Value Investor Insight Issue 239

When asked to what he attributeshis firm's success, Scott Hoodcites “that last 20%” of the

research on a company – the gruelingdetective work often required to findunique insights. “There are plenty ofdead ends, but sometimes you find theburied treasure,” he says.

Hood’s treasure-hunting skills are well inevidence: A composite of the First WilshireSecurities’ portfolios he manages with 87-year-old company founder Fred Astman hasearned a net annualized 20.3% over the pastten years, vs. 3.5% for the Russell 2000.

Primarily focused on small-cap stocks,Hood sees an eclectic mix of opportunitytoday in areas including rent-to-buy retail,water, movie projection, auto parts andelectricity transformers. See page 10

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

Scott HoodFirst Wilshire SecuritiesInvestment Focus: Seeks companieswhose stock prices don’t adequately reflectthe growth or turnaround potential he seesor are just “ridiculously cheap.”

ValueInvestor February 28, 2010

Price is RightAmong the keys to successfully managing more than $8 billion in small-capassets, says Preston Athey: courage, casting a wide net, and loads of patience.

Inside this IssueF E ATU R E S

Investor Insight: Preston AtheyCasting a wide net for small-capbargains and finding them inBrunswick, Glacier Bancorp, CSSIndustries and GTSI Corp. PAGE 1 »

Investor Insight: Scott HoodFinding unrecognized or ignoredvalue in American Water Works,Imax, Rent-A-Center, Jinpan, andMotorcar Parts of America. PAGE 1 »

Uncovering Value: KraftMarket skeptics of it and its Cadburyacquisition are likely to be deadwrong, says Bill Ackman. PAGE 19 »

A Fresh Look: ChubbWhy Tim Hartch believes the markethasn’t yet fully recognized how well ithas weathered the storm. PAGE 21 »

Strategy: Seth KlarmanThe investing great describes some ofthe many lessons – real and false –emanating from the crisis. PAGE 22 »

I NVESTM E NT H IG H LIG HTS

Other companies in this issue:ATMI, Fred's, Raven Industries, Chindex,

Harbin, Companhia de Saneamento

Basico, Atlantic Tele-Network

The Last 20%A drive “to understand companies and businesses in the same way managers andemployees do” is producing eye-popping returns for First Wilshire's Scott Hood.

The Leading Authority on Value Investing INSIGHT

INVESTMENT SNAPSHOTS PAGE

American Water Works 14

Brunswick 5

Chubb 21

CSS Industries 7

Glacier Bancorp 6

GTSI Corp. 8

Imax 15

Jinpan International 16

Kraft 19

Motorcar Parts of America 17

Rent-A-Center 13

After graduating from Yale in 1971,Preston Athey postponed a career infinance to spend five years in the

Navy, mostly as a speechwriter for AdmiralHyman Rickover. “Starting out in an envi-ronment where talented people work hardfor ideals rather than money has been quitevaluable,” he says. “It helps you keep youreye on the big picture.”

Now managing $8 billion in assets for T.Rowe Price, Athey has proven as skilledwith the details as he is with the big picture.The Small-Cap Value mutual fund he tookover in 1991 has returned a net annualized11.9%, vs. 8.3% for the Russell 2000.

Casting a wide net for value, Athey isfinding it today in such areas as boating,regional banks, seasonal gifts and informa-tion-technology distribution. See page 2

www.valueinvestorinsight.com

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

Preston AtheyT. Rowe PriceInvestment Focus: Seeks companieswhose stock charts look “like death warmedover” from operating or cyclical challengesthat over time should be overcome.

http://www.valueinvestorinsight.com

I N V E S TO R I N S I G H T : Preston Athey

Value Investor Insight 2February 28, 2010 www.valueinvestorinsight.com

Investor Insight: Preston AtheyPreston Athey and David Wagner of T. Rowe Price describe why patience can be such a virtue in small-cap investing,why holding 315 positions makes perfect sense for them, the surprising sector that sports some of today's most inter-esting bargains, and why they see unrecognized value in Brunswick, Glacier Bancorp, CSS Industries and GTSI Corp.

You consider yourself an “eclectic” valueinvestor. In what way?

Preston Athey: At the heart of being avalue investor is having a contrarian bent.Beyond that, though, there are many dif-ferent flavors of value investing. TweedyBrowne is a great deep-value investmentfirm. Chuck Royce at Royce Funds is awonderful GARP [Growth At aReasonable Price] practitioner – he’sfocused on value but definitely doesn’tlike to own bad companies. MasonHawkins at Southeastern AssetManagement and Marty Whitman ofThird Avenue are oriented toward stockstrading at significant discounts to netasset value. Bill Miller is probably bestdescribed as an all-out contrarian.

The fact that all these people havebeen successful proves that there’s no sin-gle way to do it. What the market offersup as opportunity is constantly changing,so being able to deploy a variety of strate-gies as the situation warrants allows usgreat flexibility to go almost anywhereand never get shut out of the market.That’s important because our investorsdon’t ask us to move in and out of cashdepending on how overvalued or under-valued we think the market is. Andfrankly, having an eclectic view makesinvesting a lot more interesting.

Even with an eclectic view, is there a typ-ical situation that attracts you?

PA: I stay closest to the value philosophyon the purchase side of the ledger. If ananalyst walks in and pitches a wonderfulcompany growing 20% a year whosestock trades at 20x earnings and 3.5xbook value, I’ll suggest he pass it on toour growth fund, because that’s not whatI’m looking for. What will get me excitedis a story like this: “Preston, I’ve beenfollowing this stock for two years but

haven’t found a good reason to write itup. It used to be kind of a high-flier, butthe stock chart now looks like deathwarmed over. The shares were at $40,had a big drop and have been tradingbetween $15 and $18 for months andnobody cares. The company is likely tohave some big writeoffs this year to cleanup the balance sheet. And, by the way,two months ago the board fired the CEOand the new guy is someone I know froma previous company where he did a greatjob. He’s not even talking to the Streetfor six months as he gets a handle onthings.”

In these types of cases we can analyzefairly quickly what the company’s poten-tial is relative to its peers or its own his-tory, and see how cheap it is relative towhat we consider to be normal earnings.We also like when there’s a catalyst, say,in the form of a new CEO. With largecaps, regression to the mean seems towork often enough after things havegone bad, but in small caps we believeidentifiable catalysts – like managementchanges, restructurings or maybe indus-try consolidation – increase the odds ofwinning.

Do you put a lot of emphasis on the qual-ity of the business?

PA: Speaking broadly, probably 10% ofthe businesses out there are lousy, such asselling pure commodities where the mar-ginal cost of production drives the pricingand companies find it very hard to earneven the cost of capital over time. I mayown such a company from time to time,but it’s rare.

At the other end of the spectrum areanother maybe 10% of businesses whichare of excellent quality. A perfect examplewould be money management firms,which in aggregate earn obscene returnson equity. We love to own these types of

Preston Athey

In Tune

After joining T. Rowe Price fresh out ofStanford Business School in 1978,Preston Athey was tutored by a variety ofmanagers and in several investmentstyles. For a time, he even contemplatedkeeping his responsibilities for the firm'sSmall-Cap Growth strategy when he wasasked to take over the Small-Cap ValueFund in 1991. “The set of stocks and themindset were just too different to doboth,” he says.

Athey attributes T. Rowe Price's long-termsuccess to a culture that puts the invest-ment process first. “I can't say it's entirelyunique, but the culture is collaborative,with no star system, an emphasis on learn-ing, and no incentive to climb over some-one else's back to get ahead,” he says.“It's all about doing the best research pos-sible, while minimizing the distractions thatmight take away from that.”

One distraction Athey pursues outside ofwork is singing bass for Baltimore a cap-pella group Sum of the Parts. “We all havefairly accomplished musical resumes, butwe really just perform for the love of themusic,” he says. “Of course, if the gigincludes dinner and libations, we're all themore eager to sign up.”




companies, but the opportunities to buythem cheaply are relatively few and farbetween.

So that leaves us most occupied withthe other 80%, in which there’s a chang-ing roster of winners and losers. Thosechanges in fortunes are typically tied tocycles and how individual companies aremanaged, which are the types of thingswe believe we can analyze and judge. In alot of our companies, just getting back toaverage operating performance can resultin excellent investment results.

How do you define “small cap” in man-aging your portfolio?

PA: We invest in companies with marketvalues between $50 million and $1 billionat the time of purchase. We generallywon’t buy more of anything if the marketcap gets over $2 billion, and I’ll startmoving out of a stock when it gets over$3 billion.

Where do your ideas tend to come from?

David Wagner: Our analysts are chargedwith coming up with ideas, which theyfind in any number of ways. Preston grillsthem and says no to most of the ideas, butprobably 70% of the positions we buymake it through that process.

The other 30% of the ideas that end ofup in the portfolio tend to come fromPreston seeking out the analysts whosesectors have been most beaten into sub-mission and pushing them – often againsttheir instincts – to give him names to con-sider. The analysts are often afraid tobring him things that have performed ter-ribly, but that’s exactly what he wants tohear about.

Do any sectors strike you as particularlyinteresting today?

PA: Our rule is to own something in everysector, in part to avoid missing somethingimportant because it’s out-of-sight, out-of-mind. We’re not a slave to our bench-mark – the Russell 2000 Value Index –but I typically don’t go much below half,or much above twice, the index weighting

in any sector. I’ve found that gives usplenty of room to beat the index, whileavoiding the type of relative volatility thatmakes most investors nervous.

As for a specific sector of interest,we’re actually finding some of the mostcompelling bargains today in regionaland community banks. There’s little ques-tion we’re probably less than halfwaythrough a weeding out process that willresult in a material fraction of U.S. banks

going out of business. As that’s going on,there are a significant number of smallerbanks trading at 75-80% of book value,where the jury is still out on whetherthey’ll make it through. If you’re right inpicking those that do make it through,there’s an excellent chance you’ll maketwo, three or four times your money onthem over the next three years.

Preston, you started out as a technologyanalyst. Is that a big part of your portfo-lio today?

PA: Information technology is a bit over10% of the portfolio, right around theweighting in our benchmark, but thetypes of things I own would be anathemato most tech investors. I tend to beattracted to companies more for theirdefensive attributes than offensive. Agood example is ATMI [ATMI], a suppli-er of materials used primarily in the fab-rication of semiconductors. It’s in a cycli-cal business far from the top of the cycle,has $108 million of net cash and [at arecent price of just under $17] sells foronly 1.3x book value. It has stayingpower and when the cycle turns, it willearn a lot of money and we expect thestock to go back above $30, where it hastraded for years in the past.

One distinguishing characteristic of yourportfolio is the number of positions – usu-ally more than 300. Explain the rationalefor that.

