Value investing congress notes

Value Investing Congress
October 19th and 20th, 2009
Marriott Marquis, Times Square
Notes by Nick Rugoff
nicholas.rugoff@yale.edu

-Bill Ackman Pershing Square, L.P. : Prisons’ Dilemma (pg. 3)

-Alexander Roepers Atlantic Investment Management: Atlantic’s Approach to Value
Investing (pg. 24)

-Julian Robertson: Q&A (pg. 35)

-Sean Dobson Amherst Securities: “Fishing in a Poisoned Pond” – Analytic Methods
for Distressed RMBS Investing (pg. 40)

-Lloyd Khaner Khaner Capital: Management, Management, Management – The Key
to Turnarounds (pg. 57)

-David Einhorn Greenlight Capital: Liquor Before Beer, In the Clear (pg. 65)

-Eric Sprott Sprott Asset Management: The Financial Crisis Isn’t Over (pg. 71)

-Zeke Ashton Centaur Capital Partners: Stocks the Rally Left Behind (pg. 84)

-Jason A. Stock & William C. Waller M3 Funds: Banks & Thrifts: Opportunities in a
Troubled Sector (pg. 95)

-Whitney Tilson & Glenn Tongue T2 Partners: More Mortgage Meltdown & A Stock
Idea (pg. 105)

-Kian Ghazi Hawkshaw Capital Management: Kicking the Tires (pg. 137)

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-David Nierenberg The D3 Family Funds: D3 War Stories: Practical Lessons About
Building and Protecting Shareholder Value by Improving Corporate Governance
(pg. 154)

Candace King Weir & Amerlia F. Weir Paradigm Capital Management – Bottom-up
Stock Picking: Back in Fashion? (pg. 163)

-Paul Isaac Cadogan Management: Investing as a Pari-Mutuel Proposition (pg. 167)

-Joel Greenblatt Gotham Capital: Formula Investing with a Value Mindset (pg. 171)

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Bill Ackman Pershing Square, L.P. : Prisons’ Dilemma

Bill Ackman is is the Managing Member and General Partner of Pershing Square, L.P. Prior to
forming Pershing Square, he cofounded Gotham Partners, L.P. in 1993, a public and private
equity investment partnership. Mr. Ackman earned an MBA from the Harvard Business School.

Corrections Corporation of America:

Ticket: CXW
Stock price: $24.50

-Corrections Corp owns and operates private prisons
-Owns the land and buildings at most of its facilities
-Largest private prison company
-Fifth largest prison manager behind California,

Capitalization:
-Enterprise value: $4.1 billion
-Equity market value: $2.9 billion

Recent valuation multiples:
-2009 e Cap rate: 12.2%
-2009 P/Free Cash Flow Per Share: 13.3x

CXW operates its business in two segments:

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Strong national footprint:

Tenants are unlikely to default as the consequences of default  let your prisoners lose

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CXW is the clear leader in privatized prisons, controlling approximately 46% of the
private prison and jail beds in the US:

CXW addresses a total U.S. market that exceeds $65 billion, of which only
approximately 8% is outsourced. Privatized beds have grown from nearly 11,000 in 1990
to over 185,000 today (17% CAGR).

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Public-sector correctional systems are currently operating at, or in excess of, design
capacity:
-19 states were operating at 100% or more of their highest capacity measure (29 states
were operating at 100% or more of their lowest capacity measure)
-In total, state prisons were operating at 96% of their highest capacity measure and 113%
of their lowest capacity measure
-The Federal prison system was at 137% of capacity

California prisons are running at 170% of designed capacity:

Competitive advantage in state vs. private:
-CXW has historically outperformed the public sector in safety and security

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-As a private company, CXW has cost and efficiency advantages compared with its
largest competitor (the US government):

Increasing market penetration:
-Because of constraints in new public prison construction, private prison operators were
able to capture 49% of the incremental growth in U.S. inmate populations in 2007

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-Historically, inmate populations in the U.S. have grown regardless of economic factors:

Prison populations are expected to rise:

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Federal demand drives growth:
-Federal demand alone could fill CXW’s approximately 12,000 bed inventory over the
coming years
- The Federal Bureau of Prisons (“BOP”) is currently operating at 137% of rated
capacity, with a stated desire to operate closer to 115%
- The BOP projects that between 2008 and 2011 its population will grow by ~19,000
inmates, with just over 12,000 new beds planned for development by 2012
-The United States Marshals Service (“USMS”) has a population of about 60,000-65,000
and has grown 8%-10% per annum over the last five years
-Since 1994, Immigration and Customs Enforcement (“ICE”) detainee populations
have grown by over 300% to ~35,000

State demand drives growth:
- State prison populations are projected to increase by more than 90,000 over the next
three years. If CXW can capture ~13% of this demand, it could achieve 100% occupancy
- “Of the 19 state customers that CCA does business with, we are currently estimating
that those states will have an incremental growth that will be twice as much as their
funded plan capacity by 2013.”
– Damon Hininger, CEO, Q1 Earnings Call

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Supply / Demand Imbalance Drives Growth:
- If private prisons can capture just 25% of the incremental growth in the U.S. inmate
population, CXW should achieve >98% occupancy in its Owned
& Managed business by 2012. Private prison operators captured 49% of the growth in
2007 as state budget pressures have postponed new prison construction

Near-Term Catalysts: Post-Recession Growth:
-Inmate populations have historically grown at an accelerated rate after recessions
-Of 300,000 prisoners released from 15 states in 1994, 67.5% were rearrested for a new
offense within three years

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Near-Term Catalysts: Increased Occupancy Drives EBITDA:
- At current margins, CXW management estimates its inventory of existing beds could
generate an additional ~$100mm of EBITDA
-Available bed inventory increases likelihood of winning contracts and provides pricing
leverage

Near-Term Catalysts: Operating Leverage
- Management derives its ~$100mm estimate by applying CXW’s Q2’09 margin to the
lease-up of its existing inventory; however, approximately 84% of the costs in CXW’s
Owned & Managed Facilities segment are fixed

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Near-Term Catalysts: Stock Buyback
-CXW’s repurchase of 10.7 million shares in Q4 ’08 – Q2 ’09 (~8.5% of total shares)
provides a tailwind for NTM free cash flow per share growth

Strong Free Cash Flow Generation:
-Because prisons are made of concrete and steel, depreciation expense meaningfully
exceeds maintenance capex. As a result, CXW’s free cash flow per share is substantially
greater than earnings per share

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Strong Balance Sheet:
As of Q2’09, CXW’s interest coverage ratio was 5.4x. Its next debt maturity is not until
2012. Its cash interest expense is less than 6%, and more than 80% of its debt is fixed rate

High Returns on Capital:

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Culture of Equity Ownership:

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Historical stock chart:

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Opportunity for multiple expansion:
CXW’s earning quality has improved since 2007 as its owned and management
segment now accounts for more than 90% of Facility EBIDTA

Key attributes:

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Health care REITs are the best comparison:

Sum-of-the-parts valuation:
-CXW is composed of two businesses: an operating company (“OpCo”) and a real estate
company (“PropCo”)

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An OpCo/PropCo analysis suggest the stock could be worth between $40 and $54 per
share

CXW used to be a REIT:
-From 1997 through 1999, CXW operated as two separate companies: CCA Prison
Realty Trust (a REIT), and Old CCA (the operating company)
CCA Prison Realty Trust was a huge success
-IPO’d in July 2007 at $21 per share and immediately traded up to $29
- Upon its formation, CCA Prison Realty Trust purchased 9 correctional facilities
from Old CCA for $308mm. It then leased the facilities to Old CCA pursuant to long-
term, noncancellable triple-net leases with built-in rent escalators
- Within five months of its IPO, CCA Prison Realty Trust used the remaining
proceeds from its IPO and its revolver to purchase three additional facilities from Old
CCA
 By December-97, CCA Prison Realty Trust’s stock had moved up to the $40s,
trading at a ~5% cap rate and a ~4% dividend yield

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-On January 1, 1999, Old CCA and CCA Prison Realty Trust merged to form an even
larger REIT, “New Prison Realty.” In order for New Prison Realty to qualify as a REIT,
it had to spin off its management business (“OpCo”)
 New Prison Realty was not a Success
-New Prison Realty saddled itself with debt to fund new prison builds
-Before the new prisons had been completed and could generate revenue, OpCo’s
operating fundamentals began to decline and occupancy fell
-OpCo struggled to maintain profitability and rental payments to New Prison Realty
soon had to be deferred
-As a result, New Prison Realty’s stock price declined precipitously, limiting its ability to
raise liquidity. This was further exacerbated by a shareholder lawsuit stemming from
the fall in the stock price
-By the Summer of 2000, CXW was on the verge of default and had to raise dilutive
capital to restructure and avoid bankruptcy

Why Did New Prison Realty Fail?
 New Prison Realty did not fail because it was a REIT, it failed because:
-It had too much leverage
-It had an overly aggressive development plan
-Its tenant, OpCo, was also over-leveraged

- CXW has not been a large taxpayer for the last eight years because
of substantial NOLs that are now exhausted

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-Since 2000, CXW has increasingly shifted away from a business
focused on the management of prisons toward a business focused
on the ownership of prisons

Management Gets It:

“The other thing I would point out is before we'd even sell stock, that there's a lot
of value in these assets. I hear people talking to me about regional malls selling
at six cap rates or parking garages selling at five cap rates or 20 times cash flow
and you think about -- or highways selling at 50 times cash flow, you think about
prisons as infrastructure or some type of real estate asset, I think these could be
even sold and harvested in some fashion to avoid selling stock in the future. So
there are a number of things that we could do to finance our growth, but just with
respect to cash flow and leverage, we could go quite a ways.”
– Irving Lingo, Former-CFO of Corrections Corp, Q2’06 Earnings Call

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Conclusions:

-Very shareholder-oriented management team

-Did very aggressive buyback at $10.61 in march

-Company is rated BB, but Ackman thinks it is definitely investment grade

-Very little competition

-Passive investment for Ackman (thinks board and management is incentivized in the
right way)

-Potential pair trade: short Realty Income

-Ackman owns 9.5% of the company

Q: Are you concerned about occupancy trends, because there does appear to be
decriminalization pressure for drug use from Washington?

