2013.09.30 - Value Investor Insight

Brian Rogers was only three years into his tenure at T. Rowe Price when he was tapped in 1985 to launch its val-

ue-oriented Equity Income Fund. “I raised my hand, but to be honest,” he says, “this was mostly a growth-stock organization then and not many other hands went up.”

Still at the helm 28 years later, Rogers’ $29 billion (assets) fund has earned a net annualized 11.0% since inception, vs. 9.4% for the Lipper Equity Income Fund Index. Since 2004 he has also served as T. Rowe Price’s Chief Investment Officer, and in 2007 was named its Chairman.

Rarely lacking for ideas on which to take a contrarian stance, he’s finding investment opportunity today in such diverse areas as consumer electronics, energy, department stores and cruise lines. See page 2

That most of his Wasatch Advisors’ colleagues are growth investors doesn’t bother Jim Larkins in the

least. “Our core competence as a firm is identifying great growth stories,” he says. “I just wait to pick them off if they become value priced.”

His eye thus far has proven reliably sharp. The Wasatch Small Cap Value Fund Larkins has managed or co-managed since the beginning of 1999 has earned a net an-nualized 12.5% since then, vs. 7.5% for the Russell 2000 Index.

Pursuing ideas that growth investors are leaving and value investors have yet to find, he’s seeing opportunity today in a variety of places, including biotechnology, energy, apparel retailing, enterprise soft-ware and mattresses. See page 9

ValueInvestorINSIGHT

September 30, 2013

The Leading Authority on Value Investing

Righting the ShipBadly lagging market sentiment can reflect a company’s past far more than its future. When that happens, Brian Rogers is often there to take advantage.

Inside this IssueFEATURES

Investor Insight: Brian RogersLooking beyond choppy waters to calmer sailing ahead for companies such as Apache, Apple, Carnival and Kohl’s. PAGE 1 »

Investor Insight: Jim LarkinsStepping in when fair-weather in-vestors step out in such companies as Questcor, Select Comfort, Ebix, Comstock and Chico’s. PAGE 1 »

A Fresh Look: J.C. PenneyPondering whether the relentless decline in the beleaguered retailer’s stock has gone too far. PAGE 17 »

A Fresh Look: Tesco PLCIs this value-investor favorite’s less-than-smooth journey to recovery still on the right track? PAGE 18 »

Editors’ LetterWarren Buffett on what to look for in a money manager. PAGE 19 » INVESTMENT HIGHLIGHTS

Other companies in this issue:Amgen, Avon, Body Central, Carbo

Ceramics, ConAgra, DXP, Energizer,

Ingersoll-Rand, Joy Global, JPMorgan

Chase, Microsoft, Polypore, Skullcandy,

SLM, Thermo Fisher Scientific, TriState

Capital, Whirlpool, Yes Bank

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T

Jim LarkinsWasatch Advisors

Investment Focus: Seeks companies whose growth prospects appear largely unappreciated due to a recent fall from grace, relative obscurity, or both.

Scenic DetoursSo-called “fallen angels” often never really rise back up. Jim Larkins over time has shown an impressive knack for identifying the ones that will.

INVESTMENT SNAPSHOTS PAGE

Apache 5

Apple 6

Carnival 7

Chico’s FAS 13

Comstock Resources 15

Ebix 12

J.C. Penney 17

Kohl’s 8

Questcor Pharmaceuticals 11

Select Comfort 14

Tesco PLC 18

I N V E S T O R I N S I G H T

Brian RogersT. Rowe Price

Investment Focus: Seeks companies trading at low relative valuations for cyclical or company-specific fundamental reasons that are expected to mean-revert.

September 30, 2013 www.valueinvestorinsight.com Value Investor Insight 2

Describe the early thinking behind T. Rowe Price’s Equity Income Fund, which you launched in 1985 and still manage.

Brian Rogers: T. Rowe Price through the 1970s was primarily a growth-stock orga-nization, with a small and growing fixed-income business. That positioning wasn’t the greatest in the 1973-74 bear market or in the late 1970s, and the company went through some tough times.

In the early 1980s the equity market environment was very challenging, but the company made the strategic decision that to insure its success going forward, it needed to introduce a number of new value-oriented and conservative portfolios that would appeal to the 401(k) investor. In 1985 the Equity Income Fund became an important part of that effort. The idea was to focus on somewhat tarnished blue chips with contrarian appeal and attrac-tive dividend yields. We ended up invest-ing in a higher-yielding, lower-P/E basket of mostly U.S. equities – that’s basically what we’ve done ever since.

The perfect investment for us has faced a cyclical, sector or company-specific chal-lenge, has encountered some controversy, has low visibility in terms of what ana-lysts are expecting and has lagged perfor-mance-wise. That can create a situation in which the company’s earnings, cash flow and dividend stream are mispriced relative to the market. My philosophy in a nut-shell is if you invest in a company selling at an anomalously low valuation level, have confidence in its ability to improve its fundamental performance, and have a long-enough time horizon, you can win from a pattern of mean reversion.

How do you zero in on high-potential prospects?

BR: We have a scoring system that ranks companies based on how their share

prices trade relative to the S&P 500 over time on four measures: price-to-earnings, price-to-sales, price-to-book and dividend yield. In simple terms, a relative P/E today of 0.8x the market versus a long-term av-erage of 1.2x, say, would suggest today’s valuation could be attractive. From there, our research is focused on trying to get our arms around the conditions necessary for the company to improve its underlying financial performance and the likelihood of those conditions prevailing. We make earnings and profitability projections two to three years out and estimate how the earnings and dividends streams may be valued at that time. Then we look at the gap between today’s market value and the potential future value. If it’s attractive, we buy it. Nothing fancy.

As an example, one of the easy invest-ments of all time was Home Depot [HD] about five years ago. The stock had gone from $40 to $20, the P/E went from 18x to 10x and the dividend yield went from 1.5% to 3.5%. Nothing had particularly changed in terms of the company’s com-petitive situation. If you assumed 2008 wouldn’t repeat itself any time soon, you could make a mean-reversion assumption and conclude the stock a couple years’ out was worth at least $50. [Editors’ Note: HD shares hit $50 in early 2012 and now trade at $76.]

Absent overall market routs, we’re assum-ing company-specific problems more often attract your attention.

BR: There is very often an inverse rela-tionship between recent stock-price per-formance and valuation appeal as we gauge it. So invariably we’re looking at companies that have been under pressure. A representative example of that would be Carnival [CCL], the cruise-ship company. The problems started when its Costa Con-cordia cruise ship capsized off the coast

I N V E S T O R I N S I G H T : Brian Rogers

Investor Insight: Brian Rogers T. Rowe Price’s Brian Rogers describes when he’s willing to bet on mean reversion, why Home Depot five years ago was “one of the easy investments of all time,” why his portfolio is as diversified as it is, his tactic for trying to add value at his firm during the financial crisis, and why he sees unrecognized value today in Apple, Apache, Carnival and Kohl’s.

Brian Rogers

Keeping Talent In-House

Investment management was hardly a hot field when Brian Rogers was looking to join it in 1982 upon graduation from Harvard Business School. An inflation-wracked economy was struggling and the S&P 500 for 15 years had been bumping along at around 100. “There was a contrarian ele-ment to my career choice,” he says.

His timing couldn’t have been better. He joined T. Rowe Price in the summer of 1982, eight weeks before the biggest bull market in history started its nearly 18-year run. In 1985 he was named portfolio man-ager of the T. Rowe Price Equity Income Fund, a position he still holds in addition to serving as the firm’s Chairman and Chief Investment Officer.

Rogers’ tenure at T. Rowe Price is indica-tive of one of the firm’s strengths: keeping talent in-house. There’s no magic to that, he says, but it’s not an accident either. “People ask why I never left. It’s a func-tion of being given new challenges at key points in my career, working in a decen-tralized structure where you own your own destiny, always feeling very well-treated financially and working with people I like. Good investors attract other good inves-tors, which is why strong investment cul-tures can be self-perpetuating.”

http://www.valueinvestorinsight.com/



of Italy in January 2012 and then last winter there were additional self-inflict-ed wounds from high-profile engine and water-system failures on a couple of their ships. To buy Carnival – which we first did about a year ago – we had to conclude that the damage to its brand was fixable and that its management was capable of fixing it. We accept the premise that it can pay to invest in good companies with bad psychology.

