Value Investor Insight - WordPress.com · Investor Insight: Chuck Akre Seeking high potential...

Aself-described “authority-resistanttroublemaker,”Robert Kleinschmidtfound the perfect home in joining

Tocqueville Asset Management in 1991.The firm’s philosophical heritage drew onthe writings of Alexis de Tocqueville, whocritiqued the U.S. in Democracy in Americaas unique in how “little independence ofmind" its citizens exhibited.

Kleinschmidt’s contrary nature hasserved investors well. The firm now man-ages more than $10 billion and the flagshipmutual fund Kleinschmidt still manages hasearned a net annualized 6.3% over the pastten years, vs. 2.9% for the S&P 500.

Expecting today’s volatile trading envi-ronment to continue, he’s finding upside insuch areas as timber, specialty insurance,glass containers and real estate. See page 10

ValueInvestor December 28, 2011

Many Happy ReturnsIdentifying today’s excellent businesses isn’t nearly as hard as honing in on thosethat will stay that way. Chuck Akre has proven highly skilled at doing both.

Inside this IssueF E ATU R E S

Investor Insight: Chuck Akre

Seeking high potential growth com-bined with modest valuation andfinding it in TD Ameritrade, RossStores, Enstar and Markel. PAGE 1 »

Investor Insight: Robert Kleinschmidt

Bucking the consensus to find mis-priced value in such firms as CBREGroup, Weyerhaeuser, Microsoft,Aflac and Owens-Illinois. PAGE 1 »

A Fresh Look: Toll Brothers

The ride will likely remain rocky inthis stock, says Morris Mark, but it'sstill one well worth taking. PAGE 17 »

Of Sound Mind

Why that when it comes to assessingmistakes investors' words quite oftenfar surpass their deeds. PAGE 18 »

Editors' Letter

One humble investor's post-mortemon a Lollapalooza mistake. PAGE 20 »

INVESTMENT HIGHLIGHTS

Other companies in this issue:

American Tower, Briggs & Stratton, Carbo

Ceramics, Exxon Mobil, FactSet Research,

Ford, Home Depot, Lamar Advertising,

Lennar, LPL Investment, MasterCard,

Microsoft, MSCI, Newmont Mining,

NextEra, Penn National Gaming, TJX,

Zillow

Quite ContraryThe consensus certainly isn’t always wrong, but it is wrong often enough for dis-cerning contrarians like Robert Kleinschmidt to take consistent advantage.

The Leading Authority on Value Investing INSIGHT

INVESTMENT SNAPSHOTS PAGE

Aflac 13

CBRE Group 16

Enstar 7

Markel 8

Owens-Illinois 14

Ross Stores 6

TD Ameritrade 5

Toll Brothers 17

Weyerhaeuser 12

Middleburg, Virginia, home ofChuck Akre's Akre Capital,isn't the bustling metropolis in

which many prominent investors ply theirtrade, but it has its advantages. “Being in atown with one traffic light,” he says, “thereare fewer distractions.”

Akre's unhindered focus has paid offnicely for investors. The successive mutualfunds he's managed under different namessince 1997 have earned a net 13.6% peryear, vs. 5.4% for the S&P 500. Hislong/short hedge fund since 1993 is up15.1% annually, vs. 7.6% the S&P index.

In his ongoing quest to uncover afford-able “compounding machines,” Akretoday is finding opportunity in such areasas online brokerage, off-price retail, insur-ance and credit cards. See page 2

www.valueinvestorinsight.com

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

Chuck AkreAkre Capital Management

Investment Focus: Seeks companieswith high, sustainable returns on equity andfertile reinvestment options – at times whenstock prices don’t adequately reflect either.

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

Robert KleinschmidtTocqueville Asset Management

Investment Focus: Seeks companies forwhich the current consensus is understood,demonstrably negative, and sufficiently ill-informed to create share-price bargains.

http://www.valueinvestorinsight.com

I N V E S TO R I N S I G H T : Chuck Akre

Value Investor Insight 2December 28, 2011 www.valueinvestorinsight.com

Investor Insight: Chuck AkreChuck Akre, Tom Saberhagen and John Neff of Akre Capital describe the company characteristic they find most rareand valuable today, the ways in which the financial crisis did – and didn't – alter their strategy, why selling to them israrely about pure valuation, and why they believe TD Ameritrade, Ross Stores, Enstar and Markel are mispriced.

You described when we last spoke [VII,November 30, 2006] a fairly straightfor-ward investing strategy which, to over-simplify, was to buy companies with highreturns on equity at reasonable prices.Explain how one does that well.

Chuck Akre: Underlying that is my obser-vation that the long-term rate of returnon equities in this country is in the neigh-borhood of 10%, which correlates close-ly to the actual return on owners’ capitalfor all those businesses over time. Mypremise then is that the return I’ll earn ona stock – absent distributions and assum-ing a constant valuation – will approxi-mate the company’s ROE over a numberof years. So we choose to swim in thepool of companies where the returns havebeen much better than average and wherewe believe over the next five to ten yearsthat opportunity will remain largelyintact. And because you’re saying, “Akre,you fool, you know we don’t have con-stant valuations,” we also work hard topay low valuations at the outset.

We focus our attention on three pri-mary areas, which I sort of visualize asthe three legs of an early 20th-centurymilking stool, which was actually sturdierthan those with four legs and which pro-vided a steady surface on all kinds ofuneven ground.

Leg one is the business model. High-return businesses have something specialwhich allows them to earn above averagerates on employed capital. That may beintellectual property, scale economies, aregulatory advantage, high customerswitching costs, or some sort of networkeffect. We want to see evidence the busi-ness model produces unusual returns, tounderstand why and to believe that’s like-ly to continue. Part of that is a function ofthe opportunity yet to be realized – we’realways asking, “How wide and how longis the runway?”

One of our most successful invest-ments, which we still own, is AmericanTower [AMT], which leases wireless-communications tower capacity to opera-tors like Verizon and AT&T. The wire-less-communications runway is long andwide and once a tower is up – approvalfor which is difficult to come by – andprofitable, the fractional tenant is addedat about a 90% gross margin. That’s anextraordinary business model.

Another example of a great businessmodel, which is new to our portfolio inthe past year, is MasterCard [MA]. It andVisa principally own the “rails” overwhich electronic payments travel world-wide. Those rails are exceedingly difficultto replicate, there’s a wonderful toll-booth aspect to revenues, and the busi-ness has a giant global wind at its back inthe growth of electronic exchange ofvalue away from cash and paper.

The second leg of the stool is the peo-ple. We’re looking for managers whohave demonstrated they are “killers” atbusiness execution, and who have a histo-ry of always acting in the best interests ofall shareholders. I’m not interested, forexample, in CEOs who appear personallygreedy. I frequently ask CEOs how theymeasure success. They often speak aboutmeeting the needs of their various con-stituencies, including shareholders,employees, customers and the communi-ty. Many have said they measure theirsuccess by the rise in the share price. Thecloser they get to saying they measuresuccess by growth in the company’s realeconomic value per share, the more inter-ested I am.

Our final area of focus – the third leg– is reinvestment. Does the company havethe capital-allocation skills necessary andthe market potential to invest all theexcess cash generated by the business inprojects that can earn above-averagereturns? In my experience this is perhaps

Chuck Akre

Re-Boot

After twelve years managing the FBR

Focus Fund to market-trouncing returns,

Akre Capital's Chuck Akre in 2009 was

asked to renew his firm's sub-management

contract at a substantial reduction in com-

pensation, an offer he declined. From late

August to early September, his mutual

fund assets went from $1 billion to

$10,000 in his just-launched Akre Focus

Fund. On top of that, the three analysts

who had worked for him left to run the FBR

fund in his absence. “On the investment

side of the business I was on my own,” he

says, “where I've been before.”

He hasn’t missed a beat. After outpacing

the market in 2010, the Akre Focus Fund

is up 11.7% this year, in the top 1% of all

comparable funds tracked by Morningstar.

He's rebuilt his analyst team, he says, “with

people who are not only younger, better

looking and better educated than I am, but

who challenge me every day to be a better

analyst and investor.”

After 43 years in the business, he has no

interest in slowing down. “My wife men-

tioned recently that I was working harder

than I had in years, which is true. I enjoy the

work, which is challenging and rewarding.

Why do anything else?”




the single most important issue facing anyCEO, and is also the area in which man-agement can create or destroy value mostquickly and permanently.

In the hierarchy of potential uses ofexcess capital, what are your preferences?

CA: Inasmuch as the core business hashigh returns and there’s opportunity tokeep investing in it – as opposed to pour-ing money into something brand new –we’d clearly prefer that. American Towercan put up a new tower. Ross Stores[ROST] can open a new store. PennNational Gaming [PENN] can expand anexisting casino. The best of all worlds iswhen the incremental capital required toaccess growth is minimal, which we con-sider the case today in a company likeMasterCard. In all these cases, a signifi-cant internal rate of capital compoundingin a company is very likely to translateinto a significant investment return for usover a long period of time.

Tom Saberhagen: Given today’s econom-ic environment, we can find great busi-nesses that generate a lot of cash and arerun by owner-oriented managers, but it’svery hard to find companies that can con-tinue to reinvest that cash productively.That’s why we’re seeing such high rates ofshare buybacks and dividend increases.

CA: If that’s the choice, we tend to preferbuybacks – at the right price – than moredividends. We can, of course, reallocatethe capital returned as dividends, but it’sless efficient. We prefer to find those com-pounding machines that do it for us.

Have your views on reinvestmentchanged for long-time holding PennNational Gaming?