A: 140% on average in Federal prisons, 170% in California. There is a lot of room and I
think the political backlash of letting people out early will keep prison populations high.
Just filling out the existing overcapacity fills out their available beds.

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Q: When you think about incentives and how that played into the mortgage mess, and
now you look at privatized prison, the state wants less people going to prison, whereas
the company wants people back in prison. Do you see any issues with these contracts
given the company’s incentive to keep people coming back to prison?

A: They do their best to rehabilitate prisoners and do the right thing, which is what wins
them contracts. They have higher quality of life than Federal prisons, and I think they
have their priorities in order.

Q: What keeps the government from saying that the ROC is too much and regulating
their ROC? What are leases like?

A: Leases are typically 3-5 years (called “management contracts”), with inflation-type
rates. They win these contracts and earn a high ROC due to their credibility, which
results in their large market share. Everyone wins in this scenario.

Q: What are barriers to entry?

A: It costs a lot of money to build a prison ($60-80,000 bed). It’s very hard to get
financing just to build one prison because just one asset is much riskier than a pool. The
biggest barrier is having the expertise and credibility, which makes it extremely hard for
new entrants. The management business, however, is extremely competitive.

Q: Is there a risk of political opposition?

A: Biggest risk is that people stop committing crimes, which is a low probability event.
There are more likely to be civil liberties groups suing prisons that are at overcapacity,
rather than private groups.

Q: What’s your current view on MBIA?

A: No longer short bond insurers, it takes too much psychological energy. MBIA is a bad
business, and it was allowed to leave all it’s bad risks at another company, which seems
very wrong. Bond insurance is a bad business and there are a lot of easier ways to make
money.

Q: David Einhorn told us that he’s moving into gold amidst long-term risks of a major
currency collapse. What are your thoughts on this?

A: I am not a fan of gold. I think gold is really just greater fool – you need to go around
convincing everyone else to buy it. I think the best way to protect against say, a devalued
dollar, is to own high quality businesses with pricing power. For example, we own
McDonald’s, which is now at a low multiple, and is generally, a currency-hedged,
inflation-protected stream of money. Also, Visa could be a good idea, as long as you’re
comfortable with the regulation risk.

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Alexander Roepers Atlantic Investment Management: Atlantic’s
Approach to Value Investing
Alexander Roepers is the Portfolio Manager of Atlantic Investment Management, Inc., which he
founded in 1988, a $4.2 billion global Registered Investment Advisor, with offices in New York
and Tokyo. Mr. Roepers is a graduate of Harvard Business School.

Roepers: 2,042% return in past 16 years, long only, no derivatives

Before 1988:
-Six years with Thyssen-Bornemisza Group and Dover Corporation, both multi-billion
dollar conglomerates
-Primarily active in corporate development, i.e. buying and selling of companies
-Learned a lot about valuing companies and due diligence, but came to dislike:
-Illiquidity, as it takes 9 to 12 months to sell to a private/controlled company
-Premiums of 30 to 50% when buying companies

Atlantic:
-Founded in 1988 in New York

-Premise: deploy highly concentrated, value investment strategy in the public equity
markets to get liquidity and eliminate need to pay premiums

-Today: AUM $1.5 billion, offices in New York and Tokyo

-Single strategy firm offering 5 funds: long/short U.S.; long/short Europe/Japan; long-
only funds for the U.S., Europe and Japan

-Supported by 13 highly experienced equity analysts and 3 traders providing 24 hour
coverage. Non-investment functions managed by COO/CFO

Concentrated Investment:

-Simple concept:
-Define your universe and know your companies
-Do not use leverage
-Supposed one has 20 compelling value investment ideas
Continue due diligence to select 5 or 6 highest conviction names
--Concentrate capital on those as they should outperform the other 14 to 15 names

Focus on core competency:
-Deep knowledge and experience in universe should yield superior capital appreciation

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Rules of the road when concentrating investments:
-Universe definition is key
-Invest in transparent companies that can be understood and analyzed
-Don’t use leverage
-Only invest in companies with solid balance sheets

Track record:

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Stock Selection Process:
1. Investment Universe
2. Investment Criteria
3. Buy/Sell Discipline

1. Investment Universe:

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2. Investment criteria:

Investment-grade balance sheet
-Interest expense less than 25% of gross cashflows (EBITDA)

Avoid commodity pricing dependent firms

-Always profitable companies through economic cycles

-Avoid deep cyclical firms

Recurring and predictable revenues and cashflows

-Function of nature of business, diversity of customer, products and regions served

-Prefer consumable and maintenance/repair/overhaul (MRO) businesses over capital
spending-related businesses

Low insider ownership

-Need vulnerability to takeover bids

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3. Buy/Sell Discipline

-Likes to own between 2-7% of shares of the company (2% gives you top 10 status, with
which you can knock on the door), but do not want to become illiquid (over 7%) because
wants to be able to get out within 30 days without affecting price

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Constructive Shareholder Engagement:

Objectives:
-Create unique due diligence opportunities at the CEO/CFO level as well as the
operational level through constructive engagement
-Enhance and accelerate the process of shareholder value creation
-Maintain liquidity as well as ability to continue dialogue with top management
(ie avoid proxy battles and Board seats)

Process:
-Build strong rapport with CEO/CFO through multiple on-site and face-to-face
meetings
-Craft and discuss win-win proposals for management and shareholders, including
corporate development, corporate governance, operational restructurings and use of free
cash

-Submit these proposals in writing to CEO and, as needed, to the Board of
Directors

-As appropriate, broaden discussion of proposals to include other large
shareholders, financial media and private equity groups

-As needed, apply public pressure through press articles and regulatory/public
filings

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Case study: JM Smucker (SJM)

In Atlantic’s Investment Universe? Yes
Liquidity?  Yes

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Business description
• $4.6 billion leading producer of branded packaged foods

• Acquired Folgers from P&G in late 2008, doubling sales

• 75% of sales from products with #1 share positions

• 90% of sales from U.S. customers

Thesis
• Defensive business: Consumer staples; trend to more meals and coffee brewed at home

• Well positioned among food peers: Little exposure to food service customers; iconic
market leading brands

• Margins expanding: Falling commodity prices; realizing synergies from Folgers deal

• Strong cashflows: Rapid debt repayment; solid 2.5% dividend yield; room for M&A

• Reported EPS, understate cash EPS: $0.40 of non-cash amortization from Folgers deal

• Folgers acquisition: Greater power with distributors and retail trade; larger market cap
makes SJM a potential holding for more institutional investors

• Valuation multiple expansion: from current 8.9x EV/EBIT (on next year’s estimates) to
12x, which has occurred repeatedly over the past 15 years

• Low insider control: Vulnerable to unsolicited takeover attempts

Sales and earning have grown steadily both organically and through acquisitions:

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Despite recent share price recovery, valuation remains compelling:

-Has been part of Atlantic’s universe of investment candidates for over 15 years

-Visited their headquarters several times in past years, analyzed repeatedly, attended
company presentations, but did not invest until early 2009 when its valuation fell below
8x EV/EBIT

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Atlantic’s Other Observations:

-Up 30% this year, but strategy has been hard because real move has been in cyclical
recovery plays
Tremendous rally in commodities and banking as well, which hurt their shorts
-Current portfolio is trading at 8x EV/EBIT for 2010
-In 1999, tech bubble sucked all money away from value stocks
We see that again here with money running towards cyclical recovery plans and
forgetting other companies
-ACS (Affiliated Computer Services) in Dallas is an example of this
-$7 billion in sales
-Potential acquisition target
-Share price absolutely flat March – August
-ACS is growing earnings year after year, and 85% of next year’s sales are all
ready guaranteed
-6% top-line growth through recession

-In Japan, in Secom, home security company with 25% margins and 97% renewal rates
-Should be trading at 12-14x EBIT
-Only trading at 9x
-Down 5 times year to date

-Yamato Holdings (Japanese shipper) is highly attractive as well

In Europe, like UK company G4S
-Security force deployed around the world (hotels in India, nuclear labs, US-Mexico
boarder, embassies, etc)
-Very large, stable, growing business
-Trading at P/E of 11

Q: Is Smucker a takeover candidate?

A: It certainly could be. It’s not very controlled by insiders, but there is a long history and
the Smucker family is still very involved. There is a lot of tradition, but there is nothing
stopping someone from giving a big cash bid.

Q: If the rally keeps going how will this affect your buy/sell discipline?

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A: We haven’t changed our buy/sell discipline in 20 years. Should the market decide to
value stocks like ours properly, as it does from time to some, we’ll sell into it and sit on
40% cash for a while. We’ll scale out and sell our positions once they cross our EBIT and
P/E/ levels and analyze other companies as we wait for the next big thing. We are not
market timers and we are not going to pay up and chase things. For example, in June we
got out of many names, some of them too early, but it’s not our job to hold companies at
these levels. We are extremely disciplined with our methods.

Q: What are your thoughts on Kraft?

A: Kraft is way too big for us to analyze. I think they would overpay for Cadbury by
quite a bit. Kraft is relatively inexpensive, but I imagine if they buy Cadbury at 14x
EBIT, there will be eventual earnings dilution.

Q: What is your criteria for shorts?

A: Short is 10-50% of gross exposure. 1 or 2% positions, no ETFs. Find names in the
space where we look for longs, and find those stocks with more leverage, fundamental
issues, etc. Especially now, there are many cyclical recovery plays that are overvalued.
Typical holding period – 2 weeks to 2 months. Want to stay a little more net contained
with high VIX.

Q: Do you have any thoughts on home security firms such as Brinks?

A: We’ve been in Brinks before. We might like it again, but it’s market cap is small, so it
could be illiquid for us. We want it to get a little cheaper, around $23 or $24.

Q: How concerned are you about private label competition for Smucker? How large are
the price gaps between the two? What do you think Smucker’s organic growth rate is?

