ValueInvestor

August 25, 2006

The Leading Authority on Value Investing

INSIGHT
Quality Control Inside this Issue
F E AT U R E S
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

W
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

A
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

www.valueinvestorinsight.com

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
evolved since you started your first firm,
Fusion Partners, with Wayne Cooperman
in 1994?
Ricky Sandler: The philosophy is still
very much the same. We called it then and
I call it now “quality value.” Morris
Mark, for whom both Wayne and I
worked at Mark Asset Management, had
a big influence because of his emphasis on
research and on owning great businesses
– great companies in secular growth busi-
nesses with excellent industry structures.
Morris was more willing to buy a great
business with less regard for price, but we
believed you could pay too much for even
the greatest business. We were also more
open to the fact that there was a price at
which a mediocre business could be
attractive. So our focus was along the
spectrum between “reasonable business
at a great price” and “great business at a
reasonable price”, with the rest being
uninvestable. That’s still what I do today.
One thing that has changed is my com-
mitment to shorting. Wayne and I spent
80% of our time on the long side and
20% on the short side. Shorting was more
of an afterthought, we didn’t dig in as
much on the companies there. But when
the markets tanked in 1998 – and in six
months Fusion went from something like
up 15% to down 15% – I realized it was
very uncomfortable to want to buy more
of what you own when you weren’t sure
you were still going to be in business. We
ultimately ended up flat on the year, but
when I started Eminence, I committed to
being aggressive short sellers and spend-
ing almost half our time on the short side.
You’ve said you think actively shorting
makes you a much better investor. Why?
RS: I saw in 1998 that without having a
commitment to the short side, it’s difficult
August 25, 2006
I N V E S T O R I N S I G H T : Ricky Sandler
to be offensive when you should be. The
highest-return opportunities are available
when markets are in free fall, but if you’re
getting shelled, you may not have the
emotional conviction to be aggressively
opportunistic and you may not even be
able to do it, because of redemptions.
Being able to be offensive when every-
body else is defensive, in and of itself, can
yield excess returns.
A second element is that as true, com-
mitted short sellers, we have to be
immensely skeptical, and skepticism is a Ricky Sandler
terrific quality in a value investor. A key
reason for our success is that we have a Not Far From the Tree
very high batting average on the long
side. We’re better at avoiding mistakes Ricky Sandler couldn't have asked for a
because we’re very attuned to those situa- more compatible partner when he and fel-
tions where value gets destroyed, or low Mark Asset Management analyst
Wayne Cooperman started Fusion
where it isn’t really there in the first place,
Partners in 1994. They were both in their
say, because of phony accounting.
mid-20s, shared a “quality value” orienta-
We employ gross leverage. Typical for
tion and were sons of Goldman, Sachs
us might be to be 120% long and 70%
alumni who had started their own thriving
short. We could not be 120% long with-
investment firms: Harvey Sandler of
out also being 70% short – there’d be too
Sandler Capital Management and Leon
much risk and volatility for our investor
Cooperman of Omega Advisors. “We
base. People say shorting is a waste of
both thought we were ready to run our
time and you never make money. I’d say
own portfolio,” says Sandler, “but there
just breaking even on my shorts allows
was some comfort in having a partner to
me to be 120% long and still not have a do that with.”
lot of volatility. Shorting is and should be
a profit center, but the benchmark people Within four years, Sandler and
use to compare against is often wrong. Cooperman built $28 million in start-up
The last element is that we believe the capital – $10 million from each of their
fundamental structure of a long/short families – into $350 million in assets. But
portfolio minimizes the systematic risk their investment styles were evolving in dif-
you can’t control, say of a terrorist attack ferent directions. “Wayne moved more to
or a Russian debt crisis. If you employ the a deep-value emphasis, while I was
gross leverage we do, you’re then magni- increasingly focused on the quality of the
fying your stock-specific risk – exactly the business,” says Sandler.
risk we feel we should be taking.
Since the partners went their separate
Do you tend to short specific companies ways in 1999, Sandler's Eminence
or baskets of stocks? Capital and Cooperman's Cobalt Capital
have both thrived. Says Sandler: “It goes
RS: We typically like to short individual to show you there are a lot of ways to skin
stocks. Right now, though, we have a a cat in this business.”
www.valueinvestorinsight.com Value Investor Insight 2