CA: Yes, which is why it’s gone from oneof our top two or three positions to now2% or less in our various portfolios. Wehave the macro view that consumerspending will remain constrained, whichhas caused a decline in visits to casinosand in the play per visit. At the same time,the poor economic health of governmen-

tal jurisdictions around the country hasresulted in increased taxes on gaming rev-enue and a loosening of restrictions onthe number and type of competitorsallowed. So while Peter Carlino, Penn’schairman and CEO, has to my mind beenthe best compounder of shareholder valuein the industry, his reinvestment opportu-nities today are not as profitable as theyonce were. That’s why it’s a much smallerposition than before.

How much of that position downsizingwas on purpose?

CA: Peter Carlino played his cards whenhe agreed to sell the company to privateequity for $67 per share in cash in 2008,but the deal came a cropper because ofthe crisis. One lesson we take from that isthat we should have taken some moneyoff the table when the deal wasannounced, rather than think the last 8-9% upside in the stock as the deal closedwas a lock. As it turned out, we ended upselling some shares in the mid-$30s, but itwent as low as $10 before coming back tothe high-$30s today. Should we be in asimilar situation again with a positionsize that got as large as Penn’s did, ourthought today is that as a matter of rotewe would take maybe half the capital offthe table.

Have you lowered your general returnexpectations for companies in the after-math of the crisis?

CA: We always said we wanted to investin companies with at least 20% ROEs,but that has been relaxed somewhat tothe mid- to upper-teens. In a zero-interest-rate environment, we think that’s perfect-ly reasonable.

You described last time your approach tovaluation as, “We’re not willing pay verymuch.” Can you expand on that?

CA: We’re trying to get at how much freecash the business generates relative towhat’s invested in it in terms of owners’equity. So our valuation is centered onfree cash flow multiples. What’s low? Wehave companies in the portfolio which wehave purchased at less than 10x and wehave a couple bought as high as 20x. Byand large, what gets us excited is when acompany is compounding economic valueper share in the mid-teens or higher andwe pay a multiple a good deal lower thanthat, say 10-12x free cash flow.

You mentioned having a macro viewabout consumer spending. Isn’t incorpo-rating a macro view relatively new toyour process?

CA: One conclusion I made from our2008 and early 2009 experience beingmore unpleasant than I would have likedis that I needed to better incorporate myworld view into individual security selec-tion, with the goal of trying to minimizefuture unpleasantness. We’re focused onbetter connecting the dots between theoverall economic environment and theopportunities or pitfalls facing individualbusinesses. In 2008 we were looking attrees and didn’t see the forest.

What’s your world view telling you today?

CA: We’ve been talking for some timeabout the constraints on consumer spend-ing. That’s a function of consumers’diminished access to credit and to the factthat one in six people in our workingeconomy is unemployed or not workingenough hours to meet his or her financialresponsibilities. That’s a huge drag on theU.S. economy, which is still roughly 70%driven by consumer spending.

Separately, most of the Western worldis made up of debtor nations facing finan-cial crisis. I’m not an economist, but Ithink we’re likely beyond the point wherethe system can tolerate the extent of theindebtedness, so the system has to be

ON MACRO VIEWS:

We’re focused on better con-

necting the dots between the

overall economic environment

and individual businesses.




repaired. The problem is that neither theU.S. nor Europe at this point has defineda clear path towards recovery, and electedofficials are hardly instilling confidencethat they’ll find one anytime soon. Webelieve as a result that equity markets willremain very skittish and volatile, which ifwe’re prepared, is good for us.

How is this thinking built into ourportfolio? In general, we believe the smallnumber of businesses we own can prosperin this difficult environment. For exam-ple, we’ve made significant bets on off-price retailers such as Ross, Dollar Tree[DLTR] and TJX [TJX]. We’ve also beenjudicious in putting cash to work. In ourmutual fund, for example, we alwayswant 5-10% of cash in reserve becausewe don’t want to have to sell anything tomeet unpredictable redemptions. Rightnow the mutual fund is about 25% cash,giving us plenty of dry powder to takeadvantage of volatility.

Is there a thematic element to your fairlynew investments in financials such as TDAmeritrade [AMTD], FactSet Research[FDS] and LPL Investment [LPLA]?

CA: Each story in this case is relativelyunique. We’ll talk later about TDAmeritrade, for example, but it has hugeincremental profit upside in a rising inter-est-rate environment. FactSet is a good,subscription-based business that hasimproved its competitive position byinvesting in proprietary content andoffers an increasingly competitive alterna-tive to Bloomberg and Reuters in provid-ing financial and economic informationto the investment community worldwide.For LPL Investment, we think its businessof providing essential technology, broadproduct selection, and back-office servic-es to independent financial advisors iswell positioned as retail-investor demandshifts towards independent advice.

Did the experience of 2008 cause you toquestion your traditionally high level ofportfolio concentration?

CA: No. It’s hard to find the types ofbusinesses we invest in, so when we find

them we want to hold them at a sizewhere they can have a material impact onthe portfolio. In our separate accountswe typically hold 10-15 securities. In ourpartnership we’re typically more concen-trated, with the top five positions makingup about 65% of the portfolio. Themutual fund is required to be somewhatmore diversified, but the top ten posi-tions today are slightly more than 60%of the fund.

Our primary frontier of risk manage-ment isn’t wide diversification, but the

quality of the individual businesses, theirbalance sheets and the people who runthem. In the crisis the businesses weowned held up quite well, even if theirstock prices didn’t. That type of volatilityis risk only if you’re looking at a shorttime frame, which we aren’t.

Describe your more detailed case foronline broker TD Ameritrade [AMTD].

TS: The online brokerage business hasconsolidated and matured to a set ofmore or less conventional players, withTD Ameritrade in the winner’s circlealongside Fidelity and Schwab. Given thescale and brand names of the marketleaders, customers now make little dis-tinction in terms of trust between theonline brokers and their more conven-tional competitors.

We first got interested in the companywhen looking for ideas that would bene-fit from an eventual rise in interest rates.TD Ameritrade makes money not onlywhen customers trade, but also on thefloat of customer cash held in brokerageaccounts. Today it sweeps roughly 15%of total customer asset balances over toToronto-Dominion Bank, the AAA-rated

Canadian firm that owns 45% of thecompany’s shares. It now earns about 135basis points in net interest margin on thatroughly $60 billion in swept cash, but ina more normal rate environment – say,the 10 years or so prior to the crisis – thatnet margin would be 300 to 400 basispoints.

On $60 billion, that margin differencetranslates into maybe $1.2 billion ofincremental revenue that pretty muchdrops to the pre-tax profit line. Thatwould produce an incremental $1.25 orso per share after taxes, doubling whatTD Ameritrade is likely to earn this yearin free cash flow. The effect would roll inover a number of years. Even if that takesfive years, there's a large tailwind builtinto the earnings stream if interest ratesnormalize.

That was the starting point of the idea,but as we dug in further we learned thiswas just an excellent business. Despiteeverything that’s gone on in the financialmarkets over the past five years, includingthe adverse rate environment, the compa-ny has grown its top line by 9% per year.It’s had the highest organic client growthrate in the industry – net new assetgrowth was 12% in the latest fiscal year –driven by a successful initiative to attractfinancial advisors to its platform, andgenerally by pursuing an independent andunbiased model that focuses on providingthe broadest range of options and notpushing people to buy particular prod-ucts. They pioneered the flat-rate pricingothers have adopted and have employees’incentives focused almost exclusively onattracting a larger share of customers’assets to TD Ameritrade accounts.

What’s your take on management?

TS: TD Bank has a conservative and cus-tomer-focused culture, which has trans-lated to TD Ameritrade as well. FredTomczyk, the CEO since 2008, had beenthe vice chairman of corporate operationsfor the TD Bank Group.

One positive example of manage-ment’s character was how they handledcustomer losses on auction-rate securitiesthat went bad in money-market accounts.

ON DIVERSIFICATION:

It’s hard to find the types of

businesses we invest in, so

we want to hold them at a size

that has a material impact.




Promptly and without prodding – in con-trast to Charles Schwab – the companystepped up and made clients whole. Wealso appreciate that as TD Ameritradehas used excess cash to buy in shares, itwent to TD Bank and said that for us todo right by our shareholders and share-holder value, you need to participate aswell. So governance seems to be workingfor all shareholders, not just TD Bank.

How are you looking at valuation withthe stock at a recent $15.40?

TS: Free cash flow per share over the dif-ficult past five years grew 7% per year,

coming in at around $1.25 per share forthe fiscal year ending in September. If weassume the company continues on itspath in terms of customer and assetgrowth, that the interest rate compres-sion of the past five years goes away, andthat shares continue to be repurchased at3-4% per year, we expect per-share freecash flow growth to be in the low-teens.If we get lucky and the company makes abetter spread on the float, that couldresult over the next five years in 20-25%annual free-cash-flow growth. If we canpay only a 12.3x multiple for that, wethink the math will work very much inour favor.

Is one risk that the individual investorgets scared away by the market?

TS: We talk about that. TD Ameritrade’smodel isn’t highly dependent on hyperac-tive traders and we also take comfort inthe fact that what we’ve been throughalready has been pretty bad and the busi-ness held up well. The growing advisorbusiness also helps, if individuals seek outprofessional help to a greater degree.

You mentioned Ross Stores fitting withyour macro view on consumer spending.What specifically do you like about itsbusiness?

TS: The core idea of off-price retail isvery simple. Companies like Ross offerproducts with department-store quality at20-60% off department-store prices.Their ability to do that reflects how thesupply chain works for departmentstores. They plan their merchandisingnine months or so in advance and want tomake sure they have the flexibility if anitem turns out to be popular and sells outthat they can get it restocked quickly, soas not to lose highly profitable full-pricesales. In order to satisfy those basicrequirements, there’s a natural overplan-ning on the part of both departmentstores and manufacturers – most of whichare overseas – resulting in many moreitems being made than will ultimately sellat full price.

