Arkansas. Thefounder, George Gleason, started thecompany with something like $10,000when he was 24 and has built it verymethodically and conservatively over thepast 30 years. It earns a high return onassets, controls costs very well and has agreat loan-quality track record. When wemet with Mr. Gleason, it seemed like heknew almost every loan the bank hadmade. Warren Buffett says there are farmore banks than there are good bankers,and we think Gleason is one of the best.We doubled our position when the stockwent down in 2008 and still don’t believethe share price reflects the fact that earn-ings can grow maybe 15% annually formany years.

Francois Rochon

Institutional Bias

As with many self-taught investors,

Francois Rochon's informal education

started with the books of investing leg-

ends: Benjamin Graham's Intelligent

Investor, Philip Fisher's Common Stocks

and Uncommon Profits, and Peter Lynch's

One Up on Wall Street. He wrote to ask

Warren Buffett for copies of his annual

shareholder letters, a full package of

which arrived in the mail a short time later.

“I came to understand the market wasn’t

the big casino I thought it was,” says

Rochon, “but instead a place where you

could use intelligence, judgment and

rationality to build wealth.”

After moonlighting as an investor while

working as an electrical engineer, Rochon

took the plunge in 1996, joining a well-

known Canadian money management firm

in his native Montreal. While he learned a

lot, he concluded he wasn’t cut out for a

large institution. “They said the right things

about being fundamental long-term

investors, but then at the end of every

month that you didn't beat the market you

had to explain in great detail why you were

underweight this or overweight that. The

focus was too much on short-term per-

formance, which to me just isn’t the best

way to invest.”


You’re based in Montreal, so why is yourportfolio so American?

FR: The primary reason is that theAmerican pond is ten times bigger thanthe Canadian one. Add to that the factthat probably 50% of the companiestraded in Canada are resource-based andtherefore we typically avoid them, theratio of potential ideas in the U.S. is evenhigher.

We consider the U.S. very close tohome, physically (we're closer to NewYork than Cleveland is!) and culturally.It’s easy for me to understand companieslike Buffalo Wild Wings or OutbackSteakhouse or Wal-Mart, where I’ve eatenor shopped. It’s harder for me to get thesame feel for a company based in Brazilor Poland.

What situations tend to catch your eye forfurther study?

FR: We don’t have a regimented idea-gen-eration process. I find screens tend tofocus you too quickly on valuation, whenI’m most interested first on the quality ofthe business.

I like to say my capitalist antennaeare always on, so most often our ideasjust come from tracking what’s going onat the 400 or so companies we follow ona regular basis. We’ve had our eye onboth MasterCard and Visa since theywent public, because they enjoy many ofthe classic elements of a high-qualitybusiness. But for a long time neithertraded at a price we were comfortablepaying, until a few months ago whenconcerns over changing regulation fordebit and credit card fees hit the stocks,with Visa falling 25-30% over the courseof a few weeks. In our judgment, themarket was overreacting to the actualimpact Visa is likely to see from feerestrictions, making the stock – at ourpurchase price of around $70 – highlyundervalued. [Note: Visa shares current-ly trade at just under $70.]

Of course just because the stock of aninteresting company cracks doesn’t meanwe always buy. In the case of Starbucks,for example, we weren’t convinced evenafter the valuation fell sharply in 2007

and 2008 that the company’s growthprospects in what we considered a satu-rated market were sufficient to justifyowning the stock. Similarly for WholeFoods, when the stock went downsharply in 2008 we didn’t buy because inour view they had taken on too muchdebt in buying Wild Oats Markets. Inretrospect, we certainly would have donewell to buy in either case, but we felt wehad safer options that have also turnedout quite well.

What’s a love-to-own-at-a-better-pricestock for you today?

FR: We own a few shares of Hennes &Mauritz [HMB:SS], the value-priced fash-ion retailer based in Sweden but withoperations all around the world. We con-sider it an excellent company with brightprospects, but the stock price is a bit toohigh for us to build a more substantialposition.

