Value-oriented Equity Investment Ideas for Sophisticated Investors A Monthly Publication of BeyondProxy LLC  Subscribe at manualofideas.com “If our efforts can further the goals of our members by giving them a discernible edge over other market participants, we have succeeded.” Investing In The Tradition of Graham, Buffett, Klarman Year VI, Volume V May 2013 THE When asked how he became so successful, Buffett answered: “We read hundreds and hundreds of annual reports every year.” DEEP VALUE I Top Ideas In This Report SSUE ArcelorMittal (NYSE: MT) ……………………… 20 ► Screening for Deep Value Bargains Bridgepoint Education (NYSE: BPI) ……………………… 32 MFC Industrial (NYSE: MIL) ……………………… 68 ► 20 Companies Profiled by The Manual of Ideas Research Team ► Proprietary Selection of Top Three Candidates for Investment ► Exclusive Interview with John Heldman Also Inside ► 10 Essential Screens for Value Investors Editorial Commentary ………………. 3 Interview with John Heldman ……… 5 Screening Deep Value Equities …… 10 Profiling 20 Deep Value Ideas …… 20 10 Essential Value Screens ……….. 99 About The Manual of Ideas Our goal is to bring you investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary methodology to identify stocks that are not widely followed by institutional investors. Our research team has extensive experience in industry and security analysis, equity valuation, and investment management. We bring a “buy side” mindset to the idea generation process, cutting across industries and market capitalization ranges in our search for compelling equity investment opportunities. Companies profiled include ArcelorMittal (MT), Arch Coal (ACI), AVX Corp. (AVX), Bridgepoint Education (BPI), Career Education (CECO), Citi Trends (CTRN), EnCana (ECA), Gold Fields (GFI), Hecla Mining (HL), IAMGOLD (IAG), Kulicke and Soffa (KLIC), Marvell Technology (MRVL), MFC Industrial (MIL), Orbotech (ORBK), Resolute Forest (RFP), ScanSource (SCSC), Scholastic (SCHL), STEC (STEC), Symmetricom (SYMM), and Tellabs (TLAB). Inside: New Exclusive Videos Exclusive Interview in the MOI Members Area with (log in at www.manualofideas.com or email [email protected]) John  Heldman, President, Chuck Akre discussesTriad his approach to valueManagement investing Investment  Adrian Warner on applying private equity principles With compliments of The Manual of Ideas  Ideas: Amtek, Net Holding, AMERCO, Discovery Offshore, etc. Register at ValueConferences.com Copyright Warning: It is a violation of federal copyright law to reproduce all or part of this publication for any purpose without the prior written consent of BeyondProxy LLC. Email [email protected] if you wish to have multiple copies sent to you. © 2008-2013 by BeyondProxy LLC. All rights reserved. Value-oriented Equity Investment Ideas for Sophisticated Investors Exclusive Interview with John Heldman We recently had the pleasure of interviewing fellow value investment manager John Heldman, President of Newport Beach, California-based Triad Investment Management. The firm was established in 2008 and has $117 million in assets under management. John brings decades of experience to the management of investment portfolios. Prior to founding Triad, he was a Senior Vice President and Portfolio Manager with Neuberger Berman. John has also managed investment portfolios for Deutsche Bank, Scudder Investments and Bank of America, including managing equity funds and serving on the Equity Strategy Committee. He obtained his BS degree in Finance and MBA from California State University, Long Beach. John is a CFA charterholder. The Manual of Ideas: Please tell us about your background and the genesis of your firm. What motivated you to set up Triad and what operating principles have guided you since then? “If we can understand the business, it demonstrates growth and durability, has above-average profitability and shareholder-oriented management, it becomes part of our roughly 250 company universe. Once a business makes the qualitative cut, then we focus on valuation.” John Heldman: I have been in the industry over 27 years, having worked at a handful of large firms, including Bank of America, Scudder Investments, Deutsche Bank, and most recently, Neuberger Berman, which I left in early 2008 to form Triad Investment Management. It was the best career decision I’ve made, not just for me but also for our clients. I appreciate the opportunity to be entrepreneurial and the autonomy of running my own firm. We have much greater investment flexibility. And we have terrific, loyal long-term relationships with clients who give us the latitude to do what’s best and have the necessary patience to allow our process to work. Our principles are staying focused on the investing process, keeping other distractions to a minimum, and communicating clearly and candidly to our clients. MOI: How do you generate investment ideas? Heldman: We annually review thousands of companies by reading corporate annual reports, SEC filings, and reviewing Value Line reports. In addition, we subscribe to an extensive number of newspapers, magazines, periodicals, etc. We read extensively including general publications to understand broad economic trends and specific periodicals to deepen our understanding of certain industries. We are always looking for businesses that meet our criteria with the understanding that one day we will likely get an opportunity to invest in the business. So we have accumulated a body of knowledge about a wide range of businesses. If we can understand the business, it demonstrates growth and durability, has above-average profitability and shareholder-oriented