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2010 Value Investing Congress: May 4th and 5th in Pasadena, CA

Speaker #1: Paul Sonkin from Hummingbird Funds

Fund Background:
Hummingbird focuses on microcap value and is modeled on Buffett-Graham Partnership. Focuses on
$200M and below--usually around $100M; could have over 100 names in the portfolio.

Tarsier Nanocap Value Fund: Focused on the wild, wild west of the investment management world. This
fund focuses on companies with market caps in the $15M range.

The micro and nanocap areas offer great opportunities for investors now. These sectors underperformed
during the nuclear winter. A decade of neglect has been compressed into 2 yrs. Private market values
exceed public market values by a large margin. Traditional managers have become too large and too scared
to take advantage of these opportunities. Therefore, people willing to look at this space are left with a
potential for superior returns with less risk. Huge premium you are getting paid for due to illiquidity--a
result of there being so few investors in this space.

Hummingbird takes larger positions (greater than 5%) because it makes it easier to influence management
and can influence the outcome of their investment. Focus on firms with a single or a small number of
niches because they are easier to evaluate than firms that are in 10-15 businesses. Also, management is
much more accessible

The goal is to maintain patience and a rational, disciplined approach to value investing. Try not to fall into
the trap of style and market cap drift. Manage risk by diversification.

5 factors they look at:

1. Potential upside (discount to intrinsic value)
2. Can you estimate intrinsic value?
3. Certainty of outcome
4. Timing-how long does it take for the gap to close?
5. Margin of safety

3 areas in which they believe they can develop an edge---these 3 are absolutely critical:
1. Information edge
2. Analysis edge
3. Trading edge

Other managers screen out (as a result of institutional constraints) the kind of stocks they look for and this
limits competition because others are looking for liquidity. This gives them a huge pond to fish in. There
are 5000 candidates that don’t file with the SEC and trade on the pink sheets that are on their radar. With
companies with market caps over $1B, there are probably only 2000 companies. So they have a lot of
stocks to look at without having to compete with hedge funds. They can get information by monitoring the
company’s website. Also, they produce simpler financial statements to look over and there are fewer buy
and sell side analysts covering the stocks. This allows them to get information that other don’t have. But,
they have to be in the market every single day because of the wide bid-ask spread. It is a very trading
oriented strategy.

Looking for catalysts- internal and external:

Internal (things that increase intrinsic value): things that increase ROIC, improving B/S
External (things that help close the gap between intrinsic value and price): takeout, new analyst coverage

Goldman Sachs:
“Having read the complaint, I think GS did do it”
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Investment Ideas:
Steinway Musical Instruments (LVB): $17.99
• Piano, band business, real estate are main assets
• Stock is up 100% off of its lows but still has a
long runway to go before it is at fair value
• Recent events:
o Increased ROIC,
o Reduced working cap by closing
facilities—now making more money
with less investment
o Improved their balance sheet by taking
on an Asian partner.
• Asian partner should help with distribution in
Asia--should be the growth driver
• Bought back stock, debt and paid dividends
• Great management capital allocators
• Activist on the board
• Piano business will improve as the economy improves along with margins
• As margins recover then EBITDA should recover as well
• Band business- negative competition from Asia killed margins
o Led to negative operating margins
o Company has outsourced production to China and has closed US operations;

Question: Does Yamaha compete with Steinway in Asia?

They are not competitors in the luxury markets-- only on the lower end of the business. If you are going to
spend $100K on a piano you buy a Steinway. 30% are retrofitted as player pianos (bought by people who
can’t play the piano)

Question: Pricing power for Steinway, do they have it in band or piano?

The company increases it piano prices 4% every year like clockwork. Some years they sell more pianos and
some years they sell fewer. In the band business they have pricing power to some extent. Their brand name
gives them some pricing power.

Question: How do they look Steinway’s real estate value?

They only place a value on it if there is an intention to sell. But they not going to sell in this market. They
have excess space that they do not need and it does provide an extra margin of safety up to $50-$75M if
something goes wrong.

SouthPeak Interactive Corp. (SOPK.OB): $.30

• Develops and publishes

video games for Xbox,
Nintendo Wi, etc
• Value investors in the video
game business
• Was a former SPAC
• $18M market value
• Could do a $100M in
revenue over the next year
or two
• Volume has picked up over
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the past couple of months

• Former founder had 3M shares and was blowing out shares-- dumb seller
• Make a lot of money on their sequels
• Did a messy acquisition, had to take some charges, had some legal problems
• Had poor IR until recently and no analyst coverage
• Will introduce 20 games in the next year
• Catalysts:
o Earnings shine through
o Big seller is out of the market
o Big line up of games should drive growth

Dyna Group International (DGIX.PK): $.80

• Make knick knacks--licensed goods
from the NFL, NBA
o Shot glasses, spoons, belt
• Have been in the business for 30
yrs---not fly by night and have a long
• Founder owns 50% of shares
• Dirt cheap on normalized earnings
• Market cap (with only 7M shares)
less than $7M
o Can earn $2M a year of with
an EV of $5M
• Long term value-- no catalyst but the company will recover
• They could buy back stock or the owner could decide to sell the company--that is the exit strategy

Question: What the success profile percentage in the portfolio?

Out of 10 stocks 2 blow it out, 2 crash and the ones in the middle do OK. The problem is that you don’t
know which are which ahead of time

Question: How do they go about assessing capital allocation of these firms?

Mechanically, you just look at the cash flow statement. You go to the proxy statement and look at
management compensation. They always look at the section called related party transactions.. Get into a
dialogue with mgmt at maintenance CAPEX, growth CAPEX and potential acquisitions--interviewing
management teams is an art.

Question: Market making activities--why do they do that?

Their partner makes a market for them. If they are on the bid then it is a stock they are fine buying and if
they are on the offer it is a stock they willing to sell. Need to be in the market each day just in case they
need the liquidity--in 4 or 5 days they can get in and out of most positions.

Question: Do they invest in roach motels? How do they stop redemptions?

Not investing in roach motels. When they are buying stock they are often competing with management who
is buying back stock. So they get a surprising amount of liquidity. They were able to get liquidity and cover
redemptions during the crisis. They can also sell the company back some shares directly--may not get the
best price but they do get liquidity

Question: When you hold 100 stocks, how do you get comfortable about underlying advantages of each
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company? Specifically, with Steinway they are apparently very dependent on certain employees.

According to Sonkin, Steinway does actually train new people--they have been around for over 100 years.
The knowledge base is cumulative. Steinway’s business has not changed in the last 10 years. He can jump
right in and look at Steinway after 10 years and not miss a beat. He has a cumulative advantage when large
cap investors have a wasting asset.

Question: There are lots of scams going on with small companies. How do they get comfortable with

They have gotten caught into 2 fraud situations over 10 years. So there is some risk of that in this space.

Question: Did you ever look at some companies and didn’t invest because of potential fraud?

They have avoided getting caught by reading the proxy statement. They see how management compensates
itself and how much ownership the team has. Stereotypes are stereotypes for a reason. He won’t invest in a
company with a CEO who wears a lot of jewelry. You don’t want the guy to be gawking at women all the
time. A business is a collection of assets and people. They are betting on the jockey as opposed to just the

Speaker #2: Guy Spier- Aquamarine Fund

“Value Investing for Mere Mortals”

If you haven’t had these extreme experiences and don’t have a unique wiring, then how do you become as
good an investor as some of the best investors? (He compared himself to Soros, Pabrai, Burry, Buffett and
claimed that he did not share any of their unique traits). He believes that their experiences make them
different and allow them to act better under times of extreme uncertainty. He was worried that he was not
going to be able to compete. But he has figured out a few things he thinks he can do.

Guy got incredibly interested in behavioral finance. An intellectual understanding of the factors that affect
us when we are attempting to invest is not enough. “Invest Like a Champion”—a sign that Buffett has up in
his office. Buffett is doing everything he can to set up his environment so that good investment ideas just
come naturally. This is a way to affect the way you think in certain circumstances.

Why do we imaging ourselves to be super rational? We should think of ourselves as Homer Simpson. We
should be proactive about finding ways to help us act rationally if we don’t have unique wiring.

List of things to remember:

1. Before investing, run a checklist. Don’t just go out and buy a stock but go through mistakes that you
know you and other people make. Create a short circuit to stop your brain from leading you astray. Pabrai
and Buffett prefer not to meet with management-- if you stay away from that you will be a better investor
2. Buy to hold for at least 2 years. When you take options off the table then people tend to make better
decisions (fewer choices lead to better outcomes). If you close off the option to trade all day allows you to
take a break and prevent your brain from doing dumb things
3. Reduce toxic relationships, increase productive ones. Conferences where you hear management
pitching their stocks represent a toxic environment. But the Value Investing Congress (VIC) is not a toxic
environment. People should reduce exposure to promotional conferences
4. Your friends’ friends can make you fat. Conclusion: it’s not just how obese your friends are that
determine how fat you are, but your friends’ friends have influence as well. What does that mean about
investing? You don’t even know Warren Buffett but if you know someone who knows Buffett then it could
lead to outperformance. Guy Got rid of 3rd party marketers b/c he knew they were bad influences on his
4. Create a distance from the madding crowd. Guy got out of NY and went to Zurich. Our brains pick up
fear from others in a non-verbal way. .During the crisis he was right next to the herd and he thinks he was
affected in terms of fear by being in that environment. This is not true in Kiewet Plaza where Buffett is the
only investment guy in the building. Guy thinks this had a profound effect on how he thought about things
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during the financial crisis. Templeton left for the Bahamas because he could not think straight in NYC. The
phenomenal investors in NYC have likely found ways to insulate themselves (Einhorn, for example) the
madding crowd in NY. We know Einhorn spends a lot of time out of NYC with his family instead.

Investment theme: Go long what China is short

Guy was a brands guy—Nestle & Kraft. This was very painful in the crisis. When you pay up for a
business, during bad times it can be very painful. Certain investments are bad for your psyche during a
crisis. Think about how your psyche will be affected by movements in the stock price of a specific type of
company. If you have investors who can pull all their money at the same time, you can get a double
whammy in which people are pulling money and the portfolio is going down.