A: Wal-mart and these other stores need Smucker brands to build traffic. Food scares
always push people towards branded products. These brands have been there for over 100
years, people rely on them and know the quality. Overall, this differs by region and
distributor, as do price differences.

The organic growth has been GDP +1 or 2%. In recessions, it quite often does better as
people change their behavior and eat at home more.

Q: What themes are you pursuing over the next 12-18 months?

A: We mainly focus on valuations. We could get into cyclical companies, but only if
these current valuations come way down. If you look at the 2000 tech bubble, people
hitting it now on cyclical recoveries will raise a lot of money, but by next March, 2010
economic data points should show that these 2011 expectations are too high.

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Julian Robertson – Q & A
Julian Robertson founded Tiger Management in 1980. Known as the “Wizard of Wall Street”, he
is credited with turning $8 million of start-up capital into over $23 billion by 1998. In 2000 the
fund returned its capital to investors, though Mr. Robertson retained Tiger for personal
investments. Today he is admired for his continued investing success, his seeding and mentoring
a large group of "Tiger Cub" hedge funds, which have also been remarkably successful, and his
philanthropic activities revolving around his three foundations, The Robertson Foundation, The
Tiger Foundation, and The Blanche and Julian Robertson Family Foundation.

Q: What have you been doing over the past few years?

A: I’ve been seeding new hedge funds, which has been a lot of fun for me and allowed
me to live a different lifestyle. I always worried that my epitaph might be “he died getting
a quote on the yen.” In addition to the hedge funds, I’ve really enjoyed meeting a lot of
good and worthy charities, which has also been a lot of fun.

Q: You were incredibly prescient 2-3 years ago regarding value investing and the
US housing market. What is your current macro view?

A: My big concern is the fact that we are still spending more than we earn, and like any
family, when that goes on too long, there comes a point where you have to pay it back.
We’re not even thinking about that; we’re thinking about continuing to borrow, and the
only people that can lend us that kind of money are the Chinese. I wonder if they will
continue to lend to us, as there are a lot of other things they can do with their money,
which in my opinion, would be better investments. They may eventually come to that
conclusion as well.

Q: Do you have an opinion on peak oil?

A: On peak oil, I’m kind of bullish on oil stocks, but I am tremendously impressed with
the environmentalists who’ve showed me what is happening with solar power. Just this
summer, for instance, a golf club where I play, had an entire fleet of solar powered golf
carts. As I investigated, I found out that there were cost savings as well as environmental
good. I think that solar power will get stronger and stronger, wind will get bigger and
better, and as soon as our grid is fitted out in good fashion, I think this will be big enough
to improve the environment and hurt the price of oil.

Q: During your career you took some time off from investing. The story is that you
took that time to reflect. What did you do during those 2 years and how did that
change your life?

A: It was between the time that I worked at Kitter Peabody and the time that I started
Tiger. I went to New Zealand ostensibly to write the great American novel, and I ended
up as a house-husband down there. I think every man likes to do something more
normally productive, and after a certain period of time, I was ready to come back and
start Tiger, which I did in 1980.

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Q: Could you comment on China? Do you think it’s the next bubble in the making
or that it is going to pull us out of the recession?

A: It very well could be a bubble in the making and I don’t think it’s going to pull us out
of the recession. It’s prosperity lies in effect in creating jobs which are used to export
goods, which take away jobs elsewhere. I don’t think their consumption patterns will be
big enough to offset all of that.

Q: What characteristics do you think the Tiger cubs share that contribute to their
success?

A: I think there are a number of them, and we’ve developed a test over the years that
demonstrates some of these qualities. They must be honest, reasonably smart, and very
competitive. Those three factors are key to being a really good hedge fund investor. In
addition to that, I think that there are so many hedge fund people that are trying to change
the world for the better (ex: George Soros, who probably did more to encourage the free
enterprise system in Eastern Europe than anybody, among many other great things, Paul
Tudor Jones and his help to budding charities, etc) and it’s been a thrill for me to be
associated with these people.

Q: What do you think about the price of gold? We heard earlier today that it is an
attractive asset to hold at this time. Does the price matter?

A: I’ve never been a big believer in gold. None of it has ever been used since it was first
discovered. There is no such thing as supply or demand in gold, you just state it, and it’s
there. You hope that someone who is economically turned towards gold will buy it in
higher and higher prices. The price of gold is almost the same today as it was 30 years
ago. In my own business, I’ve been the luckiest guy in the world on gold. I was presented
a seeding proposition with a guy who specialized and did only gold, and I planned to turn
that down, because I don’t really believe in gold. However, I believed in him, and this
man, over the last five years, has compounded about 50%, and I don’t know of anybody
else who has. I think one of the reasons he’s done so well, is because you have a group
that he’s competing with (“the gold bugs”), who are in many instances, certifiably crazy.
The next group is someone like me, who gets scared of inflation and wants to get into
gold. I’m told you don’t want into get into gold, but get into gold miners, because the
price of extracting gold is going down.

Q: An earlier speaker noted that we’re borrowing too much money, which will lead
to higher interest rates and inflation. How can investors protect against this?

A: I think that some sort of negative bond approach is a pretty good way to look at higher
inflation. There are a lot of ways to do that. I’ve been buying some things called curve
caps, which are for all intensive purposes, puts on 30 year bonds out 5 years. In other
words, these are bonds that will be issued in 5 years for a 30 year duration. That’s one of

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the things I am very strong on. I’m sure there are a number of commodities that would fit
that bill as well.

Q: You made your reputation as a value investor. Can you discuss the essence of
your value investing philosophy?

A: It’s changed over the years. I originally thought that a value investment was one that
was extremely cheap based on assets and earnings. I’ve changed now to feeling that a
value investment is one where there is a low price relative to the expected earnings that
the company will have over the next several years. You could make a very good case for
a lot of companies, for instance, that haven’t always been classified as value stocks. Intel
is trading at 16 or 17 times next years earnings – not bad for an company with its sort of
intellectual superiority. Google is another one that appears to be over the moon, but is
still growing rapidly.

Q: Are you diversifying out of the US dollar? If so, how?

A: I’m glad you asked that question because it gives me a chance to promote my own
book. I think the Norweigan Krona is the way to go, because I think Norway may be the
most prosperous, sound country in the world. It has a normal amount of reserves from its
oil sales, which are invested well for all of the 4 million people in Norway. I think some
other good currencies are New Zealand, in Eastern Europe – the Czech Republic is
extremely well run and I think that currency is pretty good. I have a negative view in
particular of the British Pound.

Q: I think you had some experience at one time investing in the airline industry.
What would have to happen for there to be a long-term opportunity in that business
to make money.

A: I think the airline industry is going to be a decent industry. I think the unions are no
longer in a governing position in the airlines, and I believe as that their influence
continues to wane, airlines hopes for survival get better and better. A company like
RyanAir, which is the lowest cost producer in the world, has been extremely prosperous
through this entire decimation of the rest of the industry.

Q: What is your future outlook on agricultural commodities? On treasuries? Is
there a bubble building up?

A: In light of my outlook for the economy and what’s going to happen, interest rates are
too low and bonds are too high, but I don’t think that’s really a bubble being created –
more of a wrong valuation.

Q: Is there any particular country or industry that you are especially bullish on
right now? Anything you are especially bearish on?

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A: There are a number of individual companies that I’m bearish on. I think that
Mastercard and Visa have a good situation in the credit area, and they’re really not taking
much credit risk. I think that the deal now may be to look around and try to find low cost
producers like RyanAir and maybe like Intel, which is sort of like an intellectual biggie in
terms of technology.

Q: When you look back over your career, what are some of the key lessons you’ve
learned?

A: Never be terribly overconfident. There is always something that can come and swat
you in the head. I think the best advice I’ve ever got is that a lot of us sometimes get
overly enthusiastic about our business. I did that when I was very young, and my sister
came up to me after a cocktail party when I’d expounded on some sort of theory I had at
the time, and said that I was becoming a business bore. It was excellent advice and I
found that instead of pushing my advice on other people, if I was kind of the quiet guy in
the corner of the room, people would come and solicit what I thought.

Q: It’s been attributed to you that you believe being invested 200% gross was a less
risky than being 100% invested long only?

A: I still think that say 120-80 is 40% exposure to the market. I’ve always felt that in this
business, if the 50 best (long positions) didn’t outperform what you thought were the 50
worst (short positions), you ought to be in a new business. I’ve been shocked in this
business, however, how often the bad outperform the good.

Q: Can you talk about saving and government policy?

A: I hope the government would change policy and encourage saving rather than
spending, which they are doing now. We are totally dependent on the Chinese. Can you
imagine 30 years ago someone telling you that for our financial stability we would need
the support of China? It’s almost unbelievable.

Q: You mentioned the factors that Tiger Cubs have. What characteristics encourage
you to seed a new manager?

A: Of course, I’d like to see where they’ve been. I do like to see evidence of those
characteristics I pointed out, and that’s really what we look primarily for. It’s nice for
them to have a particular expertise, and if they’ve worked for some good people along the
way.

38

Q: How much can you teach yourself and how important is it to work for someone
great?

A: I think it’s important to do both. I was extremely lucky to have hired some very good
competitive, honest, and extremely ambitious young people, who really propelled me
along. The learning goes both ways. I think it’s important to get that relationship with the
people you work with.

39

Sean Dobson Amherst Securities: “Fishing in a Poisoned Pond” –
Analytic Methods for Distressed RMBS Investing
Sean Dobson is CEO and Chairman of the Board and head trader for Amherst Securities.
Widely recognized as one of the leading traders in the RMBS markets, and currently serves on
the Executive Committee for MBS and Securitized Products Division of the Securities Industry
and Financial Markets Association (SIFMA). Mr. Robson has over 20 years of experience in the
mortgage industry, including previous positions with Spires Financial and the MMAR Group,
Inc.

-Close to 8 million homeowners in USA not paying their mortgages

-We view the world in a very specific way, in a certain light. It can be perceived that we
have cast the homeowner as a very treacherous opponent for investors. It is the system
that’s in place that makes it difficult for investors in mortgages to manage the risk that the
homeowner acts in a perfectly efficient way.