management, it becomes part of our roughly 250 company universe. Once a business makes the qualitative cut, then we focus on valuation. MOI: What are your key stock selection criteria, and what types of businesses have you favored historically? Heldman: We favor understandable businesses with durable, well-protected moats, where we can understand how the moat was created and what is likely to sustain it. Evidence includes high profit margins, relatively low competitive intensity and usually free cash flow generation. Once we identify companies that seem to have the right characteristics, we read five to ten years of annual reports, 10-K’s, company presentations and other materials that can provide further insight into the competitive strength and durability of a business, along with © 2008-2013 by BeyondProxy LLC. All rights reserved. JOIN TODAY! www.manualofideas.com May 2013 – Page 5 of 110 Value-oriented Equity Investment Ideas for Sophisticated Investors management capability and culture. We must feel comfortable with the longterm economics of the business, which means the company occupies a reasonably strong competitive position and will get a fair share of industry growth over the next three to five years. We develop an estimated three-to-fiveyear price target and daily rank each stock on that basis. Subject to a reasonable level of sector/industry diversification we select 20 to 30 companies with the greatest potential. We prefer businesses that aren’t subject to heavy government regulation, so we avoid many areas of healthcare, and almost all utilities and telecommunications. We also favor capital-light businesses that don’t require high mandatory capital investment for plant and equipment, inventories and accounts receivables. We seek businesses where the cash flow that’s generated is in excess of what is needed to maintain and grow the business. We also like recurring revenues and fee-based businesses where customers are locked in contractually or otherwise for long periods of time. And we like certain cyclical businesses because many investors have difficulty valuing them when earnings are temporarily depressed, or where patience is in short supply, creating longterm opportunity for us. MOI: How do you assess the quality and incentives of management, and what CEOs do you admire most? “We assess management quality by analyzing their historical decision making. This is where having read five or ten years of annual reports sheds light on what management said and what they actually did.” Heldman: We assess management quality by analyzing their historical decision making. This is where having read five or ten years of annual reports sheds light on what management said and what they actually did. Have they run the business for long-term results? Have they maintained and better yet strengthened the business moat over time by increasing market share, growing sales and raising profitability? Did they make strategic, sensibly-priced acquisitions during depressed periods, or did they acquire during boom periods at high valuations? Were the acquisitions paid in cash or stock? If stock, did they issue their own stock at depressed or elevated levels? Have they repurchased stock, and if so, were the repurchases done when valuations were depressed or elevated? We closely examine how well management has protected and grown shareholder value. Next we assess incentives by looking at the stock ownership of management, board of directors and large influential shareholders. We like to see large insider ownership, as a management team with ownership ten times the level of their salary is probably shareholder-oriented (they can still be incompetent or dishonest, but it’s usually a positive). Do they issue boatloads of stock options to themselves? Do the compensation plans align management with shareholders? Is the incentive plan aimed at growing business value and shareholder value over time? We admire CEOs who stay laser-focused on long-term business management and demonstrate a history of shareholder commitment. Warren Buffett is the gold standard. Others we really admire include Dinos Iordanou at Arch Capital Group, Bruce Flatt of Brookfield Asset Management, Murray Edwards and Steve Laut at Canadian Natural Resources, Phil Ryhoek at Denbury Resources, Mike White at DirecTV, Mark Papa at EOG Resources, Prem Watsa at Fairfax Financial, Glenn Chamandy at Gildan Activewear, Patrick McHale at Graco Inc., Joe Pyne at Kirby Corp., Ian Cumming and Joseph Steinberg at Leucadia National, Jim Tisch at Loews, Jeff Lorberbaum at Mohawk Industries, Howard Marks at Oaktree Capital, Charles Fabrikant © 2008-2013 by BeyondProxy LLC. All rights reserved. JOIN TODAY! www.manualofideas.com May 2013 – Page 6 of 110 Value-oriented Equity Investment Ideas for Sophisticated Investors at Seacor Holdings, Eddie Lampert at Sears, Brian Sondey at TAL International, Carol Meyrowitz at TJX, Jim Metcalf at USG, Bill Berkley at W.R. Berkley, John Stumpf at Wells Fargo and Raymond Barrette at White Mountains Group. This is only a partial list. We have spent thousands of hours analyzing management track records and feel we have a good understanding of which management teams are highly capable and shareholder-oriented. MOI: Would you outline the summary thesis behind one or two of your best ideas at this time? Heldman: Everything we do is analyzed through our three-way filter: business, management, and valuation. “Wells Fargo’s valuation is attractive now, with the common stock trading at around ten times estimated 2013 EPS. Still elevated credit costs and regulatory/legal