Oakcliff Capital / Bryan Lawrence

Value-oriented Equity Investment Ideas for Sophisticated Investors A Monthly Publication of BeyondProxy LLC

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“If our efforts can further the goals o f our members by giving them a discernible edge over other market participants, we have succeeded.”

Investing In The Tradition of Graham, Buffett, Klarman

T H E S UPERINVESTOR I SSUE

Year IV, Volume II February 28, 2011 When asked how he became so successful, Buffett answered: “We read hundreds and hundreds of annual reports every year.”

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Snapshot of 100 companies owned by superinvestors ► ►

Top Ideas In This Report

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(Nasdaq: STX) ……………………114 (NYSE: S) …………………….......118

Zimmer Holdings (NYSE: ZMH) ……………………..130

19 companies profiled by MOI MOI research research team

Proprietary selection of Top 3 candidates for investment

Seagate Technology Sprint Nextel

Latest holdings of 50 top investors

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Plus: Exclusive interview with Brian Bares

Plus: Exclusive interview with Bryan Lawrence Plus: Favorite stock screens for value investors

Also Inside Editor’s Commentary ………………...5 Interview with Brian Bares ………… 8 Interview with Bryan Lawrence …… 12 Portfolios with Signal Value™ …… 18 New or Increased Holdings ………. 70 Reduced or Offsetting Holdings …. 134 100 Superinvestor Stocks …………146 Essay by Josh Tarasoff …………… 156 Favorite Value Screens ……………158 This Month’s Top Web Links …….. 167

About The Manual of Ideas Our goal is to bring you investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary methodology to identify stocks that are not widely followed by institutional investors. Our research team has extensive experience in industry and security analysis, equity valuation, and investment management. We bring a “buy side” mindset to the idea generation process, cutting across industries and market capitalization ranges in our search for compelling equity investment opportunities.

Superinvestor companies mentioned in this issue include AbitibiBowater, Accuride, Alere, American Tower, Amylin Pharma, Anadarko Petroleum, Anheuser-Busch InBev, Applied Materials, Arris, BP, Broadridge Financial, Brookfield Infrastructure Partners, CareFusion, CBS, Charter Comms, Chesapeake Energy, China Mobile, Cisco Systems, Coca-Cola, Comcast, CommScope, Copart, Corporate Executive, DaVita, Dean Foods, Electronic Arts, Ensco, Enstar Group, Express Scripts, Exxon Mobil, Fiserv, Flextronics, Flowserve, Fortune Brands, Foster Wheeler, Gap, Gastar Exploration, General Growth, General Motors, H&R Block, Hain Celestial, Harvest Natural Resources, Hewlett-Packard, International Paper, ITT, J.C. Penney, Johnson & Johnson, Kraft Foods, Lab Corp. of America, Lamar Advertising, Leap Wireless, Learning Tree, Level 3 Comms, Liberty Global, Liberty Interactive, Lions Gate Entertainment, Inside: McDonald's, Loral Space, LyondellBasell, Massey Energy, MasterCard, McKesson, Microsoft, Molson Coors, MRV Comms, Omnicare, Owens Illinois, PDL BioPharma, Pfizer, Plains Exploration, POSCO, Exclusive Interview with Praxair, Procter & Gamble, Radian Group, Raytheon, Ross Stores, Bryan Lawrence, Schlumberger, Seagate Technology, Sears Holdings, Snap-on, Spectrum Brands, Sprint Nextel, Stanley Black Decker, Steris, Oakcliff Capital Teck Resources, Texas Industries, Theravance, Time Warner Cable, Tyco International, Vail Resorts, Valeant Pharma, Vishay Precision, Vulcan Materials, W.R. Grace, Wal-Mart,With Watson Pharma, Wendy's/Arby's, compliments of Zimmer Holdings, ZipRealty, and more.

