The Superinvestors Issue

Value-oriented Equity Investment Ideas for Sophisticated Investors
A Monthly Publication of BeyondProxy LLC  Subscribe at manualofideas.com

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

Investing In The Tradition of
Graham, Buffett, Klarman

THE SUPERINVESTOR ISSUE
Year IV, Volume IX
September 1, 2011

When asked how he became so
successful, Buffett answered: ► Screening for bargains owned by superinvestors
“We read hundreds and hundreds
of annual reports every year.” ► Latest holdings of 50+ top investors
Top Ideas In This Report ► 20 companies profiled by MOI research team

Brookfield Residential
► Proprietary selection of Top 3 candidates for investment
(NYSE: BRP) ……………………. 90
► Plus: Exclusive interview with Lisa Rapuano
Microsoft
(NYSE: MSFT) …………………. 138 ► Plus: The Manual of Ideas Model Portfolios NEW!
Sealy ► Plus: Favorite stock screens for value investors
(NYSE: ZZ) ……………………… 154

Also Inside Superinvestor companies mentioned in this issue include
3M, ABB, Abbott Labs, Accenture, AIG, Altria Group, Amazon.com,
Editor’s Commentary ……………….. 5
American Express, Amgen, Anadarko Petroleum, Anheuser-Busch, Apache,
MOI Model Portfolios ………………. 8
Apple, AstraZeneca, AT&T, Baidu.com, Banco Santander, Bank of America,
Interview with Lisa Rapuano ……... 10 Barrick Gold, Berkshire Hathaway, BP, Bristol Myers Squibb,
Portfolios with Signal Value™ …… 18 Brookfield Asset Management, Brookfield Residential Properties,
Screening for Superinvestor Stocks.. 76 Canadian Natural, Caterpillar, Cemex, Cisco Systems, Citigroup, Coca-Cola,
20 Superinvestor Holdings ……….. 86 Colgate Palmolive, Comcast, ConocoPhillips, Costco Wholesale,
Favorite Value Screens ……………166 CVS Caremark, Diageo, DIRECTV, Dollar General, eBay, Eli Lilly, EMC,
Emerson Electric, Enterprise Products, Exxon Mobil, Female Health,
This Month’s Top Web Links …….. 175
Flextronics, Freeport-McMoRan, Fresh Market, General Electric,
About The Manual of Ideas General Motors, GlaxoSmithKline, Goldman Sachs, Google, Halliburton,
Hewlett-Packard, Home Depot, HomeAway, Huntington Ingalls Industries,
Our goal is to bring you investment IBM, Intel, Interval Leisure, INTL FCStone, Johnson & Johnson,
ideas that are compelling on the
basis of value versus price. In our
JPMorgan Chase, Kraft Foods, Loews Corporation, MakeMyTrip,
quest for value, we analyze the top MasterCard, McDonald’s, Medtronic, Merck, MetLife, Microsoft, Microsoft,
holdings of top fund managers. We Occidental Petroleum, Oracle, Owens Illinois, PepsiCo, Petroleo Brasileiro,
also use a proprietary methodology
to identify stocks that are not widely Pfizer, Philip Morris, Potash, Procter & Gamble, Qualcomm,
followed by institutional investors. Rockwell Collins, Royal Dutch Shell, Sanofi-Aventis, Santander Brasil,
Our research team has extensive Sara Lee, Schlumberger, Sealy Corporation, Suncor Energy,
experience in industry and security Syneron Medical, Target, Telefonica, Teva Pharma, TOTAL, U.S. Bancorp,
analysis, equity valuation, and
investment management. We bring a Union Pacific, UnitedHealth, UPS, Valero Energy, Verizon, Visa, Vodafone,
“buy side” mindset to the idea Walgreen, Wal-Mart, Walt Disney, Wells Fargo, and more.
generation process, cutting across
industries and market capitalization
ranges in our search for compelling (analyzed companies are underlined)
equity investment opportunities.

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

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Table of Contents
EDITORIAL COMMENTARY ......................................................................... 5