Negative psychology can extend to an entire sector. We’ve been struck, for in-stance, by how dramatically conventional wisdom appears to have shifted around anything related to commodities. After years of focus on the commodity “super-cycle,” now all you hear about is global excess capacity. Consequently, the stock prices of anything related to the sector have declined pretty sharply, whether it’s an actual raw-material company or an equipment manufacturer that serves the business like Joy Global [JOY]. We’ve made a small new investment in Joy, but more generally it’s an area in which we’re doing a lot of work.

You don’t appear at all afraid of turn-around situations. What makes them more or less attractive in your eyes?

BR: Companies in need of a turnaround tend to have the valuation characteristics we like to see, but the decision to buy into one often comes down to a bet on whether management can deliver improved per-formance. If you conclude the business model is broken or the balance sheet is too stretched, that’s less likely. But if you don’t believe the business has fundamentally changed, turnarounds can offer a very at-tractive risk/reward. The low expectations built into the share price mean there can be substantial upside, while at the same time the downside is limited.

Avon Products [AVP] is one in-process turnaround we own. We believe Sheri Mc-Coy, who took over as CEO 18 months ago after 30 years at Johnson & Johnson, is doing the right things to improve the balance sheet, re-size the cost structure and address operating problems in key

markets. That probably wouldn’t mat-ter enough if you thought the company’s direct-sales model was beyond repair, but we don’t believe that’s the case. The shares have done fairly well since the beginning of the year, mostly a function of perfor-mance metrics moving off the bottom, but there is still plenty of room for continued improvement.

On the subject of turnarounds, you have been a big proponent in recent years of de-partment-store operator Kohl’s [KSS], but not of J.C. Penney [JCP]. What explains the distinction?

BR: Part of it is a function of experience – we have a long heritage with Kohl’s and consider it very well managed. We have also considered it a higher-quality compa-ny with a better competitive position and consistently better financial performance. That’s not to say it isn’t without its mer-chandising and product-mix challenges, but on the whole we consider those to be more short term and fixable than what Penney has been dealing with.

I’d also say that when Ron Johnson came to Penney from Apple, as success-ful as he’d been, it wasn’t obvious to me his experience would be that transferable. These were two very different businesses, almost like taking a star from the Balti-more Ravens and having him play NHL hockey. Being a great athlete isn’t always enough.

I don’t own J.C. Penney today, but I have to admit it deserves some attention. Retail is one of those sectors, like technol-ogy, where betting on mean reversion can be tricky, but as with Home Depot and Lowe’s five years ago, it can work out very well. Penney clearly has its work cut out

for it and it’s not something that would look attractive in our valuation rankings, but any time I see a stock-price chart like it has for a company that has been in busi-ness for more than 100 years, I will want to take a second look.

Does your fund’s asset size – now around $29 billion – limit how diversified you can be in terms of cap size?

BR: We’ve always had a large-cap orienta-tion, but it gets a little tougher to have the exposure I might prefer to less-than-$10-billion market caps. We generally have a smaller average market cap than that of the Russell 1000 Value Index, but roughly 85% of the portfolio is in companies with market caps of more than $10 billion. Most of what we invest in is very liquid.

How many positions do you typically hold in the Equity Income Fund?

BR: We’ve generally been in the 110 to 125 range. Going back to our original mission and customer base, we’ve always considered it important not to make big bets by sector or individual holding.

I’ve observed too many cases in my career in which very large bets have hurt investors, including such prominent ex-amples as being heavily overweight tech-nology in early 2000 or financials in mid-2008. I suspect the next great market crisis will involve something other than what caused the last one. Broader diversi-fication makes sense to us.

Describe generally how you think about selling.

BR: We tend to have a low-turnover ap-proach. We’re trying to buy when some-thing is trading at unusually low levels of valuation relative to the market and sell when that relative valuation is at aver-age to above-average levels. It can happen more quickly, but it’s generally at least a two- to three-year process.

We’re humble about our ability to pre-cisely time these things. We tend to buy gradually, acknowledging that we may

ON NEGATIVE PSYCHOLOGY:

We’ve been struck by how

dramatically conventional

wisdom appears to have

shifted around commodities.




average down, and we tend to sell gradu-ally, acknowledging that we’ll probably start selling prematurely. But if a stock performs relatively well versus the mar-ket and that leads to its relative valuation appeal sufficiently declining – which, for example, might mean its P/E or Price/Book goes from a long-term average of 110% of the market to 130% – we start to sell.

If things work out, we’re selling when the market’s appreciation of a company’s performance has gone from below the norm to well beyond it. In the second quarter of this year we considered that the case for companies such as Thermo Fish-er Scientific [TMO], Whirlpool [WHR], Amgen [AMGN], Ingersoll-Rand [IR], ConAgra [CAG], Energizer [ENR] and SLM [SLM].

To pick one, Ingersoll-Rand’s prospects have clearly improved from five years ago, as has the visibility of the economic envi-ronment. But to our way of thinking, the stock advanced from the mid-$20s to the $60s and has gotten ahead of the com-pany’s fundamentals. We’ll cycle out of such investments into others facing more uncertainty and investor concern.

Some of your holdings, such as Chevron [CVX], ExxonMobil [XOM] and AT&T [T], have been in the portfolio since the 1980s. How does that happen?

BR: If a company’s earnings and divi-dends compound at attractive rates but its stock never sells at a particularly expen-sive valuation, it may look attractive to us on a relative basis for a very long time. These can still be very solid investments over time.

What about those cases where things don’t appear to be working out. Are you quick to cut your losses?

BR: If something hasn’t performed well, we’ll revisit what we were thinking and try to assess if our timing was off or if we just didn’t know what we were doing. A big red flag for me is if there’s a steady deterioration in the company’s balance-

sheet position – that often encourages us to move on. But generally I have a ten-dency to be a bit stubborn, so if we think our investment thesis is still valid and our valuation analysis is still ballpark correct, we will hang in there.

With Microsoft [MSFT], what conclu-sions have you made on “the-timing-is off” versus “didn’t-know-what-we-were-doing” question?

BR: We have slightly trimmed our expo-sure to Microsoft in 2013. There are so many moving parts right now. The com-pany is very strong financially, but the industry headwinds seem increasingly problematic. All in all, the whole situation is more uncertain than I viewed it at the beginning of this year. We’re okay holding what we have, but would expect to reeval-uate the position closely after the naming of the new CEO.

Describe what attracted you to Apache Corp. [APA], one of your favorite energy-related ideas.

BR: Within an energy sector that has not been a particularly strong performer over the past 18 to 24 months, Apache has been notably weak. It’s an independent explo-ration and production company with a strong long-term record and recently was trading at only 10x earnings. I’m attract-ed to a company selling at 10x earnings when there is a lot of activist activity in the sector. If you look at Hess earlier this year and Murphy Oil before that, you see that sometimes good things happen to in-expensive stocks, and we consider Apache one of the cheapest independent oil and gas companies in the market.

What would explain that?

BR: The company has a geographically and geologically diversified mix of assets that includes mature reserves generating strong cash flow as well as high-potential prospective developments. The primary issue with the stock has been a large expo-sure to Egypt. That operation accounts for around 20% of the firm’s production and the market has been concerned about its value with all the political turmoil there. While that uncertainty hasn’t gone away, just last month Apache announced it was selling one-third of its Egyptian business to China’s Sinopec Group for over $3 bil-lion. That seemed to put a solid floor on the value of those assets, and the share price did move up a bit in response.

Are you counting on activism to push things along?

BR: We look at it more as a free option. If you’re into pattern recognition, it would not be surprising for Apache to become the focal point of activist activity. It has a wide range of assets in a wide variety of places, providing plenty of opportunity to realize value that doesn’t appear reflected in the market price.

That said, the Egypt sale to us signals that the company is serious about address-ing the value gap in the stock. This is an experienced and smart management team – stronger than at either Murphy Oil or Hess – and they’re as frustrated as anyone with the pattern of undervaluation. Excel-lent assets and capable, motivated man-agement make a very good combination.

With the stock currently at $86.25, what upside do you see here?