The majority of China’s people lives in rural areas and will move to the cities-. Accordingly, they will need
a lot of steel and iron ore. China is short on steel and are out of local iron ore. Much is being supplied by
seaborne iron ore (from Brazil and Australia). Iron ore pricing has gone from annual to quarterly. As a
commodity becomes scarce, you see pricing becoming more dynamic. People think pricing will go to spot

Key to understand Aussie iron ore companies:

-Reserves--have to be able to figure out which companies will run out of reserves and which ones won’t
-Cost of infrastructure per ton of annual capacity
-Direct production costs

Investment Idea:
Fortescue Metals Group (ASX: FMG): 4.17 (AUD)
• $70 per ton infrastructure costs; $30 cash
cost per ton
• Has done the CAPEX already and will not
have to spend as much going forward--
more free cash flow in the future
• The competitors still have to spend a lot of
money on CAPEX
• Volume is up and prices are going up => it
is potentially trading at 1x EBITDA
• If the Chinese market grows like he
expects, then the stock has substantial

Question: What is the impact of 40% tax on iron ore profits just passed in Australia?

All of the stocks are down 10% but if you don’t think this is a big deal then this is actually a good buying
opportunity. Australia needs to remain competitive with other regions of the world and in the end, the taxes
could impact that. Guy believes that there is plenty of profits to go around. China hates that they are
dependent on Australia for their growth but companies should be able to extract a lot of value from China.

Question (by Vitaliy Katsenelson): What about the bubble in China. Is there overcapacity in real estate and
production? 100 years ago there were farms in midtown NYC--there are none anymore. He may be right
that there is a massive real estate bubble. But there are 100 new cities that can hold $5M are being built and
that can’t happen with steel and concrete. Blips may come but if you are always worried, you never make

Question: For people who can’t select their clients, how should they go about isolating themselves?

Buffett has these great investments and permanent capital. For the rest of us we have to work on the
margin. We have to make compromises when it comes to the toxicity of their environments. The majority
of the money you make is often during market extremes, not being a stock picker in more normal times.
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Question: Has the move to Zurich led to looking at more European companies?

He moved at a unique time. He knows the US world of stocks a lot better. He has not become more focused
at all in Europe because it is a basket case economically. He would not want to invest in a company that
had a lot of exposure to Europe.

Question: Among the other major investors in Fortescue-- Leucadia and Harbinger--what’s your

He claimed that they are smarter than him. They figured this story out before he did. The fact that Leucadia
is in there is a big deal. They have 2 directors at the company. At some point we might be in a world where
all steel is recycled. Want to make sure that companies take the iron ore out when it is still valuable.

Speaker #3: Amitabh Singh of Surefin Investments

“The Emerging Indian Investing Landscape”

• India has been compared to an elephant: large, moves slowly, not in a hurry, smiling all the time
• Currently at $1.3 trillion in GDP, expected to add another $1 trillion in the coming years
• Public markets have exploded
• 5000 listed companies; 2nd to US
• Wealth is worshipped in India
• Overall valuations today on large companies (BSE Sensex) appear to be stretched
• To find value in India, investors need to look outside the top 100-150 companies
• No value in looking at the top 30 companies
• Have to invest in these companies on the ground- family owned without a lot of public
• Markets are prone to panic and volatility- 40% more volatile than the US markets
• There is not that much competition out there so you can sit out overvaluations and wait for them to
• India is under-owned by foreigners
• Analysts are only covering the large companies-- many companies have no coverage at all
• $500B in spending on infrastructure coming in the next few years-- ½ from private sector
• McKinsey estimates that from 2005-2025 there will be a trillion dollars in consumption created
just by the Indian middle class
• There is lot of waste in the government as well as bribery and corruption
• 31M cases pending in courts---no legal remedies available
• Major mistake: Gujurat Fluorochemicals
o Made a mistake by putting the company into buckets. As it moved from a net-net to
GARP to more fairly valued, they did not follow it because they tried to categorize it.
They missed a 25x bagger after owning it when it was a net-net

Investment Idea:
Cheviot Co. LTD (BSE Sensex- Scrip
code 526817): 276.60
• This is a cigar butt;
o Not going to like the
business but it is very
cheap. $26M market
cap with $26M in cash
• They make jute (something that
can’t be made in China)
o Jute is used to make
bags and carpets
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• Used for sugar packaging—the government forces companies to use jute packages
• Net current asset value $34M; market cap is $26M
• Makes $5M per year; doesn’t need much operating capital
• This is a cash cow since they only need $1M in operating capital
• Hit a peak in 2006 and has fallen since.
• Cash has gone up as market cap went down
• Value of investments provides a floor in the stock price
• The owner has been buying back shares again (owns 74.1%)
• Has never lost money and is a consistent dividend payer

Question: Regarding Cheviot, are you concerned about a take under? Could the value not go to

• India has specific delisting laws. After 75% ownership a shareholder has to make a tender offer.
Shareholders actually get to bid a price and if the owner doesn’t like it then he/she can’t re-tender
for 3 yrs.
• He visited the management team to see if they wanted to de-list together but the owner didn’t want
o He wants it to remain listed
• Then, the question is what is he going to do with all of the cash?
o He has a 26% ROE average in his history so his capital allocation decisions have been
o Put some cash into securities—Amitabh did not like that decision
o If he does something great with the cash then the stock could easily double

Question: In India, there appear to be low PE stocks with high volatility. Is there an opportunity to sell

The option exchange started in 2005 but there is no liquidity. It only offers 1-3 month options and there is
no liquidity for individual stocks. Offshore investors can structure something but his group doesn’t have the
ability to be very involved in options

Question: When it comes to corruption in government, are there industries to avoid?

His fund has a huge problem competing with the index because they are not involved in oil/gas, mining, etc
and those companies are in the index (sectors where there is a lot of corruption). You can find good
companies that have low single digit P/E ratios that other people are scared of. You have to be careful of
labor laws, for example.

Question: Is it possible to invest in India from offshore [meaning not being in India]?

It is much better to have a base on the ground to do scuttlebutt. Even if you don’t engage with management
you should be on the ground. Meeting management has the same problems as are inherent in the US.
Management teams are more focused on selling the company anything else.

Question: (from Guy Spier): Can they get away from the crowd in India and not fall prey to following the

Mumbai is the financial capital. He is the only financial guy in an IT building in a city focused on IT. Delhi
is government oriented.

Question: Do you favor any regions of India? Are there some that investors should avoid?

They usually avoid West Bengal. They usually look at companies irrespective of the region they are in. But,
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local nuances are important.

Speaker # 4: Bruce Berkowitz of Fairholme Capital

“Back to the Future”

Bruce recently learned something very important: everyone needs a Munger. Munger has all the symbolic
logic and thinks in terms of contingencies. Denial and death and envy are important concepts. Munger is
living proof that you can get older and can get smarter. The knowledge is cumulative. You can get better as
you get older. Munger’s career shows how important it is to have cash.

Back to the Future:

It’s about counting the cash and following the cash. It’s about the past and understanding history: déjà vu
all over again. We have seen the same financial conglomerates come back after the model had failed in the
past. Financial services and banks right now are about pigs in the python. The pig is bad debt and the
python is the institution. It’s all about leverage, liquidity and the kindness of strangers. It’s about average
lives and torture in the financial services industries. It’s about the government at its best. Bruce was really
impressed with how they have handled financial services industry.

Today is different than the 1990s when it comes to financial services. Fairholme is in a lot of cash and short
term bonds (30%) and he thinks this is a good time to be in some cash. They are the largest owners of
Regions Financial, CIT, and AIG (other than the US government). They have gigantic stake in Goldman
Sachs and are involved with real estate companies General Growth and St Joe.

Question: How did he become Morningstar manager of the decade?

You have got to get lucky. The trick in life is not to make the same mistake twice. He has avoided mistakes
that he would have made a decade earlier. He started in the financial services industry and this time he
waited to jump back into that sector. He has a big firm with great people who focus more on not losing
rather than making a lot of money. They don’t get caught up in denial. He believes that you have to put
yourself in the shoes of your shareholders and owners by putting your money on the line with your

Question: Any comments on Fortescue and general iron ore trends?

Fortescue was a fabulous investment for Leucadia. He has liked Fortescue at a certain price. From here on
out it is going to be too easy for governments for trying to get a big piece of the pie (royalty tax in Australia
as an example) and resource companies can be very easy targets

Question: What’s his current stance on Wellpoint and health insurers?

First off, he is getting older and will need them more. People want to live to 100 but they don’t want t pay
for health insurance. Health insurers are the bad boys and girls on the street even though they represent a
small portion of the health care industry. There is lots of friction in the health insurance industry. He used to
like them because they were defensive. But the real question is who is going to do it other than them? Not
the government. Wellpoint has a great franchise but they also like Humana. They like the Medicare
Advantage and Medicaid businesses because they got killed as everyone stared to hate these businesses.

Question: They recently started a focused credit fund. Why is it attractive? How are valuations?

He has a rule: they only do for themselves what they do for clients. He never gets too emotionally involved
in the investment process. They had a lot of money in T-bills and when he saw value higher in the company
capital structure, he saw attractive returns for a fund focused on income.

Question (by Marcelo Lima): You have a small staff at Fairholme and move around between sectors. How
do you do diligence in so many names and sectors with such a small staff?
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Everyone worries about too having many assets under management. One of the big problems arises when
you become a manager of people rather than managers of investments. This is the first step towards
financial death. You have to keep your firm small. You can’t hire all the best experts because when you
switch sectors then you can’t fire them. So, they use consultants instead of analysts. This not usual in the
mutual fund world. The US treasury and Fed pays the best bank analysts in the world at those institutions.
They have access to professionals and consultants that have on the ground knowledge. They hire lots of
people from the outside and ask them to tell Fairholme where they are screwing up. This makes for a much
more efficient organization and an easier life.