THE MANUAL OF IDEAS MODEL PORTFOLIOS........................................ 8

EXCLUSIVE INTERVIEW WITH LISA RAPUANO ...................................... 10

50+ PORTFOLIOS WITH SIGNAL VALUE™ .............................................. 18
AKRE CAPITAL (CHUCK AKRE) ................................................................................................... 19
ALTAI CAPITAL (TOBY SYMONDS)............................................................................................... 20
ANCIENT ART / TETON (QUINCY LEE) ......................................................................................... 21
APPALOOSA (DAVID TEPPER) .................................................................................................... 22
ATLANTIC INVESTMENT (ALEXANDER ROEPERS) ......................................................................... 23
BARES CAPITAL (BRIAN BARES)................................................................................................. 24
BAUPOST (SETH KLARMAN) ....................................................................................................... 25
BERKSHIRE HATHAWAY (WARREN BUFFETT) .............................................................................. 26
BLUE RIDGE (JOHN GRIFFIN) ..................................................................................................... 27
BP CAPITAL (BOONE PICKENS) .................................................................................................. 28
BRAVE WARRIOR (GLENN GREENBERG) .................................................................................... 29
BREEDEN CAPITAL (RICHARD BREEDEN) .................................................................................... 30
CENTAUR VALUE (ZEKE ASHTON) .............................................................................................. 31
CENTERBRIDGE (JEFFREY ARONSON AND MARK GALLOGLY) ...................................................... 32
CHILDREN’S INVESTMENT (CHRIS HOHN) ................................................................................... 33
CHOU ASSOCIATES (FRANCIS CHOU) ......................................................................................... 34
EAGLE CAPITAL (BOYKIN CURRY) .............................................................................................. 35
EAGLE VALUE (MERYL WITMER) ................................................................................................ 36
EDINBURGH PARTNERS (SANDY NAIRN) ..................................................................................... 37
ESL INVESTMENTS (EDDIE LAMPERT) ........................................................................................ 38
FAIRFAX (PREM WATSA)............................................................................................................ 39
FAIRHOLME (BRUCE BERKOWITZ) .............................................................................................. 40
FORCE CAPITAL (ROBERT JAFFE) .............................................................................................. 41
GATES CAPITAL (JEFF GATES)................................................................................................... 42
GLENVIEW (LARRY ROBBINS) .................................................................................................... 43
GOLDENTREE (STEVE TANANBAUM) .......................................................................................... 44
GREENHAVEN (ED WACHENHEIM) .............................................................................................. 45
GREENLIGHT (DAVID EINHORN) ................................................................................................. 46
H PARTNERS (REHAN JAFFER) .................................................................................................. 47
HARBINGER (PHIL FALCONE) ..................................................................................................... 48
HAWKSHAW (KIAN GHAZI) ......................................................................................................... 49
HOUND PARTNERS (JONATHAN AUERBACH) ............................................................................... 50
ICAHN ENTITIES (CARL ICAHN) ................................................................................................... 51
INTERNATIONAL VALUE ADVISERS (CHARLES DE VAULX) ............................................................ 52
JOHO CAPITAL (ROBERT KARR) ................................................................................................. 53
LANE FIVE (LISA RAPUANO) ....................................................................................................... 54
LEUCADIA (IAN CUMMING AND JOE STEINBERG) ......................................................................... 55
LONE PINE (STEVE MANDEL) ..................................................................................................... 56
MARKEL GAYNER (TOM GAYNER) .............................................................................................. 57
MHR (MARK RACHESKY) .......................................................................................................... 58
MSD CAPITAL (GLENN FUHRMAN AND JOHN PHELAN) ................................................................ 59
PABRAI FUNDS (MOHNISH PABRAI) ............................................................................................ 60
PAULSON & CO. (JOHN PAULSON) ............................................................................................. 61
PENNANT (ALAN FOURNIER) ...................................................................................................... 62
PERSHING SQUARE (BILL ACKMAN) ........................................................................................... 63

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SAGEVIEW (ED GILHULY AND SCOTT STUART) ........................................................................... 64
SCOUT (JAMES CRICHTON)........................................................................................................ 65
SECOND CURVE (TOM BROWN) ................................................................................................. 66
SOUTHEASTERN (MASON HAWKINS) .......................................................................................... 67
SPENCER (KEN SHUBIN STEIN) .................................................................................................. 68
THIRD POINT (DAN LOEB) .......................................................................................................... 69
TIGER GLOBAL (CHASE COLEMAN) ............................................................................................ 70
VALUEACT (JEFFREY UBBEN) .................................................................................................... 71
WEITZ FUNDS (WALLY WEITZ) ................................................................................................... 72
WEST COAST (LANCE HELFERT AND PAUL ORFALEA) ................................................................. 73
WINTERGREEN (DAVID WINTERS) .............................................................................................. 74
WL ROSS & CO. (WILBUR ROSS)............................................................................................... 75

SCREENING 900+ HOLDINGS OF 50+ SUPERINVESTORS .................... 76
TOP 100, BY MARKET VALUE ..................................................................................................... 76
TOP 100, BY THIS FY P/E (CONSENSUS ESTIMATES) .................................................................. 78
TOP 100, BY NEXT FY P/E (CONSENSUS ESTIMATES) ................................................................. 80
TOP 100, BY TRAILING GROSS PROFIT TO ENTERPRISE VALUE ................................................... 82
TOP 100, BY TANGIBLE BOOK VALUE TO MARKET VALUE ............................................................ 84

PROFILING 20 SUPERINVESTOR HOLDINGS ......................................... 86
BP (BP) – BAUPOST , BP CAPITAL , CHOU , GREENLIGHT , THIRD POINT  .............. 86
BROOKFIELD RESIDENTIAL (BRP) – MARKEL , PABRAI  .................................................. 90
CEMEX (CX) – SOUTHEASTERN  ............................................................................................. 94
DOLLAR GENERAL (DG) – BRK , LONE PINE , PENNANT  ................................................ 98
FEMALE HEALTH (FHCO) – BARES  ..................................................................................... 102
FLEXTRONICS (FLEX) – GLENVIEW  ..................................................................................... 106
FRESH MARKET (TFM) – SCOUT  ...................................................................................... 110
HOMEAWAY (AWAY) – TIGER GLOBAL  ............................................................................. 114
HUNTINGTON INGALLS (HII) – GREENLIGHT  ....................................................................... 118
INTERVAL LEISURE (IILG) – BARES , GATES , WEITZ  ...................................................... 122
INTL FCSTONE (INTL) – BARES , LEUCADIA  ..................................................................... 126
LOEWS (L) – EAGLE , SOUTHEASTERN  .............................................................................. 130
MAKEMYTRIP (MMYT) – TIGER GLOBAL  ............................................................................. 134
MICROSOFT (MSFT) –BAUPOST , EDINBURGH , GREENLIGHT , IVA , MARKEL  … ..... 138
OWENS ILLINOIS (OI) – ATLANTIC INVESTMENT  .................................................................... 142
ROCKWELL COLLINS (COL) – GREENHAVEN , PENNANT , VALUEACT  ........................... 146
SARA LEE (SLE) – THIRD POINT , VALUEACT .................................................................... 150
SEALY (ZZ) – H PARTNERS  ................................................................................................. 154
SYNERON (ELOS) – BAUPOST ............................................................................................. 158
VALERO ENERGY (VLO) – APPALOOSA , PENNANT  ............................................................ 162