BR: On almost any valuation measure rel-ative to peers, Apache stands out as inex-pensive. Earnings estimates for 2013 are $8.15 per share, resulting in a P/E of less than 11x. The net asset value, based on proven and probable reserves at current energy prices, is around $125 per share. With that kind of upside and a downside – absent a collapse in energy prices – that

ON MICROSOFT:

We’re okay holding, but

would expect to reevaluate

the position closely after the

naming of the new CEO.



we have a hard time seeing below $75, that’s a reasonable bet.

Do you build in a view on energy prices?

BR: We generally assume prices are go-ing to be flat. The record of investors in aggregate in terms of forecasting oil and gas prices is dismal. Our approach is es-sentially to buy companies in the sector when they’re inexpensive on a price-to-asset-value basis and then wait. When they’re expensive on a price-to-NAV basis, you sell. That sounds very basic, but it has tended to work for us over time.

You have in the past expressed some ti-midity about investing in the technology sector. Why have you overcome that with Apple [AAPL]?

BR: My timidity about technology is a function of it being, in my experience, a tough sector in which to bet on mean reversion. There’s a higher probability in fast-changing businesses that things won’t revert to the mean. We’ve had our successes, but have also made plenty of mistakes over a long history, like buying Lucent Technologies two-thirds of the way down. Or buying Hewlett-Packard

two years ago. As a generalization, I think technology is just a tougher field for the value investor.

With hadn’t been involved with Apple at all during its spectacular run. I remem-ber being on CNBC in May of 2011 and the host making note that, “Brian, you’re just about the only fund manager in America who doesn’t own Apple.” We ob-viously would have loved to have bought it at $80, or $120 or $200, but it just never fit our profile. Then starting late last year as the top-line and earnings momen-tum slowed down somewhat, we watched it go from an over-hyped, institutionally over-owned stock to one that everyone was tripping over themselves to get out of – taking the share price from $700 to below $400 in relatively short order. The P/E went to 10x, the dividend yield went to 3%, and there was far more cash on the balance sheet than they could possibly spend. It very much fit our profile of an attractive stock. It was one of our largest purchases in the second quarter.

What assumptions are you making about the business?

BR: At today’s valuation we don’t believe the investor has to make aggressive as-sumptions about the business’s trajectory. I’d argue, in fact, that at the current price there’s very little growth expectation built in. But we still consider Apple a creative company with a great global brand that is very well positioned in rapidly grow-ing sectors of the market. It’s not going to grow like it has, but can it grow at 10-15% a year? We’d argue yes.

How are you looking at valuation with the shares recently at around $483?

BR: The company is expected to earn close to $40 per share for the year ending this month, and we think $42 to $45 is a reasonable range for fiscal 2014. That re-sults in a forward multiple of around 11x, without backing out the roughly $160 per share in cash on the balance sheet.

We were buying 60 points ago, so we start out earning 3% on the dividend.


Apache (NYSE: APA)

Business: Exploration, development and production of oil and natural gas, with as-sets located in the U.S., Canada, Egypt, Australia, Argentina and the U.K.

Share Information(@9/27/13):

Price 86.2552-Week Range 67.91 – 89.17Dividend Yield 0.9%Market Cap $33.59 billion

Financials (TTM): Revenue $16.63 billionOperating Profit Margin 38.8%Net Profit Margin 15.6%

Valuation Metrics(@9/27/13):

APA S&P 500P/E (TTM) 13.4 18.3Forward P/E (Est.) 10.7 15.3EV/EBITDA (TTM) 3.9

Largest Institutional Owners(@6/30/13):

Company % OwnedCapital Research Global Inv 5.8%T. Rowe Price 5.0%Vanguard 4.6%State Street 4.3%Franklin Templeton 2.9%

Short Interest (as of 8/30/13):

Shares Short/Float 2.0%

I N V E S T M E N T S N A P S H O T

APA PRICE HISTORY

THE BOTTOM LINEIts large exposure to Egypt has led to a persistent pattern of undervaluation in the com-pany’s stock that isn’t warranted by the quality and diversity of its assets, says Brian Rogers. If the gap between its current market value and its $125-per-share net asset value remains wide, he wouldn’t be surprised by activist-investor efforts to help close it.

Sources: Company reports, other publicly available information

60

90

120

150 Adj Close0.00.20.40.60.81.0

2011 2012 2013

150

120

90

60

150

120

90

60




Then we’re willing to bet the company can grow EPS at a 10% or so rate, giving us a simple return of 13% per year. There’s nothing wrong with that, but we also re-tain an upside option that a small sentiment change could have a big impact on the valu-ation and share price. That could be helped along if the company continues to be on the offensive in terms of returning capital to shareholders, which we think it will.

Does Steve Jobs’ absence give you pause?

BR: Apple under Steve Jobs was an incred-ibly innovative company, but everyone

didn’t leave when he died. I don’t buy into the notion that the untimely departure of one person has altered the company’s abil-ity to innovate forever.

From consumer electronics to vacation cruises, describe your investment thesis for Carnival.

BR: After the Costa Concordia capsized, we asked two analysts to research all past significant consumer product and service disasters – think Tylenol or Jack in the Box – and determine how long it took for the brand in question to be restored. The

conclusion was that customers do forgive, but it typically takes two to three years from the initial incident. We took our po-sition in Carnival realizing the impact on the business wouldn’t go away immedi-ately, then the stock got hit again by the engine and sanitation issues on a couple of the company’s ships last winter. After reassessing our work, we added to the po-sition earlier this year.

The crux of our thesis is that custom-ers eventually forgive, that the company is doing the right things in responding to the problems, and that it has both the market position and financial wherewithal to ride out a tough period.

Describe the competitive position and the company’s response to its troubles.

BR: Carnival is the largest cruise-line op-erator with 100 ships in service and pas-senger capacity of around 200,000. It has 10 global brands targeting just about ev-ery relevant demographic, but it’s primar-ily a middle-market line. It’s not an easy business to enter and Carnival along with Royal Caribbean [RCL] control nearly 75% of the global market.

On the operating front, founder Mick-ey Arison stepped aside as CEO, which we consider a positive given that he’s of-ten appeared more interested in his non-Carnival activities than in running the business. The new CEO, Arnold Donald, has been almost exclusively focused on rebuilding the company’s brand image, starting with an overhaul of maintenance and emergency-response procedures. He’s also spending heavily on marketing, which depresses earnings, but is necessary to help the brand recover.

Is the cruise business generally a good business?

BR: It’s not a high-return, high-margin business. It’s cyclical, driven by consumer disposable income, and is highly capi-tal intensive. On the other hand, it has some positive demographic tailwinds and has benefitted by the success of Disney in building its cruise operation. They’ve le-

Apple (Nasdaq: AAPL)

Business: Design, manufacture, marketing and sale of a range of personal comput-ers and mobile communication and media devices such as the iPhone and iPad.





AAPL S&P 500P/E (TTM) 12.0 18.3Forward P/E (Est.) 11.3 15.3EV/EBITDA (TTM) 7.1


Company % OwnedVanguard 4.9%State Street 4.1%BlackRock 3.8%Fidelity Mgmt & Research 3.4%Northern Trust 1.5%




AAPL PRICE HISTORY

THE BOTTOM LINEBrian Rogers believes the market is overreacting to a slowdown in the company’s growth and is undervaluing its still-enviable position in rapidly growing global technology sectors. From earnings growth and dividends he expects an average annual return of some 13% on the stock, with further upside from even a small deserved change in market sentiment.


800

700

600

500

400

300

200

800

700

600

500

400

300

200200

300

400

500

600

700

800 Adj Close0.00.20.40.60.81.0

2011 2012 2013




gitimized the cruise as a family vacation, broadening the market beyond just people who are 21 or 71.

How attractive do you consider Carnival’s shares, trading recently at just under $33?

BR: We like that there’s balance-sheet sup-port on the downside, with a $31 book value that appears solid. The big ques-tion is how quickly the company’s earn-ings power can recover. We estimate EPS of only $1.55 for the fiscal year ending in November, rising to $2 next year and maybe $3 or so in fiscal 2015. To frame

that, EPS in 2011 – prior to the high-pro-file problems – was just over $2.40.

If we’re right, two years out at what we consider a reasonable 15x multiple for this type of business, you’d have a $45 share price. On top of that you’re earning nearly 3% per year from dividends.

Risks?

BR: I’m quite confident we’ll see no oper-ating problems this season, but one clear way for this to be a bad investment is if we see news footage of another stranded Carnival ship with plumbing problems

this January. Then the likely assumption of investors and customers – perhaps cor-rectly – will be that this is the gang that can’t shoot straight.