bigger than average balance sheet on the
long side – closer to 160% long – because
we’re finding all these big companies we
want to have 5% positions in. To support
that, we’re now around 90% short,
which is requiring us to use more indices
than usual. The M&A environment
makes us hesitant to significantly increase
the number of company-specific shorts
we have. We were short Albertson’s. We
were short Sports Authority. These are
structurally bad businesses that some-
body came along and bought. We have to
be aware of that and not add too much
risk to the portfolio by adding a lot of
new individual short positions.
Back to the long side, what situations tend
to result in your finding quality value?
RS: One is the good company in an
industry that’s out-of-favor, for whatever
reason. Another is the good company that
trips – the disappointment that hasn’t
impaired the long-term value of the busi-
ness, but the market overreacts in pricing
it down. The third would be the good
business that isn’t necessarily in plain
sight – it’s obscured, say, by other busi-
ness lines or special situations. Joel
Greenblatt talking in your last issue [VII,
July 28, 2006] about American Express is
a good example.
I’m probably more willing to pay up
for quality than other value investors
might be. Some of my investor friends
often tell me my ideas are “too high-qual-
ity” for them. I would distinguish some-
what here from paying up for growth –
I’ll pay more for a high-quality, slow-
growing business. I look for companies
that will grow value, not necessarily rev-
enue, at above-average rates.
The higher the quality of the business,
the lower discount to our estimated value
we need. We’re happy to buy a great
business at 75 cents on the dollar.
Something would need to be at 50-60
cents on the dollar for us to buy a
mediocre business. On average, I’d say
our typical investment is 30-35% cheap-
er than we think it ought to be and we
think it’s increasing value at 15-20% per
year on top of that.
August 25, 2006
I N V E S T O R I N S I G H T : Ricky Sandler
Describe how you come up with ideas?
RS: Our best ideas tend to come from
what I call “old research, new events”.
That’s typically the good company you’ve
studied carefully and would love to own
at the right price, that gets marked down
after it trips or its industry goes out of
favor. A great example was Yum Brands a
couple years ago. Comp sales at one of
their restaurant chains, KFC, were way
off one quarter and the stock crashed
35%. It instantly became an idea – I knew
it was a good business and now it was on
sale at a 35% discount.
We also learn a lot from other
investors. I go to idea dinners and regu-
larly talk to a lot of people in the busi-
ness. I’m not afraid of ideas owned by
other people, but you obviously need to
do your own work and make sure they fit
what you do.
ON SHORT OPPORTUNITIES:
We’ll ignore the supposed value
today and focus on whether the
“E” in a P/E is going to be mate-
rially less in three to five years.
Many of our other ideas just come
from having our eyes wide open. You
read publications like yours. You talk to
contacts you’ve developed in various
industries. It’s often just about paying
attention to what’s going on in the world.
On the short side, what attracts your
attention?
RS: We primarily look for material dis-
connects between our view of economic
earnings and the earnings that are report-
ed and people are using to value the
stock. It could be accounting related, so
we pay careful attention to things like ris-
ing accounts receivable relative to total
sales, cash from operations that is not
keeping pace with net income and
decreasing returns on capital.
We also look for long-term structural
www.valueinvestorinsight.com
declines – kind of the opposite of what we
look for on the long side. Wall Street
tends not to fundamentally mark stocks
down until bad news actually shows up in
the numbers. We’ll ignore the supposed
value today and focus on whether we
think the “E” in a P/E is going to be mate-
rially less in three to five years.
Once you’ve identified a potential idea,
what do you do next?
RS: We’ll put an analyst on it, who’s
always paired on the idea with me or one
of the two other principals in the firm.
We’re leveraging the senior person’s time,
but also want more than one pair of eyes
looking at things.
We’ll prepare a basic two-page write-
up after ripping through the 10-Qs, 10-Ks
and proxy filings and listening to confer-
ence calls. We want to get our arms
around the business both quantitatively
and qualitatively, so we summarize things
like the company’s businesses, the com-
petitive environment, recent financials,
earnings quality, management, outstand-
ing litigation and valuation.
What jumps off the page for you?
RS: I focus on return on capital and want
to see EBIT compared to invested capital
in the high-teens or better. We’ll look at it
with and without goodwill, to try to sep-
arate out the impact of capital-allocation
decisions versus operating decisions.
We favor companies with some form
of amortization, where we think cash
flow is higher than reported earnings and
that may be one reason why the stock is
undervalued. We want to understand
how net income plus depreciation and
amortization is converted to cash flow
from operations. Is anything getting lost
in working capital or coming from other
gains? We also focus on the relationship
between capital expenditures and depre-
ciation, to better understand how capital
intensive the business is.
If we still think the idea is interesting,
we’ll set up calls with the company to bet-
ter understand how they operate and
think about things like capital allocation.
Value Investor Insight 3