costs should decline over the next few years as the financial crisis fades further from view. Earnings growth of 8% annually over the next five years could result in roughly $5.00 of earnings per share. A reasonable multiple of 13 times earnings for a highquality business with 15% return on equity results in a $65 stock price in 2018. With Wells today at $37, the annual return would be 12% and a 3% dividend yield creates a potential 15% per year.” Our largest position at March 31, 2013 was Wells Fargo [WFC] warrants expiring October 2018. We love Wells Fargo’s business: a very large, very lowcost, very stable consumer/business deposit base that due to its lower cost and stability allows Wells to avoid “reaching for yield”, unlike competitors who hold riskier loans and assets. Still, the net interest margin is among the highest of major banks. Furthermore, good historical loan underwriting means Wells hasn’t suffered as much as other banks during economic downturns. In fact, Wells uses stressful periods opportunistically, such as 2008 when it was able to acquire ailing Wachovia Bank. The Wachovia purchase extended Wells’ geographic footprint to the East coast. In our view Wells has the best branch distribution system in the country. Wells’ revenues derive roughly 50% each from net interest income and fees, providing more stability than other capital marketsdriven banks such as J.P. Morgan Chase and Citigroup. It is a relatively plain vanilla financial services company focused on serving consumers and small businesses, with less emphasis on large corporations or volatile capital markets activity. Management is top notch at Wells Fargo. We’ve followed the management for 25 years. They have taken the right steps over the years. The business is run for long-term customer and shareholder benefit. Management has the right culture, a blend of Wells Fargo’s historical cost control and risk management with a strong sales culture at Norwest Bank when the two banks merged in 1998. Management is careful about capital allocation and pays attention to the business cycle. Share buybacks are done when the stock valuation is attractive, rather than mindless repurchases. Wells Fargo’s valuation is attractive now, with the common stock trading at around ten times estimated 2013 EPS. Still elevated credit costs and regulatory/legal costs should decline over the next few years as the financial crisis fades further from view. Earnings growth of 8% annually over the next five years could result in roughly $5.00 of earnings per share. A reasonable multiple of 13 times earnings for a high-quality business with 15% return on equity results in a $65 stock price in 2018. With Wells today at $37, the annual return would be 12% and a 3% dividend yield creates a potential 15% per year. We aim for 15%+ returns so Wells common meets our criteria. The warrants offer the possibility to do even better in this scenario. The warrants were issued to the U.S. government during the financial crisis when all banks were forced to sell stock to Uncle Sam. The exercise price of the warrants is currently $34 per share, so today the warrants have an intrinsic value of around $3 per warrant. Should Wells trade around our estimated 2018 price of $65 then the warrants would be worth $65 less the $34 exercise price or $31 per © 2008-2013 by BeyondProxy LLC. All rights reserved. JOIN TODAY! www.manualofideas.com May 2013 – Page 7 of 110 Value-oriented Equity Investment Ideas for Sophisticated Investors share. The warrants today trade around $12. Another kicker is a provision of the warrants whereby each quarter that Wells Fargo pays a dividend in excess of $.34 per share reduces the warrant exercise price by the amount of the entire quarterly dividend. Wells recently announced its intention to raise the dividend to $.30 per share starting with the second quarter of 2013, subject to Board approval. We assume the dividend will rise above the $.34 trigger level sometime next year. If Wells were to pay $.35 per quarter as of 2015 that would reduce the warrant exercise price by another $4 or so to $30. Our potential $65 price in 2018 less the $30 exercise price would result in a warrant value of $35 or three times the current warrant price of $12, which works out to almost 24% per year. Even better. MOI: You have written that you compare your “estimate of future value with the current stock price, and will invest only when a return of 15% per year over 3 to 5 years is achievable. If current prices offer expected returns under 10% we will reduce commitments and wait until better opportunities develop.” How do you judge prospective returns over a three- to five-year period, and what is your view on holding cash? “Since we take a private businessperson’s perspective, we evaluate what a private business buyer would pay for the business in three to five years.” Heldman: We start with Value Line Investment Survey three-to-five-year estimated sales and earnings. It’s a starting point and we modify based upon our judgment of particular business characteristics or cyclical industry considerations. Since we take a private businessperson’s perspective, we evaluate what a private business buyer would pay for the business in three to five years. We typically use multiples of several metrics including operating earnings, owner earnings—operating cash-flow less maintenance capital spending—and occasionally EBITDA for businesses with very low capital spending needs. Financial services businesses typically are valued at multiples of book value. We will also use price earnings multiples to cross check our private