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Graham & Doddsville

An investment newsletter from the students of Columbia Business School

Inside this issue: Issue XXXIII Spring 2018


Pershing Square
Challenge P. 3 A Final Lesson: Bruce
Greenwald & Mark Cooper
CSIMA
Conference P. 4
Professor Bruce C. N. Greenwald, who
Bruce Greenwald holds the Robert Heilbrunn Professorship of
& Mark Cooper P. 6 Finance and Asset Management at
Columbia Business School and is the
Student Academic Co-Director of the Heilbrunn
Investment Ideas P. 16 Center for Graham & Dodd Investing, is set
to retire from Columbia at the end of the
Michael 2017-18 academic year. Described by the
Mauboussin & New York Times as “a guru to Wall Street's
Tom Digenan P. 28 Bruce Greenwald & gurus,” Greenwald is an authority on value
Mark Cooper, CFA ’02 investing with additional expertise in
Rishi Renjen P. 40 productivity and the economics of
(Continued on page 6)
Editors:
Abheek Bhattacharya
MBA 2018 Trusting the Process: Michael
Matthew Mann, CFA Mauboussin & Tom Digenan
MBA 2018
Michael J. Mauboussin is Director of
Adam Schloss, CFA Research at BlueMountain Capital
MBA 2018 Management in New York. Prior to joining
Ryder Cleary BlueMountain in July of 2017, he was a
Managing Director and Head of Global
MBA 2019 Financial Strategies at Credit Suisse.
Gregory Roberson, Esq. Before rejoining Credit Suisse, he was
MBA 2019 Chief Investment Strategist at Legg Mason
Michael Mauboussin & Capital Management from 2004-2012. Mr.
David Zheng Mauboussin joined Credit Suisse in 1992 as
Tom Digenan
MBA 2019 (Continued on page 28)

Rishi Renjen, ROAM Global Management


Visit us at:
www.grahamanddodd.com
www.csima.info Rishi Renjen is the FounderRolf
andHeitmeyer
CIO of ROAM Global
Management that will launch in the Summer of 2018. Prior to
founding ROAM Global, Mr. Renjen was a Managing Director
and Sector Head at Maverick Capital, a Partner at TPG-Axon
Capital, and a Senior Analyst at Glenview Capital. Prior to
Glenview, he was a Private Equity Analyst at Warburg Pincus
and began his career in investment banking at Citigroup. Renjen
earned a Bachelor of Science in Economics, with a
concentration in Finance, from The Wharton School at the
University of Pennsylvania.
Rishi Renjen (Continued on page 40)
Page 2

Welcome to Graham & Doddsville


We are pleased to bring you the We also paired Michael Mau- cuss their 2nd place pitch of
33rd edition of Graham & boussin of BlueMountain Capi- Credit Acceptance Corpora-
Doddsville. This student-led tal Management and Tom tion (CACC); Mike Allison ’19,
investment publication of Co- Digenan of UBS. Both Michael Eric Herzfeld ’19, and Michael
lumbia Business School (CBS) is and Tom have spent a portion Wooten ’19 share their 3rd
co-sponsored by the Heilbrunn of their careers teaching stu- place pitch of Spotify Technolo-
Center for Graham & Dodd dents outside of their day jobs gy, Inc. (SPOT); Ryan Darrohn
Investing and the Columbia Stu- as investment professionals. ’19, Brad Headley ’19, and John
dent Investment Management They talk about the base-rate White ’19 discuss C.H. Robin-
Association (CSIMA). fallacy, sustainable competitive son Worldwide (CHRW); Ar-
advantage, ETFs, and decision- thur Brousseau ’19, Greg
Meredith Trivedi, the This is a bittersweet issue for us. making within a team. Doger de Speville ’19, and
Heilbrunn Center Director. Bruce Greenwald, the Academic Neethling McGrath ’19 present
Meredith skillfully leads the Co-Director of the Heilbrunn Rishi Renjen sat down with us Harvey Norman Holdings, Ltd.
Center, cultivating strong Center, retires at the end of this ahead of launching ROAM (HVN). Separately, Jingjing
relationships with some of academic year. Our first inter- Global Management, a concen- Huang ’19, Matthew Mann ’18
the world’s most experi- view recognizes him and brings trated long-short fund focusing and Viraj Vora ’19 bring their
enced value investors and more of his insights to our read- on single-name shorts. Rishi pitch on Digicel’s 2020 bonds.
creating numerous learning ers. Similar to the way Prof. tells us what he has learned
opportunities for students Greenwald has bridged theory from mentors such as Lee We are honored and privileged
interested in value invest- and practice, all four of our oth- Ainslie and Larry Robbins, how to have continued the Graham
ing. The classes sponsored er interviewees have had a foot mentorship and culture are key & Doddsville legacy, and we
by the Heilbrunn Center in both worlds at some point. in investing, and why he still look forward to reading the
are among the most heavily teaches not one but two clas- next generation of issues,
demanded and highly rated We started by pairing Bruce ses year-round at Columbia. helmed by three outstanding
classes at Columbia Busi- Greenwald with his former individuals in Ryder Cleary ’19,
ness School. student and current collabora- Lastly, we continue to bring Gregory Roberson ’19, and
tor, Mark Cooper, CFA ’02, a you pitches from current stu- David Zheng ’19. We want to
portfolio manager at First Eagle dents at CBS. In this issue, we thank Ryder, Greg and David
Investment Management. Mark feature ideas from finalists of for their commitment and dedi-
discusses his evolution as an the 11th Annual Pershing cation to Graham & Doddsville.
investor and what he’s learned Square Challenge in April 2018,
from Prof. Greenwald. Mark all of them shorts. Jade Hu ’19, We thank our interviewees for
talks about Deere & Co. while Asher Jacobs ’19, and Rana contributing their time and
Prof. Greenwald warns tradi- Pritanjali ’19 share their win- insights not only to us, but to
tional value investors that the ning pitch of Stericycle, Inc. the investment community as a
world has changed and that they (SRCL); Steve Cao ’19, Winter whole.
need to adapt. Li ’19, and Tyler Redd ’19 dis- - G&Dsville Editors
Professor Bruce Greenwald,
the Faculty Co-Director of
the Heilbrunn Center. The
Center sponsors the Value
Investing Program, a rigor-
ous academic curriculum for
particularly committed stu-
dents that is taught by some
of the industry’s best practi-
tioners.

Mario Gabelli ’67 and Professor Tano Meredith Trivedi with Professor Bruce
Santos, Co-Director of the Heilbrunn Greenwald
Center for Graham and Dodd Investing,
at the 2017 Omaha dinner
Volume I, Issue
Page 23 Page 3

Pershing Square Challenge 2018

Pershing Square founder William Ackman and the 2018 The judges listen to a riveting student pitch
Pershing Square Challenge judges panel

William Ackman posing with the winning team of Jade Winter Li ’19, Steve Cao ’19, and Tyler Redd ’19 deliver
Hu ’19, Rana Pritanjali ’19, and Asher Jacobs ’19 their 2nd place pitch

Michael Allison ’19, Eric Herzfeld ’19, and Michael


Wooten ’19 share their thoughts on Spotify
Page 4

2018 CSIMA Conference

Professor Bruce Greenwald and Litespeed Partners’ Columbia Business School professor and Gotham Capital
Jamie Zimmerman have an enlightening discussion founder Joel Greenblatt shares his expertise

Capital Group’s Jody Jonsson (left) and Ryan Brown Conference Chairs Justin Charles ’18 (left) and
discuss navigating the road ahead Harsh Jhaveri ’18 address the crowd

The annual CSIMA Conference always brings a packed house as investors


network and listen to new ideas
Volume I, Issue
Page 25 Page 5

SAVE THE DATE

28th Annual Graham and Dodd Breakfast

October 19, 2018

A Discussion with John Griffin of Blue Ridge Capital


and
Ian McKinnon, formerly of Ziff Brothers Investments

Presented by:
The Heilbrunn Center for Graham & Dodd Investing

For inquiries contact:


valueinvesting@gsb.columbia.edu
Page 6

A Final Lesson: Bruce Greenwald & Mark Cooper ’02


information. Media Companies (with Graham & Dodd Investing
Jonathan A. Knee and Ava at Columbia Business
Greenwald has been Seave, Penguin, 2009) and School.
recognized for his Adverse Selection in the
outstanding teaching Labor Market (Garland Mark has a BS from MIT
abilities. He has been the Press, 1980). and an MBA from
recipient of numerous Columbia Business School,
awards, including the Greenwald received a B.S. where he completed the
Business School’s Lifetime and a Ph.D. from the value investing program.
Achievement Award and Massachusetts Institute of He is a former US Army
the Columbia University Technology and an M.P.A. officer. Mark holds the
Presidential Teaching and M.S. from Princeton Chartered Financial
Award, which honors the University. Analyst (CFA) designation.
Professor Bruce best of Columbia's
Greenwald teachers for maintaining Mark Cooper ’02, a co- Graham & Doddsville
the University's portfolio manager on the (G&D): Mark, could you start
longstanding reputation International Small Cap by introducing yourself,
for educational excellence. Value strategy at First including how you first
His classes are consistently Eagle Investment interacted with Professor
oversubscribed, with more Management, is one of Greenwald?
than 650 students taking Greenwald’s former
his courses every year in students and current Mark Cooper (MC): I’ve
subjects such as Value collaborators. Mark joined been at First Eagle for the last
Investing, Economics of First Eagle’s Global Value four years. I co-manage an
Strategic Behavior, team in May 2014. He is international small-cap strategy
Globalization of Markets, also a senior research with Manish Gupta ’07. I also
and Strategic Management analyst covering surface have senior analyst
of Media. transportation and responsibilities on a few
logistics, oilfield services, sectors, including oilfield
Mark Cooper,
Since 2007, Greenwald has and automobiles. Prior to services, surface
CFA ’02 served as Director of joining the firm, Mark had transportation, logistics, and
Research, and currently both research analyst and autos.
Senior Advisor, for First portfolio management
Eagle Investment responsibilities covering I met Bruce 17 years ago. We
Management. In addition, stocks globally at PIMCO. hit it off really well, maybe
he consults worldwide on a Before PIMCO, he was a because we have two things in
variety of issues partner and portfolio common: We were both MIT
concerning capital manager at Omega undergrads, and we both
markets, business strategy, Advisors, where his jumped out of airplanes in the
corporate finance, and research focused on Army. Bruce hired me as a
labor performance. industrials, basic materials, teaching assistant for
commodities and energy. Economics of Strategic
Greenwald is the author of Mark's past experience Behavior and Value Investing in
several books including also included time at 2002 when I was at Columbia
Competition Demystified: A Pequot Capital as a Business School. After
Radically Simplified research analyst and J.P. graduation, Bruce and I stayed
Approach to Business Morgan as a portfolio in close contact and would
Strategy (with Judd Kahn, manager in fixed income, meet often to discuss ideas. In
Putnam Penguin, 2005), commodities, and 2004, right before the
Value Investing: From currency derivatives. semester began, he had an
Graham to Buffett and Additionally, since 2004, he adjunct professor back out so
Beyond (with Judd Kahn, et has been an adjunct he needed someone to teach
al, Wiley, 2001), The Curse professor of Applied Value Applied Value Investing. Bruce
of the Mogul: What’s Wrong Investing at the the asked Eddie Ramsden ’03,
with the World’s Leading Heilbrunn Center for Artie Williams ’02, and me to
(Continued on page 7)
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Harvey SawikinBruce Greenwald & Mark Cooper ’02


A Final Lesson:
co-teach the class. even though you might want to change asset classes lead you
After graduating from take a long-term view, due to to Columbia or is that
Columbia, I worked at a few the nature of the business, something that happened while
well-known places, including you’re likely to be more at Columbia?
some with Columbia-affiliated focused on the end of the year,
people. I went to work at which tends to shorten your MC: No, it led me to
Pequot Capital for Art time horizon a bit. Columbia. I had already made
Samberg ’67, where I was an the decision to become an
equity analyst, primarily in the Over the years, I’ve been equity investor. I read The
industrials sector. I then spent Intelligent Investor when I was in
five years at Omega Advisors “Bruce has made my Army officer training in the
working for Lee Cooperman fall of 1991, and I had been
’67, where I was a partner and everyone whom he’s investing in stocks since I was a
portfolio manager focusing on teenager. In my opinion, I
industrials, materials and
interacted with a little made a pretty simple decision
energy. After Omega, I spent smarter through his after asking myself, “Where do
four years at PIMCO helping I think I can get the best
develop an equity business. I probing questions and education to become a value
joined First Eagle in 2014. investor?” Columbia was
keen insight.” actually the only place I applied
Bruce Greenwald (BG): to for business school.
What did you do before you fortunate to work with and
came to Columbia? learn from many great people BG: I think there are areas in
such as Matt McLennan, which Mark is absolutely
MC: After college at MIT and Kimball Brooker, and Manish exceptional, and where I’ve
a brief stint on active duty in Gupta at First Eagle, who are learned a tremendous amount
the US Army, I spent eight more philosophically aligned from him. When you think of
years at J.P. Morgan as a with my temperament. I think the stages of an investment
portfolio manager in fixed that all of us, as we learn who process, Mark did not have an
income, currencies and we are, are trying to fit who issue with search strategy,
commodities. we are as an investor with our because he is value oriented.
boss and our clients. We set And he had industry specialties
G&D: How has your ourselves up for the most from the beginning. By
investment philosophy evolved success when we get most of partnering with Manish Gupta,
over the years? those stars aligned. I think Seth he has added industry
Klarman put it best when he specializations. Manish was a
MC: Many people who said, “You get the clients you tech analyst, and Mark was a
become investors after deserve.” generalist analyst who had
graduation think they know prior periods of specialization.
exactly what type of investor That said, my basic value
they are, but, over time, many philosophy hasn’t changed Mark had a leg up in what I’m
of them find out they’re much since my days at trying to teach you guys, which
probably a little bit different Columbia. Bruce instilled a is to not try to do everything.
once they become professional great discipline of focusing on He was always much more
investors. They are influenced competitive advantage, and sophisticated than just slapping
by their bosses, colleagues, and concentrating on that has been a ratio on things. He was really
mentors. I’d say I am no a major benefit to my career interested in the quality of a
different in this regard. I’ve and to hundreds if not business and how returns
tried to adapt to the thousands of others. Bruce has would look going forward.
environment I was in to do the made everyone whom he’s
very best for our investors interacted with a little smarter What Mark is exceptional at,
given the various constraints. through his probing questions first, is in identifying the key
In the hedge fund world, we’re and keen insight. issues and managing his
probably a little bit more research time. One of Mark’s
focused on December 31st. So, G&D: Did your desire to real contributions is his
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Harvey SawikinBruce Greenwald & Mark Cooper ’02


A Final Lesson:
willingness to say, “[Forget] management is most efficient to those Japanese investors to
what the world believes, which in giving you your money back. try to get local information on
is clearly wrong.” They’re not measured by Japanese companies in that
expansion because they’ll grow industry?
Second, Mark is very good at wherever they think they can
local information. He would export. MC: Yes, and I was trying to
read the local newspapers of develop a long-term, symbiotic
places where companies that These six investors had been in relationship where I could
he was looking at were Japan for 30 years looking at teach them a few things and
headquartered. He always small- and medium-sized they could teach me a few
would read the industry rags companies. They’ve learned things. That’s unlike what a lot
for the industries in which he about the managements of of people do. Everybody wants
was concerned. Most people those companies from a to do tons of calls, but they
sit in New York and talk to Western perspective. It's have more of a transactional
analysts in New York, but incredible what they know. focus, where it’s like, “Let me
they’re not interested in an They have non-overlapping get somebody on the phone
area where there’s a lot of knowledge and meet often to and suck all the information
local information. share their knowledge. out of them.” That may be
great in the short term, but it’s
The third thing that he I agreed to get breakfast with not nearly as good as meeting
understood is that research is them. Every single one of them somebody with whom you can
a lifetime process—that knows Mark because Mark had share information and
ultimately you become a exchanged information with compound knowledge over
specialist in companies that them about US industrial time—not someone you talk
you’ve studied before. You get companies in the same to once and think you know
better and better at it because categories of their Japanese everything, but someone you
you’ve seen the managements expertise. Mark understood talk to maybe once a quarter
involved and how they react to the value of cooperation for 10 years. You have a
different conditions and you’ve where you couldn’t get the chance to learn a lot more
seen the industry evolve and local knowledge yourself. I was over time that way.
react to global competition. impressed with that. I thought,
“That’s the right way to do G&D: Mark, you’ve previously
Last, he did something that’s business.” There are two referred to the importance of
very hard for people to do. I things you have to bring to the journaling every investment.
once gave a speech in Japan table with such networking. Why do you feel that's so
about why Japan has gone off One is a willingness to listen important?
the rails since 1990. There are and find the local experts. The
these six value investors who other is having something to MC: Jon Luft ’08, whom I
show up at the speech and trade, which means you need currently co-teach AVI with,
asked me to talk not about the to have some kind of local and I both believe this is very
Japanese macroeconomic knowledge yourself. important. Maintaining a
environment, but about journal allows you to record
companies and value I think those four topics— your thought process as you
opportunities in Japan. what’s the variant perception, are making investment
where is the local knowledge decisions, which is essential to
Now, a crucial issue for all that nobody else is carefully assisting your learning process.
Japanese companies is what looking at, how can you
they're going to do with your accumulate and build your Writing down your feelings,
money. There are four main knowledge over time, and how thought processes, and beliefs
management skills: efficient can you take advantage of a allows you to review your
operation, efficient financing, network—are areas of actual decision making and learn from
intelligent expansion to take research practice that are your successes and, more
advantage of competitive critically important. importantly, from your
advantages, and human mistakes. Charlie Munger has
resource planning. Japanese G&D: Mark, you were talking said, “It’s best to learn from
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Harvey SawikinBruce Greenwald & Mark Cooper ’02