If that checks out, we’ll probably take a
“R&D” position in the stock of 1-2%.
Why not finish your research before you
start buying?
RS: We’ve already done a lot of work, so
it’s not like we’re winging it. Action adds
a sense of urgency to the work – there are
so many things to look at in this business
that things can fall through the cracks
unless you force yourself to focus. Having
capital on the books does that.
We never stay at the R&D position
size – it’s always then an up-or-out
process. We spend another several weeks
on field research, visiting management
and speaking with as many people as pos-
sible who can give us insight into the
company and industry.
We tailor the field research to what we
need to know. In Yum Brands’ case, we
spoke to a lot of franchisees to really
understand the health of their system. It’s
not about how sales are going this month,
it’s trying to understand from the people
in the trenches things like how good the
products are, why they have the market
share they do, what’s happening to the
market share and where the money is
made in the system.
When we find out the company’s a bad
business partner, there are structural
industry issues we didn’t know about or
maybe there’s an earnings miss we decide
isn’t a short-term event – then we’ll sell.
But if every step of the way you get more
excited by what you uncover, those are
the companies that become 5%, 6%, 7%
positions in the portfolio.
Most investors try to get some sort of
informational advantage. What does it
take to be good at that?
RS: lt certainly takes a lot of effort to call
40 Cisco distributors and get them to talk
to you. It also takes a certain personality.
People fundamentally like to talk about
what they do, but they’ll only do that if
you approach them the right way. You
also have to listen very carefully. You may
ask a distributor about price discounts
and he’ll say, “That’s not much of an
August 25, 2006
I N V E S T O R I N S I G H T : Ricky Sandler
issue, but trade-in values are going up.”
That might be an interesting thing to pur-
sue – you may have noticed inventories
going up, but you didn’t really know why.
How long do you tend to hold positions?
RS: Our typical holding period is 18
months to two years. We don’t actively
trade around positions, but we do man-
age position sizes around our updated
analysis of intermediate-term risk/reward.
As that changes, we’ll add or subtract to
longer-term holdings.
Volatility can be a friend of the value
investor – it provides more situations
where stocks significantly diverge from
their intrinsic value and can allow us to
turn our capital faster. Say something
moves 50% in four months when we
thought that might take two years. If it’s
now 80-90% of what we think it’s
worth, we’ll take money off the table and
put it in something that maybe just got
ON SELLING WENDY’S:
We thought the remaining
upside – from fixing the core
business – wasn’t high enough
and would take too long.
hit and now has higher intermediate-
term potential.
Do you have any strict rules for selling?
RS: No, every situation is different.
Let’s talk about some examples. Why did
you sell Wal-Mart in the third quarter of
last year?
RS: We sold half our stake because we
began to question our thesis. One of our
reasons for buying Wal-Mart was that we
saw material gross-margin opportunity
through sourcing benefits and a reduction
in import quotas. As the U.S. went back
and forth on the quota issue, we started
to question whether that margin expan-
www.valueinvestorinsight.com
sion was going to happen.
We sold the other half because we saw
a better opportunity. We’ve owned Ross
Stores [ROST] off and on for years and
when the stock got hit, we wanted to buy
it without increasing our consumer dis-
cretionary exposure, which we think is
the most stretched part of the economy.
Why sell Wendy’s earlier this year?
RS: We had bought in the low $40s, see-
ing unrecognized value in the Tim
Hortons chain and in real estate assets.
With the stock at almost $60, that thesis
was played out. We sold because we
thought the remaining upside – primarily
from fixing the core Wendy’s business –
wasn’t high enough and would take too
long to be realized.
When Viacom broke into two pieces, also
earlier this year, you bought more of the
Viacom piece and sold CBS. Why?
RS: We like businesses that grow in
value, and each of CBS’s businesses –
broadcast TV, radio, local stations – is
under secular pressure. I think it’s a clas-
sic cheap stock that is going to stay that
way. They can do things with the balance
sheet to maybe take the shares from $25
to the low $30s, but I think they’re hard
pressed to fundamentally grow the value
of the business.
Viacom, on the other hand, has terrif-
ic secular growth prospects. If the multi-
ple doesn’t change, we think they’ll grow
their way into good returns. If the multi-
ple does change to reflect that growth, the
shares will really do well. We’ve been on
the wrong side of this trade so far, but I
stand by the thesis.
We’re assuming selling your Apple
Computer position in the third quarter of
2004 is one you’d like back.
RS: We were early in seeing – and I still
believe – that the digital online business is
saving the music industry. We thought the
iPod might be huge and that the trend to
multimedia devices at home would play
to Apple’s strengths. We bought shares,
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
something like $11 in cash.
The shares went pretty quickly from
$25 to about $38 [$19, post-split], which
we felt pretty good about. Then we start-
ing thinking, “The hardware guy never
makes money, it’s going to get commodi-
tized, so we should stick with the ‘soft-
ware’ guys like EMI.” We couldn’t have
been more wrong on that one. [Apple
shares closed recently at around $68.]
Do you focus on any particular industries
or sectors?
RS: It’s easier to describe what we don’t
do: oil and gas, commodities, utilities and
biotech. We fundamentally believe that
A perfect lead-in to talking about some
specific stocks. Tell us about your interest
in Cisco [CSCO]?
RS: The company essentially makes
switches and routers, which direct IP traf-
fic within an internal network or between
networks. The fundamental driver for
demand of this type of equipment is the
growth and complexity of data traffic. If
you think about what’s happening with
things like music, voiceover IP telephony
and the transmission and downloading of
video files, the growth tailwind behind
this industry is quite interesting.
This is a case where we probably did
INVESTMENT SNAPSHOT
more field work than usual, focusing very
closely on Cisco’s competitive advan-
tages. Why are they able to maintain 70%
gross margins? Why do they have such
incredibly high market shares?
What we ultimately concluded was
that Cisco’s service levels, combined with
the critical nature of this infrastructure,
made competitors a non-factor. No one is
willing or able to work with customers
the way Cisco does in training them and
making sure everything is working. Given
how important the functions being sup-
ported are, we kept hearing how it didn’t
make any sense to go with somebody else
to save 20-30%.

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 www.valueinvestorinsight.com 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
about valuation?
RS: We started buying Cisco late last
year when it was trading in the low- to
mid-$17s. But even after the recent
The prevailing wisdom that the semiconductor cycle is near its demand peak has
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
earnings he believes the company deserves, the shares are worth closer to $25.
Sources: Company reports, other publicly available information