Going back to the types of situationsthat catch our eye, another commontheme for us is to buy into market lead-ers when their sector or the overall mar-ket is out of favor. We believe Omnicom[OMC], for example, is the best andmost geographically diverse advertisingcompany in the world, but in 2008 itsshares got below 10x earnings – from 20-25x typically – because it was fairly obvi-ous its near-term prospects were poor.While there’s a lot of turmoil in theadvertising business, we think Omnicomprovides an essential service and that thebusiness will continue to generate highincremental returns on capital. Becausewe take a longer-term perspective thanthe market usually does, we’re thrilled toinvest in the best companies in good-quality businesses that we believe willeventually recover.

Describe your valuation methodology.

FR: It’s quite simple. We estimate whatwe think a company can earn in five yearsand then apply the P/E we believe themarket should give it. If the resultingprice is at least double the current shareprice – giving us a 15% annual return –we’re willing to buy.

Our strong preference is for the upsideto come primarily from earnings growthrather than a P/E increase. We want tobelieve our companies can increase earn-ings on average by twice the long-term6% average annual growth of S&P 500companies. That’s how we’re going tooutperform: since 1996, earnings at ourportfolio companies grew an average of12% per year, twice the rate of those inthe S&P 500. Over that time our stocksdid the same 6% per year better than themarket.

Using one of my favorite stocks todayas an example, we think Wells Fargo[WFC] on a normalized basis five yearsout should earn roughly 1.5% on assets,which translates into more than $5 pershare in net income. With that kind ofperformance, the market should apply atleast a 12x multiple to the stock, whichwould result in a share price of $60. Attoday’s price [of $23.50], we believe Wellsis a better investment today than it hasbeen in the past 20 years.

How many positions do you typicallymaintain?

FR: Generally around 25, so a full posi-tion is 3-4%. We will own more of whatwe think has the most upside, althoughit’s very rare for us to let a position goabove 10% of the portfolio.

Since I consider buying a stock a long-term commitment – our average holdingperiod is more than five years – I’ll typi-cally start with a 1-2% position and thensee how it goes. No matter how hard Itry, there’s just nothing to focus one’sattention like having money on the line.If I get more comfortable with the man-agement and the business and feel Iunderstand it better and better, we’llincrease the position as long as the valu-ation is still compelling.



ON OUTPERFORMANCE:

We expect our companies to

grow at twice the long-term

average of the S&P 500.

That’s how we’ll outperform.


Are you usually fully invested?

FR: Yes. At our asset size and especiallyas time horizons in the market have con-tracted, I haven’t yet found it difficult tofind ideas that meet our criteria.

Given your turnover, we take it youhaven’t concluded, as many have, thatbuying and holding is passé?

FR: Maybe it makes me old-fashioned,but investing to me is about owning greatcompanies for many, many years.Managing through cycles has always beena part of running businesses and of invest-ing, but I’m not convinced it’s possibleover time to accurately judge when thenext recession will be, when interest rateswill go up or down, or when the marketis about to reverse course. At least I don’tbelieve I can do it.

People look at what happened fromthe peak of the Internet bubble to the bot-tom of the financial crisis and seem toforget that stocks pay off in the long runbecause companies earn higher profits –of 6-7% per year – while paying divi-dends on top of that. So equity investorswould do fairly well just owning the mar-ket, but I think I can improve on that bybuying companies that grow their intrin-sic value faster than the market and hold-ing on to them. I can’t imagine trading astrategy that I feel puts the odds in myfavor for one I don’t believe I’ll ever beable to execute.

Turning to more specific ideas, describeyour investment case today for WaltDisney [DIS].

FR: I consider Disney a crown jewel ofAmerican capitalism, with unparalleledassets. I like to say that Mickey Mousehas three great qualities: he’s highly pop-ular worldwide, he’s immortal, and hehas no agent. That’s an excellentmetaphor for what the company does –create franchises that it owns and con-trols and can benefit from across a widevariety of businesses and geographies.

They released this year a new movieversion of Alice in Wonderland, which

was first created in 1951. With that firstversion, they basically just made moneyselling movie tickets. Since then they’vere-sold the same content to recurring gen-erations, through different media andaround the world. It’s like owning an oilfield that never runs out and costs verylittle to maintain. That’s a good business.

The newer parts of the business areequally impressive. ESPN is virtually amonopoly national sports channel, withextremely high market power and bene-fiting from strong secular consumerdemand. In theme parks, when DisneyWorld opened in Florida in 1971, theprice of a daily ticket was $3.50. They’ve

since increased price every year but one,to today’s $82, which comes out to animpressive 8% growth per year, muchhigher than inflation.