FAVORITE SCREENS FOR VALUE INVESTORS.................................... 166
“MAGIC FORMULA,” BASED ON TRAILING OPERATING INCOME ................................................... 166
“MAGIC FORMULA,” BASED ON THIS YEAR’S EPS ESTIMATES ................................................... 167
“MAGIC FORMULA,” BASED ON NEXT YEAR’S EPS ESTIMATES .................................................. 168
CONTRARIAN: BIGGEST YTD LOSERS (DELEVERAGED & PROFITABLE)....................................... 169
VALUE WITH CATALYST: CHEAP REPURCHASERS OF STOCK ..................................................... 170
PROFITABLE DIVIDEND PAYORS WITH DECENT BALANCE SHEETS ............................................. 171
DEEP VALUE: LOTS OF REVENUE, LOW ENTERPRISE VALUE ..................................................... 172
DEEP VALUE: NEGLECTED GROSS PROFITEERS ....................................................................... 173
ACTIVIST TARGETS: POTENTIAL SALES, LIQUIDATIONS OR RECAPS ........................................... 174

THIS MONTH’S TOP 10 WEB LINKS ....................................................... 175



Editorial Commentary
The recent market turmoil carries with it echoes of 2008, but relying too heavily on
analogies from the last market panic seems misguided. Europe and the U.S. must
address serious sovereign debt issues, but the financial system itself appears less
vulnerable than in late 2008.
There is now no doubt that Bernanke’s Fed will do everything in its power to
alleviate the pain of market participants. The Fed is doing many foolish things and
distorting capital allocation decisions, but one thing is clear: Given the central bank’s
ability to print dollars, repayment of U.S. government debt in nominal terms is not in
doubt. Neither is the Fed’s ability to flood the financial system with cheap liquidity.
While we are sympathetic to the cautious views of superinvestors like George
Soros and Seth Klarman, we are equally sympathetic to the view that preferring an
asset that is easily printed in unlimited quantities is foolish. Holding cash has little
appeal to us following the recent market decline. We would much rather own cheap
blue-chip corporations such as Cisco Systems (CSCO), Dell (DELL), Goldman
Sachs (GS), Hewlett-Packard (HPQ), Microsoft (MSFT), Pfizer (PFE), and Sony
(SNE), to name a few. HP’s Leo Apotheker deserves much criticism for his recent
boneheaded allocation of capital (e.g., buying Autonomy instead of HP stock), but
this does not mean investors should miss out on the capital appreciation HP shares
will likely deliver over several years. Never let anger get in the way of profits.
Researching this superinvestor issue has been quite exciting for us because most
recent superinvestor buys have traded down materially on little or no news. For those
who are not paralyzed by macro concerns, this presents an opportunity to scrutinize
investments favored by some of the smartest value investors around — and to buy at
a discount. Probabilistically speaking, this doesn’t sound like a losing proposition.

We find the following three superinvestor holdings particularly noteworthy:

Brookfield Residential (NYSE: BRP, $7.60 per share; MV $750 million)
$16

$14

$12

$10

$8

$6

$4

$2

$0
Aug 11

Brookfield Residential Properties was formed via the March 31st merger of
Brookfield Homes and the land and housing division of Brookfield Properties.
BRP provides an opportunity to invest in the North American residential
housing market at a below-book quotation and in partnership with Brookfield Asset
Management, a highly regarded Canadian manager of real assets.



While BRP carries no current payout, the company appears likely to grow book
value at a respectable rate. BRP controls more than 100,000 residential lots and has
dominant market positions in Western Canada. For example, one in five Calgary
residents live in a Brookfield community. BRP sold a total of 4,000 lots and homes
in 2010, with the potential to accelerate sales in a recovering real estate market.
The relatively strong balance sheet should allow Brookfield to acquire assets
opportunistically on favorable terms, particularly in selected U.S. markets.
Following the formation of BRP at the end of Q1, superinvestors Tom Gayner of
Markel and Mohnish Pabrai established small positions in the company. While
Pabrai’s stake likely originated from his existing position in Brookfield Properties
(BPO), we believe BRP’s fundamentals and recent market quotation may warrant
additional superinvestor interest going forward.

Microsoft (Nasdaq: MSFT, $25 per share; MV $210 billion)
$40

$35

$30

$25

$20

$15

$10

$5

$0
Aug 02 Aug 03 Aug 04 Aug 05 Aug 06 Aug 07 Aug 08 Aug 09 Aug 10 Jul 11

At the risk of inviting criticism for bringing you an idea of which you are
undoubtedly already aware, we once again highlight software giant Microsoft. The
shares continue to trade in the mid-$20s despite steady increases in revenue, profits,
and free cash flow. To grasp just how stark the change in the market’s judgment of
Microsoft has been over the past decade, consider that the share price has fluctuated
around $25 per share while net income has increased from $8 billion to $23 billion
and the share count has declined from 11.1 billion to 8.5 billion. (This reminds us a
bit of the picture of Lab Corp. that Zeke Ashton painted at the recent Nexus 2011
value investing conference.)
At $25 per share, Microsoft trades at 8.7x consensus EPS of $2.87 for the fiscal
year ending June 30, 2012, and 7.9x consensus EPS of $3.16 for FY13. These
multiples ignore the fact that, as of June 30th, Microsoft had $32 billion (~$3.75 per
share) of net cash, not counting $11 billion in long-term investments and $8.5 billion
for Skype. Adjusting for post-Skype net cash, Microsoft trades at an estimated 7.4x
FY12 and 6.7x FY13 EPS. But the story doesn’t end there: The Online Services
Division, which includes Bing and MSN, lost $2.6 billion pretax in FY11. Assigning
a value of zero to this Division while also excluding an estimated $2 billion loss
from consensus earnings estimates, Microsoft shares trade at roughly 6.8x FY12 EPS
and 6.3x FY13 EPS. In addition, Skype has the potential to “move the needle” over
time due to its 170 million-strong global user base. Finally, we note that Microsoft’s
Xbox assets appear to have under-earned relative to their potential.
Given these valuation metrics and Microsoft’s enviable business model, it is
hardly surprising that the company is widely owned by the superinvestors we track.
In fact, it is the top holding of superinvestors as a group. Most noteworthy, Seth