PA: Part of it is just the practical realityof running $8 billion in a small-cap strat-egy – with that much money, you can’thold 50 stocks without moving well outof small-cap range for many of them.

Another practical consideration is ourinvestor base, which is retail investors andlarge institutions. Performance obviouslymatters when they choose T. Rowe Priceto run their small-cap assets, but they alsowant to be comfortable that the portfolioisn’t going to blow up. For many investorsvolatility is the enemy of rational invest-ment decisions, so the less volatile we are,the more likely our investors won’t sell atthe bottom and buy at the top. Runningwith the level of diversification we have,the standard deviation of our returns hasbeen lower than that of our benchmarkRussell index.

Philosophically, I find broad diversifi-cation makes it easier to be a contrarian.We made the mistake in 2007 of buyingsome housing, recreational-vehicle andmobile-home stocks after they fell 50%,which clearly turned out to be too early.But because of the way we run the port-folio and our recognition of the risksinvolved, we never made those holdings,in aggregate, more than 3% of the portfo-lio. While that particular out-of-favor bethasn’t paid off, it hasn’t hurt us mucheither. As long as the potential upside ishigh, we should be making those types ofinvestments and they can make a real dif-ference when they work.

Another unique aspect of your strategy isvery low turnover. Why is that?

PA: Our turnover is usually in the lowteens – last year it was 8%, versus anaverage for small-cap value funds fol-lowed by Morningstar of around 70%.This is typical of T. Rowe Price funds,and is driven by the belief that if you’vetruly done your upfront research well,you should have the patience and courageto let ideas work. I don’t believe you can

ON LOW TURNOVER:

It’s driven by the belief that if

you’ve truly done your upfront

research well, you should have

the patience to let ideas work.




explain 70% turnover or more withoutassuming people are buying many thingsthey don’t really know and dumping themwhen they get a negative surprise. We’renot immune to missing things, but it’srare that unexpected risks come up soquickly that we reverse course before thethesis has had a chance to play out.

This obviously only works if you paythe right price going in, to the pointwhere the downside is truly low. One ofmy favorite examples of patience payingoff is K-Tron [KTII], which we’ve ownedsince before I took over the fund in 1991.The company makes material-handlingequipment and was a typical idea for us:the stock was exceedingly cheap becausethe company was underperforming andwe saw a relatively clear path for the rightmanagement to fix things. The mix ofbusinesses was decent enough that wedidn’t see things getting much worse, andthe upside was significant.

The problem was that for years noth-ing much happened, and it took theboard until 1998 to push out the CEOand turn to one of its members, a lawyernamed Edward Cloues. He started mak-ing the tough operating decisions andthen began making a series of smartacquisitions at extremely favorableprices. The stock eventually went on amulti-year run that culminated in K-Tronbeing bought out in January byHillenbrand for $150 per share. Our costbasis was just over $10.

As the stock went nowhere for years, itwould have been easy to sell it and moveon. But we never lost our conviction therewas something there, just waiting to beunlocked. Were we stubborn, or maybejust lucky? Probably a little of both, butwithout a willingness to be patient thatmost investors don’t have, we would havemissed an incredible run.

It’s impressive you held it the entire way.Any insights to share about knowingwhen to take profits?

PA: I don’t know that there’s a secret togetting this right. You have to constantlyassess whether the expectations built intothe share price are still reasonable. We

also pay careful attention to who owns thestock at any given time. One reason wepay brokers is for insight into who’s buy-ing and selling our stocks. When themomentum buyers who pay more atten-tion to the stock chart than what the com-pany does are coming in, it’s high time forus to be getting out. We may still lose outon some upside from there, but if the com-pany misses an earnings number with thatkind of shareholder base, the stock can beoff 50% in a day. That’s not the type ofthing we want to own.

One other relevant point on K-Tron:this was a small position in a much small-

er fund at the outset, so we didn’t have tosell much on the way up to avoid the rel-ative position size getting too big.

Do you have a current example of a long-time-coming idea that you haven’t yetgiven up on?

PA: I would put Fred’s [FRED], the dis-count retailer, in that category. We’veowned it for nearly 15 years and afterputting a wide range of credible merchan-dising and efficiency programs in place,the company so far hasn’t figured outhow to get the margins that peers likeFamily Dollar, Dollar General and DollarTree earn. Fred’s margins could doubleand still be below the average for theindustry. If that happened, we’d have apretty good stock on our hands. Hopesprings eternal.

Describe the broader investment case forone of your deeply out-of-favor holdings,Brunswick [BC].

DW: One general area of opportunity wesee in the market is in consumer discre-

tionary companies for which investorsseem to have concluded the typical up-and-down cycle won’t apply and thatthere’s a two-decade secular headwind.For those companies selling things likeboats and recreational vehicles, if they’vecut costs and maintained marginsthrough bad times that have caused com-petitors to leave the market, people arelikely to be surprised by how much theycan earn with even a modest increase inmarket demand.

Brunswick is a perfect example of thistype of opportunity. Its biggest business –accounting in normal times for roughly80% of total revenue – is boating, whichincludes the manufacture of both boatsand engines. The profit driver is engines,in which Brunswick is the clear marketleader in North America with its Mercuryand MerCruiser brands, and in which itmakes a lot of money on aftermarketparts and service. The remaining 20% ofrevenues is split between a fitness divi-sion, which makes exercise equipment,and a bowling and billiards unit.

PA: Boat sales have obviously beenextremely depressed. Retail powerboatsales from 2001 to 2007 averaged around$10 billion per year, adjusted for infla-tion. In 2008, that number was less than$8 billion and in 2009, less than $5 bil-lion. Unit sales for 15 years before thecrisis averaged around 300,000 per year –the estimate for last year was less than150,000.

We’re not going back to 300,000 unitsor $10 billion in sales per year any timesoon. But if sales even come halfway back– 225,000 units and $7.5 billion in over-all revenues – this should be an excellentinvestment.

How would that level of recovery workthrough Brunswick’s financials?

PA: We estimate that they’re taking out$425 million in fixed costs through 2010– the number of North American plantshas been cut from 28 to 14, while totalheadcount is down 37% – and there’s stillmore to come out after that from capaci-ty decisions already made.

ON SELLING:

When buyers who pay more

attention to the chart than

what the company does come

in, it’s time for us to get out.




If retail boat sales recover even 20-25% from the trough, we expectBrunswick to generate $4.1 billion in rev-enues by 2012. That’s still 25% belowthe levels from 2005 to 2007. Given thecosts they’ve taken out, we’re expectingoperating margins of between 6% and7% in 2012, also below the 2005 peaklevel of 8.4%. All that would translateinto 2012 earnings before interest, depre-ciation and amortization of around $400million.

The stock is well up from the depths ofdespair last March. What upside do yousee from today’s price of around $11.50?

DW: There’s been some recognition thatlast year looked even worse for the com-pany than it actually was. Brunswick’sproduction in 2009 was only half itsretail sales, as dealers heavily cut backon orders and sold out of inventory.Now dealer inventories are at multi-yearlows and are unlikely to go lower, sothere’s a significant amount of revenueupside this year – roughly 50% in theboat segment – if Brunswick just pro-duces to meet the level of retail sell-through from last year.

PA: Looking further out, if we put a 7.5xmultiple on our 2012 EBITDA estimate,

we get an unadjusted enterprise value of$3 billion. After a variety of balance sheetadjustments, EV then should be around$2.25 billion. That would imply a shareprice in the mid-$20s two years out.

What are the primary risks?

PA: If our experience in the U.S. becomesthat of the Japanese lost decade, boatsales aren’t likely to turn around much. Inaddition, if consumer financing remainsrestricted and people can’t borrow moneyfor things like boats, all bets are off for acompany like Brunswick.

We consider other risks to be fairlylimited. We don’t see big competitiverisks, as the company has maintained orincreased market shares through thedownturn. We don’t see financial risk –they’ve trimmed their debt and are build-ing cash. We don’t see operational risk, asmanagement has done an excellent job ofnavigating the downturn. It really allcomes down to what happens with theend consumer – even a modicum of lightat the end of that tunnel will be greatnews for Brunswick.

You mentioned smaller banks as a poten-tial area of opportunity. Describe whatyou think the market is missing in GlacierBancorp [GBCI].

DW: Glacier is based in Kalispell,Montana, with decentralized operationsprimarily in Montana, Wyoming, Utahand Idaho. They operate separately char-tered banks in each geographic area, witha clear focus on each bank having abrand, lending and deposit-taking pres-ence that is closely tailored to the localcompetitive market.

We’ve owned Glacier stock for severalyears and prior to the financial crisis hit-ting, the company had done an excellentjob of prudently and profitably growingthrough selective acquisitions and by tak-ing advantage of a vibrant regional econ-omy. That part of the country is one ofthe fastest-growing regions in the UnitedStates in terms of job creation, householdformation and personal income. As aresult, Glacier’s earnings compounded

Brunswick(NYSE: BC)

Business: Global recreational-productsmanufacturer operating in three primarylines of business: boats/boat engines, fit-ness equipment and billiards/bowling.

Share Information(@2/26/10):

Price 11.5452-Week Range 2.06 – 13.90Dividend Yield 0.4%Market Cap $1.02 billion

Financials (TTM):

Revenue $2.78 billionOperating Profit Margin (-14.3%)Net Profit Margin (-21.1%)

THE BOTTOM LINE

Investors have concluded that companies like Brunswick selling big-ticket consumerdiscretionary items face a “two-decade secular headwind,” says Preston Athey.Assuming what he considers a moderate rebound in revenues and margins, at a 7.5xEV/EBITDA multiple on his 2012 estimates, the shares would trade in the mid-$20s.

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

BC PRICE HISTORY

Sources: Company reports, other publicly available information

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02008 2009 2010

Valuation Metrics(@2/26/10):

BC S&P 500Trailing P/E n/a 21.8Forward P/E Est. n/a 14.1

Largest Institutional Owners(@12/31/09):

Company % Owned

Fidelity Mgmt & Research 15.0%T. Rowe Price 7.7%BlackRock 6.9%Dimensional Fund Adv 5.3%Fisher Investments 5.0%

Short Interest (as of 2/12/10):

Shares Short/Float 16.5%

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for most of the last decade at close to15% annually.

How exposed has Glacier proven to be tothe crisis?

DW: They clearly haven’t been unscathedby the credit problems in residential andcommercial real estate, but they wereearly in turning off credit as signs of trou-ble emerged. They also never compound-ed their problems, as many smaller banksdid, by getting into syndicated loans orother exotic financing beyond theirbread-and-butter lending to local bor-rowers. As a result, Glacier was able to

turn down the government’s offer ofTARP money and remains very well capi-talized. While many comparable banksare reporting big losses, Glacier stayedprofitable in 2009 and the worst appearsto be behind it.

With the stock down 6% in the past year,to a recent $14.50, the market doesn’tappear to be buying into that yet.