Question: Why did he stop liking Pfizer?

Recurring, non recurring expenses were the reason for exiting the position for the most part. He likes the
people and the stock was cheap enough, relative to past valuations. But, these expenses started to bother
him. They started to be real expenses. Accordingly, their cash earnings metric seemed arbitrary, even
though the entire industry behaves like that. They have legal expenses in this business and he thought they
had to count them as recurring. When they went into health care they thought it was a good defense. But, he
said that the only good hedge is in a Japanese garden because when things go bad all correlations go to one.

Question: Tell us more about St. Joe since you own almost 30%.

He believes that they bought the stock for swamp land prices. There is a misperception out there. Smart
people were short this but if you go there you see how great the land is there. A new Southwest hub is about
to be opened there. The infrastructure is good. Tax dollars were at work and seemed to have been well
spent. This land represents the last open place left in Florida, a state with no state taxes. For the 1st time you
are going to be able to land within 10 miles of the Gulf Coast, even though the project is 15 years late. The
10,000 foot runway means that you can land anything there. The BP oil spill may have been killing the
stock but the necessary cleanup is going to be like a full employment act for North Florida.

Question: Can you walk us through the AIG valuation?

The main analyst on this position is the Government Accountability Office (GAO). They have been
studying AIG every 2 months and Fairholme is going by what the GAO reports. The GAO thinks AIG is
going to make a profit on selling subsidiaries. The Chartis (P&C business) is intact. The Old Sun America
is still in existence. Other assets are worth more than what is on the books. Financial products may be up as
Maiden Lane 2 asset prices are up [with those assets being used as a barometer to value similar AIG assets].

Is there one insurance company that is doing in business in the US that is owned by a foreign government?
This is a regulated business so he assumes that the government is the 80% owner but how are they going to
perform? Can the company die? He doesn’t think so. At the price they bought it at, they are probably not
going to get hurt. They are a major owner of the convertible preferred. They are up and down in the capital
structure. AIG is a great insurance company. He likes being a partner with the government. In fact, he
thinks the government has saved us. But the government doesn’t want to be in the insurance business. They
want to make a few bucks and pay taxpayers back.

Question: St. Joe Management has been great. But how do you see actual cash flow being produced in our

Maybe we won’t but Fairholme won’t lose anything. They like the new management team. The strategy is
do no harm. Where we are in the real estate cycle, there is nothing else he can do. There are a lot of
interesting places to invest in real estate. They don’t think they will lose any money in this position. They
bought it for a swamp land prices. But it could take a while for the story to play out though. So it might be
his kids who benefit.

Question: General Growth (GGP)--can you talk about this investment?

Fairholme has the cash to help companies rebuild their balance sheets. He is hoping that they can help all
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the parties recover (up and down the capital structure). He started off thinking that the bonds were money
good. Today, they would like to take their bonds, add $2.8 billion and turn it into equity. The $2.8 billion
check is burning a hole in his pocket. If this deal goes through, everyone gets paid and moves forward. The
bankruptcy judge is very smart. He thinks that this is a win-win- situation; rising from the ashes and
allowing the company to move forward.

Question: Simon’s increased bid? Would the Brookfield group (including Berkowitz), raise their bid?

He said no way. His shareholders would kill him. The company will come out of bankruptcy and they hope
to be a long term shareholder.

Question: He says there are lots of good ideas out there, but he is in 30% cash. How does that work?

He always has cash. It is his biggest nightmare to have no cash. As long as you have cash and you know
what you are doing, you are going to be alright in this world. He assumes that his shareholders could need
cash. He needs to worry about need to liquidity, correlations between assets and commitments to
companies, etc. Cash sometimes looks as though it is worthless but he believes it is very valuable. 90% of
the time Fairholme is in 10-20% cash. It is a little higher (2x the normal level) than in the past. There is
plenty to buy but their size only allows them to buy large. He can only put 4.9% of assets into a broker
dealer. They are constrained and sometimes when things are different constraints can be a good thing [the
implication was that it helps with investment discipline].

Question: Why did he buy Goldman Sachs (GS)?

He just doesn’t get the case-- the SEC’s case. Everybody knew everything and knew what was going to go
where and when. It was a pretty common transaction. It will be a painful process. But they don’t seem to
have done anything different than anyone else was doing. The main question is whether these synthetic
CDOs have any merit to society. Thinks GS is a great firm with great people whose franchise is still intact.
But this is a case of the few versus the many. Why should so many suffer because a mistake is made by a
few? He thinks GS has a level of behavior and ethics that is quite good. He told us to go to the website and
see what requirements and standards they have for interns. They tell people how to they should behave. You
may think it is BS but he has never seen anything like it at another firm.

Speaker #5: Patrick Degorce of Theleme Partners

• Quote from Buffett: The most important quality for investors is temperament, not intellect.
• When we talk about value, are we talking about relative value or intrinsic value? How could a
great company that continued to do better than market expectations have such variation in market
multiples applied by market value?
• The biggest difficulty in this job is not to find value, but to keep value. You have to know yourself.
Philosophy is better to understand for investors than mathematics. At the end of the day the
biggest challenge in investing is to find the moral value in investing.
• Pascal quote: “All men's miseries derive from not being able to sit in a quiet room alone.”
• What can we do about it? We can create an edge in our investment process. We can all improve in
terms of limiting ego and greed. It is hard to admit mistakes due to ego and the associated
financial consequences.
• They earn no yearend bonus and have no salaries. They only make money if the portfolio makes
money. It has led to a very positive result. You never forget to sell if you only make money when
the portfolio makes money. You have a big incentive to find better opportunities to generate better
• What about risk? You have to think about time horizon. On average they think about holding a
position for 3-5 years. He said he wants to put himself in a position to not get pushed around by
the market. So, he never uses leverage. They only charge incentive fees to clients once a year.
Managing a business is a source of stress. Managing outside personal is stressful.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

• You have to invest in a business. Define the do and the don’ts. If you can’t price a commodity then
you should not invest in it, even if the market leaves you behind.
• Quote from Buffett: "John Maynard Keynes essentially said, don't try and figure out what the
market is doing. Figure out a business you understand, and concentrate."

• He has never seen a market misprice something for more than 3 years. That’s why their time
horizon is 3-5 years.
• One way to value a stock: through a DCF. How much you pay is important; but not important as
the potential for compounded returns. When the future compounded returns are high enough, the
price you pay now may not even be important. So, you can’t always just look at current price to
earnings and price to book. Paying 25x earnings for a business that compounds at 30% per year
may actually by a value investment. So the takeaway is: don’t confuse a multiple with value.

Investment Idea:
Deutsche Boerse (XETRA: DB1.DE): €52.01
• Lower multiple than what he bought if
for in 2004.
• Mixture of an infrastructure and a
subscription businesses.
• 3 businesses you are buying
o Cash equities (headline
 Cash equity is a
poor business due to
no barriers to entry.
16% compounded
rate of growth in
volume but the fees are basically flat over a long period of time
 Regulation is changing in the industry. Competitors (such as Chi X) have been
trading the larger portion of the market (the profitable portion) and have not been
trading the small and mid caps (the unprofitable portion of the market). He thinks
that this is unfair competition but the idea that the regulations should change is not
his investment thesis.

o Crown Jewel: Eurex-- fixed income, equity index and equity options
 99% operating margin in some of these markets
 Volume and fees have been going up
o Clearstream: 45% of their business
 Custody business in Europe
 Eurobonds growth rate has been growing strong (ICSD businesses)
 Bank consolidation has put pressure on fees (volume discounts lead to fee pressure)
• We know that there is a lot of growth in China. Like an insurance company this company has float
o When people trade bonds they leave a small cash balanced to make sure they have coverage
o Interest rates are low so this doesn’t yield much but when rates come back it leads to better
• Operating margins: Instituted a 150M Euro cost cutting program
o That means costs will be flat for the last few years.
o In a volatile world, the top line benefits but costs are going down and that boosts operating
margins (through operational leverage)
• Paying 10x FCF for this company
o This is evidence that you don’t have to go to microcaps to find value.
o You can find value in large caps as well

Question: The cash equities business has no pricing power vs. monopoly in Eurex and Clearstream
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businesses. What’s the competition like? What about regulations?

Regulators want to look at the OTC market, which is 8 times bigger than equities market. At the end of the
day in the OTC market, the competitors are not other exchanges, but GS and JP Morgan. Regulators in the
US are taking a hard stance against the banks. They are looking to leave the banks without the opportunity
to trade derivatives and there is a move to get them on an exchange. The cash equity market will remain
competitive. It should improve a bit but the stock is cheap enough that he doesn’t worry about it.

Question: Please give us your take on Greece’s problems..

What’s happening in Greece is a blessing to Europe. The high value of the Euro was killing the European
economy. Greece is going to save the European economies by destroying the value of the Euro. He thinks
that French and German exporters are getting much more competitive.

The market is telling us that Greece will not be able to pay their debt. Greece is a very small percentage of
Europe’s GDP. Can a failure hurt the banks/ Yes? Could they have to raise equity? Yes. But it’s not going to
be the end of the world because people don’t even really know where Greece is.

Question: Is there a hollowing out in London in terms of managers? Why is he still in London?
London looks wet and grey. He stayed in London because his wife wanted to stay in London.

Speaker # 6: Carlo Cannell of Cannell Capital

• All of their funds are named after islands and hopefully by the end of the presentation we will be
able to figure out way.
• There are 13,722 companies who file periodically with the SEC. This is the investable universe
including every company that files something with the SEC.
• The look at the distribution of the population of public companies by analyst (analyst ratio)
o They look at the analyst ratio in determining whether or not they want to look into a stock
o Sometimes hard to know if the analyst is actually following the stock or is just issuing
reports trying to get business from the company
• The greatest opportunity now, 10 years ago, 20 years ago, and 10 years from now is the side of the
chart that has little to no sponsorship.
o There are only 150 companies in the universe that are most covered by analysts
o Statistically these markets are efficient so investors interested in these stocks should buy
indexes and go passive
o They want to focus on markets that no one is looking at: the underbrush.