A Final Lesson:
others’ mistakes,” but I believe investment process was honed level. However, when teaching,
we should learn from our own at Columbia itself and how someone might ask a question
as well. Having a record of much has improved over time? which you might think is basic,
your decisions is the only way I but to properly respond, you
know to do what, in the Army, MC: It’s impossible to say must go back to first principles.
we called an After Action exactly how it’s evolved over
Review. It allows you to do an time. As a student, you learn We taught the syllabus that
honest self-assessment after how to be a good analyst. How was given to us the first year
the fact to determine what you you evolve over time is a Artie, Eddie, and I taught
were thinking and feeling when function of how close you Applied Value Investing (AVI).
you made the original decision. were to really knowing When I started teaching it the
yourself, your firm, your second year with Jean-Marie
We all have faulty memories of mentors, and the environment Eveillard, I thought, this is not
the conversations that took you experience when you the way I invest. I really can’t
place when we made an invest professionally. I’d say I’m teach that. The only way I
investment. Think of a a more risk averse investor know to do it is the
situation where an analyst is methodology that has worked
recommending something to for me.
two portfolio managers. There “I thought about it
will be three opinions of what I am not saying that my
was said and what assumptions
and said, ‘Yes, we do approach is the only way to
were made. Odds are all of have a [positive] invest, but it’s based on how I
them are incorrect. The think an analyst should
“truth” is probably a fourth message for approach learning an industry
version of reality. Writing or a company before even
down the investment idea companies: focus on thinking about trying to value
enables us to have a record of the business. It’s why all the
our beliefs at that time. Having markets that you can AVI sections in Columbia’s
a personal journal performs a Value Investing Program are
dominate.’”
similar function. different—they’re intended to
because of my experience be. The investors/instructors
Another thing that makes during the 2008 financial crisis. are different and bring their
investing difficult is the fact own style and approaches to
that your feedback loop isn’t There’s no question I got a investing.
perfect. Attributing most of phenomenal foundation at
our success to skill is human Columbia. The continual After the class is over,
nature. Journaling helps one interaction with people like students are free to determine
get better feedback. First, it Bruce and Jean-Marie Eveillard, what parts of our approach
will help determine if you have along with hundreds of they want to take with them
a good or bad process. You students I’ve worked with, has and which they want to
must develop a good process been wonderful. Teaching has discard.
to be successful over time. forced me to really articulate
Second, it can determine the what I believe. What was it MC: I have some questions for
role that luck played in the that Richard Feynman said you, Bruce. Why’d you decide
outcome. An honest review of about teaching? to teach in the first place?
your journals will help you
honestly assess your decision- BG: The best way to learn BG: Oh, that’s easy. I wanted
making process. something is to explain it to to be a professor when I was
somebody else. 12 years old because I knew I
If writing a journal convinces wasn’t going to be able to do a
you that you cannot predict MC: And you need to explain job where I had to get up
the future, then I would say it it in simple terms. What often before nine in the morning
was time well spent. happens as a professional more than two days a week.
investor is that you assume
G&D: How much of your that everybody’s at a certain MC: What has changed over
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Harvey SawikinBruce Greenwald & Mark Cooper ’02


A Final Lesson:
the years teaching at business school got into a MC: What do you think has
Columbia, specifically with the good business school. It’s just changed about value investing
Value Investing Program and gotten tougher and tougher as a discipline?
the students themselves? since: more international
students, more women, more BG: I think it’s much tougher.
BG: The first thing is that with kids interested in business, I recently gave this interview
respect to the program, you more college graduates in to Barron’s questioning
really do learn more and more. every possible sense. whether value investing still
When I first taught Economics works. I think late-cycle
and Strategic Behavior… And I’m not really well- problems are part of it because
behaved in class. I’m not gentle everything looks overvalued.
Jingjing Hua ’19 and Viraj MC: What year was that? with the students. One of the But there is also a very specific
Vora ’19 win 1st place at nice things about teaching problem that people are
the UCLA Fink Center BG: It was probably 1993, MBAs: They didn’t used to dealing with now, and I think it
Credit Pitch Competition maybe 1994. The course was care about that. They were has to do with this transition in
just about barriers to entry going to do fine in life, and it the economy from
and it was really a downer, didn't matter that I disagreed manufacturing to services.
because it was about how with them. Now, students are
there was a range of much more resistant. Services are local businesses,
businesses that did not local businesses mean small
dominate markets. Then we MC: What’s the warning I gave markets, and small markets
gradually learned from student you guys the first day of my mean more dominance. If you
examples that when you look AVI section? If you’re easily think of the width of a moat as
at companies and markets as a offended or can’t deal with the minimum sustainable
whole, you’re making a criticism, you might want to market share, it’s going to be
mistake. There may be lots of leave the class right now. The much higher in a small market
firms that don’t dominate the reality is the job is not easy. than in a global market. For
grocery industry nationwide, example, with global
but there are firms that BG: The students have gotten automobiles, you’re viable at
dominate groceries in South tenser, but taller and better 2% market share. But with
Texas. We learned to think in looking. local cell phones, you’re not
terms of detail and viable until you get to 15%.
specialization. What finally did MC: On average now, do you You're not going to make your
it was when we wrote the believe the students are better cost of capital.
book, the editor said, “This read on value investing
book is a real downer. Can because there are so many Plus, service businesses are
you come up with a positive more books available today? continuous-interaction
thought to put in the book?” I businesses, much more so than
thought about it and said, “Yes, BG: Yes, they come in with a manufacturing. What that
we do have a [positive] more sophisticated means is you have much more
message for companies: focus background. But that’s not customer captivity. The moats
on markets that you can always an advantage. One of are much wider in these
dominate.” We re-wrote the the most important things to businesses, and as a result,
book with that in mind, and teach people is to learn what you’re much more profitable
you will see that that insight your own mistakes are. You even with less investment.
immediately leads to have to understand that you’re
specialization. going to make them again and In the late 1980s through the
again. You have to learn about 1990s, corporate profits were
The second thing that changed who you are. That’s hard for 8.5% of national income.
over time is that during the era kids who come in thinking Today, they’re somewhere
in which Mark came to school they’re sophisticated investors between 13.5% and 14%, and
[in 2000], we were accepting by the time they’re 26 years they’re going up. We’ve been
around 25% of the applicants. old. It’s a mixed benefit that in an environment where
It used to be that everybody they’re more sophisticated. profits have consistently been
qualified to go to a good going up. Value investors will
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Harvey SawikinBruce Greenwald & Mark Cooper ’02


A Final Lesson:
pay for today’s profits, but franchise businesses, and the won’t tolerate the ones that
they’re very nervous about net-nets tend to come from look cheap on reproduction
paying for future profit growth, foreign countries, you’ve got value and could be a net-net
which doesn’t exist except in to have a much longer horizon. but are losing a lot of money.
franchise businesses. And a lot You depend a lot more on the In those cases, you’re in a race
of businesses that were efficacy of management and against time as the value
previously not franchise them curating the future to decays every day.
businesses, such as
manufacturers like Deere & “Value investors [are] BG: All value traps have
Co., now are because they management problems. You
have this huge local service very nervous about didn’t used to have to worry
component. That’s a very hard about value traps, but now
paying for future profit management is a big factor.
concept for value investors.
growth, which doesn’t There are a lot of crappy
The other thing is, especially in managers out there. One thing
the United States, we have just exist except in I’ve learned is that if
produced a lot more value management is creating value,
investors. The fact that Buffett franchise businesses. reinvesting your money
is so prominent now means properly, running the business
that people are just better. And a lot of businesses so the earnings grow, and
distributing the earnings
If you put those three factors
that were previously usefully, who cares when the
together, the environment is not franchise market finds out? If you bought
tougher. In Jean-Marie the stock for $5 and the
Eveillard's generation, he could businesses...now are return is $1, you could live
be a generalist. These days, I with that 20% return forever,
think you have to specialize, because they have this whether it goes to $20 or not.
and I think you have to
specialize in geography too. huge local service G&D: Aren’t the good
component.” managers always well-known?
G&D: On that point—that
more of the value of an make sure that they create BG: They are. So, yes, they’re
enterprise is now in the future value going forward. Those are not going to be cheap. But you
for some of these local- all things that traditional value want to find managers at
dominant service businesses— investors didn’t have to worry companies that are perceived
how do value investors get about. as having problems.
over that? Do they have to
change the way they think MC: Can I add two things to And you need a good
about the business? that? One, we recently sold managerial checklist. What’s
one of our net-nets. It was a their attitude towards
BG: They have to adapt. Look, minor net-net—it basically efficiency? Is there an
more of the value of the stock traded at less than the cash organization in place that is
market is in franchise value of the business—but working to get more out of
businesses. With franchise their business strategy was the same resources? Does the
businesses, the assets don’t changing. It looked to me that CEO visit that war room first
matter as much. But you look they didn’t understand how thing every morning? That’ll
at the Marty Whitman-esque they would compete going tell you a very important thing
investors, they really focused forward. So, though it looks to about these companies. When
on assets. Ben Graham really be a cheap stock today, I think they grow, do they grow
focused on assets. The net- they’re going to bleed money where they have the
nets are straight balance-sheet for the next five years or competitive advantage and can
calculations. longer. We find some earn more than their cost of
opportunities like that in the capital and create value? In
When you’re in a world where small-cap space, but there are other words, do they
most of the profits are not a lot of them, and we understand their competitive
(Continued on page 12)
Page 12

Harvey SawikinBruce Greenwald & Mark Cooper ’02


A Final Lesson:
advantage? If they don’t, they drought?” Everybody’s focused emphasis was no longer on just
can destroy incredible amounts on the last five years of the selling the product, but about
of value. Do they have a cycle, but the real question is: selling it profitably. This was all
decent human resource what’s the right amount of public knowledge, but nobody
management policy? Do they history to look back? We accepted that they would do
hire like crazy in good times went back to the early 1970s this.
and then fire everybody in bad and thought that was the
times when people can’t find period, from a commodities There would be hiccups along
jobs? Is there a decent perspective, that was more the way, especially when a
succession plan? Are they good comparable for Deere. I company goes through a
at taking advantage of debt actually believed they could be manufacturing transition. But
when it’s cheap? Are they on the cusp of a cyclical and from our perspective, we had a
good at distributing the cash secular upturn, but, more cheap, cyclically depressed
they don’t need? importantly, I realized that company with secular tailwinds
they had initiated a self-help and a management team
MC: Bruce brought up Deere program. focused on the things they
as a company that’s evolved could control, such as
into a local-service business— There were two enormous improving their competitive
this is a stock that he and I internal changes that the advantage in manufacturing and
have talked about for a long market didn’t appreciate. First, making money in all parts of
time. I want to talk a little bit Deere was modernizing its the cycle.
about what it was when I first manufacturing facility. It went
discovered it in the early 2000s from a process where, in the It took them six years to fully
and contrast that with what Quad Cities in Illinois and Iowa implement the changes. The
you’ve seen in the last two they had six floors in a building cycle kicked in about two
years with its switch to that manufactured tractors, to years later, and Deere was
services. What Bruce has been straight-line manufacturing. No making so much equipment
able to discover in the last one I spoke with appreciated that it took longer than
handful of years has that improving the expected to slow production
tremendously enhanced my manufacturing process would to retool their factories.
knowledge of the company. reduce the time to Meanwhile, their nearest
manufacture a tractor from 42 competitor was shipping the
What I saw in the early 2000s days to six days and greatly stuff from Europe—it would
was a company that, on the enhance their cost advantage. take that firm two months to
surface, was cheap. The ship it over on a boat. Deere
valuation of the business was Second, Deere had historically had created a huge competitive
low, sentiment was poor, and lost a ton of money at the advantage by accelerating
people were very bearish on bottom of the cycle. Why was manufacturing time and
corn. The conventional that? Because Deere paid its reducing costs. It was about
wisdom is that Deere stock is salespeople the traditional way: local economies. When the
highly correlated with corn it paid them for sales. farmer gets to harvest season,
prices because the price of Salespeople didn’t care if it was he needs that combine to
corn basically drives Deere’s profitable selling another work today. It can’t come back
earnings. But this is a case tractor or combine—they to him three days from now.
where if you did deep enough were going to sell it if they You end up with huge local
work and had a good in-depth could. This was especially monopolies around a Deere
understanding of the industry, problematic during cyclical distributor, because farmers
you could have a great variant downturns, when salespeople are likely to buy equipment
perception. had to sell excess production from the manufacturer with
at large discounts. However, the closest service facilities.
By the early 2000s, most Deere started to pay the
people were looking at the salespeople on a more BG: And Deere’s management
previous five years and asking, complicated formula, which did understand that. They had
“Is this [agricultural] cycle like was ultimately a return-on- a very focused strategy.
’97 and ’98 during the assets-based focus. The
(Continued on page 13)
Page 13

A Final Lesson: Bruce Greenwald & Mark Cooper ’02


MC: I have another question our return from growth down are not going to be captive
for Bruce. There’s been a lot to 20/3 = 6.66%. since the product is changing
of talk in the last 10 years of so much. And the market is
platform companies and You have to be very careful going to be changing so much
compounders. Earlier, you about this calculation. I don’t that it’s very hard to secure
mentioned that we are seeing think most of these people scale.
more and more of companies’ who talk about compounders
value tied up in future growth. are careful in that way. You If you’re disciplined enough to
Does it worry you that many stay away from the difficult
investors see themselves as the “All value traps have industries in the world, I don’t
next Buffett and think they can think industry challenges are
identify these compounders? management problems. the problem. The real problem
is management challenges.
BG: I think the real test of You didn’t use to have
people who understand You can find what looks like a
compounders is whether they to worry about value good company—with lots of
understand that you can’t put a assets, earnings, and potential
traps, ut now
value that’s reliable on a earnings—at a cheap price, and
compounder. That the management is a big the management can still kill
discount rate (r) and the you. An example of that was
growth rate (g) are too close factor. There are a lot Dell. Dell was trading at a 20%
together when analysts try to earnings return. Yes, it was
estimate terminal value in a of crappy managers out maybe shrinking at 7-9% a
DCF. So when you try to year, but the decline wasn’t
select a multiple for that there.” going to accelerate, so it was
compounder, you really can’t have to look at where growth still a good return. But CEO
do it. really creates value. That Michael Dell was taking 80% of
means verifying the franchise, the earnings and trying to buy
So, you’ve got to do a looking at the quality of the his way into businesses he was
calculation of returns. All the capital allocation and so on. never going to get into. He
return calculations people use Just because a business is was destroying 80% of the 20%
are basically dividend discount growing quickly nominally earnings return, on top of
models, just rearranged. doesn’t make it a real which you have a business
Return (r) = Dividend (d) / compounder. that’s shrinking by 7%. It was
Price (p), or the cash return, + just not a happy outcome.
Growth (g). MC: Disruption is a common
narrative in many industries So, I think the hardest thing for
There’s an implicit but missing these days. What industry people to get their heads
term here. g is not simply the challenges make identifying around is management and
nominal growth in cash flows, great investments more what they can do to you.
it is the growth in value. To difficult for value investors? Especially if they don’t
anchor that g, we must understand where their
multiply it by intrinsic value v BG: The hardest challenges competitive advantage in
and then divide it by market are not industry challenges, business is. When that plays
price p. So r = d/p + g(v/p). because where industries are a out, a guy who used to be a
That is to say, our returns challenge, it’s almost always good manager, like Michael
from growth will be greater if where somebody like Amazon Dell, is not a good manager
we buy the business at half has come in and grabbed share. while the industry changes.
intrinsic value (v/p = 2). Well, if somebody can come in
and grab share, it’s not a stable Now, even as I talk about that
The problem is that at crazy market yet. In disruptive I think I’m learning something
valuations, p is going to be industries, before the from it. It’s the interaction of
much greater than v. So g may disruption settles down, there the management with changing
be 20%, but if p is three times are not going to be barriers to circumstances that’s hard to
v, then we’ve effectively cut entry because the customers chart.
(Continued on page 14)
Page 14

A Final Lesson: Bruce Greenwald & Mark Cooper ’02


MC: It’s impossible to BG: Yeah, we weren’t going to much better than my value
successfully and consistently lose any money with that one, investing book [Value Investing:
predict. but still I couldn’t bring myself From Graham to Buffett and
to do it. You are who you are. Beyond]. That’s just not a good
BG: Right, and most start That’s why I’m not really a book. There’s no serious
reacting badly and trying to professional investor. discussion of what a good
buy their way into [other manager is like. There’s no
businesses]. A lot of the PC MC: How teachable is being a serious discussion of risk
companies did it. They said, good investor? management. There’s no
“Oh we’ve got a lot of serious discussion about the
business customers. We can BG: I don’t think it’s research process. There’s no
become SAP or Oracle.” They teachable. That’s my lesson. decent discussion of how to
wasted an unbelievable amount When you’re a kid, the way evaluate growth stocks. It’s
of money. you think you’re going to make just not a complete book. So,
money is that you’re going to my first priority is writing the
MC: What about your guess the cycle. You’re going second edition. Hopefully, I’ll
investing philosophy has to guess oil prices better than finish it by the end of this year.
changed the most over the last other people guess oil prices.
20 years? You’re going to speculate on G&D: Will it have the same
the future, and good investors authors as the first edition?
BG: Oh, nothing at all. My don’t speculate on the future.
favorite book to recommend is They look at, for example, BG: No, it’s going to be me,
Jane Austen’s Pride and which oil companies have good Mark, Tano Santos, Erin
Prejudice, because it’s about self capital allocation, because the Bellissimo, and Judd Kahn.
-awareness. I have learned amount they spend on
what it takes to be a good exploration and development The second thing is, I’ve always
investor. And I have learned dwarfs what their profits are. had a good modus operandi
that I do not have that kind of with Joe Stiglitz for when we
character. I would say that for 80% of my write major things together: I
students, it’s all about: “What’s do an outline and a sort of first
I know what my mistakes are. the price of oil going to be,” model and then he does all the
I’m always trying to be the or, “The cycle is going to turn hard work. And he puts my
smartest guy in the room, and and I’m going to catch it just name on it. We have a story to
it’s really dumb. The last time I right,” or, “This new manager, write about structural crises—
made that mistake was when I who has no track record, is from the Great Depression to
invested in Deere stock. I going to turn this company today—about big industrial
wanted to absolutely bottom- around and we’re going to get transformations, such as from
tick it. I wanted a $70 average in there first and make agriculture into manufacturing
cost. money.” Despite what we to today’s transformation from
teach them, it’s very hard to manufacturing into services.
I initially bought a big position be disciplined enough to stay That book has to be done.
at $75, but then the stock focused and say no.
went up to around $80. I knew I’m hoping Joe will get bored of
I should buy the last 80,000 MC: What are you going to me not writing it and he’ll
shares of Deere at this price, do after you retire? Warren write it himself like he did with
but I stopped buying because I Buffett is 87, you’re a very our other book, Creating a
said, “Oh, I’ll get it at $70 or vibrant and motivated… Learning Society. Anyway, I'll
$75.” So, I didn’t fill the rest of probably have to do something
the position despite the fact BG: I’m 71. on that.
that I thought it was worth
$150 to $200. So, you students have taken And, I’m going to watch a lot
my Value Investing course of television.
MC: If you’re correct about which is based on what I’ve
the fair value, then buying at learned over the years. It MC: So, nothing else for after
$75-80 doesn’t matter. should be clear: That course is retirement? You watch a lot of
(Continued on page 15)
Page 15

A Final Lesson: Bruce Greenwald & Mark Cooper ’02


TV now anyway… and contribution to the
program.
BG: I mean, what am I going
to do? I was never interested
in making money. I was a crazy
investor earlier in my life. The
first investment that changed
my life was in 1970. I had
accumulated $37,000 in
various crazy stocks but then
managed to lose $12,000 on
soft-shell egg futures. I had
made my first enormous
investment mistake, and I had
to do something with the
$25,000 I had left.