DW: As the economy mends, we expectloan demand to increase and, becausefewer competitors will be in the marketlending, for Glacier’s loan spreads towiden. If we also assume a mid-cycle level

of about 50 basis points for loan charge-offs, we believe the company can earnbetween $1.50 and $1.75 per share twoyears from now.

So the share price today is less than 9xour 2012 earnings estimate, for a compa-ny that has proven itself capable of grow-ing the bottom line at a mid-teens rate.Given the organic growth potential in theregion, the opportunity to steal sharefrom damaged competitors, and the like-lihood that failing or failed banks in theirmarkets will be available at firesaleprices, we see no reason they can’t growat a similar rate in the future. Were that tohappen, it’s not a stretch for such a bankto trade at 15x earnings, which wouldresult in a $24-25 share price in the nextcouple of years.

Are you concerned by the stock’s shortinterest, now more than 15% of the float?

DW: It’s certainly no secret that credit-quality problems in commercial realestate are going to hurt regional banks,which is why the short interest on theETF tracking the KBW Regional BankingIndex – of which Glacier is a member – isextremely high. That makes the shortinterest in all the individual banks in theindex high as well. That doesn’t overlyconcern us – in fact, that the stock isbeing painted with the same brush as oth-ers when it’s objectively in much bettershape is one reason we think it’s as attrac-tively priced as it is.

PA: I would characterize this as a low-risk investment. The company makesmoney, has plenty of capital and is gain-ing share in each of its markets, all ofwhich have attractive growth prospects.The CEO, Michael Blodnick, is a largeshareholder himself and has always beendisciplined in allocating capital. Thebiggest risk to my mind is that the stockis dead money for a while. If 2010 isanother weak year, maybe people gettired of it and the shares go to bookvalue, which is around $11 per share.Given our optimism about Glacier’sfuture and our willingness to be patient,that wouldn’t be a catastrophe.

Glacier Bancorp(Nasdaq: GBCI)

Business: Decentralized bank holdingcompany offering commercial and retailbanking services in Montana, Wyoming,Idaho, Colorado, Utah and Washington.


Price 14.5052-Week Range 11.80 – 19.61Dividend Yield 3.6%Market Cap $893.5 million

Financials (TTM):

Revenue $203.7 millionOperating Profit Margin 18.6%Net Profit Margin 16.9%

THE BOTTOM LINE

By capitalizing on diminished competition in regional markets that retain bright growthprospects, David Wagner believes the company can generate mid-teens earningsgrowth as the economy regains strength. Such growth would warrant a 15x multiple, hesays, which on his 2012 earnings estimate would result in a share price closer to $25.


GBCI PRICE HISTORY


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GBCI NasdaqTrailing P/E 25.9 18.5Forward P/E Est. 13.1 16.6


Company % Owned

T. Rowe Price 9.5%BlackRock 7.1%Vanguard Group 4.6%Wells Capital Mgmt 3.5%Fisher Inv 3.4%



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What are you finding particularly com-pelling today about long-time holdingCSS Industries [CSS]?

PA: This company has been around fora long time and is primarily in the holi-day gifts and greetings business. Theysell things like giftwrap, bows, ribbons,gift cards and decorations, primarilythrough high-volume retailers like Wal-mart or Target. They essentially createthe designs and then source the manu-facturing in China or wherever they findthe most efficient supply, so as time hasgone on the business has become muchless asset-intensive and now generates

excellent free cash flow. We have gottento know the company and managementvery well, having owned the stock formore than 15 years.

This isn’t the most economically sensi-tive business, but when people are cuttingback on gift buying, dying fewer Eastereggs, or going a bit lower-end onHalloween costumes, CSS revenues do gethurt and margins suffer. Tough times alsoprompt their retail customers, who arealways pushing them on price, to get evenstingier. In the fiscal year that ends inMarch, the company may earn as little as$1.20 per share, which is down from$2.30 two years ago.

Is the basic idea again at least a partialreturn to “normal” translating intohealthy upside for the stock, now tradingaround $16.90?

PA: In these small companies that fewpeople are paying attention to, that canbe all it takes.

CSS’s average revenues from fiscal2005 to fiscal 2009 were $515 million. Solet’s assume they see sales in an improvingeconomy get back to $500 million overthe next couple of years. Their highest netmargin in the past five years was 5.7%,so let’s assume that gets back at least to5%. At that point the company is earning$25 million, which is around $2.60 pershare and represents a 10% return onequity. Put an 11-12x multiple on thoseestimated earnings and the stock wouldbe around $30. That wouldn’t beuncharted territory – the shares tradedabove $40 in mid-2007.

How well protected here are you on thedownside?

PA: We think we’re well protected by ahard book value, taking out intangibles,of close to $19 per share. There’s a soliddividend yield of 3.4%. We also particu-larly like the company’s consistent will-ingness to use cash flow to buy backshares when the stock is undervalued.

I’m not describing an exciting businessor a growth business. But it is a solid onethat has operated through a variety of upsand downs. If they just continue to dowhat they’ve done in the past, earnings –and the stock price – should come backquite nicely.

Before talking about one of the many tinystocks you find interesting, explain whyyou bother investing in micro caps whenyou’re managing $8 billion.

PA: Our view is that if we’re finding bet-ter values in even the smallest companies,we should own them. If I pay the rightprices and own a lot of them, my down-side should be limited, most of themshould earn a fair return, and every oncein a while something like K-Tron will

CSS Industries(NYSE: CSS)

Business: Producer of seasonal and spe-cial-occasion “social expression” products,including giftwrap, costumes, greetingcards, and decorative ribbons and bows.



Financials (TTM):


THE BOTTOM LINE

Ignoring history, says Preston Athey, the market is valuing the company’s stock as if itwon’t come out of the current poor economic cycle with its business model and prof-itability intact. If it in fact does so, as he expects, “normal” EPS within the next coupleof years of $2.60 and an 11-12x multiple would yield a share price closer to $30.


CSS PRICE HISTORY


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CSS S&P 500Trailing P/E 14.0 21.8Forward P/E Est. n/a 14.1


Company % Owned

T. Rowe Price 15.3%Royce & Assoc 11.9%Dimensional Fund Adv 9.3%Barclays Global Inv 4.1%Vanguard Group 4.0%



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take off and have a real impact on theportfolio.

Why could IT-products distributor GTSIbe one of those big winners?

DW: The company is based just outsideof Washington, D.C. and is a distributorof a wide variety of technology products,primarily to the government. They are amini version of companies like CDW andIngram Micro, selling at an enterpriselevel a wide range of third-party net-working gear, computers, software andprinters.

The distribution of IT products is alow-margin affair, but we like that threeor four years ago the company decidedthe only way to survive in this businesswas by adding engineering talent andmoving beyond order taking towardmore of a consultative role in definingtechnology solutions for their customers.GTSI has long-term relationships withmany of its government clients, so hasmade progress in involving itself earlierin the purchase process, adding value toit, and then still delivering systems moreefficiently and at better prices thanclients could do on their own.

PA: A few years ago a government cus-tomer would have called GTSI and said,“What’s your best price for 100 Dell lap-top computers that I plan to networktogether?” The customer could expectnothing more. Now GTSI has answerswhen the same customer says, “I’mthinking about changing out some lap-top computers, what technology is bestfor what I need done? What kind of geardo I need to network them? Are theresecurity issues I haven’t thought of?”Starting under the Bush administrationthere have been fewer internal govern-ment resources devoted to answeringthese types of questions, so there’s anincreasing reliance on private providerslike GTSI to help solve problems, ratherthan just provide products.

How is the strategy working so far?

PA: It’s difficult to see the results yet in

the financials, given the heavy invest-ments they’ve made to support the newstrategy and the fact the onset of therecession resulted in many governmentclients cutting back on IT spending.We’re seeing reasonable progress in rev-enues and are encouraged by what we’rehearing from management, which hasbeen quite upfront and disciplined as itremakes the company.

Our analysis here is focused primarilyon what a reasonable margin for the busi-ness should be in the future, and whetherthe company is doing the right thingsinternally in order to deliver that poten-tial. We believe they are.

How would success impact the shareprice, currently at $5.65?

PA: The stock currently sells for less than70% of book value, which is a hard num-ber consisting primarily of inventoriesand receivables. We think it’s reasonableto expect the company to grow its topline at 8% per year – maybe 3-5% fromwhat government typically spends on ITand the rest from GTSI selling morevalue-added systems. That would resultin close to $1 billion in revenues withinthree years. Pre-tax margins of 4% arecertainly conceivable, but even at 3% thatwould result in a 2% net margin, or $20

GTSI(Nasdaq: GTSI)

Business: Reseller and integrator of infor-mation technology hardware, software andsystems, primarily for federal, state andlocal governmental clients.



Financials (TTM):


THE BOTTOM LINE

Preston Athey believes the company’s increased emphasis on value-added sellingand an inevitable rebound in governmental spending on information technology canresult in 8% annual top-line growth and $2 per share in earnings within the next twoto three years – “which makes today’s share price look extremely cheap,” he says.


GTSI PRICE HISTORY


15

12

9

6

32008 2009 2010


GTSI NasdaqTrailing P/E 7.6 18.5Forward P/E Est. n/a 16.6


Company % Owned

T. Rowe Price 9.9%Dimensional Fund Adv 8.7%Franklin Resources 6.5%Netols Asset Mgmt 3.7%HSBC Holdings 3.3%



15

12

9

6

3




million in net earnings. Without heroicassumptions, that gets us to estimatedearnings per share of better than $2,which makes today’s share price lookextremely cheap.

This isn’t a sexy story, but it’s the typeof unloved and unknown idea that we’vefound can be very attractive. No analystsfollow the company. It has net cash on thebalance sheet. Management gets it. If thestock just got back to the $14 level atwhich it’s traded several times over thepast 15 years, we’d have an excellentreturn from today’s price.

Can you generalize at all about mistakesyou’ve made?

PA: We’re from time to time remindedthat analysis can be overwhelmed byevents, and that you better have a handleon the worst that can happen. Wethought Accuride, which is the biggestNorth American manufacturer of largetruck wheels, would be well positioned

when its market came back, a thesis thatwas reinforced when a new CEO weadmired took over in the fall of 2008.What we didn’t account for was thatAccuride’s balance sheet was too weak tosee it through the day when the market

finally came back, and the company filedfor bankruptcy protection last October.

The second general category of mis-takes I’d mention probably relates tomanagement. Given the importance weoften put on management’s ability to fixproblems, it’s inevitable that from time totime we’ll fall in love too easily and make

excuses for those in charge when the com-pany continues to do poorly. In thesecases, my patience works against me andwe tend to ride a stock down until I getdisgusted and sell it.

