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August 25, 2006

The Leading Authority on Value Investing
Quality Control Inside this Issue
It’s rare for great businesses in structurally sound industries to get relatively
cheap. When they do, Ricky Sandler is quick to take advantage. Investor Insight: Ricky Sandler
Seeing bright future prospects for

ith a highly successful investor
I NVE STOR I N S IG HT Cisco, Applied Materials, Oracle
as a father, Ricky Sandler has and Arbitron, but clouds on the
often been tempted to join the horizon for Lexmark. PAGE 1 »
family’s investment firm. “My dad has
asked me something less than a 1,000 Investor Insight: Robert Robotti
times, but more than a 100, to come work Finding eclectic mix of unrecognized
with him,” he says. “I've always wanted to value in shares of Atwood Oceanics,
Drew Industries, Zenith National
do things on my own.”
and Pre-Paid Legal. PAGE 1 »
Sandler’s independent streak has paid
off handsomely for his Eminence Capital Special: SuperInvestor Insight
investors since he started the firm in 1999. Our new publication, tracking the
Now with $3.2 billion in assets, Eminence activity of the world’s best investors:
has returned 20% net to investors annual-  Up Front PAGE 19 »
ly, vs. a 2% annual gain for the S&P 500. Ricky Sandler  What They’re Buying PAGE 20 »
Eminence Capital, LLC What They’re Selling PAGE 22 »
Sandler today sees particular opportunity 

in large-cap growth stocks. “When valua- Investment Focus: Seeks companies  What They Own PAGE 24 »
earning high returns on capital which have  Stock Spotlight PAGE 26 »
tions are compressed and everything trades “tripped” or are in secularly strong but
for 13-17x earnings, it's time to trade up for currently out-of-favor industries. Editors’ Letter
quality and growth,” he says. See page 2
“Why wouldn’t you look at what
other great investors have found?”
Not-So-Ugly Ducklings Why, indeed. PAGE 28 »

There are plenty of prosaic companies in his portfolio, but Bob Robotti’s ability INVESTMENT HIGHLIGHTS
to unearth great values over the past 20 years is anything but dull. INVESTMENT SNAPSHOTS PAGE

I NVE STOR I N S IG HT s CFO of the then 12-person Gabelli Applied Materials 6
& Co. in the early 1980s, Bob Arbitron 9
Robotti got plenty of exposure to Atwood Oceanics 14
the investment process – if not much input Cisco Sytems 5
into the actual decisions made. “Let’s just Drew Industries 15
say Mario Gabelli didn’t need me to pick
Lexmark 10
stocks,” he says.
Oracle 8
Since starting his own investment firm in
Pre-Paid Legal Services 17
1983, Robotti’s record as a decision-maker
Walter Industries 26
has been superb. Focusing on unloved or
Zenith National 16
unknown smaller-cap stocks, he’s returned
an average 17.4% annually to investors Other companies in this issue:
over the past 20 years, vs. 10.3% per year Acergy, Advanced Marketing Services,
Robert Robotti
Robotti & Co. for the Russell 2000. Apple Computer, CBS, Clear Channel,

Investment Focus: Seeks ignored or Great runs by the energy and small-cap Comcast, First Data, Hewlett-Packard,

temporarily struggling small-cap companies companies on which he focuses haven't McDonald's, Microsoft, NewMarket, News
with the potential to at least double their diminished his ability to find values, he says: Corp., Ross Stores, Sears, Viacom, Wal-
share price within three years. “Volatility will likely be up, but we’re find- Mart, Wendy's, Williams, Yum Brands

ing plenty of things to buy.” See page 12
I N V E S T O R I N S I G H T : Ricky Sandler

Investor Insight: Ricky Sandler
Ricky Sandler of New York’s Eminence Capital describes why he’s finally gotten interested in technology stocks, why a serious
commitment to shorting makes him a better investor, what he thinks the market is missing in Cisco, Applied Materials, Oracle
and Arbitron, and why he thinks Lexmark is a great short.

How has your investing philosophy to be offensive when you should be. The
evolved since you started your first firm, highest-return opportunities are available
Fusion Partners, with Wayne Cooperman when markets are in free fall, but if you’re
in 1994? getting shelled, you may not have the
emotional conviction to be aggressively
Ricky Sandler: The philosophy is still opportunistic and you may not even be
very much the same. We called it then and able to do it, because of redemptions.
I call it now “quality value.” Morris Being able to be offensive when every-
Mark, for whom both Wayne and I body else is defensive, in and of itself, can
worked at Mark Asset Management, had yield excess returns.
a big influence because of his emphasis on A second element is that as true, com-
research and on owning great businesses mitted short sellers, we have to be
– great companies in secular growth busi- immensely skeptical, and skepticism is a Ricky Sandler
nesses with excellent industry structures. terrific quality in a value investor. A key
Morris was more willing to buy a great reason for our success is that we have a Not Far From the Tree
business with less regard for price, but we very high batting average on the long
believed you could pay too much for even side. We’re better at avoiding mistakes Ricky Sandler couldn't have asked for a
the greatest business. We were also more because we’re very attuned to those situa- more compatible partner when he and fel-
open to the fact that there was a price at tions where value gets destroyed, or low Mark Asset Management analyst
Wayne Cooperman started Fusion
which a mediocre business could be where it isn’t really there in the first place,
Partners in 1994. They were both in their
attractive. So our focus was along the say, because of phony accounting.
mid-20s, shared a “quality value” orienta-
spectrum between “reasonable business We employ gross leverage. Typical for
tion and were sons of Goldman, Sachs
at a great price” and “great business at a us might be to be 120% long and 70%
alumni who had started their own thriving
reasonable price”, with the rest being short. We could not be 120% long with-
investment firms: Harvey Sandler of
uninvestable. That’s still what I do today. out also being 70% short – there’d be too
Sandler Capital Management and Leon
One thing that has changed is my com- much risk and volatility for our investor
Cooperman of Omega Advisors. “We
mitment to shorting. Wayne and I spent base. People say shorting is a waste of
both thought we were ready to run our
80% of our time on the long side and time and you never make money. I’d say
own portfolio,” says Sandler, “but there
20% on the short side. Shorting was more just breaking even on my shorts allows
was some comfort in having a partner to
of an afterthought, we didn’t dig in as me to be 120% long and still not have a do that with.”
much on the companies there. But when lot of volatility. Shorting is and should be
the markets tanked in 1998 – and in six a profit center, but the benchmark people Within four years, Sandler and
months Fusion went from something like use to compare against is often wrong. Cooperman built $28 million in start-up
up 15% to down 15% – I realized it was The last element is that we believe the capital – $10 million from each of their
very uncomfortable to want to buy more fundamental structure of a long/short families – into $350 million in assets. But
of what you own when you weren’t sure portfolio minimizes the systematic risk their investment styles were evolving in dif-
you were still going to be in business. We you can’t control, say of a terrorist attack ferent directions. “Wayne moved more to
ultimately ended up flat on the year, but or a Russian debt crisis. If you employ the a deep-value emphasis, while I was
when I started Eminence, I committed to gross leverage we do, you’re then magni- increasingly focused on the quality of the
being aggressive short sellers and spend- fying your stock-specific risk – exactly the business,” says Sandler.
ing almost half our time on the short side. risk we feel we should be taking.
Since the partners went their separate
You’ve said you think actively shorting Do you tend to short specific companies ways in 1999, Sandler's Eminence
makes you a much better investor. Why? or baskets of stocks? Capital and Cooperman's Cobalt Capital
have both thrived. Says Sandler: “It goes
RS: I saw in 1998 that without having a RS: We typically like to short individual to show you there are a lot of ways to skin
commitment to the short side, it’s difficult stocks. Right now, though, we have a a cat in this business.”

August 25, 2006 Value Investor Insight 2
I N V E S T O R I N S I G H T : Ricky Sandler

bigger than average balance sheet on the Describe how you come up with ideas? declines – kind of the opposite of what we
long side – closer to 160% long – because look for on the long side. Wall Street
we’re finding all these big companies we RS: Our best ideas tend to come from tends not to fundamentally mark stocks
want to have 5% positions in. To support what I call “old research, new events”. down until bad news actually shows up in
that, we’re now around 90% short, That’s typically the good company you’ve the numbers. We’ll ignore the supposed
which is requiring us to use more indices studied carefully and would love to own value today and focus on whether we
than usual. The M&A environment at the right price, that gets marked down think the “E” in a P/E is going to be mate-
makes us hesitant to significantly increase after it trips or its industry goes out of rially less in three to five years.
the number of company-specific shorts favor. A great example was Yum Brands a
we have. We were short Albertson’s. We couple years ago. Comp sales at one of Once you’ve identified a potential idea,
were short Sports Authority. These are their restaurant chains, KFC, were way what do you do next?
structurally bad businesses that some- off one quarter and the stock crashed
body came along and bought. We have to 35%. It instantly became an idea – I knew RS: We’ll put an analyst on it, who’s
be aware of that and not add too much it was a good business and now it was on always paired on the idea with me or one
risk to the portfolio by adding a lot of sale at a 35% discount. of the two other principals in the firm.
new individual short positions. We also learn a lot from other We’re leveraging the senior person’s time,
investors. I go to idea dinners and regu- but also want more than one pair of eyes
Back to the long side, what situations tend larly talk to a lot of people in the busi- looking at things.
to result in your finding quality value? ness. I’m not afraid of ideas owned by We’ll prepare a basic two-page write-
other people, but you obviously need to up after ripping through the 10-Qs, 10-Ks
RS: One is the good company in an do your own work and make sure they fit and proxy filings and listening to confer-
industry that’s out-of-favor, for whatever what you do. ence calls. We want to get our arms
reason. Another is the good company that around the business both quantitatively
trips – the disappointment that hasn’t and qualitatively, so we summarize things
impaired the long-term value of the busi- ON SHORT OPPORTUNITIES: like the company’s businesses, the com-
ness, but the market overreacts in pricing We’ll ignore the supposed value petitive environment, recent financials,
it down. The third would be the good earnings quality, management, outstand-
business that isn’t necessarily in plain today and focus on whether the ing litigation and valuation.
sight – it’s obscured, say, by other busi- “E” in a P/E is going to be mate-
ness lines or special situations. Joel What jumps off the page for you?
Greenblatt talking in your last issue [VII, rially less in three to five years.
July 28, 2006] about American Express is RS: I focus on return on capital and want
a good example. to see EBIT compared to invested capital
I’m probably more willing to pay up Many of our other ideas just come in the high-teens or better. We’ll look at it
for quality than other value investors from having our eyes wide open. You with and without goodwill, to try to sep-
might be. Some of my investor friends read publications like yours. You talk to arate out the impact of capital-allocation
often tell me my ideas are “too high-qual- contacts you’ve developed in various decisions versus operating decisions.
ity” for them. I would distinguish some- industries. It’s often just about paying We favor companies with some form
what here from paying up for growth – attention to what’s going on in the world. of amortization, where we think cash
I’ll pay more for a high-quality, slow- flow is higher than reported earnings and
growing business. I look for companies On the short side, what attracts your that may be one reason why the stock is
that will grow value, not necessarily rev- attention? undervalued. We want to understand
enue, at above-average rates. how net income plus depreciation and
The higher the quality of the business, RS: We primarily look for material dis- amortization is converted to cash flow
the lower discount to our estimated value connects between our view of economic from operations. Is anything getting lost
we need. We’re happy to buy a great earnings and the earnings that are report- in working capital or coming from other
business at 75 cents on the dollar. ed and people are using to value the gains? We also focus on the relationship
Something would need to be at 50-60 stock. It could be accounting related, so between capital expenditures and depre-
cents on the dollar for us to buy a we pay careful attention to things like ris- ciation, to better understand how capital
mediocre business. On average, I’d say ing accounts receivable relative to total intensive the business is.
our typical investment is 30-35% cheap- sales, cash from operations that is not If we still think the idea is interesting,
er than we think it ought to be and we keeping pace with net income and we’ll set up calls with the company to bet-
think it’s increasing value at 15-20% per decreasing returns on capital. ter understand how they operate and
year on top of that. We also look for long-term structural think about things like capital allocation.