So when excess inventory isn’t going tobe sold at full price, manufacturers’ next-best option is to send it to the off-pricechannel, where the biggest players likeRoss and TJX (the parent company of T.J.Maxx and Marshall’s) can convert thatinventory to cash and move the mostproduct quickly, often in-season. Themanufacturers are motivated sellers –they don’t want to carry over inventory –so will typically sell to Ross and TJX atbelow the wholesale price paid by depart-ment stores. Because Ross and TJX canmost efficiently sell what they buy, theyusually pay the best prices the manufac-turers can get. Often the manufacturermakes a cash profit or even a fully-loadedprofit on these sales.

TD Ameritrade(Nasdaq: AMTD)

Business: Electronic securities brokerage,

offering to retail investors and investment

advisors trading in stocks, bonds, options,

futures and other asset classes.

Share Information

(@12/27/11):

Price 15.4152-Week Range 13.43 – 22.90Dividend Yield 1.5%Market Cap $8.46 billion

Financials (TTM):

Revenue $2.73 billionOperating Profit Margin 37.8%Net Profit Margin 23.4%

THE BOTTOM LINE

The company’s per-share free cash flow should grow at a low-teens annual rate from

asset growth combined with share buybacks, says Tom Saberhagen, and at double

that rate if interest rates return to more normal levels. In paying only 12.3x free-cash-

flow for that potential, he says, “we think the math will work very much in our favor.”

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

AMTD PRICE HISTORY

Sources: Company reports, other publicly available information

25

20

15

102009 2010 2011

Valuation Metrics

(@12/27/11):

AMTD S&P 500Trailing P/E 13.9 14.5Forward P/E Est. 13.4 12.6

Largest Institutional Owners

(@9/30/11):

Company % Owned

Fidelity Mgmt & Research 3.5%JPMorgan Chase 2.8%T. Rowe Price 2.6%Winslow Capital 2.2%Citadel Advisors 2.0%

Short Interest (as of 11/30/11):

Shares Short/Float 3.8%

25

20

15

10




The sustainability of the businessmodel comes from Ross’s scale, purchas-ing skills and efficiency, which allows it tostock quality merchandise at prices farbelow its structurally higher-cost compe-tition. At the customer level, you can seethe appeal of the concept at any time, butespecially when people have tight budgetsand are trying to save money.

Does Ross do much better in tough times?

TS: The business does improve when theeconomic environment is difficult. Butexperience has shown that when new cus-tomers discover the bargains available, a

good percentage of them keep shoppingat off-price stores when times get better.Ross hasn’t had a down same-store-saleyear since 2004 and TJX’s streak goesback further, to 1996. It hasn’t proven tobe a hugely volatile business and returnson equity are in the 40% range.

How long is the growth “runway”?

TS: The company is now in 29 states,with 1,000 Ross Dress for Less stores andless than 100 in a secondary conceptcalled dd’s Discounts, which offers evencheaper prices and a broader range ofitems for the whole family. Historic store

growth has been more in California,through the Southwest and into Florida,but Ross is now moving north primarilyinto Midwestern states where there’s lowmarket penetration. The company is tar-geting square footage growth of around6% per year and probably has roomdomestically to go to 1,500 Ross storesand maybe 500 dd’s Discounts.

Do you make any distinction between thepotential for Ross and for TJX?

TS: We think they’re both excellent com-panies. They have developed somewhatdifferently geographically, with T.J. Maxxand Marshall’s starting out in theNortheast and Ross coming out ofCalifornia. When they are in the samemarkets, they often have stores closetogether, because people shop at both justto see what they have – it’s kind of atreasure-hunt environment. What’s mostimportant is that these are the only twocompanies with the scale, merchandisingskill and logistics capability to execute thestrategy successfully, which is why theydominate the market.

The shares, recently at just under $49, areup more than 50% in the past year. Whatupside do you see from here?

TS: We see a clear path for them to growsquare footage at least by the targeted 6%per year, aided by all the retail spaceavailable at good prices that has openedup in recent years. Positive same-storecomps have been running 3-4%, a ratelikely to continue in the consumer envi-ronment we expect. With excess cashused to retire shares at roughly 5% peryear, that gets us to top-line per-sharegrowth of 14-15%. There aren’t manystable businesses out there today with thiskind of growth potential.

The key issue is whether the marginexpansion the company has realized –operating margins have gone from 7% to12% since 2007 – is sustainable. Webelieve it is, due primarily to more sophis-ticated inventory planning. The dollarvalue of average inventory on the floordeclined by 40% over the past five years

Ross Stores(Nasdaq: ROST)

Business: Second-largest discount retailer

of brand-name apparel and home acces-

sories in the U.S., primarily operating under

the Ross Dress for Less brand name.

Share Information

(@12/27/11):


Financials (TTM):


THE BOTTOM LINE

The company has been firing on all cylinders through troubled economic times, but

Tom Saberhagen expects top-line growth to continue at 14-15% annually and for

improved margin levels to hold. Given that growth potential, with the shares trading at

14x his estimate of next year’s free cash flow, “We still think that’s cheap,” he says.


ROST PRICE HISTORY


50

40

30

20

102009 2010 2011

Valuation Metrics

(@12/27/11):

ROST S&P 500Trailing P/E 18.1 14.5Forward P/E Est. 15.5 12.6


(@9/30/11):

Company % Owned

Fidelity Mgmt & Research 13.7%Vanguard Group 6.3%Wellington Mgmt 3.9%State Street 3.7%T. Rowe Price 3.1%



50

40

30

20

10




at a time when sales were going up. Wedon't count on further margin expansion,but we think the current levels can hold.

Looking a year out, for the fiscal yearending January 2013, we estimate Rosswill earn around $3.50 per share in freecash flow. Even with the strong run-up inthe share price, that’s only a 14x multiple.For the growth potential here, we stillthink that’s cheap.

From off-price retail to runoff insurance,what do you think the market is missingin Enstar [ESGR]?

CA: The company, of which I’m a direc-tor, operates in a narrow niche of theproperty/casualty insurance business,which is buying insurance or reinsurancethat is in runoff and then looking torationalize and resolve those liabilities ata net gain over what they paid to acquirethem. That’s all they do.

The driver of the business is that oper-ating insurance companies regularly startnew lines of business that they later decidethey can’t make enough money in, or theyhave existing lines that have stoppedworking. They want to get out but can’tjust close up shop because insurance regu-lators require some entity to be in place tomeet future claims that occur. They couldtake someone from inside the companyand put them in charge of the runoff, butthey often find current employees aren’teager to oversee a business that’s goingaway. They could also hire an outsidemanager for a fee, but the liability stays ontheir balance sheet. Or they could sell it,which is where Enstar comes in.

The hierarchy in the business is thatNational Indemnity – owned by BerkshireHathaway and run by Ajit Jain – is themarket leader, with Enstar a distant #2but still bigger than each of the otherplayers. National Indemnity has a com-pletely different approach to the businessthan Enstar. It hangs onto the assets aslong as it can, to earn money on the floatfor as long as possible. Enstar’s approachis to get rid of the liabilities as quickly asit can. That means only a small portion ofits investment portfolio can be investedfor the long term, so investing skill isn’t

their competitive differentiator. Theirexpertise is in doing great due diligenceon the portfolios they go after, being verydiligent in the prices they pay, and thenexecuting smartly to wind up the liabili-ties in the runoff.

Has several years of soft pricing in prop-erty/casualty insurance been a tailwindfor them?

CA: It’s possible that if the pricing cycleturns, Enstar might have less new busi-ness to bid on. But if you look at the his-tory of the business, the supply of runoffinsurance has continued to grow quite

nicely over time. I don’t believe they’reapt to run out of opportunities.

At a recent $98.70, how inexpensive doyou consider the shares?

CA: The company has over the past sixyears compounded book value per sharein mid-20% range. That’s the metric overtime on which to focus, because theincome statement reporting can be con-fusing to the casual reader. The biggestaccretion of value, for example, falls inthe expense category, when they recap-ture reserves after a liability has beencommuted. When the amount of insured

Enstar(Nasdaq: ESGR)

Business: Bermuda-based holding com-

pany that acquires and manages insurance

and reinsurance policy portfolios that have

been placed in runoff by previous owners.

Share Information

(@12/27/11):


Financials (TTM):

Revenue $106.2 millionOperating Profit Margin (-26.2%)Net Profit Margin 140.5%

THE BOTTOM LINE

Chuck Akre believes the company is well-positioned to compound book value per

share at a mid-teens annual rate. If he’s right, its shares trade today at around 100%

of estimated 2012 year-end book value. It would not be unusual, he says, for the mar-

ket to pay twice that multiple for an insurer compounding book at the rate he expects.


ESGR PRICE HISTORY


120

100

80

60

402009 2010 2011

Valuation Metrics

(@12/27/11):

ESGR Russell 2000Trailing P/E 9.1 38.3Forward P/E Est. 8.4 22.0


(@9/30/11):

Company % Owned

Christopher J. Flowers 10.9%Goldman Sachs 10.5%Beck, Mack & Oliver 8.6%Advisory Research 5.6%Akre Capital 3.5%



120

100

80

60

40




loss they recognize is less than the reserve– the positive outcome – it shows up as anegative expense. The results will likelybe lumpy, but change in book value pershare measured over a period of years isthe metric that makes the most sense.

My view is that the company is well-positioned to compound book value pershare at a rate in the mid-teens. The ques-tion then is what the market will pay rel-ative to book value for a business that canachieve this. At today’s price, the stocktrades at less than 140% of book value asof year-end 2010. If Enstar on averagegrew book value per share at 15%, 2012year-end book value could easily be in themid-$90 dollar range, so the multiple onnext year’s book is barely more than100%. In a more normal environment,the market would typically pay 200% to300% of book value for a company thatcan grow book value at the rate Enstarhas achieved in the past. We expect it tobe a great investment even with no multi-ple expansion, but if the multiple doesgrow it really gets interesting.