DW: If Preston is guilty of anything, it isof being too patient. But we’ve been paidoff so many times for being patient thatit’s hard to be critical. One of our largestholdings today is Raven Industries[RAVN], which has a rather eclectic mixof industrial businesses. There have beenmany times since we’ve owned it that youcould have said this company will neverdeliver. But after some relatively minorchanges in management and strategy, itwent from a below-average business to awell above-average one over the past fouror five years and became a star performerfor the fund.

It all comes back to what Preston saidearlier, if you pay the right price at theright time, you can afford to wait forgood things to happen. VII

For more information and a full list of speakers please visit www.ValueInvestingCongress.com

The Early Bird Rate Expires 3/16/10!Don’t miss your chance to SAVE $1,300. Register now with discount code P10VIID!

It’s time to LOOK UP!

The 5th Annual VALUE INVESTING CONGRESS WEST

The Langham, Huntington Hotel & Spa

SpeakersBruce BerkowitzFairholme Capital Mgmt.Eric SprottSprott Asset Mgmt.Mohnish PabraiPabrai Investment FundsPaul SonkinThe Hummingbird Value FundsThomas RussoGardner, Russo & GardnerDavid NierenbergThe D3 Family FundsLloyd KhanerKhaner CapitalJ. Carlo CannellCannell CapitalPatrick DegorceThélème PartnersWhitney Tilson & Glenn TongueT2 PartnersGuy SpierAquamarine FundAmitabh SinghiSurefin Investments

...and many more!

ON PATIENCE:

If Preston is guilty of anything,

it’s of being too patient. But

patience has paid off so many

times it’s hard to be critical.


http://www.valueinvestingcongress.com/?utm_source=VII&utm_medium=A&utm_campaign=P10VIID&ocode=P10VIID

I N V E S TO R I N S I G H T : Scott Hood


Investor Insight: Scott HoodScott Hood and Fred Astman of First Wilshire Securities explain where growth can be found at a discount, why inter-national due diligence needn’t be daunting, where they never scrimp in their research, and what they think the marketis missing in Rent-A-Center, American Water Works, Imax, Jinpan International and Motorcar Parts of America.

Stocks can be cheap for a variety of rea-sons, but what situations are most likelyto attract your attention?

Scott Hood: Our stocks tend to fall intothree broad categories. The first, wherewe have the majority of our money at anygiven time, is in stocks that are cheap rel-ative to the growth potential of the com-pany. Here I’m not talking about some-thing with a 30 P/E and 60% potentialgrowth, but more like a less than 10xmultiple and 20% growth. We prefer thecompanies to be in industries that are alsogrowing. It’s possible to find gems indeclining industries, but we’ve found thatit’s usually not wise to swim against thecurrent. One added benefit of the indus-try being on the rise is that the stocks in itare more likely to be recognized by otherinvestors, which can accelerate the returnon our investment.

The second general category would bein stocks that may not be growing but arejust ridiculously cheap. They’re few andfar between, but if you’re constantlylooking as we are, you can still from timeto time find companies with P/Es in thelow single digits, trading at big discountsto tangible book and/or with market val-ues less than cash. These companies typi-cally operate in mature industries thathave been overlooked by the market for along time. If a stock’s trading at three tofour times earnings, it doesn’t take muchincremental recognition by the invest-ment community to make a big differencein the share price.

The last category would be turn-arounds. The company may have missedearnings estimates, had a product prob-lem of some kind or lost a key customer,resulting in disappointed investors whojust care about near-term results and sellthe stock at a depressed price. That’swhere we’ll get interested, although we’reunlikely to act until we see tangible signs

of the turnaround or some clear positivesentiment from the industry or manage-ment. A few years ago, for example, wegot very interested in reinsurance compa-nies following the big hurricanes, but did-n’t dive in until we got early industryfeedback that rates were increasingsharply and had studied up on hurricanedata and probabilities.

I’d add that getting turnarounds rightis very tough. It takes a tremendousamount of research effort, the turn-arounds almost always take longer thanyou expect, and it’s just easy to get itwrong. That doesn’t scare us away, butwe’re very cognizant of the risks.

Particularly in ideas with strong potentialgrowth, why might the market miss that?

SH: Something about the company has tobe misunderstood. Many times it’s in anemerging industry or a growing nichewithin a mature one and the market justhasn’t caught on yet. Examples of that forus over the years would have been in pay-day-loan companies when that businesswas getting started, or in Asian Americanbanks founded to serve thriving immi-grant communities in California. We alsofind opportunity in companies with slow-growing legacy businesses, but with highgrowth at hand from a new productintroduction, distribution channel oremerging market. In small caps, thosetypes of things can make a big difference,but may be obscured if the bigger tradi-tional business isn’t so hot at the moment.

We also find that geography makes adifference. The further a company is fromNew York, Boston, Chicago, L.A. andSan Francisco, the less attention – andoften less respect – they get. In the 1990s,we started finding a lot of companies inthe upper Midwest that weren’t well-fol-lowed but had smart, entrepreneurialmanagers who were building great busi-

Scott Hood

Pedal to the Metal

Scott Hood very much enjoyed his time inHong Kong as a supervisory analyst forMerrill Lynch in the mid-1990s. He stud-ied a wide variety of industries, witnessedfirst-hand the early economic transforma-tion of China and took full advantage of liv-ing in one of the most dynamic cities in theworld. So why move to southern Californiato become Pasadena-based First WilshireSecurities' co-portfolio manager in 1998?“To be honest, too much of the job waschanging 'will' to 'might' or 'would' to'should' in analyst reports,” he says.

The move also reunited him with FredAstman, who founded First Wilshire in1977 and for whom Hood worked prior tomoving to Hong Kong. Now 87, Astmanstill manages the portfolio jointly withHood, who offers his investment mentorhigh praise: “Fred combines two veryimportant qualities in an investor. On theone hand, he's a rock in terms of stickingwith his discipline and strategy regardlessof how bleak things may be at the time,”Hood says. “At the same time, he's incred-ibly open to new businesses, new indus-tries and new markets and is constantlypushing us to figure out where the oppor-tunities are. We sometimes joke that he'sthe gas pedal and I'm the brakes.”


nesses. Minnesota is still probably ourfavorite state for stock ideas.

This out-of-sight, out-of-mind dynam-ic now applies to companies overseas.Over the past ten years we’ve found agreat number of opportunities in smallU.S.-listed companies that operate almostexclusively outside the U.S., particularlyin China. It’s rare for someone to visit a$100 million market-cap company that’s15 hours away, which can result in com-panies with 15% growth trading at 5P/Es. We’ve been going to China, forexample, for more than ten years andalways have a list of companies to visitthat look incredibly cheap on paper. Wethink being there allows us to better dis-tinguish those that deserve to be cheapfrom those that don’t.

How much of your portfolio today is ininternational companies?

SH: It’s usually 20-25%. In addition tofinding great valuations, we also like thegeographic and currency diversification.You could argue that with more than30% or so of your portfolio outside theU.S., you may be starting to make curren-cy bets and adding risk to the portfolio,but we think our level of exposure is inthe sweet spot where it improves ourdiversification and return potential. Still,that’s just an added kicker – we buy thesestocks because they offer good value andreturn potential regardless of where theyare located.

You pride yourself on your level of duediligence. Isn’t that much tougher outsidethe U.S.?

SH: It can be, but we tend to stick withcompanies that list in the U.S. and sohave to meet all the standards for finan-cial disclosure and communication thatentails. We also don’t scrimp on doing thesame types of site visits, channel checksand industry research we do in the U.S. Infact, I’d argue that our experience inplaces like China has made us even morediligent about digging for information inthe U.S. You don’t take anything forgranted in China – we shouldn’t do thathere either.

Whether we’re investing international-ly or not, we look for companies withlong operating histories, that have suc-cessfully been through a variety of cyclesand that have stable management. Theyhave well-respected auditors and take theinvestor-relations function seriously. Thatall makes due diligence somewhat easier.

I’ll give you a couple examples of thetypes of companies we own in China.Chindex International [CHDX] owns andoperates Chinese hospitals and clinics andalso sells medical capital equipment.We’ve owned the stock for years andthink it’s one of the blue-chip U.S.-listedcompanies, with a great managementteam, great relationships with the govern-

ment and a leading franchise in a boom-ing market. The company today isn’t ter-ribly cheap on earnings – 16x trailing 12-month EPS – but we believe that’s more afunction of heavy spending on buildingnew hospitals and a cyclical dip in equip-ment sales masking the earnings powerthat should come out of there. If youwant to participate in healthcare inChina, there’s probably no better way.

Another company we’re high on isHarbin Electric [HRBN], which makesdirect-drive motors used in things likesubway trains, car seats, postal sortingmachines and even meat slicers. The mar-ket can get overexcited and then com-pletely abandon the stock, but the compa-ny grows fairly steadily and the CEO is afanatic about product improvement andbuilding the company. There’s a tremen-dous emphasis in China on engineeringand product development. Companieslike Harbin can have 50 engineers forevery one at a comparable U.S. company,and they’re all focused on making evenobscure parts or processes better. LikeChindex, it’s a high-quality company. We

don’t find the research into these types ofcompanies any harder than it would behere, though the opportunity to find agood company at a low price is greater.

Turning to your research process, how doyou generate ideas?

SH: It’s almost always triggered by valu-ation. Rarely will we get into a new stockunless it has a trailing earnings multiplebelow 10x or hidden earnings power thatmakes it below 10x in the near future.One screen we perform every day goesthrough companies that announce quar-terly earnings, which we annualize to cal-culate P/Es. We’ll then go through thelowest P/Es on the list and after a verycursory look will pick out those we thinkdeserve a closer review.

For those stocks we’ll produce whatwe call a quick-take report, whichanswers the core 17 questions we want toknow about each company. It’s prettystandard stuff to get a quick and consis-tent read on earnings quality, the balancesheet, management and the competitiveenvironment. From that, Fred or I willmake the call whether to do a full report.

The research from here on is where wetry to distinguish ourselves. We’re bigbelievers in that Peter Lynch quote, that“the person who turns over the mostrocks wins the game.” We always say thatpeople who know what they’re doing canget 80% of the story in no time, just bylooking through the financials. But it’sthat last 20% that requires tremendouseffort and that is going to set you apart,or not. That’s the detective work, the sitevisits, the channel checks, the backgroundchecks, the legal research – all the thingsthat may or may not give you uniqueinsight, but which you have to do well toget any kind of edge.

Are there particular areas you emphasizein your research?

SH: In the old days, with small companiesanalysts could practically send their earn-ings model to the CFO and he'd correct itand send it back. With information moretightly controlled, that's put the burdenback on analysts to really do their work.



ON RESEARCH:

We’re big believers in the

Peter Lynch quote, that “the

person who turns over the

most rocks wins the game.”