August 25, 2006 Value Investor Insight 3
I N V E S T O R I N S I G H T : Ricky Sandler

If that checks out, we’ll probably take a issue, but trade-in values are going up.” sion was going to happen.
“R&D” position in the stock of 1-2%. That might be an interesting thing to pur- We sold the other half because we saw
sue – you may have noticed inventories a better opportunity. We’ve owned Ross
Why not finish your research before you going up, but you didn’t really know why. Stores [ROST] off and on for years and
start buying? when the stock got hit, we wanted to buy
How long do you tend to hold positions? it without increasing our consumer dis-
RS: We’ve already done a lot of work, so cretionary exposure, which we think is
it’s not like we’re winging it. Action adds RS: Our typical holding period is 18 the most stretched part of the economy.
a sense of urgency to the work – there are months to two years. We don’t actively
so many things to look at in this business trade around positions, but we do man- Why sell Wendy’s earlier this year?
that things can fall through the cracks age position sizes around our updated
unless you force yourself to focus. Having analysis of intermediate-term risk/reward. RS: We had bought in the low $40s, see-
capital on the books does that. As that changes, we’ll add or subtract to ing unrecognized value in the Tim
We never stay at the R&D position longer-term holdings. Hortons chain and in real estate assets.
size – it’s always then an up-or-out Volatility can be a friend of the value With the stock at almost $60, that thesis
process. We spend another several weeks investor – it provides more situations was played out. We sold because we
on field research, visiting management where stocks significantly diverge from thought the remaining upside – primarily
and speaking with as many people as pos- their intrinsic value and can allow us to from fixing the core Wendy’s business –
sible who can give us insight into the turn our capital faster. Say something wasn’t high enough and would take too
company and industry. moves 50% in four months when we long to be realized.
We tailor the field research to what we thought that might take two years. If it’s
need to know. In Yum Brands’ case, we now 80-90% of what we think it’s When Viacom broke into two pieces, also
spoke to a lot of franchisees to really worth, we’ll take money off the table and earlier this year, you bought more of the
understand the health of their system. It’s put it in something that maybe just got Viacom piece and sold CBS. Why?
not about how sales are going this month,
it’s trying to understand from the people RS: We like businesses that grow in
in the trenches things like how good the ON SELLING WENDY’S: value, and each of CBS’s businesses –
products are, why they have the market broadcast TV, radio, local stations – is
We thought the remaining
share they do, what’s happening to the under secular pressure. I think it’s a clas-
market share and where the money is upside – from fixing the core sic cheap stock that is going to stay that
made in the system. way. They can do things with the balance
When we find out the company’s a bad
business – wasn’t high enough sheet to maybe take the shares from $25
business partner, there are structural and would take too long. to the low $30s, but I think they’re hard
industry issues we didn’t know about or pressed to fundamentally grow the value
maybe there’s an earnings miss we decide of the business.
isn’t a short-term event – then we’ll sell. hit and now has higher intermediate- Viacom, on the other hand, has terrif-
But if every step of the way you get more term potential. ic secular growth prospects. If the multi-
excited by what you uncover, those are ple doesn’t change, we think they’ll grow
the companies that become 5%, 6%, 7% Do you have any strict rules for selling? their way into good returns. If the multi-
positions in the portfolio. ple does change to reflect that growth, the
RS: No, every situation is different. shares will really do well. We’ve been on
Most investors try to get some sort of the wrong side of this trade so far, but I
informational advantage. What does it Let’s talk about some examples. Why did stand by the thesis.
take to be good at that? you sell Wal-Mart in the third quarter of
last year? We’re assuming selling your Apple
RS: lt certainly takes a lot of effort to call Computer position in the third quarter of
40 Cisco distributors and get them to talk RS: We sold half our stake because we 2004 is one you’d like back.
to you. It also takes a certain personality. began to question our thesis. One of our
People fundamentally like to talk about reasons for buying Wal-Mart was that we RS: We were early in seeing – and I still
what they do, but they’ll only do that if saw material gross-margin opportunity believe – that the digital online business is
you approach them the right way. You through sourcing benefits and a reduction saving the music industry. We thought the
also have to listen very carefully. You may in import quotas. As the U.S. went back iPod might be huge and that the trend to
ask a distributor about price discounts and forth on the quota issue, we started multimedia devices at home would play
and he’ll say, “That’s not much of an to question whether that margin expan- to Apple’s strengths. We bought shares,

August 25, 2006 Value Investor Insight 4
I N V E S T O R I N S I G H T : Ricky Sandler

pre-split, at $25, when the company had A perfect lead-in to talking about some more field work than usual, focusing very
something like $11 in cash. specific stocks. Tell us about your interest closely on Cisco’s competitive advan-
The shares went pretty quickly from in Cisco [CSCO]? tages. Why are they able to maintain 70%
$25 to about $38 [$19, post-split], which gross margins? Why do they have such
we felt pretty good about. Then we start- RS: The company essentially makes incredibly high market shares?
ing thinking, “The hardware guy never switches and routers, which direct IP traf- What we ultimately concluded was
makes money, it’s going to get commodi- fic within an internal network or between that Cisco’s service levels, combined with
tized, so we should stick with the ‘soft- networks. The fundamental driver for the critical nature of this infrastructure,
ware’ guys like EMI.” We couldn’t have demand of this type of equipment is the made competitors a non-factor. No one is
been more wrong on that one. [Apple growth and complexity of data traffic. If willing or able to work with customers
shares closed recently at around $68.] you think about what’s happening with the way Cisco does in training them and
things like music, voiceover IP telephony making sure everything is working. Given
Do you focus on any particular industries and the transmission and downloading of how important the functions being sup-
or sectors? video files, the growth tailwind behind ported are, we kept hearing how it didn’t
this industry is quite interesting. make any sense to go with somebody else
RS: It’s easier to describe what we don’t This is a case where we probably did to save 20-30%.
do: oil and gas, commodities, utilities and
biotech. We fundamentally believe that INVESTMENT SNAPSHOT

energy and commodities have been value-
destroying businesses over time. At the Cisco Systems
(Nasdaq: CSCO) Valuation Metrics
same time, their value tends to be driven (Current Price vs. TTM):
Business: Global manufacturer and mar-
by the price of a commodity that we have CSCO S&P 500
keter of routers, switches and other digital
no ability to predict. With utilities, they networking products that facilitate data, P/E 23.8 19.3
don’t tend to be businesses that can create video and voice communications. P/CF 17.8 13.7
excess value. They might be nice surro- Share Information Largest Institutional Owners
gates for bonds, but not much more. In (@8/23/06) (@6/30/06):
biotech, we just have no illusions that we Price 21.05 Company % Owned
know how to analyze the business. 52-Week Range 16.83 – 22.00 Barclays Global Inv 5.0%
Outside of these few areas, just about Dividend Yield 0.0% Capital Res & Mgmt 4.1%
anything else is fair game. Market Cap $128.50 billion State Street Corp 3.0%
Vanguard Group 2.5%
Financials (TTM):
You own a lot of technology companies. Wellington Mgmt 2.0%
Revenue $28.48 billion
Has that always been a strength? Operating Profit Margin 25.0% Short Interest (As of 7/10/06):
Net Profit Margin 19.6% Shares Short/Float 0.6%
RS: Up until two years ago, I would have
said we didn’t do much in technology – CSCO PRICE HISTORY
30 30
not by design, but because we rarely
found companies that met our criteria.
The great companies were valued ridicu- 25 25
lously and the cheap ones were rarely
good businesses and could be wiped off
the face of the earth pretty quickly. 20 20
That world has changed 180 degrees.
It’s really been in the last six to nine
months that we’ve significantly increased 15 15
our holdings in technology. Some of the 2004 2005 2006
greatest businesses in the world – still
growth companies in growth industries – THE BOTTOM LINE
are at significant discounts to small, lousy Cisco’s unassailable competitive strength in a business ideally positioned to benefit as
companies and to the market. It goes back the volume and complexity of data traffic grows is not being adequately valued by the
to where we tend to find quality value. market, says Ricky Sandler. At a more appropriate valuation, he believes the shares
You find it when whole industries or sec- are worth at least $25, with value compounding 20% annually on top of that.
tors are out of favor, and both large-caps Sources: Company reports, other publicly available information
and technology are out of favor.

August 25, 2006 Value Investor Insight 5
I N V E S T O R I N S I G H T : Ricky Sandler

So it’s almost game-over in the enter- move, the shares trade at only 15x both Applied Materials [AMAT] is another
prise marketplace, where Cisco gets calendar 2007 earnings and after-tax technology leader you’re high on. Why?
about 80% of its business. In the carrier cash flow, ex-cash. So we’re getting a
marketplace, they still have great share, 7% free-cash-flow yield in a company RS: The company is the largest and
but not quite as strong a position. with a fortress balance sheet that is most dominant player in the semicon-
Carriers have more sophisticated engi- growing its top line at double-digits, ductor-equipment industry and operates
neers in-house, so Cisco’s service isn’t without requiring capital. Assuming across most of the industry’s verticals.
quite as important, and price is more only modest increases in operating mar- Unlike Cisco – where I’d say the whole is
important. gins and continued share buybacks, we greater than the sum of the parts –
think they can easily grow earnings at Applied’s strength comes primarily from
Are growth prospects slowing? 20% annually. its strength in the individual businesses
At a more appropriate multiple, we they’re in, which often have different
RS: We actually became convinced that think the shares should trade for at least competitors and different industry
this was an accelerating growth story, $25 per share – with the value of the dynamics. Their market shares range
not just a growth story. In the last two company growing by at least 20% annu- from 10% to 80%, with an average in
quarters you’re starting to see that hap- ally on top of that. the high-30s.
pen. First-quarter revenue growth was
11%, up from 9%. In the second quar- INVESTMENT SNAPSHOT
ter, sales rose over 12%.
Applied Materials
(Nasdaq: AMAT) Valuation Metrics
Do you consider management to be good (Current Price vs. TTM):
Business: Manufactures, markets and serv-
capital allocators? AMAT S&P 500
ices a broad range of fabrication equipment
used by semiconductor manufacturers in P/E 18.8 19.3
RS: One of the most impressive things North America, Asia and Europe. P/CF 17.1 13.7
about Cisco has been the way they’ve
Share Information Largest Institutional Owners
integrated acquisitions. Most big compa- (@8/23/06) (@6/30/06):
nies have done dumb acquisitions and Price 15.91 Company % Owned
this is not one of them. They bring in a 52-Week Range 14.39 – 21.06 Capital Res & Mgmt 12.1%
swat team and integrate the business Dividend Yield 1.3% Fidelity Mgmt & Res 4.0%
quickly into their own infrastructure and Market Cap $24.88 billion Barclays Global Inv 2.8%
sales force. So we’re very comfortable State Street Corp 2.6%
Financials (TTM):
with their capital-allocation strategy, Vanguard Group 2.5%
Revenue $14.10 billion
which is somewhat unusual for a tech- Operating Profit Margin 23.3% Short Interest (As of 7/10/06):
nology company. Net Profit Margin 15.7% Shares Short/Float 1.6%
The market didn’t like the Scientific
Atlanta deal and I was a bit skeptical AMAT PRICE HISTORY
30 30
myself. [Note: Cisco’s $6.9 billion acqui-
sition of the set-top box maker closed in
25 25
February.] But if you start to think
about how telco and cable networks are
converging, how important video is 20 20

becoming to Cisco’s business and the
type of infrastructure Scientific Atlanta 15 15
has, the deal begins to make more sense
in helping Cisco provide solutions for 10 10
video IP. 2004 2005 2006

Having rebounded recently to just over THE BOTTOM LINE
$21 per share, how are you thinking The prevailing wisdom that the semiconductor cycle is near its demand peak has
about valuation? made the company’s shares “incredibly cheap,” says Ricky Sandler. He believes the
cycle has much further to run and that at the 16x multiple of next year’s estimated
RS: We started buying Cisco late last earnings he believes the company deserves, the shares are worth closer to $25.
year when it was trading in the low- to Sources: Company reports, other publicly available information
mid-$17s. But even after the recent

August 25, 2006 Value Investor Insight 6
I N V E S T O R I N S I G H T : Ricky Sandler