Does the absence of deep pockets likeBerkshire’s limit growth potential?

CA: Relative to National Indemnity,Enstar is somewhat capital constrained.That has not caused them problems his-torically. The latest addition to the equitybase came this year, when an affiliate ofGoldman Sachs committed to a nearly20% stake in the company for close to$300 million. The last tranche of that set-tled just before this Christmas.

Markel [MKL] is a long-time holding thathas hit a bit of a wall in recent years.Explain the upside you see in it today.

CA: We’ve owned the stock for 20 yearsand for more than half that time the com-pany compounded book value at morethan 20% annually. It has not done thatin the last six or seven years, whenreturns have been more in the high singledigits, low double digits. That’s been afunction of the down insurance pricingcycle and the way that works its waythrough the company’s business model.

Markel sells specialty property/casual-ty insurance, operating in 95 to 100 dif-ferent lines of business. It has historicallyunderwritten with great discipline, suchthat reserves over time have been redun-dant rather than deficient. That hasallowed them to invest a significant pieceof their portfolio for the long-term, mean-ing in common stocks, where they’ve cre-ated value at a rate beyond the S&P 500.As part of that model, they constructed aholding company balance sheet whichtypically had $4 of investments for every$1 of book value, so that when theyearned 5% after-tax on their investments,that was magnified four times and the

change in book value was 20%. Whenpricing is soft and the business isn’t grow-ing, that gearing ratio shrinks becausethey can’t add enough to the investmentportfolio to maintain the 4:1 ratio. Todaythe gearing is more like 2.5:1.

Is your bet on the pricing cycle turning?

CA: We’re in the seventh year of a softpricing cycle. We’re going to have a hardcycle again, just like we’re going to havehigher interest rates again. When thecycle turns it is likely to result in top-linegrowth and help the underwriting side ofthe business, thereby increasing the gear-

Markel(NYSE: MKL)

Business: Underwriter and marketer of

specialty insurance, covering non-standard

risks such as racehorses and summer

camps, primarily in the U.S. and U.K.

Share Information

(@12/27/11):


Financials (TTM):


THE BOTTOM LINE

The company is a “coiled spring” levered to an upturn in the insurance pricing cycle,

says Chuck Akre. Trading today at 125% of book, he sees upside both from the mid-

teens annual book-value growth he expects and from multiple expansion to the 200-

300% of book that would be reasonable for the company in a better part of the cycle.


MKL PRICE HISTORY


500

400

300

2002009 2010 2011

Valuation Metrics

(@12/27/11):

MKL S&P 500Trailing P/E 17.4 14.5Forward P/E Est. n/a 12.6


(@9/30/11):

Company % Owned

Southeastern Asset Mgmt 7.1%Sprucegrove Inv Mgmt 4.8%Baillie Gifford & Co 4.1%Vanguard Group 3.8%Select Equity Group 3.6%



500

400

300

200




ing ratio. Just as TD Ameritrade is acoiled spring levered to rising interestrates, so too is Markel when there’s anupturn in the insurance pricing cycle.

In addition, I expect to see economicvalue created through the relatively newMarkel Ventures division. It like the restof the investment portfolio is very ablyrun by Tom Gayner [VII, June 30, 2011],with the stated goal of creating value out-side of the insurance business. MarkelVentures has made 10 or 11 acquisitionsso far, representing about $400 million inrevenue, and I expect it to continue to addpositively to the mix over time.

As I look out at the opportunity forMarkel over the next 5 to 10 years, Ibelieve book value ought to be com-pounding at a mid-teens level.

What are you paying for that with theshares today at just over $414?

CA: Book value today is $330 per share,so you’re paying around 125% of book.That is hardly expensive for a high-quali-ty, well-run and transparent insurancecompany that I believe can compoundbook value at 15% annually. As I men-tioned earlier, 200% to 300% of book isnot at all out of line for this type of com-pany in a different part of the cycle.

If I’m right on growth, book value inthe next two years increases to $435 pershare. Even if the multiple stays the same,I have an attractive return. But when themarket hardens, the impact should beeven more exciting.

Describe in general how you think aboutselling.

CA: Our portfolio turnover tends to bevery low on an annual basis. People char-acterize that as a buy-and-hold strategy,but that’s not entirely correct. We’re try-ing to find companies with all the ele-ments for great compounding and as longas the three legs of the stool remainintact, we’re likely to stay invested. Thatmay imply buy-and-hold, it may not.

Selling for me is rarely about pure val-uation. The really good ones are too hardto find – you don’t want to part with

them lightly. Life experience tells me thatif you sell something at $50 and tell your-self you’ll get back in if it goes back downto $35, it will go down to $35.01 and thenext time you have a serious look it willbe at $300. That hurts.

We are fully aware when valuationsare getting stretched, which often coin-cides with a position getting outsized inthe portfolio. In those cases, we will like-ly take money off the table by managingthe position size down.

Has MasterCard stock going from $200to $375 over the past 15 months prompt-ed any action?

CA: We’re in it because of its extraordi-nary business model, not to speculate onthe price movement of the stock, say, bybuying at 8x and selling when it hits 12x.MasterCard is now around 10% of theportfolio and has grown that way natu-rally through appreciation, as we haven’tsold any shares. It now trades at 16x our2012 estimate of free cash flow and 13.5x2013 numbers. We consider that modest-ly valued for a business that can com-pound free cash flow at 20% annuallyover the next five years.

You did sell your position in financial-index company MSCI [MSCI]. Why?

CA: What originally attracted us was thehigh margins and low capital intensity ofthe business, which has a great tailwind inthe trend toward passive investing. But aswe looked more carefully at manage-ment’s reinvestment record and thethought process behind it, we concludedthat their record wasn’t that great andtheir thinking was, for want of a betterterm, fuzzy. Because of that fuzziness, we

decided to exit the position. I should add,however, that nothing remains etched instone. If we conclude on further inquirythat the reinvestment discipline hasimproved and been clarified, we’ll lookseriously again at investing.

Are all the legs of the stool in good work-ing order for billboard owner LamarAdvertising [LAMR]?

CA: You’re touching on something aboutwhich there’s active debate among us.John can tell you his side of the story.

John Neff: I basically concluded thatLamar no longer met our criteria on a fewfronts. They have a significant opportuni-ty in turning their asset base over to digi-tal billboards, but even factoring in rela-tively optimistic projections for pricingand sell-through, it’s hard for me to seetop-line growth of more than maybe 4%a year, which isn’t compelling. I alsobelieve the company has made some sig-nificant reinvestment errors, primarilythrough acquisitions, which has resultedin a return on total capital only in themid- to upper-single digits. In terms of theoverall market, there’s also risk that rela-tively new competition from advertisingon mobile devices or through Groupon-like schemes will eventually take a mean-ingful bite out of billboard-spendingbudgets.

CA: The reasons we haven’t sold includemy view that there is somewhat of a moataround the billboard business, that thebusiness will improve considerably whenthe cycle for local advertising finallyturns, and because the stock appears real-ly inexpensive at less than 10x this year’sestimated free cash flow. As with every-thing in the portfolio, there’s an ongoingdiscussion.

This points up what’s so great aboutthis business. You have to have your eyesopen all the time and devote yourself, asCharlie Munger says, to lifetime learning.As I like to say, in life as well as in busi-ness I’m lucky if I have learned somethingnew every day – and I’m doubly lucky ifit didn’t cost too much to do so. VII

ON SELLING:

It’s rarely about pure valuation.

The really good ones are too

hard to find – you don’t want

to part with them lightly.


I N V E S TO R I N S I G H T : Robert Kleinschmidt


Investor Insight: Robert KleinschmidtRobert Kleinschmidt and Peter Shawn of Tocqueville Asset Management explain why the most obvious contrarian ideaoften isn't the best one, their current take on gold, why we should get used to high market volatility, why they value asense of humor, and why they see unrecognized upside in Weyerhaeuser, Aflac, Owens-Illinois and CBRE Group.

Tocqueville bills itself as a contrarianvalue investor. Isn’t that redundant?

Robert Kleinschmidt: It is, but it actuallycaptures separate aspects of our disci-pline. We’re first contrarian, meaning weonly pursue ideas in which we understandthe consensus and where that consensus iseither negative or indifferent. Once wecan credibly articulate the anti-consensusview, we approach valuation as a privateowner would, meaning we determinewhat we would be willing to pay for theexpected cash flow stream from the busi-ness. If the share price is at a sufficientdiscount to that value, we’re interested.

It may go without saying, but it’simportant to remember as a contrarianinvestor that the consensus is often right.My colleague François Sicart likes to say,"Just because everyone says it's rainingoutside is no reason not to take anumbrella." But because we believe theconsensus is priced into any given invest-ment, going along with that is a very hardplace from which to make money.

How do you figure out what the consen-sus is?

Peter Shawn: We think of it as a marriageof the stock price chart and our read oninvestor sentiment. We’re obviously look-ing at stocks that are down significantlyin price, often at the very low end of his-torical price or valuation ranges. Togauge investor sentiment we use WallStreet research as a contrarian indicator,so we're attracted to names where analystratings have turned broadly negative andsell ratings are in the majority. We canalso pick up a lot about how any particu-lar company is currently being perceivedthrough our day-to-day research of talk-ing to company management, competi-tors, suppliers, industry experts and otherinvestors.

RK: To give an example of how we tendto think, our initial entry point intoExxon Mobil [XOM] a couple years agowas when the stock starting falling out offavor after it made a big bet on naturalgas in buying XTO Energy. Our feelingwas that the company had a distinguishedrecord of capital allocation and there wasa very strong likelihood that it knew moreabout the long-term prospects for naturalgas than the analysts who were so nega-tive on the deal. If our valuation worksupports it, that’s the kind of bet we willoften make.