Kohl’s shares have been in a funk for some time. Why are you confident that can change?

BR: This is a company that for many years was universally well regarded by the market, but which has lost some of that goodwill after a fairly drawn-out period of weak same-store-sales and margin com-parisons. The key question is whether its problems are a few missed fashion cycles and not having enough of the right hot brands, or if there’s something more fun-damentally wrong with its competitive position and customers are just shopping elsewhere. In owning the stock, we’ve ob-viously concluded there’s nothing wrong with its position and we have confidence in management’s ability to get the opera-tions back on track.

How would you describe its market position?

BR: The company has 1,100 or so stores in the U.S., targeting the middle-income and value-focused customer with moder-ately priced apparel, footwear and home goods. The stores generally have a wider selection of brand-name apparel than a competitor like Target, and are in more-convenient stand-alone locations than one like J.C. Penney. One historical strength has been a greater focus on private-label and exclusive-label merchandise, which account for more than 50% of total sales and have driven better-than-average gross and operating margins.

We meet twice a year with Kevin Man-sell, who has been with the company for more than 30 years and was named CEO in 2008, and there’s no question that he’s focused on rejuvenating the merchandis-ing organization and getting the product mix back on track. That doesn’t guarantee success, of course, but we don’t need mir-acles for the stock to perform well from today’s price.

Carnival (NYSE: CCL)

Business: World’s largest cruise-ship operator, with more than 100 ships operat-ing under such brand names as Carnival, Holland America, Cunard and Costa.





CCL S&P 500P/E (TTM) 17.0 18.3Forward P/E (Est.) 19.1 15.3EV/EBITDA (TTM) 11.0


Company % OwnedNorthern Trust 7.9%T. Rowe Price 6.5%Barrow, Hanley, Mewhinney & Strauss 4.3%Capital World Inv 3.6%Vanguard 3.4%




CCL PRICE HISTORY

THE BOTTOM LINEWhile its high-profile mishaps will not be overcome quickly, Brian Rogers believes the company is doing the right things in response and that it has the market position and financial wherewithal to win customers fully back. At 15x his fiscal 2015 earnings-per-share estimate of $3, the shares would return to their early-2011 level of around $45.


50

40

30

20

50

40

30

2020

30

40

50 Adj Close0.00.20.40.60.81.0

2011 2012 2013




How cheap do you consider the shares at today’s $52?

BR: If we assume same stores sales do a little better, operating margins expand a little bit and we have reasonable retail consumer spending, we think the compa-ny can earn around $5 per share next year. Put a 12x multiple on that and you’d have a $60 stock a year from now and would have earned 2.7% from the dividend. That would be a 17-18% total return, which in today’s market is quite attractive.

There’s also an important capital-return story here. The company has continued to

increase its dividend and has bought back more than 25% of its total shares over the past four years. There’s no reason to be-lieve that won’t continue.

T. Rowe Price recently publicly resisted Michael Dell’s buyout offer for Dell. Do you expect to do more of that?

BR: We believe activism is a constructive force and enhances shareholder value. But most of the time we’re not that vocal. If we have a large stake in a company and have material concerns, we will invari-ably have extensive conversations with

management and will sometimes reach out directly to the board. Earlier this year you probably didn’t read much about our involvement, but we played an active role in the conversations between Elliott Asso-ciates and Hess, which had a very positive outcome for shareholders. In the case of Dell, the LBO proposal was such a one-sided, stacked game that we just felt like we had to say something publicly.

Much activism revolves around balance-sheet structure and capital allocation. What do you tell companies when they ask for advice?

BR: We like to invest in companies that have a balanced, intelligent financial strat-egy. That means not buying back stock at any price. That means not taking on heavy leverage or pursuing unsound dividend policies. All of this is particularly impor-tant today because of the well-document-ed buildup of cash on corporate balance sheets. There’s no one-size-fits-all response – companies should evaluate every arrow in the quiver to build shareholder value.

Do you have any general market views that impact what you’re buying and selling?

BR: We don’t usually invest based on macro views. Occasionally, however, it can be necessary to have a view in extreme environments. For example, one of the most helpful things I did during the finan-cial crisis was constantly remind people around here that the world doesn’t end that often, and that we should be focused on how best to come out the other side.

Today I have a view that interest rates can only go up. As the global economy grows it only makes sense that central banks become less accommodative. But that view doesn’t make me like the stock of JPMorgan Chase [JPM] more or less. What makes me like JPMorgan is its rela-tive valuation appeal. What will make me like it less is when the stock outperforms and sells at $60. I believe we can do a bet-ter job for our investors by focusing on individual opportunities than by trying to play investment strategist. VII

Kohl’s (NYSE: KSS)

Business: Owner and operator of U.S. de-partment stores that sell moderately priced apparel, accessories, footwear, soft home goods and housewares.





KSS S&P 500P/E (TTM) 12.2 18.3Forward P/E (Est.) 11.1 15.3EV/EBITDA (TTM) 5.6


Company % OwnedT. Rowe Price 11.9%State Street 5.2%JPMorgan Chase 4.4%Vanguard 4.3%Franklin Templeton 3.4%




THE BOTTOM LINEThe key question around the company is whether its problems are a few missed fashion cycles or if there’s a fundamental problem with its competitive position, says Brian Rog-ers. Having concluded the former, he expects better same store sales and operating margins to drive $5 in EPS next year. At a 12x multiple, the shares would trade at $60.


KSS PRICE HISTORY

40

50

60 Adj Close0.00.20.40.60.81.0

60

50

40

60

50

40 2011 2012 2013



An important part of your strategy is in-vesting in “fallen angels.” Why is that a worthy cohort for ideas?

Jim Larkins: I look for successful, grow-ing small-cap companies that have a hit a bump in the road that causes growth and momentum investors to bail because their growth and momentum criteria are temporarily not being met. At the same time, these ideas don’t hit value investors’ screens because the company still prob-ably looks expensive on book value and earnings, which have just taken a hit. The overall dynamic can create inefficiency in share prices that we try to exploit.

We have an added institutional advan-tage because Wasatch is more of a growth shop than a value shop. We often already have extensive research done that can help inform whether a company is hitting a bump in the road or coming to the end of the road. If we conclude it is a bump, we can pounce quickly. Probably my best source of new ideas is the most-down list among our internal holdings.

You’ve said your ideal investment has three distinct stages of performance. What are they?

JL: The first leg is what I call the intrinsic-value stage, where the price increases back to some average historical valuation level. We’re trying to buy below those average levels on metrics such as EV/Sales or Price/Book, and the return to average usually comes from the market realizing the com-pany is a going concern with relatively in-tact earnings power.

The second stage comes from earnings improvement as the company gets back on its feet and starts to perform again. At that point the stock should at least move in line with earnings, which we typically are ex-pecting to grow 10-15% per year over the intermediate term. The final leg, if we’ve

chosen well, comes from multiple expan-sion. If the growth is there, it’s likely the market again falls in love with the stock.

Describe a real-time example or two of your fallen angels.

JL: Carbo Ceramics [CRR] would be a representative one. The company primar-ily makes ceramic proppant that is used in fluids that are blasted into rock forma-tions during fracking operations to extract oil and gas. The company has a long track record of excellent financial performance, but it really took off a few years ago when the use of fracking in the U.S. significant-ly increased. Then Chinese competition came in, natural-gas prices collapsed and gas drilling was sharply curtailed. That re-sulted in a glut of proppant inventory that had to be worked through, putting a huge dent in Carbo’s growth story.

The question to answer as the share price fell from $180 in the summer of 2011 to the low-$60s a year ago was whether the company’s problem was a cyclical one that would correct itself over time or whether the Chinese competition was a game-changer. We concluded that the science and data support the fact that the uniform, high-quality ceramic prop-pant that Carbo makes, while more ex-pensive upfront, will over the life of a well produce more oil and gas and a better ROI for drillers. If we’re right, the company’s earnings power as a supplier to a thriving global market for shale drilling is intact.

With the stock now at nearly $100, which stage of performance do you think it’s in?

JL: The panic is out of the shares, so the valuation is almost back to historical lev-els. What we need to see now is the num-bers to turn, so that we can capture the revenue and earnings growth and perhaps a bit of multiple expansion.