Examples of inefficiently price companies:

Core-Mark (CMRKW.PK): $25.89 (No chart available)
• $7B in revenue but only 1 true analyst (2 others “follow” it but not really)
• Distribute Slim Jims and potato chips to convenience stores
• Logistics more than a distribution company
• Diets are changing and convenience stores are changing
o Becoming better lit and are adding higher margin produce goods

Kennedy Wilson Holdings (KW): $11.18

• Went dark in Nov. 2004
• Bought back 50% of its shares
between 2000 and 2009
• Kind of public but not really
o Stock is in Never-never
• What they do is conduct auctions of
CRE property
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

• They apparently are able to hold the auction beforehand and skim the best properties for
• Are a wonderfully predatory real estate company
• Are doing amazingly good deals
• Recently bought back warrants
• Have a property management business as well

Golfsmith International Holdings (GOLF) $4.46

• Small, illiquid company
• Have golf ranges and stores
• Followed by only 1 analyst
• Discounting land value, it was
trading at 1x EBIDTA
• This is an example of why it’s
worth going into the garbage
o They are too lazy to do
the work on RIMM or
o Can’t take easy
opportunities like this if you are running $7B

Question: Can you give some examples of the Kennedy Wilson deals?

The property management business and auction business are not particularly pretty, but they generate cash
flow. But the deals they are doing with banks look like they are deploying capital to distressed RE assets
with very attractive potential returns.

Question: Is Kennedy Wilson the self dealing?

His thesis weakens if it can be argued that they are not self dealing [meaning that his investment thesis is
based on advantages they receive from self dealing]. However, it does appear to be legal. It seems like
something that if GS did it, GS would be sued. But, apparently in real estate you can flip flop between
agent and principal. It is an issue and is an important question for the future.

Question: How many names do they hold and what do position sizes look like?

He is not interested in world domination. They got to $1 billion under management, thought it was too
much and gave back $488M in 2004 to investors. He didn’t want to own 400 names like Golfsmith. It
depends on what you want in the market but he likes to be concentrated. The optimal size is $1M.

Question: What is his return experience?

Up until 2008, it was about 30% annual rate of return. But he does engage in a lot of short selling, which is
a very different topic. The nature of these securities he invests in: there is a heartbeat but it is the cadence of
a crocodile. Things happen very sporadically with these companies. In this garbage dump, valuations are
far cheaper than private equity deals. You have greater liquidity and you don’t have a huge staff. You can
get out of these things when the thesis does not play out but due to the illiquidity you may have to endure
some losses. This is the chicken way to play private equity.

Question: Is he still shorting Chinese companies? Where are you shorting now?

Tonight they are shorting more in China. Two years ago he presented a list of companies that had unusual
discrepancies between the cash flow statement and income statement and that had an auditor that no one
had ever heard of. They were looking for increasing receivables as well. Those trades have worked out. He
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

believes that a lot of these companies are fraudulent. The best shorts are not shoring Proctor & Gamble and
Coke. They are shorting companies that are dying or coming apart. It is like driving in your pickup truck
and seeing a pigeon with one leg and walking up to it and shooting it. He is way too lazy to try to short
good quality companies. We all know a bunch of restaurants that are not ever coming back as well as some
airlines, hardware companies. Rather than pick on companies that are just expensive, why not just short the
dying ones?

Question: What’s your advice regarding the way shorts have been killed over the last year?

He said investors should manage risk and keep small pieces of these shorts. Inertia can be a good thing. If
you are patient long enough all businesses will go out of business. The question is how long you can wait.

Question: Paul Sonkin was really excited about really small companies and so do you. How do you explain
the flight to crap? These things seem to be at odds with each other. Is this really an attractive space to focus

He doesn’t look at macro stuff so this is a better question for other investors. He is hoping that this year and
next year will be more rational. 2008 went to one extreme and then we have gone to another extreme from
March of 2009 until now. The best market for him would be down 1-2% forever. This strategy works but
you can’t know when it will work. You just need to wait for the investments that come along.

Speaker # 7: Lloyd Khaner of Khaner Capital

The merits of owning gold:

• Why some of the best value investors in the world own gold
o He has owned gold from 2005-2009
 Has been a benefit to his returns
• Why is he a gold expert?
o Made regular visits to gold mines over the years--Nope
o Because he pitched gold in Value Investor Insight in 2006--Nope
• The price of gold in July 1999 was $262
o He got a call from Morgan Stanley broker who said that it was time to buy gold
 No shortage, no catalyst (but little downside), no other uses than jewelry, price
had gone down for 20 straight years
• Looked like a terrible investment that he now wishes he had made
o Went straight up from there and he finally bought it in 2005
• He loves meeting with management and decided to do some work on gold so he could meet
management teams
• Gold has been used as a currency for 3000 years
o You can get pricing on gold since 1833
 The metal flatlined from then until the 1930’s when the US let the price of gold
o From 2000-2009 it has gone straight up
 Does it have more room to go?
• Why do people own gold?
o Valuation:
 Oil/Gold Ratio: for every ounce of gold you should be able to buy 15 barrels of
• This ratio works fairly well (if oil goes up then you want to own gold)
• Oil shocks were followed by huge price increases in gold, except
during the first Iraq War
 1-2 ounces of gold should buy you the DJIA
• This implies gold at $5500 now
• Right now 10 ounces of gold buy the DJIA
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

 Price of gold versus a nice men’s suit

• 1 ounce of gold should buy a nice men’s suit
• He went back to 1900 and found that correlation between the price of a
good men’s suit and gold was strong
o People think there will be new uses for gold:
 39,000 patents in the last few years (drug delivery, cancer delivery, fuel cell)
 Used very little in manufacturing
o Gold supply is falling on a yearly basis
 It’s getting harder to extract
• Now have to deal with environmental issues, more dangerous locals,
and the gold is more difficult to get to
o Personal consumption:
 China, India, Russia: if everyone buys a little bit then the price could go way us
 The populations in these countries own very little gold
o Asset diversification of retail investors
o Central banks
 Were net buyers of gold in 2009 for the first time since 1980
 These banks have nowhere to go but up in terms of their gold holdings.
• If gold gets too high you risk hyperinflation
o Gold is a safe haven
 Gold crowd is the apocalypse crowd
o Deflation
 Gold could go up in a deflationary environment
• He does not believe this
• You need deflation of mining costs for the miners to do well as margins
• Owning the miners was the way to make money in the 1930s
o Inflation
 We are all looking for it but we don’t know where it is.
 Hyperinflation: you don’t want this. It is very severe. You don’t want to be there.
If we get there we should buy canned soup and guns.
 Inflation adjusted, Bloomberg says gold would have to double to get to where it
was in 1980s.
o Soros: There is a positive feedback loop.
 Price increases (or decreases) feed upon themselves and then gold keeps on
going up (or down).
 Then these can be a negative feedback approach that eventually bursts a bubble
 He is planning to ride this bubble up.
o Last currency
 This is the most important rational
 World is full of fiat currencies
 Global financial crisis, stimulus, wars, debt, and lack of confidence in currencies
make currencies look very unattractive.
• This all should be great for gold.
o Gold is a survivor because it is not backed by one country-- it is what it is.
• Decision to make for investors:
o Deflation/recession/ strong fiat currencies vs. Inflation/growing economies/weak fiat

Things to look for in gold stocks:

• Low cost, safe production and good areas where the mines are located
• Pristine management with no red flags at all
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

• Companies that do not need capital and do not need to go to the market every 6 months
• Management has a high equity (not options or warrants) stake so they are in there with you

Question: There is a conspiracy theory out there that the gold isn’t there in the GLD (Gold ETF). Instead,
futures and paper gold are all that is in there:

He doesn’t know the whole story. He met the GLD guys when it went public and they assured him that the
gold is there. Could they by lying? Could they be using options and futures? Possibly. There will always be
conspiracy theories when it comes to gold. It is the nature of the beast.

Question: How do you assess fair value? How do you know when you are overpaying?

He traded gold more in the past but those correlations disappeared. Now, he doesn’t know. You need to
decide where it is going to go. What ratio to use is hard to know. $900 gold is necessary for most mining
companies to keep earnings up. Gold is very volatile and you have to decide how high it is going to go and
hold on. If you think it is going to double then pick a percentage of you assets and stick with it.

Question: How long did it take to get comfortable with no way to estimate intrinsic value?

If you are worried about this, then look at the miners instead of the metal. Determine a multiple of NAV
that you are willing to pay for gold stocks. With the metal itself, you have to forget about intrinsic value.

Question: What do you own and what do you like?

They own GLD, GDX, GDXJ and one small junior miner. It is harder for inflation to hit the profits of the
miners with gold at these prices.

Question: Do the crazy gold infomercials bother you? Is that a red flag or mark of the top?

He has yet to get gold stock tips from the cab drivers or shoe shine people. He thinks it is a bubble also but
he plans on riding it up. The gold commercials bug him and he wishes they had waited another few years
before they started.

Question: Warren Buffett talked about the possibility of inflation. But, at what point do you know you are
wrong about gold?

If currencies around the world were strengthening, financial markets were stabilizing, and sovereign debt
issues went away, then he would sell gold.

Question: Why not buy a curve steepener as opposed to gold?

Those could work perfectly well. He noticed amazing value investors buying gold so this is what he
decided to talk about. But there are other ways to play it. He doesn’t feel like there is too much company in
this trade now. Soros’ feedback loop is a good description of what might happen here.

If it doesn’t work out, gold could go down for sure. There are inexpensive ways to short gold. These can be
used as a hedge. There are gold mining companies for which if this does not work out they are just about
worthless (or are going way down).

Question: How does deflation work into the thesis, especially with the money supply falling?