One key part of our thesis is confi-dence in Bob Iger, who we believe is mak-ing all the right moves since taking overas CEO in 2005. He’s gotten out of lessattractive businesses such as radio and theMiramax movie studio, while investing inbusinesses like Pixar and Marvel, whichplay perfectly to Disney’s strengths. He’sreoriented the business focus to makinggreat animated movies, which has a posi-tive impact over long periods on so muchof what they do.



Walt Disney(NYSE: DIS)

Business: Diversified entertainment and

media company with five operating units:

TV networks, movie studios, parks and

resorts, consumer products and interactive.

Share Information

(@8/26/10):

Price 31.9452-Week Range 25.25 – 37.98

Dividend Yield 1.1%

Market Cap $61.09 billion

Financials (TTM):

Revenue $38.19 billion

Operating Profit Margin 17.8%

Net Profit Margin 10.5%

THE BOTTOM LINE

Francois Rochon considers the company a classic example of an exceedingly high-

quality business trading at a surprisingly pedestrian price, of less than 15x estimated

2010 earnings. He believes the company can double its earnings per share in the

next five years and earn by then an 18x multiple, translating into an $80 share price.

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

DIS PRICE HISTORY

Sources: Company reports, other publicly available information

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35

30

25

20

152008 2009 2010

Valuation Metrics

(@8/26/10):

DIS S&P 500

Trailing P/E 15.4 16.5

Forward P/E Est. 13.4 12.9

Largest Institutional Owners

(@6/30/10):

Company % Owned

Fidelity Mgmt & Research 4.8%

State Street 3.6%

Vanguard Group 3.5%

BlackRock 2.6%

Southeastern Asset Mgmt 2.5%

Short Interest (as of 8/13/10):

Shares Short/Float 2.6%

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15




Weighing at least somewhat on all mediacompanies is concern over the economicsof changing distribution in an Internetage. How do you assess that here?

FR: I don’t profess any unique insightinto how that plays out, but I fall backon the premise that if you own whatpeople want to see, it’s not going to mat-ter so much how they access it. Whatyou want is to create enough excitementaround your content that people will payfor it, regardless of the distributionmethod. Disney has proven over a longperiod of time its ability to create thatexcitement.

There is certainly risk that cable com-panies over time try to pull back on whatthey’re willing to pay for ESPN, or thatInternet distribution of movies doesn’tprove as profitable as DVDs were. But inthe five years I’ve owned Disney stock –as the distribution of media continues toevolve – the company’s earnings haveincreased 68%. That’s 10% per year overa pretty tough period, which makes meoptimistic about their ability to navigate achanging environment.

How can such an admired company havean undervalued stock, currently tradingjust under $32?

FR: At less than 15x the $2.20 or so weexpect the company to earn this year, thestock doesn’t at all reflect the earningsgrowth we expect over the next five years.We think earnings per share can doubleover that period, through a combinationof revenue growth, much of it interna-tional, and margin improvement from amore attractive business mix and operat-ing leverage in all its key businesses. Wesee net margins going from 10.5% todayto closer to 12.5% in five years.

The stock has historically traded at 20-25x earnings, but even at 18x our 2015earnings estimate, we arrive at a targetprice of close to $80. It may not alwaysbe a smooth ride, but that would be aquite satisfactory destination.

Is Medtronic [MDT] a great-company-in-an-out-of-favor industry type of idea?

FR: The company is a leader in almostevery product category in which it com-petes and has done an excellent job ofbroadening its product mix beyond pace-makers, defibrillators and heart valves toinclude devices such as insulin pumps,glucose meters and spinal implants. Theproducts mostly address non-discre-tionary problems and either save lives ordramatically improve lives. You can post-pone the purchase of a car, but you don’tpostpone getting a defibrillator put in.The same goes for insulin pumps if you’rediabetic, or for spinal implants if you’resuffering from acute back pain. Givenhow essential the products are to cus-

tomers’ health, the business isn’t toocyclical and earns very high net marginsof 20%.

We like that the device business tendsto be much more stable than other health-care areas like pharmaceuticals. They’veobviously grown and diversified sincethen, but if I compare Medtronic’s busi-ness from when I first started researchingit in the mid-1990s with today, they’rebasically still in the same businesses withthe same market positions. You constant-ly have to improve your products’ capa-bilities, but for the most part, doctors arereluctant to switch from devices theyknow and trust.