-The Pre-2005 Definition of Single Family Mortgage:
-Secured by Valuable Real Estate
-Guaranteed by a Fully Vetted and Credit Worthy Borrower
-Senior to Equity Position Commensurate with the Price Risk of the Asset
-Originated Under Standards Established by Investor or Guarantor

-His firm went around the country in 2005 and saw that single family home loans had
moved entirely away from our past expectations (buyer can no longer be expected to
sustain payments, no guarantee on fundamental real estate values, your significant equity
position in the home would be aligned with the borrower)

-By 2006, we were 0/4 on these 4 criteria

40

Now:

-Terrible Lending Standards – Namely, Limited Documentation Loans to Borrowers with
Poor Credit Histories – Account for Bulk of Defaulted Mortgages

-There is no one factor that prescribes a bad loan (all depends on rate, equity, etc)

-Average credit score used to be FICO around 700, by 2006, below 700s start to take over
market (2/3 of people fail to pay loans)

41

-Among securitized loans, new defaults have plunged, in part due to seasonality;
liquidations also have dropped recently

-Once new defaults equal liquidations, the inventory overhang stops getting larger every
month

-Broad averages of recovery outcomes is between $.20 - $.90 on the dollar

-Gap between time borrower stops paying and loss is recognized creates period of
confusion

-In 2007, homeowners are abandoning their loans at rate of 120,000 people/month.

-Private label mortgage market is left with 2.2 million loans not being serviced by the
borrowers (Fannie MAC estimates 1/3 of these homes are now empty)

-November 2008 was realization of losses of 60,000 abandoned loans/month.

-The inventory problem continues to worsen rapidly among prime mortgages held by
portfolio lenders or insured by GSEs, as new defaults remain high and liquidations low

42

-Cure rates have fallen such that once a homeowner misses two payments, a foreclosure
is almost inevitable
30 Day Delinquent Cure Rate is under 30%
60 and 90 Day Delinquent Cure Rates are under 5%

-The resolution process is grinding to a halt
Real Estate Owned liquidation rates have doubled to 20% per month, while the rate at
which non-performing loans are being foreclosed upon has fallen by half to less than 10%
per month, resulting in falling REO, but rising inventory

43

-The Current “Housing Overhang” is 7 million homes (which doesn’t include any new
defaults)

-Affordability is a reasonable predictor of home prices
Home prices today are fair to cheap without adjusting for supply demand
imbalances

44

Where are we today?

-Overall median income numbers are actually not that far down, while interest rates are
very low
Boosted buying power beyond where it was in 2005 and 2006, this should serve
as a buffer for the market

-Borrower behavior is rational and efficient
Believes expecting otherwise is dangerous

Example:
-90% of borrowers who took out a GSE-insured mortgage in the year 2000 at a 7.5% rate
had refinanced within four years
90% efficiency
-50% of these borrowers refinanced when the savings were less than $200 per month
Deadly efficient

Example:
-Mortgages originated in California in 2006 went from experiencing $165k of equity
relative to the first lien on average in January 2007 to an average Negative Equity of
$149k
-The Cumulative Default Rate during the same period went from 1% to 48.5%

45

-In a recent Harvard Business School report, the authors estimated the implied value of
the homeowners’ option to walk away. By refinancing their homes at peak prices,
borrowers increased the value of this option by $1.3 trillion in only three years.

-The Cash Flow Process (Before Modifications Became Common):

-More than half of always-performing loans are at high risk of default

46

-51% of the performing loans have attributes that have recently experienced a
significantly greater rate of default than prepayment

-The worst category of borrowers (limited doc, sub-730 FICO, >120 LTV), accounting
for 11.3% of the total, has an annual default rate of 32.7%, while prepayments are 0.8%.
If this pattern continues, 98% of these loans will default in only 3 years.

-Borrowers who are underwater are much more likely to default and are far less likely to
prepay
Those borrowers that can prepay generally will and those that cannot will likely
exercise the other option – the option to default

47

Default rates are brutally high:

48

-Another wave of resetting loans is on the horizon. The last wave was driven by subprime
loans. This time, it will be option ARMs.

-Re-Performing loans are of very poor quality
61% of borrowers with modified loans are currently underwater
Only 11% of borrowers have equity in their homes today, and, at origination,
had an LTV below 80% and were fully documented at origination

-29-50% of modified loans have re-defaulted within six months

-Re-Performing loans are re-defaulting at a pace of over 11% per month

-All modifications are performing poorly, regardless of loan type or credit score

49

-Non-Performing Securitized Loans are of terrible quality
79% of all defaulted loans have a current combined LTV above 120%
48% are borrowers with limited documentation loans and negative equity
Among defaulted fully documented loans, 60$ are borrowers with below-700
FICO scores and negative equity

50

-Non-Performing loans are taking much longer to go through the foreclosure pipeline
in 2007, only 4.5% of all defaulted loans were delinquent more than 18 months
In 2008, this number rose to 8.8%
Today, 17.5%

-Loss Severities (Recovery Rates) have stabilized in all states
As the mix of properties getting liquidated changes, average severity will
increases
The final disposition of the overhang of distressed properties looms

51

-When Non-Performing loans are finally liquidated, severities range from 40% on large
prime loans to 90% for small subprime loans

52

Investment Opportunities: The Search for Double-Digit Returns:

Investment Themes they like:

I. Loss severities will not increase substantially
 properly priced Alt-A Senior Securities

II. Loses will take longer to realize
 Subprime mezz and select Subprime Senior Sequentials

III. Loan Modifications/Government programs will evolve
Various bonds where extension and success of lower coupon loan/principal “cram
down” modification boost return even in the face of forward rates

53

Highly likely that there will be a re-tooled modification plan, that will hopefully start
to solve the major problem of buyers willingness to pay (in addition to their ability to
pay). This plan will hopefully reduce the loan plan to something that is less than the
losses that the investors would sustain in the foreclosure process (which helps no one).

-On some assets, they believe borrow can pay 50-60% of original payment, which while
impairing the asset, greatly decreases the risk of default (everyone wins).

-A brief word on Commercial Mortgage Backed Securities (CMBS):

Parallels Between RMBS and CMBS:

RMBS
1. Higher debt to income (DTI) expanded leverage
2. Low documentation begat larger loans and dodgier borrowers
3. Subordinated finance changed borrower behavior
4. Teaser payment created funding mismatch

CMBS
1. Lower debt service coverage ratio (DSCR) expanded leverage
2. Pro-forma underwriting begat larger loans and dodgier borrowers
3. Mezzanine and B-Note finance changed borrower behavior
4. Balloon loan and lease terms create funding mismatch

Rating agencies set lending standards
Ratings-based capital allocation determined “leverageability:
Shadow banking system provided the capital

Ex: CMBSs paid lower and lower entry yields as the bubble inflated from 2000-2007 as
debt entry yield declined

54

-The CMBS market in the bubble years was characterized by adverse selection. As the
riskiest hospitality/retail loans exploded more than 10x from 2000-2005.

-Net Operating Income for CMBSs is dropping

55

-When they mature, most CMBS loans today are simply being extended, with no loss
taken (extend and pretend)

-For a typical bubble-era commercial mortgage loan, if NOI drops 20% and the cap rate
rises to 8%, LTV jumps to 200%

Typical commercial mortgage loan:
-NOI = $1 million annually
-Cap rate = 4%
-Property value - $25 million
-At 80% LTV, loan amount = $20 million

As cap rate increases from 4% to 8%, the value of the property falls from $25 million
to only $10 million, which is half the amount of the loan

56

Lloyd Khaner Khaner Capital: Management, Management,
Management – The Key to Turnarounds
Lloyd Khaner is the General Partner of Khaner Capital, L.P., a long-short hedge fund. Without
the use of leverage and after all fees the fund has outperformed the S&P 500 for the following
standard comparable periods: one year, three years, five years, ten years, fifteen years and
eighteen years. Mr. Khaner earned a Bachelor of Arts, cum laude, from Tufts and holds an M.F.A
from NYU.

-We think about turnarounds the way real estate people think about successful real estate
investing (location, location, location  management, management, management)

The Key to Turnarounds – 18 years of Outperformance
No use of leverage, no illiquid investments, all investments made in regulated public
markets, Mr. Khaner has 90% of his net worth in the fund
-Up almost 450% in past 18 years
-Down 14% in 2008

57

-Significant underperformance in 1999, but significant out-performance in bubble crash
of 2000

-Focus on turnarounds shows that the portfolio will protect him.

The Key to Turnarounds: Strategy: Value with a Catalyst

-Screening out process to avoid value traps
First look at debt level, anything about 60-70% debt to equity gets tossed out
You can find great value in dying industries, but bad industry often beats out great
managers

-It takes unique management talent to turn around a troubled company. Finding and
investing in this talent is their expertise

58

Researching Management and finding companies:

“Past is often prologue”
-Screens for C-Suite changes
-Newspaper/news service reports of management changes
-52 week low list
-Value investing newsletters
-Value investing world in general
-Research from anywhere (industry experts, former employees, lexus-nexus, etc)

CEO Family Trees:

59

 Great CEOs train great future CEOs

 Also look for board seats

Extends to finance:

Wait to see where great management goes when they leave companies

Turnaround Hall of Fame CEOs:

60

Signs of a Successful Turnaround:

-Cut unprofitable sales
stock gets hit hard (why are you cutting sales?)
-Cut headcount
-Bring in new senior managers
-Communicate with entire company
-CEO must visit with every part of the company
-Coach employees to a winning spirit, winning attitude
-Fix relationships with customers (apologize, deal with them directly)
-CEO must present a new plan within 3 months of taking over (most importantly, for
Wall Street)
-Set high, yet achievable goals (build confidence within the company)
-Improve products and/or services
-Sales down (slammed by Wall Street, people freak out, but this helps gross margin)
-Gross margins up
-SG&A down (cutting fat, creating lean and mean organization, you want to see this early
on)
-Operating expenses down
-Inventory levels decline, inventory turns rise (inventory probably bloated so levels have
to come down, but you want to see turns going up)
-Cut and/or restructure debt and covenants if needed (want to maximize breathing room)
-No acquisitions for at least 1 year (first figure out what you are before you figure out
what you’re going to be)
-Focus on Return on Invested Capital

Return on Investment Capital (ROIC):
-How effectively and efficiently a company reinvests capital back into its own operations

61

The Key to Turnarounds: Turnaround Categories:

Example 1: Molex, Inc. (MOLXA)

62

Example 2: Praxair, Inc. (PX)

Example 3: Campbell Soup Co. (CPB)

63

Starbucks:

Q: Clearly McDonalds and other regional stores have taken away Starbucks market share.
Does your model take into account that these people may not return to Starbucks?