Our goal is to understand companiesand their businesses in the same way themanagers and employees do. You can’tdo that without being out in the industrytalking to suppliers, customers and com-petitors, without spending a lot of timewith management, without visiting facil-ities. We encourage our analysts to becreative and want included in every fullreport a description of what he or shedid that was different in looking at thecompany. One of our analysts recentlyvisited the properties behind the 20largest loans made by a bank we wereresearching, canvassing the neighbor-hood, speaking with tenants, takingphotos. Those types of things greatlyimprove the quality of the discussionyou can have with a company.

We won’t buy into any companyunless Fred or I have personally spenttime with the management. It’s certainlynot an exact science, but we want to beconvinced the people running the compa-ny are knowledgeable, capable, trustwor-thy and energetic. If times are tough wewant them to be upfront about it, and iftimes are good we want them to alwaysbe looking around the next corner fortrouble. We believe getting to know man-agement over time builds a rapport thatallows us to pick up subtle clues aboutthe company’s prospects that others arelikely to miss.

I’m still amazed by the things you’llhear or see on a company visit. We visit-ed one company in Florida that madesimulators for pilot training and amuse-ment rides and heard all about the longlead time between the start of contractnegotiations and product delivery, includ-ing nine months or so for manufacturing.Later on in the day we toured the manu-facturing facility and of the 12 assemblybays, only two had anything going on.That wasn’t a big endorsement of thecompany’s prospects.

We’ve built a database over the past 15years in which we keep all the companyresearch we’ve done. We type up notesfrom every conversation, include photosof company visits, and include all of ourmodels. It’s a great complement to theknowledge we try to carry around in our

heads, and allows anyone at the firm toget up to speed quickly on any companyin our universe.

We’re assuming your research processitself produces adjacent ideas from timeto time.

SH: Absolutely. In one recent example, indoing research on American WaterWorks, which we’ll speak about later, wedid a screen to find the cheapest water

utilities in the world. What came up wasCompanhia de Saneamento Basico doEstado de Sao Paulo [SBS], the water util-ity in Sao Paolo, Brazil which happens tobe listed in the U.S. In looking into it, wewere very impressed with managementand liked the exposure to the city, thecountry and the currency. But we reallyliked the 6x P/E and the 6% yield, whichis still around where it trades today.

What’s a typical position size for youwhen you’re ready to buy?

SH: There are certain situations in whichwe might work our way into a position,say a turnaround in which we want moretime and experience with the companybefore deciding to fully step in. But ingeneral, our initial position sizes for corepositions are from 2-5%. We’ll havebetween 15 and 20 of those core positionsat any given time, with the rest of theportfolio in ideas that are either in theincubation phase or have to be kept smallbecause the market caps are so tiny.

Do you have any strict rules on selling?

SH: For ideas that have worked out, val-uation is usually the primary driver. We

don’t follow strict rules, but just as some-thing trading below 10x is a buy, some-thing over 20x on a forward basis is typ-ically a sell.

In between, it depends what’s going onwith the company. We’ve found that if wereally understand a company and have ahigh level of confidence in its earningsover the next three or four quarters,there’s no rush to sell unless the market’sexpectations outstrip ours.

We get concerned when companiesstart veering from what they do well. Ifthey start diverting cash flow to acquisi-tions in new areas or on major capitalspending for a product diversification,there’s a good chance we won’t be in theposition much longer.

We’re curious how you’ve handled yourposition in Atlantic Tele-Network[ATNI], which went from $14 to $53between March and September of lastyear, making it your biggest position atthe end of the third quarter.

SH: This is an interesting case – wehaven’t sold because the earnings multi-ple is probably lower than it was a yearago, even though the stock has taken off.The company’s legacy asset had been theprimary telephone operator in the coun-try of Guyana, on the northern coast ofSouth America. By putting itself in theright place at the right time, last yearATNI bought wireless assets serving800,000 rural customers primarily in thesouthern U.S., which Verizon had to sellto get regulatory approval for its pur-chase of Alltel.

ATNI paid about $250 per subscriber,one-sixth what AT&T paid for compara-ble assets from Verizon and one-eighthwhat Verizon paid for the subscribers inthe first place. The end result is that thecompany has added nearly $4 per share inearnings power going forward. They haveto execute, but we’re optimistic abouttheir prospects and still find the valuationquite compelling.

Turning to some specific ideas, explainthe investment thesis behind Rent-A-Center [RCII]?



ON SELLING:

We get concerned when com-

panies veer from what they do

well. When cash flow is divert-

ed elsewhere, so are we.




SH: This is the largest rent-to-own retail-er, ahead of Aaron’s, with around 3,200stores in the U.S. and Canada and a prod-uct mix that includes a variety of big-tick-et items like furniture, flat-panel TVs andappliances. Their typical customer issomeone with a job, but who doesn’thave the savings or can’t get the financingto purchase outright, say, a full bedroomset or a flat-panel TV. By renting fromRent-A-Center they can have the mer-chandise now, paying something on theorder of $32 per week in rent over a 24-month period for merchandise that mightcost $1,600 at retail. If they pay throughthe end of the term, it’s theirs to keep, but

they can return it whenever they wantwithout any more payments.

We’ve actually become a customer sowe can go through the process, includingvarying our payments to see how theyrespond. It’s quite impressive how uni-form and consistent the response isregardless of the store or region. They’llcall and know your situation and are verypersistent in making sure everything is ontrack. If it’s not, they’ll come around topick up the merchandise. That level ofresponsiveness allows them to never letnon-payment problems get out of control.

This era of tight credit should be a realpositive for Rent-A-Center. They have

been in this business for decades, servingthese types of customers, and now theydon’t have to compete as much with theeasy-credit folks. The countervailing fac-tor, of course, is the lousy economy andhigh unemployment, but we’d arguethose things should improve before theera of easy credit returns.

Who is the typical customer?

SH: They’re working, have below-aver-age household income and little or no realbanking relationship. That probablydescribes 20-25% of the working popula-tion in the U.S. Customers fill out a fairlyquick application, which requires land-lord, employer and personal references,used in the approval process and to fol-low up with at any sign of a late payment.

The business is somewhat cyclical, butthe swings are moderated by the fact thatin good times more people have jobs andmove into the company’s demographic,while in tough times people who beforemight have bought outright start to findRent-A-Center’s type of affordable pay-ment schedule a better option. Same-storesales declined somewhat in 2009, butthey’re expected to increase 1% or so in2010. Because the company has aggres-sively cut expenses – closing some previ-ously acquired redundant stores and cut-ting store-level labor and inventory costs– EPS actually grew 20% last year.

How cheap are the shares, now tradingaround $22.20?

Frederick Astman: The company earnedjust over $2.50 per share last year and isexpected to earn about the same this year.That results in a P/E of less than 9x. Evenwith no same-store sales growth, webelieve they’ll continue to reduce costsand earn around $2.70 per share in 2011.

The company hasn’t always had the mostpristine balance sheet. Is that an issue?

FA: They’ve actually been paying downdebt, reducing long-term debt by over$230 million last year. The companyshould have free cash flow of $160 mil-

Rent-A-Center(Nasdaq: RCII)

Business: Owns and franchises storesthat offer big-ticket durable goods – suchas consumer electronics, appliances andfurniture – under rent-to-own agreements.



Financials (TTM):

Revenue $2.75 billionOperating Profit Margin 10.6%Net Profit Margin 6.1%

THE BOTTOM LINE

The company’s rent-to-own business is well positioned to benefit as target customersfind credit financing tight and seek out more affordable payment schedules for big-ticket items, says Scott Hood. At the mid-point of their historical P/E range on his2011 earnings estimate, the shares a year from now would trade at close to $30.


RCII PRICE HISTORY


35

30

25

20

15

102008 2009 2010


RCII NasdaqTrailing P/E 8.8 18.5Forward P/E Est. 8.3 16.6


Company % Owned

BlackRock 9.4%Hotchkis & Wiley 6.7%Vanguard Group 4.5%Robeco Inv Mgmt 4.4%Artisan Partners 4.4%



35

30

25

20

15

10


lion in 2010 to pay down more debt orbuy back stock.

Today’s P/E is in the lower end of itshistorical range, which has pretty consis-tently been between 7x and 15x. If theyjust keep plugging along while continu-ing to pay down debt, there’s no reasonthe stock shouldn’t trade at 11-12xexpected earnings a year from now,which would result in a share price ofclose to $30. If we’re right and the com-pany starts growing again as the econo-my recovers and the lack of credit avail-ability drives customers their way, thatalso should be quite a catalyst for thestock on top of that.

You mentioned water utilities earlier,what attracts you to American WaterWorks [AWK]?

SH: American Water Works is the largestwater and wastewater-treatment utility inthe U.S., operating in more than 30 U.S.states but with roughly half its business inPennsylvania and New Jersey. The originsof the company go back to 1886 and itfirst went public more than 60 years ago,but it was taken private by the Germanutility company RWE in 2003. It cameback public again in 2008 when RWEdecided it didn’t want to be in this busi-ness in the U.S.

A big problem for the stock has beenthat RWE, to get regulatory approval forthe acquisition, agreed to not ask for rateincreases for up to five years even thoughit was spending a lot of money on capitalprojects. So you have a company thatcame public in a bad market, with theoverhang of a big shareholder looking tounload shares, and with lousy numbersbecause of goodwill writeoffs and histor-ical rate restrictions. All that is what cre-ated the opportunity in the first place.

How are those issues working out?

SH: RWE is now completely out, so theoverhang issue should be gone. The good-will writeoffs should be over. On the rateissue, it will probably be two to threeyears before all the original agreementsexpire and the company is able to get

catch-up increases that will allow it toapproach the typical 10% returns oninvested capital other utilities get. Thatissue alone gives American Water a high-er growth profile over the next few yearsthan most of their peers.

What’s appealing in general about thewater-utility business?

SH: There’s a great deal of emphasis bymany municipalities on improving waterquality, and environmentally and eco-nomically, clean tap water is a much bet-ter alternative to water in plastic bottles,which are shipped hundreds or thousands

of miles and then discarded or recycled.There’s also no comparison on cost –maybe only a penny for every two gallonsof clean tap water, which is transportedby infrastructure that’s already in place.

An important catalyst may come fromthe federal government: the EPA estimatesthat for its standards on clean drinkingwater to be met, hundreds of billions ofdollars in capital spending is necessary toupgrade and add water-related facilities inthe U.S. That’s a growth opportunity forAmerican Water – it plans to invest $5 bil-lion in new facilities over the next fiveyears, on which it expects to generateroughly 10% returns going forward.

Value Investor Insight 14February 28, 2010



American Water Works(NYSE: AWK)

Business: Founded in 1886, largestprovider of water and wastewater servicesto residential, commercial and industrialcustomers in the United States.