Klarman established a new position of 12 million shares in Q2, while David Einhorn
boosted Greenlight’s stake from 9 million shares in Q1 to 15 million shares in Q2.

Sealy (NYSE: ZZ, $1.70 per share; MV $165 million)
$20

$18

$16

$14

$12

$10

$8

$6

$4

$2

$0
Aug 06 Aug 07 Aug 08 Aug 09 Aug 10 Jul 11

Sealy has led the U.S. mattress market for a long time (19% market share in
2010). The company generated $1.2 billion in sales last year, almost 10% more than
competitor Tempur-Pedic (TPX). Meanwhile, Sealy’s enterprise value totals less
than $900 million, compared to $4.0 billion for TPX. The high financial leverage of
Sealy suggests that capital structure changes are likely, and management expects
certain notes to convert into equity in 2012. Following the dilutive event, Sealy
should end up with a manageable capital structure while retaining equity upside.
Distressed investor H Partners has been a recent buyer of Sealy common stock.
While other investors have generally shunned the equity in favor of the debt, we find
the equity interesting for aggressive investors focused on risk-reward rather than
strictly on downside protection.
Sealy’s recent operating performance has been masked by one-time items,
including $13 million in product launch expenses in 1H11. The new Posturepedic
line appears to be meeting management’s rollout expectations.
Sealy as an enterprise is here to stay, and the equity deserves a closer look.


We are pleased to bring you an exclusive interview with Lisa Rapuano of Lane
Five Capital Management. Lisa is one of the superinvestors we track on a regular
basis. She first gained recognition in the investment community for the work she did
at Legg Mason while working with Bill Miller. At Lane Five, she has carved out her
own path, investing in misunderstood yet strong business at attractive prices. We’re
sure you’ll enjoy Lisa’s insights and opinions.

Sincerely,

John Mihaljevic, CFA
and The Manual of Ideas research team



The Manual of Ideas Model Portfolios

We are pleased to inaugurate a model portfolio consisting of the following three
sub-portfolios:
 Downside Protection Model Portfolio: Undervalued equities that, in
our judgment, offer strong downside protection and material upside
 Deep Value Model Portfolio: Equities that are deeply undervalued on
an asset basis, but may have downside risk due to financial leverage
 Magic Formula Model Portfolio: Equities that meet Joel Greenblatt’s
dual criteria: high returns on capital employed, and high earnings yield

Since launching The Manual of Ideas in 2008, our goal has been to add value to
your idea generation process by bringing you compelling equity investment
ideas in a format that enables you to quickly sift through a fairly large number of
companies meeting certain value-oriented criteria.
In the January 2011 issue, we evaluated the price performance of the ideas
highlighted by our team in each monthly issue. We found that those top monthly
ideas had materially outperformed the S&P 500 Index. However, in order to
make our idea generation process more valuable, we felt we needed a way to
provide you with a more consistent view into our best ideas at any given time.
This has led us to the creation of The Manual of Ideas Model Portfolios.
The model portfolios will enable you to track our favorite investments in
three broad categories. We will track the performance of those ideas in real time
on the Internet, enabling you to consume this information in a manner that suits
your investment needs and preferences.
In the inaugural portfolios shown on the following page, we establish initial
positions in twenty securities profiled in past issues of The Manual of Ideas. For
illustrative purposes, we start with a portfolio of $1 million, choosing to allocate
this fictional capital equally across the twenty companies.
As the model portfolios evolve over time, we may make greater allocations
to certain securities or keep a portion of the model portfolios in “cash.”

Please note that the model portfolios are not buy and sell recommendations. As
always, you are solely responsible for your investment decisions. Persons or
entities affiliated with The Manual of Ideas and BeyondProxy LLC, our
publisher, may buy or sell any securities shown in the model portfolios. We will
not inform you of such trades, and we will not necessarily update our thesis on
the securities contained in the model portfolios. For more information and
disclosures, see our Terms of Use at http://manualofideas.com/terms.html



THE MANUAL OF IDEAS MODEL PORTFOLIOS
Latest % Move to Model Portfolio
Share 52-Week “Entry Information”
Price Low High Date Price Allocation Comments

Downside Protection Model Portfolio
GigaMedia GIGM $0.92 -2 143 8/24 $0.92 $50,000 Trades at fraction of book, with large cash position; buying back stock
Gravity GRVY $1.51 -17 45 8/24 $1.51 $50,000 Trades below cash; profitable, with major game (RO2) expected in 1Q12
K-Swiss KSWS $5.06 -3 161 8/24 $5.06 $50,000 Trades in line with tangible book, with net cash and capable, friendly CEO
Sony SNE $20.41 -1 81 8/24 $20.41 $50,000 Major Japanese exporter with >$80 billion of revenue and strong franchises
$200,000