Medtronic(NYSE: MDT)

Business: Worldwide developer and mar-

keter of a broad range of medical devices,

including pacemakers, defibrillators, insulin

pumps, heart valves and stents.

Share Information

(@8/26/10):

Price 32.2852-Week Range 30.80 – 46.66

Dividend Yield 2.9%

Market Cap $34.96 billion

Financials (TTM):

Revenue $15.82 billion



THE BOTTOM LINE

The market’s assessment of the company’s prospects is at odds with Francois

Rochon’s expectation that secular demand for its products and share buybacks can

help lift earnings per share at a 10% annual clip. At what he believes would be a

reasonable 15x his $5 EPS estimate five years’ out, the shares would trade at $75.


MDT PRICE HISTORY


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202008 2009 2010

Valuation Metrics

(@8/26/10):

MDT S&P 500




(@6/30/10):

Company % Owned

Capital World Inv 5.5%

Wellington Mgmt 4.7%

Vanguard Group 4.0%

Primecap Mgmt 3.9%

Capital Research Global Inv 3.7%



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The market’s perception of Medtronichas changed dramatically. Ten years agothe stock got as high as $60 and tradedfor 55-60x earnings. Revenues and earn-ings have tripled since then, but the stockis down 40% and the P/E is now 10x.

What’s going on?

FR: Part of it is that the stock was over-valued ten years ago. Part of it is that thegrowth prospects of a company threetimes bigger usually don’t warrant thesame P/E. But what seems to most trou-ble the market is concern about whathealthcare reform will do to Medtronic’sbusiness. In particular, medical-devicecompanies were singled out for specifictaxes to help fund the reform package.The market seems to be saying not onlythat that’s bad, but that there may bemore yet-to-be-defined pain as well.

We’re not nearly so pessimistic andbelieve the revenue benefits of tens of mil-lions of new people having insurance cov-erage for Medtronic products will moreor less compensate for any incrementaltaxes. If we’re right, the question then iswhether Medtronic is well-positioned togrow in the future, and we think they are.They spend heavily on product develop-ment, which has allowed them to at leastmaintain leading shares in what should becontinually growing markets – the inci-dence of the problems their products treatwill only go up as the population ages.From top-line growth of 5-7%, somemargin improvement and some sharebuybacks, we expect annual EPS growthof at least 10%.

What upside do you see in the shares,now near a 52-week low of $32.30?

FR: The company should earn $3.40 pershare this year. If we’re conservative andassume that grows only 8% – less thanwe actually expect – that would result inan EPS five years from now of $5. At evena 15x multiple – again, less than what wewould consider justified – that wouldresult in a share price of $75.

There’s always some risk a superiorcompetitive product hurts one of their

key businesses, but that hasn’t really hap-pened since the company sold its firstpacemaker in the 1950s. We just thinkthere’s a very large margin of safety here.This isn’t some run-of-the-mill business,it’s the best medical-device company inthe world – trading at 10x earnings.

Switching gears, describe your interest indiscount flooring retailer LumberLiquidators [LL].

FR: I knew very little about LumberLiquidators when I saw it listed maybesix months ago in a ranking of the bestsmall companies. They basically buy

wood at wholesale and transform it intohardwood and laminate flooring thatthey sell in company-owned retail stores,mostly serving urban areas from subur-ban locations. They claim to sell at a 20-30% price discount to the industry, pass-ing on efficiencies by selling greater vol-umes from larger-footprint stores in less-expensive areas. The average ticket isabout $1,500.

Over the past five years the companyhas grown from 76 stores to more than200. Revenues increased from $245 mil-lion in 2005 to $545 million last year,from both same-store-sales growth aswell as all the new stores. The profitabil-

Value Investor Insight 6August 27, 2010



Lumber Liquidators(NYSE: LL)

Business: Discount retailer of hardwood

and laminate flooring sold through more

than 200 company-owned stores located

almost exclusively in the United States.