I N V E S T O R I N S I G H T : Jim Larkins

Investor Insight: Jim LarkinsJim Larkins of Wasatch Advisors explains the three stages of performance he expects from his ideal stock, the category of catalyst on which he most often counts, his “picks and shovels” alternative to market darling Tesla Motors, and why he believes Questcor Pharmaceuticals, Ebix, Comstock Resources, Chico’s and Select Comfort are mispriced.

Jim Larkins

Fertile Ground

Soon after earning an MBA from Brigham Young University and joining Wasatch Ad-visors as a growth-stock analyst in 1996, Jim Larkins noticed somewhat of a discon-nect between his investing nature and that of many of his colleagues. “It was often hard for me to make the valuation math work in high-quality small caps,” he says. “I found myself getting interested when a growth story would blow up, which is when the growth guys would peel out.”

The following year Larkins helped launch a new fund, the Wasatch Small Cap Value Fund, set up in large part to take advan-tage of just such broken-growth stories. He was named a co-portfolio manager in 1999 and has been running the fund solo since 2008.

When not tending to his portfolio, Larkins in is spare time is an avid gardener, par-tial to growing fruit, tomatoes and even the occasional mega-pumpkin, including an award-winning 650-pound specimen a few years back. “I realize it’s a bit corny, but there really are parallels between gar-dening and investing,” he says. “You put in a lot of work upfront, do all you can to make sure everything’s healthy, and you wait. The end result isn’t always perfect, but when it is, it’s extremely satisfying.”




Another classic fallen angel that is still one of our top holdings is Polypore In-ternational [PPO]. The company makes membranes that create in batteries an ion-exchange barrier that allows the pro-duction of electricity. These membranes are highly engineered, based on exacting requirements from battery manufacturers, but they’re not a big component of the overall cost. It’s a nice consumable-prod-uct, recurring-revenue business.

Polypore’s stock did extremely well as the economy recovered after the crisis, ris-ing from $3 a share in March 2009 to over $70 in mid-2011. But the company built out too much capacity to supply large-format lithium batteries used in electric vehicles, so when demand for electric cars came in lower than expected, a lot of air came out of the stock. Then we had a real-ly warm winter a year and a half ago and traditional lead-acid batteries didn’t sell, which hit the shares further. We think the stock today [at $41] is attractively priced just on the core, lead-acid-battery busi-ness. Any future homerun from electric vehicles we get for free.

Give an example in another favored idea category, the “undiscovered gem.”

JL: These types of ideas are more in line with what other small-cap managers say they’re looking for – high-quality com-panies below Wall Street’s radar and un-dervalued relative to their prospects. One we added to the portfolio in the second quarter was TriState Capital Holdings [TSC], a regional, business-focused bank that came public in May. The company is following the type of branchless, rela-tionship-focused strategy that we’ve seen succeed very well in previous holdings by our growth managers – such as Signature Bank [SBNY] – but it came public and still trades at only 1.2x to 1.3x book value, vs. the closer to 2x book at which comparable banks trade. If it grows like we believe it can and the story is better known, it’s hard to imagine that valuation gap persisting.

Are there any themes informing your in-vestment interest today?

JL: One thing we’ve been doing a lot of work on is how the advent of horizon-tal drilling and well fracking is likely to bring more stability to the domestic oil and gas market and the businesses that service it. With the ability to more eas-ily shift shale-deposit production between oil, with more-stable prices, and gas, with less-stable prices, we’re expecting steadier, less-cyclical ups and downs in the energy-services sector.

The stock has already done extremely well, but one of our plays in this area is DXP Enterprises [DXPE], which is a maintenance, repair and overhaul supplier of products and equipment to industrial end users, the largest number of which are in oil and gas. In DXP we own a business that by its nature is fairly stable – selling replacement parts – and which is becom-

ing more so as its end users face less cycli-cality. As the market recognizes the lower cyclicality, these types of businesses can be re-rated.

How active are you outside the U.S.?

JL: We have less than 10% of the portfo-lio in non-U.S. stocks, but the fallen-angel concept works as well outside the U.S. as in it. With stocks getting clocked in India, for example, I just bought into a pharma-ceutical company with a strong export business that will benefit from the cheap currency. I can’t name that one because we haven’t disclosed it yet publicly, but anoth-er Indian name we’ve owned for a while is Yes Bank [YES:IN], which is one of the new, leading-edge private-sector banks in India that we believe have a long runway for growth as India’s credit culture grows along with the economy. We’ve added to our position recently as the whole banking sector has gotten hit over concerns about the economy and currency.

How generally do you approach valuation?

JL: We think of ourselves as value inves-tors off the income statement, but in iden-tifying ideas the current P/E often isn’t

ON INVESTING THEMES:

One is the potential for more

stability in the domestic oil

and gas market and for the

companies that service it.

Expand Your Idea “Grapevine”

*For current Value Investor Insight subscribers.Non-VII subscribers still pay only $199.

Expand Your Idea “Grapevine”

NVEST

Subscribe now and receive four quarterly issues of SuperInvestor Insight for as little as $149*.That’s less than $30 per month!

Subscribe Online »

Mail-In Form »

Fax-In Form »

Want to learn more?

Please visit www.valueinvestorinsight.com

THE NEW SII CAME OUT EARLIER THIS MONTH – SUBSCRIBE NOW!Or call toll-free:

866-988-9060


http://www.valueinvestorinsight.com/superinvestorinsight

http://www.valueinvestorinsight.com/superinvestorinsight/subscribe

http://www.valueinvestorinsight.com/superinvestorinsight/download/SII_MailForm

http://www.valueinvestorinsight.com/superinvestorinsight/download/SII_FaxForm

http://www.valueinvestorinsight.com



meaningful because earnings have just gone down for some reason. So as a first pass we’re looking for stocks trading at a discount to historical price-to-book or enterprise-value-to-sales.

As we dig in further we come up with price targets, based on earnings power two years out at what we consider an ap-propriate multiple for the earnings growth profile in the three to five years after that. We try to find stocks we expect to return at least 20% per year, but in today’s mar-ket 12-15% is an acceptable return.

Are you looking for particular catalysts?

JL: We’re basically looking for the re-versal of whatever it was that made the stock go down. In many cases, earnings have stalled or fallen and we’re expecting growth to resume. Or it could be a regu-latory issue that works itself out. We’ll talk later about Questcor Pharmaceuticals [QCOR], but one reason the stock got in-teresting last year was an announcement that the U.S. government was investigat-ing certain marketing practices going back two to three years. Could they find some-thing? Yes. Is it likely Questcor has im-proved compliance and addressed what-ever was the problem already? Yes. If we conclude the headline event will have little to no impact on the underlying operations of the company going forward, that “de-valuation” catalyst can work to our ben-efit when it reverses.

On the subject of Questcor, describe in more detail your investment case for it.

JL: The company’s main product is H.P. Acthar Gel, a biologic drug developed in the 1950s to treat a variety of disorders that have an inflammatory component. As steroids became the more popular stan-dard of care in such situations, Acthar was almost forgotten and abandoned, kept alive by its efficacy in treating sick babies with infantile spasms. The market was very small, so in 2007 the company to survive had to dramatically increase the product’s price, which insurance paid be-cause it saved lives.

As Questcor got profitable, it began to look for other applications for the drug. It had originally been approved for more than 50 indications, but in 2010 the com-pany went back to the FDA to get a new la-bel, this time approved for 19 indications. The strategy since has been to roll out new treatments typically for second-line use – generally when steroids aren’t working – for multiple sclerosis, nephrotic syndrome and rheumatic diseases.

What we like about the business model is that growth is primarily a function of identifying an already-approved target market and then putting a sales and mar-

keting effort behind it. There isn’t the un-certainty and cost associated with trials. The multiple indications and that Acthar is a second-line treatment also mean there’s no one knockout punch competitively against it. All in all, we think the company can grow on both the top and bottom lines by 20% per year over the next year or two and at a mid-teens rate beyond that.

Sounds wonderful. Why isn’t the market recognizing all that?

JL: There seem to be two primary con-cerns. One is around insurance-company

Questcor Pharmaceuticals (Nasdaq: QCOR)

Business: Development and sale of bio-pharmaceuticals; primary drug treats several conditions, including multiple sclerosis, nephrotic syndrome and infantile spasms.