There aren’t scale advantages? 12-to-15 year cycle. The second effect, back 6-8% of the company per year and
from increasing complexity, is more con- that’s likely to go up.
RS: Scale does help them with the out- sistent and steady over time. The result
sourced foundries, like Taiwan is that the curve plotting capital spend- Moving to another technology titan,
Semiconductor, which are a growing ing against revenue slopes upward to the what do you think the market is missing
part of the business and want a one-stop right, with one-time step reductions on Oracle [ORCL]?
shop. It’s less of an advantage with Intel, every 12 to 15 years.
which has its own engineers and is more The industry went through a wafer- RS: Oracle, of course, is one of the
than willing to buy etching equipment size increase from 2001 to 2003 and we largest software companies in the world,
from one company and lithography won’t see another one until maybe 2014. with a roughly 35% market share in
equipment from another and put it all So the key driver going forward, putting database software, 17% of the applica-
together. upward pressure on cap-spending tion-sever market and a growing appli-
Scale also helps them in the backend, requirements, will be ongoing increases cation-software business. About 65% of
in investing in development of next-gen- in chip complexity. The combination of their total revenue is maintenance and
eration technology. It’s not the core of that dynamic and the fact that compa- services, which is extremely stable and
our thesis, but management here really nies have been so cautious about spend- sustainable.
gets how the technology is evolving and ing makes us believe that we’re below One of the appeals here is that this is
how to create value. They’re always a maturing, big company that really
doing interesting micro things at an understands how to use its balance
operating level to diversify and expand ON CHIP CYCLES: sheet. In 2004, they started buying best-
their business. of-breed application-software compa-
We believe we’re below mid-
nies, which, financially, has been a very
What is the core of your thesis? cycle in semiconductor capital good use of capital. Oracle runs at 40%
operating margins and can go into a
spending. That is not, however,
RS: There has been a massive underin- PeopleSoft, say, and take them from
vestment in capacity in the semiconduc- the prevailing wisdom. 15% margins to 40% or higher by inte-
tor industry since the bottom of the last grating them well.
cycle in 2003. This has been an atypical In each of the big acquisitions –
recovery, as the foundries and other mid-cycle in semiconductor capital PeopleSoft, Retek and Siebel Systems –
manufacturers have been extraordinarily spending. That is not the prevailing wis- the prevailing concern has been that
cautious in adding capacity, even as they dom, however, which says we’re much Oracle would abandon the acquired
operate near 100% capacity and even as more near the peak of the cycle. products in order to shove their own
we continue to have great growth drivers products down customers’ throats.
for semiconductors. This industry has If the market thinks the cycle is peaking, Customers wouldn’t like it and, as a
grown at double-digit rates for the last how cheap has that made AMAT shares, result, license sales in applications would
30 years and that will continue, as more now at $15.90? drop. If you look at Wall Street’s sell-side
and higher-value chips make their way models for the company, combined
into new digital cameras, iPods, cell RS: The shares trade at only 11x applications revenue over the next cou-
phones and computers. October 2006 free cash flow, ex-cash. ple of years is estimated at maybe 20%
We went back over time and com- That’s incredibly cheap – at below mid- below what the separate companies gen-
pared overall semiconductor-industry cycle earnings – for a dominant compa- erated in 2003.
revenue with industry capital spending. ny in a growth industry. What you find when you go out in the
The relationship has been relatively sta- If the company grows just at the rate of field, though, is that customers have
ble, but two big things affect it over the industry – 10-11% per year – I see no been surprised at how well Oracle has
time. One is that as wafer sizes get big- reason why this shouldn’t trade at a mid- supported, upgraded and maintained
ger, capital spending per dollar of rev- to high-teens multiple of mid-cycle earn- these newly acquired applications. By
enue actually drops, as customers get ings. At 16x times next year’s earnings – integrating what they’ve bought and
more chip for their money. Offsetting which we think will to be closer to mid- making each of the individual pieces
that, though, is that as the circuits on cycle – this is a $25 stock, with double- stronger, they’re starting to regain mar-
each chip get smaller and more complex, digit annual growth in value beyond that. ket share from competitors like SAP. The
the capital spending versus revenue The company also thinks the shares bottom line is that we believe there’s
increases. are cheap. They have $3.40 per share in meaningful upside to the market’s expec-
The first effect, from bigger wafer net cash and have been aggressively buy- tations on how Oracle is executing on
sizes, is more of a one-time event with a ing back shares. They’ve been buying these acquisitions.

August 25, 2006 Value Investor Insight 7
I N V E S T O R I N S I G H T : Ricky Sandler

Is the growth potential here as high as it How does Larry Ellison’s stewardship fit RS: Our estimate for calendar 2007 free
is at Cisco or Applied Materials? into your thesis? cash flow is $1.15 per share, higher than
the $1 consensus estimate that we think
RS: It’s a bit less, in the high single-dig- RS: He’s obviously a visionary who has misjudges how well the company is exe-
its, but the inherent stability is higher. built one of the country’s outstanding cuting. That’s a 13.5x multiple for a
The core database business has very high companies. We’ve spent more time with company with a great franchise, great
retention rates, a large recurring mainte- the co-Presidents, Chuck Phillips and margins and growing at a stable rate in
nance revenue stream, very low capital Safra Catz, and think they’re very disci- the high single-digits. We also see this as
requirements and it generates tremen- plined operators who really get where worthy of a mid- to high-teens multiple,
dous cash flow. We don’t believe the the company is in its lifecycle. We think worth $21-22 per share, with growth
market fully recognizes the sustainability it’s a nice balance – a visionary at the beyond that.
of that business. If you look at the ana- top, combined with people who really
lysts’ models, they don’t have interest understand financial management. We’re guessing Arbitron’s [ARB] ties to
income building up or the share count the radio business aren’t doing the stock
coming down – as if all the cash they’re At a recent $15.30, what upside do you any favors.
generating just disappears into thin air. see for the shares?
RS: Therein lies the opportunity.
INVESTMENT SNAPSHOT Arbitron supplies ratings to the radio
industry, which are then used to sell
Oracle advertising. We’re going into a digital
(Nasdaq: ORCL) Valuation Metrics
(Current Price vs. TTM): world where radio audiences are becom-
Business: Develops, markets and services
database, middleware and application ORCL S&P 500 ing more fragmented and, while that
software products for large enterprise P/E 24.3 19.3 might concern radio broadcasters, it’s
customers worldwide. P/CF 19.4 13.7 actually a big positive for Arbitron.
Share Information
Arbitron’s ratings business is one of
Largest Institutional Owners
(@8/23/06) (@6/30/06): the all-time great businesses. Its data is
Price 15.32 Company % Owned the certified currency advertisers use to
52-Week Range 11.75 – 15.95 Capital Res and Mgmt 9.9% buy radio advertising. They’re a monop-
Dividend Yield 0.0% Barclays Global Inv 2.4% oly supplier – in a business where it
Market Cap $80.25 billion State Street Corp 2.1% makes sense to have only one supplier –
Fidelity Mgmt & Res 2.0% to an industry that can’t survive without
Financials (TTM):
Vanguard Group 1.9%
Revenue $14.38 billion its product. In 2004, CBS balked at
Operating Profit Margin 34.5% Short Interest (As of 7/10/06): Artbitron’s contract terms and tried to
Net Profit Margin 23.5% Shares Short/Float 1.1% play hardball with them. Arbitron stock
took a hit, but a month later, CBS signed
ORCL PRICE HISTORY up. They really had no choice.
20 20
What’s particularly interesting now
about Arbitron is that they have two sig-
15 15
nificant projects – the rollout of the
“portable people meter” and what they
call Project Apollo – that are penalizing
10 10
earnings. You see sell-side analyst
reports saying nothing is going to hap-
pen with the stock because the earnings
5 5
are down, but the earnings are down
2004 2005 2006 because investments are going up for
good reason.
Ricky Sandler says the market isn’t fully recognizing the sustainability of the company’s What’s a portable people meter?
database business and how well it is executing against its recent application-software
acquisitions. If Oracle delivers the growth in profits he expects, he believes the shares RS: It’s a small pager you clip on that
will be worth 40-45% more than their current price of $15.32. picks up an inaudible code that each
Sources: Company reports, other publicly available information radio station sends out, automatically
tracking what you’re listening to. It

August 25, 2006 Value Investor Insight 8
I N V E S T O R I N S I G H T : Ricky Sandler

knows if you switch stations, if there’s A lot goes into the accreditation franchise, and everyone’s at least three
radio on in the background at the store process. For example, the people meter years behind.
you’re in, or if you’re listening over the can miss a signal if a horn is honking or
Internet. The meter data will be much there’s some other noise interruption. What is the pricing difference for the
more precise and accurate – and there- There has to be a specific policy laid out people-meter ratings?
fore valuable – than information from for how a situation like that is to be rec-
the paper-and-pencil diaries that are cur- ognized and the results recorded in the RS: It will be 30-50% higher. Part of
rently used. final data. that will be justified by Arbitron’s own
Arbitron is already one year into the increased costs in getting the informa-
Is the technology ready for primetime? give-and-take of the accreditation tion this way. But they’re also providing
process. The next-closest company is much more information that is of better
RS: The technology hasn’t yet gotten just starting a friends-and-family sort of quality and more targeted. It scares some
MRC [Media Ratings Council] accredi- test on whether their technology actual- people in the industry and nobody loves
tation, but it’s close. We don’t think ly works. This technology transition was a big price increase, but I think it’s ulti-
there’s a risk they won’t get accredited, actually the one opportunity someone mately going to benefit the industry
it’s just a question of time. might have had to attack Arbitron’s overall – both in helping them sell and in
programming, as they better understand
INVESTMENT SNAPSHOT people’s habits.
Most of the big radio players have
Arbitron signed on, but Clear Channel is trying to
(NYSE: ARB) Valuation Metrics
(Current Price vs. TTM): play hardball and see if they can find an
Business: Media and marketing research
firm focused on the measurement and ARB S&P 500 alternative. Because nothing else is close
composition of local and national radio P/E 19.3 19.3 to being ready, I think what will happen
audiences in the U.S. and Mexico. P/CF 16.0 13.7 is the MRC accreditation will come
Share Information
through, Arbitron will start turning on
Largest Institutional Owners
(@8/23/06) (@6/30/06): markets with the people meter, and the
Price 35.41 Company % Owned local Clear Channel stations aren’t going
52-Week Range 32.68 – 42.78 Eminence Capital 11.4% to be able to sell. They’ll ultimately
Dividend Yield 1.1% Neuberger Berman 10.9% come around.
Market Cap $1.04 billion Schupf & Co 9.2%
Capital Res & Mgmt 6.8% What is Project Apollo?
Financials (TTM):
Pamet Capital Mgmt 6.2%
Revenue $320.2 million
Operating Profit Margin 26.0% Short Interest (As of 7/10/06): RS: This is a joint venture with Nielsen –
Net Profit Margin 18.0% Shares Short/Float 6.2% with Procter & Gamble also actively
involved – that will marry people-meter
ARB PRICE HISTORY data across different media with actual
50 50
purchase behavior. I call it the “holy
grail” for advertisers and the potential is
enormous. This is long-term optionality,
though – you’re not paying at all for this
40 40 in the stock price.

The shares, at around $35.50, don’t
look particularly cheap.
30 30
2004 2005 2006 RS: With the investment spending
included, Arbitron is expected to earn
THE BOTTOM LINE $1.75 per share this year, so people see
Excluding the investment spending on projects that Ricky Sandler expects will pay off 20x earnings and think that’s expensive
handsomely, the company’s shares trade for only around 14x estimated 2006 net for a company supplying a troubled
income. That’s too cheap for the ongoing franchise, he says, let alone for the growth industry.
from new products he thinks can make the shares a “major, major homerun.” If you exclude the people-meter and
Sources: Company reports, other publicly available information Apollo expenses, though, the stock
trades for only 9.5x 2006 EBIT and

August 25, 2006 Value Investor Insight 9
I N V E S T O R I N S I G H T : Ricky Sandler

around 14x net income. That’s cheap industry. If your business model is business Lexmark needs just doesn’t
just for the ongoing radio franchise with reliant on very high ink prices, heavier materialize.
5-6% annual top-line growth and a price competition in that area won’t be
monopoly business. But we expect the good news. Won’t positive secular growth trends in
people-meter rollout for radio to ulti- printing, such as increased photo print-
mately result in a roughly 40% lift to Is Lexmark’s manufacturing of Dell- ing and use of color, benefit Lexmark?
revenues and profits. On top of that branded printers a positive or negative
you’ve got optionality from the people for the company? RS: We think their product line is very
meter doing other things – it can also poorly positioned and that they haven’t
track TV usage and outdoor advertising, RS: I think the relationship has hurt invested enough in R&D to change that.
for example – and from the eventual Lexmark because Dell beats them up on They’ve historically been heavily skewed
rollout of Project Apollo. price and then basically gives the print- to black-and-white, inkjet printers, while
We started buying this within the last ers away with their computers. By defi- the world is going to color and to laser. So
six months and now own more than nition, then, the person getting the print- even if the overall printer business grows,
10% of the company. We think it could er may not actually want it and may we don’t see Lexmark taking much
be a major, major homerun. never use it. So the add-on consumables advantage.