The Manual of Ideas

(analyzed companies are underlined)

Copyright Warning: It is a violation of federal copyright law to r eproduce all or part of this publication for any purpose without the prior written consent of BeyondProxy LLC. Email [email protected] if you wish to have multiple copies sent to you. © 2008-2011 by BeyondProxy LLC. All rights reserved.

Value-oriented Equity Investment Ideas for Sophisticated Investors

Exclusive Exclusive Interview with Bryan Lawrence We had the pleasure of spending time and learning from Bryan Lawrence at the recent VALUEx in Zurich/Klosters, Switzerland. We caught up with Bryan after the event and are pleased to bring you some of his insights in this interview. After eleven years as a banker at Lazard, Bryan started his own partnership, Oakcliff Capital, in 2004 in order to invest his family’s capital and the capital of partners and CEOs of the private equity firm his father founded. In 2010, Bryan partnered with Glenn Greenberg to start Brave Warrior, but has returned to Oakcliff full-time because he found investing only in larger U.S. companies to be confining. Bryan is a graduate of Yale University.

“Experience shows that the highest returns come from the investments with the lowest risk of permanent loss at the time the investment was made. That is not what they teach in business school…”

The Manual of Ideas: Tell us a little about the genesis of your firm. What goals did you have at the outset, and what operating principles have guided you since then? Bryan Lawrence: Oakcliff was started in 2004 in order to invest capital for my family and our business partners. My family’s and most of my partners’ wealth comes from a private equity firm that invests in energy companies. So a goal from the beginning has been to diversify into non-energy investments (though sometimes our knowledge of the energy industry has made it hard to pass up on things that we see in the public market). Another goal is to maximize returns while taking as little risk as possible. If you look at how to do this, you quickly come to concentrated value investing as the most sensible way, especially on an after-tax basis.

One of the best advantages you can have as an investor is patient capital, and so we have done everything that we can to be able to stand at the plate all night. My family owns roughly 65% of Oakcliff, and we consider our capital to be permanent. Our partners have all been known to us for decades, and have the same goals that we do. There has not been and never will be a marketing effort. When new people enquire about becoming Oakcliff partners, we think carefully about taking them on. We have found that asking for a two-year lock-up is a smart test of someone’s commitment to our strategy. We also have found that people who like to talk with us about businesses are usually great partners, as they are likely to think long term, and also can be great sources of investment ideas. We only need a couple of ideas a year, and so a partner who comes up with one of them, or who helps us think through something, is adding an enormous amount of value to the partnership. Another principle is that this really is our money. So we do not do anything that might cause financial distress, which we define as being forced to do something when we don’t want to do it. This rules out leverage at the partnership level, and makes us suspicious of companies with too much debt. Experience shows that the highest returns come from the investments with the lowest risk of permanent loss at the time the investment was made. That is not what they teach in business school, but that is what we have found, in both energy and non-energy.

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Our goal is for the partnership to beat the market by double-digit percentages, which it has done overall against the S&P. Net of all fees and expenses, returns to limited partners have been 10% annualized. More than 90% of these returns have been unrealized or long-term gains, and they were achieved with cash balances that ranged from zero to 70% of the portfolio. We weren’t smart enough to hold onto our cash until the bottom, but the experience of living through the crash makes us even more certain that we want to own good businesses, have a clear sense of how much cash they generate, and have no way for the bank to take the keys away. It’s just too painful to live otherwise. MOI: Help us understand the kind of investor you are, perhaps by highlighting a couple of examples of companies you have invested in or decided to pass up. What are the key criteria you employ when making an investment decision?

“At the core of our investment process are five basic questions: (i) do we understand the business; (ii) is it a good business; (iii) is it run by people who act like owners; (iv) is it cheap; and (v) why is it cheap.”


Lawrence: At the core of our investment process are five basic questions that will be familiar to most value investors: (i) do we understand the business; (ii) is it a good business; (iii) is it run by people who act like owners; (iv) is it cheap; and (v) why is it cheap. To get these questions answered positively, we are willing to look at small and big companies, as well as overseas. Our capital totals $55 million today, which means that we are able to look at a broad range of equity investments, as well as options and debt instruments that can create interesting risk/reward situations.