A: It’s definitely built in. I believe you’ll see Starbucks taking market share back in 2010.
Surveys are all ready starting to show this. Additionally, you really cannot get the same
product at McDonalds or Dunkin Donuts than you can at Starbucks.

Q: Anthony Mozillo, Ken Lay, etc were all legends. The worst guys are always good
salesman. How do you avoid them?

A: One simple rule, if I’m going into a meeting and asking the questions, if I walk out of
the meeting with more questions than before, I walk away quickly. A background check
is very helpful since you can see when a CEO just jacked up a company’s financial
through leverage as opposed to actually solid

64

David Einhorn Greenlight Capital: Liquor Before Beer, In the
Clear
David Einhorn is Chairman of Greenlight Capital (a value-oriented investment advisor), believes
an investment approach emphasizing intrinsic value will achieve consistent absolute investment
returns and safeguard capital regardless of market conditions. Prior to founding Greenlight, he
was at DLJ.

-Even though you may not always be right in investments, you don’t have to be. Decent
portfolio management allows for bad luck and bad decisions (which you can learn from).

A bad decision and its lessons:

-At May 2005 Ira Sohn Investment Conference, Einhorn recommended MDC Holdings,
which quickly shot up, then collapsed with the rest of its sector
-5 years later, anyone who listened to David would have lost 40%
-Loss was not bad luck, but bad analysis
-Downplayed risk of housing bubble fueled by growing debt bubble
-Smart investors have been complaining about the housing bubble since at least 2001.
-David ignored Stan Druckenmiller’s advice on the bubble
Lesson: it isn’t reasonable to be agnostic about the big picture
-Considered himself a bottom-up investor, neglected macro viewpoints, which hurt him

-Must view overall industries, sometimes move into macro-level insurance

-2 basic problems in government
1. Short-term bias (caused by need for immediate popularity, upcoming elections,
etc)
Internet, modern news cycle, etc, demands short-term solutions
-Bernanke and Geithner are examples of short-term decision makers
-Paul Volcker made unpopular decisions in the 1980s, but history ultimately shows that
these were wise long-term choices

2. Problem of special interests
Small minorities get heard through intensive lobbying
-Banking lobby is an example of this
-Small consequences spread out across individuals across the country
-Financial institutions caused the problems, received bailout
Once you bail them out, what do you do to discipline the misbehavior?

-In the last few months, we see the beginning of another party, which satisfies both need
for short-term solutions and banking special interests

-These new regulations don’t make anything safer

-We’ve now institutionalized too big to fail

65

Test ought to be that no institution should ever be of individual importance that
if we were faced with its demise, the government would have to intervene

Lesson of Lehman: Not that government should have intervened, but that Lehman should
have never been that big to begin with

-Government dismantled AT&T 25 years ago, which led to great growth and social
benefit in the telecommunications industry

-Leaders are too influenced by banking special interests

-Bailouts have installed a great deal of moral hazard, which in the absence of radical
change, every major financial institution will be granting a government backed stock

-In effect, we all continue to subsidize the big banks, even though we keep hearing that
the worst of the crisis is behind us

-Big banks are now developing oligopolies

-Mortgage originators are now earning ridiculous profits

-Proposed reform does not deal with our current needs

-CDS are highly anti-social instrument, because basis packages (bond + CDS) make more
money if company fails, so these basis package holders have an incentive to create
bankruptcies (GM, Six Flags, etc)

-Idea of CDS Clearinghouse just maintains private profits and socialized risks

-Trying to make safer CDS is like trying to make safer asbestos

-Money markets created systemic risk

-During the bubble, companies like GMAC, AIG, GE Capital, etc took enormous,
unregulated risks

-Rather than deal with simple problems with simple obvious solutions, reform plans are
convoluted, only have veneer of reform, serve special interests, and actually reduce
transparency

-Idea that asset bubbles don’t matter because they can be dealt with after they pop is
entirely false

-Now told most important thing is to maintain fiscal and monetary support

66

-Alternative lesson from 1938 double dip economy: GDP created by massive stimulus is
artificial (whenever it is removed, there will be significant economic fallout)
We must accept some level of fiscal discipline

-Social security and Medicare commitments to retiring baby-boomer generation is
astronomical, and federal government does not even count future promises to these
retirees

-In near term, deficit on cash basis is $1.6 trillion, next years forecast - $1.4 trillion
Other studies show US fiscal scenario compares to other countries on verge of
default

-Fed cannot sell its treasuries without destroying the market

-Fed will have to shrink the monetary base if inflation actually shows up

-Fed must make sure not to repeat error of holding rates too low too long

-Higher rates will become both a fiscal and monetary issue

-Fed may need to become a buyer of treasuries of first and last resort

-Japan may all ready be past the point of no return since it cannot reduce its ratio of
debt/GDP, it can only refinance, but never repay its debt

-Japanese debt is financed at 2%, but even with this cheap financing, it cannot repay its
debt
Imagine effect of market changing Japanese rate to 5%

-If market re-prices Japanese debt, Japan could experience default, hyperinflation debt
spiral and currency crises

-Fiat currencies with structural deficits and large unfunded commitments to agencies are
of serious concern

-Structural risks are exacerbated by credit rated agencies who overrate sovereign debt of
large companies
No reason to believe credit agencies will do better on sovereign risk than on
corporate risk
Greenlight met with Moody’s sovereign agency team, and Greenlight was very
disappointed (lack of quantitative models, incredible small team, very short term outlook)
Credit ratings only pile on downgrades at the worst possible time, which just
makes everything worse

67

-Einhorn’s views have changed in the recent crisis
How does one know what the dollar is worth given that it can be created out of
thin air?
-We should continue to buy stocks in great companies, but we must look at gold as well
-Gold does well when monetary fiscal policies are poor, and poorly when they are
sensible
-Gold did great in Great Depression when FDR debased the currency
-Ultimately made bottom in 2001 when excitement about future budget surpluses peaked
-Gold will do very well in sovereign debt default or currency crisis

-Einhorn is tempted to short the dollar, but upon examination of Euro, Yen, and British
Pound, everything looks bad
Holding gold is better than holding cash (especially now when both are no yield)

-Buys options because he can limit losses and create as much leverage as needed

-Believes that our solvency is ultimately at risk

-Investors need to buy some insurance to protect themselves from some systemic event

-As investors, we can’t change the course of events, but we can protect capital in the face
of foreseeable risks

Q: How can you peg the value of a dollar in this environment? Can you peg the intrinsic
value of an ounce of gold?

A: Gold is a monetary asset. It is a unique asset because it has no liability associated with
it (dollar bills actually say Federal Reserve note  actually liabilities of Fed balance
sheet). No corresponding liability with an ounce of gold (not subject to leverage, so
therefore, highest quality monetary asset). When you look at a dollar, you see a
secondary monetary asset. The question isn’t so much what is gold worth relative to a
dollar, but what is dollar worth relative to gold. We need to look at gold as a currency of
its own.

Q: You predicted collapse of Lehman Brothers by looking at its balance sheet, what do
you see when you look at the Federal government’s balance sheet?

A: Lehman was not an inevitable failure. I didn’t label it as such, I just thought it had a
lot of risks and its equity was overvalued. The fact that it went bankrupt had a lot to do
with a colossal mismanagement of the situation. The leaders of our country didn’t force
Lehman to do the right thing quickly enough. I don’t believe the US is past the point of
no return, btu there is a risk that we are heading in that direction unless we do something
soon.

68

Q: Why are you short GE?

A: Not discussing that.

Q: Why do you own physical gold versus ETFs or futures?

A: Physical gold is cheaper and is actually more liquid than the ETF market, with lower
carrying costs. Plus, just fun to visit bars at the vault.

Q: Where is the gold located? In the depression era, US government confiscated gold,
and the Nixon administration made it illegal to own gold as Americans.

A: Gold is located in New York.

Q: Could you update your views on the rating agencies?

A: The rating agencies are a problem for many reasons. They do a bad job on pretty much
everything ranging from municipal to corporate to sovereign debt. Typically, lawsuits
against rating agencies are either too vague or dismissed by the First Amendment. Recent
ruling stated that the plaintiffs had secure enough reason and potentially viable fraud
claim of several billions against rating agencies. The rating agencies may ultimately
suffer the fate of the asbestos companies. The regulators should just get rid of credit
agencies (too interested in protected shareholders of rating agencies). If shares lost value
from this lawsuit, it would help.

Major issue with credit agencies is that they are cyclical. They excessively boost
companies in good times and excessively harm them in bad times.

Q: Are oil or energy stocks a hedge against inflation?

A: They are more of a play on the supply and demand of oil or other commodities. There
are reasons to worry that the price of oil could go a lot higher (but also worries that it
could go a lot lower). Greenlight sometimes invests in energy companies, but this is
based on individual valuations, not as a form of solid macro insurance that he spoke
about.

Q: To what extent is gold all ready pricing in some sort of currency crisis?

A: I don’t think that gold is necessarily just about CPI and Inflation. I think there are
other forms of inflation (ex: asset inflation). You can look at overall sensibility of fiscal
and monetary policies. As they seem to go awry, the price of gold goes up. I think that it
makes sense for everybody to have a small fraction of their assets in gold as an insurance
just in case something bad happens.

Q: What (housing, wages, equity markets, etc) is going to cause inflation?