Deep Value Model Portfolio
Arbor Realty ABR $4.01 -11 87 8/24 $4.01 $50,000 Steep discount to adjusted book; buying back stock; Cooperman buying
Crimson Exploration CXPO $2.41 -17 96 8/24 $2.41 $50,000 Strong asset value, with natural gas price leverage; Oaktree owns 34%
Torm TRMD $1.99 0 302 8/24 $1.99 $50,000 Beaten-down shipping company; $100 million rights offering a positive
Harvest Natural HNR $9.76 -34 79 8/24 $9.76 $50,000 Strong Venezuela assets; recent U.S. asset sale; exploration upside
MEMC WFR $6.80 -27 121 8/24 $6.80 $50,000 Plays across solar value chain; trades at steep discount to tangible book
Nokia NOK $6.06 -20 94 8/24 $6.06 $50,000 ~$9 billion net cash; strong global distribution, patents, MSFT partnership
Penson PNSN $2.08 -16 256 8/24 $2.08 $50,000 Steep discount to book; problems look transitory; insiders own 18%
Thomas Properties TPGI $2.70 -26 70 8/24 $2.70 $50,000 Mgmt incentivized to create value; steep discount to sum-of-parts value
$400,000

Magic Formula Model Portfolio
Aeropostale ARO $11.28 -8 146 8/24 $11.28 $50,000 Teen retailer missed fashion cycle; high-return business, capable mgmt
Cisco CSCO $15.46 -14 59 8/24 $15.46 $50,000 Leader in growing data networking market, with net cash, strong FCF
Corinthian COCO $1.90 -17 287 8/24 $1.90 $50,000 Value of Heald alone may exceed recent EV; regulatory risks overblown?
Dell DELL $14.68 -23 20 8/24 $14.68 $50,000 Michael Dell focused on the right things: profitability, FCF, equity value
SanDisk SNDK $34.92 -8 53 8/24 $34.92 $50,000 Digital data storage company; consensus EPS estimate of $4.63 for 2012
Lender Processing LPS $16.23 -4 115 8/24 $16.23 $50,000 Profitable, not capital-intensive; cheap, but lacks downside protection
Microsoft MSFT $24.90 -6 18 8/24 $24.90 $50,000 Too cheap to ignore, esp. adjusted for cash and money-losing businesses
Net 1 UEPS $7.12 -15 98 8/24 $7.12 $50,000 High-ROIC, recurring-revenue processor, with incentivized CEO, catalyst
$400,000

The Manual of Ideas Model Portfolios – Grand Total $1,000,000

Access The Manual of Ideas Model Portfolios in Real Time!
Visit our Exclusive Members Area at

http://members.manualofideas.com



Exclusive Interview with Lisa Rapuano
We recently had the pleasure of interviewing one of the superinvestors we track,
Lisa Rapuano of Lane Five Capital Management.

The Manual of Ideas: Tell us about the genesis of Lane Five. What goals did
you have at the outset, and what principles have guided you since then?
Lisa Rapuano: At the end of 2006, I sat down with a blank sheet of paper to
design a firm and product I thought would do three things: (i) optimize the skills
I had learned in my fifteen years (at the time) of managing money; (ii) create a
vibrant workplace of smart, energetic people with shared values; and (iii) attract
clients with a long-term focus and a deep understanding of our values and
process.
To optimize my own skills, I looked at my experiences, my temperament,
what I had loved to do and what I had not. I love and am good at picking apart
companies, finding and evaluating contrarian ideas, gaining deep conviction
from thorough research, looking at businesses with a long-term view, ignoring
short-term noise, getting to know managements and companies exceedingly
well, and working collaboratively with a small team. I’m very patient in my
investments. So, Lane Five was designed to invest in a relatively small number
of names with a three-to-five-year time horizon with no constraints on market
cap or stylistic definitions of value.
We adopted a long-biased approach, where we run 60-100% long. We can
hold tons of cash and/or short if we think the opportunities merit that approach,
but we’re not running a hedged, volatility constrained portfolio. I think that
shorting is appropriate in certain circumstances and the ability to short makes
you a better analyst. When I co-managed a traditional long/short low exposure
fund at Matador Capital Management, I learned a lot about shorting. I am very
“To have a large short book good at identifying bad businesses and high valuations, and if you are patient
and manage risk, you must with those two characteristics in place, shorting can be a low-risk, value-added
have many more positions activity. However, if you are running a very long-term value portfolio on the
and you have to be very long side, a traditional hedge portfolio is often largely mismatched with your
sensitive to timing. This type long book and mismatched with your analytical resources. To have a large short
of thinking is not the mirror book and manage risk, you must have many more positions and you have to be
very sensitive to timing. This type of thinking is not the mirror image of the long
image of the long investment
investment process; it is actually counter to it. I found one could spend an
process; it is actually counter
inordinate amount of time on hedge shorts, add very little value and create a
to it. I found one could spend
massive diversion of resources. So, when I decided to create something new, I
an inordinate amount of time
decided shorting would be a limited part of the strategy and exposure would run
on hedge shorts, add very predominately long.
little value and create a
massive diversion of Once I settled on the investment vehicle, I decided to have an innovative fee
resources.” structure as well. Given the long bias, I did not think it appropriate to charge full
hedge fund fees. However, given the specialty, boutique nature of the firm and
the desire to have a small, cohesive team with a go anywhere approach, I
decided the long-only market structure and fees also weren’t appropriate. I
settled on a hybrid approach with a 1.5% management fee and a performance fee
of 20%, charged only on positive returns above the S&P 1500 [includes all
stocks in S&P 500, S&P 400 and S&P 600]. Initially, I deferred the performance
fees for three years in exchange for a three-year lock-up. After the first three-