So, I decided to go to the


library and—just as Buffett
found ideas reading the
Moody’s manuals—look at
bonds. I found these McCrory
bonds that are 7.5% bonds
trading for 25 cents on the
dollar. The interest itself is a
30% return.

I start reading the indentures,


and it’s clear that, short of
bankruptcy in every corner of
this company, these guys have
to pay these bonds. So I say,
even though this company is
run by a scumbag, he’s not
going to be able to not pay
these bonds.

So, I bought them and spent


the $25,000 on it. All of a
sudden, I had a capital income
of $7,500 a year. I used to
teach at Wesleyan then. Now,
my first salary as an assistant
professor was $12,500—full
professors were making
$20,000—so these bonds
moved me up. I was one of
richest professors at Wesleyan
based on those bonds.

G&D: Prof. Greenwald, we


know you have another
appointment. It’s been a
pleasure sitting down with you.
Thank you both for your time
Page 16

Stericycle (NASDAQ: SRCL) - Short


1st Place - 2018 Pershing Square Challenge
Jade Hu Asher Jacobs, CPA Rana Pritanjali, CFA
Shu19@gsb.columbia.edu AJacobs19@gsb.columbia.edu RPritanjali19@gsb.columbia.edu

Recommendation Key Statistics


We recommend a short on Stericycle (SRCL) with a
price target of $38, presenting nearly 40% downside FY 2017, in millions USD, unless otherwise noted
Jade Hu ’19 from today’s price of $61. We believe that unprece- Revenue $3,581 Share Price $61.10
dented competition, a high fixed-cost structure, and a Adj. EBITDA 757 Market Cap 5,351
Jade is a 1st year student at
stretched balance sheet will drive declines through Margin 21.2% NTM EV/EBITDA 9.8x
CBS. Previously, she
Adj. EBIT 487 EV 8,255
worked as an Associate in 2020. Accounting red flags and poor management bol-
Margin 13.6% Net Leverage 4.0x
the Investment Banking ster our thesis. At 9.5x forward EBITDA, SRCL should
division at J.P. Morgan. This be worth $38 by YE2019. Further scenario analysis FCF 360 2019 EV/EBITDA 9.5x
summer, Jade will be in-
presents a compelling 3.8x downside/upside. P/FCF 14x 2019 EBITDA 632
terning at William Blair
Investment Management in Business Description
Stericycle provides four types of services: regulated Adj. ROIC 5.3% 18-month PT $38
Chicago.
waste and compliance services to SQ (e.g. physicians, Short interest 7.3% Downside (base case) 38%
dentists) and LQ (e.g. hospitals), secure information
destruction, communication, and manufacturing and Revenue Bridge
industrial. Since its inception in 1989, Stericycle has
grown from a small start-up in medical waste manage-
ment into a leader across a range of complex and regu-
lated arenas through nearly 500 acquisitions.

Asher Jacobs, CPA ’19 EBITDA Bridge


Asher is a 1st year student
at CBS. Previously, he was
a Tax Consultant for
Deloitte’s Private Equity
group in New York, This
summer, Asher will be Investment Thesis
interning at DG Capital 1) Fallout From Pricing Lawsuit & Increased
Management in New York. Competition Drive Revenue & Margin Declines
The $295m settlement reached in the class-action law-
suit in October 2017 has brought Stericycle’s pricing EBITDA Forecast vs. Consensus
practice to the forefront. Our research shows that
Stericycle’s retention department is now staffed at rec-
ord level to combat increasing customer attrition. Both
Adam Xiao ’17 local and national peers are proactively training their
employees to help Stericycle’s existing, disgruntled cus-
tomers across the country to get out of their contracts.

Rana Pritanjali ’19 What competitors say: Unlike Stericycle, we don’t


Rana Pritanjali is a 1st year charge monthly fuel charges, or environmental fees.
student at CBS. Previously, Our contracts are shorter and easier to read. A lot of
she worked as a Research Stericycle customers have come back to us. Their cost
Analyst at The Motley structure is very high. Stericycle offers very little flexibil-
Fool. This summer, Rana
ity. Make sure you read the contract three times.
will be interning at Cause- What Stericycle says: From Jan 1, 2018, we elimi-
way Capital in Los Angeles
nated all extra costs for new customers. We will cap
and Artisan Partners in
As a result, we expect revenue to drop by 7% annually, fee increase at 5%. We are offering 1 month off on 1-
Milwaukee.
primarily driven by Stericycle’s inability to raise pricing year and 3 months off on 3-year contracts.
going forward, as compared to the 10% average pricing Our assessment: Based on data we collected, Steri-
increase they have had in the past. However, due to the cycle prices are 60-100% higher for the same service.
over 50% of fixed cost structure the business has,
Page 17

Stericycle (SRCL) - Short (Continued from previous page)


EBITDA is expected to decline by 14%.

2) Shrinking SQ End Markets Leading to Further Margin Erosion: The ongoing consolidation within healthcare industry has
shrunk the customer base for SQ segment, the most profitable business for Stericycle. From 2012 to 2016, the percentage of physicians
that are employees of large hospital groups has increased from 42% to 47%. Given the drastic difference in margin profile for SQ and LQ
(30%+ EBITDA margin for SQ, as compared to mid-teen for LQ), every dollar shifting from SQ to LQ has a decremental margin of 20%.

3) Value Destructive Acquisitions Have Significantly Eroded margin and ROIC and Strained Balance Sheet: Adjusted
ROIC declined to 5.3% in 2017 from 10.9% in 2013 primarily as a result of value destructive M&A in non-medical waste segments, espe-
cially in Shredding since 2015. Take the 2.1bn Shred It acquisition for example. This is a highly cyclical business (50% EBITDA from selling
recycled paper) in a secularly declining industry. There’s limited economies of scale between the core medical waste business and paper
shredding business. We expect recycling margin to face downward pressure as recycled paper pricing comes off its cyclical peak. And yet
it was sold to Stericycle at a 9x EBITDA multiple, including synergies. At the same time, the company has loaded its balance sheet with
debt to 4x net leverage, making it extremely difficult for them to continue the roll-up strategy. Stericycle has close to $750 million of obli-
gations due by 2019. Its credit rating and outlook was recently downgraded. It has $1.2 billion debt maturing in 2020 that’s paying 2-3%
interest rate. We expect that to spike once the company resorts to refinancing. It was also close to tripping its covenants in March this
year, until it obtained a temporary relief from lender through 2019.

4) Accounting Assumptions & Adjustments Highlight Deteriorating


Fundamentals: In addition to weak internal controls and multiple late filings
and restatements, we believe numerous changes in accounting assumptions
earnings adjustments are concerning. Allowance for doubtful accounts has tri-
pled over the past two years. Useful lives of customer relationships, for which
Stericycle has paid a premium over the course of its 500 acquisitions, has halved
over the past four years. In terms of earnings adjustments, the delta between
GAAP EPS and adjusted EPS is growing, as free cash flow conversion (as % of
adjusted EPS) declines.

5) Common Ground for Bulls & Bears– Stericycle’s Management:


Over the past four years, Stericycle has lost $5 billion in market value despite
spending more than $3 billion on acquisitions. However, CEO base compensation has tripled over this time period. We believe manage-
ment is focused on empire-building at the expense of shareholders. The lack of stock ownership by management is also alarming, especial-
ly considering their long tenure with the company. Multiple long-term shareholders have expressed frustration with management’s focus
on acquisitions rather than stabilizing the core business.

Catalysts
We expect continued earnings misses and a large asset impairment (>70% of assets are intangibles) over the next 12-18 months. We also
wouldn't be surprised by further restatements or an SEC investigation into the company’s accounting policies, considering the SEC’s per-
sistent questioning of the company in recent years.

Valuation
Based on multiple valuation methodologies and scenario analyses, we believe Stericycle remains overvalued and offers an attractive risk /
reward. Our base-case assumes continued SQ deterioration and slight shredding growth, with other segments achieving management’s
2018 guidance and stabilizing through 2020. Using a 9.5x forward multiple on 2020E EBITDA, our $38 price target presents ~40% down-
side over the next 18 months. A sum-of-the-parts valuation confirms this price target. Even in our bull case, which assumes stabilizing
operations, the mere shift of revenue to lower-margin businesses limits upside potential. We also believe there is room for further deteri-
oration and continued multiple compression. As such, our bear/bull scenario analysis presents a 3.8x downside/upside ratio.

Key Risks
Activist pressure: An activist investor can replace management or push for a sale/break-up of the business. Jana Partners took a position
in SRCL in 2016 but exited shortly thereafter. Discussions with investors close to the situation have revealed that Jana noticed underlying
problems with Stericycle’s business model - similar to what our research has exposed. At SRCL’s current valuation, we don’t believe an-
other activist will take a gamble. Breaking up the business would also be tough, as Shred-it would receive a far lower multiple than the
core MedWaste business.

Takeout: Waste Management or a competitor may acquire Stericycle. Although WM has made multiple unsuccessful attempts to enter
the MedWaste market, it is extremely prudent when allocating capital and seeks stable revenue/earnings. We don’t believe it will pay a
11x multiple (or >$8bn) for a business facing pricing pressure/contract resets simply to acquire customer routes and incinerator/autoclave
infrastructure. Conversations with former WM executives have confirmed this belief, and lead us to believe that WM may acquire regional
competitors to compete with Stericycle now that SRCL’s balance sheet is constrained.
Page 18

Credit Acceptance Corporation (NASDAQ: CACC) - Short


2nd Place—2018 Pershing Square Challenge
Steve Cao Tyler Redd, CFA Winter Li, CFA
SCao19@gsb.columbia.edu JRedd19@gsb.columbia.edu WLi19@gsb.columbia.edu

Recommendation Key Trading Statistics


We recommend a short on Credit Acceptance Share Price $ 314 ADTV (3M) $ 51
Corporation (CACC) with a price target of FDSO 19 P/E (NTM Con.) 11.7x
Steve Cao ’19 $210, 33% below today’s price of $314. We
Market Cap $ 6,100 P/B 4.0x
Debt 3,071 Net Debt/EBITDA (LTM) 3.6x

Steve is a 1st year student believe the risk-reward is now favorable with Cash 8 Short Interest 19%
Enterprise Value $ 9,163 Dividend Yield 0.0%
at CBS. Previously, Steve 71% downside in our bear case and 30% upside Book Value $ 1,536 Cost to Borrow GC
was an Associate at Gold- in our bull case, or a downside/upside ratio of
man Sachs Private Equity 2.4x. We project EPS to decline by 13% to $21
Group (PEG). This summer Key Financials
per share in 2020, 30% below street consensus, Historical Projected
he will be interning at driven by flat growth in new loan originations, a (US$M) 2015 2016 2017 2018E 2019E 2020E
AllianceBernstein Arya declining yield, and an increase in provisions for
Partners in New York. He Revenue $ 825 $ 969 $ 1,110 $ 1,259 $ 1,382 $ 1,498

holds a BA from Rutgers credit losses. growth 14.1% 17.4% 14.5% 13.4% 9.7% 8.4%
EPS $ 14.28 $ 16.31 $ 24.04 $ 26.65 $ 30.23 $ 34.00
University. growth 19.8% 14.1% 47.4% 10.9% 13.4% 12.4%
Business Description Book Value $ 928 $ 1,174 $ 1,536
$ $ 1,803 $ 1,957 2,136

CACC is a $6B market cap subprime used car P/E 13.1x 11.8x 10.4x 9.2x
auto-lender based in the US. The company op- P/B 4.0x 3.4x 3.1x 2.9x

erates two lending programs—Purchase (30% of


2017 originations) and Portfolio (70% of 2017 originations). The Purchase Program is similar to traditional,
indirect loan originations; CACC buys loans from dealers, dealers earn an upfront profit, and CACC retains
100% of both the upside and the downside. CACC’s Portfolio Program allows dealers to earn a smaller up-
front profit, but in exchange, an opportunity to share in future collections in what the company calls Dealer
Holdback payments. CACC has a first priority on all collections until its upfront advance to the dealer and
servicing fees are recovered; thereafter, remaining collections are split 80% to dealers and 20% to CACC. This
structure incentivizes dealers to originate high-quality loans and also reduces CACC’s risk of principal loss on
Tyler Redd, CFA ’19 its upfront dealer advance. The Portfolio Program is unique to CACC and is one of the reasons its stock has
Tyler is a 1st year student
performed so well in a risky sector.
at CBS. Previously, Tyler
was a Senior Analyst at Investment Thesis
Privet Fund Management, a 1) High competition has led to deteriorating conditions within the subprime auto industry
small-cap activist fund, and Non-bank lenders such as CACC and its peers have poured ~20% more capital into the subprime auto sector
a Financial Institutions today than at any point leading up to the financial crisis. As a result, delinquencies for non-bank lenders are
M&A Analyst at Raymond approaching 2009 highs, despite the backdrop of 4% unemployment in the U.S. Very recently, the industry has
James. This summer he will seen prior tailwinds become headwinds. Subprime auto lending has been a beneficiary of persistently high
be interning at Aravt Glob- used car prices, including increases throughout 2017 due to multiple hurricanes. However, the Manheim Used
al in New York. Car Index has declined by mid-single-digits over the last few months, and we expect to see continued near-
and medium-term pressure on used car prices as a glut of off-lease inventory comes to market. In addition,
the industry will suffer in a rising rate environment. We believe CACC and many of its peers are already lend-
ing to customers at or near maximum interest rate ceilings in many states.
Adam Xiao ’17
2) Credit Acceptance’s competitive advantage is eroding as unit-level economics decline
i) “Show me the incentive and I will show you the outcome”: The key to the Portfolio Program has
been getting a used car dealer to originate better quality loans. However, we question whether CACC is still
able to incentivize dealers to wait for Dealer Holdback payments versus originating more—but lower quali-
ty—loans to maximize upfront profit. Dealer Holdback payments per active dealer have declined 50% in the
last five years. In addition, dealers now take twice as long—five years—before they originate the required 100
Winter Li , CFA ’19 loans necessary to be eligible to receive Dealer Holdback.

Winter is a 1st year stu- ii) Loan-level metrics indicate secular challenges: Bears and “Loan-Level ROIC” Comparison
dent at CBS. Previously, he bulls diverge on whether declining metrics, such as Holdback per
was an Investment Associ- dealer, are signs of secular challenges in the business or simply
ate at MFS Investment
symptoms of the late stages of an industry cycle. We lean towards
Management, where he will 9%
also be interning this sum- the first camp (holdback per dealer was 120% higher in 2007, a
similarly buoyant time in the previous cycle). On the surface, 4%
mer. Winter will serve as 21%
the Co-President of CSIMA Credit Acceptance’s adj. ROIC in 2017 (11%) is comparable to
15%
in 2018-2019. what the company produced in 2007 (12%). However, CACC has 12% 11%
gained considerable operational scale in originating and servicing
loans over the last decade. We estimate that an adj. ROIC of 11% 2007 2017
Page 19

Credit Acceptance Corporation (CACC) - Short (Continued from previous page)


today actually equates to 15% adj. ROIC at the loan-level. This compares to 21% loan-level adj. ROIC in 2007. In Credit Acceptance’s
CEO’s own words, competitors have “much more information available today and a much longer historical track record upon which they
can base their conclusions.” Going forward, we question how much further CACC will be able to offset declining loan-level returns with
operational leverage. The firm already reduced opex by 5% points over the last decade. Using Santander Consumer (~8x the assets of
CACC and opex as a % of Invested Capital of 2% vs. CACC’s 4%) as the benchmark suggests the opex ratio won’t decline much more.

3) Credit Acceptance is worse positioned relative to the previous downturn


i) Bulls are expecting a similar level of counter-cyclicality: Many of CACC’s investors are actually rooting for the industry cycle to
turn. These investors believe the company will be able to take market share and emerge stronger, similar to what happened in 2009-10.
We have our doubts that the pattern will repeat itself to the same degree. Most importantly, CACC is a much larger company today, with
4x the dealers as in 2007. Given its extremely high level of dealer attrition (29% in 2017), the company is churning through 5% of its 60K
dealer TAM each year. CACC’s Purchase Program
ii) Unprecedented cycle length is forcing Credit Acceptance into aggressive
40% 80%
actions: The current industry cycle is into its seventh year. Loan growth on a per-unit

% of Loan Pools Not Performing to


70%
basis was negative in 2017 (-8% for Portfolio loans) which CACC was able to offset by

Expctations at Origination
As a % of Total Loans
30% 60%
increasing the amount of capital it advances to its dealers by 10%. The company is increas-
ingly deploying capital to its Purchase Program where it takes 100% of losses. These loans 50%

are no longer performing just as the company has increased its Purchase book to record 20% 40%

levels. The dollar value of Purchase loan pools which are underperforming original expec- 30%

tations increased 250% in 2017. 10% 20%


iii) 2017 underwriting metrics look markedly worse than 2007: CACC’s books 10%
appear much worse compared to a similar point in the previous cycle. Loans are 45% 0% 0%
larger, 35% longer, and skewed to the Purchase Program. The spread between Forecast 07 08 09 10 11 12 13 14 15 16 17

Collections and Advance Rates is at record lows, especially in the Purchase book. CACC % of Total Loans (LHS)
% of Loan Pools Not Performing to Expectations (RHS)
ended 2017 with 40% less reserves than in 2007.