August 25, 2006 www.valueinvestorinsight.com Value Investor Insight 6


There aren’t scale advantages?
RS: Scale does help them with the out-
sourced foundries, like Taiwan
Semiconductor, which are a growing
part of the business and want a one-stop
shop. It’s less of an advantage with Intel,
which has its own engineers and is more
than willing to buy etching equipment
from one company and lithography
equipment from another and put it all
together.
Scale also helps them in the backend,
in investing in development of next-gen-
eration technology. It’s not the core of
our thesis, but management here really
gets how the technology is evolving and
how to create value. They’re always
doing interesting micro things at an
operating level to diversify and expand
their business.
What is the core of your thesis?
RS: There has been a massive underin-
vestment in capacity in the semiconduc-
tor industry since the bottom of the last
cycle in 2003. This has been an atypical
recovery, as the foundries and other
manufacturers have been extraordinarily
cautious in adding capacity, even as they
operate near 100% capacity and even as
we continue to have great growth drivers
for semiconductors. This industry has
grown at double-digit rates for the last
30 years and that will continue, as more
and higher-value chips make their way
into new digital cameras, iPods, cell
phones and computers.
We went back over time and com-
pared overall semiconductor-industry
revenue with industry capital spending.
The relationship has been relatively sta-
ble, but two big things affect it over
time. One is that as wafer sizes get big-
ger, capital spending per dollar of rev-
enue actually drops, as customers get
more chip for their money. Offsetting
that, though, is that as the circuits on
each chip get smaller and more complex,
the capital spending versus revenue
increases.
The first effect, from bigger wafer
sizes, is more of a one-time event with a
August 25, 2006
I N V E S T O R I N S I G H T : Ricky Sandler
12-to-15 year cycle. The second effect,
from increasing complexity, is more con-
sistent and steady over time. The result
is that the curve plotting capital spend-
ing against revenue slopes upward to the
right, with one-time step reductions
every 12 to 15 years.
The industry went through a wafer-
size increase from 2001 to 2003 and we
won’t see another one until maybe 2014.
So the key driver going forward, putting
upward pressure on cap-spending
requirements, will be ongoing increases
in chip complexity. The combination of
that dynamic and the fact that compa-
nies have been so cautious about spend-
ing makes us believe that we’re below
ON CHIP CYCLES:
We believe we’re below mid-
cycle in semiconductor capital
spending. That is not, however,
the prevailing wisdom.
mid-cycle in semiconductor capital
spending. That is not the prevailing wis-
dom, however, which says we’re much
more near the peak of the cycle.
If the market thinks the cycle is peaking,
how cheap has that made AMAT shares,
now at $15.90?
RS: The shares trade at only 11x
October 2006 free cash flow, ex-cash.
That’s incredibly cheap – at below mid-
cycle earnings – for a dominant compa-
ny in a growth industry.
If the company grows just at the rate of
the industry – 10-11% per year – I see no
reason why this shouldn’t trade at a mid-
to high-teens multiple of mid-cycle earn-
ings. At 16x times next year’s earnings –
which we think will to be closer to mid-
cycle – this is a $25 stock, with double-
digit annual growth in value beyond that.
The company also thinks the shares
are cheap. They have $3.40 per share in
net cash and have been aggressively buy-
ing back shares. They’ve been buying
www.valueinvestorinsight.com
back 6-8% of the company per year and
that’s likely to go up.
Moving to another technology titan,
what do you think the market is missing
on Oracle [ORCL]?
RS: Oracle, of course, is one of the
largest software companies in the world,
with a roughly 35% market share in
database software, 17% of the applica-
tion-sever market and a growing appli-
cation-software business. About 65% of
their total revenue is maintenance and
services, which is extremely stable and
sustainable.
One of the appeals here is that this is
a maturing, big company that really
understands how to use its balance
sheet. In 2004, they started buying best-
of-breed application-software compa-
nies, which, financially, has been a very
good use of capital. Oracle runs at 40%
operating margins and can go into a
PeopleSoft, say, and take them from
15% margins to 40% or higher by inte-
grating them well.
In each of the big acquisitions –
PeopleSoft, Retek and Siebel Systems –
the prevailing concern has been that
Oracle would abandon the acquired
products in order to shove their own
products down customers’ throats.
Customers wouldn’t like it and, as a
result, license sales in applications would
drop. If you look at Wall Street’s sell-side
models for the company, combined
applications revenue over the next cou-
ple of years is estimated at maybe 20%
below what the separate companies gen-
erated in 2003.
What you find when you go out in the
field, though, is that customers have
been surprised at how well Oracle has
supported, upgraded and maintained
these newly acquired applications. By
integrating what they’ve bought and
making each of the individual pieces
stronger, they’re starting to regain mar-
ket share from competitors like SAP. The
bottom line is that we believe there’s
meaningful upside to the market’s expec-
tations on how Oracle is executing on
these acquisitions.
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.
THE BOTTOM LINE
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 www.valueinvestorinsight.com 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 www.valueinvestorinsight.com 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
just for the ongoing radio franchise with
5-6% annual top-line growth and a
monopoly business. But we expect the
people-meter rollout for radio to ulti-
mately result in a roughly 40% lift to
revenues and profits. On top of that
you’ve got optionality from the people
meter doing other things – it can also
track TV usage and outdoor advertising,
for example – and from the eventual
rollout of Project Apollo.
We started buying this within the last
six months and now own more than
10% of the company. We think it could
be a major, major homerun.
industry. If your business model is
reliant on very high ink prices, heavier
price competition in that area won’t be
good news.
Is Lexmark’s manufacturing of Dell-
branded printers a positive or negative
for the company?
RS: I think the relationship has hurt
Lexmark because Dell beats them up on
price and then basically gives the print-
ers away with their computers. By defi-
nition, then, the person getting the print-
er may not actually want it and may
never use it. So the add-on consumables
business Lexmark needs just doesn’t
materialize.
Won’t positive secular growth trends in
printing, such as increased photo print-
ing and use of color, benefit Lexmark?
RS: We think their product line is very
poorly positioned and that they haven’t
invested enough in R&D to change that.
They’ve historically been heavily skewed
to black-and-white, inkjet printers, while
the world is going to color and to laser. So
even if the overall printer business grows,
we don’t see Lexmark taking much
advantage.

Tell us about one of your short ideas, INVESTMENT SNAPSHOT

Lexmark [LXK]?
Lexmark
(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 www.valueinvestorinsight.com Value Investor Insight 10


The stock, close to $100 two years ago,
now trades around $55. How much
worse can it get?
RS: The shares are both well off their
high and well off their low. When quar-
terly earnings fell off a cliff late last year,
the stock crashed down to the low $40s.
Since then, they’ve actually beaten earn-
ings estimates handily in the last three
quarters. They’ve been pulling out of
lines of business where they were losing
even more money than usual on printer
sales. Optically, earnings go up when
you stop selling negative-margin hard-
ware and you cut a lot of costs. But by
later this year, when you start to
anniversary when they started to lose
hardware share, we think you’ll start
seeing a negative impact on consumables
sales from the lower installed base.
The stock trades about 14x this year’s
cash earnings and, we think, at 16x next
year’s. So Lexmark trades at a premium
to all the great growth businesses we
spoke about earlier and we think its
business is disintegrating. We view this
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August 25, 2006
I N V E S T O R I N S I G H T : Ricky Sandler
as a long-term short – their market share
is going down and we don’t think that’s
going to change. I would go so far as to
say I think this company could go away
in the next five years.
Are there any general short themes
you’re focused on now?
RS: One is our view on the relative val-
uations of large-caps versus small-caps.
Most of our shorts are in small-caps. On
the index side, we’re short the Russell
2000 – it trades at a 20% premium to
large-caps, but it has much worse
prospects and is much more levered to
the domestic economy.
The last five years have been really
great for small-caps and, like everything
else, it tends to go on longer than it real-
ly should. I think that’s been exacerbat-
ed by the growth of hedge funds. Most
hedge-fund managers don’t look at a
Cisco because it’s too big and too well-
followed and they don’t know what their
edge is going to be. They like to find –
and their investors want them to find –
Or call toll-free:
866-988-9060
www.valueinvestorinsight.com
the obscure little things. My feeling on
that is that investors pay us to find value
and value is in the Ciscos of the world
right now.
What do you like most about investing?
RS: You mean besides the incredibly
attractive financial characteristics?
[Laughing] Yes, we’ll take that as a
given.
RS: I love learning about businesses and
the intellectual challenge of investing.
I’m also intensely competitive about gen-
erating great returns. I love that you get
a scorecard at the end of the day and I
love to win. Winning to me is looking
back after 30 years and saying, “Wow,
look at that track record – these guys did
it well and they did it right.”
That’s not to say I’m particularly fond
of those days when you feel like an idiot
and your numbers make you look like an
idiot. But as a competitive person, I
wouldn’t have it any other way. VII
Value Investor Insight 11