69

A: In 1930s, we had tremendous deflation. Effectively, we defaulted when FDR changed
price of gold, and gold performed well. We should not measure a gold investment by
inflation vs. deflation, but rather sensible vs. non-sensible policy.

Q: How are you executing the trade betting on higher Japanese interest rates?

A: Effectively buying call options sold by big banks, 2-5 years out. Volatility is low so
premiums are low as Japanese rates have been stable for so long.

Q: Do you think there are prospects of higher future taxes?

A: There need to be a variety of means to resolve our situation. Taxes can be one of them.
There is too much current concern about economic slowdown, which causes us to avoid
sacrifices.

Q: Japanese have a lot of short-term debt. How does this effect your options?

A: There is no way to know exactly what the course will be. What we’ve seen,
particularly with AAA rated financial institutions, is that they go from AAA to basically
insolvent very very suddenly. The underlying basis for why they were AAA was flawed
from the first instance. So, seemingly suddenly, you wake up and find that no one will
lend to them. You certainly find that possibility in Japan as well.

Q: In inflationary periods, gold is probably the premier asset, but there are other precious
metals, as well as real estate and productive economic assets. Have you considered other
productive assets as alternatives to gold?

A: P/E ratios will collapse with significant inflation (future earnings will have to be
discounted back to account for inflation). Real estate is an interesting idea, but the
problem is that we all ready have a very over-levered, and probably still very overvalued
commercial real estate sector.

Q: Have you looked at a pair trade, say short copper/long gold, that could increase the
your return?

A: We haven’t considered that short of pair trade. I have heard questionable things about
the copper market and that the price may be overvalued. The better way to manage risk is
through position sizing,

70

Eric Sprott Sprott Asset Management – The Financial Crisis Isn’t
Over
Canada's “Energy Guru”, manages $4.8 billion worth of hedge and mutual funds as CEO and
portfolio manager of Sprott Asset Management. After graduating from Canada’s Carleton
University and earning his designation as a Chartered Accountant, he entered the investment
industry as a research analyst for Merrill Lynch. In 1981, he founded Sprott Securities Inc. (SSI),
which became one of Canada’s largest independently owned institutional brokerage firms. In
2000, he divested his entire ownership of SSI to its employees and formed Sprott Asset
Management to focus on the investment management business. He is also Chairman of public
company Sprott Resources.

-Fund run out of Toronto
Mining is becoming huge, Toronto is the place to be

-Sprott Hedge Fund LP has returned over 450% in the past 10 years.

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Dow now at 10,000.
We were at 10,000 at 1999 and we’ve accomplished nothing. This could go down as
the lost decade.

A History of Market Forecasts:

-Excessive Speculation (March 2000):
“In the next few motnhs, if not weeks, we anticipate that the Nasdaq will capiutlate to
market liquidity. Valuations are screaming at us! Excessive speculation is running
rampant. DON’T BE A PART OF IT!!!”

-All That Glitters is Gold (October 2001)
“But what will happen to the price of gold if and when it is universally considered as the
safe haven of last resort? $400? $500? $700? This is easily conceivable.

- Requiem for a Housing Bubble (August 2006)
“All manias play out the same way. They are dynamics of greed and fear. The greed
of making easy money. The fear of missing the boat.…The housing market was a
textbook bubble. It was déjà vu all over again.”
“Wealth creation via a housing bubble will ultimately prove to be a sham. In our
view, it’s a tautology that a hard landing in housing will mean a hard landing in the
economy…and with it, a rough ride for the stock market as well.”

72

The Financial System is a Farce (October 2007)
“We have long maintained that the magnitude of the credit bubble that has been built up
over the past several years continually needs more and more credit and liquidity to
sustain itself, else it would implode under its own weight…. Therefore (central banks)
will use all means at their disposal to ensure that the bubble lives on for as long as
possible, and the means available in this case is the only one they know: to
indiscriminately throw money at all problems that surface.”

Surreality Check … Dead Men Walking (November 2007)
“In spite of recent beatings, the markets continue to believe that (GM’s) stock is worth
$27 per share, or a market cap of $15 billion. Yet after the latest write-down in the third
quarter, the book value of GM now stands at an eye-popping minus $74 per share. … The
stock markets need a surreality check. Connect the dots and the evidence is
overwhelming that the equity of many companies is at risk of being wiped out. They are
dead men walking.”

Looking into the abyss:

“Britain was within hours of a banking shutdown last autumn as the government batteld
to piece together a rescue plan for the stricken Halifax and Royal Bank of Scotland, it has
emerged. Treasury mandarins and Bank of England officials battled the clock to come up
with a support package on the weekend of October 12th, 2008. If they had failed, the
Financial Services Authority could have ordered the closure of cash machines and
prevented deposits at either of the two main casualties of the global financial chaos”
-The Observer, September 9th, 2009

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The Bank Balance Sheet:

-Fundamental problem: what is appropriate leverage ratio for banks?
-Certainly not 20/1, as Einhorn said, banks must de-leverage
-Banks’ assets are only getting riskier (both short term and over the long term)

FDIC to the Rescue:

ColonialBank, Alabama (Aug 14):
-Total Assets: $25 billion
-Total Deposits: $20 billion
-Cost to FDIC: $2.8 billion
(11% write down)

Guaranty Bank, Texas (Aug 21):
-Cost to FDIC: $3 billion
(25% write down)

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Corus Bank, Chicago (Sep 11):
-Cost to FDIC: $1.7 billion
(24% write down)

Georgian Bank, Atlanta (Sep 25):
-Cost to FDIC: $892 million
(45% write down)

Quantatative Easing:
-Won’t be found in economics books, new thing, essentially the simple printing of money
-From Federal Open Market Committee minutes (Aug 11-12, 2009):
 “The [Federal Open Market] Committee directs the Desk to purchase
agency debt, agency MBS, and longer-term Treasury securities during the
intermeeting period with the aim of providing support to private credit
markets and economic activity... The Desk is expected to purchase up to
$200 billion in housing-related agency debt and up to $1.25 trillion of
agency MBS by the end of the year. The Desk is expected to purchase about
$300 billion of longer-term Treasury securities by the end of October,
gradually slowing the pace of these purchases until they are completed.
The Committee anticipates that outright purchases of securities will
cause the size of the Federal Reserve’s balance sheet to expand
significantly in coming months.”

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-Basically said commercial banks are not buyers of bonds and nobody in their right mind
would be a buyer of US bonds
-US government raised 200% in the bond market this year than last year
Who is buying 200% more?
Nobody, the central banks are the buyers of the bonds
-This gets to the heart of the potential problem: what happens when quantitative easing
finishes?

-China is growing, but has done some odd things:
-Had a $600 billion stimulus in $4 trillion GDP economy
-Exports aren’t improving and have yet to recover
-Economy is export driven
-Chinese market had tough August when government-owned banks slowed down
lending, which brought down the market 25%
-Beyond stimulus, we have the same situation in the US (big stimulus, but what happens
after?)

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Beyond the stimulus:

- In their 2008 annual report, the Bank for International Settlements (BIS) reviewed
previous banking crises and suggested that a sustainable recovery would require the
banking system to take losses, dispose of non-performing assets, eliminate excess
capacity and rebuild capital bases. The BIS concludes that “these conditions are not
being met and any stimulus will therefore only lead to a temporary pick up in
growth followed by a protracted stagnation.”

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-We all ready have 2 data points:
-Car sales (cash for clunkers ended)
-Housing incentive for first time buyers (being abused, expires in November)
Data point from homebuilders survey is that foot-traffic fell 15%, building permits
down 1.5%
-If there is no extension, since 35% of homes have been sold under this program,
December home sales will fall by 35%

“Revenues in 2009 were almost $420 billion (or 17 percent) below receipts
in 2008 and totaled about 15 percent of GDP, the lowest level in over 50
years. At the same time, outlays increased by over $530 billion (or 18
percent) in 2009, to nearly 25 percent of GDP, the highest level in over 50
years. Individual income taxes, the largest source of tax receipts, account
for more than half of the total drop in receipts, declining by $230 billion (or 20
percent). Corporate tax receipts declined for the second consecutive year, falling by about
$166 billion (or 54 percent).”
- Congressional Budget Office
Oct. 7, 2009

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HUI Gold Index:

Up 1,133% Greatest stealth bull market of all time
While Dow flat-lined for 10 years, you could’ve had over a 1100% return
-Sprott Asset Management hit this

Various reasons to like gold:
-Supply/demand situation (failures to deliver, impure gold)
-Sprott sees shortage of gold (more used than produced every year)
-Central banks have decided to sell gold for the past 10 years and instead, bought US
bonds
-Sprott thinks central banks will sell less gold

We’re in the stealing business:
-We focus on long-term secular trends. “Buy and hold” is not dead if you own the right
things
-We tend to look for small-mid cap “hidden gems” with a strong chance of significant
upside potential, similar to the style of Peter Lynch.
-We typically take a big ownership interest
-Is it too risky to “swing for the fences?” We don’t believe it is. If market expectations of
growth are well below our own growth expectations, we leave ourselves plenty of room
for error.
-“Prospectivity” is paramount, regardless of “quality” management team.