Why Now: Attractive Risk/Reward


i) Attractive Reward: Credit Acceptance is under-provisioned compared to peers despite underwriting converging
CACC’s loans, having increased by 20 months compared to only 13 months for the next closest peer, are now larger than those of peers,
and generate 10 percentage points lower in yield than they did a decade ago. However, even though delinquencies, provisions, and charge-
offs have increased across the industry, the gap between Credit Acceptance and peers on these metrics has widened considerably.
Size of Avg. Loan Avg. Term of Loan (months) Provisions Charge-Offs

ii) Attractive Reward: Near-term downside: CACC reported a 4Q17 provision 2x above street estimates and at the highest level
since 2008. Importantly, CACC management stated that the increased provision was purely due to the timing of cash flows. CACC ex-
pects to collect the same amount of cash flows as before, just at a later time. We believe further provisions are likely as the company
recognizes loan losses. Additionally, management is sending mixed signals to the market. Over the last 18 months, two long-time insid-
ers—President Steven Jones and founder and former Chairman Don Foss—have left the company. Since leaving the company, Foss has
sold $450+ million worth of shares. Management’s share repurchase activity has also decelerated and the company has not repurchased
shares above ~$220, which is 30% below today’s stock price.
iii) Limited Risk: Valuation remains high, but growth is becoming more challenging: At CACC’s current valuation of 12x P/E
and 4x P/B, we believe there is limited upside to the current stock price. CACC’s ROIC is declining and its cost of capital is increasing,
resulting in flat growth in economic profit. Rising interest rates and lower loan IRRs are squeezing
net interest margins. Short interest has declined meaningfully following forced covers of existing
short positions, resulting in a low cost to borrow for current investors.

Valuation
Based on our underwriting, we project EPS to decline by 13% over the next three years to $21
per share, which is 30% below consensus forecasts. Our forecast is driven by three main varia-
bles: flat growth in new loan originations, a declining yield, and an increase in provisions for credit
losses. We believe the first two variables will be driven by today’s competitive environment, with
the increase in provisions driven by an under reserved loan book. Our price target is $210, 33%
below today’s stock price, with an attractive 2.4x downside/upside ratio.
Page 20

Spotify Technology S.A. (NYSE: SPOT) - Short


3rd Place - 2018 Pershing Square Challenge
Mike Allison Eric Herzfeld Michael Wooten
MAllison19@gsb.columbia.edu Eherzfeld@gsb.columbia.edu MWooten19@gsb.columbia.edu

Recommendation Trading Statistics


We recommend a short on Spotify Technology
S.A. (SPOT) with a price target of $72 at the
Mike Allison ’19 end of 2019, offering ~50%+ downside from
Mike is a 1st year student today’s price of $155. Our downside is support-
at CBS. During his first ed by our diligent primary research with 23
year, he interned at Sen- music industry experts, which includes 4 music
tentia Capital Management, label CEOs, 3 media/music industry CEOs, mul-
a value-focused long/short tiple executives of music royalties, musical art-
equity fund. This summer, Return Expectations
ists, former Spotify employees, and others.
Mike will be interning at
Fithian, a long-biased hedge
fund. Business Description
Spotify is a digital music streaming service that
operates in two segments, Premium service and ad-
based service. On the premium side, users pay a
monthly fee and have access to Spotify’s entire
music catalog. On the ad-based side, users can
listen to music for free, but their service is periodi-
cally interrupted by advertisements. As of March
2017, Spotify has 71 million premium users and 92
million ad-based users.

Investment Thesis: Multiple Valuation Approach


Eric Herzfeld ’19 Spotify is a Good Product, but a Bad Busi-
ness
Eric is a 1st year student at
CBS. During his first-year,
1) Record Labels Control Industry with
he interned at VectoIQ and
Alrai Capital, venture capi- Their Consolidated Power
tal funds in New York. This Spotify immediately pays out 52% of its revenue to the record labels in order to supply the music content on
summer, Eric will be in- its platform. The music industry is highly consolidated with three major record labels (Big Three) controlling
terning at Bowery Capital, nearly 75% of the market share and 87% of the musical content. The majority of the Big Three power comes
a venture capital fund in from their control of the back catalog of musical content. Any song older than 18 months is considered back
New York. catalog content. 70% of all music listened to is back catalog content. By controlling this content, the Big
Three have power over the industry.

2) Increased Competition From Major Tech Players with Low Barriers to Entry
Spotify currently has a favorable deal with the Big Three record labels thanks in large part to Spotify being the
entire paid streaming market in 2015.
Adam Xiao ’17 Even with their control of the paid
streaming market, Spotify had to give
up 16% of equity and growth cove-
nants in order to get these lower
royalty rates. Since 2015, Apple and
Amazon have launched streaming
platforms, while YouTube has contin-
Michael Wooten,
ued to test the market. Though
CFA ’19
Spotify has 71MM paying users, Apple
Michael Wooten is a 1st has quickly grown to over 40MM
year student at CBS. Previ- paying users and Amazon has recently
ously, he worked as an doubled their base from 16MM to
Associate at Corrum Capi-
tal Management and as an 32MM in only 6 months.
Analyst at Reicon Capital.
This summer, Michael will The major tech players entering the music industry do not care about the profits of their music business be-
be interning at WEDGE cause they are platform companies that extract value from their consumers in different ways.
Capital in Charlotte. With the increasing competitive landscape and dwindling bargaining power, what incentive do the Big Three
record labels have to give Spotify a better deal?
Page 21

Spotify Technology S.A. (SPOT) - Short (Continued from previous page)


3) Spotify’s Business Model Has Nega-
tive Economics
Most sell-side analysts believe Spotify is the
next Netflix, but they have completely differ-
ent business models. Netflix has high fixed
costs for original content, but little to no mar-
ginal cost for each new user on its platform.
Spotify, on the other hand, has to pay a per-
centage of revenue to the record labels for
each new user on their platform. In addition,
the more content users listen to on Spotify,
the more Spotify pays in variable costs to art-
ists on a pay-per-stream basis.

Many people believe Spotify has the best music


product today, but if you compare their reten-
tion rate with that of other subscription-based
services, you will find that Spotify is dead-last
at 49% retention in 2019. This means that
51% of paying customers left Spotify in 2017.

Catalyst: Spotify’s Margins Will Fail to Meet Market Expectations Following Unfavora-
ble Royalty Negotiations with the “Big Three” Record Labels in 2019
Spotify needs to renegotiate deals with the Big Three record labels in 2019. Each record label re-
quires individual deals, but the Big Three record labels have a “Most Favored Nations” clause which
ensures that they receive the highest of the negotiated royalty rates. This clause makes the record
labels a de-facto monopoly. Due to the headwind on mechanical rates and high market expectations,
Spotify needs to reduce their royalty rate from 52% to 48% at minimum. In speaking with four CEOs
of record labels, including the CEO of a Big Three record label, we are confident that Spotify won’t
be able to meet market expectations. The CEO of a Big Three record label stated “He [Daniel Ek]
doesn’t have the back catalogs that we have. He needs those to be successful today…He has com-
mitted to using tech to try and beat us. I am determined to not be beaten by him...we’re going to use
all of our levers to control Spotify’s behavior.” Every indication from the record labels is that they
plan to fight Spotify to show their dominance in the market.

Valuation
Based on multiple valuation methodologies and scenario analyses, we believe that Spotify is signifi-
cantly overvalued and offers an attractive short opportunity: In our base-case scenario, we believe
that shorting the stock offers ~50% return by 2020 and the stock will fall from its current price of ~$149 to below $75 per share. Our
base-case scenario assumes ~17% CAGR revenue and user growth, but due to the lack of operating leverage in the business model and
intensifying competition, Spotify’s operating margin will never reach 10% as the company stands today and therefore the intrinsic value of
the stock is half of the current market price. Our base-case model incorporates a 7.5% terminal discount rate and 4.0% terminal growth
rate, and implies a 1.5x forward EV/Revenue multiple. We also used relative valuation techniques, which indicated an intrinsic price range
of $24-$71, depending on whether net or gross revenues were used for comparison.

4 Key Risks
1. Spotify is able to generate original content, although we believe that the threat of the music labels pulling the back catalogs will
mitigate this risk.
2. Spotify’s market share growth exceeds expectations. The current total addressable market for cell phones with payment capa-
bilities is 1.3 billion phones, and the market is expected to grow over 1.7 billion in the next couple of years. Increased competition by
Apple Music, Amazon Music, and others.
3. Spotify is able to expand its margins. Spotify doesn’t have pricing power and has limited ability to renegotiate better royalty rates
with the big three music labels.
4. Spotify gets taken out. Spotify’s users and data make it a potential target of M&A. We believe that Pandora Radio is a strong case
study showing how much value a music streaming business can lose without being acquired.
Page 22

C.H. Robinson (NASDAQ: CHRW) - Short


2018 Pershing Square Challenge
Ryan Darrohn Brad Headley John White
RDarrohn19@gsb.columbia.edu BHeadley19@gsb.columbia.edu JWhite19@gsb.columbia.edu

Business Description
C.H. Robinson is a transportation broker, acting as a middleman for shippers and
Ryan Darrohn ’19 carriers. Two-thirds of the company’s revenues are derived from trucking broker-
Ryan is a 1st year student age services in North America (referred to as NAST). C.H. focuses on dry-van
at CBS. Previously, he was truckload brokerage services, a commodity service. The company does have other
a Captain and acquisitions
revenue streams, but they represent a minority of total operations, have much
officer in the U.S. Air
Force. Ryan graduated lower operating margins, and are irrelevant to this thesis.
from the U.S. Air Force
Academy with a degree in
Business Administration. Investment Thesis
1) Changing market dynamics will accelerate CHRW’s margin degrada-
tion: CHRW takes the spread (“net revenue margin”) between the cost of
truckload capacity purchased and the rate charged to the shipper. It sells truckload capacity on a spot-
contract mix of 35%-65% but purchases 95% of capacity on the spot market, a weakness as spot prices in-
crease. Spot prices have already increased 28% YoY, and are predicted to rise to over 2x the previous record.
With truckload utilization at 100%—the largest driver shortage on record—and GDP growth above 2.5%,
new capacity will not be able to decrease market tightness. The Electronic Logging Device (ELD) mandate,
requiring that all time be recorded electronically, was enforced on April 1, 2018. Immediately, 7% of supply
was removed from the market, compounding an already tight market.

2) C.H. is overearning, thereby in-


creasing competition and attracting
Brad Headley, CPA, new entrants: There has been
CFA ’19 >$2B of funding raised for VC-backed,
Brad is a 1st year student
tech-enabled start-ups globally from 2015
at CBS. Previously, he
worked in public account- -2017. Without a large headcount, these
ing and investment ac- tech start-ups are able to offer this com-
counting.
modity service at much lower margins
than incumbent brokers. Since starting in
May 2017, Uber Freight has been ex-
tremely successful in Texas, as Uber
targets only a 5% spread. Additionally, carriers have invested in their own technology systems and have started
their own brokerage segments. The combined effects of these new entrants are illustrated in the above chart.

3) Deteriorating business fundamentals in an environment in which competitors are thriving.


Although C.H.’s ROIC looks attractive (average 31% since 2010), the average return on incremental invested
capital has been -2% since 2010. A paradigm for this shift is an increase in headcount combined with stagnant
volume growth. C.H.’s volume growth has lagged the FTR TL Loadings Index by 6% since 2015. Also, since
shippers want reliability in this tight market, they are calling carriers directly. C.H.’s recent volume perfor-
John White ’19 mance highlights shippers’ reliability worries: -3% in 4Q and -7% in January (meanwhile carrier volumes had
the best January on record).
John is a 1st year student
at CBS. Previously, he
worked as a Private Equity Competitive Landscape
Associate in the T&L and CHRW has 3% of the total truckload market and 20% of the brokerage truckload market in North America.
tech sectors, and as an
With such a high percentage in a fragmented market, our primary research suggests that C.H. is fully saturated
M&A Analyst in FIG.
in North America. Currently, 50% of C.H.’s orders are fully automated, meaning 50% of C.H.’s revenues are
competing strictly on price. Considering Uber is targeting a 5% spread, C.H.—with a ~16% spread—will be
unable to compete in this commodity market. Also, technology platforms, such as Odyssey Logistics’ WIN
Page 23

C.H. Robinson (CHRW) - Short (Continued from previous page)

platform, already help carriers fill empty back-hauls and allocate inventory in advance without needing to rely on, or pay, high fees to
brokers. As travel platforms have reduced demand for legacy travel agents, CHRW’s reselling services will have trouble competing
with online portals that directly connect carriers and shippers. Additionally, these platforms will continue to weaken brokers’ relationships
with shippers and carriers through creating a “second-bid.”

Valuation
Since peaking in 2006 at ~35x forward EPS, C.H.’s multiple has gradually de-rated to the current ~21x. We expect the multiple to com-
press to 16x (trough levels) when C.H. misses consensus estimates, as there are a multitude of factors working against C.H. Our research
suggests NAST revenues will only grow at 8% in 2018 and 6% in 2019. Additionally, C.H.’s NAST spread will compress from 15.7% to
14.6% and 14.3% respectively. With Robinson’s hidden operating leverage, the spread decreases are exponentially detrimental to the bot-
tom line. For example, a 1% decrease in NAST spread decreases net income by 13%, while a decrease in the spread from ~15% to ~10%
(twice Uber Freight’s margin) turns net income negative. Using performance results from last year to project forward results, we estimate
2019 EPS to be $4.31. After the release of 2018 results, we think the Street’s 2019 estimates will align with our research. Applying a 16x
multiple to our 2019 EPS estimate produces a $70 price target.

Key Risks
1. If C.H. is able to increase its spot market exposure in the first half of 2018, profitability could surpass estimates.
2. If C.H. can overcome its historical weakness of passing on price increases, net revenues could be higher than estimates.
3. If C.H. is able to convince a tech player that a partnership would be beneficial for both companies, C.H.’s future prospects could invert.
Page 24

Harvey Norman (ASX: HVN) - Short


2018 Pershing Square Challenge
Arthur Brousseau Greg Doger De Speville Neethling McGrath
ABrousseau19@gsb.columbia.edu GdeSpeville19@gsb.columbia.edu NMcgrath19@gsb.columbia.edu

Business Overview:
Harvey Norman (HVN) is an Australian- Key Trading Statistics Company Enterprise Value
based, multi-national “big-box” electronics Current Share Price A$ 3.38 Market Capitalization (A$) A$ 3,776 m
Arthur Brousseau ’19
and furniture retailer: 52-Week Range A$ 3.38 - 4.62 Less: Cash (A$) A$ 151 m

Arthur is a 1st year student • U.S. equivalent would be a hybrid be- EV / EBITDA
Plus: Debt (A$)
6.8 x Plus: Minority Interest (A$)
A$ 852 m
A$ 25 m
at CBS. Previously, he tween Best Buy and Bed Bath & Beyond P/E Ratio 9.4 x Enterprise Value (A$) A$ 4,493 m
worked as an Associate at • HVN operates in both Australia and Dividend Yield 7.7%
B-29 Investments. Arthur Short Interest 8.3%
graduated from Princeton some international markets Cost of Borrow (A$ 50m) 0.0% Market Capitalization ($USD) $ 2,899 m
University in 2012 with an • HVN owns and operates 86 stores in Less: Cash ($USD) $ 116 m
Plus: Debt ($USD) $ 656 m
A.B. in Politics. international markets Target Share Price 2Y A$ 2.19 Plus: Minority Interest ($USD) $ 19 m
• HVN franchises the entire Australian Base Case Return 35.3% Enterprise value ($USD) $ 3,724 m

retail store base


• There are 195 Australian stores operated by a network of 684 franchisees, and there are multiple fran-
chisees operating within a single store

Recommendation:
We argue that HVN is a fragile business at the top of an economic cycle that is facing structural challenges from in-
creased competition and is run by a management team that avoids transparency and lacks accountability.
Thesis:
 Franchisee revenue is unsustainable and some loans advanced to franchisees are likely not recoverable.
Opaque financial reporting does not reflect true economic reality of franchise business.
 We’ve identified numerous unprofitable locations that should be closed down. These locations are con-
Greg Doger de Speville, centrated in HVN-owned real estate and closing them will impair the value of HVN’s real estate.
CFA ’19  Intense competition, slower consumer credit, and stagnant housing growth will lead to the weakening of
Greg is a 1st year student the already fragile franchise network.
at CBS. Previously, he
worked as an Investment No sell side analyst report includes the proprietary data we analyzed to assess the underlying health of the franchise
Analyst at IPRO Funds network and the sustainability of the franchise network revenue.
Management. Greg gradu-
ated from the University of
Western Australia with The Fake Franchise Network:
First Class Honors in Eco- By using a franchise model, HVN is able to obscure the true economic value of the core AUS retail business.
nomics. • HVN controls franchisees operationally, but has a legal structure to create the illusion that franchisees are
independent so that HVN does not have to consolidate franchise-level financials.
• The franchise network is opaque and complicated; HVN discloses only the franchisee network sales, the
total number of franchisees, and the total number of stores.
• Consolidation would reveal the true economic value of the franchise network.