Tell us about one of your short ideas, INVESTMENT SNAPSHOT

Lexmark [LXK]?
(NYSE: LXK) Valuation Metrics
RS: This is a case where we think the (Current Price vs. TTM):
Business: Manufacturer of inkjet, laser and
market is giving the company the benefit dot-matrix printers – as well as associated LXK S&P 500
of the doubt as they try to fix some oper- ink and supplies – for both home and P/E 19.1 19.3
ating mistakes, primarily because people commercial use. P/CF 10.5 13.7
believe the printer business is a great Share Information Largest Institutional Owners
business. (@8/23/06) (@6/30/06):
Hewlett-Packard and Lexmark used Price 54.71 Company % Owned
to own the business – with Lexmark at 52-Week Range 39.33 – 65.19 Maverick Capital 7.1%
the low end – selling hardware at little or Dividend Yield 0.0% Franklin Resources 7.0%
no margin and making a ton of money Market Cap $5.49 billion State Street Corp 5.1%
on ink and supplies. That’s all consider- Brandes Inv Partners 4.4%
Financials (TTM):
Barclays Global Inv 4.3%
ably changed, to the point that we Revenue $5.09 billion
believe the printer business is no longer Operating Profit Margin 10.3% Short Interest (As of 7/10/06):
a great business. Epson, Canon, Net Profit Margin 6.2% Shares Short/Float 5.7%
Samsung, Xerox and other competitors
have expanded in the business and the LXK PRICE HISTORY
100 100
standard now is to lose 20 to 40 points
of gross margin on hardware. It’s still
80 80
theoretically a razor/razor blade model,
except it costs you a lot more money to
give the razors away. 60 60

As printers have become so cheap, the
replacement cycle has increased fairly 40 40
quickly. With a two-year replacement
cycle, how valuable is the “blade” busi- 20 20
ness in a hotly competitive market when 2004 2005 2006
you can lose market share almost
overnight? That’s a particular problem THE BOTTOM LINE
for Lexmark, which never had that great The computer-printer business is no longer the great business it once was and
a brand and was primarily just the cheap Lexmark’s product line and undistinguished brand name make it particularly vulnerable
alternative. to competition, says Ricky Sandler. “We view this as a long-term short – their market
It’s early yet, but the growth in pri- share is going down and we don’t think that’s going to change,” he says.
vate-label replacement ink is also going Sources: Company reports, other publicly available information
to be a negative for the whole printer

August 25, 2006 Value Investor Insight 10
I N V E S T O R I N S I G H T : Ricky Sandler

The stock, close to $100 two years ago, as a long-term short – their market share the obscure little things. My feeling on
now trades around $55. How much is going down and we don’t think that’s that is that investors pay us to find value
worse can it get? going to change. I would go so far as to and value is in the Ciscos of the world
say I think this company could go away right now.
RS: The shares are both well off their in the next five years.
high and well off their low. When quar- What do you like most about investing?
terly earnings fell off a cliff late last year, Are there any general short themes
the stock crashed down to the low $40s. you’re focused on now? RS: You mean besides the incredibly
Since then, they’ve actually beaten earn- attractive financial characteristics?
ings estimates handily in the last three RS: One is our view on the relative val-
quarters. They’ve been pulling out of uations of large-caps versus small-caps. [Laughing] Yes, we’ll take that as a
lines of business where they were losing Most of our shorts are in small-caps. On given.
even more money than usual on printer the index side, we’re short the Russell
sales. Optically, earnings go up when 2000 – it trades at a 20% premium to RS: I love learning about businesses and
you stop selling negative-margin hard- large-caps, but it has much worse the intellectual challenge of investing.
ware and you cut a lot of costs. But by prospects and is much more levered to I’m also intensely competitive about gen-
later this year, when you start to the domestic economy. erating great returns. I love that you get
anniversary when they started to lose The last five years have been really a scorecard at the end of the day and I
hardware share, we think you’ll start great for small-caps and, like everything love to win. Winning to me is looking
seeing a negative impact on consumables else, it tends to go on longer than it real- back after 30 years and saying, “Wow,
sales from the lower installed base. ly should. I think that’s been exacerbat- look at that track record – these guys did
The stock trades about 14x this year’s ed by the growth of hedge funds. Most it well and they did it right.”
cash earnings and, we think, at 16x next hedge-fund managers don’t look at a That’s not to say I’m particularly fond
year’s. So Lexmark trades at a premium Cisco because it’s too big and too well- of those days when you feel like an idiot
to all the great growth businesses we followed and they don’t know what their and your numbers make you look like an
spoke about earlier and we think its edge is going to be. They like to find – idiot. But as a competitive person, I
business is disintegrating. We view this and their investors want them to find – wouldn’t have it any other way. VII

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August 25, 2006 Value Investor Insight 11
I N V E S T O R I N S I G H T : Robert Robotti

Investor Insight: Robert Robotti
Robert Robotti of New York’s Robotti & Co. explains which special situations most attract him, the parts of the energy sector
he thinks have the brightest prospects, why tougher audits create opportunity and where he sees unrecognized value in Atwood
Oceanics, Drew Industries, Zenith National and Pre-Paid Legal Services.

Your portfolio is a hodgepodge of less- private placement of shares, you have to
than-glamorous stocks. Is there a common offer the same terms to public sharehold-
theme to your investing? ers, which turned out to be an offering
price of $2.20 per share.
Bob Robotti: The first security I ever The $2.20 share price valued the com-
bought, which worked out very well, was pany at around $400 million. That was for
a defaulted New York City Housing a company with $1.5 billion in revenue, no
Authority bond at 36 cents on the dollar. net debt and fixed assets with replacement
When I set up my own firm in the early values far in excess of $400 million. New
1980s, we focused at the beginning mostly management had restructured the business
on pink-sheet, trade-by-appointment type and industry consolidation was improving
stocks. So I’ve always been a bit attracted contract terms and pricing. We bought
to distressed or messier situations. 1.25 million shares in the offering, increas- Robert Robotti
Our general focus is on companies that ing our position by four to five times.
attract little attention from Wall Street We didn’t need energy prices to go up to By the Books
and/or are beaten up and out of favor. We do well on this, but when they did,
Bob Robotti was “bitten by the investment
usually invest in small- and micro-caps, demand for Stolt’s services took off.
bug” while serving on the audit team por-
where I still think there are more opportu- Almost every piece of equipment they have
ing over the books of Tweedy, Browne Co.
nities to find things that are truly ineffi- is contracted out for the next two or three
in the late 1970s. “It became quite clear to
ciently priced. I want to believe going in years. Today, the stock trades around $18.
me that investing was far more interesting
that things we buy can double in price
than the ‘ticking and footing’ of the audit-
within the next two or three years. Have you taken money off the table?
ing process,” he says.
You’re a big proponent of special-situa- BR: We’ve sold very little. They now have
Robotti, however, has not turned his back
tions investing. What kinds of situations $300 million in cash, no debt, around $2
on his accounting roots. “Bob is without
attract your attention? billion in revenue and will earn $1.40 per
peer in drawing insight about a company
share this year. The number of deep-water
and its business from its financials,” says
BR: We’ve been successful with a variety provinces where you can find and pro-
Mario Cibelli (VII, June 30, 2006), who
of special situations, such as spin-offs, duce oil and gas is going to double over
once worked for Robotti and now manages
bankruptcies and rights offerings. With the next five years, as provinces open up
his own investment partnership. In fact,
rights offerings, for example, these are in Australia, Malaysia, China and else-
Robotti lets the numbers do much of the
usually done by companies under some where. That’s where people are looking
talking when analyzing a company. “I find
stress and we’re looking to see insiders now and that’s going to be very good for
that subjective judgments about manage-
step up as standby purchasers in the offer- Acergy’s business. I think this can ulti-
ment and the industry are tough to make
ing. You’re basically looking for an insid- mately be a 25x-multiple stock when peo-
until you’ve actually owned the shares for a
er trade, where people in a position to ple recognize the strength of their busi-
while,” he says, “We focus first on an objec-
know the business better than the market ness and how well positioned they are.
tive look at the reported numbers.”
might be telling you something.
One of our biggest wins ever was with Do you pay attention to share buybacks?
The post-Enron shift toward tougher
Stolt Offshore, a deep-sea, oil-and-gas
audits and board scrutiny of financial
drilling contractor which is now called BR: We often look at cases in which a
reporting has created new opportunity for
Acergy. It trades on the Oslo exchange and company with significant insider owner-
sleuths like Robotti. One of his most fertile
on Nasdaq [ACGY]. In May of 2004, the ship is aggressively buying back shares, but
areas for ideas today? “Companies delin-
company did a rights offering as one of the the insiders don’t participate in the buy-
quent in filing their financial statements,”
final events in a long restructuring. The back. Again, that indicates that someone
he says. “It’s a real growth area.”
Oslo exchange has a rule that if you do a who may know more about the business

August 25, 2006 Value Investor Insight 12
I N V E S T O R I N S I G H T : Robert Robotti

wants to own more at a particular price. Are there relatively new special situations from blue-chip clients and the inventory
An example of that – which took a you’re seeing more of? was mostly books returnable to the pub-
long time to play out – is the old Ethyl lishers for full refund. The company was
Corp., which does chemical additives for BR: One newer area is companies that are and is losing money, but it has in the past
petroleum products and is now called delinquent in filing financial statements. earned around $1 per share, which we
NewMarket [NEU]. In the late 1990s, the Up until 2002-2003, corporate audits were believe should be achievable again.
controlling Gottwald family bought back really commodity items and there was lit- Unfortunately, rather than get in com-
25% of the outstanding stock at $46.25 – tle value added. The value added, such as pliance and resume their listing, the com-
adjusted for a 1-for-5 reverse split – and it was, was in distorting the economic real- pany now says they plan to de-register
we began buying about a year later when ity to fit accounting rules and regulations. their shares. It will still trade in the pink
it traded down to $35. The world today is very different and audi- sheets, but we’re concerned about the
Unfortunately, the business deteriorated tors have come to rule the world. With information we’re going to get going for-
and the stock a few years ago got down to ward. The stock now trades around $3,
about $4, which was 1x trailing 12-month and while the risk has increased, we still
cash flow. We liked that the company was think there’s value here.
generating cash and paying down debt, Whether oil is $40 or $70 per
and we thought the industry dynamics You’re a long-time investor in the energy
were finally changing for the better, so we
barrel, I’d argue it’s not going business. Where do you stand on the ques-
bought a lot more. The business turned to have that much impact on tion of whether things are “different this
around beautifully and it’s still a big posi- time” with respect to prices?
tion for us. [NewMarket shares closed
demand for services.
recently around $61.] BR: Our portfolio is currently about 30%
in energy, so it’s the biggest industry expo-
We see that like any good value investor, long, drawn-out audits and conflicts over sure we have. Having invested in the busi-
you’re not afraid of doubling down when reporting, you see more and more compa- ness as long as I have, the one thing I know
something goes against you. nies fall behind in filing, getting de-listed about energy prices is that whatever the
or even choosing to de-register their shares consensus is about future price movements
BR: You have to be willing to do that to avoid filing requirements. Those things will be wrong. It always is.
when you invest in the types of companies usually cause a dramatic repricing of the The big increase in energy prices has
we invest in, where things often get worse shares and may provide opportunity. added a lot more commodity risk to invest-
well before they get better. ing in the sector today. It’s harder to be
I don’t want to leave you with the Can you give a current example? totally agnostic about the prevailing price
impression, however, that it always levels. I do believe the energy market has
works. In the late 1990s I had about a BR: We own Advanced Marketing Services fundamentally changed and there will be a
12% portfolio position in Superior [MKTS.PK], which trades in the pink new long-term, market-clearing price for
National, a big player in California work- sheets. The company distributes books, energy that is higher than it has been. How
ers’ compensation insurance. I increased mainly to major wholesale-club retailers much higher, I have no idea. The excess
my position in a rights offering and it got like Sam’s Club, Costco and BJ’s. In 2004, supply in the global industry actually start-
to as much as 20% of my portfolio. they discovered that the head of marketing ed to be used up by the mid-1990s.
When the workers’ comp business in was defrauding customers. They had to Because this is a long lead-time, capital-
California fell apart, the company turned hire forensic accountants and lawyers to intensive business that has gone through
out to be too leveraged and the shares track the extent of the fraud and determine 20 years of underinvestment, it will take
went from $22 to zero. the restitution to customers, so they many years for responses on the supply
became delinquent in their filings with the and demand side to work their way
Ouch. SEC. As a result, they got kicked off the through the system.
New York Stock Exchange in April of last
BR: The lesson wasn’t to not be aggres- year and the stock went from $7 to about As that happens, what areas of the energy
sive, but to not be overweighted in any- $3.50, which is when we got interested. business do you consider most attractive?
thing that’s so leveraged that it really has There was enough information avail-
the risk of going to zero. Acergy is now able that we thought the stock was trading BR: In general, I believe the service com-
about 13% of my portfolio, but it has no for less than our $5-per-share estimate of panies are more attractive than produc-
debt and $300 million in cash. The earn- what the restated, tangible book value ers in the current environment. Whether
ings might slow down, but there’s no would be. The balance sheet was mainly oil is $40 per barrel or $70 per barrel, I’d
issue with the viability of the company. receivables and inventory – the receivables argue it’s not going to have that much

August 25, 2006 Value Investor Insight 13
I N V E S T O R I N S I G H T : Robert Robotti

impact on demand for services. Many of Isn’t the concern here that many in the capacity. The world just needs the produc-
the big oil companies have declining industry won’t be so prudent and too tion from these deep-water provinces.
reserves and will be desperate to add much capacity will be added?
reserves. To do that, they’ve got to spend How does this view play out in your earn-
on finding and developing new produc- BR: Exactly. There are currently around ings estimates for Atwood?
tion or getting more production out of 200 deep-water rigs on the market – semi-
what they already have. Well-positioned submersibles and drill ships – and another BR: Their full fleet is contracted out for
service companies will benefit from that 35 are under construction. Most of those next year and almost all contracted the fol-
trend for a long time. rigs are not being built by the traditional lowing year. Based on contracted rates, the
As I mentioned earlier with Acergy, industry players, but by speculators who company should earn $5 per share next fis-
service companies involved in deep-water are betting on day rates staying high. cal year and more like $9 in fiscal 2008.
exploration should be particularly strong. Is that too much new capacity? As I Given that some contracted rates are well
Exploration success as the number of said, I’m convinced demand for deep- below current rates and that they have a
provinces expands will only breed more water drilling is going to explode. So much new rig coming on in 2008, we think sus-
activity. At the same time, because of the so that I don’t think the market will be able tainable earnings – at current market con-
expense and lead times on the capacity to meet the demand, even with the new ditions – are more like $11-12 per share.
side, there’s much less risk of oversupply
than with land-based drilling. INVESTMENT SNAPSHOT