He doesn’t think that labor inflation will increase overall inflation. If there was not so much stimulus being
pumped into the market, he would bet on deflation. But the governments around the globe are trying to
prevent deflation. If deflation kicked in he would go home when it came to gold. He definitely wants
inflation for this position to work.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Question: Why would you invest in an asset with a negative carry? What books would you recommend
that explain this love of gold?

The Harry Brown books from the 1970s ("How You Can Profit From the Coming Devaluation" and "You
Can Profit from a Monetary Crisis" are good primers on gold. Reading Soros’s book from last year (“The
Crash of 2008 and What it Means”) might be smart based on the behavioral component of feedback loops.
He thinks that’s what will drive any asset bubble and then eventually break it. Also, read what you can on
the internet.

With such low interest rate the negative carry is not as bad. If they jack up interest rates like Volcker did
then gold prices will get killed. But he doesn’t think they have the appetite to increase rates right now.

Speaker #8: Richard Vogel of Alatus SA

“Europe: A Greek Tragedy”

How does he look for value?

• Likes companies that generate and return free cash flow (FCF)
• Likes solid a solid balance sheet
• He won’t pay up for growth.
• Looks for 8-10% FCF yield
• He takes a long time to determine what FCF looks like.
• Also looks for something else
o A new product or a new market
 This is what they call inflection
Assessment of Europe:

• All of Europe is in red ink when it comes to government deficits in relation to GDP
• Germany, Finland and Sweden are just about the only countries that are not bleeding red ink
• The combination of high public sector debt and current account deficits are going to stifle growth
o When you hit 100% debt to GDP it is going to be very hard to get out
• Euro zone GDP growth was not really driven by Germany
o It has only grown about 1% per year
• Even in an economy that is flat, if you choose the right companies and identify the right
management team and sectors, then you can add value.
o Their portfolio grew in value much more than the major companies in Europe.
o With just about 0% GDP growth they were able to create value.
o This can work as long as they entire system does not melt down.
o There were always defaults prior to the most recent period.
o Well run companies did not default during this period but in reality it is normal to have

Types of companies they like:

• Oligopolistic nature
• Product that people will need that has pricing power
• He does not like banks since they look like black boxes
• Predictable assets

Value drivers of European investments:

• New management teams at poorly managed companies with great assets
• Market under prices slow growth
o They usually find companies that grow 3-5% growth
• Large emerging market exposure
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

• National market finally consolidating into the Pan European market

Investment Ideas:
Inditex (MCE: ITX.MC): €42.71
• Founded in the 1960s and has
grown it into the largest apparel
retailer in the world
• Company is worth 28 billion
Euros and the owner still owns
• Not well-known in the US
because this country is a not a
o Would rather be in
emerging markets and Asia
• Model is meant to penetrate this markets with little costs
o Does not spend on ads
• Efficient and Safe Play
o No fashion risk
o No or little inventory risk
o No or little CAPEX
o Stores in prime locations
o Short lead times (3-6 weeks)
 Don’t need to have inventory because of short lead times and IT technology that
tells them what is popular at stores
o Proximate manufacturing
o Centralized, distribution and logistics
o Generate a ton of data from every single store
o As soon as they see something is selling in a flagship store they know it will start selling
well in other stores
• May have a lower margin than H&M but their ROIC is higher
• Opened fewer stores than usual during the crisis and recession
• Taking market share from mom and pops
• They continually beat their own 10 % sales growth target
• Their market is the world
• Generate $2 billion in cash flow per year and put in $500M/year for new stores
o Get a 30% return on that investment
• Don’t need a lot of growth for this to be a good investment but would like to see it

Valora Holding AG (Swiss:

VALN.SW): CHF 250.75
• Owns major locations in all the
major railroad stations in
• Used to have a bad board and
bad management team
o During the crisis both
changed and they
brought in a former
McKinsey guy.
• How do they drive margins?
o Proper logistics will drive costs down and worst comes to worse the margins stay flat
• No debt
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

• $100M in FCF with a $700M market cap

• 12% FCF yield

Where are we right now?

• Market volatility is creating opportunities for value investing
• Investors need to be on the ground and meet management
• People are going to need to eat, drink beer and buy basic services
o Stick with business with pricing power
• He is a true bottom’s up investor

Question: How does living in Europe help w/ due diligence?

He is not influence by the crowd since he is in Switzerland. They try to come up with their own estimates
and don’t rely on the sales pitches of management. But, it does help a lot to be on the ground in Europe.

Question: Will you talk about the economics of Inditex? The company requires very little CAPEX but they
do have long term leases?

They have $2.3 billion in cash so whatever long term leases they have, they are not levered. What we saw
in Spain was that this was not the hardest hit portion of the economy when things got bad. It is still the right
price point for cost-conscious consumers.

Question: With Valora what happens if the leases that give them sole access to consumers run out?
It is not a near-term concern because they just signed a long term lease for a major location.

Question: With Inditex, is there risk if the founder dies?

No, there is a full-fledged management team in place and the founder is not involved that much.

Question: Greece? Is it a problem?

The Euro was too high so it may be a blessing if the Euro falls. The common currency is tough to manage.
The Germans don’t want to bail out Greek retirees. There is a negotiation between the Germans and the
Greeks. The Germans don’t want to create precedent. It is important that Greece actually reforms itself. If
countries don’t want to be dropped out of the EU, they need to start cutting their deficits. Germany leaving
might be the most logical solution so that they don’t have to pay for everyone else’s sins.

Question: When it comes to Zara and online sales? How far along are they?

They are just launching now as we speak. When H&M did the same they added 2-3% to top line growth. It
might not be that high for Zara but the online business will be effective. They have 7 different formats and
they are doing well. Zara is only 60% of sales. As opposed to H&M. which is focused on one brand, Inditex
has diversified offerings.

Question: What have Inditex and H&M done to be successful in exporting their business models over the

Some American companies (such as Gap) didn’t feel the need to grow outside of the US due to the size of
the US market. But these two companies were in Spain and Switzerland and were in small markets. So they
had to grow outside their markets to grow at all.

Speaker #9: Mohnish Pabrai- Pabrai Funds


The Origin of the Checklist:

The Inoculated Investor http://inoculatedinvestor.blogspot.com/

He started to study the concept of a checklist after reading Atul Guwande’s article in the New Yorker on
checklists. The aviation checklist approach to flying came about after the failure of the Boeing B-17 project
for the Army. Checklists in aviation became absolutely fundamental from there.

Key Breakthrough: all checklists for complex airplanes are similar and most of them are less than 12 items
long. You couldn’t have a 7 page checklist because you could never get pilots to actually follow it. So, they
broke it down to the most critical functions that absolutely had to be done. Aviation is now extremely safe
and cheap. The system works well as a result of checklists.

What are the parallels to investing? How do we design the right checklist?
The FAA is a highly successful organization. They do nothing until a crash has happened but then they will
spend months and years figuring out what happened. They will then model and see how many lives will
best lost over the next 30 years if they do nothing. That entails determining what the value of a human life
is. Right now we are each worth about $3M. They then multiply that times the number of potential deaths
and use that value as a budget to try to make the changes they recommend. The changes will be within the
context in terms of cost. Aviation improves only when there is a crash.

The best way to create an investment checklist is based on looking at crashes. These only include
permanent loss of capital in Pabrai’s mind. The only humans who are 100% transparent when it comes to
their mistakes are Warren and Charlie. But, to create a full list of pitfalls he then went through other high
profile mistakes.

He looked at the error and each time he found a mistake, he added a question to the checklist that
corresponded to that mistake. The project is still ongoing but he now has 80 on the list. This has not
changed any of his processes for looking at companies. It is when he is about to pull the trigger that he
pulls out the checklist. The first time he runs it then he usually finds 5-7 things that he doesn’t have
answers to. This tells him to go find the answers and then run the checklist again. No company could give
him a “go” on all 80 questions. But, the checklist system has started to show him how he should position
size investments. He went from being very concentrated to being more diversified. The current baseline is
5% bet and then 10% if he thinks it is a homerun or 2% if it is a basket trade. So far, the error rate is 0%
and he has made the most investments in his career during the period in which he began using the checklist.

Speaker #1: Eric Sprott of Sprott Asset Management
“Investing in Precious Metals”

Macroeconomic Assessment:
Those who think there are green shoots should review the data. What is going in the world today seems to
justify his concerns. This is especially true when it comes to the Greek and European problems.

The world has a busted formula. Governments spend money to boost GDP with the sole intention of
boosting GDP. The US got $28 billion in GDP growth from the $1.5 trillion in extra debt that the
government took on. GDP could grow 4% or 5% this year. But, what is the asset that comes out of that
GDP growth? We don’t know. But we do know what the liability is. It is another $1.5 trillion in debt. The
dots do not connect. The Keynesian formula is busted and is failing all over the world. It will fail here.

He wrote a piece called “Surreality Check 2: Dead Government Walking. This has a nice ring to it given
what is going on in the world today regarding sovereign risk. Just as in Greece, the UK and Japan, the US
government will not be able to pay off all of its debts, especially when unfunded liabilities are included.
Everyone should question fiat currencies. The US currency has been winning the race to the bottom as
people figure out what the worst currency is going to be.

The US Consumer
The US Census hiring is boosting the number of jobs and there is some job growth. But he think this will
soon be offset by a decline in state and municipal payrolls. Sprott has been bearish since 2000 when he
called NASDAQ top. The powers that be are always trying to prevent what should happen from happening.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Where are the bond vigilantes? We can say now in the last 4 weeks that they have shown up as Greece
bonds have gone up to 18% and corporate bonds are falling in the US. Vigilantes are back as they should
have. We need to look at government debt issuance to see if it can be paid back and what form that payback
will be in.

Gold was the investment of the decade. Gold is the only asset that has made any progress in the last decade
and is where people should have had their money. Why did they get into gold? They read a book by Frank
Veneroso (“The 1998 Annual Gold Book”). In 1999 the gold market was undersupplied. The central banks
were selling gold. The gold market produces 2600 tons a year and recycling adds 1000 tons per year. Banks
were selling 400 tons per year in 1999. But, 10 years later, mining companies do not lease, production is
down 150 tons, there are now ETFs, and there are new investors (big names) in the gold arena. Gold is now
an investment class and central banks are buying. The price is likely to go up much further. As a gold bug,
the words quantitative easing are his favorite words. People are printing money all over the world. The IMF
is getting printed money from everywhere. Greece is not just a European problem. It will spread to Italy,
Portugal, and Spain.