Is the impetus for a given idea typicallybad news?

PS: Or at least news that’s perceived to bebad. We bought Ford [F] stock last sum-mer when it fell sharply due to the marketsell-off and to specific concerns abouthow a flagging economy would impactnear-term U.S. car sales. We liked that itremained profitable at a lousy point in thecycle, and our work on the demographicsof the U.S. market indicated – based onthings like cars per household, the aver-age age of the existing automobile stockand historical scrappage rates – that new-car sales were likely to come back furtherand faster than what was built into theshare prices of companies like Ford.When its shares sold off, that gave us anexcellent opportunity to buy.

RK: Which points up the fact that ourthesis often is based on the passage oftime. What makes a negative story nega-tive may just be that the next three to sixmonths – the time space in which WallStreet analysts live – don’t look so great.Again, we try to look at companies as aprivate investor would. To that investor acompany’s near-term bad news is onlyinstructive if it informs the long-term out-look. If it doesn’t, why should we care?

Robert Kleinschmidt

Making Connections

In pursuing his original goal to be an eco-

nomics professor, Robert Kleinschmidt

was exposed to a variety of teaching ven-

ues. The most unusual: teaching econom-

ics to executive-MBA students of Adelphi

University while they commuted in and out

of New York City. “We had dedicated cars

on commuter trains and I'd stand up front

with a microphone and a blackboard,” he

says. “It was only somewhat more civilized

than it sounds.”

His first foray on Wall Street, at Irving

Trust, wasn’t much of an improvement. “I

basically read Wall Street research and

then recommended to portfolio managers

what they should buy or sell,” he says. “To

my horror, they'd actually listen.”

He found a more satisfying home at David

J. Greene & Co., where he spent 13 years

prior to joining Tocqueville in 1991. He

credits his time there for instilling the

importance of rigorous independent

research and for making valuable con-

tacts. Sitting to his right when he started

was John Hathaway, now manager of the

Tocqueville Gold Fund, and to his left was

Dennis Delafield [VII, May 27, 2011],

manager of the highly successful Delafield

Fund, which Tocqueville acquired in 2009.


We try to use those situations as buyingopportunities in stocks that we like.

How do you try to distinguish betweennews that matters and news that doesn’t?

PS: We obviously don’t always get it right.In 2008 we in certain cases let our con-trarianism get the better of us and tried tocatch falling knives – Fannie Mae andAIG come most painfully to mind – thatin retrospect we clearly shouldn’t havetried to catch.

One important lesson we’ve learnedover time is to not focus our attention toonarrowly when bad news is rampant.With financials, for example, we’vesought out ways to benefit from the even-tual healing of financial markets andpotential increases in transactional activi-ty without taking the leverage and busi-ness-model risk that comes along with,say, money-center banks. That’s led us tocompanies like real estate broker CBREGroup [CBRE], title insurer FidelityNational Financial [FNF], and Lazard[LAZ], the boutique M&A advisory andasset management firm.

Another example: After the Gulf oilspill last year we spent time with litiga-tion lawyers, including those involved inthe cases being launched against compa-nies like BP and Transocean. Our conclu-sion was that it was going to be too hardto jump in front of that train at that timein those companies, but that the collater-al damage created buying opportunitiesin energy names we already knew welland owned, like Murphy Oil [MUR].

We’re curious how a utility company likeNextEra [NEE] is a contrarian play.

PS: Part of the story revolves around thecompany having one of the cleaner assetbases among its competitors. As theindustry comes under a cloud due topotential environmental regulation andresulting rate pressures, we believeNextEra’s generating assets in natural gasand alternatives might help them avoidsome problems.

RK: This is the old Florida Power &Light and we also believe that despite the

current economic hangover, babyboomers over time will continue to maketheir way to Florida in large numbers.We’re intrigued by the utility industry, butyou only want to be invested in areaswhere you’re going to see ratebasegrowth – that’s the only way these com-panies can really prosper.

You make a distinction between youranti-consensus views in large versus smallcompanies. Please explain.

RK: It’s much easier to find large-capstocks that are out-of-favor – they’re onthe front page of The Wall Street Journal

and the folks at CNBC are all over them.But in addition to looking for what othersdon’t like, we also look for what is rela-tively neglected, which are almost alwayssmaller to mid-cap names. In these casesour anti-consensus view is that the quali-ty of the business and its prospects arejust being missed by the market.

I’m quite interested in the natural gasindustry, which I consider one area thatcould be a real positive for the U.S. econ-omy if the expansion of domestic reservesushers in an era of cheap energy. Thatdoesn’t mean natural gas prices are goingto be high in the future, but we believethere’s potential investment opportunityin companies involved both in extractingnatural gas and in using it. One example isa smaller-cap name we own called CarboCeramics [CRR], which makes the ceram-ic proppants used in hydraulic fracturingmethods that can access hard-to-extractgas and oil. Environmental concerns overwhat’s commonly known as fracking maycause the stock to be volatile, but the com-pany has a very strong secular tailwindthat we don’t believe the market adequate-ly appreciates.

How do you think about valuation?

PS: We use our own discounted cash flowmodel to calculate an intrinsic value esti-mate and then we want to be buying at aprice at least 30% below that. We alsolook at how we believe that intrinsicvalue can grow and want to believe thevalue of the equity can double to our tar-get price over the next three to five years.

RK: I’d add that while this is not true ofeveryone here, I’m still more back-of-the-envelope when it comes to valuation. Tome it all comes down to the assumptionsyou’re making. If they’re correct, a back-of-the-envelope calculation works per-fectly well. If they’re not, sophisticatedmodeling isn’t going to help.

You don’t let a position get to more than4-5% of the portfolio. Why?

RK: It’s a function of having seen thestocks of too many good companies falloff a cliff as a result of something out ofleft field. One example I like to use iswhen Merck announced it was pullingVioxx off the market in 2004. You wentto bed with the stock at $45 and woke upwith it 25% lower. I’ll give up some of theupside you might get from an outsizedposition in order to be better protectedfrom a risk you couldn’t possibly foresee.

What’s behind your view that the marketvolatility and high correlation amongstocks we’ve been seeing is something wemight have to live with for awhile.

RK: The social safety nets built up overtime in the U.S., Western Europe andJapan were in large part built on a demo-graphic conceit, with a great big genera-tion over here paying into the system anda relatively small generation over theretaking out of it. The problem is that thebaby-boom generation is now turning 65and the promises made to them in theform of retirement and health benefitswill prove impossible to keep without sig-nificant alteration either to the promisesor the resources paid into the system.

Compounding that demographic-endgame problem is that we’re seeing a



ON MODELING:

It all comes down to the

assumptions. If they’re correct,

a back-of-the-envelope calcu-

lation works perfectly well.


resolute inability on the part of electedofficials and society at large to deal withit. My view is that until that gets resolved,macro factors back and forth will contin-ue to have a disproportionate influenceon markets, meaning stocks are likely tomove sharply and more or less together.The overhang of that demographicendgame playing out is just too large.

I say that, but will then tell you wecontinue to pick stocks one at a time ontheir individual merits. We do, however,believe the likely scenario is that politi-cians try to inflate the problem away,which will have the effect of deflating thepromises that have been made. So as abackdrop to the bottom-up work we do,we’re particularly sensitive to how ourcompanies will behave in an inflationaryenvironment. That means putting moreemphasis than ever on pricing flexibility,which goes hand in hand with competi-tive advantage and some kind of moat.

Is that also behind your continued affini-ty for gold?

RK: Gold is a logical alternative for thoseworried about governments’ ability tomanage their finances. If western politicalleaders adopt practices which result indevalued currencies, large budget deficitsand rising inflation, gold to us representsa pretty decent store of value relative tocurrency alternatives.

When we started the Tocqueville GoldFund in 1998, the nadir of a 20-year bearmarket in gold, it was clear that was acontrarian move. Though it doesn’tchange what I just said, I’ll acknowledgethat it’s also very clear that our view ongold is not so contrarian now.

Why is Newmont Mining [NEM] thelargest gold-related position in the portfo-lios you manage?

RK: A good proxy for gold-companyexpenses is the price of oil, so during thislong period of rising gold prices you’veseen the cost of production go up evenmore. So while gold miners have certain-ly been decent investments, the expensedrag on earnings has held them back.

It’s started to happen already, but ifgold prices stay somewhere around wherethey are today, we believe miners likeNewmont could continue to see the rev-enue/cost equation turn more in theirfavor, resulting in some real earningsgains. That would be an added kicker tothe stock, separate from any impact onthe change in the metal’s price.

Is part of your thesis for Weyerhaeuser[WY] that it’s an inflation hedge?

PS: The core of the thesis is that if youlook at long-term normalized productionlevels from timberlands like theirs and

capitalize that production at a reasonablevaluation multiple, the stock is extremelycheap. So it’s first a question of waitingout the cycle, but there is also consider-able appeal in the fact that timber hasshown to be an excellent inflation hedgeover time.

After simplifying its business, describe thecompany’s focus today.

PS: After unloading its paper, corrugated-packaging and transportation businesses,it now operates in four primary businesssegments: timberlands, wood products,cellulose fibers (used in products like dia-



Weyerhaeuser(NYSE: WY)

Business: U.S. real estate investment trust

operating in four primary businesses: wood

products, timberlands, cellulose fibers and

real estate development.

Share Information

(@12/27/11):


Financials (TTM):


THE BOTTOM LINE

Given ongoing concerns about the U.S. housing sector, the market is sharply under-

valuing the company’s productive and profitable timberland assets, says Peter Shawn.

Separately valuing the timber business from other operating subsidiaries, he believes

the stock over the next 12 to 18 months should be worth around $25 per share.