Extreme Franchisee Churn:


The franchisee network is extremely fragile - much more so than the market knows.
• As much as 15% (~100) of franchisee base fails each year.
• Number of failed franchisees doubled from 2010 to 2011, indicating the franchisee network is fragile and
that there are likely many franchisees running at break-even profitability.
• Franchisees are failing in specific areas, and there is a concentration of locations that HVN is keeping alive.
Neethling McGrath ’19
Fragile Franchisee Network Franchisee Failures are Concentrated in Specific Stores
Neethling is a 1st year Franchisee Liquidation (RHS)
180 Month
160 Month
Average Operating Months (LHS) # Failed Franchisees (RHS)
90
80
student at CBS. Previously,
$ 5.3 Bn 300
Franchisee Revenue (LHS) 140 Month 70
$ 5.2 Bn
he worked as a TMT con- $ 5.1 Bn
250 120 Month
100 Month
Concentration of Locations that are rolling over every 2 Years 60
50
sultant at KPMG Manage- $ 5.0 Bn 200 80 Month 40
$ 4.9 Bn
ment Consulting. Neethling $ 4.8 Bn
150
60 Month
40 Month
30
20

graduated with a Bachelor’s $ 4.7 Bn 100 20 Month 10

in Engineering and a Mas- $ 4.6 Bn 0 0


Mt Druitt

Wodonga
Mile End

Maryborough

Coorparoo
Mildura

Gympie
Moore Park

Bendigo

Parkes

Port Kennedy

Taree
Rosebery

Bondi Junction

Lake Haven

North Ryde

Broadway on the mall

Armadale WA

Whyalla
Hamilton

Toowoomba
Bathurst

Mt Gravatt
Young

Rockhampton

Port Lincoln
Oxley

Mandurah

Macgregor

Morayfield

Burleigh Waters
Bunbury

Geelong
Mt Barker

Cannonvale

Peppermint Grove
Moss Vale

Alice Springs
Burnie

Cranbourne

Auburn

Albany
Caringbah
Balgowlah

Wiley Park

Freemantle

Noarlunga

Capalaba
Wangaratta

Chadstone

Mentone

Dalby
Alexandria

Cairns

Fortitude Valley

Innisfail
Melbourne City

Liverpool

Fyshwick

Castle Hill

Bennetts Green
Southland

Ipswich
Greensborough Plaza

Preston

Cleveland
Launceston

Warrnambool
Hoppers Crossing

Munno Para
Broadway
taralgon

Chatswood

Ringwood

Karratha

Hervey Bay

indooroopilly

Belmont

50
$ 4.5 Bn
ters in Philosophy from $ 4.4 Bn 0

Stellenbosch University. 2008 2009 2010 2011 2012 2013 2014 2015 2016
Page 25

Harvey Norman (ASX:HVN) - Short (Continued from previous page)


Divergence of Earnings & Cash Flow: Franchisee Revenues vs. Cash Receipts from Franchisees
We believe HVN is overstating earnings and accumulating bad debt.
• Franchise revenues and cash receipts from franchisees started to diverge A$ 1200 m Cumulative Difference (RHS) Revenue from Franchisee (LHS)
A$ 1900 m
following the 2010 decline in franchisee network sales. A$ 1100 m Net Cash Receipt from Franchisee (LHS)
A$ 1600 m
• The cumulative divergence has reached A$970m as of FY 2017. A$ 1000 m

• A$614m of this divergence has been expensed as “tactical support.” The


A$ 1300 m
A$ 900 m
A$ 1000 m
remaining A$340m has not yet been collected or expensed. A$ 800 m

• Poor disclosure makes it impossible to track the evolution of this receivable A$ 700 m A$ 700 m

on the balance sheet. Receivable from franchisees (A$942m) was disclosed A$ 600 m A$ 400 m

for the first time in the notes to the FY 2016 annual report. A$ 500 m
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
A$ 100 m

• In FY 2017, the receivable from franchisees declined by A$407m (41%) fol-


lowing a change in accounting policy.

Catalysts:
1. Australian Parliamentary Inquiry: Australian Parliamentary Inquiry into the franchise industry scheduled for Sept 2018. Testimony of
franchisees in this inquiry is privileged; therefore, franchisees have immunity to any other legal contracts.
2. Intense Competition: December 2017 launch of Amazon Australia turned out to be a “soft launch.” Amazon will launch Amazon Prime
in mid-2018. True impact of Amazon on brick-and-mortar retailers will only start to show in 2018. Since December, Amazon has cut pric-
es by 15% in electronics relative to competitors.
3. Consumer Credit & Housing Markets Sour: The already fragile franchisee network will be severely and adversely affected by a macroe-
conomic shock. Increase in failed franchisees from FY 2010 to FY 2011 highlights the fragility of the franchisee network.
4. Increased Scrutiny from Auditors & Regulators: HVN has been the subject of a number of regulatory investigations over last two years.
Increased attention from media and vocal proxy advisors has placed pressure on auditors and will likely lead to more disclosure.

Valuation:
Bear Base Bull A$ 634 m A$ 6 m
A$ 22 m

No. of Stores in AUS 170 170 195 A$ 88 m

No. of Franchisees 597 597 684


Tactical support 3-year
33.3% 9.6% 0.0% A$ 35 m A$ 191 m -29%
CAGR
Franchise Network Sales -4.8% -2.8% 4.2%
A$ 38 m
A$ 655 m

3-year CAGR
Rent revenue 3-year A$ 36 m
-0.3% -0.3% 4.6%
CAGR A$ 464 m

EBITDA Margin 12.0% 15.2% 22.1%


EBITDA A$ 361 m A$ 464 m A$ 719 m
2017A EBITDA International Franchisee Franchise Fee Rent Lost from Tactical Support Operating 2019E EBITDA Difference Consensus
EV/EBITDA 6.0 x 7.0 x 9.0 x Retail Sale Network Lost from Store Closure Increase Deleveraging FY19 EBITDA
Growth Sales Growth Store Closure
Enterprise value A$ 2.17 bn A$ 3.25 bn A$ 6.47 bn
Non-operating assets A$ 59 m A$ 59 m A$ 59 m
Base Case: Closure of 25 unprofitable stores. 20 of those closures are located in
Impairment of receivable A$ 141 m A$ 141 m
company-owned properties. Impairment of unrecoverable franchise receivables
Net debt A$ 746 m A$ 729 m A$ 669 m
Equity value A$ 1.34 bn A$ 2.44 bn A$ 5.86 bn
associated with failing franchisees. Tactical support is assumed to increase by 58%
Share price A$ 1.20 A$ 2.19 A$ 5.26 to provide finance relief to struggling franchisees.
Upside/downside -64.5% -35.3% 55.8% Bear Case: Overlay a deteriorating macroeconomic environment on the base
case.
Bull Case: Our thesis is completely wrong and HVN proves to be a resilient com-
petitor.
Corporate Governance Red Flags:
Trend of over-spending on opaque non-core investments followed by significant write-downs. Lack of independence & accountability at the Board level.
• HVN has lent money to parties to buy horses in Gerry Harvey’s thoroughbred auctions. HVN’s operating subsidiaries have borrowed
money directly from entities controlled by Gerry Harvey. HVN has advanced A$100m to a 50% retail joint venture run by a former
CIO and ex-franchisee. There is limited information on this venture and HVN has written off A$30m of this investment.
• Gerry Harvey’s (Chairman) wife, Katie Page, is CEO, and his son, Michael Harvey, sits on the Board of Directors. The only two
“independent” directors have Board tenure of over 15 years. Ernst & Young has been the company’s auditor for over 20 years.

Risks and Mitigates:


 Amazon fails to gain traction in Australia.
 Macroeconomic tailwinds keep going for much longer than we anticipate.
 The high dividend yield limits the life of the trade
 Franchisee network churn could be sustainable.
Page 26

Digicel 8.25% 2020 - Long


Winner - 2018 UCLA Credit Pitch Competition
Jingjing Huang, CFA Matthew Mann, CFA Viraj Vora, CFA
JHuang19@gsb.columbia.edu MMann18@gsb.columbia.edu VVora19@gsb.columbia.edu

Bond Information
Recommendation
The DLLTD 8.25% Senior Unsec’d Notes due Outstanding $2.0bn Current Price 89.25
2020 offer attractive total return opportunity for Priority Sr. Unsecured Yield-to-Maturity 13.50%
a short-duration (2.5 years) bond with strong Rating CCC+ / NR Issuer Digicel Group Limited
Jingjing Huang, CFA ’19 liquidity ($2bn issuance). Capital appreciation will
Maturity 9/30/2020 Ticker DLLTD
Jingjing is a 1st year student be driven by 1) continued growth in wireless
Coupon 8.25% Net Leverage 6.4x
at CBS. Previously, she data, business solutions, and cable segments, 2)
worked at J.P. Morgan improvements in cost base and FCF generation, and 3) rapid deleveraging potential from current trough
Asset Management as a EBITDA and peak leverage as operational momentum translates into financial results.
fixed income client portfo-
lio manager in Hong Business Description
Kong. Jingjing will be in- Digicel Group offers telecommunications (wireless, cable, business services), media, and entertainment ser-
terning at Morgan Stanley vices to 14 million subscribers in 32 markets in the Caribbean and Central America. Largest markets include
Investment Management as Haiti (16% of revenues), Jamaica (16%), Papua New Guinea (13%), and Trinidad & Tobago (6%). Over the past
a Sustainable Investing
13 years, Digicel has expanded from 8 markets to 32, while increasing revenue from <$500mm to >$2.5bn
Fellow.
alongside a 10x increase in profitability and subscribers. Digicel’s major markets are generally duopolies; com-
petitors vary by market but include incumbent Cable & Wireless and state-owned operators. n 2014, C&W
acquired Columbus, and under the new leadership of Liberty, has become a more competitive player. Digicel
has responded by increasing investments into complementary services to its core wireless offering, including
cable, media, and business services, to offer triple- and quad-play
TTM Capex / Sales
offerings to improve the value proposition to customers. Digicel 26.0%
is owned privately by billionaire Denis O’Brien. 24.0%

22.0%

20.0% 4FQ12 - 3FQ18


Investment Thesis 18.0%
Avg: 18.2%

1) Growth in Wireless Data / Business Solutions / Cable 16.0%

Matthew Mann, Digicel is coming off a heavy investment cycle to expand product 14.0%

CFA ’18 offerings into cable and business services alongside wireless ser- 12.0%

10.0%
vice improvements to LTE. The bulk of these investments are
Matthew is a 2nd year now complete and Digicel is reaping the benefits with significant
student at CBS. Previously,
growth in earnings and subscribers; these new product areas Subscriber Growth
he was a Portfolio Manager
at ClearArc Capital, Inc. in now represent 16% of revenue. In the wireless business, in- 16 700
600
Grand Rapids, MI. His creased price competition, declining voice revenues, and lower 15

Cable RGUs (000s)


Total Subs (mm)

500

coverage included foreign wholesale revenues are being offset by continued growth in data 14 400

currency and emerging usage (smartphone penetration across Digicel markets is 54%, 13 300

market debt. Matthew will versus 49% a year ago). As a result, earnings grow and FCF turns 12
200
100
be joining Goldman Sachs positive in FY18, excluding the impact of recent hurricanes which 11 0
& Co. LLC. in New York. have had a $15-20mm and $10-15mm impact on revenue and
EBITDA for the full year. Total damages (recoverable from in-
total subs cable RGUs
surance, but with a timing lag) are $60-70mm.

2) Ongoing Improvements to Cost Base and FCF Generation


The Digicel 2030 Transformation plan launched at the end of 2016 aims to improve EBITDA margins by 2-4%
by the end of 2018 by centralizing back office functions at regional hubs, renegotiating procurement contracts,
eliminating redundant management layers, and investing LTE wireless networks to bolster subscriber growth.
As of 3FQ18 (ended 12/31/2017), Digicel is well on track to achieving its target goals; 2,600+ headcount (25%
of total) has been eliminated and
LTE networks have been deployed
EBITDA Bridge
Viraj Vora, CFA ’19 1400
in 17 markets, with another 9 ex-
Viraj is a 1st year student 1200 88 (20) (15) (25) (100) 35 (5) (40)
pected to be rolled out shortly. As
55
at CBS. Previously, he 1000
70 30
a result of these operational im-
worked at Post Advisory 800 provements, moderating capital
Group as a buy-side credit 600 expenditures, and organic growth,
1,088
analyst in Los Angeles. Viraj 400
1,015 1,013
Digicel will improve its free cash
covered telecom, autos, 200 flow generation thereby enabling
paper/packaging, and utili-
ties in high yield bonds and
0
debt and leverage reduction. Free
leveraged loans. Viraj will cash flow is roughly breakeven
be interning in the Multi- currently but will rise to $200-
Asset division at T. Rowe 250mm (3-4% of debt) in FY2019
Price this summer. and FY2020.
Page 27

Digicel 8.25% 2020 - Long (Continued from previous page)


3) Rapid De-leveraging Potential 3,000 5%
Recent financial results from 2015 onwards have been hampered from non-
4%
operational issues (FX, hurricanes, start-up business costs). Underlying 2,500
3%
operations and fundamentals remain solid, and should drive earnings and 2,000 2%
FCF improvement under normalized operations. The DLLTD 8.25% 2020 1%
bonds, though a holdco bond, represent the first maturity in Digicel’s capi- 1,500
0%
tal structure following the refinancing of Digicel’s near-term bank loans and 1,000 -1%
bonds with a new $100mm 3-year revolver, $300mm L+350 5-year term -2%
500
loan A, and $955mm L+375/1% 7-year term loan B. The bank loan has since -3%
been repriced 50bps tighter and upsized by $100mm in March, with the 0 -4%
proceeds used to repay a temporary drawdown on the revolver to finance
network repairs given the uncertain timing around receipt of insurance
proceeds. Further, the company was recently bolstered by a Paris court Revenue EBITDA FCF / Debt
ruling that mandated Orange, a competing operator in certain territories,
FYE 3/31 FY2016 FY2017 LTM 12/31 FY2018E FY2019E FY2020E
to pay €346mm to Digicel as reparations for anti-competitive practices. As Revenue 2,665 2,496 2,424 2,403 2,413 2,557
a result, liquidity has improved, EBITDA should resume growth under nor- EBITDA 1,122 1,030 1,032 1,013 1,088 1,151
malized operations, and FCF is bolstered with declining capital expenditures FCF / Debt -2% -1% -2% -3% 3% 4%

and receipt of insurance and lawsuit payouts; net leverage will decline from Leverage 5.6x 6.1x 6.3x 6.4x 5.8x 5.2x

6.4x currently by ~0.5x each year, reaching 5.2x by the end of FY2020.
12/31/2017
Capital Structure & Covenants
As of: 12/31/2017

DGL Consolidated Digicel


levg
ash DGL
195 Cash Consolidated Digicel
195
levg
Consolidated Cash 195 Cash 195
enior Bonds due Sept 2020 2,000 Secured / Project Debt 1,425 1.4x
Senior Bonds due Apr 2022 8.25% DGL Senior Bonds 1,000
due Sept 2020 2,000 DL Debt
Secured / Project Debt 2,225
1,425 1.4x 3.5x
es) 7.125% DGL Senior Bonds due
20Apr 2022 1,000 DGL /DL Debt
Panama Debt 2,225
3,020 3.5x
Other (Licenses) 20 DGL / Panama Debt 3,020
Total DGL Debt
3,020 3,020
Total Debt
Total Debt
6,670
6,670 6.5x
6.5x
Net Debt
Net Debt 6,475
6,475 6.3x 6.3x

DL LTM EBITDA 1,032


DL LTM EBITDA 1,032
100% L2QA EBITDA
6.00% DL Senior Bonds due Apr 2021 1,300
100% Digicel Pacific Limited (DPL) L2QA EBITDA
nior Bonds due Apr 2021 1,300
6.75% DL Senior Bonds due Mar 2023 925 Digicel Pacific Limited (DPL) Digicel Limited Only
nior Bonds due Mar 2023 Total DL Debt 925 2,225 Digicel Limited Only
levg
DPL Project Finance 70 Cash 113
2,225 levg
DPL Project Finance 70 Cash Secured / Project Debt 113
1,355 1.5x
DHL DL Debt 2,225
2.4% by DGL / 42.5% by DL Secured / Project Debt
Total Debt 1,355
3,580 4.1x 1.5x
DIFL DHCAL Net Debt 3,467 4.0x
DHL DL Debt 2,225
L+350 $100mm Revolver due May 2020 2.4% by
100DGL / 42.5% by Panama
DL Project Debt 0 DGL g'tee Total Debt
LTM EBITDA 3,580 876 4.1x
DIFL L+350 TL-A due May 2022 300 DHCAL Net Debt
L2QA EBITDA 3,467 4.0x
L+325/0% TL-B due May 2024 955
Other 0
m Revolver due May 2020 Total DIFL Facility Debt
100 Panama
1,355
Project Debt 0 DGL g'tee LTM EBITDA 876
ue May 2022 300 = DGL restricted group L2QA EBITDA
-B due May 2024 955
0 = DL restricted group

ity Debt 1,355


The DLLTD 8.25% 2020 bonds reside at the holdco-level of Digicel’s
= DGL restrictedcapital
group structure, which benefits from support from a broader re-
stricted group. Based on debt incurrence covenants, $1.2-1.3bn of additional secured debt could be raised to refinance these 2020 bonds
= DL restricted group
at the operating company level (DIFL) where the current credit facility is issued. Payments out of the structure for dividends are currently
restricted by leverage, though cash can flow freely from the opco to the holdco to service interest payments. The company has multiple
options to refinance these 2020 bonds, including raising secured debt, equity infusion by Mr. O’Brien (he has hinted at this on calls), a fu-
ture IPO (was attempted but pulled in 3Q15 due to market conditions), and asset sales (tower sale-leaseback, Panama asset sales).
Valuation FY20 ends 3/31/20 for Digicel
Comps (EV / '19E EBITDA)
Key Risks and Mitigants Low Mid High
Cable & Wireless Takeout 11.2x
1) Increased Pricing Pressures: Liberty Global acquired Cable & Wire- FY20E EBITDA 1,051 1,151 1,251 Columbus Intl Takeout 9.6x
FY20E Multiple 6.0x 7.0x 8.0x AT&T 5.1x
less in 2016; C&W has since become a much stronger competitor, after America Movil 6.5x
EV 6,305 8,056 10,007 Telefonica 5.9x
years of losing share to Digicel. C&W initially clawed back some market T-Mobile 6.5x

share through pricing promotions, though this has now stopped as the com- +Cash
-Secured Debt
195
(1,425)
195
(1,425)
195
(1,425)
Orange
avg
4.8x
7.1x
pany seeks to improve its lagging technology and wireless networks. Still, LTV (%) 20% 15% 12%

irrational pricing pressures remain a risk. Value to Unsec'd 5,076 6,827 8,777

-Opco Debt (2,225) (2,225) (2,225)