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-
than-glamorous stocks. Is there a common
theme to your investing?
Bob Robotti: The first security I ever
bought, which worked out very well, was
a defaulted New York City Housing
Authority bond at 36 cents on the dollar.
When I set up my own firm in the early
1980s, we focused at the beginning mostly
on pink-sheet, trade-by-appointment type
stocks. So I’ve always been a bit attracted
to distressed or messier situations.
Our general focus is on companies that
attract little attention from Wall Street
and/or are beaten up and out of favor. We
usually invest in small- and micro-caps,
where I still think there are more opportu-
nities to find things that are truly ineffi-
ciently priced. I want to believe going in
that things we buy can double in price
within the next two or three years.
You’re a big proponent of special-situa-
tions investing. What kinds of situations
attract your attention?
BR: We’ve been successful with a variety
of special situations, such as spin-offs,
bankruptcies and rights offerings. With
rights offerings, for example, these are
usually done by companies under some
stress and we’re looking to see insiders
step up as standby purchasers in the offer-
ing. You’re basically looking for an insid-
er trade, where people in a position to
know the business better than the market
might be telling you something.
One of our biggest wins ever was with
Stolt Offshore, a deep-sea, oil-and-gas
drilling contractor which is now called
Acergy. It trades on the Oslo exchange and
on Nasdaq [ACGY]. In May of 2004, the
company did a rights offering as one of the
final events in a long restructuring. The
Oslo exchange has a rule that if you do a
August 25, 2006
I N V E S T O R I N S I G H T : Robert Robotti
private placement of shares, you have to
offer the same terms to public sharehold-
ers, which turned out to be an offering
price of $2.20 per share.
The $2.20 share price valued the com-
pany at around $400 million. That was for
a company with $1.5 billion in revenue, no
net debt and fixed assets with replacement
values far in excess of $400 million. New
management had restructured the business
and industry consolidation was improving
contract terms and pricing. We bought
1.25 million shares in the offering, increas- Robert Robotti
ing our position by four to five times.
We didn’t need energy prices to go up to By the Books
do well on this, but when they did,
Bob Robotti was “bitten by the investment
demand for Stolt’s services took off.
bug” while serving on the audit team por-
Almost every piece of equipment they have
ing over the books of Tweedy, Browne Co.
is contracted out for the next two or three
in the late 1970s. “It became quite clear to
years. Today, the stock trades around $18.
me that investing was far more interesting
than the ‘ticking and footing’ of the audit-
Have you taken money off the table?
ing process,” he says.
BR: We’ve sold very little. They now have
Robotti, however, has not turned his back
$300 million in cash, no debt, around $2
on his accounting roots. “Bob is without
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
provinces where you can find and pro-
Mario Cibelli (VII, June 30, 2006), who
duce oil and gas is going to double over
once worked for Robotti and now manages
the next five years, as provinces open up
his own investment partnership. In fact,
in Australia, Malaysia, China and else-
Robotti lets the numbers do much of the
where. That’s where people are looking
talking when analyzing a company. “I find
now and that’s going to be very good for
that subjective judgments about manage-
Acergy’s business. I think this can ulti-
ment and the industry are tough to make
mately be a 25x-multiple stock when peo-
until you’ve actually owned the shares for a
ple recognize the strength of their busi-
while,” he says, “We focus first on an objec-
ness and how well positioned they are.
tive look at the reported numbers.”
Do you pay attention to share buybacks?
The post-Enron shift toward tougher
audits and board scrutiny of financial
BR: We often look at cases in which a
reporting has created new opportunity for
company with significant insider owner-
sleuths like Robotti. One of his most fertile
ship is aggressively buying back shares, but
areas for ideas today? “Companies delin-
the insiders don’t participate in the buy-
quent in filing their financial statements,”
back. Again, that indicates that someone
he says. “It’s a real growth area.”
who may know more about the business
www.valueinvestorinsight.com Value Investor Insight 12