Tell us about another of your favorite oil- Atwood Oceanics
(NYSE: ATW) Valuation Metrics
service holdings, Atwood Oceanics [ATW]. (Current Price vs. TTM):
Business: Houston-based contractor of
large-scale offshore rigs used in the drilling ATW S&P 500
BR: Atwood is a contractor of large off- of exploratory and developmental oil and P/E 19.1 19.3
shore drilling rigs. Four of their rigs are gas wells around the world. P/CF 13.8 13.7
semi-submersibles, which can drill in Share Information Largest Institutional Owners
3,000 to 5,000 feet of water, for which (@ 8/23/06): (@6/30/06):
the leasing rate is now about $400,000 Price 41.18 Company % Owned
per day. The other rigs they own, which 52-Week Range 32.55 – 58.44 Columbia Wanger Asset Mgmt 7.2%
drill in shallower water, go for closer to Dividend Yield 0.0% Trafelet & Co. 4.6%
$200,000 per day. There’s huge operat- Market Cap $1.28 billion Barclays Global Inv 4.1%
ing leverage at current rates: operating Mackenzie Financial 4.0%
Financials (TTM):
Mellon Financial 3.6%
costs are $45,000 per day on the semi- Revenue $240.6 million
submersibles and $30,000 per day on the Operating Profit Margin 30.9% Short Interest (@ 7/10/06):
shallower-water “jack-ups.” Net Profit Margin 28.9% Shares Short/Float 9.6%
From investing in energy for a long
time, you develop an appreciation for ATW PRICE HISTORY
60 60
smart managements that know how to
operate in a cyclical business. They don’t 50 50
spend money on capacity when everyone
else is and they add it on the cheap when 40 40
no one else wants to.
From 1982 to 1991, Atwood didn’t 30 30
spend a penny on equipment because
20 20
they thought the business was going to be
oversupplied for years. Then in 1991 10 10
they bought an interest in three rigs for 2004 2005 2006
$6 million. They spent $10 million to
refurbish the equipment and then in THE BOTTOM LINE
1995 bought the remaining interest for Oil companies desperate to add energy reserves will fuel a long-lived explosion in
another $16 million. So for $32 million, demand for the deep-water drilling equipment the company provides, says Bob Robotti.
they owned equipment that had been Based on contracted day rates and the addition of new capacity, he believes the com-
built in the early 1980s for $240 million. pany’s sustainable earnings are $11-12 per share, less than 4x today’s share price.
They’re very good capital allocators and Sources: Company reports, other publicly available information
understand how to build value.

August 25, 2006 Value Investor Insight 14
I N V E S T O R I N S I G H T : Robert Robotti

Given our view on supply and demand, we Why do you think the manufactured hous- the relative affordability of manufactured
believe that’s sustainable for some time. ing business is set to improve? housing. Lending to the industry is now
much stronger and default rates are way
With the stock recently around $41, the BR: The industry has been beaten up for down. In fact, terms have gotten so rigid
market seems to disagree. some time. In the late 1990s, the industry that legitimate potential buyers – who gen-
was selling 370,000 new homes per year, erally have lower FICO scores – can’t get
BR: Yes, given that the shares trade at less driven by very aggressive financing offers. loans. We expect that all to adjust as time
than 4x what we think the company is Many of those loans blew up, dumping a goes on. Clayton Homes is the biggest
going to earn in three years, the sustain- lot of inventory on the market. At the same player in the industry and you can imagine
ability of earnings is clearly where our time, falling interest rates made stick-built one reason Berkshire Hathaway bought it
view differs from the market. homes a more affordable option for many was for the opportunity to lend money to
The company will have no debt by the people. As a result, sales of new manufac- help finance the industry’s rebuilding.
middle of next year, so their net earnings tured homes fell to 130,000 per year and Getting back to even 200,000 new
will be mostly cash earnings. So within have stayed around that level. manufactured homes sold per year, which
three years, then, not only will they be We now think higher interest rates will is fully achievable, would result in
earning at a very high level, but they will refocus many low-end buyers’ attention on tremendous upside for Drew. We think
have accumulated $20 or so per share of
cash. If that happens, it doesn’t take very INVESTMENT SNAPSHOT
sophisticated math to arrive at a share
price significantly above where it is today. Drew Industries
(NYSE: DW) Valuation Metrics
Business: Supplier of windows, doors, (Current Price vs. TTM):
What if oil prices go down?
chassis and other components used in the DW S&P 500
manufacture of recreational vehicles and P/E 14.0 19.3
BR: Exploration to find a deep-water field manufactured homes in the U.S. P/CF 9.9 13.7
costs $5-7 per barrel. Producing it then
Share Information Largest Institutional Owners
costs another $3-5 per barrel. So whether (@ 8/23/06): (@6/30/06):
oil is at $75 or $40 won’t make that much Price 24.95 Company % Owned
difference on demand. 52-Week Range 20.95 – 38.90 Fidelity Mgmt & Res 8.6%
Dividend Yield 0.0% Royce & Assoc 8.1%
What attracted you to your next pick, Market Cap $537.2 million Munder Capital 5.6%
Drew Industries [DW]? Columbia Wanger Asset Mgmt 4.9%
Financials (TTM):
Mellon Financial 3.9%
Revenue $762.0 million
BR: This is a relatively straightforward Operating Profit Margin 8.6% Short Interest (@ 7/10/06):
story. Drew sells component parts – like Net Profit Margin 5.2% Shares Short/Float 8.8%
windows, doors, chassis and axles – to
manufacturers of recreational vehicles and DW PRICE HISTORY
40 40
manufactured homes. They do business
with almost all manufacturers and proba- 35 35
bly have 50% market share in both busi- 30 30
nesses. The revenue mix is two-thirds RVs, 25 25
one-third manufactured housing.
20 20
There are two main things that attract-
ed us here. First, we’re convinced they 15 15
have an excellent model for growth. 10 10
They’ve been very good at identifying
0 0
products that will have broad appeal and 2004 2005 2006
then making small acquisitions to fill out
their product line and leverage their rela- THE BOTTOM LINE
tionships and sales infrastructure. Earnings should increase at double-digit annual rates as the company capitalizes on
We’re also big believers in the turn- add-on acquisitions and an expected turn in its business supplying the manufactured-
around potential of the manufactured- housing industry, says Bob Robotti. He expects significant multiple expansion – of at
least 50% from today’s 12x forward earnings – to accompany that growth.
housing industry – where Drew operates at
maybe 50% of capacity and where they
Sources: Company reports, other publicly available information
have historically earned higher margins.

August 25, 2006 Value Investor Insight 15
I N V E S T O R I N S I G H T : Robert Robotti

that business can double for them in the the market got very undisciplined and much healthier industry. The major players
next few years. started to crack in the late 1990s. Fremont in the business are much better-run and
Insurance was seized by the state insurance new regulations, such as requiring a med-
With the stock currently trading just under department. Superior went bust. ical-review process for claims, have been
$25, how are the shares valued? instituted. That all plays particularly to
Where was Zenith during all this? Zenith’s hand, because their focus and
BR: The stock currently trades at around expertise is on smart underwriting and
11-12x our estimate of next year’s earn- BR: Stanley Zax, who has run Zenith for claims management.
ings. As they continue to add new products 30 years, is a very disciplined operator
and the manufactured-housing business who has been through all the ups and What does the current rate environment
turns, we think earnings will increase at downs of the business. He kept Zenith on look like in California?
double-digit annual rates. With that kind track and relatively well reserved, so the
of growth and the high-teens multiple we company came out of the turmoil of the BR: Rates are coming down, but that’s
believe the business will then deserve with- late 90s in a stronger position, as many of because losses have come down. Given
in three years, you’ve got a lot of upside the dumb competitors went away. that, I don’t think Zenith’s margin of prof-
from today’s price. Fast forward to today and you have a itability comes down all that much over

After your Superior National experience, INVESTMENT SNAPSHOT

we’re surprised you still own a workers’
comp company, Zenith National [ZNT]. Zenith National
(NYSE: ZNT) Valuation Metrics
Business: Insurance holding company pri- (Current Price vs. TTM):
BR: The California workers’ comp market marily focused on the underwriting of ZNT S&P 500
– where Zenith does about two-thirds of workers’ compensation insurance in P/E 7.7 19.3
its business – is very large, very volatile California and Florida. P/CF 7.7 13.7
and, as I learned firsthand, has historically Share Information Largest Institutional Owners
destroyed a lot of capital. (@ 8/23/06)): (@6/30/06):
It’s important to give some history here Price 37.19 Company % Owned
about the market. In the early 1990s, the 52-Week Range 36.14 – 55.30 Gilder, Gagnon, Howe & Co 14.6%
economy in California turned down and Dividend Yield 2.9% Fidelity Mgmt & Res 6.1%
people were losing their jobs. When that Market Cap $1.38 billion Barclays Global Inv 5.5%
happens, you see a big increase in workers’ American Century 4.5%
Financials (TTM):
Vanguard Group 3.8%
comp claims, because the benefits are gen- Revenue $1.19 billion
erally much better than those provided by Operating Profit Margin 23.9% Short Interest (@ 7/10/06):
unemployment insurance. This was all Net Profit Margin 15.4% Shares Short/Float 4.3%
facilitated by a significant number of less-
than-ethical doctors and lawyers, who saw ZNT PRICE HISTORY
60 60
this as a great way to make a buck.
That led to regulatory reforms in 1993- 50 50
1994 that were meant to address the
increase in the number of claims and the 40 40
resulting increase in the price of workers’
comp insurance. They changed things like 30 30
increasing how much of one’s stress had to
20 20
be related to their job to qualify for a
claim. They also cracked down on doctor 10 10
and lawyer mills generating bogus claims. 2004 2005 2006
Wall Street then came into the picture
and started to pour capital into workers’ THE BOTTOM LINE
comp insurers in California. This too Fears over the capital-destroying tendencies of the California workers’ compensation
ended badly, because the companies were insurance market are outdated, says Bob Robotti, and the healthier dynamics of the
overly leveraged and thought they were industry bode well for disciplined competitors like Zenith. At a more appropriate 10x
transferring a lot of risk to undisciplined multiple on normalized earnings, he believes that shares are worth $55-60 per share.
reinsurance companies who didn’t know Sources: Company reports, other publicly available information
what they were doing. The result was that

August 25, 2006 Value Investor Insight 16
I N V E S T O R I N S I G H T : Robert Robotti

the next couple of years. I also think they’ll you get access to certain legal services for lem was they wouldn’t get involved until I
be able to offset any rate decreases with free and to others at deeply discounted already had the co-op picked out, but in
both increases in investment income and rates. We think that’s an interesting prod- New York you have to have your attorney
adjustments from excess reserves they’ve uct offer for $300 a year, with applicabili- involved earlier in the search process to get
put on the books in recent years. ty to even more people in the U.S. than for access to certain information. So it didn’t
the tax-prep services of H&R Block. The work there. Where it did work for us: we
Is there a growth story here? model is actually similar to H&R Block – bought a $700 TV from Best Buy and it
providing a level of service most people broke a month or two later and they
BR: If there’s a negative, it’s that growth need on a more cost-effective basis. wouldn’t take it back. For no additional
prospects – at least the way Stanley Zax cost, the Pre-Paid lawyer wrote a letter for
runs the company – are limited. He sticks Describe how the service works. us and we received a refund shortly after.
to what he knows and executes well, but he A friend of mine, who also owns the
shows little aspiration for growing his pol- BR: You’re assigned a local law firm as stock, bought his house in Westchester
icy count. Over time, then, the business will your point of contact, which improves cus- County and used a Pre-Paid lawyer for his
grow as payrolls in their markets grow. tomer service. The first time I tried to use closing, paying less than half what every
it was when I bought my co-op. The prob- other lawyer wanted. He’s even used one
What upside do you see for the shares,
recently trading just about $37?
Pre-Paid Legal Services
BR: Last year Zenith earned $4.25 per (NYSE: PPD) Valuation Metrics
share, including a loss of about $1.30 per Business: Provider of legal services to (Current Price vs. TTM):
share from a reinsurance business they’ve roughly 1.5 million U.S. families who pur- PPD S&P 500
since exited. So the stock is trading at only chase plan memberships carrying monthly P/E 12.5 19.3
6.8x the current earnings run rate of $5.50 fees of approximately $25. P/CF 10.0 13.7
or so per share. Share Information Largest Institutional Owners
The stock is so cheap because every- (@ 8/23/06): (@6/30/06):
body still assumes workers’ comp in Price 36.77 Company % Owned
California is a horrible business. We think 52-Week Range 32.15 – 48.40 Thomas W. Smith 20.8%
if the market recognized the improved Dividend Yield 3.3% Steadfast Capital Mgmt 5.6%
dynamics of the industry and gave Zenith Market Cap $533.7 million Goldman Sachs 5.0%
Wellington Mgmt Co 4.3%
full credit for running a disciplined, con- Financials (TTM):
Barclays Global Inv 3.9%
servative business, a 10x multiple on nor- Revenue $438.0 million
mal earnings of $5.50 to $6 per share Operating Profit Margin 18.3% Short Interest (@ 7/10/06):
would be more reasonable. Net Profit Margin 10.3% Shares Short/Float 54.3%