Financials (TTM):

Revenue $2.41 billionOperating Profit Margin 25.5%Net Profit Margin (-9.7%)

THE BOTTOM LINE

Industry growth from needed spending on water-related infrastructure and company-specific growth from catch-up rate increases should fuel 10% annual earningsgrowth over the next five years, says Scott Hood. At a peer multiple on his 2011 EPSestimate of around $1.65, the shares would trade in the low-$30s a year from now.


AWK PRICE HISTORY


25

20

15 2008 2009 2010


AWK S&P 500Trailing P/E n/a 21.8Forward P/E Est. 15.5 14.1


Company % Owned

JPMorgan Chase 6.0%Capital Guardian Trust 3.8%Pictet Asset Mgmt 3.5%Vanguard Group 3.1%Capital World Inv 2.9%


Shares Short/Float n/a

25

20

15


Another tailwind is that so many statesand municipalities are having budgetproblems that we’re likely to see anincrease in their willingness to sell theirwater-utility operations off to companieslike American Water. Roughly three-quar-ters of all utilities are government-owned,and while turning the operation of themover to private interests is politically diffi-cult, it’s often the best economic solution.

With American Water shares just above$22, how are you looking at valuation?

SH: We’re expecting $1.50 per share inearnings this year, and just from organicgrowth and the catch-up in rates we thinkthat can grow at least 10% annually forthe next five years. But at 15x estimated2010 earnings, American Water’s sharestrade at a significant discount to its peers,which trade at around 20x. Given thatthey have better growth prospects and adecent balance sheet, that discount makesno sense to us. Just by matching the peermultiple, we’d expect the stock to be trad-ing at least in the low $30s over the nextyear or so.

The dividend is also nice here, with acurrent yield of 3.8%. We expect themto increase it further this year, andwouldn’t be surprised if the annual divi-dend run rate was closer to 95 cents bythe end of 2010.

The shares of your next idea, Imax[IMAX], have been on a bit of a tear.Why are you still bullish?

SH: Imax has been around for more than40 years, with a name everybody knowsworldwide even though they’ve spentvery little on promoting it. After focusingfor much of its history on niche marketslike museums for their movie-projectiontechnology, in the past few years the com-pany has focused on broadening its the-ater base in two primary ways. First, theydeveloped a more cost-effective digitalprojection system, looking to tap whatover time will be a significant turnover attheaters from reel-based projection todigital. At the same time, they’ve recasttheir business model to significantly

lower the upfront cost to theater ownersof their high-end systems, while taking abigger cut of the ongoing net profits fromthe Imax-equipped theater.

No transition like this is entirelysmooth, but Imax is now hitting its stride.It finally started generating earnings inthe second quarter of last year and thesales backlog for new systems – about170 screens and growing – remains verystrong. They put in more than 80 newsystems last year, bringing the totalinstalled base to over 400.

Consumer enthusiasm for the technol-ogy is proven and keeps getting better.For a movie shown in Imax, 10% of gross

revenues come from Imax screens,although those screens make up only 2%of the total. A multiplex showing a movielike Avatar or The Dark Knight on threescreens, one of which is Imax, will sell outthe Imax showing before they fill out theother theaters – and people will pay a pre-mium to see it in Imax. This is not just aU.S. phenomenon – we sent people tocheck out Imax showings of Avatar inChina and they came back saying therewere lines to purchase tickets stretchingfor blocks. Given that Imax is on onlyeight screens in China today – withanother 22 on order – the growth poten-tial there is enormous.



Imax(Nasdaq: IMAX)

Business: Design, manufacture, sale andlease of digital and film-based theater sys-tems used in the presentation of large-for-mat 2-D and 3-D motion pictures.



Financials (TTM):

Revenue $145.3 millionOperating Profit Margin 4.1%Net Profit Margin (-5.5%)

THE BOTTOM LINE

Scott Hood doesn’t believe the market fully recognizes the strength of the company’sbrand and the earnings power of its newly evolved business model. If he’s right thatthe company will earn well over $1 per share a couple years out and can grow beyondthat at 20-30% annually, he expects today’s share price to prove quite inexpensive.


IMAX PRICE HISTORY


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12

9

6

3

02008 2009 2010


IMAX NasdaqTrailing P/E n/a 18.5Forward P/E Est. 22.7 16.6


Company % Owned

Tremblant Capital 7.1%Gilder Gagnon Howe & Co 5.3%William Blair & Co 5.0%First Wilshire Securities 4.5%Manatuck Hill Partners 4.2%



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Given the rapid increase in the stock price,to a recent $13.40, isn’t the story out?

SH: We still don’t think the market under-stands the power of the business model.Because Imax is adding screens at a rapidpace, the impact of the back-end revenuethey get from ticket sales and concessionshasn’t fully worked itself into the finan-cials. We expect first-quarter numbers,partly reflecting the huge success ofAvatar, to surprise on the upside. We alsothink the consensus 58-cent estimate for2010 earnings per share will turn out tobe conservative.

FA: Over the next five years we believethe number of screens can grow by 10-20% per year, while earnings may growcloser to 20-30% per year. Their eventualtarget is for up to 1,000 screens globally.

If we’re right, the company a coupleyears out is earning well over $1 pershare. What kind of multiple does some-thing growing that fast deserve? We don’tspend much time speculating on that typeof thing, but we can imagine it will behigh enough to make today’s share pricelook quite cheap.

What are the biggest risks?

SH: There’s always the risk that a newtechnology comes along to make Imaxseem less special, but given how trulysuperior the Imax viewing experience istoday, we think that risk is fairly low.

There’s some risk, especially as Imaxbecomes more dependent on ticket salesand concessions, that it will get whip-sawed by Hollywood’s hits and misses.Given the strong growth in the installedbase, we don’t at all need each movie tobe an Avatar to get the type of growthwe’re expecting. Also, with digital sys-tems it’s easy to switch out of a moviethat isn’t working to one that will.

There is some concern that the revenueshare with studios and the new joint-ven-ture business model with theater ownerswill prove to be too good and Imax willhave to renegotiate terms. In the grandscheme of things, it’s hard for us to seethat as a big problem.

For every risk, we also see plenty ofother opportunities. With systems goingdigital, Imax could potentially extend itsbrand to showing live events like theSuper Bowl. It also recently announced aventure with Disney and Discovery todevelop a 3-D television station. We thinkthe brand has a lot of room to run.

Talk about one of your favorite U.S.-list-ed Chinese companies, JinpanInternational [JST].

SH: Jinpan designs and manufactureslarge cast-resin transformers used in thedistribution of electricity. Its transformers

are mostly used in institutional settingssuch as large buildings, subway systems,factories and airports, and while they canbe more expensive than the typical oil-filled transformer used in the U.S., theyare also less flammable, more energy-effi-cient and require less maintenance.

We discovered Jinpan ten years agoand it’s done an excellent job since in cap-italizing on the dramatic development ofChinese industry and infrastructure.Management has proven to be both excel-lent operators and builders of long-termshareholder wealth. They spend heavilyon R&D and have nearly 100 engineerson staff (out of 700 or so employees) who



Jinpan International(Nasdaq: JST)

Business: Based in Hainan, China,designs, manufactures and distributes castresin transformers used in high-voltageelectricity distribution equipment.



Financials (TTM):


THE BOTTOM LINE

The company’s shares trade as if its growth prospects are moderate, but that’s not thecase, says Scott Hood. Expanded capacity to meet ongoing growth in Chinese power-related infrastructure can help generate 20%-plus earnings growth over the next fiveyears, he says. At 18-20x his 2011 EPS estimate, the shares would trade closer to $40.


JST PRICE HISTORY


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25

20

15

10

52008 2009 2010


JST NasdaqTrailing P/E 12.2 18.5Forward P/E Est. 12.5 16.6


Company % Owned

First Wilshire Securities 4.0%Royce & Assoc 2.4%Wells Fargo & Co 2.0%Albion Financial 2.0%Munder Capital 1.2%



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5



constantly focus on upgrading the com-pany’s products to compete against state-owned and private competitors in China.Revenues have quadrupled over the pastfive years, to $160 million in 2009.

Our basic view is that while the sharestrade as if growth prospects are moder-ate, that’s not at all the case. The infra-structure needs in China to support theeconomy’s growth remain enormous. Toget its fair share of that, Jinpan has a sig-nificant amount of new capacity comingfully on line this year, adding a newlybuilt plant in Wuhan and an acquired onein Shanghai to its existing facility inHainan. From China alone, we expect thecompany over the next five years to gen-erate 20% top-line growth and a fewpoints better than that on the bottom line.

How inexpensive do you consider theshares, at a recent $22.20?

SH: The stock trades today at less than13x estimated 2010 EPS of $1.70. Youwon’t find many U.S. companies capableof growing earnings at 20-25% a yeartrading at that kind of multiple.

We think one issue is that Jinpan getslumped in with newer Chinese companieslisted in the U.S. that just aren’t of thesame quality. It’s a proven company witha long track record through variouscycles. While there’s always going to besome additional risk because it’s in China,trading at a P/E that is half the expectedgrowth rate strikes us as far too large adiscount. That’s especially true given thestrength of the balance sheet, which cur-rently has more cash than debt. They evenpay a small dividend, which is rare forfast-growing Chinese companies.

A year from now the market will belooking toward a 2011 in which webelieve Jinpan can earn $2.10 to $2.20per share. If the growth profile is what weexpect, there’s no reason that shouldn’twarrant at least an 18-20x multiple.

Does the company have aspirations out-side of China?

SH: They’ve been smart to stay primarilyfocused on their home market, but have a

great deal of potential beyond that. Theirtransformers have been UL-certified inthe U.S., which opens a big opportunityfor them here over time. They also havesignificant potential in new end-user mar-kets, like General Electric’s use of theirtransformers in wind-power generators.We expect them to be extremely competi-tive in whatever markets they choose topursue.

Tell us about a micro-cap idea, MotorcarParts of America [MPAA].

SH: The company remanufactures vehiclealternators and starters for U.S. cus-

tomers. We found it years ago when itwas having accounting problems andgoing through a painful process of chang-ing management, changing auditors andtrying to get back into the good graces ofthe investment community.

Through all that, the underlying busi-ness proved quite simple and resilient.After five to seven years, alternators andstarters in your car are likely to wear out.You can replace them with new ones or,for less money, with those that have beenremanufactured by MPAA or one of itscompetitors. MPAA is the leader in itsmarket, with an excellent reputation forquality and reliability.

Motorcar Parts of America(Nasdaq: MPAA)

Business: Remanufacturer of car andtruck alternators and starters, sold to auto-motive retail outlets and the professional-repair market in the U.S. and Canada.



Financials (TTM):


THE BOTTOM LINE

The company’s business is simple and resilient, says Scott Hood, evidenced by thefact he expects its earnings in the fiscal year ending in March to double. But on his2011 estimates, the shares today trade at less than 6x earnings and only 5x freecash flow. What’s the market missing? “We can’t figure that out,” he says.