One example was Dr. Reddy’s Laboratories, an Indian company that sells drugs in developing countries, and develops challenges to the patents of large Western drug companies. The company has an attractive business model because Indian researchers are very high quality but cost 80% less than Western researchers, and developing country demand for pharmaceuticals is growing rapidly. The company sounds like it has a silly name, but Dr. Reddy was one of the most respected businessmen in India, and his family was a significant owner of the company. In mid-2005, the company looked cheap. The branded drug business generated predictable cash flows worth $18 per share, and a portfolio of twelve patent challenges was worth $5-8 per share assuming a 30% success rate, compared to a historical success rate of 70%. Including $2 per share of cash, intrinsic value was $25-28 per share, compared to the market price of $17 per share. An unlevered balance sheet, strong free cash flows, and low share price relative to the value of branded business looked like a pretty good margin of safety, and there was also a decent case to be made that the low valuation would be temporary. Patent challenges require three to four years of legal expense before success or failure in court. This was obscuring the cash flows of the branded drug business. The company had recently lost its challenge of Prozac’s patent, which was the largest potential pay-off in its portfolio. This reduced investor confidence about the remaining twelve challenges. Finally, India had recently agreed to begin respecting Western patents, causing investors to worry about entry into India by Western drug makers. But Western drug makers worried about global pricing consistency had to price at Western levels, which were 5-10x Indian prices, so it seemed very unlikely that Western drug makers would gain much share. We had a positive answer to all five of our basic questions, and the investment played out happily. Oakcliff bought at $17 per share in mid-2005, and exited after 14 months at $31 per share, a long-term gain of 88%.




“The option market did not appear to understand how bipolar the [Fairfax] situation was [in 2006], and was offering two-year call options to purchase Fairfax stock at 1.0x book for a premium equal to 0.02x book value.”


Another example was Greenfield Online, which operated two businesses — the world’s largest online market research panel, and the second-largest comparison shopping site in Europe. Scale is important to market research, because it allows highly specific polling to be statistically significant (e.g., what do hunters aged 30-45 in Maine think of Toyota’s new pick-up truck?). Prior management had raised capital at $16 per share in order to make acquisitions, but had overpaid and undelivered. The new CEO had a strong reputation in the industry, a large option package that would be worth a lot if he fixed things, and a very clear-minded approach to talking about the business. Greenfield looked very cheap in December 2005. The company was generating 40 cents per share of free cash flow, worth $4 per share at a 10x multiple, and had $2 per share of cash. Private market valuation for the comparison shopping business was $12 per share, based on four recent transactions. But the company was trading for $5 per share. This price offered a good margin of safety — 7.5x free cash flow for a business with no debt. Why was it cheap? Investors appeared to have been disappointed by the grand promises of the preceding CEO. Certainly the research community was disappointed — the investment bank sponsoring the capital raise with a buy at $16 per share now rated the company as a sell at $5 per share. And Fortune magazine called the stock the 2 nd-worst performer of the year. It was December, and many money managers wanted it out of their portfolios by yearend. Again, we had a good answer to all five of our basic questions, and Oakcliff bought at December 2005 at $5 per share. We sold twelve months later for $13 per share, a 145% gain, almost all of which was long term. A final example is Fairfax Financial, a property and casualty insurance company with an outstanding long term record of value creation. P&C insurance is highly dependent on the character of management, as management has broad discretion to determine reserves, and thus manipulate current income. CEO Prem Watsa was highly regarded for his honesty and stock-picking, and had compounded book value per share at 37% annually from inception in 1985 through 2000. In mid-2006, Fairfax was under assault by the short-selling community. Poor results from 2000-2005 had convinced some investors that Prem Watsa was lying about reserve adequacy. Investors were worried that the 2006 hurricane season would be as bad as the 2005 season, which had included Hurricane Katrina. Fairfax was trading at 0.7x book value, well below the 1.5x more typical of a well-run P&C insurer. This was a situation with a binary outcome. If the reserves were inadequate, the company’s equity would be worthless. If adequate, the company’s equity might be worth 1.5x book value. The stock market appeared to be assigning 50/50 odds to these outcomes. To make the investment attractive, we bought long-term call options, minimizing our capital at risk. The option market did not appear to understand how bipolar the situation was, and was offering two-year call options to purchase Fairfax stock at 1.0x book for a premium equal to 0.02x book value. Oakcliff bought call options in spring 2006, and sold them in the fall of 2006 after a quiet hurricane season and strong operating results drove Fairfax’s stock price up to 1.3x book. The position was equal to 1.5% of Oakcliff’s capital at cost, and appreciated 18x, a very happy result for our partnership.