We’re curious, is Berkshire Hathaway get- 60 60
ting more involved in the market?
50 50
BR: They actually bought a company
recently, Applied Underwriters, which is a
player in the workers’ comp business. 40 40

These are pretty smart capital allocators,
so we obviously see that as a positive com- 30 30
ment on the business. It hasn’t happened
so it probably never will, but we’ve actual- 20 20
2004 2005 2006
ly thought Berkshire would be a logical
acquirer of Zenith one day.
There no dearth of controversy around your More-traditional marketing of the company’s proven and unique legal-services plan to a
last idea, Pre-Paid Legal Services [PPD]. broader audience, combined with a heightened focus on customer retention, can
unleash tremendous untapped revenue and earnings potential, says Bob Robotti.
Success on both fronts, he says, would result in a “multiple” of today’s share price.
BR: Our interest is primarily based on our
conviction that they have a great product. Sources: Company reports, other publicly available information
For a monthly payment of around $25,

August 25, 2006 Value Investor Insight 17
I N V E S T O R I N S I G H T : Robert Robotti

of their lawyers for routine securities more carefully at the lifetime value of a There were accounting concerns, pri-
work, at one-fifth the cost I pay for the customer. They have more than enough marily over the company amortizing over
same work at my regular law firm. resources to invest in better marketing, and three years commissions on new customer
we think they will. sales. Now those commissions are
Who is the target audience? We’re also optimistic about the identi- expensed immediately. Today, cash earn-
ty-theft product they launched in 2003 in ings slightly exceed reported EPS.
BR: The company says it’s not the top a joint venture with Kroll. It’s a relatively With all this, we come back to the fact
10% or bottom 10%, but the 80% in unique service that doesn’t just monitor that we believe in the product – that it’s a
between. The reality is they reach mostly for problems with identity theft, but also proven, cost-effective service for con-
middle- to lower-income people, which I has a restitution part if something goes sumers that has been around for 30 years.
think is more a result of how they sell than wrong. Kroll is a part of Marsh & The “noise” has calmed down quite a bit,
of who might benefit from the product. McLennan and the entire company is but sometimes a high short interest takes
quite sophisticated in how they sell their on a life of its own. As long as you’re com-
A dreaded multi-tiered marketing system? products. I believe this relationship can fortable with your work, you just can’t
open new doors to Pre-Paid. worry about that.
BR: Yes, they use a system just like
Amway’s, which is one reason Wall Street The stock has been stuck near its current
hates the company. We agree that how it’s ON CHANGING TIMES: level, around $37, since the beginning of
sold is a limitation, but not based on any 2005. Where do you think it can go?
The particulars might change
elitist view of what’s appropriate.
The first problem is that by selling to from time to time, but people BR: The shares currently trade for around
people you know, who sell to people they 11x trailing earnings, if you adjust for the
drive the environment and
know, they don’t reach large parts of the fact that the identity-theft earnings are
population – namely higher income levels. human nature is pretty constant. temporarily lower because the start-up
The current system also isn’t adequately selling expenses are being expensed imme-
educating people on how to use the prod- diately. There’s no capital spending, so the
uct and what a great value it is. The more Is the competitive environment agreeable? earnings translate to free cash flow.
people use and take advantage of the serv- Protecting the downside is that they have
ices, the longer they remain customers. BR: The other main players – the Hyatt no debt and they’re using free cash flow to
We think there’s great untapped poten- Legal Plans division of MetLife and a for- buy back stock. The company has gone
tial in promoting to a broader population mer Montgomery Ward business that’s from over 24 million shares outstanding to
base through advertising and more tradi- now owned by General Electric – operate less than 15 million today, which has had
tional marketing. They also should mostly in the corporate market, offering a significant effect on EPS growth.
enhance customer-service efforts to con- plans as employee benefits. Pre-Paid is by I can’t give you a specific target number
nect more often with paying customers. far the market leader with consumers. for the stock price. But if they can really
The growth upside from doing both of get at the untapped potential I think this
these is tremendous – they win from dra- The short interest, nearly 55%, is about as product has, the share price will be a mul-
matically increasing the customer base high as it gets. Why do so many investors tiple of what it is today.
and from higher retention of the cus- loathe the stock?
tomers they already have. You’ve been in the investment business for
BR: There have been lawsuits against the over 25 years. How would you say the
The founder, Harland Stonecipher, still company alleging various damages, usual- business has changed?
runs the business. What makes you think ly amounting to no more than a few hun-
things will change? dred dollars each. One case, in Mississippi, BR: You know, the particulars might
resulted in a punitive-damage award of change from time to time, but people
BR: Management has been open to sug- $9.9 million, which is now on appeal. drive the environment and human nature
gestions of certain long-time shareholders. Many business people would not consider is pretty constant. A year ago,
Tom Smith, the managing partner of an early negative verdict from a NewMarket shares were at $15 and
Prescott Investors, has been on Pre-Paid’s Mississippi jury as great cause for concern, nobody wanted them and today it’s at
board since 2004. I’m sure he’s introduce- and we agree. The Connecticut Attorney $61 and everybody wants to own it.
ing ideas that will continue to impact how General also announced he was looking Fundamentally, it was positioned a year
they look at the business. We see it already into the company’s sales practices, but ago to earn what it’s earning today.
in how they’ve started new programs to try nothing’s come of that since it was Things like that are as likely to happen
to increase usage, in how they’re looking announced with great fanfare a year ago. today as they were 25 years ago. VII

August 25, 2006 Value Investor Insight 18
August 25, 2006

From the Editors of Value Investor Insight

Distinction With a IN THIS ISSUE
What They’re Buying

Difference Industry turmoil, as in healthcare
today, typically creates value
opportunities that attract smart
investors’ attention. Page 20

he eclectic nature of value Table: Heart and Home
investors is on full display in ana- Table: Biggest New Bets
lyzing the portfolios of the best of
the breed. Homebuilders like D.R. Horton What They're Selling
and Centex share space in portfolios with Consumer and financial stocks,
media companies such as Time Warner and light on buy lists in the second
News Corp. Energy firms Transocean and quarter, are well represented
Williams stand alongside Microsoft and among popular sells. Page 22
Table: Consumer Isn’t King
Oracle. At the same time Greyhound-bus
Table: Up (or Down) and Out
parent Laidlaw International attracts
attention, so do biotech firm Nuvelo and
What They Own
controversial videogame maker Take-Two
Media and technology may be out
Interactive. of favor on Wall Street, but you
We’re coming to believe that the tradi- wouldn’t know it from the portfo-
tional distinctions between “value” and lios of star investors. Page 24
“growth” investors are increasingly artifi- Table: Core Holdings
cial and irrelevant. As Charlie Munger returns rather than on relative returns or Table: Below the Radar
once said, “All intelligent investing is value outperforming a benchmark. They typical-
investing,” meaning all smart investors are ly invest with a multi-year time horizon Stock Spotlight
trying to buy a stake in a company for as rather than focusing on the month or quar- Unfocused businesses tend to
little as possible relative to its intrinsic ter ahead. They focus on the difference attract the attention of investors
value. But there’s great leeway in how one between a company’s current share price expecting change – witness the
ascribes value to any given stake, from a and their estimate of its true worth, rather case of Walter Industries. Page 26
focus on hard current assets to more than trying to guess where the herd is
weight given to higher future profits. The going to go next. The SuperInvestors
best investors are comfortable with assign- Another trait we believe most
ing value from along that continuum, as is SuperInvestors share: an ability to learn SuperInvestor Insight tracks the activity
clearly evidenced by the breadth of busi- from experience. Knowledge is cumulative, of an elite group of value-oriented
nesses in their portfolios. and savvy investors realize that there’s no hedge-fund managers (plus Berkshire
This is not to say there aren’t core prin- capacity limit on what one can learn and Hathaway), based on their holdings as
ciples that set apart the SuperInvestors we apply toward becoming a better investor. filed in Forms 13F with the SEC. While
track. They tend to buy what’s out of favor Our hope with SuperInvestor Insight is certain activity of specific investors will
rather than what’s popular. They invest that it can be an additional and regular be highlighted, the focus is on drawing
heavily in their best ideas rather than hide contributor to your own store of investing collective insight from this group of 25-
behind the “safety” of closet indexing. knowledge – with the help of the best 30 of the world’s best investors, which
They focus on generating high absolute “teachers” in the business. SII currently includes William Ackman,
David Einhorn, Joel Greenblatt,
Carl Icahn, Seth Klarman, Edward
Lampert, Warren Lichtenstein,
Stephen Mandel, Larry Robbins,
John Heins Whitney Tilson Jeffrey Ubben and many more.
Co-Editor-in-Chief Co-Editor-in-Chief

SuperInvestor Insight 19

Healthy Expectations
Dynamic change, such as that currently roiling the healthcare industry, tends to create
the types of value opportunities that attract smart investors.

It’s not surprising that the giant U.S. Scientific overpaid for damaged goods. earnings news from Thermo have
healthcare industry produced several of Guidant’s sales of implantable defibrilla- returned the shares to their merger-
the most prevalent buying opportunities tor devices have fallen due to concerns announcement level of around $39.25.
for SuperInvestors in this year’s second over the product’s safety and Boston Sentiment appears particularly divided
quarter. Shifting legal and regulatory Scientific announced earlier this year that on one of the quarter’s biggest bets, the
winds buffeting the industry, combined it faced some 550 individual and class- new $280 million position reported by
with hotly-competitive and high-growth action lawsuits related to problems with Larry Robbins’ Glenview Capital in
markets, create the type of turmoil that Guidant’s heart devices. BSX shares, at a Omnicare, which provides pharmaceuti-
attracts against-the-grain investors. recent $16.78, remain barely above their cal services to nursing homes. Omnicare
Market skepticism about mergers-and- second-quarter low. shares are off more than 30% from their
acquisitions activity appears to have While less controversial, Thermo March high as concerns over its Medicaid
played a role in two healthcare buys. Electron’s announcement during the billing practices have resulted in a recent
Stent-maker Boston Scientific completed quarter that it was merging with fellow fraud charge by the Michigan attorney
its $27.5 billion purchase of Guidant dur- lab-equipment supplier Fisher Scientific general. While Glenview was buying,
ing the quarter, but the stock remains raised integration concerns about the however, three other SuperInvestors
plagued by concerns that Boston $10.6 billion deal. Only recently upbeat closed out their Omnicare positions dur-

What They’re Buying: Healthcare-related and home-builder shares attracted particular buying attention from superstar
investors in the second quarter. Below are stocks in which at least three SuperInvestors established
Heart and Home new positions or increased their existing share positions by more than 15% during the quarter.

Price@ Q2 2006 # of New or % Change In Total
Company Ticker Industry 8/23/06 Low High Inc. Positions Shares Held

Microsoft MSFT Computer Software/Services 25.67 21.46 27.94 6 170.1%

Walter Industries WLT Diversified Industry/Construction 51.70 44.60 71.45 5 220.8%

NTL NTLI Cable TV 26.46 22.40 31.00 4 43.2%

Williams Companies WMB Oil & Gas 24.61 20.01 23.59 4 3626.4%

Dell DELL Computers 21.64 23.53 30.25 4 49.1%

UnitedHealth UNH Health Insurance 49.64 41.44 56.60 4 903.4%

Comcast CMCSA Cable TV 34.86 26.18 33.55 3 109.6%

D.R. Horton DHI Residential Construction 21.02 22.55 35.27 3 All new positions

Mirant MIR Power Generation 28.66 23.36 26.86 3 148.0%

Boston Scientific BSX Medical Devices 16.78 16.47 23.58 3 1200.1%

Caremark Rx CMX Specialized Health Services 56.40 42.40 50.66 3 101.6%

Centex CTX Residential Construction 48.59 44.13 64.62 3 165.5%

Smurfit-Stone Container SSCC Paper Products 11.17 10.21 15.15 3 145.1%

Thermo Electron TMO Medical Equipment 39.21 33.85 41.85 3 All new positions

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006 SuperInvestor Insight 20

ing the quarter (see table, p. 22). While shares bought on non-U.S. mar- best-positioned companies to benefit
Volatility in two previously booming kets need not be disclosed in 13F filings from increasing prosperity in developing
sectors, energy and housing, also resulted with the SEC, those in holdings of foreign countries such as China and India.
in significant buying activity. Four companies with shares trading on U.S. Microsoft, in which six SuperInvestors
investors increased their positions in exchanges are. The sole such company significantly increased their holdings in
Williams, the natural-gas and power-gen- appearing in this quarter’s buying activity the second quarter, will certainly not be a
eration company which hit its 52-week new idea to readers of Value Investor
low in March, as energy prices took a Insight. Co-Editor Whitney Tilson laid
short-lived dip. Mitch Julis of Canyon ON DELL: out his thesis for the shares in detail a
Capital argued in a recent Value Investor SuperInvestors are betting year ago (VII, July 29, 2005), focusing on
Insight (March 31, 2006) that Williams the software behemoth’s peerless brand
shares traded at a significant discount to against Dell shares becoming franchise, stellar economics and still-vital
the sum of its parts, weighed down by a the computer industry’s lat- growth prospects. The change in the
complex business structure and the taint shares over the past year: $0. He now has
of past miscues in telecommunications est dead-money champion. plenty of elite company in expecting the
and energy trading. Evidenced by their company’s shares to prosper.
purchase of WMB shares, many of his Will Dell shares replace Microsoft’s as
peers seem to agree. was Swiss-based food giant Nestlé, in the computer industry’s latest dead-
The implosion of homebuilder shares which Ricky Sandler’s Eminence Capital money champion? The shares, at a recent
attracted multiple buyers to two compa- disclosed a new $157 million holding at $21.64, trade below their second-quarter
nies in the industry – D.R. Horton and the end of June. While we didn’t speak low. The SuperInvestors apparently see
Centex. As perceived-to-be-cyclical com- with Sandler about Nestlé in this month’s potential, though, as four of them
panies tend to do at the end of cycles, interview (see p. 1), the company was a increased their holdings during the quar-
both trade at miniscule trailing P/E mul- featured pick by Gardner Russo & ter. We wouldn’t bet against them. SII
tiples – Horton at 4.4x and Centex at Gardner’s Thomas Russo when we inter-
5.2x – and are at least 40% off their 52- viewed him in June (VII, June 30, 2006). Funds managed by Co-Editor Whitney Tilson
week highs. Russo sees Nestlé as one of the world’s own Crosstex Energy, Dell and Microsoft.