business valuations. We maintain an extensive business merger and acquisition database with hundreds of transactions over the past five years or so, so we have a good source of objective valuation multiples. Cash is a residual of the investment process. We are highly selective and only include in our 250 company universe those companies that we would feel comfortable owning should the market be closed for an extended period. So the deciding factor for purchase is valuation. When we can find 20 to 30 candidates within our 250 company fishing pond that meet our 15%+ return potential over three to five years, we will be fully invested. When we have a shortage of candidates, we maintain cash until our purchase criteria are met. Our sell process is essentially the reverse of the buy process. We begin selling if the current price is projected to result in appreciation potential under 10% per year, or if another stock offers significantly greater potential, or the business competitive position weakens. MOI: How has market volatility over the past several years affected your investment process, and have you tweaked your approach in any way as a result? Heldman: Over the past twelve years the stock market has experienced two very severe market downturns, and we understand the fragile nature of investor sentiment. We emphasize through client communications that we seek to protect against long-term permanent loss through extensive research and thoroughly understanding the companies we invest in. We invest in a well-researched, concentrated portfolio of 20-30 companies, so volatility can affect us in the © 2008-2013 by BeyondProxy LLC. All rights reserved. JOIN TODAY! www.manualofideas.com May 2013 – Page 8 of 110 Value-oriented Equity Investment Ideas for Sophisticated Investors short-term. We attempt to ease investor concerns by communicating clearly and candidly during stressful periods when investor behavioral mistakes can occur. But, we firmly believe some volatility is central to our process and results, as we seek to benefit from other investor’s mistakes. If the market were perfectly rational, we’d have much less to do. Underlying business value and management change very gradually, while stock prices fluctuate dramatically in the shortterm. MOI: You have argued that, “Investor behavior is more important than superior intellect. Emotionally-stable investors recognize the occasionally irrational nature of markets and maintain a disciplined focus on business value versus market price.” What do you consider to be the worst behavioral errors investors make, and how can investors guard against those mistakes? “Lack of understanding and impatience are probably the two greatest mistakes, and they are often intertwined.” Heldman: Lack of understanding and impatience are probably the two greatest mistakes, and they are often intertwined. Most investors can’t take the time to truly understand the most important elements of investing, such as business/competitive strength, financial statement analysis, management capability and motivation, business valuation measures, etc. This lack of understanding can be amplified by investor behavioral biases that cause people to do the wrong thing at the wrong time. Therefore, lacking true understanding of what drives a company’s valuation over long time periods, when companies experience short-term setbacks—as almost all do at some time--investors often get impatient and sell a stock when it’s depressed. This might lead to buying a stock that appears to be doing better, without realizing that the better results are usually incorporated into the current stock price. So investors can move from one disaster to another, without really understanding the true causes. It’s the classic case of buying high and selling low. But the cause is sometimes found by looking in the mirror. The best way to guard against this is to invest in companies you can understand, and pay attention to market cycles and business valuations. A great company selling at a very inflated valuation can become a very poor long-term investment. MOI: Can you recommend one or two recent books that have given you new insights into the art of investing? Heldman: I’ve just started reading The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, by William Thorndike. I’m looking forward to finishing it as I’m very familiar with most of the profiled CEOs, having followed them for years. I’d highly recommend learning from this book how truly gifted CEOs manage their businesses over the long-term. As the title implies, greatness often requires an unconventional approach. We feel the same way about the investment business. MOI: Thank you so much for your time and all the insights. Diclaimer provided by Triad Investment Management: The comments by John Heldman are not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. His comments are intended for informational purposes only and should not be construed as investment advice or as a recommendation to sell or buy any security or other investment, or undertake any investment strategy. © 2008-2013 by BeyondProxy LLC. All rights reserved. JOIN TODAY! www.manualofideas.com May 2013 – Page 9 of 110 The Manual of Ideas research team is gratified to have won high praise for our investment idea generation process and analytical work. “I highly recommend MOI — the thoroughness of the product coupled with the quality of the content makes it an invaluable tool for the serious investor.” —TIM DAVIS, MANAGING DIRECTOR, BLUESTEM ASSET MANAGEMENT “Wonderful.” —THOMAS S. 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