Financials (TTM): Revenue $620.6 millionOperating Profit Margin 55.0%Net Profit Margin 36.4%


QCOR S&P 500P/E (TTM) 15.3 18.3Forward P/E (Est.) 9.8 15.3EV/EBITDA (TTM) 9.2


Company % OwnedFidelity Mgmt & Research 14.6%BlackRock 8.1%Vanguard 5.7%Broadwood Capital 5.5%LSV Asset Mgmt 3.3%




THE BOTTOM LINEThe market’s concerns over insurance reimbursement and an ongoing investigation into the company’s past marketing practices have excessively obscured the fundamental strength of its business and growth prospects, says Jim Larkins. At a roughly small-cap market multiple on his 2014 EPS estimate, the shares would trade at around $100.


QCOR PRICE HISTORY

0

10

20

30

40

50

60

70

80 Adj Close0.00.20.40.60.81.0

80

70

60

50

40

30

20

10

0

80

70

60

50

40

30

20

10

0 2011 2012 2013




reimbursement. The drug is very expen-sive and typically needs pre-approval for any of the indications other than infantile spasms. But there’s nothing new in that, and the company over the years has seen a roughly 80% acceptance rate by insurance companies for Acthar use. In fact, we be-lieve one of Questcor’s core competencies is its ability to get payment approval by walking doctors and insurance companies through how the drug saves lives or im-proves the quality of life.

The second big concern is around the government investigation. Again, while it was a really bad headline, our conclusion after speaking at length with management is that even if a rogue salesperson or two ran afoul of the rules a few years ago, the company today has made significant strides in all aspects of training and com-pliance, so that any finding might involve a fine but won’t impact the operation go-ing forward.

With the shares having recovered from last year’s debacle, at today’s price of $56.90 how are you looking at valuation?

JL: The stock trades at only 12.2x our $4.65 EPS estimate for this year. That’s a significant discount to the median P/E multiple for my small-cap universe today of about 17x.

Given the company’s competitive posi-tion and growth runway, we’d argue that there’s a significant opportunity to benefit both from higher earnings and a higher multiple. If you put an 18x multiple on our 2014 earnings estimate of around $5.50, the shares would trade at $100. If the market falls in love again, the upside is much better. Alexion [ALXN], which has a biologic drug that the market adores, currently trades at 35x estimated 2014 earnings.

Sticking with controversial ideas, describe your interest in Ebix, Inc. [EBIX]

JL: Ebix sells software and services that primarily facilitate the secure exchange of information between insurance brokers and insurance companies. One straight-

forward application would be in providing the front-end system for a life-insurance agent, say, to enter all of a potential cus-tomer’s information and then to electroni-cally elicit bids on the policy from multiple carriers. The company’s products cover a variety of tasks in the insurance ecosystem, from sales and the binding of transactions, to customer relationship management and compliance. It’s a toll-booth kind of busi-ness and the track record in terms of mar-gins, free cash flow and long-term revenue and earnings growth is exceptional.

The CEO, Robin Raina, doesn’t have the greatest public persona. The company

over the years has been acquisitive both in the U.S. and internationally, and is known to be fairly ruthless in cutting costs as businesses get integrated. We talked to one business owner who sold his company to Ebix and the first thing he said was how aggressive it was in cutting costs, and the second thing he pointed out was that they didn’t lose any clients. So while it all seems to work, there’s often an element of ill will created.

The bigger controversy, however, was the announcement in June that the U.S. attorney for northern Georgia – the com-pany is headquartered in Atlanta – was

Ebix(Nasdaq: EBIX)

Business: Provider of software and e-commerce systems primarily used by bro-kers and underwriters in the sale of a broad range of insurance and annuity products.


Price 9.8552-Week Range 8.21 – 24.35Dividend Yield 3.0%Market Cap $374.0 million



EBIX Russell 2000P/E (TTM) 5.7 86.3Forward P/E (Est.) 6.2 19.4EV/EBITDA (TTM) 5.0


Company % OwnedFidelity Mgmt & Research 7.2%BlackRock 6.3%Vanguard 5.4%Bank of Montreal 5.0%Wedge Capital 4.2%




THE BOTTOM LINEThe company’s toll-booth business model and exemplary long-term performance receives little weight today from a market concerned by an inquiry into its accounting, says Jim Larkins. If resolution of the investigation doesn’t fundamentally alter the company’s pros-pects, as he expects, he believes the shares can double over the next 12 to 18 months.


EBIX PRICE HISTORY

5

10

15

20

25

30 Adj Close0.00.20.40.60.81.0

30

25

20

15

10

5

30

25

20

15

10

5 2011 2012 2013




investigating Ebix’s accounting and re-porting practices. Very little detail has been disclosed, but as best we can tell the inquiry probably revolves around inter-company transfers between various sub-sidiaries and potentially aggressive tax positions taken by the company. That in-quiry caused Goldman Sachs – which had already completed months of due diligence on Ebix – to pull a $20-per-share buyout offer it made for the company in May, and the stock promptly fell below $10. We knew the company and had owned the stock before, and ended up taking a new position after that fall.

How do you get past the risk of the gov-ernment investigation?

JL: We don’t know any specifics, nor does anyone else who’s not directly involved. But there have been very few times in my career when someone has deliberately tried to defraud in a way that can end up sinking the company. It can certainly hap-pen, but there are two main reasons I think it’s unlikely here. One, concerns over the company’s accounting have been around for years and nothing has ever happened, which argues that the most controversial issues have been vetted. Two, the compa-ny generates real cash. It pays a nice divi-dend and despite making several acquisi-tions over the years still has roughly the same share count it did in 2008. It’s hard to fake cash.

What do you think the shares, now at $9.85, are more reasonably worth?

JL: The company earned roughly $60 mil-lion in free cash flow in the past 12 months, which at today’s market value translates into a free cash flow yield of about 16%. We estimate earnings will come down a little bit this year, to $1.75 per share, but can a year from now be back in the $1.90 or so range. At even a 10x multiple, that would get us back to near what Goldman was willing to pay.

The obvious catalyst on the upside would be a positive resolution of the gov-ernment inquiry. The company has also

not been shy about the potential for more acquisitions to consolidate and extend its position in existing lines of business. The more the market incorporates a business-as-usual outlook for the stock, the better it’s likely to perform.

What do you see in apparel retailer Chi-co’s [CHS] that the market doesn’t?

JL: The market’s perception of Chico’s today seems to be driven by negativity toward apparel retailing in general and by concern about the company’s weak same-store-sales performance last quarter.

As value investors we’re always pointed toward what people don’t like at the mo-ment, and this is a good example.

Our basic premise is that neither of the market’s worries reflects fundamental problems with the company’s business and that its long-term growth story is intact. The company now has four distinct con-cepts, Chico’s, Soma, White House|Black Market and Boston Proper. Chico’s is the core brand, differentiated by serving a more-mature customer, a segment of the market that isn’t as hyper-competitive as retailing to young women, especially now that other stand-alone concepts like Ann

Chico’s FAS (NYSE: CHS)

Business: Specialty retailer primarily of women’s apparel through four store con-cepts: Chico’s, White House|Black Market, Soma Intimates and Boston Proper.





CHS Russell 2000P/E (TTM) 16.4 86.3Forward P/E (Est.) 13.3 19.4EV/EBITDA (TTM) 6.1


Company % OwnedVanguard 5.7%Blue Harbour Group 5.0%Fidelity Mgmt & Research 4.3%State Street 3.6%BlackRock 2.9%




THE BOTTOM LINEWith store growth, a modest uptick in same-store sales and 200 basis points in extra operating margin, Jim Larkins believes the company can grow earnings at a 20% annual rate – potential he does not at all consider built into the current share price. At even a below-market multiple on his 2015 EPS estimate, the shares would trade at $24.


CHS PRICE HISTORY

5

10

15

20 Adj Close0.00.20.40.60.81.0

20

15

10

5

20

15

10

5 2011 2012 2013



Taylor, J. Jill and Talbots have tried to go younger. Among the other brands, Soma is proving to be a big hit, an intimates con-cept that looks to take over for more ma-ture women where Victoria’s Secret leaves off. It’s still relatively small, with 235 stores at the end of the second quarter, but that’s up from 200 a year ago. Overall, to-tal-company stores are growing at around 8% per year.