Share Information

(@8/26/10):

Price 19.9952-Week Range 19.33 – 33.41

Dividend Yield 0.0%

Market Cap $548.1 million

Financials (TTM):

Revenue $597.5 million



THE BOTTOM LINE

The company’s low-cost model has allowed it to grow smartly through the residential

real estate downturn and positions it well for future growth in a fragmented market, says

Francois Rochon. If a doubling of the store base results in the $2.70 EPS he expects in

five years, he believes the shares will trade then at closer to $50 per share.


LL PRICE HISTORY


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15

10

52008 2009 2010

Valuation Metrics

(@8/26/10):

LL S&P 500




(@6/30/10):

Company % Owned

Fidelity Mgmt & Research 15.0%

T. Rowe Price 4.3%

Friess Assoc 3.9%

Aster Inv Mgmt 3.6%

Century Capital 3.4%



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ity record is equally impressive: netincome last year was $27 million on aver-age shareholders equity of about $130million. Given that the equity included$35 million in cash, the return on opera-tional equity was 28%. All of this, by theway, has happened during a time in whichthe real estate market has been mostlyawful. I’ve heard it said that if you sell forless, consumers will find you even ifyou’re in the middle of the ocean. LumberLiquidators appears to be taking clearadvantage of that.

Describe the company’s current competi-tive environment.

FR: In hardwood flooring, Lowe’s andHome Depot combined have about 23%of the market, while Lumber Liquidatorsnow has around 11%. The other two-thirds of the business is fragmentedamong smaller independent retailers,from which we expect LumberLiquidators to continue to take marketshare.

Are you still expecting significantgrowth?

FR: Management expects to double thenumber of stores to around 400 over thenext five years, which we think is a plau-sible target. We also believe there’s anexcellent chance that same-store sales willgrow over that time as well. That’s partlybecause hardwood flooring and laminatesare increasingly preferred over carpet andshould continue to take a bigger share ofthe flooring market. At some point thehousing market might even rebound a lit-tle bit, which would also improve same-store sales.

We estimate that revenues will growat least 18% per year over the next fiveyears, 15% coming from new stores and3% from an uptick in same-store comps.With no expected margin improvement,that would result in earnings per shareof around $2.70 in 2015. Given howwell Lumber Liquidators has performedin such a difficult industry environment,we think that might turn out to be con-servative if the residential real estate

market comes back from the dead earli-er than anticipated.

What five-year target do you have for theshares, now around $20?

FR: If they hit our growth numbers, we’dexpect the shares to trade for at least 18xearnings five years out. That works out toa target price of close to $50 per share.

The short interest in the stock is nearly25%. Why do you think that is?

FR: It’s difficult to say. It’s lower today,but the P/E has recently been above 20x,which may strike some short sellers as toohigh for a company serving the residentialreal estate market. We’d argue that skep-ticism is unfounded in this case, given

that the company now has $50 million innet cash on its balance sheet and has con-tinued to grow so well through a terriblepart of the cycle.

Looking closer to home, what do youthink the market is missing in MTY FoodGroup [MTY:CN]?

FR: This is a Montreal-based companythat franchises 25 different restaurantbanners in Canada. They have every typeof chain you can imagine, from sushi toGreek to burgers, with most of the loca-tions in mall food courts.

The company at one point consisted ofa computer-services business and a smallrestaurant division. In 2003 managementdecided that franchising restaurants was amuch better business than computer serv-



MTY Food Group(Toronto: MTY:CN)

Business: Montreal-based franchisor of

more than 20 branded restaurant concepts,

with 1,600 current locations found primarily

in Canadian shopping-mall food courts.

Share Information

(@8/26/10, Exchange Rate: $1 = C$1.06):

Price C$11.44

52-Week Range C$8.06 – C$12.98

Dividend Yield 0.0%

Market Cap C$218.7 million

THE BOTTOM LINE

The company’s growth-by-acquisition strategy makes it difficult to forecast earnings,

says Francois Rochon, whose thesis for MTY’s stock comes down to price. After cash,

he says, the shares trade at 11x this year’s expected earnings: “For a company that

has grown 30% per year with a shareholder-focused CEO, that's pretty cheap.”


MTY PRICE HISTORY


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12

9

62008 2009 2010

Financials (FY ending 11/09)

Revenue C$51.5 million

Pre-Tax Profit Margin 34.8%


Valuation Metrics

(Current Price vs. TTM):

MTY S&P 500

P/E 15.3 16.5

15

12

9

6


ices, so they got out of computers andhave since grown the food business veryquickly and profitably, mostly throughacquisition. The number of restaurantshas increased at a 28% compound ratesince 2003, to more than 1,600, whileearnings per share has grown 30% peryear, to over 90 cents (Canadian) thisyear. The recession hasn’t really hurt themmuch: earnings this year will be 80%higher than they were in 2007.