Europe is NOT a country problem: it is a BANK problem. We don’t know all the data but people are
moving their money away from banks in tenuous states. People are being forced to start the thinking
process regarding where they should put their money. He has thought for a while that the world’s banks
were over-levered. Banks that fail in the US are not valuing their assets properly. They are being revalued
at 30 cents on the dollar when they taken over by the FDIC and wiped out. The FDIC continues to grow a
bigger and bigger deficit and the government is ultimately on the hook. We need to start worrying about

He does not see the end of QE actually happening. Why? Because he has no idea who is buying US bonds.
When you go from $500 billion to $1.5 trillion, then people have to buy 200% more bonds. He doesn’t
know who is buying more. He knows people such as China who are buying less. Last year it was the Fed
but he thinks the government will have to keep some form of QE going.

Gold has its difficulties. There are big players in the gold markets that do bad things to gold prices. JP
Morgan and the other bullion banks manipulate the markets. Precious metals are not friends of commercial
banks or central banks. They both hate gold. It is ironic that when the market gets killed, gold gets killed

3 Things that Sprott does:

1. Connects the dots
2. Are in the “stealing” business: They don’t find large stocks that are overwhelmingly cheap but they try to
be early on ideas in which they can be extraordinarily successful
3. The search for prospectivity: Always want to know in the precious metals space how big can it get

Gold Miners:
When you think of the gold mining business today, since the gold price is so much higher it is a much
better industry.

Gold mining universe:

• Pure Play Exploration
o Need to calculate the value per ton.
o Look at where it is: underground or open pit.
o What is the size of the deposit?
• Initial Production with Exploration Upside
o Market has not been able to handicap where this stock could go
• Full Production
• Other gold catalysts: price goes up, M&A, turnaround
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Investment Ideas:
Oceanagold Corp ((Toronto: OGC.TO):
CAD 2.33
• Nobody has heard of it but it is a
large producer
• Located in New Zealand
• $565M market cap
• They had a hedge book
o Didn’t allow investors to
get the upside
o Raised money and paid
off the hedge book
• This is a new company now
o Now they are levered to the price of gold
• Steady state production: 200-300 thousand ounces per year
• 8 million ounces in reserves
• Kinross just paid $700 per ounce in the ground
o That price would make this stock worth $5 billion
• Gold Price= $1100; Production Cost =$500 => they make at least $500/oz

Avion Gold Corp. (AVGCF.PK): $.53

• They had some bad news in Q1
• Own 20% of the company
• Will produce 85,000 ounces this
• Say they will produce 200,000
ounces by 2012
• Multiply $500 profit per ounce and
by 2012 and they have $100
million in cash flow by then
• Compared to the market cap: “I’ll
take it”

East Asia Minerals (OTC: EAIAF.PK): $7.25

• Indonesian company
• Pure play exploration
• Miwah Mine looks incredibly
compelling based on drill results
• Have announced some serious
high grade gold findings
• Eric can imagine that this is one of
the largest finds in recent memory
o He thinks there could be
2M oz in deposits
o Multiply that by whatever
price in the ground and
you get a huge value compared to the market cap

Question: Gold mining stocks are leveraged to the price of gold. Margins go up as price goes up. So, is it
better to buy a GDX and GDXJ versus the individual companies?

The ETFs are not a bad way to play it since he thinks gold is going to go up. He wants to buy a stock at two
times two year out cash flow. When the price of gold went from $850 to $1150 he ended up paying .85
times 2 year out CF. These are some of the most profitable companies in the world with gold prices this
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Question: Drill results can be misleading. Has that happened to Sprott?

Yes, it has happened to him many times. You have to be very careful and you have to be a student of the
science of geology. You buy in and as results come in you dig deeper to make sure that the results confirm
your beliefs. Some of the companies they have bought have failed. But, when they think a company has
something legitimate, they really go after it.

Question: Comment on some shorts and Canadian currency. How likely is a mining tax in Canada?

Australia is leading the way so he thinks there is a good chance of a tax on mining companies. He thinks
that the prices of the metals will go up and investors will be winners regardless of the tax. In the Great
Depression all people bought were gold and gold stocks. When it comes to the Canadian dollar, the fiscal
situation is not as clean as you would think.

He is short the financials and consumer discretionary. Negative things can happen in a big hurry. European
events are like a meteorite that has come in and now it looks like a black swan. But these countries should
not have been able to get away with their profligate ways as long as they did.

He had to buy back some shorts when the rally looked like it had some steam. He loves the hedge funds
because they have a defensive and an offensive team. As long as the longs are doing better than the shorts
then you can sit with your shorts. Their precious metals longs are continuing to perform.

Question (by Marcelo Lima): With East Pure Minerals, does it make sense to send someone there? Did
they do a management check?

Lots of people go and visit things and can’t tell a damn thing. Going to the property doesn’t do much. He
has been to 4-5 gold properties in his life and they all went broke. So, he is never going to do it again.

You have to research the management. All of the people who run East Asia had very high level positions at
major mining companies.

Question: Can you talk about Sprott Resources Corp (TSE: SCP)

It is a public company that invests in hard assets and has done very well over time. He has nothing to say
especially on Orion Oil and Gas, which is owned by SCP.

Question: Banks are not lending so companies are going to the debt markets to get financing. Is he seeing
high quality debt out there?

He owns things that make him queasy because he thinks we are in a bear market. He needs to find high
quality companies that people think are low quality companies. By the time people think they are high
quality Eric is usually out. Right now his portfolio is 70% precious metals and 20% energy but he doesn’t
feel uncomfortable.

Question: Given his macro view does he forecast gold prices?

No, they don’t have a specific forecasting method to get to a specific price. They use some technical
services. They predict that gold eventually goes parabolic, but that is not definable. Tell me how much you
print and I will tell you how high the price goes.

Question: Will you talk about the Sprott Physical Gold Trust (PHYS) ETF?

Units can be redeemed for gold. The capital gains rate is 18% versus 28% for GLD. The gold is held by the
Canadian mint in Canada. He knows they have the gold in there but he doesn’t know if GLD and SLV have
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the actual gold and silver.

Speaker # 2: David Nierenberg of the D3 Family Funds

“Finding Growth and Operating Leverage While the US Stagnates”

• Strategy:
o A concentrated portfolio of undervalued microcap growth companies
 They work with companies proactively
o They try to create durability of the model
 No leverage at the portfolio level
 Stay close to the companies
 Have 300 investors they know
 Develop “insight information”
 Practice constructive engagement
• If they do well you are not going to hear about it in the public
• They prefer to be partners
o Unless they get lied to or tricked they don’t go public and
become an “activist”
o Investment Criteria
 Like industry leaders, excess cash, and very little leverage
 100 yr flood seems to come every 2 years so they want to feel good in the
foxhole with the management team
 Take 5-20% stakes in companies with average market caps of $400M
 Like a free growth option
• When companies are distressed people don’t think about growth
• They think about survival so they can get a free option on growth

• Free Growth Ride: Emerging Markets

o For the rest of our lives, the companies located in emerging markets are likely to grow at
a multiple of US growth
o If they US only grows 2.5%, the emerging markets grow at 5% and their currencies
appreciate grow 1%, then over 40 yrs you get two extra doubles during that period
o Things to worry about:
 Rule of law
 Corporate governance
 Financial reporting
 Liquidity
 Access to insiders
 Shareholder friendliness
o Company’s involvement in emerging markets:

Investment Ideas:
RadiSys Corporation (RSYS): $9.03
• Embedded computing company
• OEMs don’t put their own computers in
machines anymore
o They buy from other companies
• Have 2 next generation products
o ATCA and Media server products.
o These are the future of the
• Sold in to defense, media and telecom
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• Growth divers:
o Internet video and outsourcing for embedded computing
• Total market could triple from 2009 to 2013
• OEMs are migrating from captive manufacturing to the use of 3rd party merchants
• 60% market share in media server, 40% market share in ATCA
o They are the market leader in these two and seem to be growing
• 3 smart acquisitions to date
o He thinks they paid good prices
• Balance Sheet
o Does have some convertible debt that would convert at $13
o In any event (with or without the diluted from conversion) cash per share ranges from $3.5 to
$4.70 per share in net cash
o Have balance sheet strength to buy more assets
• Revenues are down over 2009, margins are low, and have some customer concentration
o He thinks all three problems are going away
• Not many people looking at what is going on here
o Very little brilliant analysis in any case
• Will benefit from the migration from the legacy products to the next generation products
o Average gross margins for next generation are almost twice as high
o The company has stated that by the end of the year the majority of revenue will be coming
from the new products
• The company expects to reach 100% outsourcing, mainly in low wage locals, by the end of the year
• None of the potential growth is included in their models
• There is a valuation anomaly
o Thinks the mix shift and outsourcing leads to a P/E to growth ratio that is attractive

Natus Medical (BABY): $16.00

• Has been involved for 21
years in this company
• Offer newborn hearing
screening services
• Carlo Cannel owns this is as
o They love the CEO
Jim Hawkins
o The CEO is a
shrewd seller and as
the market cap
increases he thinks
that a bigger player
would like to own this company
• Have neurological screening applications that should be a growth driver
• New legislation placed a tax on medical device companies
• BABY has 8 analysts following the stock
• Has become an acquisition machine
o But has good integration history
o No one wants to include these in their models or predictions
o The company will make more accretive acquisitions going forward
o Most acquisitions are horizontal, integrated fast, and where they bring gross margins up to
60% very quickly
o Looking to build a 4th leg of the business though more acquisitions
• In the last quarter, international revenues were 43% and the goal is to get to 50%
• They are an industry leader and are gaining pricing power
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• Nice EBIDTA margin that should continue to grow

• Newborn hearing screening
o US is fully penetrated: only grows with US births
o Except to get to 80% penetration in other developed nations (at 35% now)
o There is a lot of room to grow in emerging markets
 Penetration will occur and with lower price products (in emerging markets) but due
to potential high volume they expect to be very profitable
• Think organic growth could be 10% per year
• There is a big opportunity for niche growth in neurology
• He is looking at earnings $.65 this year and then run to $1.75 to $2 eventually
• PEG ratio is only about .5 right now, even though it is trading at about 23x non-GAAP EPS

Strategy: Try to hit the long ball

• Looking abroad
• Willing to consider improved sources of profitability that the street neglects due to uncertain
• Looking for constructive engagement opportunities with management

Question: Can you give us an idea about BABY’s return on acquisitions?