2) Macroeconomic and FX Risks: Many of the markets Digicel operates LTV (%) 55% 43% 35%

in are small with volatile currencies. Hedging mis-matches can result in lower Value to Holdco 2,851 4,602 6,552

translational earnings, and market instability can impact operations (as is -Holdco Debt
LTV (%)
(3,020)
103%
(3,020)
80%
(3,020)
65%

currently the case in Papua New Guinea). Equity Value (169) 1,582 3,532
Page 28

Trusting the Process: Michael Mauboussin & Tom Digenan


(Continued from page 1)

a packaged food industry Tom was a senior manager want to understand how things
analyst and was named in the tax department of work from the ground up.
Chief U.S. Investment KPMG Peat Marwick, While the world was and still
Strategist in 1999. where he worked is replete with rules of thumb
exclusively in the and old wives’ tales, we can
Mr. Mauboussin is the investment services decompose a lot of it.
author of three books, industry .
including The Success For one of my first early
Equation: Untangling Skill Tom is a member of the projects, I remember thinking:
and Luck in Business, CFA Institute and the what do the great investors
Sports, and Investing and is American Institute of do? I built files on Warren
also co-author, with Alfred Certified Public Buffett and Ben Graham and
Michael Rappaport, of Expectations Accountants, and he is on other great investors, just to
Mauboussin Investing: Reading Stock the board of CFA Society study how these folks operate.
Prices for Better Returns. Chicago. He is currently There were some common
Vice Chairman of the CFA threads. They seemed to be
Mr. Mauboussin has been Society Chicago. long-term oriented. They
an adjunct professor of seemed to be focused on cash,
finance at Columbia Tom was an adjunct not accounting numbers. They
Business School since 1993 professor in the Marquette seemed to really value good
and is on the faculty of the University Graduate businesses. Those are the sorts
Heilbrunn Center for School of Business from of things that stood out to me.
Graham and Dodd 2012-2016.
Investing. He earned an Then, in 1987, I had my
A.B. from Georgetown Graham & Doddsville professional epiphany. A guy in
University. (G&D): Can we get started my training program handed
with each of you discussing me a copy of Al Rappaport's
Tom Digenan is the head your background? book, Creating Shareholder
Tom of the US Intrinsic Value Value. It was awesome. There
Digenan, CFA Equity team at UBS Asset Michael Mauboussin (MM): were three things in that book
Management. In this role, I was a liberal arts major in that have remained the
he is responsible for U.S. college so I never studied bedrock of everything I do, and
equities portfolio business. It’s an interesting are things Tom and I have
construction and research. question whether that’s an talked a lot about over the
Prior to this role, Tom had asset or a liability. I came to years. The first was: value is
been a Strategist with the the business world knowing not about accounting numbers,
team since 2001, where he close to nothing. My father it’s about cash. This is a lesson
participated in the analysis made me take principles of that we relearn from time to
and development of U.S. accounting when I was a senior time. The great analysts always
equities portfolios, in college and I got a C+ in the focus on cash.
focusing on alpha class, and only out of the
generation and ensuring generosity of the professor's The second thing was that
client investment heart. competitive strategy and
objectives were met. valuation should be joined at
I started at Drexel Burnham, the hip. It’s interesting, even in
Prior to his role with the which is now defunct but was business school we teach
U.S. Intrinsic Value Equity an amazing place to learn strategy and finance separately.
team, Tom was president about the business. I was in the The strategy professors will
of the firm’s mutual funds training program and was say, “well, you want your
and relationship funds confused for a very long time. I strategy to create value” but
organization. guess I still am confused to they don’t really explain the
some degree, but the virtue of financials. The finance guys say
Prior to joining the UBS being a liberal arts major was “well, it’s good to have a
predecessor organization that I was compelled to go competitive advantage,” but
Brinson Partners in 1993, back to first principles. I always don’t quantify it. As an
(Continued on page 29)
Page 29

Trusting the Process: Michael Mauboussin & Tom Digenan


investor, you’re operating at So I write this report and my whole time.
the intersection of those two senior analyst’s reaction is
fields. You can’t do an tepid. But he figures, nobody Tom Digenan (TD): I didn’t
intelligent valuation without cares, let’s just publish the go out into the world knowing
understanding strategy. And piece anyway. The content was I was going to be an investor. I
the litmus test for a strategy is all Rappaport. It was all cash worked at the Chicago
whether it creates value. Even flow, why buybacks made Mercantile Exchange in college
though the book was written sense in the context of what as a runner. That’s not
for corporate executives, the they were doing, and so forth. investing. The one investment
relevance for investors was concept I got from that is that
obvious. One of the first phone calls I the futures business, unlike the
got after the report came out equities business, is a zero-sum
The third lesson came from game, and it’s also mark-to-
chapter seven of the book, market. If you invest in cattle
Stock Market Signals to “This is a lesson that futures and they go up today,
Managers. The argument was you can run up to the office
that your stock price reflects we relearn from time and pull money out of your
an expectation about how account. If they go down,
you’re going to perform as a to time. The great you’ve got to run up to the
company. You, as an executive, office and put money into your
need to understand what the analysts always focus account. You don’t think about
market expects, and exceeding yesterday. One thing that
on cash.”
those expectations will make surprised me when I got into
your stock go up. The market the investment business is how
may think you’re going to was from Bill Stiritz’s office. focused people are on what
create a lot of value, but if you They said, “Bill really liked happened yesterday.
don’t create as much value as your report. Can you to come
the market thinks, your stock out and talk to our senior I’d be driving in to work and
is actually going to executive team about how you somebody calls in these stock
underperform. Again, think about valuation?” I’m a shows on the radio and they
executives were the audience pretty young guy at the time, ask, “should I sell XYZ?” And
but the implication for and so it was a very exciting the host asks, “well what did
investors was also clear. imprimatur. you buy it at?” And I’m almost
going off the road saying, “it
In the early 1990s, I was After that, I became a senior doesn’t matter what you
working for a senior analyst analyst at First Boston bought it at!”
following consumer companies. following the packaged food
One day, he said, “You work companies. I had other jobs I was an accounting major in
for me from 9 to 5, but if you there, which is now Credit college because I wanted that
want do more on the Suisse, and is was around the stability and I liked having an
weekends, you can write about time I joined First Boston that I answer. And I’ve got to tell
whatever company you want. started teaching at Columbia you, this is a business where
But my name will be on the Business School. you don’t get an answer. In
top.” The first company I accounting, you get an answer.
wrote about was Ralston From there I went to Legg In the early 90s, I had an
Purina. The CEO of Ralston at Mason Capital Management for opportunity to join Brinson
the time was Bill Stiritz. You nine years, implementing a lot Partners and work with Gary
may have read the book The of these same ideas on the buy Brinson and Jeff Diermeier.
Outsiders by Will Thorndike, -side. Then I went back to They were my two most
which is awesome. There’s a Credit Suisse for a short stint, significant mentors from an
whole section on Bill Stiritz. and now I’m back on the buy- investment perspective. They
He was considered the side. So I’ve been back and followed a pure discounted
smartest guy in the food forth between sell-side and buy cash flow approach. If you stick
industry, kind of like the -side, but really thinking about to it, it helps you avoid
Warren Buffett of the industry. the investment process the bubbles, but you must have
(Continued on page 30)
Page 30

Trusting the Process: Michael Mauboussin & Tom Digenan


faith in it, and your faith will heuristics like P/E or they didn’t do – but also
get tested. For you young guys Enterprise Value to EBITDA, added, “we're going to grow
going into the business, I you don’t blow yourself up 50% a year for ten years with
would say you will be wrong a because the markets are an eventual net margin of 10%
lot — even when you follow smarter than you are, so your and a P/E multiple of 20x.” If
your process — but be ready heuristics don’t really make you work out the math, it gets
to be right and have the world that big a difference. to $700 billion. By the way, if
temporarily think you're someone gave that problem to
wrong. In the end, you’re only You mentioned the “Base Rate me, I would do what you guys
wrong if you don’t stick to Book.” If you asked me what I would do. I would open an
your process. wish I knew when I was a 22- Excel spreadsheet, then figure
out how big the auto market
G&D: Michael, a lot of your is, what percent would be
research reports focus on “I’d be driving in to electric, and what percent
broad investment themes, for would be Tesla. And then I’d
work and somebody
example the “Base Rate Book.” ask, “does this seem
How did you go from being a calls in these stock reasonable or not?”
sell-side research analyst
covering a single sector to the shows on the radio and The outside view, the base
very broad, multi-disciplinary rate, would say, “has any
perspective you’re now known they ask, ‘Should I sell company with six billion in
for? revenues ever grown 50% a
XYZ?’ And the host year for 10 years?” The answer
MM: When I was an analyst, I is that it’s never been done,
asks, ‘Well what did you
was very influenced by Al not even close. Might it
Rappaport and his work on buy it at?’ And I’m happen? Yeah, it might happen,
valuation. I was also very but it certainly wouldn’t be
interested in value investing. almost going off the your base case, and it’s
When I was an analyst, it was certainly a very low
increasingly the case that I road saying, ‘It doesn’t probability. Something like
would go out to talk to clients that’s a sobriety check right
and they would ask me about matter what you away.
specific stocks, but they’d also
bought it at!’”
say, “tell us more about your Back in March, there was a
valuation approach.” So I feature story in The Economist
ended up spending a lot of year-old analyst starting out, I about Amazon. An analyst
time just talking about how to would say without hesitation, projected them growing 15% a
do valuation. It was a natural it’s on the idea of base rates. year off a $100 billion revenue
evolution because that’s what Danny Kahneman, the base. Has that ever been done
people were asking about. renowned psychologist, calls before? No. Might Amazon be
this the inside versus outside the first? Of course. Is it your
If I were to break down my view. The idea is to integrate base case? It would seem
approach, the first really historical corporate optimistic for that to be your
important thing to think about performance into my bottoms- base case. You might assign it
is why stocks are mispriced. up model. some modest probability, but
Every day, you have to ask the it’s certainly not the most
question, “what is the market We wrote about Tesla in 2015 likely outcome.
not getting that I think I when Elon Musk laid out the
know?” That’s a nontrivial path for Tesla to get to a $700 The outside view is incredibly
problem. The second billion market capitalization. powerful, and gives you a
component is valuation and That was Apple’s market cap practical way to integrate
how to do it properly. at the time, so it was a very concepts such as regression
ambitious plan. He said, “we’re toward the mean. Everyone
What’s interesting about going to do six billion in knows that regression toward
valuation is if you use revenues in 2015,” – which the mean is important,
(Continued on page 31)
Page 31

Trusting the Process: Michael Mauboussin & Tom Digenan


especially if you’re a value addition, there is a value trap These are the people you
investor, and the “Base Rate element in play where you can trade with. It’s ridiculous.
Book” tells you how to justify maintaining the position People get set in their ways. I
operationalize it. It’s not just by saying, “but it’s really cheap don’t think most organizations
that you understand there’s now.” have an actual process that
this thing called regression pushes you toward continuous
toward the mean, you now It was the appropriate sale for improvement and it’s
know how to do it the portfolio I manage and something that you’ve got to
quantitatively, which is really based on other opportunities be adamant about because it’s
helpful. available to me at the time. not comfortable. I have one
We own this stock in our person at my firm who said,
G&D: Speaking of base rates, Global Equity portfolio, “but that would be overriding
Tom, do you and your team managed by one of my analyst judgment.” I said,
utilize these types of colleagues. That team, after “that’s exactly right.” There
frameworks? analyzing the situation, felt are times when you must
there was enough downside override an analyst’s judgment
TD: Yes, quite often. Michael protection to maintain a because it’s the process, and
wrote a great piece called position in the stock. you have to follow the
“Managing the Man Overboard process.
Moment.” Last summer, My advantage and disadvantage
Kroger took a rapid nosedive as an investor is that I’m not an MM: I’d like to just talk a little
and I pulled out Michael’s bit about the story behind
analysis and used it to frame “I think most “managing the man overboard
the situation. moment.” Decision making is
managers stray from difficult in all environments, but
We ended up selling Kroger. It it’s particularly difficult at
was a good sell. The reason I their process more emotional extremes. For
say it was a good sell is that example, if you’re feeling really
this was a stock where we had often than they good or really bad, it’s very
two signposts relevant to our difficult to have a clear head
don’t.”
long position: one, we will see about anything. Having been on
a return of food inflation in the analyst. I don’t know more the buy-side, there were these
U.S. which will improve than the analysts do about unfortunate incidents where
margins in the grocery these companies. I have faith in we’d have a stock go down
business, and two, Amazon will our process. I realize that if more than 10% versus the
have less than 1% market share you don’t formalize the market. As an analyst, you’re
in groceries. process, you won’t follow it, disappointed, you’re frustrated,
because when you get to that and maybe you’re even angry.
In a span of two days, both event, there will be some
signposts were debunked. On emotional reason to stray from TD: You’re defensive.
a Thursday, they announced your process. I think most
earnings and lowered guidance managers stray from their MM: You’re defensive. No
because they weren’t seeing process more often than they one’s happy. We created this
any signs of food inflation. don’t. I'll use a baseball analogy analysis going back to 1990,
Then literally the following day, Moneyball by Michael Lewis just looking at thousands of
Amazon announced the Whole came out in 2003. In 2005, if instances of stocks going down
Foods acquisition. We had an you asked general managers in 10% versus the S&P. Then we
analyst who is incredibly smart, Major League Baseball if they introduced factors including
very well-educated. The had read Moneyball, over half momentum, valuation, and
natural analyst bias is to of them hadn’t read it. Can quality. As you introduce the
maintain the position. you imagine that? You’re one factors, you increase your
Cognitive dissonance impairs of 30 competitors in the specificity but you reduce your
our ability to immediately world, and one of them is sample size. We then asked,
incorporate evidence refuting telling you exactly how he “how did the stocks do in
your current hypothesis. In does things. subsequent periods?”
(Continued on page 32)
Page 32