MPAA PRICE HISTORY


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12

9

6

3 2008 2009 2010


MPAA NasdaqTrailing P/E 11.5 18.5Forward P/E Est. 7.1 16.6


Company % Owned

Rutabaga Capital 9.2%Wellington Mgmt 6.4%Janus Capital 5.4%First Wilshire Securities 4.9%Keane Capital 4.7%



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The business is relatively stable, withrevenues tied to overall miles driven andthe age of cars in the country. Right nowoverall miles driven are down, but peoplecutting back on new-car purchases is apositive for MPAA and will likely contin-ue to be as the car population ages. Thebottom line is driven by how efficiently itturns out high-quality parts at its facilitiesin Mexico and Malaysia. It’s hard tomake profitability comparisons becausemost competitors are private, but MPAAin normal times generates operating mar-gins in the 6-10% range.

How are earnings holding up?

SH: The company earned 32 cents pershare in the fiscal year ending in March2009 and should earn close to 65 cents inthe year ending next month. Free cashflow on a per-share basis in fiscal 2010should be around 80 cents. So the shares[at a recent $5.30] trade at 8x estimatedearnings and 6.5x free cash flow. On our2011 estimates of 90 cents in EPS and

$1.05 in free cash flow, they’re that muchcheaper.

What’s the market missing?

SH: We can’t figure that out. The compa-ny’s earnings and cash flow have never

been better and the balance sheet is per-fectly fine, but the stock is roughly one-third its level of three years ago. There’salways a chance they’ll lose a contract, orcustomers will push them on margins, orbad weather will temporarily cause milesdriven to fall off, but things on thosefronts aren’t much different today than

they have been. If the issue is just that noone is paying attention, we’d expect thatto at least partly change as the companyconfirms good earnings numbers.

Scott, you recently presented a value-investing seminar in China. Any stories totell from that?

SH: We were at one of the top universi-ties and drew a good crowd, which sur-prised me a bit because the focus forinvestors there is so much about growth –they’re generally not afraid of high P/Es.Our talking about finding opportunity attimes in marginal companies that are justvery cheap was a concept very differentfrom the current mindset.

But in terms of whether they werewell-versed in private enterprise and cap-italism, I could have been speaking to theRepublican Club at the University ofTexas. If there’s anyone left who doesn’tthink the Chinese understand how tocompete in a global economy, they’reobviously not paying attention. VII

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ON CHINESE STUDENTS:

Were they well-versed in pri-

vate enterprise? I could have

been with the Republican Club

at the University of Texas.



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U N C O V E R I N G VA L U E : Kraft


There was no shortage of good theaterin Kraft Foods' recent takeover battle forCadbury PLC. Included in the dramawere nasty top-executive barbs, hand-wringing over matters of national pride,rumored third-party bids, and even somewell-chosen cautionary words fromKraft's largest shareholder, WarrenBuffett. In the end, Kraft clinched the dealon January 19th with a sweetened $19.4billion bid, bringing the curtain down onCadbury's nearly 200 years as an inde-pendent company.

Wall's Street's reaction to Kraft's boldacquisition stroke? An extended yawn.On the day before Kraft launched its firstbid last September, Kraft shares closed at$28.10. Since then they've waffledbetween $26 and $30, closing mostrecently at $28.40. Zzzzzz.

Count Pershing Square Capital's BillAckman as one prominent investor whofinds the market's torpor to be misplaced.He expects the combination to acceleratealready-in-place initiatives to improvemargins and to significantly enhance eachcompany's standalone organic growthprospects. “The candy business is one ofthe great businesses in the world,” hesays. “I hesitate to call any acquisition asteal, but this deal should ultimatelyprove to have been done at a very favor-able price.”

Key to his optimism is the fact thatCadbury was doing many of the rightthings to improve its profitability and thestrength of its brands – which includeCadbury confectionary products, Hallscough drops, and Dentyne and Tridentgums – the results of which will nowaccrue to Kraft. Cadbury has investedheavily in emerging-market distribution,where it now earns more than 40% of itssales. It has in recent years increasedspending on marketing and R&D, whilealso building new plants now coming online in low-labor-cost countries. As those

investments pay off, Ackman expectsCadbury's EBIT margins to rise to themid-to-high teens, from 13.5% today.

“Often in branded-foods acquisitionsthe acquirer ends up buying a portfolio ofbrands that has been starved of marketingsupport and capital investment,” saysPershing Square partner Ali Namvar.“This is not at all the case with Cadbury.”

Kraft has been on a similar long-livedcampaign to improve its own peer-laggingoperating margins, which fell from 21%in 2002 to 12.8% in 2008 due to a vari-ety of product and marketing missteps, aneed for catch-up R&D spending, andcommodity-cost woes. Ackman creditsmanagement with improving the quali-ty/value propositions for many of Kraft's

Food for ThoughtAcquiring-company managers typically tout the “transformational” nature of big deals while Wall Street lookson with skepticism. In the case of Kraft buying Cadbury, Bill Ackman expects the skeptics to be dead wrong.

Kraft Foods(NYSE: KFT)

Business: Global manufacturer and mar-keter of branded snacks, packaged foodsand (increasingly after agreement to buyCadbury) confectionary products.



Financials (TTM):

Revenue $40.39 billionOperating Profit Margin 13.8%Net Profit Margin 7.5%

THE BOTTOM LINE

The market is underestimating both the independent progress Kraft and Cadbury havemade in improving profitability as well as the revenue and cost benefits to accrue fromtheir combination, says Bill Ackman. With the dividend and even a 15x multiple on his2012 earnings estimate, the shares would return 50-60% over the next two years.


KFT PRICE HISTORY


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20 2008 2009 2010


KFT S&P 500Trailing P/E 14.0 21.8Forward P/E Est. 12.2 14.1


Company % Owned

Berkshire Hathaway 9.4%State Street Corp 5.0%Barclays Global Inv 4.9%Capital Research Global Inv 4.0%Capital World Inv 4.0%



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U N C O V E R I N G VA L U E : Kraft


products, weeding out weak brands andimproving supply-chain efficiencies, andhe expects EBIT margins to improve to15% by 2011. That level shouldn't be theultimate goal, he says, as other U.S.branded-food companies like GeneralMills, J.M. Smucker and Campbell Soupconsistently earn margins above 17%.

Beyond the increased profit potentialof each company on its own, Ackman isalso enthusiastic about incrementalupside from combining the companies'efforts. The new Kraft will earn 50% ofits revenues from branded candy, cookiesand snacks, categories in which storebrands have found it difficult to makeinroads, and which are particularly well-suited to take advantage of developing-country growth. Each company's distri-bution strengths – Kraft in direct-to-storedistribution in North America andCadbury in emerging markets and in“instant-consumption” channels like con-venience stores and gas stations – shouldbenefit the other company's products.While he believes the old Kraft was capa-ble of 3% to 3.5% annual organic rev-enue growth, Ackman thinks the new one

is more likely to grow at 4.5% to 5% peryear. On top of potential revenue syner-gies, there are plenty of costs to be cut aswell. Kraft management has so far identi-fied $675 million in annual cost savings,

a number Ackman expects to increase.Add it all up, and by 2012 Ackman

estimates Kraft will be earning $2.70 to$2.90 per share. At a minimum 15x mul-tiple – “still way too low for a companyof this quality,” he says – Kraft shareswould trade at $40 to $44 per share.With the 4% annual dividend yield, thatwould translate to a 50%-60% returnfrom Kraft's current price of $28.40.“The biggest risk is whether [CEO] Irene

Rosenfeld and her team execute toachieve the potential that's here,” he says.“How do we lose a lot of money? I don'tsee it, given how the quality of the exist-ing business more than supports the cur-rent valuation. We think it's more a ques-tion of how long it takes them to executethan whether they're able to get it done.”

And what of Warren Buffett's protes-tations that Kraft agreed to pay too deara price for Cadbury? Ackman argues thatgiven the expected margin improvementat Cadbury and assuming the announcedcost savings targets are met, Kraft is pay-ing only 12x what he expects the compa-ny to earn after taxes in 2011. That's asignificant discount, he adds, to whatMars paid in 2008 for Wrigley – a dealpartly funded by Berkshire Hathaway.“Buffett's making a stink about the priceKraft was paying did a real service toKraft shareholders,” Ackman says. “I'msure it helped the Cadbury board feel likethey were doing a great job in selling thecompany.”

To view Pershing Square’s presentation onKraft, “A Krafty Combination,”click here.

VII

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ON THE CADBURY PRICE:

Buffett’s making a stink about

the price Kraft was paying for

Cadbury did a real service to

Kraft shareholders.


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A F R E S H L O O K : Chubb


Financial markets were crumbling, butthere was no sense of panic in last year'sinterview (VII, February 23, 2009) withTim Hartch and Michael Keller of BrownBrothers Harriman & Co. As Hartchsummed up their approach at the time:“When their stocks are on sale, we thinkbuying into leading companies that pro-vide essential products to large, loyal cus-tomer bases is always a strategy for doingwell. That's going to prove more impor-tant today than ever.”

Hartch and Keller saw particular valuein five stocks – Chubb, Aflac, Intuit, eBayand Dentsply – an equally weighted port-folio of which to-date would havereturned 74% since the issue appeared,vs. a 46% gain for the Russell 3000. ButHartch still believes the types of blue-chipcompanies he favors are getting relativelyshort shrift from today's market. “Manyof the best companies have come throughthe past twelve months in excellentshape,” he says, “but haven't fully partic-ipated in the market rebound.

He cites Chubb as a prime example.The property/casualty insurer, known forits high-end property and professional-liability lines, had an excellent 2009: itearned $6.20 per share, up 25% over theprior year; its combined ratio (insuranceexpenses and losses divided by premiumincome) came in at an impressive 86%; itsinvestment portfolio remained remark-ably clean and rebounded nicely as creditmarkets improved; overall, the firm'sbook value increased 23% from year-end2008. Despite all that, while the compa-ny's shares have rebounded off March2009 lows, at just over $50 they are at thesame level they were at the end of 2008.

The primary weight on the stock, saysHartch, is malaise in the property/casual-ty insurance business. Slack demand dueto the economy and a surfeit of industrycapital are exerting downward pressureon prices. Rather than chase sales by cut-

ting rates, Chubb has been turning awaybusiness on which it doesn't expect toearn an adequate return. As a result, itsnet written premiums fell 6% last year,and Hartch believes they may fall againthis year. “Wall Street hates to see that,”he says, “but the long-term benefit ofmaintaining pricing discipline exceeds theshort-term cost of lost premiums.”