A willingness to make significant bets on their best ideas is a hallmark of superior
What They’re Buying: investors. Below are the ten largest brand-new positions taken by individual
Biggest New Bets SuperInvestors in this year’s second quarter.

Price@ Q2 2006 Value @ 6/30
Company Ticker Industry Investor
8/23/06 ($mil)
Low High
Omnicare OCR Specialized Health Services 43.30 41.00 58.02 Glenview $280.4

Crosstex Energy XTXI Oil & Gas 91.28 71.50 96.00 Chieftain $243.0

Comcast SPCL CMCSK Cable TV 34.73 25.99 33.40 Lone Pine $231.1

Microsoft MSFT Computer Software/Services 25.67 21.46 27.94 Greenlight $207.4

Boston Scientific BSX Medical Devices 16.78 16.47 23.58 Highfields $206.6

Nestlé NSRGY Food Consumer Products 84.30 71.85 78.45 Eminence $156.9

Valeant Pharmaceuticals VRX Pharmaceuticals 18.62 15.75 18.44 ValueAct $139.8

Walter Industries WLT Diversified Industry/Construction 51.70 44.60 71.45 JANA $119.1

Cigna CI Insurance 109.49 88.05 133.13 Icahn $104.4

Williams Companies WMB Oil & Gas 24.61 20.01 23.59 Omega $82.1

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006 SuperInvestor Insight 21

Consumption Patterns
Consumer and financial stocks, light on SuperInvestors’ buy lists in the second quarter,
are quite well represented among the most popular sells.

The U.S. consumer’s voracious appetite as were those in financial firms tied closely years, partly through the efforts of
to spend has clearly been a significant con- to the consumer. activist investor Bill Ackman of Pershing
tributor to the economy’s and the market’s Each individual story, of course, is Square Capital to force management's
relative health in recent years – fattening different. Four SuperInvestors each hand to spinoff its Tim Hortons dough-
corporate profits along the way for those decreased their holdings in McDonald's nut-shop empire and unlock hidden real
positioned to benefit. That the consumer and Wendy’s following sharp turn- estate value. That some investors in both
spend-fest would end has been much antic- arounds in each company’s share price of these stocks have realized profits isn’t
ipated, if not much observed. since bottoming in early 2003. Having terribly surprising.
From their portfolio activity in the sec- lost its way early in the decade, That four investors decreased their
ond quarter, it would appear that many McDonald’s has turned itself around holdings in Sears is somewhat surprising.
SuperInvestors are positioning themselves through wholesale menu and opera- The old-line retailer’s shares have per-
more for a slowdown in consumer spend- tional changes and the shares have formed remarkably well since investor
ing than the contrary. Money was taken responded, nearly tripling from their Edward Lampert – whose fund is included
off the table in traditional consumer stal- February 2003 low to a recent $35.60. in the roster of SuperInvestors – took con-
warts such as retail and restaurants. Wendy’s shares, recently around $63.50, trol of the company. While Lampert’s rep-
Consumer-media positions were reduced, have nearly doubled in the past two utation as a value creator remains

What They’re Selling: Shares in retail, restaurant and entertainment companies came in for some selling by
SuperInvestors in the second quarter. Below are companies for which threee or more superstar
Consumer Isn’t King investors reduced their positons by 15% or more in the quarter.

Price@ Q2 2006 # of Decreased or % Change In Total
Company Ticker Industry 8/23/06 Low High Closed Positions Shares Held
News Corp. NWS Entertainment/Media 19.45 17.61 20.57 6 (-49.9%)

McDonald's MCD Restaurants 35.59 31.73 35.99 4 (-94.5%)

NRG Energy NRG Power Generation 50.16 42.44 52.61 4 (-34.5%)

Oracle ORCL Computer Software 15.32 13.07 15.21 4 (-48.3%)

Sears SHLD Retail Stores 142.40 130.38 167.95 4 (-80.3%)

Wendy's WEN Restaurants 63.46 56.25 63.65 4 (-69.6%)

Advanced Medical Optics EYE Medical Devices 48.15 43.94 50.87 3 (-31.2%)

American Express AXP Financial/Travel-Related Services 53.00 50.92 54.91 3 (-100.0%)

CBS CBS Media 28.34 24.05 27.24 3 (-59.7%)

Int'l Game Technology IGT Gaming Equipment 37.47 34.71 39.39 3 (-100.0%)

Kohl's KSS Retail Stores 60.89 51.51 59.73 3 (-44.3%)

Morgan Stanley MS Investment Banking 68.05 54.52 66.00 3 (-41.2%)

Omnicare OCR Specialized Health Services 43.30 41.00 58.02 3 (-100.0%)

Sprint Nextel S Telecommunications 16.42 19.33 26.89 3 (-51.4%)

Talisman Energy TLM Oil & Gas 18.10 14.93 20.33 3 (-95.8%)

TXU TXU Power Generation 65.24 44.10 59.93 3 (-54.3%)

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006 SuperInvestor Insight 22

undimmed, the heavy Sears’ share sales Similarly, Gotham Capital’s Joel While SuperInvestors generally invest
would indicate some smart investors feel Greenblatt sees great opportunity in for the long-term, their opinions on a given
the easy money has already been made. American Express shares – also explained company can change rapidly. Independent
While strong share performance likely recently in VII (July 28, 2006) – but three power generator NRG Energy was a pop-
explains many of the quarter’s prevalent SuperInvestors sold their positions entirely ular pick in this year’s first quarter, held in
sales – in International Game Technology, in the latest quarter. five portfolios. The company was expected
Procter & Gamble and energy companies Messages are similarly mixed on News to participate in consolidation in the
Talisman, Suncor and Chevron, for exam- power-generation business, and, in fact,
ple – other sales bear the whiff of capitula- ON CHANGING OPINIONS: received a bid in May from competitor
tion. Warren Buffett’s Berkshire Hathaway Mirant Corp. The bid died, as, apparently,
appears to have closed its position in Gap, As Mirant’s bid for competi- has enthusiasm for NRG’s shares.
whose shares trade at the same level they Interestingly, Mirant is currently on the
tor NRG Energy died, so,
did in 1998. Freddie Mac shares, unloaded popular buy list (see table, p. 20). Its
in volume by Chieftain Capital, haven’t apparently, did enthusiasm response to the failed merger attempt has
moved since 2001. Even worse is the per- been to restructure itself, selling off assets
for NRG’s shares.
formance of wireless provider Sprint and aggressively buying back shares.
Nextel, sold by three SuperInvestors, It's inevitable that some sales appear to
whose shares are off nearly 40% in the have been premature. Shares of wholesale
past year. Corp. While a total of six investors power company TXU, which peaked in
That smart investors are bailing on decreased their holdings in Rupert the second quarter just under $60, now
Sprint Nextel highlights the fact that even Murdoch’s global media empire, four trade at around $65.25. That’s not at all a
the best investors can arrive at diametrical- retain holdings of greater than $50 million criticism – it’s just nice to see that selling
ly opposed positions on a given invest- each. Less ambiguous was the reaction to too early happens to even the best
ment. Legg Mason’s Bill Miller, for exam- broadcast media’s CBS, which Viacom investors, as well as to the rest of us. SII
ple, remains strongly bullish on Sprint’s spun off earlier this year. As the shares
prospects, as he recently explained to started to trade separately, three investors Funds managed by Co-Editor Whitney Tilson
Value Investor Insight (June 30, 2006). collectively sold 60% of their CBS shares. own McDonald’s and Wendy’s.

What They’re Selling: Whether after great runs (Suncor Energy, Chevron, PNC), or not-so-great (Freddie Mac, Gap),
big steps were taken out of these stocks in the second quarter. Below are the ten largest posi-
Up (or Down) and Out tions that individual SuperInvestors eliminated during the quarter.

Price@ Q2 2006 Value @ 3/31
Company Ticker Industry Investor
8/23/06 ($mil)
Low High
Freddie Mac FRE Mortgage Loans 61.80 56.50 63.99 Chieftain $403.3

Suncor Energy SU Oil & Gas 80.25 67.36 89.88 Lone Pine $348.4

Applied Biosystems ABI Medical Instruments 30.84 26.38 33.00 ValueAct $280.2

Teva Pharmaceutical TEVA Pharmaceuticals 34.30 29.83 43.90 Glenview $240.7

Sears SHLD Retail Stores 142.40 130.38 167.95 Pershing Square $206.4

Gap GPS Retail Stores 16.52 16.83 19.10 Berkshire Hathaway $186.8

Procter & Gamble PG Consumer Products 60.92 52.75 58.73 Blue Ridge $140.0

American Express AXP Financial/Travel-Related Services 53.00 50.92 54.91 JANA $128.0

PNC Financial PNC Banking 70.52 65.30 72.00 Third Point $114.4

Chevron CVX Oil & Gas 65.68 55.41 63.65 Highfields $103.2

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006 SuperInvestor Insight 23

High and Low Concept
While media and technology stocks have generally been out of favor on Wall Street,
they're not out of favor in the portfolios of superstar investors.

It’s a safe bet that a similar list in early the market.” He describes in the interview videogames, has been buffeted by hard
2000 of the most prominent large holdings his thesis for two such companies, Cisco times in the videogame business – due to
of superstar value investors would have and Oracle, that were also held in volume transitioning game platforms – many ques-
looked absolutely nothing like the list by other SuperInvestors at the end of the tions about its accounting and legal prob-
below. Cisco? Microsoft? Oracle? No way. second quarter. lems over hidden sex scenes in some of its
Time Warner? News Corp.? Sprint? Not all of the popular technology-relat- games. Take-Two shares, at a recent
Highly unlikely. ed holdings are large-cap icons. Agere $12.67, are half their 52-week high. Even
Such are Wall Street’s changing moods Systems, spun off from Lucent in 2002 and biotech company Nuvelo, with an active
that so many once-untouchable shares currently sporting a $2.6 billion market pipeline of cardiovascular and cancer
have found their way into value-investor cap, has struggled to find its footing in drugs in development, was owned by three
portfolios. As Eminence Capital’s Ricky hotly competitive markets for hard-disk- SuperInvestors at quarter’s end. With a
Sandler puts it in his interview in this issue drive and communication-product semi- market cap of just over $1 billion, Nuvelo
(see p. 1): “Some of the greatest businesses conductors, but is starting to deliver reported $1 million in revenues in its latest
in the world – still growth companies in improved financial results. Take-Two quarter.
growth industries – are at significant dis- Interactive Software, publisher of the con- Media, both content and distribution, is
counts to small, lousy companies and to troversial Grand Theft Auto series of well represented on the widely-held lists.