Trusting the Process: Michael Mauboussin & Tom Digenan


That analysis does two things. valuation, or knowing how to hardest part of the business. If
First, it gives you a naïve do the strategy analysis is you can be right 55% of the
default. If you know nothing almost the ante to the game. If time, you’ll be good. If you can
about the situation and the you can’t do that, you’re not admit when you’re wrong,
stock has bad momentum, even in the game. Everyone has then you will be great.
good valuation, and high to be able to do that. If you
quality, it will say: buy, sell, or distinguish the great investors MM: There's a famous quote
hold. Now you have the from the average investors, it’s from John Maynard Keynes,
default. It’s not an answer. It’s not because their cost of “worldly wisdom teaches that
a part of a distribution, but at capital calculation is more it is better for reputation to
least something to hold onto. accurate. It almost always has fail conventionally than to
Second, I think because you to do with the fact that they’re succeed unconventionally.” If
have that naïve default in your able to make good decisions I’m short retail, and everybody
back pocket, you can have a and be correctly contrarian in else is short retail and it goes
calmer conversation. You have adversity. up, yeah, it’s too bad, but
this sort of backdrop behind it everybody else had the same
and you can say, “all right, let’s Seth Klarman’s got this line view. We’re all together, right?
think about this properly.” that I love: “value investing is, That’s where it becomes really
at its core, the marriage of a difficult. A lot of the great
We wrote two pieces. The contrarian streak and a investors I’ve been around,
first was “Managing the Man calculator.” The contrarian somehow they don’t care
Overboard Moment,” and the streak means if everyone much about what other people
other was “Celebrating the thinks one thing, I’m going to think. It’s actually a
Summit,” which dealt with at least examine the other phenomenally good trait as an
situations in which stocks had side. But the consensus is investor and a phenomenally
outperformed. I don’t know if often right. Being a contrarian not good trait as a human
this is true, but apparently for the sake of being a being.
most mountaineering accidents contrarian is a bad idea.
happen on the descent, not on G&D: Can you each talk
the ascent. Partly it’s because The second part, the about your specific strategies
descents can be more calculator, is really crucial. It’s and process?
technically difficult, but it’s also really the combination of being
because people are more willing to take the other side TD: My flagship strategy is a
excited at the top of the when expectations are core U.S. equity fund. It has
mountain. They’re high-fiving, mispriced. There’s another about 70 names. There are
taking pictures, and they let interesting question, which is, periods when we have pretty
their guard down. I don’t want how much of this is just your high tracking error, and
to stretch the analogy too far, natural personality? How many periods when it’s not as high. I
but in investing too, we were value investors are born that tend not to be sensitive to
trying to say, “let’s address way, and how many can be sector allocations. I think
process at emotional trained? I think a lot of this is there’s some opportunities out
extremes, when you’ve made a based on people’s natural there right now. We find both
lot of money or you’ve lost a proclivities, and we can add on semiconductors and financials
lot of money.” some tools to help people get really attractive, which is great
better at it, but guys like because they are low
G&D: Would you say in your Warren Buffett, Charlie correlation, kind of like energy
opinion, an important Munger, and Gary Brinson and airlines.
difference between a good seem to be that way naturally.
versus a great investor is that My newest strategy is a U.S.
ability to manage the TD: Yeah, I think that’s true. sustainable portfolio. That
behavioral side? Both a good investor and a one’s going to be really
great investor will be wrong interesting. It’s about two
MM: That’s why I evolved that 45% of the time. But a great years old. It’s a concentrated
part of my course because investor will admit when he’s strategy. I think investors more
knowing the mechanics of wrong. I think that’s the and more want concentrated
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strategies, which I think is a compare price to pure value. efficient. When the standard
secular shift and not a trend. Then we get a ranking of deviation of the alphas widens,
There is also growing stocks. I can print out a and I can tell you that when
sensitivity to sustainability, like histogram. I can rank it by the distribution goes from
Environmental, Social, and analyst, by sector, and by narrow to wide, we will
Governance, or ESG. What country. The other thing that’s underperform in that area,
we’ve been trying to do is during that period. It means
Greg Doger de Speville incorporate some ESG metrics the expensive stocks are
’19, Neethling McGrath into our valuation “I think one of the getting more expensive and
’19, and Arthur Brousseau methodology. If you’re a pure the cheaper stocks are getting
’19 deliver their HVN investor trying to figure out biggest mistakes you cheaper. We’ll underperform
pitch the cash flows that are going see in the investment when this widening occurs
to accrue to the owner of a because we tend to own more
business, you should always business is people fail of the cheaper stocks that are
have been incorporating that, getting cheaper.
right? You’ve always cared to distinguish
about governance. You always Think back to the end of 1999
care about environmental between what’s when the market was
impact. You produce exploding. That’s the tricky
something that has a need for priced in and what’s part of this business, and when
water and you’re not near a going to happen your clients become really
water supply, things like that. important. When the standard
But right now, we’re starting fundamentally.” deviation of the alphas widens,
to see a lot of interest from that means two things. One,
clients in some of the ESG you will have just
stuff. nice is that we don’t have just underperformed by a lot, and
all of our outputs, but we have two, you will also have the
G&D: Can you talk a bit about all of our inputs. We have all greatest opportunity. That’s
GEVS, and why you guys have of our inputs for the last 35 when you want to sit in front
set the system up that way? years for every company that of your clients and say, “this is
we’ve been covering. what we’ve been waiting for.
TD: So Gary Brinson, Jeff This is probably the only thing
Diermeier, and Bob Moore The nice thing is, if you come you’ll purchase in your life that
built this thing in 1980. Back in and say, “IBM looks cheap,” I you don’t get excited about
then we called it EVS, Equity can see if it looks look cheap when it goes on sale.” If you
Valuation System. They threw relative to our history. How wanted some new Nike shoes,
a ‘G’ on there at some point, have we modeled this and you see they’re on sale,
for Global. I’m surprised Gary historically? Have we tended you get all excited. When the
did, because when I started to be right on IBM? No, we’ve stock goes on sale, you say,
with the firm, our 401(k) had been wrong. Since I have all of “uh, I’m not sure.”
four options: equity, fixed- the inputs, I can basically look
income, balanced and cash. at it and say, “well, if our I know so many people — I
Those were the names. They analysis is correct now, what call them the dry-powder
were all global. Gary didn’t are our assumptions?” brigade — who have lived
even put global because he their whole life with dry
said, “how else would you Where it helps me the most is powder. Most of them were
invest?” when you go through that not investing in March 2009.
period when you These investors need some
The valuation system for us is underperform. We measure kind of “true North” that will
basically a means of the standard deviation of the tell them when the
incorporating all of the alphas, because the alpha from opportunity set is wide and
analyst’s ideas and insights into our valuation system is when the world is expensive
something where I can use the expected excess return, and if or cheap. At the moment, it’s
calculated part for my the alphas are really tight, that not that exciting. The spread’s
contrarian analysis and means the market's pretty about average, which is okay.
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You can make money during things. The first is ignorance, job every day.
average periods. Also, I don’t meaning you just don’t know
think the world is as expensive what you’re doing. You don’t To me, those are the two big
as most people think it is. know how to do this particular areas: just getting better and
operation or whatever it is. executing effectively day in and
G&D: Michael, do you feel The second way doctors fail is day out. I think Gawande’s
comfortable talking about the execution. People just don’t do major contribution to the
strategy? what they know they should world is really recognizing that
be doing. When you read The there’s huge upside to just
MM: Well, BlueMountain has Checklist Manifesto, it’s much executing what we already
multiple strategies. We do a more about the latter than the know how to do. It’s
lot: anywhere from credit to former. remarkable how often people
systematic and discretionary deviate from their process.
equity, to distressed, to TD: They weren’t washing
volatility trading. As a their hands. TD: On our team, adding a
consequence, the processes name to the portfolio requires
range from quantitative and MM: He’s getting people to two out of three votes. So, if I
systematic strategies to wash their hands. Now, by the vote yes and the other two
fundamental analysis, credit, way, I wouldn’t want to be too vote no, it’s not going in the
and parts of discretionary critical, because if I’m a portfolio, even though I’m the
equity. It runs the gamut. The physician, and I’m trying to head of our team.
unifying theme is ultimately treat a patient, I’m interested
decision making, which is in the patient’s well-being. That I know a boss who wasn’t
thinking about probabilistic becomes the most important happy with this structure. He
bets. thing. These other things said, “you’re the decision
become, I don’t want to say maker. You should have the
What’s interesting is that that they’re sidebars but they final say.” I replied with, “no, I
there’s an opportunity in a firm don’t seem to be the most want the process to be the
like this to really collaborate pressing things at the moment. final decision maker.” If us
across asset classes. As an getting it right depends on me
equity analyst, is it helpful to When I think about investing, being smarter than the next
talk to a credit analyst, or even it’s really trying to bring both guy, we’re not going to win.
someone who trades volatility? of those things to bear. Are Once you have a well-
My job as Director of there tools that we can developed process, it’s easier
Research is basically to work provide people with to make when you bring people in. And
on all aspects of the them even more effective at it’s easier with the current
investment process. what they do? team, if they understand and
appreciate it. It’s like parenting,
G&D: What are the biggest The second part is we make in that you need to be
challenges you face as a sure people are very consistent. If you start
Director of Research, methodical in their decision- deviating, then there are no
overseeing that many different making. Every time we make a rules. In the investment
types of strategies and so many decision, are we thinking about process it’s important that you
different types of people? things properly and considering have tight guidelines and rules.
all the different alternatives?
MM: There’s a great essay that Why do investment MM: I want to say a couple
I learned about from Atul committees exist? Why are more things about investment
Gawande, who wrote The there committees at all? Why process. One is to have a
Checklist Manifesto. It was an do people work in teams? The clearly stated thesis and some
essay written back in the 1970s answer is that a team, if done sort of identifiable edge when
by, of all things, two properly, surfaces and entering into a position. The
philosophers about medicine. considers more alternatives phrase I really like is “linchpin
The question was, “why do than you might consider by issues.” What are the key
doctors fail?” They said it yourself. It offsets some of the things that this story’s going to
basically comes down to two biases that we all bring to the pivot on? Usually as an analyst,
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you’re looking at a lot of the investment industry has to be consensus because
information, but for the most changed radically in the past 30 there’s just too much stuff
part you're looking at two or years. It used to be the case going on.
three key things. Tom that almost all portfolios were
mentioned with Kroger the run by individual PMs, and a The second component is
food inflation and Amazon very small minority was run by team composition. The ideal
participation, but it could be teams, but now it’s the here is to have what social
whatever is relevant in that opposite. Something like three- scientists call cognitive
particular case. quarters of all mutual funds in diversity, people with different
the United States are run in training, experience,
The second thing that is personality, and background,
extremely relevant is “sign- “I think the weak and who are willing and able to
posts,” which is, if my thesis surface different points of
unfolds as I anticipate it is players at the poker view. Every analyst who walks
going to unfold, here's what in has their own distribution of
we should see happen. If it table used to play and potential outcomes. Cognitive
doesn't, this gets to one of the diversity makes sure that we’re
most difficult things we have to lose. Now, they’re in- thinking about things that we
do as investors, which is to may not have thought about
update your view. The fancy
dexed. They show up otherwise, or we’re placing
term is Bayesian reasoning. at your house Friday greater weight on it than we
Every day, we all wake up with otherwise would have. So
prior views of how the world night and they drink cognitive diversity is important.
works. Then we walk into the If everyone’s thinking the same
world and things confirm or your beer, but they way, it does you no good.
disconfirm what we believe.
The question becomes, how don’t actually play The third component is how
good are you at updating your you manage the team. If you’re
views when new information
poker.” the head PM, the key is to
comes in? teams, which is an interesting methodically draw out
thing. different points of view. If you
That’s incredibly difficult, and walk into the meeting and
part of it is overconfidence. For teams to be successful, you’re the head guy and you
Another huge component is there are sort of three key sort of indicate that you like it
confirmation bias. Even if you elements to get right. The first or don’t like it, people will
struggle to invest in something is the size of the team. Tom tend to fall in line for social
you’ve done a lot of work on, mentioned this, but the reasons, whereas if you truly
once you’ve made the decision empirical research shows that are managing the process
and it’s in the portfolio, your the ideal team size, the team correctly, you’re soliciting
reputation is on the line. You size that creates the most views openly, getting them on
will tend to seek information excess return relative to an the table, and properly vetting
that confirms your view. individual management them. You’re even conducting
You’re going to dismiss portfolio, is three. The second your voting with secret ballots.
information that disconfirms best is five. By the way, when I talk to
your view. It’s incredibly investors about this, they
difficult to overcome. Why three and five? The always nod knowingly because
answer is odd numbers. To opinions are often suppressed
G&D: What are the pros and reinforce what Tom just said, in real meetings because of
cons of working in investment you can get situations where seniority or whatever it is.
teams? it’s two-to-one and you can
proceed, which is really G&D: Tom, you mentioned
MM: We’ve also done a lot of interesting. People talk about the importance of admitting
work on teams in general, and decision making like it’s all when you’re wrong, and
I have some thoughts on that. about consensus. This is not an Michael you mentioned sign-
The first thing I’ll say is that industry where there’s going posts. How do you marry the
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two of those? If you see a implementation, like Brier very heuristic-based in their
stock go down, do you have a scores (which measure the portfolio construction.
mechanical process that says accuracy of probabilistic
get out or do you allow predictions). We put these G&D: On the topic of value
yourself to re-evaluate? ideas out there, and very few versus growth, do you think
people follow up, but Tom is there’s room for actually
TD: There are three things one of them. having a preference, in the
that could put the stock on same way that someone might
our radar screen. One is that TD: Do you keep Brier scores prefer chocolate to vanilla,
man overboard moment when here? other than simply recognizing
the stock's down 10% and we that historically, value has
run Michael’s screen. The MM: We’re working on it. quantitatively outperformed?
second is if a stock has When you go through memos,
underperformed its sector by it’s obvious that most people TD: Think about it as though
25% since the date we initiated are not used to thinking about you’re fishing on a big lake, and
our last review, we do what things like Brier scores. you’re going to go in one
we call a “stop look.” The They’re much more segment of the lake. Well,
analyst comes back in to pitch comfortable with vague sometimes the fish aren’t
the stock. language. there. Sometimes they’re at
the other side of the lake. If
The third scenario we look at TD: My guess is they don’t like you’re a quality guy, you’re
is if a stock that we’ve held for it. basically limiting yourself to
two years has underperformed this segment of the lake.
its sector. We identified that MM: Yeah, well, the key is to Maybe you’re a good stock
holding onto old losers was not frame it as a scoreboard picker, but your opportunities
hurting our performance. or as a way to embarrass have been minimized just by
When you think about it, if our people. It can be personalized; putting yourself in that box.
thesis hasn’t played out in two I just give it to you one-on-one
years, maybe we were just and it’s here to make you MM: To me, I would translate
wrong in the first place. We better. We know that value investing into an
owned Teva a couple years everywhere that Brier scores expectations model, so that
back and our linchpin was that have been kept and the what you’re trying to do is buy
they’re not going to lose the feedback’s been shared on a low expectations and sell high
Copaxone patent. Well, they timely basis, people get better expectations. Everything else
didn’t, and it was still a at making probabilistic follows from that. Value
horrible stock. This was in our forecasts. investing to me is just buying
old losers’ bucket and this is low expectations. In the Fama-
one where I went to the Another thing we’ve been French model, value is
analysts and said, “You know doing a lot of work on lately is statistically cheap stuff, which
what, unless this is the most portfolio construction. It’s a is a proxy for low
compelling idea we have, we’re thing that seems to be expectations, but sometimes
getting this out of the remarkably underdiscussed. it’s just bad stuff. That said you
portfolio.” When you read books about might ask, “what does quality
blackjack like Beat the Dealer, mean?” Let’s decompose that.
G&D: Do you want to talk there are only two things that You might come up with a
about your relationship, how it are really important. One is little checklist. You might say
started, and how it’s evolved? gaining an edge, and the well, quality means high return
second is how much you bet, on capital, which is often
MM: It goes back to Brinson, given the edge you have. We associated with low leverage
just the discipline of the spend a ton of time thinking because you can finance your
Brinson approach. That’s about this. Many people spend growth internally and
something I’ve always admired almost no time thinking about reasonably readily.
about Tom is his disciplined this. I’ve talked to a lot of
process. We’ve also done portfolio managers and a lot of High quality might be
some interesting things in different organizations that are “sustainable competitive
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advantage,” so some kind of attractive. The quality thing is literature is limits to arbitrage.
moat. We have to figure out only an input to a broader Even if there are amazing
what that moat is and whether construct. arbitrage opportunities, if you
it’s going to stick around. High can’t execute, it doesn’t make
quality might imply TD: People like to say, “it’s any difference. I think bitcoin is
management that’s really different this time,” but that’s a big limit to arbitrage. I think
judicious with capital the one thing that can never be tons of people would love to
allocation. So this all becomes different. “It’s different this go short, but it’s just not really
part of the analysis of time” implies finding a new viable to go short.
fundamentals versus way to value companies
expectations. I say this all the because it’s the only way to These are just markets. There
time, but I’ll say it again right make them look attractive. are many other aspects of
now: I think one of the biggest That’s when you should run. interaction where I’m sure
mistakes you see in the human emotions will continue
investment business is people G&D: Is the future of investing to play a big role. These are
fail to distinguish between going to consist solely of interesting questions, even for
what’s priced in and what’s algorithms and artificial you guys who are thinking
going to happen fundamentally. intelligence or will humans about going into the
have a role? investment world. How do I
These are two different think about where my
mindsets. It’s the difference MM: This is an interesting opportunities are?
between the odds at the horse question. I think Ben Graham
race and how fast you expect talked about this. What is G&D: The last few years have
the horse to run. Those are consistent in the last 500 years been tough on the long/short
fundamentally different things. of markets? The answer is space with many high-profile
An interesting experiment funds reducing AUM or
would be to break your shuttering altogether. How do
research department into two “If you get the wrong you see the long-short space
groups. One group looks at evolving over the next five, or
just expectations. If Cisco’s at [mentor], move. The 10 years? Do you think recent
$45 a share, what has to trends are cyclical or secular?
happen for that price to make move might not be
sense? MM: One of the most
upward, it might be interesting departure points
Then the second group looks lateral, but you want for thinking about that
just at fundamentals. They’re problem is a paper Sandy
basically consultants. They just to make sure you’re at Grossman and Joe Stiglitz
look at businesses and profit wrote in 1980 called On the
paths and so on. Then, bring a company with the Impossibility of Informationally
them together at the very last Efficient Markets.
second. This is the starkest right culture. It’s really
way how to combine the two Now, if you’re a bit of a
parts of the analysis and have a important.” historian, you know that the
truthful discussion. 1970s were probably the peak
human behavior. Humans of enthusiasm for the efficient
Everybody has the same oscillate between periods of market hypothesis. In 1978,
person doing both of those euphoria and periods of Michael Jensen, a prominent
things, but they’re very despondence. finance professor, proclaimed,
different. The great investors “I believe there is no other
always separate those in their Can that ultimately get proposition in economics
head. Just because things are arbitraged out by a machine? I which has more solid empirical
going well doesn’t mean the think that’s an open question. evidence supporting it than the
stock is good. Just because Bitcoin is evidence that’s not Efficient Market Hypothesis.”
things are going badly doesn’t the case. An idea that’s The argument in Grossman-
mean the stock is not important in the finance Stiglitz is pretty
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straightforward. They say that TD: Especially if the things prepared.
if there is a cost to gathering that lead to mispricing or
information that determines dramatic movements are TD: That would create a great
asset prices, there should be a human beings. Humans haven’t opportunity because none of
requisite benefit in the form of evolved that much in the last that impacts value.
excess returns. Lasse Pederson 50 years.
has this catchy phrase, MM: Right. When you sell the
“markets have to be efficiently MM: The 2008 financial crisis, ETF, you’re selling stuff in
inefficient.” Enough inefficiency which started in housing proportion without regard for
to get you to do it, but not so before spilling over into other value, so everything goes up or
much inefficiency that you sectors, was more leverage everything goes down. It
avoid markets altogether. related. Today, the concern reintroduces the question:
isn’t leverage. I think the banks we’re humans, will things
So, if the amount of available and regulators are taking care change? It’s very important to
alpha has been coming down, of that, for the most part. I understand that the
the amount you should be think the concern is more ecosystems are very different
wanting to pay to capture the liquidity. today. It will be a different
alpha should also be coming path.
down. I think that’s a rough Envision this scenario. Pick an
cartoon version of what we’ve ETF with a bad liquidity profile TD: The growth of passive has
actually seen: people flipping — high yield is probably the been very tough on active
from active to passive in order best example. You trade your management. It has really
to reduce their fees. If you high yield ETF all day, but the changed the business. The
look at the standard deviation underlying liquidity is not as investment opportunity would
of excess returns from mutual good as you’d expect. Today, be if Michael and I were the
funds on an alpha basis, you the authorized participants are only two investors in the
see that alpha used to have a okay, but if there was a wave world and we’re both trying to
big, fat distribution. There was of sellers, there isn’t the make money. I’m trying to beat
lots of positive alpha and lots underlying liquidity, so they the market and he’s trying to
of negative alpha. Smart guys might have some problems. beat the market. Then, one
win, dumb guys lose. Today, day, you enter and say, “Yeah,
that distribution has shrunk. TD: They’ll have a run on the I’m going to do this too, but
Very little positive alpha, very bank. I’m just going to buy and sell
little negative alpha. based on market cap.” The
MM: They’ll have a bit of a run two of us would look at each
That partly relates to the lack on the bank, and then what other and say, “Finally!” It’s
of volatility in the market. It’s will happen is, all the like you’re playing poker. You
very difficult to distinguish newspapers will write, “ETFs want something you can make
yourself when realized are bad.” Mom and pop will money at, right? You don’t
volatility is around 6-7%. Is this see that, and they won’t want to sit down with world-
volatility decline secular or distinguish between high yield class poker players.
cyclical? I don’t know the ETFs and everything else, and
answer. Having been around the thing just cascades. You MM: I think the weak players
for a long time, I don't know might initially say, “I own at the poker table used to play
what the mechanism is to SPDRs,” or “I own the and lose. Now, they’re
make volatility go up, but I’d be financials ETF. I’m cool.” The indexed. They show up at your
willing to bet that the current problem is, if it cascades, house Friday night and they
low volatility environment is you’re not going to be cool. drink your beer, but they don’t
not going to stay here forever. That to me would be the way play poker. I think it’s actually
We’ll see a reintroduction of the disaster scenario might gotten harder to generate
volatility at some point. That’s propagate. I’m not predicting alpha, even though intuitively
going to freak out a lot of it, but I’m saying that’s not an you might think fewer
people, I think, when that implausible scenario to participants should make the
occurs. consider. I think very few game easier.
people are really totally
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G&D: We talked a lot about field for learning with amazing
changes in the industry. Do people.
you have any advice for
students interested in Opportunities are a big deal.
investment management on Think about stepping back and
how they should be spending saying, “If I want to generate
their time? excess returns, where is that
likely to happen?” Being the
TD: Michael talked earlier 500th large-cap US manager is
about the man versus the probably a tough way to
machine. You need to know distinguish yourself. However,
how to use the machine. Be there might be other markets
familiar with the machine. I can where that could be the case.
stick my head in the sand and
say, “Oh, it’s not going to The last thing I’ll say is this is a
make any difference,” but it is fabulous business for constant
real, and understanding the learning. You can never rest.
ability to code, things like that, You have to learn every day,
I think are important. knowing you’re never going to
whip this game. I think it’s a
The other thing is to not huge commitment. The best
assume life is a straight line. I’m investors I know are really big
tapping into hindsight bias readers. They are very
here, but I actually think it’s thoughtful and they’re deeply
good, whether it’s in your life committed. That’s not for
or your career, for your path everybody.
to be jagged. Sometimes you’re
on the elevator and sometimes G&D: Do you have a favorite
you’ve got to take the stairs. non-investment book that’s
shaped the way you view the
Earlier, Michael and I were markets?
talking about the value of
mentors. I feel very lucky in my MM: I usually recommend
career because you don’t three books: Consilience by E.
always get to pick who your O. Wilson, How the Mind
mentor is or who you work Works by Steven Pinker, and
with. If you get the wrong one, Complexity by Mitchell
move. The move might not be Waldrop.
upward, it might be lateral, but
you want to make sure you’re TD: My three to bring on an
at a company with the right island would be: Atlas Shrugged
culture. It’s really important. by Ayn Rand, The Baseball
Abstract by Bill James (historical
MM: I think it’s important for or early 80s annual edition)
people who want to go into and one I am reading right
the investment management now, Thinking in Bets by Annie
industry to do it for the right Duke. A great read and also a
reasons. A lot of it is about great way of improving your
passion for what you’re doing. decision-making ability when
I’m not sure everyone who dealing with uncertainty, which
goes into it is passionate about is what we do every day.
it, but it’s important that you
really love it. It can be really G&D: Thank you so much for
challenging, it can be really your time.
humbling, but it’s an amazing
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ROAM Global Management