We have used small options positions to create other interesting investments: against the bond insurers (which worked), against the investment banks (which worked slightly); for American Express at the height of concern about dilution (which worked); for Fannie and Freddie (which did not work); and for gold (which did not work). Overall, returns from owning good businesses have been about 70% of our profits, and from owning options about 30%. It seems quite attractive to continue looking for mispricings in the options markets, as they sometimes can be less picked-over than the stock markets, and are especially suited to a small base of capital like O akcliff’s. But our preference is to own good businesses, and have them compound over time. I have a policy of not discussing current investments broadly, but there are several companies that we have owned for years with strong results. MOI: It’s been said that all successful investing is “value” investing, with growth being a component of value. How important is that component for you?

“Often the great investor works alone much of the time, which makes sense given the difficulty that two people will have agreeing on which are the best ten stocks to own. But it is very smart to find a small number of other investors whom ou res ect

Lawrence: Growth is very important, especially when it is not capital-intensive. Without growth, you are dependent on a cheap entry price, or a very smart management team that allocates capital incredibly well. Growth makes things easier. MOI: How do you generate investment ideas? Lawrence: Voracious reading, talking to other investors, and looking for areas of disturbance in the markets that may create opportunities. It has been interesting to study the records of the great investors, and see how they generated ideas. Often the great investor works alone much of the time, which makes sense given the difficulty that two people will have agreeing on which are the best ten stocks to own. But it is very smart to find a small number of other investors whom you respect, and with whom you can share ideas. You do not have to agree on everything, and their different perspectives can enhance your own thinking. Oakcliff shares space with two other firms run by first-class people. I enjoy having a collegial environment in which to kick around an idea, but also the freedom to make my own decisions. MOI: At the recent VALUEx in Zurich/Klosters, you made the point that investor redemptions in late 2008 and early 2009 reflected at least in part value managers’ failure to properly communicate and condition their investors for tough times. What best practices can you share when it comes to communicating with your investors? Lawrence: If you look at the history of value investing, you will find that every practitioner has experienced big downturns. It did not matter how smart you were in 1929-33 or 1973-74, you got marked-down by 50% or more. This includes Buffett himself, who had been smart enough to close his partnership, but still saw Berkshire Hathaway stock get cut in half. So why should we have been surprised by the 2008-2009 experience? And should we have done anything differently to prepare our investors?

To make matters worse, you don’t even need a crisis to see painful periods of underperformance. Tweedy Browne did an interesting study for their clients in 2005 that looked at nine value-oriented managers with great track records. Seven of these managers were the Superinvestors mentioned by Buffett in his famous talk at Columbia Business School. With the exception of Buffett, the managers tended to underperform the market for 30-40% of the time. These © 2008-2011 by BeyondProxy LLC. All rights reserved.




periods of underperformance lasted for one to four years. Four years is a long time to underperform! In the spirit of “invert, always invert,” I know a man who manages the marketing efforts of one of the big wire houses. One of the ways he makes money is to keep his more than 10,000 brokers updated as to which mutual funds have underperformed over the prior six or twelve months. The brokers call the clients who hold those funds, and get them to switch into better-performing funds. The clients pay a new front-end load to make the change, and the broker and the wirehouse get their cut. It’s easy money, though obviously not great for the clients.