What They Own: Media and technology stocks are well represented among those companies with multiple
superstar owners. Below are stocks in which three or more SuperInvestors held positions of
Core Holdings more than $50 million at the end of the second quarter.
52-Week Portfolios with
Price@ % Change In Total
Company Ticker Industry $50+million
8/23/06 Low High Shares Held
Comcast CMCSA Cable TV 34.86 25.35 35.31 5 14.6%

First Data FDC Payment Systems 41.28 38.60 48.88 5 15.1%

Microsoft MSFT Computer Software/Services 25.67 21.46 28.38 5 158.8%

American Tower AMT Communications Infrastructure 35.49 22.73 36.05 4 0.1%

News Corp. NWS Entertainment/Media 19.45 14.76 20.57 4 (-20.5%)

Time Warner TWX Entertainment/Media 16.54 15.70 19.00 4 0.0%

Transocean RIG Offshore Oil & Gas Drilling 67.04 52.34 90.16 4 20.8%

Tyco TYC Diversified Industry 26.19 24.65 31.28 4 13.3%

Cisco Systems CSCO Networking/Communcations 21.05 16.83 22.00 3 (-3.6%)

Dade Behring DADE Medical Testing 38.68 32.90 43.11 3 2.6%

Freescale Semiconductor FSL Semiconductors 28.80 20.87 33.04 3 2.2%

NTL NTLI Cable TV 26.46 19.99 31.00 3 42.2%

Oracle ORCL Computer Software 15.32 11.75 15.95 3 (-6.9%)

Sprint Nextel S Telecommunications 16.42 15.92 26.89 3 (-24.6%)

Williams Companies WMB Oil & Gas 24.61 19.35 25.72 3 135.3%

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006 SuperInvestor Insight 24

Five investors hold positions in excess of highs, Copart’s business of auctioning seek to replenish depleting reserves.
$50 million in Comcast, the bluest of blue cars from insurance companies for sal- The investment case for payments-
chips in an industry beset by concerns over vage value is growing nicely, and the com- processor First Data, owned in five portfo-
the cost of competing with phone and pany had a debt-free balance sheet and lios at quarter’s end, was made by
satellite companies. Also attracting atten- Glenview Capital’s Larry Robbins in Value
tion have been shares of NTL, the domi- Investor Insight last fall (October 28,
nant market leader in the U.K. cable mar- ON BKF CAPITAL: 2005). Western Union, the company’s
ket, whose shares trade in the U.S. Even the best investors have money-transfer gem which Robbins felt
Four portfolios each held big stakes in the market wasn’t fully valuing, is now
media titans News Corp. and Time their Waterloos. BKF shares, slated to be spun-off. One remaining risk:
Warner. News Corp. is generally credited above $35 a year ago, now that Wal-Mart pulls its credit-card process-
as being the most international and nimbly ing business from First Data if it ultimate-
run media company, but its shares have trade at around $4. ly receives the bank charter it seeks.
done little for the past five years. Time Even the best investors have their
Warner, blessed with remarkable media Waterloos, which appears to be the case
brands, is still reeling more than five years over $250 million in cash at the end of its for three SuperInvestors in investment
after its disastrous merger with AOL – its fiscal second quarter. manager BKF Capital. Activist investors
shares, after a steep plunge early in the Offshore contract driller Transocean were successful in gaining control of the
decade, have flat-lined for more than four was the SuperInvestors most widely held company, but assets under management
years and trade today around $16.50. energy bet, with large positions owned by have since fallen off a cliff, leaving the
It’s not all glitz and glamour, of course. four investors. Bob Robotti of Robotti & company a shadow of its former self. The
Retailer Advance Auto Parts, automotive Co. (see p. 12) – who doesn’t currently shares, above $35 a year ago and still at
supplier Lear and vehicle-salvage firm own Transocean – makes the case in his nearly $20 earlier this year, now trade
Copart were all owned by three or more interview in this issue that offshore around $4. SII
SuperInvestors at quarter’s end. While drillers are particularly well positioned to
Advance Auto and Lear are off 35% and prosper, as he expects deep-water drilling Funds managed by Co-Editor Whitney Tilson
50% respectively from their 52-week to significantly increase as oil companies own Microsoft and Tyco.

What They Own: It isn’t only high-profile large-caps that attract the attention of great investors. Below are ten
companies with market capitalizations below $6 billion that were owned by at least three
Below the Radar SuperInvestors at the end of the second quarter.

Price@ 52-Week Market Value
Company Ticker Industry 8/23/06 @8/23/06 (mm)
Low High
BKF Capital BKF Investment Management 4.00 3.80 35.10 $32.9

Take-Two Interactive TTWO Videogames 12.67 9.06 25.07 $919.2

Nuvelo NUVO Biotechnology 19.41 7.53 19.89 $1,010.0

Lear LEA Automotive Parts 19.41 15.60 39.73 $1,310.0

Copart CPRT Vehicle Salvage 27.30 21.14 28.19 $2,470.0

Laidlaw LI Bus Transportation 25.81 21.09 29.40 $2,520.0

Agere Systems AGR Integrated Circuits 15.16 8.81 17.18 $2,570.0

Advance Auto Parts AAP Retail Automotive Stores 29.60 27.65 45.50 $3,110.0

Pioneer Natural Resources PXD Oil & Gas 41.78 36.43 56.35 $5,210.0

DaVita DVA Dialysis Services 56.79 43.99 60.70 $5,880.0

Sources: Forms 13F filed with the Securities and Exchange Commission for holdings as of June 30, 2006.

August 25, 2006 SuperInvestor Insight 25

Out of Focus
Few companies have as unlikely a mix of business units as Walter Industries – which explains
its attraction to so many SuperInvestors last quarter.

Investors’ appetite for conglomerates quently been responsive, agreeing to spin what from their second-quarter low of
rises and falls over time, but the empha- off 25.1% of Mueller Water in an initial $44.60 and recently traded at $51.70.
sis today is clearly that focus is a virtue. public offering in June and committing The ongoing investment thesis for
Focused businesses are considered more to dispose of the rest in a tax-free spin- Walter is relatively straightforward, says
nimble and responsive to changing com- off before the end of the year. Walter Gary Claar of SuperInvestor JANA
petitive environments. From an invest- shares – at $15 only two years ago – Partners. “It’s just what we look for –
ment perspective, the more uncluttered a traded as high at $71.45 earlier this year value, plus a catalyst,” he says.
given business is – the thinking goes – before falling off sharply after the “Business by business, each piece of
the more likely it is to be accorded full Mueller IPO. They’ve recovered some- Walter deserves a more robust valuation
value by the market. That’s a big reason
behind the steady stream of high-profile
completed or contemplated corporate
restructurings of late: Viacom’s breakup, Walter Industries
American Express’ spin-off of financial- (NYSE: WLT) Valuation Metrics
advisory subsidiary Ameriprise, Tyco’s Business: Conglomerate operating in (Current Price vs. TTM):

prospective breakup, First Data’s plans three discrete business segments: coal WLT S&P 500
to spin-off Western Union … the list and natural gas, home building and water- P/E 46.1 19.3
system infrastructure. P/CF 62.6 13.7
goes on.
This backdrop may help explain why Share Information Largest Institutional Owners
conglomerate Walter Industries was one (@ 8/23/06): (@6/30/06):

of the most hotly pursued stocks by Price 51.70 Company % Owned
SuperInvestors last quarter. No fewer 52-Week Range 39.45 – 71.45 Pirate Capital 8.5%
Dividend Yield 0.3% JPMorgan Chase 7.9%
than five investors increased their posi-
Market Cap $2.25 billion Steel Partners 5.2%
tions by more than 15% in the quarter – JANA Partners 4.7%
and four of those were newly-established Financials (TTM):
Stephen A. Feinberg 4.6%
positions. Revenue $2.80 billion
Operating Profit Margin 18.7% Short Interest (@7/10/06):
Walter, based in Tampa, Florida, has
three quite disparate lines of business, Net Profit Margin 1.6% Shares Short/Float 7.4%
producing approximately $3.1 billion in WLT PRICE HISTORY
annual revenue: Mueller Water Products 80 80
is a leading maker of piping, flow-control 70 70
systems and end-of-line water transmis- 60 60
sion products like fire hydrants. Jim 50 50
Walter Resources is a leading producer of
40 40
high-quality metallurgical coal, used by
30 30
steelmakers to make the coke that fuels
20 20
blast furnaces and by utilities in produc-
ing steam. Jim Walter Homebuilding, the 10 10
company’s original business, builds and 0 0
2004 2005 2006
finances low-end single-family homes
throughout the southeastern U.S.
Walter’s motley crew of businesses
last year attracted the attention of The company is in the middle of the process of rationalizing its disparate businesses,
which should result in each being more highly valued by the market, says JANA
activist-investor Pirate Capital, which
Partners’ Gary Claar. JANA’s purchases of WLT shares during the second quarter
filed a 13D with the SEC calling for the were at an up to 50% discount to the estimated value of the sum of its parts, he says.
breakup of the company to better realize
shareholder value. Walter has subse- Sources: Company reports, other publicly available information

August 25, 2006 SuperInvestor Insight 26

than it’s getting as part of a conglomer- company a cost advantage over many than his estimate of 3.5x today.
ate, and they’re in the process of ration- competitors. The business is tied to steel- Even Walter’s homebuilding business
alizing that structure.” industry cyclicality, but steel is in a rela- – which Claar calls “lousy” – has poten-
Mueller Water’s vertically integrated tively strong part of what many consider tial upside. The company’s focus is pri-
line of products is well positioned to to be a long-lived cycle. marily on homes priced between
take advantage of the heavy infrastruc- In addition, coal’s central role in $50,000 to $150,000, which should bet-
ture spending necessary to upgrade and ter position it for a tough housing mar-
replace aging water systems throughout ket. Just as low interest rates and easy
the country, says Claar. He believes the ON THE COAL BUSINESS: financing allowed many low-income
growth and sustainability of the business buyers to trade up from Walter’s typical
warrants at least a 10x multiple of earn- Less susceptible to natural- offering during the boom, more difficult
ings before interest, taxes, depreciation gas competition in power gen- times should increase demand for its
and amortization – 25% higher than the homes. Claar values the business at
8x multiple it currently sports – which is eration, coal should be a lot roughly $5 per share and expects it ulti-
likely only after Mueller shares are fully mately to be sold to a competitor or in a
less cyclical going forward.
spun out later this year. management buyout.
The natural-resources business is also All in, Claar says JANA bought into
a much better business than it currently Walter at a 30-50% discount to the esti-
gets credit for, says Claar, and might power generation, now less susceptible mated value of the sum of its parts. “We
eventually make an excellent acquisition to competition from higher-priced natu- typically look for a very dynamic period
target for a large, diversified coal com- ral gas, “makes coal companies a lot less of a company’s public life when it under-
pany. High-quality metallurgic coal sells cyclical going forward than looking goes a lot of change and gets revalued by
for a solid premium to lesser-quality coal back,” Claar says. He believes Walter’s the market,” he says. “We think we’re
and the location of Walter’s mines near coal business should trade for a premi- right in the middle of that period now
steel mills in the southern U.S. gives the um 6x EBITDA multiple, up from less with Walter.” SII

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August 25, 2006 SuperInvestor Insight 27

High-Level Networking
When we launched Value Investor why energy makes up the largest share of much the same thing to us earlier this
Insight eighteen months ago, we deliber- his portfolio. Neither is “right” – and both year (VII, April 28, 2006): “Why would-
ately ignored the typical formula for have consistently produced remarkable n't you look at what other great investors
investment newsletters. We made no returns. have found?”
promises to regularly unearth the next So if investing is the individualistic We couldn't agree more. Each quarter,
Microsoft, or to double your money in affair we believe it is, why are we launch- SuperInvestor Insight will analyze the
two weeks, or to let you in on our ing a new quarterly newsletter – the first collective portfolio activity of 25 to 30 of
SECRET!, PROPRIETARY! system for issue of which is included herein – to track the best value-oriented hedge-fund man-
market-beating returns. the latest portfolio activity of superstar agers. The list will evolve over time, but
What we set out to do was present value investors? The reason is that while will always include the investors we most
intelligent interviews and commentary on winning investors clearly make their own respect, such as Bill Ackman, David
investing, drawing insight and wisdom decisions, they also have an insatiable Einhorn, Joel Greenblatt, Seth Klarman,
from the best value investors in the busi- appetite for good ideas. That's the thesis Stephen Mandel, Larry Robbins, Jeffrey
ness. The goal was – and is – to provide behind SuperInvestor Insight. Learning Ubben and many more. The one non-
both actionable investing ideas and ongo- that five of the best investors in the world hedge-fund manager included: Warren
ing learning on how to become a better bought shares of Walter Industries last Buffett’s Berkshire Hathaway.
investor. Our aspiration is to help readers quarter doesn't mean you should buy it, A trial subscriber to VII called us early
invest more successfully tomorrow, next but our hope is that such knowledge may on to say he wouldn’t subscribe unless the
year … and ten years from now. spark a line of inquiry worth pursuing. format evolved. “I basically want you to
Like fingerprints, no two investing What you do with it is up to you. tell me what to do,” he said. No, we
strategies are exactly alike. We very much In fact, great investors freely admit to won’t do that. But we’ll keep doing every-
believe there are central principles upon relying on their “grapevine” of peers for thing we can to help you better figure it
which sound investments are made, but good ideas. “We learn a lot from other out for yourself. VII
any investor's given performance is a func- investors,” Ricky Sandler tells us in this
tion of hundreds of individual decisions issue's interview. “I'm not afraid of ideas
over time about what, how much and owned by other people, but you obvious-
when to buy and sell. In this issue, Ricky ly need to do your own work and make
Sandler explains why he's never touched sure the ideas fit what you do.” John Heins Whitney Tilson
energy stocks and Bob Robotti describes Fairholme Fund's Bruce Berkowitz said Co-Editor-in-Chief Co-Editor-in-Chief

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from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter.

Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, an investment adviser
registered with the U.S. Securities and Exchange Commission. T2 Partners Management, LP may purchase or sell securities and
financial instruments discussed in this newsletter on behalf of certain accounts it manages.

It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of this
newsletter before purchases or sales of any securities or financial instruments discussed herein are made.

Value Investor Media, Inc. receives compensation in connection with the publication of this newsletter only in the form of subscription
fees charged to subscribers and reproduction or re-dissemination fees charged to subscribers or others interested in the newsletter

August 25, 2006 Value Investor Insight