(Continued from page 1)

Renjen has been an smartest person on your RR: Yes, exactly. I was
Adjunct Assistant name” and holds each member introduced to Lee Ainslie in
Professor in the Value of his team to a high standard 2011 and we spent a year
Investing Program at of detail with investment write getting to know each other. At
Columbia Business School -ups, financial models and deep that point in my career, my
since 2012 and continues fundamental research. I often thought process focused not
to teach year-round. He is say that Glenview is one of the only on investing but also
also on the Board of best places on Wall Street to leadership and culture.
Trustees of the Excellence train—the analytical rigor is
Community Schools, a tremendous. At Glenview, I I was fortunate to join
charter school observed first-hand how to Maverick Capital in 2012 as a
management organization, manage volatility within a sector head and, over my five
Rishi Renjen and on the liaison concentrated portfolio as well years there, I ran a number of
committee to the DREAM as how to motivate a team sectors—business services,
Charter School and through a challenging period. consumer, and media and
Washington Heights Glenview left a strong mark on telecom. What was critical to
Expeditionary Learning me and my career. my decision is the one-
Schools (WHEELS) as a portfolio approach of
Board Member of the In 2009, I joined TPG-Axon in Maverick, where capital flows
Maverick Capital London as I wanted to truly to the best ideas. I believe
Foundation. understand the global strongly in this investment
component of investing, and approach, and during my time
Graham and Doddsville Dinakar Singh was at the there was asked to join the
(G&D): Can you talk about forefront of that. I spent a Stock Committee and
your background and what led third of my time in Asia Advisory Committee as part of
you to this point of launching covering a range of industries the leadership team at the
your own fund? and dove into investing in India firm.
as that market grew. I had a
Rishi Renjen (RR): I grew up range of experiences in India, Working at Maverick, I was
in the Northeast and had an from visiting IT parks to very cognizant of the legacy I
interest in finance from an assessing land banks while was a part of. Few funds have
early age, which led to my sitting on the board of a built a twenty-five year track
undergraduate path at private real estate company. record at that level across
Wharton and four investment multiple businesses, from
banking internships during my TPG-Axon gave me a deep fundamental investing to
four summers in college. After appreciation for the nuances of venture capital to quant. I have
college I joined Citigroup and global investing as well as for even more appreciation for
then Warburg Pincus, working managing risk, which was a this legacy now that I am
in private equity from 2005 to core component of that firm. starting my own fund, ROAM
2007 which was the peak of Returning to the U.S. as a Global Management. Lee is in a
the buyout boom. Early on, I Partner in 2011, I felt I had league of his own. Sitting next
was taught to take the long made the jump from an analyst to him for five years—my
view in my career, and I covering a single position to an office was right next to his—
consider those first eight years investor driving portfolio-level was one of the most
my foundation in investing decisions – I credit Dinakar for remarkable things to happen in
where I developed critical that. I also began to hone in on my career, not just for
analytical and business skills. my own investing style, which investing but also from a
was rooted in my experiences business and leadership
I spent the next ten years in at Glenview and TPG-Axon perspective.
global, equity long/short but clearly moving in a
investment management. My different direction. G&D: What will you bring to
early days as an analyst at ROAM Global from working
Glenview are still very present G&D: Is that what led you to with three such notable
for me, as Larry Robbins Maverick Capital? investors in your career?
instills in you to be “the
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ROAM Global Management


RR: Mentoring is critical to the and we focus on four sectors creation strategy align with our
business of investing, and I of expertise where I have investing principals. That’s
have been very fortunate to managed portfolios in the critical for concentrated
learn from three pioneering past—consumer, media and portfolio investing and we have
investors. From Larry Robbins, telecom, business services, and no flexibility on that mandate.
I learned that you should have select cyclicals. I believe our Beyond that, a certain degree
an extraordinary level of four-sector focus provides of analytical rigor and a variant
knowledge on a name before enough breadth to be perception, be it quantitative
underwriting it, so that you opportunistic and flexible, yet or qualitative, are requisite for
have pre-built the conviction is targeted enough to allow us us to initiate a position. Lastly,
when the market goes against to develop deep expertise—an margin of safety is key, since
you. Working for Larry is ideal balance. we will size positions based on
where I gained the perspective the asymmetry of return
and confidence to run a Given that we run a outcomes.
concentrated portfolio. concentrated portfolio, our
On the other side, an
From Dinakar Singh, I learned “Mentoring is critical attractive short is not about
about investing on a global where a stock price will be in
basis, which is a defining to the business of 90 days but rather a business
component of our strategy at model that is undifferentiated,
ROAM Global. And from Lee investing, and I have and where moats are eroding
Ainslie, I learned about culture, at a greater speed than the
been very fortunate to
vision and risk management. I market appreciates. I often find
believe culture is what has learn from three myself shorting businesses that
kept Maverick in the top-tier are operating at near-peak
of a hyper-competitive industry pioneering investors.” fundamentals where one
for more than two decades. I variable or one line item in the
still sit on the Board of the maximum position sizes are P&L is driving our variant
Maverick Capital Foundation 20% on the long side and up to perception.
for this reason. 10% on the short side, if the
opportunity presents itself. We Single-name, alpha shorts are
Beyond those investors, the offset this level of where we spend a significant
other noteworthy mentor in concentration by running a amount of our time at ROAM
my life is my uncle, Rana lower level of gross exposure, Global, and how we will drive
Kapoor, who is one of the typically between 75% and a lot of our differentiation over
founders of Yes Bank, one of 150% of the fund’s capital, the long term.
the leading private-sector which we believe is critical to
banks in India. My uncle has managing a portfolio in an G&D: What is the duration of
been hugely influential in increasingly volatile a typical long?
driving my entrepreneurial environment. I firmly believe
spirit from an early age. gross exposure is the best risk RR: Although I have been
management lever, in part teaching the Applied Value
G&D: What is ROAM because I have seen the Investing class at Columbia for
Global’s strategy? adverse effects of portfolio six years, I am not a traditional
leverage during key points in value investor. While margin of
RR: ROAM Global my career. safety is a governing principle
Management is a global, equity for my investing philosophy—
long/short fund with an G&D: What kind of we are constantly questioning
emphasis on single-name companies make for a core “How much money can we
shorts. It is an extension of the long holding? And what about a lose from here?”—we ideally
strategy I ran at Maverick core short? like to compound earnings
Capital, but with a higher with our core holdings,
degree of concentration. Our RR: An attractive long position assuming the reward-risk
approach is entirely is one where business quality merits capital and the market
fundamental and bottoms-up and management value hasn’t fully realized our view of
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ROAM Global Management


intrinsic value. In that context, time period, I find that short to trough margin frameworks to
we tend to think about long be an extremely huge win names like Tesla, as I have in
positions on a one-to-three- because of the spread we the past, but in their
year basis. We have a private- generated against it. Still, I have assessment of intrinsic value
equity approach to investing to ask in my post-mortem, may not be considering the
given my background, but we which is critical to our possibility that Elon Musk is
will let risk-reward drive the investment process: If I one of the greatest
portfolio. thought fair value for that technologists of our generation
name was $12.00, then what since Steve Jobs. There is no
G&D: And shorts? changed and was I “right” in margin of safety in the latter.
my assessment of fair value?
RR: On average, we G&D: Is there any significance
underwrite shorts to a one-to- G&D: You mentioned margin to the name ROAM Global?
two year time horizon. We are of safety. Most people can
compelled to short more as define that on the long side, RR: There is. I wanted to have
those names go up because we but how do you define it on “global” in the firm name
have high conviction in our the short side? because it speaks to my
fundamental analysis—tying experience and is core to our
back to my learning from RR: It is much harder on the investing mandate. One of my
Glenview. On a max short, I short side, and often comes colleagues who joined early
am focused on take-out risk down to judgment and asked me, “So what do you do
and more broadly risk when you go to a new city?” I
management. We are now in a “We are now in a said, “I usually grab my iPhone,
world where organic growth put in my ear buds, and roam
remains challenged, debt is still world where organic the streets.” She said, “Why
cheap by historical standards, don’t we name the firm ROAM
and private equity firms have growth remains Global?” I love it because
significant dry powder—so “roaming” also signifies being
even take-outs that seemed
challenged, debt is still freethinking—remaining
inconceivable in the past may cheap by historical independent of the crowd.
happen. It also means Internally, our tagline is “we
companies can extend their standards and private are roaming globally” which
lifelines longer than we captures the spirit of how we
anticipate. equity firms have invest, and our mindset.

Western Union is a great significant dry G&D: Can you talk about the
example. I was short the stock global aspects of ROAM
for five years and the stock
powder—so even take-
Global?
price hadn’t changed during outs that seemed
that time even as the broader RR: Being truly global is a
market has gone up. It was at inconceivable in the critical way to differentiate.
$18.50 five years ago, and is at Fact-pattern recognition helps
$19.00 today. past may happen.” us find compelling investments.
For example, one of the most
G&D: Isn’t that situation a experience as an investor. I fruitful opportunity sets in my
win? As long as the short was often find that a stock with a career has been connecting
flat, you can fund long high multiple is probably the patterns from developed
investments with that capital, one that has the greatest markets to emerging markets.
correct? continued upside as people are We look for markets
conceptualizing new markets rebounding off cyclical troughs
RR: Yes, and our or growth not apparent in the with accelerating fundamentals,
measurement of success is the near-term cash flows. Tesla is a like in Latin America, or
long/short spread that we great example. Autos investors markets where political
generate. Given the market has assess units sold, track global realignment is complementing
more than doubled over that SAAR trends and apply peak/ economic recovery to create a
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ROAM Global Management


large new fishing pond, like in collective, which I believe is required but it is never about
India. I have been investing critical to concentrated building consensus. It is about
globally my entire career, have investing and a one-portfolio the debate and constantly
lived and worked abroad, and approach. I have experienced challenging the thesis,
have deep family and business various compensation schemes something I very much enjoy.
roots in India. All of this lends and cultures across the That is why we come into
to unique perspective. That institutions I worked for, work every day. In my classes
said, we are not making top- which allowed me to think at Columbia, I ask students
down calls. about how I wanted to “What do you think?”
approach these topics at Sometimes they start with
G&D: How have you built the ROAM Global. I want “Well, the market is…” To
rest of your team? everyone to feel that we are in which I say: “No! What do you
this together. think?” This is a job where
RR: The ROAM Global team everyone’s opinion matters. It
comprises six professionals The other important cultural is then incumbent upon me, as
today who will be the team at component is our physical the portfolio manager, to
launch and for the foreseeable space. We have a large, open weigh the viewpoints as
future. Point to point, it will be trading floor—no separate appropriate.
a year from when I left offices. I have a small office
Maverick to when I launch without a computer in it for a G&D: You talked about post-
ROAM Global because I reason. If you want to discuss mortems earlier. Can you
wanted to spend the time something, just stand up. elaborate how and why you
investing in the build-out of the There is no need to wait for conduct them?
business and in finding the right the team meeting because we
people. Talent development don’t have those. The debate is RR: You can make money
and setting a culture upfront is continuous, always happening. without being right. For
core to differentiation and There is a clear, documented example, a stock may
therefore core to ROAM process for how we do our appreciate from a takeout
Global. It is the “X factor” that research, but the debate is offer, but was a takeout
people can’t directly analyze iterative and organic in the anywhere in your thesis? If not,
when assessing a fund’s office. then it is a failure in your
returns. investment process. Or, if you
G&D: How does the team assessed fair value at $175 to
Very few businesses have such bring up ideas, conduct $200 a share but the
clear and frequent dynamics of research, and put them into management team is choosing
being right and wrong as the the portfolio? to sell out in an all-stock deal
investing business. When at $150, then where was your
you’re wrong, not only are you RR: Our analyst-first mentality understanding of
wrong, but you are wrong with and analytical rigor will management’s alignment of
extremely talented people on differentiate us. How do we incentives? This type of
the opposite side and in an get to a name? We start with reflection is why post-mortems
extremely public manner. themes that we come up with are important—you have to
There are flashing lights in collectively. Our view is if we make sure your process is
front of you daily signaling get the themes right, we will strong. Reflecting on your wins
whether you are right or make money, and if we get the and losses can help build a
wrong. For me, what cuts right one or two names within repeatable process that is
through this intensity and a theme right, we will truly constantly improving.
pressure is culture. differentiate returns. Beyond
that, our defined stages of our G&D: What have you looked
G&D: How did you specifically investment process help us for so far in analyst candidates?
set the culture upfront? cycle through names in an
efficient manner. RR: I look for passion for
RR: Every person who joined investing and intellectual
the firm from day one is a In terms of how we work curiosity—a desire to learn
partner, so our success will be together, everyone’s opinion is combined with a work ethic.
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ROAM Global Management


Zach Rieger ’17, my first you incorporate that into your everyone who interacts with
analyst hire, has these qualities process? ROAM Global.
and also understands my
investment process from being RR: A dialogue with G&D: Teaching at Columbia
a student in my class at management is important, but seems to have been an integral
Columbia. We have other not the single variable driving part of the last seven years of
similarities as well—the an investment decision. We your career. Students have
Brad Headley ’19, Ryan University of Pennsylvania, are fortunate to have a long talked about how you
Darrohn ’19, and John investing banking, private list of management teams we challenge them in class. What
White ’19 are short
equity-—but beyond this I was have invested behind, and the do you get out of it?
CHRW at the 2018
Pershing Square Challenge
drawn to his sound business frameworks we have taken
judgment and his deep from those case studies are RR: Teaching means a great
appreciation of analytics. I deal to me—the classroom is a
think one of the primary seamless extension of what I
reasons he wanted to join “Teaching means a do at work. When people ask,
ROAM Global was that he great deal to me—the “How do you have time for
knew my commitment to teaching?” I say, “It’s the best
talent development. classroom is a thing I’ve ever done.” You have
to be passionate about
Across the team, passion is key seamless extension of investing. You have to live and
because we are communicating breathe it. I teach application
all the time, even on what I do at work. of theory, so for me teaching is
weekends, about stocks and like replicating my workplace
investing. You have to really When people ask, environment—the sense of
love this business to be “How do you have responsibility and
successful. accountability, the idea that
time for teaching?” I your voice really matters and
G&D: Some people may have that it’s incredibly important to
expected you to launch your say, “It’s the best thing calibrate what you know and
own fund sooner. Why now? don’t know. My students keep
I’ve ever done.” me honest and in tune with the
RR: It is not about age but world, which I deeply
about being at a certain stage applied in our investment appreciate.
in your career and your life, decisions. We are focused on
when you can sit credibly in management incentives and G&D: Since you’ve worked
front of your team and alignment, and with that comes with so many students and
potential investors. You only a history of value creation that young analysts, what are the
get one shot at this, and I we can study. biggest mistakes you see them
wanted to be prepared and make?
methodical. And a decade of G&D: If you were to
global investment management summarize in one phrase the RR: The most common
experience gives me great biggest differentiating factor at mistake I see in all analysts, not
confidence at ROAM. ROAM Global, what would just the younger ones, is
Launching an investment that be? underappreciating the range of
management firm is about possible outcomes. Often, it is
building an institution that RR: I believe it is the difficult to analyze that range
instills confidence in the firm’s combination of our investing and realize things can be very
business operations and its DNA and my teaching DNA. different from where they
clearly defined investment You need a sustainable, were six months ago. I see
process. repeatable process combined analysts account for 30%
with the intangible quality of upside and 30% downside all
G&D: When analyzing an understanding and managing too often, but I promise you
investment, what kind of talented people to invest in there is a broader range of
conversations do you have today’s challenging markets. I outcomes for every business,
with management, and how do believe that has resonated with even the boring, stable ones.
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ROAM Global Management


G&D: Any other advice for
students?

RR: First, identify the work


you can do on your own early
in your career. This is a
business that requires you to
be a self-starter. Second, find
your own authentic voice. We
all can have the same
information, but how we
choose to refine it can be very
different. You may think long, I
may think short—ultimately, it
comes down to judgment.
Work towards synthesizing
what the information means to
you to find your own voice.
This is how you build your
own investing DNA.

G&D: Thank you.


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Contact Us:
ABhattacharya18@gsb.columbia.edu Graham & Doddsville Editors 2017-2018
MMann18@gsb.columbia.edu
ASchloss18@gsb.columbia.edu Abheek Bhattacharya ’18

Abheek is a second-year MBA student and a member of the Heilbrunn Center’s


Value Investing Program. He spent last fall interning at Firefly Value Partners, and
worked for Davis Selected Advisers in the summer of 2017. He’s done stints
previously with Indus Capital and Hound Partners. Prior to Columbia, he wrote
for the Wall Street Journal in Hong Kong, most recently for its flagship Heard on
the Street investment column. He studied philosophy at Yale University. He can
be reached at ABhattacharya18@gsb.columbia.edu.

Matthew Mann, CFA ’18

Matthew is a second-year MBA student and a member of Columbia Business


School’s Private Equity Fellows Program. During the summer, he worked in the
Investment Banking Division at Goldman Sachs & Co. LLC. Prior to Columbia,
he was a Portfolio Manager at ClearArc Capital, Inc. focused on foreign currency
and emerging market debt. Matthew studied finance at Grand Valley State Uni-
versity. He is a CFA Charterholder and a 2018 McGowan Fellow. He can be
reached at MMann18@gsb.columbia.edu.

Adam Schloss, CFA ’18

Adam is a second-year MBA student and a member of the Heilbrunn Center’s


Value Investing Program. During the summer, he worked for the Intrinsic Value
Team at UBS Asset Management. Prior to Columbia, he worked for T. Rowe
Price and Lincoln International. Adam graduated from the University of Illinois at
Urbana-Champaign with a BS in Finance. He is also a CFA Charterholder. He can
be reached at ASchloss18@gsb.columbia.edu.