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Want small to mid-cap stocks, overlooked (little analyst coverage, news coverage),
trading at low multiples within the industry

Cheapness in the peer group is key

-Gold and silver can always be sold (don’t need to worry that there won’t be a market)

Investment examples:

-Norseman Gold Plc (ASX: NGX):

-Market Cap: A$138 mill. / Ownership: 11.1%*
-Based in Australia where they operate the country’s longest
continually running gold mine
-Successful at reducing costs and increasing production after
undergoing operational restructuring in late 2008
-Current goal is to increase production to over 100,000 ounces by
reaching capacity at their underutilized mill
-Further exploration could lead to an upward revision of their
production forecast

-First 2 long run targets on gold are $2160 and $2450 (from Sprott’s chartist)

Multiple at 2000 will be like buying this stock at 0.5x earnings

-Every time you hear quantitative easing, you should think gold

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-Corridor Resources Inc. (TSX: CDH)

-Market Cap: C$287 mil
-Ownership: 19.7%
-Based in New Brunswick, Canada
-Net production of 20 million cubic feet per day from tight sands play, which could
double in the near future as two newly producing wells come on line
-Independent report recently estimated the potential for over 50 trillion cubic feet (tcf) of
gas is in place amongst its extensive shale properties
-If they can prove our reserves of 1 tcf, it should be worth C$1 billion in the market, more
than triple the current market cap

-Sensio Technologies Inc (TSX-V:SIO):

-Market Cap: C$67 mil
-Ownership: 13%
-Montreal-based company with patented technology that facilitates the broadcast and
distribution of 3-D content using existing 2D/HD infrastructure
-They can also enable broadcasters to upgrade their HD channels from 1080i to 1080p/60
without using any additional bandwidth
not reflected in analysts’ estimates
-They provide encoding/compression software for minimal or no cost to 3D
movie, television and video games producers
-Generate revenue by licenses decoding software to makers of televisions,
video game consoles, BluRay/DVD players, set-top boxes, personal computers
or other playback devices
-Addressable market of at least 1.2 billion units per year with royalty rates
ranging from $0.50-$8.00 per unit
-Expect typical IP licensing gross margins in the 70-80% range

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Other stocks:

Yukon Nevada Gold Corp (TSX:YNG)
-Just got license to restart mill, got 600 million to replace mill
-Expects $60 million cash flow

Excellon Resources Inc. (TSX:EXN)
-Lead zinc silver worth $1000/ounce

Romarco Minerals Inc (TSX-V:R)
-Think they could have 5 to 7 million ounces of ore, potentially 10 million
At market cap of 330, that’s still pretty cheap ($33/ounce)

History of out-performance:

Q: You commented a few weeks ago that a few major financial institutions were short
maybe 600 million ounces of silver. Can you talk about this?

A: On the commodity exchange, there’s a report every week that shows if people are long
or short silver. The silver short is usually about $6 billion, and about $30 billion of gold
is short. These precious metals are moving up. Two banks have about 80% of the short
silver position and about 4 represent 60% of gold short(doesn’t know who they are). If it
continues to jump up, it’s going to hurt them big time.

Q: Can you comment on your position of rare earth metals?

A: We’re not in them, even though they’re getting a lot of attention. There are a lot of
rare earth metals with all sorts of strange names. Each one has an incredibly small
market, so there is hardly anything to invest in, in that area. I have no doubt that they are
rare, but it’s not something that I tend to invest in.

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Q: You previously wrote about dead firms walking (Fannie, Freddie, GM, etc). What is
your updated version of this list? Who’s walking around dead these days?

A: Government. What my concern is, is that people have to buy these government bonds
everyday. The research we find says that the central banks are buying the bonds. This
can’t go on forever - there will be an auction where we face this problem. When we step
back and realize the size of demands on the bond market, and the unwillingness of most
people to buy them (why should anyone in Canada buy a US bond with the currency
risk?). With social security, unfunded pension payments to federal employees, health
care, etc, these government liabilities are unfunded and estimated around $70 trillion.
There is no way that the government can deal with these commitments, which are coming
due. The piper’s coming.

Q: You like to invest in real things. What do you consider real things (aside from gold
and other resources)?

A: 70% of our long side funds are in gold and silver. About half of which is in physical
bullion, the rest in stocks. We believe in peak oil, so we invest in oil and gas stocks as
well. We’ll look at anything else, but those make up 85-95% of our holdings.

Q: Can you talk about your views on inflation and deflation?

A: That is the toughest question these days. I think we’re in a deflationary economy,
where left to its own devices, we’d be very deflated. If there is another round of
quantitative easing, then the move will be on to real things, and we’ll get inflation of real
things. We still may have a deflating economy, but real things will inflate.

Q: What are your thoughts on natural gas? On the Canadian economy?

A: I don’t spend a lot of time thinking about the Canadian economy. Whatever happens
in the US, happens in Canada a day or two later, so I tend to focus on the US. Everyone
believes that Canada is in great shape, but we really depend on the US, so bad things in
the US hurt Canada. The Canadian budget deficit has exploded. We are creating jobs, but
any US issues affect Canada.

I think natural gas can go into double digits. Since oil and gas drilling has been cut by
50%, production will fall off (decline rate on natural gas could be 30%). With 30% less
gas with no drilling, we can lose 15% of the gas production we now have. I think this is
setting the stage for a big move in the natural gas price, and a cold winter would only
further boost this.

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-Zeke Ashton Centaur Capital Partners: Stocks the Rally Left
Behind
Zeke Ashton is the founder and Managing Partner of Centaur Capital Partners, a Dallas-based
value-oriented investment firm. He and co-portfolio manager Matthew Richey are the advisors to
the Centaur family of private partnerships using a long / short equity strategy, and are the sub-
advisors to the Tilson Dividend Fund, a mutual fund utilizing a unique, income-oriented value
investing strategy.

About Centaur Capital Partners:

Founded in 2002, Centaur Capital Partners (CCP) specializes in value-oriented
strategies based on fundamental, bottoms-up securities research
and analysis. CCP is based in Southlake, Texas, just outside Dallas.
CCP serves as the investment advisor to the Centaur Value Fund, a long /
short, long-biased private investment partnership that was launched in
August, 2002.
Centaur Capital is also the sub-advisor to a retail mutual fund, the Tilson
Dividend Fund (TILDX), launched in March 2005 in partnership with
Whitney Tilson and Glenn Tongue of T2 Partners in New York.
In managing TILDX, CCP utilizes a unique, value-based long-only equity
income strategy that seeks to identify undervalued securities and
emphasizes income through a combination of dividends and selective use
of written covered call options.
Early seed investors in Centaur Capital include Whitney Tilson, John
Schwartz, and West Coast Asset Management.
As of September 30, 2009, Centaur Capital had ~ $80M in AUM.

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Stocks that left the rally behind:

Alleghany: Good value, low risk

Alleghany (NYSE:Y) is a unique holding company that operates primarily in the
specialty and property & casualty insurance industry.
The company has produced an enviable long-term track record of value creation,
by building, acquiring, and selling businesses, and has particular expertise in the
insurance, investment management, and natural resource areas.
Alleghany uses a “total return” approach to investing its float, and has a very good
investing track record. Over the five years ended 2008, the Alleghany equity
portfolio produced an average annualized return of 10.6% versus a -2.2%
annualized return for the S&P500.
Despite the terrible double-shot of large gulf hurricanes in 2008 (Ike was the third
most costly weather event in the history of the insurance industry) and the
destruction on the asset side of the ledger due to declining equity and fixed income
prices, Alleghany managed to see its book value per share decline by only 5%.
In mid 2008, Y sold its 55% interest in Darwin Specialty Insurance at 2X BV.
As of mid-2009, the company is sitting on a $4.2 billion investment portfolio, of
which about $725 million is at the parent company. Alleghany has a fortress
balance sheet, with no debt after redeeming convertible debt in June ’09.
Alleghany reported book value per share at June 30, 2009 of $284.00 per share

An overview of the assets at Alleghany:
RSUI is a very profitable underwriter of commercial property insurance and
casualty lines including professional liability. RSUI writes over $1 billion in
premiums annually, and has produced extraordinary combined ratios the past three
years: 80.1% in ’08, 68.9% in ’07, and 70.6% in ’06. The average annual
underwriting profit for these three years is ~ $185 million / year.

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Capitol Transamerica is a specialty P&C underwriter with a focus on the Midwest.
The company writes over $200 million per year in premiums with consistent
underwriting profits and combined ratios in the high 80s and low 90s.
Employers Direct Corp. writes workers compensation coverage primarily in
California. Workers comp in California is not currently priced to allow industry
profits, so Alleghany has written down EDC in 2009 and is exiting the business.
Alleghany owns a 33% interest in Homesite, a large homeowners insurance
operation. The company paid $120 million for this interest in 2006. Homesite has
grown impressively over the last two years.
Alleghany also owns 38% of ORX Energy, an oil and gas exploration company.
Alleghany owns some left-over real estate in Sacramento, about 315 acres.
Alleghany has a $4.2 billion investment portfolio, $725 million at the parent level. The
company has a bullet-proof balance sheet, with no debt.

The Alleghany Equity Portfolio:
- Alleghany’s equity portfolio was valued at approximately $622 million as of June 30th,
2009, or about $70 per share. Shareholder equity was $284.82 per share, so the equity
portfolio accounts for roughly 25% of shareholder equity
-Approximately 66% of the portfolio is invested in energy.
-Top 10 holdings as of June 30th, 2009:

A sum of the parts valuation exercise:

RSUI has $1.1 billion in shareholder equity at Dec ’08, including the investment
portfolio. An insurance company that can produce combined ratios in the mid-70s
in good years and the high-80s in bad years is clearly worth way more than book
value. Assigning a 1.5 X book value multiple to RSUI yields $1.65 billion.
Capitol Transamerica is a pretty good insurance company with ~$300 million of
shareholder equity. We value it at 1.15X book value, which is $345 million.

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EDC is now impaired and has been written down to <$100M in SE. Using a 0.5X
book value multiple, I value the remaining assets at $50 million.
Y purchased its 33% stake in Homesite in 2006 for $120 million. Homesite has
grown since then, but I don’t have access to full financial statement data. I will
conservatively mark it down to $100 million just to be conservative.
Y paid $50 million for its stake in ORX Resources in July 2008 at a time of peak
oil and gas prices. We assume this asset might be worth $25 million.
We assign no value to the 315 acres in Sacramento; it’s a small free call option
The cash and investments at the parent company was $725 million as of Q2 ‘09.
Book value at June 30, 2009 was $284.82. Stock price as of Oct 1st was $260, so
price / book value was ~ 0.91X.

Adding up the pieces:

Equity portfolio increased in value by ~15% in Q3 (+$100M?)
Fixed income portfolio likely increased in value in Q3 as well (+$100M?)
No major insured catastrophes in Q3; underwriting profit(+$40M?)
Book value at June 30, 2009 was $284.82. We estimate Q3 book value per share
will be ~ $20-25 per share higher ($305-310).