wants to own more at a particular price.
An example of that – which took a
long time to play out – is the old Ethyl
Corp., which does chemical additives for
petroleum products and is now called
NewMarket [NEU]. In the late 1990s, the
controlling Gottwald family bought back
25% of the outstanding stock at $46.25 –
adjusted for a 1-for-5 reverse split – and
we began buying about a year later when
it traded down to $35.
Unfortunately, the business deteriorated
and the stock a few years ago got down to
about $4, which was 1x trailing 12-month
cash flow. We liked that the company was
generating cash and paying down debt,
and we thought the industry dynamics
were finally changing for the better, so we
bought a lot more. The business turned
around beautifully and it’s still a big posi-
tion for us. [NewMarket shares closed
recently around $61.]
We see that like any good value investor,
you’re not afraid of doubling down when
something goes against you.
BR: You have to be willing to do that
when you invest in the types of companies
we invest in, where things often get worse
well before they get better.
I don’t want to leave you with the
impression, however, that it always
works. In the late 1990s I had about a
12% portfolio position in Superior
National, a big player in California work-
ers’ compensation insurance. I increased
my position in a rights offering and it got
to as much as 20% of my portfolio.
When the workers’ comp business in
California fell apart, the company turned
out to be too leveraged and the shares
went from $22 to zero.
Ouch.
BR: The lesson wasn’t to not be aggres-
sive, but to not be overweighted in any-
thing that’s so leveraged that it really has
the risk of going to zero. Acergy is now
about 13% of my portfolio, but it has no
debt and $300 million in cash. The earn-
ings might slow down, but there’s no
issue with the viability of the company.
August 25, 2006
I N V E S T O R I N S I G H T : Robert Robotti
Are there relatively new special situations
you’re seeing more of?
BR: One newer area is companies that are
delinquent in filing financial statements.
Up until 2002-2003, corporate audits were
really commodity items and there was lit-
tle value added. The value added, such as
it was, was in distorting the economic real-
ity to fit accounting rules and regulations.
The world today is very different and audi-
tors have come to rule the world. With
ON OIL-SERVICE COMPANIES:
Whether oil is $40 or $70 per
barrel, I’d argue it’s not going
to have that much impact on
demand for services.
long, drawn-out audits and conflicts over
reporting, you see more and more compa-
nies fall behind in filing, getting de-listed
or even choosing to de-register their shares
to avoid filing requirements. Those things
usually cause a dramatic repricing of the
shares and may provide opportunity.
Can you give a current example?
BR: We own Advanced Marketing Services
[MKTS.PK], which trades in the pink
sheets. The company distributes books,
mainly to major wholesale-club retailers
like Sam’s Club, Costco and BJ’s. In 2004,
they discovered that the head of marketing
was defrauding customers. They had to
hire forensic accountants and lawyers to
track the extent of the fraud and determine
the restitution to customers, so they
became delinquent in their filings with the
SEC. As a result, they got kicked off the
New York Stock Exchange in April of last
year and the stock went from $7 to about
$3.50, which is when we got interested.
There was enough information avail-
able that we thought the stock was trading
for less than our $5-per-share estimate of
what the restated, tangible book value
would be. The balance sheet was mainly
receivables and inventory – the receivables
www.valueinvestorinsight.com
from blue-chip clients and the inventory
was mostly books returnable to the pub-
lishers for full refund. The company was
and is losing money, but it has in the past
earned around $1 per share, which we
believe should be achievable again.
Unfortunately, rather than get in com-
pliance and resume their listing, the com-
pany now says they plan to de-register
their shares. It will still trade in the pink
sheets, but we’re concerned about the
information we’re going to get going for-
ward. The stock now trades around $3,
and while the risk has increased, we still
think there’s value here.
You’re a long-time investor in the energy
business. Where do you stand on the ques-
tion of whether things are “different this
time” with respect to prices?
BR: Our portfolio is currently about 30%
in energy, so it’s the biggest industry expo-
sure we have. Having invested in the busi-
ness as long as I have, the one thing I know
about energy prices is that whatever the
consensus is about future price movements
will be wrong. It always is.
The big increase in energy prices has
added a lot more commodity risk to invest-
ing in the sector today. It’s harder to be
totally agnostic about the prevailing price
levels. I do believe the energy market has
fundamentally changed and there will be a
new long-term, market-clearing price for
energy that is higher than it has been. How
much higher, I have no idea. The excess
supply in the global industry actually start-
ed to be used up by the mid-1990s.
Because this is a long lead-time, capital-
intensive business that has gone through
20 years of underinvestment, it will take
many years for responses on the supply
and demand side to work their way
through the system.
As that happens, what areas of the energy
business do you consider most attractive?
BR: In general, I believe the service com-
panies are more attractive than produc-
ers in the current environment. Whether
oil is $40 per barrel or $70 per barrel, I’d
argue it’s not going to have that much
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
the big oil companies have declining
reserves and will be desperate to add
reserves. To do that, they’ve got to spend
on finding and developing new produc-
tion or getting more production out of
what they already have. Well-positioned
service companies will benefit from that
trend for a long time.
As I mentioned earlier with Acergy,
service companies involved in deep-water
exploration should be particularly strong.
Exploration success as the number of
provinces expands will only breed more
activity. At the same time, because of the
expense and lead times on the capacity
side, there’s much less risk of oversupply
than with land-based drilling.
Isn’t the concern here that many in the
industry won’t be so prudent and too
much capacity will be added?
BR: Exactly. There are currently around
200 deep-water rigs on the market – semi-
submersibles and drill ships – and another
35 are under construction. Most of those
rigs are not being built by the traditional
industry players, but by speculators who
are betting on day rates staying high.
Is that too much new capacity? As I
said, I’m convinced demand for deep-
water drilling is going to explode. So much
so that I don’t think the market will be able
to meet the demand, even with the new
INVESTMENT SNAPSHOT
capacity. The world just needs the produc-
tion from these deep-water provinces.
How does this view play out in your earn-
ings estimates for Atwood?
BR: Their full fleet is contracted out for
next year and almost all contracted the fol-
lowing year. Based on contracted rates, the
company should earn $5 per share next fis-
cal year and more like $9 in fiscal 2008.
Given that some contracted rates are well
below current rates and that they have a
new rig coming on in 2008, we think sus-
tainable earnings – at current market con-
ditions – are more like $11-12 per share.

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

PPD PRICE HISTORY

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.
THE BOTTOM LINE
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 www.valueinvestorinsight.com Value Investor Insight 17