WY PRICE HISTORY


25

20

15

10

52009 2010 2011

Valuation Metrics

(@12/27/11):

WY S&P 500Trailing P/E 22.7 14.5Forward P/E Est. 41.7 12.6


(@9/30/11):

Company % Owned

Capital World Inv 9.4%T. Rowe Price 6.0%Paulson & Co 4.4%Vanguard Group 3.8%State Street 3.5%



25

20

15

10

5




pers) and real estate. The company isstructured as a real estate investment trustand isn’t required to pay federal incometaxes on timber-harvesting earnings. Theother businesses are taxable.

One result of the restructuring is thatthe company is now more dependent thanever on the health of the housing market,which obviously has been a drag. Most ofthe timberlands Weyerhaeuser owns go tomaking softwood lumber, the U.S. con-sumption of which is maybe 50% of whatit was in the mid-2000s. Wood productsis still the largest division – accounting forabout 35% of gross sales – and is strug-gling to get to cash breakeven after amulti-year process of cost cutting. Thatbusiness has been highly profitable in thepast, but won’t be again without somereturn to normalcy in the housing market.

We see other factors working toenhance the value of the company’s tim-berlands. One is the expected increaseddemand for Pacific Coast timber to makeup for significant log-harvest declines inBritish Columbia due to devastation bythe mountain pine beetle. Another is thefact that the Pacific Northwest is the onlyU.S. tree-growing region that can prof-itably serve China, where log demand hasconsistently outstripped domestic supply.

How are you valuing Weyerhaeusershares, trading recently at $18.35?

PS: The majority of the value is in itsmore than six million acres of REIT-qual-ified timberlands, which have provenquite productive and profitable.Capitalizing our $660 million estimate of2013 normalized earnings from thosetimberlands at a cap rate of 5% results ina value of around $13.2 billion. That’sjust over $2,000 per acre, which is quitereasonable in relation to transactions thathave occurred in the industry.

For the taxable subsidiaries, we’re put-ting a 5x multiple on estimated 2013EBITDA of $700 million, resulting in avalue for those businesses of $3.5 billion.Subtracting net debt and adjusting forrecent asset sales, we arrive then at a pershare value over the next 12 to 18 monthsof between $24 and $25 per share.

The wildcard, of course, is the pace atwhich housing starts recover in the U.S.We haven’t come close to assuming areturn to mid-2000s levels, but the upsidehere won’t come without some pickupfrom today’s depressed levels.

What’s your anti-consensus take on spe-cialty insurer Aflac [AFL]?

PS: Aflac sells cancer, supplementaryhealth and various life insurance productsfor which the benefits payments are large-ly capped. A cancer policy, for example,might pay a lump sum of $5,000 upondiagnosis and $150 per day in hospital

expenses up to a pre-defined limit.Approximately 75% of the business is inJapan, where the company uses a third-party distribution model and enjoysretention rates of around 95% per year.This business model drives consistentmargins – in the mid- to high-teens on anoperating basis – and strong returns onequity of better than 25% over time.Another manifestation of the strength ofthe franchise: the dividend rate hasincreased for 29 straight years.

Two items in particular have beenweighing on the stock. The first is anissue that has been around but has flaredup recently, which is a still relatively large

Aflac(NYSE: AFL)

Business: Marketing and sale of supple-

mental health and life insurance products in

Japan and the U.S.; sold by independent

distributors and directly through employers.

Share Information

(@12/27/11):


Financials (TTM):


THE BOTTOM LINE

Peter Shawn believes the market is overreacting to concerns about the company’s expo-

sure to the European debt crisis and to potential increases in Japanese cancer rates.

Once those concerns recede, he expects the stock to again earn at least its historical

10x earnings multiple, which on his 2011 estimate would result in a $63 share price.


AFL PRICE HISTORY


60

50

40

30

20

102009 2010 2011

Valuation Metrics

(@12/27/11):

AFL S&P 500Trailing P/E 11.0 14.5Forward P/E Est. 6.5 12.6


(@9/30/11):

Company % Owned

Vanguard Group 4.4%State Street 4.2%BlackRock 2.5%Wellington Mgmt 1.8%Wells Fargo 1.6%



60

50

40

30

20

10


exposure to European financial-institu-tion debt in the company’s investmentportfolio. While some investors see thatand run the other way, we believe wehave a fairly good handle on the scope ofthe exposure and what the ultimate riskmight be. In our view, while there stillmay be some mark-to-market losses to betaken on the European exposure, they aremore or less at a level today that can beoffset by unrealized gains in the rest ofthe investment portfolio.

The other issue concerning the marketis the impact the nuclear-power disasterearlier this year in Japan might have onthe incidence of cancer in the country.While this is a very difficult issue to ana-lyze, we generally believe that over thelong term any increase in cancer-relatedinsurance payments in the country due toradiation fallout will result in rising insur-ance rates to compensate.

Are there secular arguments to make forthe sale of supplemental insurance?

PS: There’s an argument to be made thatas the breadth of what’s covered by tradi-tional health policies shrinks – particular-ly with underfunded federal plans – andthe co-payments required increase, thatwill create growth opportunity for sellersof supplemental insurance like Aflac. Wehaven’t quantified that impact or built itinto our assumptions, but we do believelong-term it can be a significant positive.

From today’s price of $43.30, whatupside do you see in the shares?

PS: We expect the company to earn morethan $6.30 per share this year. After aslower-growth 2012 as the investmentportfolio is turned over into lower-yield-ing securities, we expect EPS to grow inthe high single-digits annually over themedium term, from pricing power, costefficiencies and share buybacks.

But even if we assume this year’s earn-ings is a conservative estimate of earningspower and put on those earnings a farmore reasonable 10x multiple – thestock’s average P/E over the past ten years– we arrive at a share value 45% above

today’s price. If investors get past theircurrent concerns, the multiple would jus-tifiably be higher.

Owens-Illinois [OI] investors have cer-tainly had a bad 2011. Why do youexpect that to be short-lived?

PS: The company is the world’s largestglobal glass-bottle manufacturer, whichby the nature of the business – capitalintensive, high shipping costs, advantagesof scale – is prone to more or less oligop-olistic competition. It is #1 or #2 in all ofthe 20 or so markets it’s in, with particu-larly strong positions throughout South

America. It also has good exposure gener-ally to emerging markets, where bottledbeverage consumption is on the rise.

There’s been no shortage of bad newshere. The weak economy has arguablycaused some beer drinkers to trade downto cans from bottles. Venezuelaannounced a year ago it was taking overOwens-Illinois’ plants in that country.Earnings in the U.S. have been hit bywhat turned out to be poor productionplanning to meet an unexpected increasein customer demand. Input costs havebeen rising faster than revenues, squeez-ing margins. The company’s asbestos lia-bility remains a significant Achilles heel.

Value Investor Insight 14December 28, 2011



Owens-Illinois(NYSE: OI)

Business: Largest global manufacturer of

glass bottles, used to package a wide vari-

ety of beer, wine, spirits, non-alcoholic bev-

erages, condiments and packaged foods.

Share Information

(@12/27/11):


Financials (TTM):

Revenue $7.27 billionOperating Profit Margin 10.6%Net Profit Margin (-2.1%)

THE BOTTOM LINE

The laundry list of bad news affecting the company’s operations and share price are at

varying stages of being worked out, says Peter Shawn. Assuming 2-3% annual revenue

growth and a return to the 13% EBIT margins historically earned, his DCF model sug-

gests a $29.25 intrinsic value for the company’s stock, nearly 60% above today’s price.


OI PRICE HISTORY


40

35

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15

10

52009 2010 2011

Valuation Metrics

(@12/27/11):

OI S&P 500Trailing P/E n/a 14.5Forward P/E Est. 6.6 12.6


(@9/30/11):

Company % Owned

Wellington Mgmt 9.3%Farallon Capital 6.2%Vanguard Group 5.3%Atlantic Inv Mgmt 4.9%Manning & Napier 4.2%



40

35

30

25

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10

5


On top of all that, it certainly hasn’thelped investor sentiment that 40% ofannual revenues come from Europe.

Your contrarian take on all that?

PS: Over time the economy will improveenough for volumes to recover. The con-fiscation of the Venezuelan assets isn’tpositive, but not an insurmountable prob-lem given that they accounted for lessthan 5% of the overall business. Theoperational problems in the U.S. areworking themselves out, and were more afunction of poor forecasting on the partof customers than an endemic flaw inOwens’ processes. The margin squeezewill also recede, as contracts typicallyallow for cost increases to be passedthrough, but with a lag. It’s hard to knowwhat impact the European financial crisiswill have on the actual economy, but thefact that the expenses and debt of theEuropean operations are euro-denomi-nated provides somewhat of a hedgeagainst currency devaluation.

Then there’s the asbestos liability,stemming from long-ago use of the mate-rial at its former Kaylo subsidiary.Asbestos-related payments reduced thecompany’s free cash flow by approxi-mately $170 million in 2011. Here webelieve we have a good understanding ofhow this plays out, having spent an enor-mous amount of time to understandasbestos litigation and claims history,stemming from our experience as long-term shareholders of W.R. Grace. Thereality is that as time passes most of thepeople who were truly hurt by asbestoshave already been compensated and/orhave died. While still large, the claims lia-bility declined 7% this year, a rate thatwill accelerate.

With the shares at $18.65, how are youlooking at valuation?

PS: One thing we’ve done is to look at thebusiness without the asbestos liability, toget a sense of how the operating businessis being valued. Absent asbestos pay-ments, Owens generated $400 to $500million in annual free cash flow over the

last few years, translating at today’s mar-ket cap to a free cash flow yield on theshares of 13-14%. That’s extremely highfor this type of business and illustrates thevaluation upside as the market over timerefocuses on the underlying business.