year period expired, I elected to move to a one-year fee, still with the hurdle
rates of both zero and the market, and a traditional high-water mark as well. This
is a specialty fund with an appeal to a certain type of client. Since it is a hybrid,
it doesn’t fit into a lot of institutions’ pre-defined “buckets”. I decided I didn’t
need to compound the problem further by asking for a three-year lock-up in the
market we’re in today. We’ve been very fortunate to find clients who understand
and appreciate the approach.
After nearly five years, we remain as we set out to be. There are three of us
on the investing team, and we have an operating person to handle all the non-
investment related issues and a part-time marketing person to handle all the
“…the value of a company is outreach and communications, though I also am very involved in that. We have
the present value of its future about $125 million in AUM and will limit that based on keeping our team small,
free cash flow. This is a collaborative and cohesive. I’m not sure what that limited AUM number is, but
concept that goes all the way it’s probably somewhere between where we are now and $1 billion. We have
back to the first dividend lots of room to grow and compound without changing what we do.
discount model developed by We set out a list of Core Values when launched, which I have found very
John Burr Williams in 1938.” helpful in guiding my decisions about the firm over the years.

Lane Five Core Values:
• Invest with integrity
• Strive for excellence in all areas
• Work with brilliant people
• Adapt and evolve actively
• Learn and read widely
• Collaborate with each other and with clients
• Be authentic, trustworthy and open

MOI: How would you describe the investment philosophy you adopted while
working with Bill Miller at Legg? How has your approach evolved since then?
Rapuano: One of the great things about working for Bill all through the 1990s
was we got to define and refine the process together. So, I came into working for
this brilliant guy in the early 1990s and I learned a ton from just analyzing
companies for him. In the mid 1990s, when I started doing technology stocks,
and then AOL in 1996, we were all learning and adapting what were then “new”
ideas of behavioral economics, Economic Value Added and ROIC concepts and
things like that. Standards of practice in process have gotten much more
sophisticated since then, but at the time we were, I think, way ahead of our time.
The core things I learned from Bill and from formalizing our process at
Legg Mason back in the day haven’t changed. One is the value of a company is
the present value of its future free cash flow. This is a concept that goes all the
way back to the first dividend discount model developed by John Burr Williams
in 1938. I find most people are still afraid of using discounted cash flow because
there are so many sensitivities in the assumptions, but you really can’t dismiss
the use of DCF if you use any sort of discount rate or earnings multiple



approach. It’s the same thing! But, somehow people think slapping a multiple on
something is a less fuzzy approach. You have to choose the right multiple, and
that’s all a DCF process does, help you disaggregate the elements of existing
earnings power, growth, sustainability, and risk to determine the right multiple
for this particular business.
Another element I learned from Bill is that since 100% of the value of a
company is in the future, you simply cannot refuse to think about the future. So,
a very intensive analysis of a business, its competitive advantage and its likely
future path is another key element. I think this is something people associate
strongly with Bill (and with a lesser extent me) because we have both owned
these stellar growth companies and felt very comfortable that they were
undervalued at points in time. This was simply because we understood that you
had to look forward, and that it is logically more likely that something is
undervalued because the market and investors misperceive the potential of a
“Valuing something is easy if new business model as it is that they misperceive the value of assets that have an
you know how much cash analyzable record of producing earnings and cash flow.
flow it will generate, how
much capital is required to I developed a financial model at Legg that I still use, at least the core of it.
It’s evolved fairly dramatically, (anyone who worked for me back then will be
generate that cash flow and
shocked to know it involves color now!) but it is designed to be a tool that
how long the cash flow
allows you to understand how a business works and how to look at the value of
stream will persist. Of
the company in a variety of different ways. At Legg we called it determining the
course, determining those
“Central Tendency of Value” which is a great term because it acknowledges that
things is incredibly difficult value is different from “Target Price”, that using multiple valuation techniques
and can never be done with improves your likelihood of being correct, and that there are a variety of
certainty.” scenarios one has to consider to understand what a company is worth. I use these
same ideas, and I am always open to and striving for a new and interesting and
hopefully more accurate way to think about valuing an asset.
I saved the two most important things I learned from Bill for last. You must
strive to learn and to actively adapt your tactics, and you must “know yourself”
to understand how to obtain an advantage in the incredibly competitive business.
MOI: A core objective of Lane Five is to “find significantly undervalued
companies and invest in them long-term.” What are the key factors you consider
when appraising a business, and how much weight do you place on growth?
Rapuano: Valuing something is easy if you know how much cash flow it will
generate, how much capital is required to generate that cash flow and how long
the cash flow stream will persist. Of course, determining those things is
incredibly difficult and can never be done with certainty.
We use a variety of approaches, always with a focus on the three elements
above. It always starts with business analysis – what sort of business is this?
What returns has it earned in the past, how has it grown, why might it be
mispriced today, and can we reasonably assess a range of value in which we
have confidence?
Once we have an idea of the sort of business model we’re working with,
and if we think there is a decent chance it is quite undervalued and we can figure
it out, we’ll start looking in depth at the financials. We go through a typical
exercise in securities analysis, understanding the elements of the past in order to
better predict what the future may hold. You learn a lot about a company just