of their lawyers for routine securities
work, at one-fifth the cost I pay for the
same work at my regular law firm.
Who is the target audience?
BR: The company says it’s not the top
10% or bottom 10%, but the 80% in
between. The reality is they reach mostly
middle- to lower-income people, which I
think is more a result of how they sell than
of who might benefit from the product.
A dreaded multi-tiered marketing system?
BR: Yes, they use a system just like
Amway’s, which is one reason Wall Street
hates the company. We agree that how it’s
sold is a limitation, but not based on any
elitist view of what’s appropriate.
The first problem is that by selling to
people you know, who sell to people they
know, they don’t reach large parts of the
population – namely higher income levels.
The current system also isn’t adequately
educating people on how to use the prod-
uct and what a great value it is. The more
people use and take advantage of the serv-
ices, the longer they remain customers.
We think there’s great untapped poten-
tial in promoting to a broader population
base through advertising and more tradi-
tional marketing. They also should
enhance customer-service efforts to con-
nect more often with paying customers.
The growth upside from doing both of
these is tremendous – they win from dra-
matically increasing the customer base
and from higher retention of the cus-
tomers they already have.
The founder, Harland Stonecipher, still
runs the business. What makes you think
things will change?
BR: Management has been open to sug-
gestions of certain long-time shareholders.
Tom Smith, the managing partner of
Prescott Investors, has been on Pre-Paid’s
board since 2004. I’m sure he’s introduce-
ing ideas that will continue to impact how
they look at the business. We see it already
in how they’ve started new programs to try
to increase usage, in how they’re looking
August 25, 2006
I N V E S T O R I N S I G H T : Robert Robotti
more carefully at the lifetime value of a
customer. They have more than enough
resources to invest in better marketing, and
we think they will.
We’re also optimistic about the identi-
ty-theft product they launched in 2003 in
a joint venture with Kroll. It’s a relatively
unique service that doesn’t just monitor
for problems with identity theft, but also
has a restitution part if something goes
wrong. Kroll is a part of Marsh &
McLennan and the entire company is
quite sophisticated in how they sell their
products. I believe this relationship can
open new doors to Pre-Paid.
ON CHANGING TIMES:
The particulars might change
from time to time, but people
drive the environment and
human nature is pretty constant.
Is the competitive environment agreeable?
BR: The other main players – the Hyatt
Legal Plans division of MetLife and a for-
mer Montgomery Ward business that’s
now owned by General Electric – operate
mostly in the corporate market, offering
plans as employee benefits. Pre-Paid is by
far the market leader with consumers.
The short interest, nearly 55%, is about as
high as it gets. Why do so many investors
loathe the stock?
BR: There have been lawsuits against the
company alleging various damages, usual-
ly amounting to no more than a few hun-
dred dollars each. One case, in Mississippi,
resulted in a punitive-damage award of
$9.9 million, which is now on appeal.
Many business people would not consider
an early negative verdict from a
Mississippi jury as great cause for concern,
and we agree. The Connecticut Attorney
General also announced he was looking
into the company’s sales practices, but
nothing’s come of that since it was
announced with great fanfare a year ago.
www.valueinvestorinsight.com
There were accounting concerns, pri-
marily over the company amortizing over
three years commissions on new customer
sales. Now those commissions are
expensed immediately. Today, cash earn-
ings slightly exceed reported EPS.
With all this, we come back to the fact
that we believe in the product – that it’s a
proven, cost-effective service for con-
sumers that has been around for 30 years.
The “noise” has calmed down quite a bit,
but sometimes a high short interest takes
on a life of its own. As long as you’re com-
fortable with your work, you just can’t
worry about that.
The stock has been stuck near its current
level, around $37, since the beginning of
2005. Where do you think it can go?
BR: The shares currently trade for around
11x trailing earnings, if you adjust for the
fact that the identity-theft earnings are
temporarily lower because the start-up
selling expenses are being expensed imme-
diately. There’s no capital spending, so the
earnings translate to free cash flow.
Protecting the downside is that they have
no debt and they’re using free cash flow to
buy back stock. The company has gone
from over 24 million shares outstanding to
less than 15 million today, which has had
a significant effect on EPS growth.
I can’t give you a specific target number
for the stock price. But if they can really
get at the untapped potential I think this
product has, the share price will be a mul-
tiple of what it is today.
You’ve been in the investment business for
over 25 years. How would you say the
business has changed?
BR: You know, the particulars might
change from time to time, but people
drive the environment and human nature
is pretty constant. A year ago,
NewMarket shares were at $15 and
nobody wanted them and today it’s at
$61 and everybody wants to own it.
Fundamentally, it was positioned a year
ago to earn what it’s earning today.
Things like that are as likely to happen
today as they were 25 years ago. VII
Value Investor Insight 18
SuperInvestor
From the Editors of Value Investor Insight
UP FRONT
Distinction With a
Difference
T
he eclectic nature of value
investors is on full display in ana-
lyzing the portfolios of the best of
the breed. Homebuilders like D.R. Horton
and Centex share space in portfolios with
media companies such as Time Warner and
News Corp. Energy firms Transocean and
Williams stand alongside Microsoft and
Oracle. At the same time Greyhound-bus
parent Laidlaw International attracts
attention, so do biotech firm Nuvelo and
controversial videogame maker Take-Two
Interactive.
We’re coming to believe that the tradi-
tional distinctions between “value” and
“growth” investors are increasingly artifi-
cial and irrelevant. As Charlie Munger
once said, “All intelligent investing is value
investing,” meaning all smart investors are
trying to buy a stake in a company for as
little as possible relative to its intrinsic
value. But there’s great leeway in how one
ascribes value to any given stake, from a
focus on hard current assets to more
weight given to higher future profits. The
best investors are comfortable with assign-
ing value from along that continuum, as is
clearly evidenced by the breadth of busi-
nesses in their portfolios.
This is not to say there aren’t core prin-
ciples that set apart the SuperInvestors we
track. They tend to buy what’s out of favor
rather than what’s popular. They invest
heavily in their best ideas rather than hide
behind the “safety” of closet indexing.
They focus on generating high absolute
John Heins
Co-Editor-in-Chief
returns rather than on relative returns or
outperforming a benchmark. They typical-
ly invest with a multi-year time horizon
rather than focusing on the month or quar-
ter ahead. They focus on the difference
between a company’s current share price
and their estimate of its true worth, rather
than trying to guess where the herd is
going to go next.
Another trait we believe most
SuperInvestors share: an ability to learn
from experience. Knowledge is cumulative,
and savvy investors realize that there’s no
capacity limit on what one can learn and
apply toward becoming a better investor.
Our hope with SuperInvestor Insight is
that it can be an additional and regular
contributor to your own store of investing
knowledge – with the help of the best
“teachers” in the business. SII
Whitney Tilson
Co-Editor-in-Chief
August 25, 2006
INSIGHT
IN THIS ISSUE
What They’re Buying
Industry turmoil, as in healthcare
today, typically creates value
opportunities that attract smart
investors’ attention. Page 20
Table: Heart and Home
Table: Biggest New Bets
What They're Selling
Consumer and financial stocks,
light on buy lists in the second
quarter, are well represented
among popular sells. Page 22
Table: Consumer Isn’t King
Table: Up (or Down) and Out
What They Own
Media and technology may be out
of favor on Wall Street, but you
wouldn’t know it from the portfo-
lios of star investors. Page 24
Table: Core Holdings
Table: Below the Radar
Stock Spotlight
Unfocused businesses tend to
attract the attention of investors
expecting change – witness the
case of Walter Industries. Page 26
The SuperInvestors
SuperInvestor Insight tracks the activity
of an elite group of value-oriented
hedge-fund managers (plus Berkshire
Hathaway), based on their holdings as
filed in Forms 13F with the SEC. While
certain activity of specific investors will
be highlighted, the focus is on drawing
collective insight from this group of 25-
30 of the world’s best investors, which
currently includes William Ackman,
David Einhorn, Joel Greenblatt,
Carl Icahn, Seth Klarman, Edward
Lampert, Warren Lichtenstein,
Stephen Mandel, Larry Robbins,
Jeffrey Ubben and many more.
SuperInvestor Insight 19
WHAT THEY’RE BUYING