Why has Alleghany been left behind?

EDC (California workman’s comp) had terrible first half and is likely to be wound
down. EDC reported a 1H ’09 loss of $60.7 million due to a combination of reserve
strengthening and large reduction in new business volume. This $60.7 million loss
effectively masked the fine underwriting profits ($88.9 M) at RSUI & CATA.

87

In Q3, Alleghany sold certain assets of EDC for an undisclosed amount. Going
forward, EDC should not be a drag on reported underwriting profits.
Book value at June 30, 2009 was $284.82. This was only a 2.7% increase from the
Q1 ’09 figure, during a quarter in which many other P&C insurers reported doubledigit
% increases in book value per share.
But Alleghany was not coming off depressed book value figures. BV per share
declined by only 5% in 2008 and by only 0.3% in Q1 ’09.
WHAT ARE THE RISKS?
As is the case for all P&C insurers, a major catastrophe would ding book value
Perhaps the biggest risk is simply opportunity cost. Alleghany is over-capitalized
and very conservatively managed, and they did not take advantage of market
weakness in Q4 or Q1 ’09.

Lab Corp. of America: Healthy Profits

Lab Corp (LH) is the #2 player in the U.S. clinical lab business behind Quest
Diagnostics (DGX).
LH was founded in 1971, and operates 36 primary regional labs and 1,600 patient
service centers. The company processes 440,000 lab tests / day
In 2008, LH had $4.5 billion in revenue and $465 million in net income. Quest
reported $7.2 billion in revenue and $581 million in net income.
The U.S. clinical lab industry accounted for approximately $52 billion in sales in
2008. Of this, 55% is accounted for by hospital labs, 34% by independent labs such
as LH and DGX, and 11% by physician offices.
Between them, LH and DGX account for approximately 2/3 of the revenue from
the independent labs. DGX has ~40% share, while LH has about 25% share. DGX
and LH can be thought of as the Coca-Cola / Pepsi of the U.S. lab business.
LH has grown impressively over the last ten years through a combination of
acquisitions and organic growth. Revenue grew from $1.7 billion to $4.5 billion
over the ten years from 1999-2008.
LH has achieved growth and margin expansion by its early and aggressive push
into higher-margin “genomic and esoteric” testing, which are now ~35% of sales.

From growth story to cash cow:

LH has been very effective in allocating capital. While revenues grew by 46% over
the five year period from 2004-2008, EPS grew by 70% from $2.45 to $4.16.
LH has been an aggressive and consistent purchaser of its own shares. The average
diluted share count has fallen from 150.7 million shares in 2004 to 111.8 million at
2008, a reduction of 26%.
LH is likely to continue to buy back shares aggressively. As of June 30, 2009, the
share count was down to 108.3 million. LH purchased $95.2 million worth of

88

shares between Q2-end and August 10th, and announced a new $250 million
authorization in early Q3.
The company generates substantial excess free cash flow. Free cash flow has
ranged between 13-15% of revenue over the past seven years. As the company’s
growth slows down, cap-ex should decline and FCF should increase.
In mid-2009, LH acquired Monogram Biosciences, a leader in “companion
diagnostics” that are used to determine patient selection for existing or newlydeveloped
gene-based therapies. Total purchase price is ~ $155M.
The market cap is ~$7.05 billion. Net debt is ~$1.35 billion, so EV is ~$8.4 B.
LH should produce $670 million in FCF for 2009. At the current price of $65, LH

A picture of consistency:

The table below shows selected financial metrics for LH over the last eight years.
As you can see, this is a terrific business with OCF margins in the high teens and
FCF margins in the low to mid teens.
The business kicks off tremendous excess cash, which has been used traditionally
for acquisitions and share buybacks.
What kind of a multiple would one normally expect for a business of this quality?
Assuming the market assigned a 15-17X FCF multiple, LH is worth $95-105.

Why has lab corp. been left behind?

Like other health care stocks, DGX and LH have suffered from the uncertainty and
political risks associated with “Obamacare.”
These risks aren’t just perceptions. In September, Senator Max Baucus introduced
the so-called “Framework for Comprehensive Health Care Reform” in which he
proposed the following: 1) a $2.3 billion annual tax on the pharmaceutical sector,
allocated by market share; 2) a $4 billion annual tax on medical device

89

manufactures, by market share; 3) a $6 billion annual tax on health insurance
providers, allocated by market share; and 4) a $750 million annual tax on clinical
labs, allocated by market share.
Given the relative market size of clinical lab testing, this tax would have had a
wildly disproportionate effect on LH and DGX, which combined had 66% market
share amongst independent labs and 33% overall share. LH and DGX together had
2008 profits of $1 billion. On Sept 22, the clinical lab tax provision was killed.
WHAT ARE THE RISKS?
Political risk remains the biggest danger to the clinical lab businesses.
Other risks include potential lack of growth opportunities given the significant
market potential for competitive price war between LH and DGX

MVC: A dollar trading for 55 cents?

MVC is a business development company (BDC) that is oriented toward equity
investments in “small and middle market companies with secure market positions,
predictable profit margins, and stable free cash flow.”
MVC grew reported NAV / share from $9.40 as of Oct. 30, 2004 to $17.38 per
share at Oct 30, 2008 and paid out $1.86 per share in distributions.
The vast majority of the NAV per share growth came from investment operations,
NOT from selling shares at a premium to NAV.
Unlike most BDCs, which are essentially high-yield lenders, MVC is equity
oriented with a portfolio mix of 65% equity / 35% debt.
As of 9/30/09, MVC reported net assets of $403 million, and NAV per share of
$16.59. The recent stock price was about $9, so the current price to NAV is less
than 0.55.
The portfolio contained 32 active investments as of July ’09. The top 10 positions
accounted for ~ 68% of the portfolio value.
MVC isn’t highly leveraged, with $65 million in debt against a portfolio of cash
and investments of $467 million.
MVC pays out a modest

The interesting history:

MVC was originally founded in March 2000 by a well-known Silicon Valley VC
firm to invest in internet and technology start-ups.
Over the next three years, MVC suffered a decrease in value of $182 million on
$206 million in investments (-88%). Luckily the firm had not invested all of the
cash raised in the IPO. As of October 2003, there was $124 million in cash and $24
million in VC investments on the books. The company also had tax losses in excess
of $150 million that could be used to shield future gains.

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In September 2003, the MVC board appointed Michael Tokarz to be the Chairman
and Portfolio Manager. Tokarz was previously a general partner at KKR, and a 30-
year veteran in the private equity industry.
Tokarz signed on for three years for a compensation package consisting of no
salary and an incentive fee of 20% of any realized gains. The new board members
also voluntarily reduced their salaries by 50%.
With shares selling significantly below NAV, in December 2003 MVC did a tender
offer and bought back 23% of the shares at 0.95X NAV. The stock subsequently
traded at a much smaller discount to NAV.
Tokarz began investing in “old economy” cash generating businesses, and by yearend
2004 NAV increased by $11.2 million and MVC paid its 1st dividend in Q4.
In December 2004, MVC did another rights offering, raising $60 million at the
0 95X lti l t th h t hi h l l th li )
Centaur Capital Partners 18
same 0.95X multiple to NAV (though at a higher NAV level than a year earlier).

Extreme make-over:

In 2006, Tokarz set up an external management firm to run the portfolio, and
signed a new management agreement with the more standard 2% of AUM fee as
well as 20% incentive fee on realized gains.
The new agreement put a cap on total expenses at no more than 3.25% of AUM for
2007 and 2008 and no more than 3.5% of AUM for 2009 and 2010.
In February 2007, MVC raised $78.4 million at $16.25 per share, a premium to
NAV.
MVC reported realized gains in FY 2007 of $66.9 million on the sale of two of the
early Tokarz investments, Baltic Motors and BM Auto.
The track record of MVC over the past five years ending October 31, 2008:

Questions about the NAV:

MVC’s valuation committee states the NAV at $16.59 as of September 30th. Can
we trust them?

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MVC does not employ an external valuation service so all valuations are done by
the MVC Valuation Committee. Naturally, one should be skeptical when
management gets to grade their own tests.
NAV per share actually went UP during the period between June 2008 and March
of 2009, a period of time when the Russell 2000 declined by 38%. How is this
possible?
MVC provides no transparency into the financials of the underlying investment
portfolio companies in terms of revenue, profitability, etc. This isn’t unusual in the
BDC universe, but providing better disclosure would likely help MVC’s cause.
Of the $30 million in 2008 operating income, PIK income accounted for $5.5
million, or 18.3% of the total. (PIK, or payment-in-kind, consists of portfolio
companies paying a portion of their interest in the form of additional securities or
by adding to the principal amount of the current debt instrument. It is non-cash.
MVC must include PIK income in its distributable cash flow to shareholders)
BDCs have terrible incentive structures. with management fees and allowable
leverage all predicated on reported NAV. This creates

Can we trust MVC?

We don’t derive any incremental comfort from independent valuation services. In
our view, there are still significant incentive misalignments. Most valuation
services only provide the vague assurance that the valuation approach “does not
seem unreasonable” and even then only on a cross-section of the portfolio.
It is our understanding that MVC’s valuation philosophy is heavily weighted
towards trailing EBITDA, and portfolio company performance on this metric did
not decline nearly as much as the R2K. However, some EBITDA erosion can be
seen in the NAV decline from $17.29 to $16.59 between March and Sep ’09.
MVC has significant insider ownership, with consistent insider buying and no
insider selling. Insiders own ~11%. We don’t consider this definitive, but is
supporting evidence of alignment between management and shareholder.
Unlike many other BDCs that have willingly raised significant capital at large
discounts to NAV, MVC has not done a dilutive secondary offering and does not
appear to be preparing one.
The past behavior of Michael Tokarz and the board in creating a fair fee structure,
keeping expenses to a minimum, and delivering significant capital gains well in
excess of prior portfolio marks causes us to be favorably inclined towards them.
The current 45% discount to NAV captures a whole lot of bad stuff.

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