putting the numbers together, disaggregating the sources of profit in the past and
understanding the assets and what cash these assets have thrown off.
Almost all companies in which we are looking to invest are in the midst of
some controversy or setback that is giving us a price opportunity. We’ll look to
the past to come up with a base of earnings power and cash flow generation that
we think is more “normal”. Ideally, we can purchase something at the value of
the depressed cash flow stream should it never grow again, thus allowing us to
profit from the normalization of earnings and the potential future growth.
With a firm view of the business model, we go into a lot of nuts and bolts of
the process, attempting to estimate the most likely future of the company. We
run lots of scenarios of what may happen, and we’ll value the company under all
these various scenarios using all tools we think are appropriate, including DCF,
private transaction comparisons, break-up values, and any multiples-based
approach that is suitable. We spend a lot of time on our most-likely outcome
case, but we also try to think through the value under a variety of other potential
“Almost all companies in
circumstances. This gives us a couple of great tools. First, it allows us to
which we are looking to
understand the range of possible outcomes for one company versus another.
invest are in the midst of
Some companies have a fairly tight range, others are incredibly wide. Second, it
some controversy or setback gives us an ability to differentiate between ideas that appear to have the same
that is giving us a price base-case undervaluation. I’d rather own something I feel very confident trades
opportunity… Ideally, we can 50% below its value and has the potential to be 100%, even if that potential is a
purchase something at the rather small probability, than something that is just 50% and that’s it.
value of the depressed cash
flow stream should it never This process is inherently probabilistic. We assign probabilities to scenarios
based on common sense, but we don’t honestly know the exact probability. It is
grow again, thus allowing us
our hope that by at least thinking through these outcomes we might recognize
to profit from the
when they start to occur, thus helping us understand when we’re wrong about
normalization of earnings
something (so, a low probability negative scenario starts to look more likely) or
and the potential future
when we’ve been too conservative and to manage our position size accordingly.
growth.”
You ask specifically how much weight we put on growth. We don’t
consciously go out and look for growth, instead we look for situations where
what is discounted in the price is significantly below what is most likely to
happen. In some cases, we find things that are undervalued because the market
doesn’t understand a growth opportunity. In others, we find things that are
undervalued even if they never grow again. Growth has a lot of value, and we
try to recognize that, but we understand that the further out into the future you
have to look to realize value, the more discount you might need to make the
investment make sense.
MOI: How do you judge whether managements have shareholder interests at
heart? Do you need the CEO to own a lot of stock?
Rapuano: You can learn a lot about managements by not talking to them until
you’ve analyzed the financials. Managements who truly understand shareholder
value usually have been successful in creating it over time, whether they say all
the right things or not. One of the absolute worst CEOs I ever knew, who shall
remain nameless, talked about ROIC and free cash flow and shareholder
friendliness extremely well, but when you looked at his record the company
rarely earned its cost of capital, had made stupid, expensive value-destroying
acquisitions, had a terrible rubber stamp board of directors and had
compensation packages that enriched him and his minions whether they did a



good job or not. But, if you met the CEO in person he made you feel good about
their processes. So, what I’m saying is judge a management by what they do, not
by what they say. Good returns, smart capital allocation and sensible, goal-
oriented compensation are the cornerstones.
There are some basic common sense things we do like to see. We like
companies that buy back stock when it is low and don’t when it is high, or that
pay out special dividends when the cash is not deployable for a good return. We
like companies that eschew acquisitions or store openings or other capital
deployments when they think the price is too high. We like companies that set
strong goals in bonus plans and then stick to not paying out those bonuses if
they don’t hit the targets. We like companies that show a sense of frugality and
cost consciousness as a business owner would. We analyze the boards pretty
aggressively, to see if they are cronies or are qualified or have been part of not-
so-great companies in the past.
We find that it is not a necessary condition for a CEO to own a lot of stock,
“You can learn a lot about but that in many companies that have the types of behaviors I’ve just described,
managements by not talking there is management ownership of stock throughout.
to them until you’ve analyzed We do talk to managements; we just try to have a quantification of their
the financials. …judge a actual record before we do so. Once you do talk to them, it’s pretty easy to spot
management by what they do, the ones that simply don’t get it. These are the guys that talk about their stock
not by what they say. Good price, or the sell side, or the shorts, or that seem to always be doing what they
returns, smart capital think Wall Street wants them to do. Those kinds of managements may have
allocation and sensible, goal- good records, but you can be sure it’s just because they’re lucky.
oriented compensation are
MOI: How do you generate investment ideas?
the cornerstones.”
Rapuano: Idea generation is fairly idiosyncratic, frankly. We run screens of
high-return, low-multiple names (the so-called Magic Formula) and of low-
multiple names and of things that have recently moved down in price
aggressively. My favorite screen is the New Low list – at least it tells me what is
truly out of favor. From there, it’s a fairly labor-intensive process of going
through the names and seeing if any of them look like they would be down for
temporary reasons and that there are decent business models on the other side of
what is causing the controversy. More often than not, we come up with ideas
from much more random sources than screens: magazine articles, talking with
other managers, randomly typing the wrong ticker in Bloomberg, sell-side
downgrades that might signal capitulation, looking at spin-offs or
recapitalizations, tracking management changes and turnarounds. In my
experience, the nice neat little funnel of screening to portfolio doesn’t really
work. Undervalued things are sometimes hiding under expensive-looking or
very complicated rocks.
MOI: In investing, good ideas are only one piece of the success equation.
Skilled portfolio management is indispensable. You have said in the past that a
portfolio should consist of positions with a range of different risk-reward
profiles. What are the main challenges you face in constructing such a portfolio?
Rapuano: The main challenge is that risk is not quantifiable. Using the
probability-based framework I described earlier, I try to make descriptive
differentiation between one opportunity and another, and to make sure the
portfolio has a representation of many differently described positions. When I
say descriptive differentiation, I mean a narrative that I associate with a certain