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 www.valueinvestorinsight.com SuperInvestor Insight 20

WHAT THEY’RE BUYING

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 www.valueinvestorinsight.com SuperInvestor Insight 21

WHAT THEY’RE SELLING

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 www.valueinvestorinsight.com SuperInvestor Insight 22

WHAT THEY’RE SELLING

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 www.valueinvestorinsight.com SuperInvestor Insight 23

WHAT THEY OWN

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
position
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 www.valueinvestorinsight.com SuperInvestor Insight 24

WHAT THEY OWN

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 www.valueinvestorinsight.com SuperInvestor Insight 25

STOCK SPOTLIGHT: WALTER INDUSTRIES

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
rises and falls over time, but the empha-
sis today is clearly that focus is a virtue.
Focused businesses are considered more
nimble and responsive to changing com-
petitive environments. From an invest-
ment perspective, the more uncluttered a
given business is – the thinking goes –
the more likely it is to be accorded full
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,
American Express’ spin-off of financial-
advisory subsidiary Ameriprise, Tyco’s
quently been responsive, agreeing to spin
off 25.1% of Mueller Water in an initial
public offering in June and committing
to dispose of the rest in a tax-free spin-
off before the end of the year. Walter
shares – at $15 only two years ago –
traded as high at $71.45 earlier this year
before falling off sharply after the
Mueller IPO. They’ve recovered some-
INVESTMENT SNAPSHOT
Walter Industries
(NYSE: WLT)
Business: Conglomerate operating in
what from their second-quarter low of
$44.60 and recently traded at $51.70.
The ongoing investment thesis for
Walter is relatively straightforward, says
Gary Claar of SuperInvestor JANA
Partners. “It’s just what we look for –
value, plus a catalyst,” he says.
“Business by business, each piece of
Walter deserves a more robust valuation
Valuation Metrics
(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.
THE BOTTOM LINE
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 www.valueinvestorinsight.com SuperInvestor Insight 26

STOCK SPOTLIGHT: WALTER INDUSTRIES
than it’s getting as part of a conglomer-
ate, and they’re in the process of ration-
alizing that structure.”
Mueller Water’s vertically integrated
line of products is well positioned to
take advantage of the heavy infrastruc-
ture spending necessary to upgrade and
replace aging water systems throughout
the country, says Claar. He believes the
growth and sustainability of the business
warrants at least a 10x multiple of earn-
ings before interest, taxes, depreciation
and amortization – 25% higher than the
8x multiple it currently sports – which is
likely only after Mueller shares are fully
spun out later this year.
The natural-resources business is also
a much better business than it currently
gets credit for, says Claar, and might
eventually make an excellent acquisition
target for a large, diversified coal com-
pany. High-quality metallurgic coal sells
for a solid premium to lesser-quality coal
and the location of Walter’s mines near
steel mills in the southern U.S. gives the
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August 25, 2006
company a cost advantage over many
competitors. The business is tied to steel-
industry cyclicality, but steel is in a rela-
tively strong part of what many consider
to be a long-lived cycle.
In addition, coal’s central role in
ON THE COAL BUSINESS:
Less susceptible to natural-
gas competition in power gen-
eration, coal should be a lot
less cyclical going forward.
power generation, now less susceptible
to competition from higher-priced natu-
ral gas, “makes coal companies a lot less
cyclical going forward than looking
back,” Claar says. He believes Walter’s
coal business should trade for a premi-
um 6x EBITDA multiple, up from less
www.valueinvestorinsight.com
than his estimate of 3.5x today.
Even Walter’s homebuilding business
– which Claar calls “lousy” – has poten-
tial upside. The company’s focus is pri-
marily on homes priced between
$50,000 to $150,000, which should bet-
ter position it for a tough housing mar-
ket. Just as low interest rates and easy
financing allowed many low-income
buyers to trade up from Walter’s typical
offering during the boom, more difficult
times should increase demand for its
homes. Claar values the business at
roughly $5 per share and expects it ulti-
mately to be sold to a competitor or in a
management buyout.
All in, Claar says JANA bought into
Walter at a 30-50% discount to the esti-
mated value of the sum of its parts. “We
typically look for a very dynamic period
of a company’s public life when it under-
goes a lot of change and gets revalued by
the market,” he says. “We think we’re
right in the middle of that period now
with Walter.” SII
SuperInvestor Insight 27
 E D ITOR S’ LETTE R

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

Value Investor Insight™ is published monthly at

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General Publication Information and Terms of Use

Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the “Site”) by Value Investor Media,
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August 25, 2006 www.valueinvestorinsight.com Value Investor Insight