Our DCF model assumes 2-3% annu-al revenue increases, that EBIT marginsrecover to just over 13% – the typicallevel prior to this year – and that asbestospayments decline at 7% per year. With aweighted average cost of capital of just

over 9%, that results in an estimatedintrinsic value today of $29.25. If theearnings power gets to the $5 per sharewe believe is possible longer term, there’sa good deal of upside beyond that.

Describe what attracted you to real estatebrokerage CBRE [CBG].

PS: This was a case where we startedlooking at commercial REITs in the after-math of the financial crisis, but more orless passed on the sector because of refi-nancing risk and lack of transparencywith respect to asset values. What didinterest us, however, was commercial realestate brokerage, where transactions hadfallen off a cliff and we couldn’t imaginethings getting much worse. On top of thatyou had an enormous amount of com-mercial mortgage-backed securities[CMBS] on financial institutions’ booksthat were underwater and would eventu-ally need to be refinanced and/or sold off.We expected that process to result in asignificant number of real estate transac-tions, from which the brokers woulddirectly benefit.

The industry has consolidated inrecent years, so that CBRE, Jones LangLaSalle [JLL] and Cushman & Wakefield

are the primary global players in the highend of the market, where most of theactivity is today. What attracted us toCBRE was that it has diversified its rev-enue base so that some 50% of its busi-ness today is in recurring-revenue proper-ty and asset management, while the restcomes from leasing and sales brokerage.That gives it flexibility in riding out toughtimes, while still being levered to whenthe most cyclical part of the business –brokering sales – improves.

The boom in transactions you expectedas CMBS portfolios were restructuredhasn’t happened yet. Why?

PS: By and large the banks holding thispaper chose to “extend and pretend,” bypushing out debt maturities rather thanrisk the chaos of seeing too much dis-tressed real estate dumped on the marketat such an economically precarious time.The problems haven’t gone away, howev-er, and this mountain of CMBS still has tobe restructured. Prices will be lower thanthey were, but that process is still going todrive transaction volume, which is a greatthing for CBRE.

How is the rest of the business doing?

PS: Property-management revenues havebeen growing 10%+ per year, as enter-prises continue to increasingly outsourcethat function. The investment manage-ment business has held up well despitesharp declines in property values, andshould see strong growth as commercialreal estate prices bottom and as full-yearresults from the recent purchase of ING’scomparable business flow through.

At $15.30, how cheap are the shares?

PS: The stock trades at about 8x estimat-ed 2011 EBITDA on an enterprise valuebasis, at a time when commercial salestransactions are still 50% off their peakand when operating margins are pressuredby the company maintaining much of itsbroker staff in anticipation of a recovery.

Without heroic assumptions abouttransaction volumes and margin improve-



ON HUMOR:

In a deadly serious business,

having a sense of the absurd

eases tension and helps put

things in perspective.


ment, we believe earnings over the nextfew years can get to a mid-cycle level ofaround $2 per share. With a reasonablemid-teens earnings multiple at that pointin the cycle, the share price would be clos-er to $30.

Have you ridden this position up anddown since 2009?

PS: We’ve done better than that, havingsold some of our position as the stockwent to $30 earlier this year and buying itback as the shares fell sharply with every-thing else over the summer. The long-termthesis is still very much intact.

What’s something you’ve sold recentlyand why?

PS: Our long-term orientation doesn’tmean we don’t cycle out of names whenthe thesis is slow to develop and we havebetter opportunity elsewhere. We boughtBriggs & Stratton [BGG], for example,betting on the delayed replacement cyclefor its lawn and garden equipment finallypicking up and on it possibly taking mar-ket share from Japanese competitors hurtby the earthquake and tsunami. As timewent by we became less confident in thecycle turning in a timely fashion – whenmoney’s tight, it’s not a big decision to

keep the lawnmower for another year –and felt its business as a supplier tobranded equipment manufacturers didn’thave much pricing power. With betteralternatives elsewhere, we moved on.

You have shown more patience withMicrosoft [MSFT]. Why?

PS: The bear case is so well known, thatMicrosoft is a lumbering giant whosebusiness is under threat because of the“cloud” and the rise of mobile comput-ing. Our view is that Microsoft is actual-ly well-positioned in the cloud with itsWindows Azure platform and with itshosted software products that are tightlyintegrated with the desktop. We also gen-erally believe desktop computers willdominate the enterprise environment forlonger than the market seems to thinkand will have plenty of room for growthin developing markets where peoplewon’t be going straight to iPads.

With the stock [at a recent $26] trad-ing at less than 8x earnings ex-cash and ata trailing free cash flow yield of 11%, fewpeople seem focused on how well thecompany has executed in recent years oron what could actually go right.Windows 8, out next year, could establishitself as highly relevant in today’s worldof tablets, app stores and touch inter-faces. The Windows mobile operatingsystem could be a solid competitor toApple’s iOS and Google’s Android. Theshares are priced for almost everything togo wrong and our view is that that’sunlikely to be the case.

You’ve spoken about the virtues of havingfun at work. What’s up with that?

RK: Humor is an important part ofTocqueville’s culture. That’s not to saywe’re cutting up all the time or that we’reeven that funny, but in a deadly seriousbusiness like ours if you can’t find humorin what you’re doing, it’s going to killyou. Having a sense of the absurd easestension and puts things in perspective.Without that, people burn out or tend intheir desperation to roll the dice. That’sthe last thing we want to do. VII



CBRE Group(NYSE: CBG)

Business: Provider of commercial real

estate services worldwide, including trans-

action brokerage, property and facility man-

agement and investment management.

Share Information

(@12/27/11):


Financials (TTM):


THE BOTTOM LINE

The company has successfully diversified its revenue base, says Peter Shawn, but is

still strongly levered to what he considers an inevitable rebound in depressed com-

mercial real estate sales transactions. At 15x his $2 per share estimate of mid-cycle

earnings, he believes the stock price can double within the next few years.


CBG PRICE HISTORY


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5

02009 2010 2011

Valuation Metrics

(@12/27/11):

CBG S&P 500Trailing P/E 19.4 14.5Forward P/E Est. 11.9 12.6


(@9/30/11):

Company % Owned

Goldman Sachs 8.2%Blum Capital 7.4%T. Rowe Price 6.1%Fidelity Mgmt & Research 5.3%Vanguard Group 5.3%



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0


Given the value destroyed in the indus-try over the past five years and the factthat the housing market in the U.S. rela-tive to its history is still flat on its back,it's no surprise that investors are skittishwhen it comes to housing-related stocks.Most of those seeing opportunity in thesector, such as Mark Asset Management'sMorris Mark in recommending homebuilder Toll Brothers a year ago [VII,December 2, 2010], have done so only bytaking a very long-term view. While Markthought Toll's earnings power in animproved housing environment couldresult in a doubling of the then shareprice of around $18.50, he cautioned:“We don't claim great insight into howlong that could take, but the IRR isn't ter-rible even if it takes five or six years.”

Toll shares have outpaced the marketover the past year and now trade at$20.10, but the ride has hardly beensmooth. After rising to $22 in February,the shares fell below $14 in Octoberbefore snapping back again, driven lessby anything the company was doing andmore by vacillating macro views on theU.S. economy. “Housing will follow theeconomy,” says Mark. “It isn't structuredto lead it.”

Optimistic that the domestic economyis poised for continued – if subpar –growth, Mark argues that the shell-shocked housing market has bottomedand that Toll remains one of the bestways to play its recovery. The companyhas been taking market share as competi-tion, especially from private builders, hasbeen sharply curtailed. It operates morein the higher end of the market – its aver-age single-family-home sale price is morethan twice the industry average – wherepotential buyers are on much sounderfinancial footing. Its geographic base isbroader than most homebuilders and istilted more to the Mid-Atlantic andNortheast, healthier markets that weren'tas heavily overbuilt in the boom. Finally,

Toll's balance sheet remains liquid, givingit the opportunity to troll for bargainssuch as the recent acquisition ofCamWest Development, the largesthomebuilder in metropolitan Seattle.

Mark says the company has increasedthe number of communities in which it isselling homes by roughly 15% in the pastyear, but the monthly number of sales it'smaking per community remains mired atmaybe half the four to five homes sold ina more normal market. Sales productivitywould bounce back, he says, if the overallmarket returned to a 900,000 to 1 millionhousing-start level – still less than two-

thirds of peak levels, but better than theNovember run rate of 685,000. He main-tains his view that Toll's earnings powerin an improved market is $3 to $3.50 pershare, on which he'd expect a multiple ofat least 11-12x.

He isn't putting all his housing-relatedeggs in one basket. Among other “attrac-tive businesses, currently doing reason-ably well that will participate in animproved housing environment,” he says:homebuilder Lennar [LEN], retailerHome Depot [HD] and – with only a“tiny” position – online real estate infor-mation provider Zillow [Z]. VII

Solid FoundationVacillating views on the U.S housing market have made for a rocky ride in Toll Brothers' stock since MorrisMark recommended it a year ago. But if you believe the bottom is in, he says, it's a ride worth taking.

A F R E S H L O O K : Toll Brothers


Share Information (@12/27/11):

Price $20.0952-Week Range $13.16 – $22.42

Toll Brothers(NYSE: TOL)

NEW BOTTOM LINE

The U.S. housing market’s fortunes will follow the economy’s, which to Morris Marksignals ongoing, if slow, recovery. Having added to his share position in the companyover the summer, be believes its significant upside in a recovery remains fully intact.

ORIGINAL BOTTOM LINE – DECEMBER 2, 2010Morris Mark believes the housing cycle is at or near its bottom and that the company’sbalance sheet and diverse, higher-end product portfolio ideally position it to benefit asmarket conditions improve. At 11-12x what he considers normalized earnings power of$3-3.50 per share, the stock would trade for roughly double today’s price.