Almost all are immediately accretive. They have been able to merge sales forces and to relocate
manufacturing to lower cost venues. The CEO has tremendous discipline and only pays 1-1.25x revenues.
He will not pay up for companies. These companies often reach the limits of their capabilities and the
family owners often need a partner to go further. BABY often sees a 30% revenue bump after the acquired
companies get to use BABY’s distribution infrastructure.

Question: Can competitors to RadiSys erode their margins?

The main competitor is a division of Emerson Electric. But, he believes that they have been struggling. This
is a high growth business and they believe Emerson is losing share. Other competitors only focus on the
boards and blades as opposed to the entire system. RSYS provides small, best of breed niche products.
They feel very good about RadiSys’s position in the industry competitively. All Oregon manufacturing has
been moved to China and Malaysia. They anticipated margin pressure so they moved manufacturing
offshore to save on costs.

Speaker #3: Tom Russo of Gardner, Russo and Gardner

“Case Studies in Global Value Investing: Nestle, Pernod Ricard, SABMiller”

International Strategy:
Today is about as good a day to talk about this subject as ever. Global investing may not look good at first
glance since currencies are in flux and there is turmoil abroad. But there are new parts of the world that are
opening up to global companies. With all of the uncertainty in the headlines, it sounds like a good time to
be value investors: when there is blood in the street.

Charlie and Warren are internationally minded even though they claim they have enough to look at in the
US. You can’t forget about POSCO, PetroChina and BYD as great investments. Poor Charlie’s Almanac is
now in Chinese and may be a big hit there. The Burlington North Santa Fe deal also has an international

He likes family controlled companies that have discipline and patience. Brands and balance sheet are
important. These companies that have been in countries for years but now the markers are opening up
more, these incumbents are entrenched and entrants may not be able to take away share. There is a long
runway until profitability so you need a patient management team when going into new countries.

He started to invest in international stocks in the 1980s. The question was always, but what about the
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accounting? Nestle was a good example as they only provided minimum disclosure. The answer now is, as
compared to what? The American system has not been much better. There has been plenty of fraud and
manipulation under GAAP. But what about the currency (they have unhedged currency exposure and it has
actually helped on average)? The US has had a strong currency but it is not guaranteed.

In 2008, he upped the ante when it came to international investing. Emerging market stock markets got
killed and great international companies lost a lot of their market values. Most businesses that were focused
on international markets got killed. But the domestic companies in the US have fewer places to invest cash
flows because they only stayed within the US border. So, he sold domestic shares and bought international
stocks because they went down more than the domestic stocks despite the better growth prospects. The fear
was that if America stalled out then China and the other emerging markets would crash too. So, the stocks
with exposure to emerging markets sold off tremendously.

Consumer products companies need to have a full product tier --good, better, best-- to compete in emerging
markets. High features can lead to better profits. But the important thing is the size of the runway in a
country like China in something like the diapers market.

Russo learned a lesson from the management team at Richemont (CFR.VX). He learned that you should
invest cash flow into just the markets that you think are the most attractive. Accordingly, he decided to
divert money away from Japan (which is losing population) to China. When Richemont went into Russia
they had the option to go with a local agent. But, they wanted to build the business to last so they did not
take it. They paid a lot more and understood that those fixed costs might not be recouped for many years.
But, since it is family controlled and since they don’t worry about quarterly earnings they were able to take
the long term view.

This is a good times to make investment abroad. Good time to be an international investor

Investment Ideas:
Nestle (VTX: NESN.VX): CHF 50.40
• Very future oriented
o New product development and
emerging market focused
• Focused on getting it right and getting
it market slowly
o Kraft rushed a product that
was similar that turned out to
be very flawed and not
• What these companies are playing for
is rising GDP in emerging markets
o Consumers will pay more for prepared products.
 Then they move to branded products and then finally luxury.
 This is the progression they are investing to benefit from
 This is the exact opposite of what is happening in the US and Western Europe

Pernod Ricard (Paris: RI.PA): €59.65

• Strong positions in China and India
• 15 leading global brands
• They expand the spirits they serve
through acquisitions
o Absolut was an example
• People were worried that the
company would not be able to
finance the $5B acquisition-related debt
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• CDS went up and people started shorting the stock

• Tom doesn’t look at the balance that much usually
o But in this case it became important
o He is usually more earnings-focused
o They old Wild Turkey and did a $2 billion rights offering
 This broke the back of the CDS threat
• When they got to China, they doubled the price of Absolut
o Thought that the consumer would not respect the brand unless the price hurt them in the
 They lost 50% of share but now can build the brand

SABMiller ((LSE: SAB.L): 1,873.00 GBp

• Strategy example:
o Colombia: Had very little control over
the retail pricing and they decided to
try to get involved in pricing
o This led the pricing to actually go
down to a point that the product was
affordable to consumers
o Russo saw then that this was a smart,
savvy management team
 They allowed to let their margins drop in order to invest for the future

Question: Does he look at pure domestic emerging market plays?

He stays with global companies for a reason. They have the ability to move capital around to where the
returns are likely to be the best. China will eventually get to a point in which the returns on capital decline
and these global companies can move capital to the next base place. He likes management teams that
learned in non-US markets because he thinks they are more savvy when it comes to international

Question: When it comes to Nestle, how do you think of valuation? What is the organic growth rate?

The growth rate should be mid to high single digits. Net income/share should do better over time since they
are buying back so many shares. When he first went there in 1987, the company was not even allowed to
buy back stock. Shares are probably a little bit undervalued, not terrible so. The next thing to watch is to
how they deploy all their capital. He is willing to wait it out because he likes the proper orientation and
duration of the company. He thinks it is bond-like at the center but has the ability to invest in venture
capital-like opportunities in emerging markets.

Question: Why does he not favor Heineken over SABMiller?

At one level, the competition is getting less collegial. They are very different at the moment. SABMiller is
less leveraged and has a better emerging market portfolio. Heineken has better opportunities in Western
Europe and the developed world. As the euro goes down, it is actually good for these companies and they
can become more competitive.

Question: How good is SABMiller in the US?

The moves that Heineken made in the UK were based on what SAB had done in the US. SAB partnered
with Coors in the US. They are looking for massive cost reduction opportunities. He thinks that prices in
the US may go up due to cooperative behavior between companies.

Speaker #4: Lei Zhang of Hillhouse Capital Management

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He runs the largest hedge fund in China. He started with $30M and now he is running $3.8 billion (after
52% compounded returns for 5 years).

Investing in the Middle Kingdom: The Hillhouse Way

• Run a concentrated portfolio
• Never use leverage
• Focus on bottoms up research
• Global industry research
o Consumer businesses focus
• Focus only on where they can lose money in the form of a permanent capital loss
o Since they have locked up capital they don’t care about short term volatility
o Long term orientation
• They short for fraud
o In places like China there is always fraud
 Can even be large companies)
 They even look 18 months out for the investment to pay off
• Focus on the people and organization behind the business
• Only look at areas that they have an edge
o Factors that they can understand, appreciate, monitor and to some extent influence and
add value
• Look for ethical long term managers
• Always ask: how do managers re-invest free cash flow?
• They have 15 people who maybe find 3-4 good ideas per year
o Cross coverage: 3 people at least cover each company
• Analyze global franchises to see how they evolved
o Then, try to translate that to China
• Look at commodities carefully
o Within the context of Chinese demand
• Try to connect the dots to put together the Chinese supply and demand curve
• Reconcile what they see on the ground in terms of trends in China with the valuations of specific
stocks that are impacted by not necessarily obvious events going on in China
• Believe that the consumer environment in China is similar to that of the US in the 1950s and
o Looking for a Chinese baby boom
• Younger Chinese people are more optimistic
o They are becoming mainstream consumers

Common Mistakes in Investing in China

• Short term orientation
• Over-excited by short term growth
• Parachute investing
• Investing based on Wall Street Journal headlines
• Casual/intuitive investors and herd behavior
• Believing that relationships are over-rated
• Losing sight of optionality
o Hypothesis and monitoring
 They have a very high hurdle to invest in small caps
 There are 400 companies in China with valuations more than $1 billion
 Does not like small caps because you lose the optionality.
• The best days for growth are gone for China and the economy is going
to be much more cyclical
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• The transition from export-based to consumption-based will be bumpy.

• Forgetting to focus on total dollar return on invested time
o Wants to make a lot of money and over the long run so he doesn’t have to sell after
modest appreciation
• Making concentrated bets and fall in love with them
• Performing well and then become overly conservative

Investment Idea:
Changyu Wine Company Ltd. (Shenzhen:
• Usually wineries are the worst liquor
businesses in the world
o Very fragmented and people
don’t care about returns
• Investment thesis:
o High growth industry: people
are becoming more health
conscious and have stopped
drinking the unhealthy alcohols.
o As income goes up, people start
to look for more upscale
alternative alcohols
o Alignment between shareholders and management-
 Management receives 5% over a certain profit amount
• The B shares are available to foreign investors
o Are trading at a 15% discount to the A shares even though they have the same voting rights
and rights to dividends
• Easy to build brand equity right now
o China has the lightest liquor regulations in the world.
 No licenses or age requirements.
 No additional taxes.
 Brand companies can own distribution.
o There is an advantage to going with the #1 guy.
 Whoever is the first mover and gets monopoly power will be the de facto winner as
regulations get tighter and more restrictive.