Isn’t growth tough to forecast when thestrategy is based on acquisitions?

FR: Yes, so this is a case where we’re put-ting a lot of faith in management doingthe right thing. The CEO, Stanley Ma,owns 26% of the company and he hasproven to be an excellent steward ofshareholder capital. The company has aclean balance sheet, uses conservativeaccounting, and has been extremely disci-plined in allocating capital. One companyhe acquired last year originally balked athis offer price three years ago and hewalked away. It was only when theyagreed to a reduced price that a deal gotdone.

We still see plenty of potential for fur-ther consolidation in the industry, but arecomfortable that if earnings can’t be wise-ly reinvested, management will pay themoney out to shareholders. As WarrenBuffett says, most managers are willing togrow intelligently if they can, or in other

ways if that’s not possible. We don’t con-sider that to be a risk with Stanley Ma.

What upside do you see from the recentshare price of C$11.45?

FR: It’s difficult here to estimate a targetprice. The way we look at it, after nettingout C$1 in net cash, the stock currentlytrades at only 11x estimated EPS this yearof 92-93 cents. For a company that hasbeen growing 30% per year and is run bya disciplined and shareholder-focusedCEO, that’s pretty cheap.

Do you have general advice on selling?

FR: Our bias toward buying and holdinghas at times made us too quick to ration-alize a problem that hits one of our com-panies as temporary and “already pricedinto the stock.” If the problem turns outto be more long-term and fundamental,it’s likely not fully discounted into thecurrent price at all. We’ve been blind attimes to fundamental changes in a com-pany’s business because we think thequick 25-30% drop in the share pricemakes the stock too cheap to sell.

One technique that helps me avoid thatis to regularly look at what we own andask as objectively as possible if we wouldbuy the exact same portfolio if we werestarting from scratch with the sameamount of money. For positions where theanswer is no, the likely reason is that the

company’s situation has fundamentallychanged, but I haven’t fully admitted it yet.

We’re not hearing the pessimism fromyou that many money managers tell usthey feel today. Why?

FR: One of the biggest mistakes investorsmake is to look at the last few years andassume that’s the new norm. If recentyears have been volatile and unreward-ing, that’s what people generally expectthe next few years to be like as well.

Normalized earnings for the S&P 500over time have grown 6-7% per year.Given the recession, earnings today arestill probably depressed 20% from whatwould be a normalized level. If earningsget back to the normalized trend, the S&P500 would be earning something like$120 per share in five years. Put a 16xP/E ratio on that, and you’ve got a 1,900target. That’s not a market call, but it tellsme that the earnings power for manycompanies today is not being reflected intheir share prices. We believe we ownsuch undervalued companies and we’ll bepatient for the value to be recognized.

Whatever the environment is we try toremain humble, which means maintain-ing our discipline of buying only greatcompanies with strong balance sheetswhen they’re priced with a wide marginof safety. It’s when you’re not humble thatyou end up doing things that will makeyou humble. VII




Value Investor Insight August 27, 2010

This reprint is furnished for general information purposes in order to provide some of the thought process used by Giverny Capital tomake investment decisions. It is provided for illustrative purposes only. This material is not intended to be a formal research reportand should not, under any circumstance, be construed as an offer or recommendation to buy or sell any security, nor should informationcontained herein be relied upon as investment advice. Opinions and information provided are as of the date indicated. Securities iden-tified in this article may not be currently held in client portfolios.

Performance presented is gross of fees and is as of September 10th, 2010.

Annual returns are audited by PricewaterhouseCoopers through December 31, 2009. Returns before 2000 are based on private portfoliosmanaged by Francois Rochon (also audited).

Past performance is not indicative of future returns and the value of an investment may decrease as well as increase, and an investor maynot receive the amount initially invested, and income, if any, may fluctuate. Potential Giverny Capital clients should primarily considerand rely on their understanding of their personal investment constraints and objectives, among other things, before selecting GivernyCapital as an investment advisor.

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VII Giverny Capital August 2010