We think multiple concepts provide a more-stable platform for growth and also make us less worried about the company running into a big ditch from a fashion perspective – though we don’t see Chico’s as a super-aggressive fashion story any-way. We also see significant opportunity to expand margins as the company lever-ages shared-service costs for things like IT, warehousing and marketing across mul-tiple concepts. With store growth, modest improvement in same-store sales and 200 basis points in incremental operating mar-gin within five years, we think the com-pany can grow earnings at a 20% annual rate for many years.

How do you see that translating into up-side for the shares, now at around $16.70?

JL: The stock trades at less than 17x trail-ing earnings, in line with today’s small-cap market multiple. Being conservative be-cause they’re struggling a bit on the fash-ion side, I’m using a 15x multiple on our 2015 EPS estimate of $1.60 to arrive at a target price of $24. If they get same-store sales back on track and earnings grow as we expect, there could be nice additional upside from multiple expansion.

Select Comfort [SCSS] has given share-holders a wild ride over the years. Why is now a good time to be on board?

JL: We often return to ideas we’ve owned in the past and this is one, as you say, that has provided some interesting entry points. In general we like the business, which is built around Sleep Number brand mat-tresses that have separate air bladders on each side of the bed and a remote control that allows people to adjust the firmness

as desired. It’s a unique product concept that addresses a key sleep-related problem – partners who don’t like the same kind of mattress – and the company has typically marketed it very well.

They’ve also built an excellent finan-cial model. They manufacture the beds and mostly sell them in their own stores, capturing the manufacturing, distribution and retail margins for themselves. There’s also very little working capital required, as they only build and ship the beds af-ter getting paid upfront. That results in healthy cash flows that can then be used to self-fund growth.

So what caused the share-price swoon this past Spring, taking the stock from $28 to less than $18 in a matter of weeks?

JL: Same-store sales comps took a hit, which the company attributed to botching the execution of a turnover of its media-buying program. They may have under-spent a bit as well, but they appear to have made certain changes too quickly and that just didn’t work. It’s not an immediate fix, but they say they’ve increased oversight of the process and feel like it is turning around. This is obviously something we’re watching closely, but we have no reason


Select Comfort (Nasdaq: SCSS)

Business: Vertically integrated seller of adjustable-firmness air mattresses that are sold primarily in the United States under the Sleep Number brand name.





SCSS Russell 2000P/E (TTM) 19.1 86.3Forward P/E (Est.) 14.5 19.4EV/EBITDA (TTM) 9.4


Company % OwnedState Street 8.0%Putnam Inv 7.7%Disciplined Growth Inv 7.0%William Blair & Co 5.8%Vanguard Group 5.8%




THE BOTTOM LINEThe company’s unique branded product offer and vertically integrated approach position it well to prosper as high-end mattresses take a larger share of the overall market, says Jim Larkins. Assuming 20% bottom-line growth over the next two years and a conserva-tive 15x P/E on his 2015 earnings estimate, the stock would rise to at least $30.


SCSS PRICE HISTORY

5

10

15

20

25

30

35

40 Adj Close0.00.20.40.60.81.0

40

35

30

25

20

15

10

5

40

35

30

25

20

15

10

5 2011 2012 2013




to believe it signals a more intractable problem.

Assuming it is a temporary glitch, what are your growth expectations here?

JL: One secular tailwind is that Sleep Number mattresses address the premium end of the market, which is taking share as people see the benefits of higher-quality beds and are willing to pay for them.

The company also still has the ability to roll out additional stores. It has done a good job of identifying markets across the country that it felt had the right demo-graphic profiles and then on a blitzkrieg kind of basis of taking share by opening multiple stores and spending heavily on advertising. They’re now shifting the store mix somewhat away from malls, which they believe will offer them more space to better merchandise their products. Over-all we expect the number of stores, now around 415, to increase at 5-6% per year.

It’s early, but we also see potential in new-product rollouts. For example, they just launched a line of dual-temperature mattress pads which work on any kind of bed. They’re trying to address another common sleep issue, one partner liking it hotter or cooler at night than the other.

Overall, from getting back on track after the marketing stumble, benefitting from the changing store mix, opening new stores and rolling out new products, we think the company can grow profits 20% annually for the next two years. Growth likely slows down after that, but we esti-mate will still be at a low-teens rate.

At $24.50, how inexpensive is the stock?

JL: The shares are up nicely since we start-ed buying in the second quarter, so the upside from today to our two-year target price of $30 – 15x our $2 per share 2015 earnings estimate – isn’t overly exciting. But that would still be a 10% compound return, which isn’t bad for this market. If earnings pick up as we believe they can and you get some multiple expansion to 17-18x, you could easily see $30 in a year rather than two.

Comstock Resources [CRK] has been a depleting asset for shareholders over the past five years. Why do you expect that to change?

JL: This is a straightforward story, built on the thesis that the natural gas price pendulum has swung too far to the cheap side and is going to swing back to normal.

While its heritage is natural gas – ex-plaining the poor stock performance – the company has a two-pronged approach. It has a large position in the Haynesville Shale, one of the most-productive and lowest-cost U.S. gas basins, but to which

the company isn’t directing incremental capital at $3.50 [per-million-BTU] gas. Where it is deploying capital is in the Ea-gle Ford in south Texas, which along with the Bakken in North Dakota are the two most-prolific oil-shale plays in the U.S.

The company says it can earn 50% IRRs in deploying capital at Eagle Ford, which provides healthy cash flow. But the real upside comes from cranking up pro-duction at Haynesville, which will require gas prices in the $4.50 to $5 range. We can’t know exactly when that happens, but would expect some return to normal-cy in gas prices within the next two years.

Comstock Resources (NYSE: CRK)

Business: Acquisition, development, explo-ration and production of oil and natural gas, with assets located primarily in the Haynes-ville and Eagle Ford formations in the U.S.


Price 15.8852-Week Range 12.83 – 21.16Dividend Yield 3.2%Market Cap $767.2 million

Financials (TTM): Revenue $440.7 millionOperating Profit Margin (-17.2%)Net Profit Margin (-1.4%)


CRK Russell 2000P/E (TTM) n/a 86.3Forward P/E (Est.) 26.5 19.4EV/EBITDA (TTM) 4.2


Company % OwnedDimensional Fund Adv 7.5%Vanguard 5.7%Wellington Mgmt 5.5%Capital Research Global Inv 5.2%GW Capital 4.8%




THE BOTTOM LINEJim Larkins doesn’t believe the market is adequately recognizing either the diversity of the company’s assets or the upside it has when natural gas prices move off their lows. The company’s low-$20s per share current net asset value provides solid downside protec-tion while waiting for a closer to $30-per-share value at $5 [per MMBtu] gas, he says.


CRK PRICE HISTORY

10

15

20

25

30

35 Adj Close0.00.20.40.60.81.0

35

30

25

20

15

10

35

30

25

20

15

10 2011 2012 2013




Why at first glance do Comstock’s finan-cials look so lousy?

JL: When shale companies aggressively drill you’ll often see high upfront costs and rapid well depreciation, which im-pacts reported earnings. The company also recently sold some assets in the Perm-ian basin, which while it strengthens the balance sheet, can make the income state-ment look a bit messy.

What upside do you see in the stock price from today’s $15.90?

JL: Comstock’s net asset value today based on proven and probable reserves is in the low-$20s per share. At $5 gas that number is closer to $30. So we basically look at this as a solid energy company, with downside protection from its assets and a strong balance sheet, that also hap-pens to pay a 3.2% dividend. If you want an option on natural gas prices going up and everybody one day wanting to own a

gas play again, we think this is one of the better ways to get it.

Talk about a recent investing misstep or two and any lessons attached.

JL: Two fairly recent mistakes that are top of mind are Skullcandy [SKUL], which makes headphones, and Body Central [BODY], a teen-apparel retailer. In both cases – and I’d say this is fairly common in ideas that haven’t work out – we just misread how strong the competition was. That’s a particular challenge in fashion-oriented businesses – you know they’re competitive but can underestimate that when a company has historically grown very well.

For-profit education is an area that has been showing up on our valuation screens but that I’ve specifically avoided because of the hyper-competitiveness of the mar-ket. Not only do you have incumbents fighting over a smaller market pie, but you also have every strong state college

or second-tier university rolling out online programs. There’s been a value bounce in some of the stocks, but I haven’t partici-pated in it and don’t expect to try.