name that helps me recall the range of possible outcomes, the confidence we
have in our base case, the external factors that could make us wrong, and the
amount of control a company really has on its own destiny. So, control and
external factors are big parts of companies with high levels of cyclicality.
Ranges of outcomes may be associated with this cyclicality and therefore I want
to have a limit on holdings that are correlated with the same cyclical factors.
External factors could also be non-cyclical – like regulation or Medicare
reimbursement rates or oil prices or farm subsidies.
We do try to diversify in ways that ensure we are not counting on one
economic trend to make our companies realize value, or are not taking too much
exposure to a particular external factor. This sometimes has the effect of giving
us sector diversification but we try to take that thinking to another level. The
possible range of outcomes is a little trickier. Some businesses are very
understandable and our investment thesis is often not that complicated for these
types of businesses. Similarly, the things that could go very wrong are fewer.
“One has to be careful in a But, in these types of situations you also rarely have the outlier probability of a
situation like [the financial very large return. So, we own things with this type of profile. We also own
crisis of 2008] to distinguish things with much wider ranges of outcomes. These are what we consider riskier
outcome from process. If the names. They must have the potential for the outlier upside return because the
bad outcome was a result of uncertainty is usually higher and the range is usually wider. As uncertainty
a bad process, you should fix, abates, however, some of these distributions narrow and we end up with a
change and adapt. If the bad lower-risk holding.
outcome is a result of bad
Portfolio construction as a whole is a very difficult process, and it doesn’t
luck, but the process behind
get the attention it deserves.
decisions was solid, you
really can’t do much about MOI: How did the volatility experienced during the financial crisis of 2008
that.” affect your investment process, and have you tweaked your approach in any way
as a result of the experience?
Rapuano: At the end of 2008, I identified the drivers of what made us do
poorly, and which ones could be improved upon and which ones couldn’t. One
has to be careful in a situation like this to distinguish outcome from process. If
the bad outcome was a result of a bad process, you should fix, change and adapt.
If the bad outcome is a result of bad luck, but the process behind decisions was
solid, you really can’t do much about that. Unfortunately, 2008 had elements of
both for Lane Five.
First, I’ll tell you what we did not do. We did not decide to become more
macro-oriented. I believe that macro forecasting is impossible, and the best one
can do is try to understand what is actually happening around them, not forecast
it. I watched lots of value investors divert hours of time away from valuation
and stocks into macro speculation, and I did not and do not think that is
productive. Our philosophy has been to understand, and I did not change that. I
could have vastly improved my execution of that understanding in 2008, but that
is not a change in process, that’s just doing what you do better.
We did stress-test some of our valuation techniques and found that with our
long-term orientation we were too prone to “look through” things when they
started to deteriorate. We re-emphasized our commitment to using multiple
valuation tools, including ones more focused on two- and three-year time
horizons in addition to the five to ten-year models. We also recognized some big
behavioral errors in a few of our larger mistakes that we hopefully will not



repeat. The biggest one was overconfidence in a large position that honestly was
a good idea, but we positioned it like a great idea because of positive feedback
we received from almost everyone we talked to. My best ideas are never liked
by anyone when I am buying them, so this should have been a huge red flag.
I also got a little more careful on position sizes. I am not afraid to take a
large position and I think that when conviction is high and risk is low because of
valuation, large positions are important and warranted. But, I think in 2008 I
made the error of having larger positions because there was little else to buy. I
am now more careful about saving the very large positions for truly great
opportunities.
I’d like to make one more point about 2008. I don’t think any portfolio is
truly crisis-proof. The biggest mistake we made was not recognizing when the
markets moved from fear into panic. I have always bought fear and uncertainty –
this is one of the only ways to find mispricing – but there is a real difference
“When I embraced when you move into a state of panic. And even after and during that panic, it
Amazon.com, it was the most does turn out that buying into the fear was the right thing to do. You had to
reviled, hated, short-infested survive to buy, and you had to have cash to buy. To me, being ready to take
name in the world. It was advantage of that opportunity and to recognize the slide into panic were the
written up in Barron’s greatest lessons of the time.
negatively every single MOI: You famously embraced Amazon.com before it became a multi-bagger.
weekend for two years (thank What analysis led you to conclude that the company’s growth would not falter at
you, Mark Veverka.) People some point? Do you still scrutinize Internet firms, and if so, what is your opinion
thought it was going out of of companies such as LinkedIn, Groupon, Zynga and Facebook?
business.” Rapuano: When I embraced Amazon.com, it was the most reviled, hated, short-
infested name in the world. It was written up in Barron’s negatively every single
weekend for two years (thank you, Mark Veverka.) People thought it was going
out of business. People thought it was burning billions and billions in cash (it
wasn’t). People thought it would never make money.
I started buying it at $17 per share, and it went to $5.51, and I bought it all
the way down. I didn’t have to conclude that growth would not falter at some
point; I just had to believe there was a business there.
This was one of the most difficult investments I ever made, because it was
so obviously bad to so many smart people. I think Joel Greenblatt still talks
about how Amazon.com doesn’t have a competitive advantage, but when it was
a single-digit-stock-price former high-flyer, there were virtually no true
believers outside of Bill Miller and me and the rest of us at Legg. But, it’s also a
classic case of how business analysis and an understanding of how the market
might evolve, married with a very low price created a low-risk situation out of
something that appeared to be a very high-risk situation. What I knew was that
even under very disappointing circumstances, based on the cost advantage the
company had, the cash generative model it possessed and the advantage it had
over land-based retail, it could modestly grow sales at a single-digit CAGR to
$10 billion or so in ten years, and a 5% operating margin, lower than most
retailers. (It’s now a $34 billion sales company with “only” 4% margins because
they reinvest in anything they can earn a return on and improve the competitive
position.) Based on those now modest looking assumptions, and using
astronomically high discount rates I thought the company was worth in the mid-
$20s. The allure of it, though, was it was very clear that Jeff Bezos “got it” in


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