TOL PRICE HISTORY


25

20

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102009 2010 2011

Valuation Metrics (@12/27/11):

TOL S&P 500Trailing P/E 83.7 14.5Forward P/E Est. 27.1 12.6

� VII, December 2, 2010

�


It may be somewhat a sign of thetimes, but there appears to be a mini-boom in new books on the subject of mis-takes. Among the many new titlesreleased in recent months on the subject:Being Wrong: Adventures in the Marginof Error; Better by Mistake: TheUnexpected Benefits of Being Wrong;Brilliant Mistakes: Finding Success on theFar Side of Failure; and The Blame Game.It’s a subject that should be of keen inter-est to investors, even the best of which arelikely to make errant choices a painfullyhigh percentage of the time.

One theme running through the com-mentary on mistakes is that Americansare particularly bad at recognizing,acknowledging and learning from errors.To err is not so much considered humanas it is a sign of things far worse. WritesKathryn Schulz in Being Wrong: “In ourcollective imagination, error is associatednot just with shame and stupidity but alsowith ignorance, indolence, psychopathol-ogy and moral degeneracy.”

It’s surely no surprise then that peoplego to considerable lengths to ignore bad

decisions, explain them away or blamethem on someone else. “For most of us,it's tough not to tack that 'but' on toevery admission of error,” says authorSchulz. “Try saying an unadorned 'I waswrong' – the full stop at the end, thesilence afterward – and you'll see howuncomfortable it feels. Most of us don’thave a mental category called ‘Mistakes IHave Made.’”

The internal misdirection is often noteven a conscious act, as one of the found-ing fathers of introspection, SigmundFreud, described in his study of errors,The Psychopathology of Everyday Life.In settling his accounts one year, Freudsaw reference to the name of a patienthe'd seen nearly every day for weeks sixmonths previously. Initially unable torecall the woman's case, he finallyremembered that she had come to himcomplaining of constant stomach pain.He diagnosed hysteria, but it turned outshe had abdominal cancer and she diedrelatively shortly thereafter. Freud himselfmarveled at this “almost incredibleinstance of forgetting.”

The pervasiveness of mistake-relatedhang-ups, of course, hinders the insightthat can be gleaned and the progress thatcan be made from an honest and thought-ful understanding of why errors occurred.No less achievers than Albert Einsteinand Thomas Edison are frequently heldup as adopted patron saints of learn-from-mistakes advocates, Einstein forfamously remarking that, "Anyone whohas never made a mistake has never triedanything new." The canon also typicallycites some variation of Edison goingthrough more than 9,000 experiments inhis quest to create the incandescent lightbulb. When derided by colleagues forwhat they perceived to be the foolishquest, Edison responded: “I haven't evenfailed once – 9,000 times I've learnedwhat doesn't work.”

Value investors, who fancy themselvesas an introspective lot, speak often aboutthe importance of drawing insight frommistakes in an effort to improve theirfuture performance. But scratch muchbeneath the surface – about processes putin place to track and assess errors, or evenon specific lessons learned – and theanswers get shorter or turn into exercisesin justification. In an often unforgivingmeritocracy, the near-celebration of mis-takes advocated by many commentatorsdoesn't seem to fully resonate.

But if experience is the best teacher,why not go the extra yard to figure outhow to learn from it? Those who do takeanalysis of mistakes seriously cite a fewsimple guidelines for maximizing the ben-efits of doing so. First, keep detailed scoreon what you buy and sell and what hap-pens after you've done so. This maysound obvious, but a useful post-mortemis only possible if you track carefullywhat you've done, document why you didit, and review the individual and collec-tive data for patterns on how things haveturned out over time. Mariko Gordon ofDaruma Asset Management [VII,


O F S O U N D M I N D : Mistakes


Making “To Err” HumanNo self-respecting investor would say he or she doesn’t pay careful and diligent attention to learning frommistakes. Protestations aside, however, this is a subject in which words very often surpass deeds.





December 30, 2009] hires an outsideresearch firm to assist in this process, andcredits it with helping her see issues shemay not have noticed otherwise, such as atendency to too-often mistakenly averagedown on losing portfolio positions.

Beyond keeping score, it's also impor-tant to install a regular and consistentprocess around error analysis. While hecredits his firm with an ongoing open dis-cussion of mistakes and what to do aboutthem, GMO's James Montier [VII,November 29, 2011] says the best lessonsoften derive from an annual and formal-ized mistake-assessment process. Key isnot to leave the assessment in the handsof those most identified with the originalwork, he says, but to also include inde-pendent arbiters of what went wrong. Inaddition, the less stigma attached to theprocess and the more Thomas Edison-likethe overriding goal in carrying it out, themore productive it is likely to be.

Because the specific situation thatresulted in a mistake, by definition, can't

be exactly replicated in the future, themost-useful lessons learned tend to bemore general in nature. “You don't wantto conclude something like the next timethe CFO has a mustache and the compa-ny is based in Florida, it's a short,” says

Mariko Gordon. Davis Advisors’Christopher Davis [VII, May 31, 2007]offers a similar example: Had he conclud-ed from a poor experience investing inAT&T under CEO Michael Armstrongthat the problem was a high-profile exec-utive taking over an iconic company in abusiness other than the one that made

him famous, he would have missed out onthe renaissance of IBM that started undernew CEO Louis Gerstner. “Mistakes ofjudgment are the toughest to learn from,”says Davis, “because each one is different.

The best lessons uncover gaps in aninvestment process or can prove applica-ble in a variety of situations. GMO'sMontier cites as an example his conclu-sion after the recent review of a troublingposition that he wasn't adequately con-sidering in his analysis who the otherholders of a prospective position wereand how their motives and reactions maydiffer from his.

To those who consider an obsessionwith mistakes as paranoia-inducing navelgazing, Gordon offers a different perspec-tive: “Because this is a business in whichyou're always making mistakes and,frankly, there's so much arrogance, I'vefound a healthy dose of introspection isfar more liberating that it is paralyzing. Itleaves you that much better prepared tofight another day.” VII


ON THE RIGHT LESSONS:

The best lessons uncover

gaps in an investment process

or can prove applicable in a

variety of situations.


http://www.valueinvestingcongress.com/landing/o12/partners/vii/january.php?utm_source=VII&utm_medium=A&utm_campaign=O12VIIB&ocode=O12VIIB

Try as I might, I couldn't help inpreparing this issue's article with adviceabout learning from mistakes (see p. 18)from re-living my own worst investmentblunder: Have I truly owned up to it? DoI understand why it happened? Have Ilearned anything from it?

I should preface the discussion by say-ing I'm not a professional investor. I have,however, since I've had money to investalways kept a portion of my assets in apersonally managed equity portfolio. Ienjoy it, believe I have the right tempera-ment for it, and while the results haven'tprompted me to quit my day job, I'veover time more than held my own. If Ihave a “strategy,” it's to invest in industryand/or company stories that make senseto me at a time when the prevailing wis-dom appears to be otherwise. Among mybig winners, for example: investing inAltria when litigation fears were at a feverpitch, buying Lockheed Martin whendefense stocks were in the dumps, scoop-ing up Weight Watchers when the AtkinsDiet was going to put it on life support.

Similarly, on September 29, 2000, Ibought what was then 1,500 shares ofApple Computer for an average price of$25.81. I had been a company acolytefrom the beginning and loved the wholeanti-Big Brother, “Think Different” vibe.Though Steve Jobs had returned as CEOthree years earlier, in many ways Applewas considered an after-thought, per-ceived as having lost the PC war toMicrosoft and on a one-way trip towardirrelevance. My modest view was that thiswasn't true, and if any company couldfigure out how to prosper in the unsettledworld of media and technology “conver-gence,” it would be Apple.

Little happened. The iPod, launched in2001, proved successful, but not enoughto counter the drumbeat of negativismaround the company and technologystocks in general. The stock languishedbelow my purchase price for more thanthree years, at which point Barron's pub-lished an article questioning the future of

a computer company whose computersnot enough people wanted. The hook wasset and I started to look for a gracefulexit. As the stock moved up based on theiPod's latest successes in the early monthsof 2004, I sold my shares at $27, a 4.5%gain on my original investment.

Until this moment, I have never calcu-lated exactly how big this mistake was.Were I to still own the shares I sold in2004 – accounting for a 2:1 split in 2005– my Apple position would now be worthmore than $1.2 million, 31x what I orig-inally paid. Ouch.

If there are stages of investor grief, I'vecertainly been through them all: denial,anger, despair and acceptance. I've triedout most of the rationalizations to makeme feel better: “It was the right decisionat the time given what I knew.” “I cer-tainly would never have been able toresist selling anyway as the stock pricekept going up and up.” “I'm sure whatI've bought with the proceeds over timehas done pretty well.” My outwardlydirected anger has subsided, but I stillhesitate every year in renewing myBarron's subscription after what it did tome. For the most part, though, I've

accepted that I blew it and there's nothingI can do about it now.

The lessons learned? The first primaryone is that my Achilles heel as a part-timeinvestor is not having a clear view ofwhat I believe a company is truly worth,which makes selling more of an intuitive– and potentially emotional – guessinggame than it should be.

The second lesson is that if you have aconviction upon which you're investing,don't bail on it until it's been given ampletime to play out, right or wrong. I obvi-ously didn't know what Steve Jobs had uphis sleeve, but the iPod was supportingevidence for my bullish case that Applewould be a winner as media and technol-ogy converged, and nothing had hap-pened yet to disprove it.

I've been much better in the interim inletting stories supporting my stock posi-tions fully unfold. I'm still waiting, alas,for the next 30-bagger payoff from mypatience. VII


E D I TO R S ’ L E T T E R

My Lollapalooza Mistake

John HeinsCo-Editor-in-Chief

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Value Investor Insight December 28, 2011

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