Chubb shares trade for less than 1.1xbook value, well off their traditional mid-cycle valuation of closer to 1.5x. Evenwith no re-rating of the shares, Hartchexpects the company's 15% returns on

equity to translate over time into compa-rable annual returns for shareholders –through increases in book value, divi-dends, and share buybacks. One fly in theointment, he says, would be a sharp risein interest rates, which would negativelyimpact the market value of Chubb's giantfixed-income investment portfolio.

“There's no exciting catalyst or dra-matic turnaround story here,” saysHartch, “but this is the type of low-riskopportunity we're finding most attractivetoday. Boring is likely to be better in thenext twelve months.” VII

“Boring is likely to be better”High-quality companies that best weathered the crisis weren't the biggest stock-market winners over the pastyear. Brown Brothers’ Tim Hartch and Michael Keller don’t expect that to be the case in the coming one.

Share Information (@2/26/10):

Price $50.4652-Week Range $34.44 – $53.79

Chubb(NYSE: CB)

NEW BOTTOM LINE

Malaise in property/casualty insurance has only highlighted the company’s operationalstrength, says Tim Hartch, who expects its typical 15% ROE to yield a comparablereturn for shareholders. Eventual multiple expansion provides further upside, he says.

ORIGINAL BOTTOM LINE – FEBRUARY 23, 2009

In painting its shares with the same negative brush being used on all insurers, the mar-ket is not recognizing the company’s competitive strengths in underwriting, customerservice and financial management, says Tim Hartch. His discounted cash flow analysisindicates an intrinsic value for the shares of closer to $75, nearly twice today’s level.


CB PRICE HISTORY


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Valuation Metrics (@2/26/10):

CB S&P 500Trailing P/E 8.2 21.8Forward P/E Est. 9.1 14.1

! VII, February 23, 2009

!


Editors’ Note: As we approach the one-year anniversary of March 9, 2009, theday the market hit what we suspect willprove to be a generational low, it’s anexcellent time to reflect on the lessons ofthe market’s collapse and subsequentrebound. And who better to provide per-spective than Baupost Group’s SethKlarman, who has given us permission topublish the following excerpt from hisnew annual letter, in which he describes20 lessons that should have been learnedfrom the crisis … as well as 10 wrong les-sons investors appear to have learnedinstead.

One might have expected that thenear-death experience of most investorsin 2008 would generate valuable lessonsfor the future. We all know about the“depression mentality” of our parentsand grandparents who lived through theGreat Depression. Memories of toughtimes colored their behavior for morethan a generation, leading to limited risktaking and a sustainable base for healthygrowth. Yet one year after the 2008 col-lapse, investors have returned to shock-ingly speculative behavior. One stateinvestment board recently adopted a planto leverage its portfolio – specifically itsgovernment and high-grade bond hold-ings – in an amount that could grow to20% of its assets over the next threeyears. No one who was paying attentionin 2008 would possibly think this is agood idea.

Below, we highlight the lessons that webelieve could and should have beenlearned from the turmoil of 2008. Someof them are unique to the 2008 melt-down; others, which could have beendrawn from general market observationover the past several decades, were cer-tainly reinforced last year. Shockingly, vir-tually all of these lessons were eithernever learned or else were immediatelyforgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happenedbefore are bound to occur with someregularity. You must always be pre-pared for the unexpected, includingsudden, sharp downward swings inmarkets and the economy. Whateveradverse scenario you can contem-plate, reality can be far worse.

2. When excesses such as lax lendingstandards become widespread andpersist for some time, people arelulled into a false sense of security,creating an even more dangerous situ-ation. In some cases, excesses migratebeyond regional or national borders,raising the ante for investors and gov-ernments. These excesses will eventu-ally end, triggering a crisis at least inproportion to the degree of theexcesses. Correlations between assetclasses may be surprisingly high whenleverage rapidly unwinds.

3. Nowhere does it say that investorsshould strive to make every last dollarof potential profit; consideration ofrisk must never take a backseat toreturn. Conservative positioning enter-ing a crisis is crucial: it enables one tomaintain long-term oriented, clearthinking, and to focus on new oppor-tunities while others are distracted oreven forced to sell. Portfolio hedgesmust be in place before a crisis hits.One cannot reliably or affordablyincrease or replace hedges that arerolling off during a financial crisis.

4. Risk is not inherent in an investment;it is always relative to the price paid.Uncertainty is not the same as risk.Indeed, when great uncertainty – suchas in the fall of 2008 – drives securitiesprices to especially low levels, theyoften become less risky investments.

5. Do not trust financial market riskmodels. Reality is always too com-plex to be accurately modeled.

Attention to risk must be a 24/7/365obsession, with people – not comput-ers – assessing and reassessing the riskenvironment in real time. Despite thepredilection of some analysts tomodel the financial markets usingsophisticated mathematics, the mar-kets are governed by behavioral sci-ence, not physical science.

6. Do not accept principal risk whileinvesting short-term cash: the greedyeffort to earn a few extra basis pointsof yield inevitably leads to the incur-rence of greater risk, which increasesthe likelihood of losses and severeilliquidity at precisely the momentwhen cash is needed to cover expens-es, to meet commitments, or to makecompelling long-term investments.

7. The latest trade of a security creates adangerous illusion that its marketprice approximates its true value.This mirage is especially dangerousduring periods of market exuberance.The concept of "private marketvalue" as an anchor to the proper val-uation of a business can also be great-ly skewed during ebullient times andshould always be considered with ahealthy degree of skepticism.

8. A broad and flexible investmentapproach is essential during a crisis.Opportunities can be vast, ephemeral,and dispersed through various sectorsand markets. Rigid silos can be anenormous disadvantage at such times.

9. You must buy on the way down. Thereis far more volume on the way downthan on the way back up, and far lesscompetition among buyers. It is almostalways better to be too early than toolate, but you must be prepared forprice markdowns on what you buy.

10. Financial innovation can be highlydangerous, though almost no one willtell you this. New financial productsare typically created for sunny daysand are almost never stress-tested for

The Forgotten Lessons of 2008In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisiswhich, he says, “were either never learned or else were immediately forgotten by most market participants.”

S T R AT E GY: Seth Klarman



stormy weather. Securitization is anarea that almost perfectly fits thisdescription; markets for securitizedassets such as subprime mortgagescompletely collapsed in 2008 andhave not fully recovered. Ironically,the government is eager to restore thesecuritization markets back to theirpre-collapse stature.

11. Ratings agencies are highly conflict-ed, unimaginative dupes. They areblissfully unaware of adverse selec-tion and moral hazard. Investorsshould never trust them.

12. Be sure that you are well compensatedfor illiquidity – especially illiquiditywithout control – because it can createparticularly high opportunity costs.

13. At equal returns, public investmentsare generally superior to privateinvestments not only because they aremore liquid but also because amidstdistress, public markets are more like-ly than private ones to offer attractiveopportunities to average down.

14. Beware leverage in all its forms.Borrowers – individual, corporate, orgovernment – should always matchfund their liabilities against the dura-tion of their assets. Borrowers mustalways remember that capital marketscan be extremely fickle, and that it isnever safe to assume a maturing loancan be rolled over. Even if you areunleveraged, the leverage employed byothers can drive dramatic price andvaluation swings; sudden unavailabili-ty of leverage in the economy maytrigger an economic downturn.

15. Many LBOs are man-made disasters.When the price paid is excessive, theequity portion of an LBO is really anout-of-the-money call option. Manyfiduciaries placed large amounts ofthe capital under their stewardshipinto such options in 2006 and 2007.

16. Financial stocks are particularly risky.Banking, in particular, is a highly lever-aged, extremely competitive, and chal-lenging business. A major Europeanbank recently announced the goal ofachieving a 20% return on equity(ROE) within several years.Unfortunately, ROE is highly depend-

ent on absolute yields, yield spreads,maintaining adequate loan lossreserves, and the amount of leverageused. What is the bank's managementto do if it cannot readily get to 20%?Leverage up? Hold riskier assets?Ignore the risk of loss? In some ways,for a major financial institution evento have a ROE goal is to court disaster.

17. Having clients with a long-term ori-entation is crucial. Nothing else is asimportant to the success of an invest-ment firm.

18. When a government official says aproblem has been "contained," payno attention.

19. The government – the ultimate short-term-oriented player – cannot with-stand much pain in the economy orthe financial markets. Bailouts andrescues are likely to occur, though notwith sufficient predictability forinvestors to comfortably take advan-tage. The government will take enor-mous risks in such interventions,especially if the expenses can be con-veniently deferred to the future. Someof the price-tag is in the form of back-stops and guarantees, whose cost isalmost impossible to determine.

20. Almost no one will accept responsi-bility for his or her role in precipitat-ing a crisis: not leveraged speculators,not willfully blind leaders of financialinstitutions, and certainly not regula-tors, government officials, ratingsagencies or politicians.

Below, we itemize some of the quitedifferent lessons investors seem to havelearned as of late 2009 – false lessons, webelieve. To not only learn but also effec-tively implement investment lessonsrequires a disciplined, often contrary, andlong-term-oriented investment approach.It requires a resolute focus on risk aver-sion rather than maximizing immediatereturns, as well as an understanding ofhistory, a sense of financial market cycles,and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.

2. Bad things happen, but really badthings do not. Do buy the dips, espe-cially the lowest quality securitieswhen they come under pressure,because declines will quickly bereversed.

3. There is no amount of bad news thatthe markets cannot see past.

4. If you’ve just stared into the abyss,quickly forget it: the lessons of histo-ry can only hold you back.

5. Excess capacity in people, machines,or property will be quickly absorbed.

6. Markets need not be in sync with oneanother. Simultaneously, the bondmarket can be priced for sustainedtough times, the equity market for astrong recovery, and gold for highinflation. Such an apparent discon-nect is indefinitely sustainable.

7. In a crisis, stocks of financial compa-nies are great investments, becausethe tide is bound to turn. Massivelosses on bad loans and soured invest-ments are irrelevant to value; improv-ing trends and future prospects arewhat matter, regardless of whetherprofits will have to be used to coverloan losses and equity shortfalls foryears to come.

8. The government can reasonably relyon debt ratings when it forms pro-grams to lend money to buyers of oth-erwise unattractive debt instruments.

9. The government can indefinitely con-trol both short-term and long-terminterest rates.

10. The government can always rescuethe markets or interfere with contractlaw whenever it deems convenientwith little or no apparent cost.(Investors believe this now and, worsestill, the government believes it aswell. We are probably doomed to alasting legacy of government tamper-ing with financial markets and theeconomy, which is likely to create themother of all moral hazards. The gov-ernment is blissfully unaware of thewisdom of Friedrich Hayek: “Thecurious task of economics is todemonstrate to men how little theyreally know about what they imaginethey can design.”) VII

S T R AT E GY: Seth Klarman



Value Investor Insight February 28, 2010

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Value Investor Insight Issue 239

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