“Your investment theses are like sticks. Every now and then the market will try to bend them. If you have chosen the wrong stick, it will break, and you will sell at a loss.”

My friend Chris Davis runs a large mutual fund. Returns have been especially good on an after-tax basis because he keeps turnover very low. To keep his investors enjoying these after-tax returns, and from being churned by the brokers, he spends a lot of time communicating about the advantages of long-term compounding. His website has a section for investors to educate themselves, which is good business for him, and good for his clients. It makes interesting reading. At Oakcliff, we have not solved the problems of human nature, but there are some things that we do to try to be thoughtful. First, we only communicate results every six months, which strips out much of the volatility. Second, we are upfront about the likelihood of a major decline. In 2005 and 2006, as we reported solid results, we repeatedly warned of the possibility of financial distress. This won us credibility at the end of 2008, when we called the portfolio the most attractive it had ever been, though it had been marked down by half. Third, we try to make financial stress not impair decision-making by me or my partners. For myself, though most of my net worth is in Oakcliff, I keep five years of living expenses sitting in cash. For my partners, I ask them to not commit so much of their net worth that having it cut in half would change the way that they live. MOI: 2008-09 presented many challenges for value-oriented investors, but it also threw up some of the best opportunities in a long time. How did the volatility affect your investment process, and have you tweaked your approach in any way as a result of the downturn? Lawrence: The key lesson of 2008-09 for me is something that a smart investor told me when I was starting Oakcliff. Your investment theses are like sticks. Every now and then the market will try to bend them. If you have chosen the wrong stick, it will break, and you will sell at a loss.

For me, the depths of the crisis were manageable because it was clear that what we owned were good businesses with minimal debt, and they were trading at a 20%+ trailing free cash yield. Being able to say that to myself, and to my partners, was a calming experience. After going through that, it will be very hard to tempt me into owning something other than a good business. MOI: Those who have “graduated” from analyst to portfolio manager often point out that good ideas are only one piece of the success equation. Skilled portfolio management is indispensable. How concentrated is your investment portfolio, do you use leverage, and what is your view of short selling?





Lawrence: We tend to own ten to twelve businesses, and keep large amounts of cash on hand. Our cash on hand reflects our inability to find more things to own at acceptable prices. Leverage makes no sense — it makes things move faster on the way up and on the way down. Why would we want to do anything for ourselves and our partners other than get richer at a decent pace? Finally, we have only shorted something once, and it was a disastrous experience. You won’t see us do that again. MOI: What is the single biggest mistake that keeps investors from reaching their goals?

“Leverage makes no sense — it makes things move faster on the way up and on the way down. Why would we want to do anything for ourselves and our partners other than get richer at a decent pace?”

Lawrence: Not having the right temperament or sufficient balance in their lives, to manage through the humbling experience of the markets. The Great Crisis found the cracks in a lot of relationships and the demons in a lot of personalities. Buffett talks about the financial consequences of a receding tide, but we should also think about the psychological consequences. Certainly the brokers don’t have to push too hard to get the clients to change managers after a bad streak. MOI: What books have you read in recent years that have stood out as valuable additions to your investment library? Lawrence: There is a long list of investment books that includes lots of the obvious value investing pantheon. Others that I have found useful are the following: Emotional Intelligence , as a way to think about temperament; Politics and the English Language, which helps cut through the nonsense written and spoken by many management teams; Poor Charlie's Almanack , which is a mustread for value investors; No Excuses, an introduction to an area of philanthropy that, like investing, interests me greatly; and Consolations of Philosophy , which is thoughtful about living a balanced life, and an easy read in stressful times.




Oakcliff Capital / Bryan Lawrence

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