Question: Local versus international companies? Who has the advantage?

It depends on the company. P&G is great in China and Unilever is terrible. Sometimes the local companies
have an advantage. In any case they have to learn and evolve to compete. They need to invest in the future
and create brand equity.

Question: What is the competition like in the money management business in China?

There are going to be a lot of smart people in China in the future. Right now they are all small. The
problem is the lack of stable, long term capital. China investors are China centric. This handicaps people
because the truth is that no country is unique. There is always something that you can learn from the
experiences of other countries.

The competition in the money management business is going to catch up. His returns are not going to
continue like they were. But, everyone has a strong tail win. Inefficiency in such a large scare attracts him.
In the long run it is going to get more efficient.

Question: What does he think of Japan?

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He visits Japan a lot. He spends a lot of time abroad. Japan has a great products portfolio. The Japanese just
don’t believe the China story. He thinks that over time they will believe the story. The problems between
the countries are still there but modern consumers won’t care too much. It really depends on the execution
of the specific companies.

Question: What is your approach towards shorting?

Only engage in plain vanilla stock shorting. They do not use options or futures. 200 of the 350 Chinese
companies listed in the US are frauds or there is something wrong with the model. There are great
companies as well. For him, fraud is the #1 short. Shorting is not a large part of their business butt they find
opportunities when they are doing long research. People tend to get too optimistic and then he gets great
opportunities to short stocks.

Question: Is there a Chinese housing bubble?

There are some unsustainable housing prices in the coastal areas. However, nationwide it is not a problem.
Only in the top 10 cities is there a problem. There really is no leverage in the system. Consumers have 43
trillion Yuan in deposits. Consumer net debt is only 9 trillion Yuan. The entire consumer debt as a
percentage of GDP is only 16% versus 120% in the US.

Question: What does he think of investing in the Chinese currency?

If you can go long the Yuan then do it. But he doesn’t think there is going to be a one-off re-valuation. He
said it will likely be gradual. He believes that China is blessed to have the government managing the
currency so well.

Question: What does he think of BYD (a Buffett and Munger favorite)?

He does not understand the valuation or the technology. There are over 100 car makers in china so it is a
very competitive environment. He likes the company and thinks that Wang Changfu is very smart and a
nice guy. There was a demand shock upward for cars that people did not expect that during the financial
crisis. Accordingly, he worries about the potential for overcapacity later. This is not their expertise. They
would rather invest in consumer businesses and commodities.

Speakers # 5: Whitney Tilson and Glenn Tongue of T2 Partners

Macroeconomic perspective:
One of the lessons learned is that you can be a good bottoms up investors but if the world goes to hell then
intrinsic values gets killed because cash flows get killed. Thus, investor should have some idea of what the
macro environment looks like and look for black swans. You should figure out if you are swimming
upstream or downstream.

Are we poised for a great stock market run? In order to determine, that one can look back to see what the
environment was like when the market took off previously. What were the conditions then? The metric they
prefer is the Schiller Price to Earnings Ratio. The long term average multiple is 16.3x versus 20.4x today.
In the early 1980s when the bull market started this PE ratio got down between 9x and 10x. When you
could get 15% on bonds it made sense not to be in stocks. But as rates dropped for the next few decades
stocks took off. They believe that the change in the stock market had mostly to do with changing interest
rates. Corporate earnings grew at only about 3% for year. So the truth is that it was the dropping interest
rates that led to the stock bull market. Interest rates now have nowhere to go but up. Thinks we are going to
be in a range bound market for at least 5 years as we adjust to the bursting of the largest asset bubble ever.
Stocks are richly valued. There is a strong correlation between multiples and interest rates. If the stock
market is priced for the best outcome, then you should be cautious and play defense. They are now buying
large cap blue chips that are cheap and letting their short book get really big.

Corporate profits could be hampered by:

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Pro labor administration

Higher taxes going forward

Housing Market:
• 2/3rds of homes have mortgages
o 35% held on the balance sheets of banks and thrifts
o 15% that were securitized
o 90% originated or guaranteed by the US government (Fannie, Freddie FHA)
• Prices are down a lot from the peak
o Housing is more affordable due to low interest rates and depressed prices but a lot of
people are under water, a circumstance that leads to foreclosures
• US government involvement in housing
• 2 US taxpayer credits expired on Friday
o US stimulation of demand is going to be very costly
o Fed bought over $1 trillion in MBS
o Fannie, Freddie, FHA were given the mandate to lend to anyone and everyone
o Limited supply by insisting on mortgage modifications
• There are many more homes than those listed for sale are on the market
 Foreclosures and shadow inventory
• 91% estimate of the people who are not paying their mortgages will not get back to current
• Foreclosure moratoriums (but explicit and implicit) have led to $100-$150 billion a year for free
accommodations for people
o This has helped consumer spending and may be a big reason why consumer spending is
o People usually spend 25% of their income on rent
• Why is OREO down?
o Banks have slowed down the foreclosure process.
o Banks have been modifying everyone and not taking properties onto their books.
o They have been using the government stimulus package and low rates to get these homes
off of their books
o Of homeowners that have not paid in a full year, 24% have not been foreclosed upon
o Some permanent modifications are sticking but many are being canceled
o Most modifications will fail
 Especially if you only cut the interest payments and not principal
 Turns out that even when you modify payments, re-default rate is over 50% for
people who got a 50% cut in interest expense
• American homeowners are walking away because the value of the properties have fallen below the
debt burden
• Unemployment rate is not a really driver for defaults with people with equity
o But default rates are much higher when people have negative equity, especially if
unemployment is high
o One half of 1st lien mortgages in California from 2006 have defaulted
 This follows directly the rise in negative equity
• Modifications are failing and house prices that had been increasing have no started to turn down
again month on month
o Some of this is seasonal
o Prices may stabilize here but if interest rates go up or the people who are not paying the
mortgages get foreclosed on then prices could drop more
o A further 10% drop in house prices leads to a 56% increase in the number of homes under
 That could lead to millions of foreclosures and cause a vicious cycle
• 2nd liens are still a problem
o The big 4 banks have not written down their 2nd liens
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 14% of first liens have defaulted and only 3-4% 2nd liens have defaulted
 People are paying 2nd liens instead of the 1st liens even though the banks cant
foreclose on them for not paying the 2nd liens.
 Banks have not written down their 2nd liens and if they had to it could wipe out
all of their equity
Commercial real estate
Nothing is happening with most loans that are coming due. They are not being foreclosed upon and they are
not refinancing. This is an extend and pretend policy. They do not see this being a calamity because banks
will be able to extend these losses over many years.

Short the homebuilders:

There is still a lot of debt and a lot of inventory but the stocks are trading at a 60% premium to book.
Constricted supply and stimulated demand are boosting the home builders but that should be short lived.

Investment Idea:
Anheuser Busch Imbev (BUD):
• Looks interesting again after they
owned Budweiser before the
• 4 questions they ask about any
o Is it a business they
understand? Yes
o Is it a good
business? Yes
o Are they shareholder friendly? Yes
o Is it cheap? Yes-- 8.5x FCF 2 yrs out
• Beer is a high quality business: stable and profitable
• Enormous moat and huge economies of scale
• Beer is a timeless product
• 44.7% EBITDA margins
o These are remarkable
• Have shown the ability to come into a market and dominate
o Are #1 in 7 of the top 10 markets they are in
o They want to grow through acquisitions but focus on integration
o They come in, cut costs, grow sales, and boost EBITDA margins significantly
 Looking to implement the same strategy with Anhueser Busch
• People thought they were taking on too much debt with the deal
o Have de-levered the company and then re-financed all their acquisition debt
o Might be able to take out that debt through cash flow
• Scale is incredibly important
• Other opportunities:
o They might like to buy the remainder of Modelo
 There could be some synergies there
o Bud has been launching successful new products
o Other acquisitions to be done
 There may be an opportunity in China
• Why is it cheap?
o Do not consolidate Modelo
 Have to add that back from a cash flow basis
o People are not aware of their story of growth and amazing margin expansion
o Leverage was high but has come down
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

 They think that by 2012 the worst case scenario is 2x leverage

o Market is ignoring synergy opportunities.
 25% Anheuser Busch EBITDA margins could get bumped up to 35% where the
rest of the company’s margins are
o Future free cash flow estimate translate to 8.5x FCF
o Even right now they think it is trading at about 10x FCF

Question: Where do people live when they walk away from their homes? If renting and buying are the
same price, are people less likely to walk away?

There is no housing shortage based on the ultra low interest rates. People can move right across the street
and rent or maybe even own another house. This does not make any sense. The best way to get people out
is through negotiated short sales. If the foreclosure occurs instead, then it can cause other foreclosures as
the contagion spreads. Banks are looking to push off write downs on 2nd liens as long as possible. The
government could give banks years to write down 2nd liens but something has to be done. Re-negotiations
that lead to people be re-equitized are probably the best options. Banks made bad loans and they should pay
the consequences. Housing prices are a lot lower so there is not that much more room to go down. He
didn’t anticipate that the US government would throw so much money at the problem to stabilize the
housing market. Now, he doesn’t think the government will allow prices to fall another 20%. Thinks the
taxpayer will have to subsidize this market.

Question: Is most of the margin gain for BUD due to cost reductions or price increases?

The majority of their margin expansion has been through cost cutting. When you have huge market share it
doesn’t hurt because you have some pricing power.

Question: Why are the homebuilder stocks up?

They probably got too cheap. Also their competition--foreclosures and short sales-- were basically taken off
the market. The government is offering zero money down loans with low interest rates to subprime buyers.
So .potential homeowners are rationally taking advantage. The management teams of the homebuilders are
being very promotional, a fact that has helped boost stock prices. In fact, they have all called the bottom of
the housing market on their conference calls.