What’s your gut telling you about the mar-ket today?

JL: My gut is I’m running the highest cash balance I’ve run in a long time – we’re at high-single-digit cash, which is a lot for us. It certainly feels like there’s more to sell than to buy.

I really believe success in this business comes down to patience. One aspect of that is patience to continue to own things that are working and have really good fun-damentals while the market is figuring that out. On the buy side, you often just have to wait for things to happen. You have your watch list, you look at your names every day, you look for what’s down, and you’re just waiting for an event that you can act on. You can’t count on when, but interesting things will happen. VII

“I often judge a book by how many times I get my highlighter out and dog-ear pages. On that metric, this book is wonderful – simply packed with insight from some of the best long-term investors. Everyone will learn something from this book.”James Montier, GMO

“An outstanding addition to the volumes written on value investing. Not only do the authors offer their own valuable insights but they have provided in one publication invaluable insights from some of the most accomplished professionals in the investment business. I would call this publication a must-read for any serious investor.”Leon G. Cooperman, Omega Advisors

“I learned the investment business largely from the work and thinking of other investors. The Art of Value Investing is a thoughtfully organized compilation of some of the best investment insights I have ever read. Read this book with care. It will be one of the highest-return investments you will ever make.”William A. Ackman, Pershing Square Capital Management

The Reviews Are In...

Order Your Copyof The Art of Value Investing

Learn More About The Art of Value Investing


http://www.amazon.com/The-Art-Value-Investing-Investors/dp/0470479779

http://www.valueinvestorinsight.com/pdfs/Art_of_Value_Investing.PDF


A F R E S H L O O K : J.C. Penney

In a testament to careful ongoing research vigilance, Advisory Research escaped unscathed from its investment in ill-fated J.C. Penney. The question for today: Has the relentless punishment of Penney stock gone too far?

Savvy balance-sheet-focused investors like Chicago’s Advisory Research were naturally drawn to J.C. Penney stock two years ago. As co-portfolio manager Jim Langer explained it [VII, October 31, 2011], the company’s share price, then $33, almost exactly matched his firm’s estimate of Penney’s tangible book value after adjusting for the value of its owned real estate. With protected downside, the upside for the still-profitable retailer rest-ed in the hands of new CEO Ron Johnson, whose resume – first at Target and then as architect and leader of Apple’s retail strategy – was without peer. The value realization from a successful turnaround wouldn’t happen right away, but was of a scale to make it more than worth the wait.

We all know how that turned out. John-son implemented a new strategy focused on refashioning selling space into branded stores-within-a-store and on weaning Pen-ney customers of their seeming addiction to coupons and price markdowns. As investment spending took off, customers revolted, resulting in a sea of red ink that cost Johnson his job and continues to dev-astate Penney’s share price. Above $40 in the early part of 2012, the shares at a re-cent $9 trade where they did in 1986.

In a testament to ongoing research vigi-lance, Advisory Research actually escaped unscathed from this debacle. Hinged as the thesis was to the strategy revamp work-ing, says co-portfolio manager Matthew Swaim, his team regularly spoke with both large and small Penney competitors to understand what was happening in the market. As the share price started pushing $40 at the same time competitors increas-ingly said they were gaining share at Pen-ney’s expense, Advisory Research headed for the exits. “What we saw playing out was consistent with the idea that it’s a lot easier to fire a customer than to hire a new one,” says Swaim. “At the price we were able to sell, we thought the execution risk had gotten too high.”

Has the relentless fall in Penney stock gone too far? High-profile investors such as Glenview Capital, Soros Fund Manage-ment, Perry Capital and Hayman Capital have – too early so far – all established or added to large Penney equity positions in recent months. Swaim reports that Advisory Research has yet to join them, although “we’re looking very closely,” he says. The problem is that while there

appears to be asset value supporting the shares – Advisory Research’s estimate of adjusted tangible book value is in the mid-teens per share – the company has pledged real estate against certain debt obliga-tions and may be forced to continue that practice, to the detriment of shareholders. “The key is liquidity – what they have and what they’ll need,” he says. “We’re still going through the calculations.” VII

Dodging a Bullet

J.C. Penney (NYSE: JCP)

Business: National department store chain founded in 1902, selling a broad range of apparel, footwear and home furnishings through some 1,100 stores in 49 states.



Financials (TTM): Revenue $12.11 billionOperating Profit Margin (-14.8%)Net Profit Margin (-13.3%)


JCP Russell 2000P/E (TTM) n/a 86.3Forward P/E (Est.) n/a 19.4EV/EBITDA (TTM) n/a


Company % OwnedSoros Fund Mgmt 9.1%State Street 8.1%UBS 6.0%Perry Capital 5.4%Evercore Trust 5.1%




JCP PRICE HISTORY

THE BOTTOM LINEHaving dodged a bullet on his firm’s investment two years ago in J.C. Penney, Matt Swaim says he and his partners are looking very closely at whether the relentless fall in the company’s share price has gone too far. The answer to date, not yet. “The key is li-quidity – what they have and what they’ll need. We’re still going through the calculations.”


0

10

20

30

40

50 Adj Close0.00.20.40.60.81.0

50

40

30

20

10

0

50

40

30

20

10

0 2011 2012 2013



A F R E S H L O O K : Tesco PLC

Following Warren Buffett’s lead, many value investors in recent years have been enamored with the turnaround/international growth story at British grocery chain Tesco. It hasn’t been a particularly smooth ride.

British grocery giant Tesco PLC has been on value investors’ radar screens for some time now. Warren Buffett’s Berkshire Hathaway initiated a position in 2006, which by the end of last year was one of the insurer’s top holdings, a 5.2% stake valued at nearly $2.3 billion. Causeway Capital’s Harry Hartford [VII, February 29, 2012] and Vulcan Value Partners’ C.T. Fitzpatrick [VII, September 28, 2012] both made cases for Tesco’s stock last year in interviews, and others would have done so had we not demurred in order to avoid repetition.

The basic case for the shares was fairly consistent. The company had taken its eye off the ball in the U.K., where it was the dominant player with a 30% market share, and was spending heavily to recon-figure and refresh its store base there. At the same time, it was making large invest-ments outside of its home country, primar-ily in Eastern Europe, Asia and in launch-ing its Fresh & Easy budget-grocery concept in the U.S. Trading at 10x or less what were considered depressed earnings, the upside from the U.K. back-to-basics strategy and from increased profitabil-ity as international markets matured was considered substantial.

It hasn’t been a smooth ride. The U.K. makeover under Philip Clarke, CEO since early 2011, has moved forward in fits and starts. After upgrading service and putting more focus on fresh foods, the company is now reconfiguring stores to better utilize floor space overly cluttered in many cas-es with high-priced non-food items that generate revenue but not enough profits. Outside the U.K., same-store sales have generally been lower than expected and the company has announced over the past 18 months that it was exiting both Japan and the U.S., while putting its loss-making Chinese operation into a joint venture with that country’s largest food retailer.

The investment case for Tesco today? Despite considerable volatility, the stock is

up 14% since Causeway’s Hartford sung its praises in early 2012. Causeway has maintained its stake, says the firm’s Foster Corwith, for two primary reasons. One, he’s optimistic that the U.K. revival is on track. CEO Clarke, who started at Tesco as a teenager stocking shelves, knows the business and market inside and out, he says, and the store restylings that he has pushed so far – still a drawn-out process – have shown largely positive results. With the U.K. accounting for roughly two-thirds of the company’s overall operating profit, as goes the domestic operation, so will go Tesco.

The second key aspect of the story, says Corwith, remains valuation. The shares today trade at 11.7x his 31 pence EPS estimate for the fiscal year ending in February, vs. a roughly 14x average P/E for European food retailers who he argues aren’t as close to trough earnings. His tar-get share price, off his next fiscal year’s 33-pence earnings estimate, is £4.20. The stock also currently pays a nearly 4.5% dividend yield. “The company is paying down debt for now,” says Corwith, “but as it pulls back on empire building, capital return to shareholders likely becomes even more important.” VII

The Empire Pulls Back

Tesco(London: TSCO:LN)

Share Information (@9/27/13):

Price £3.6352-Week Range £3.06 – £3.88

Valuation Metrics (@9/27/13):

TSCO S&P 500Trailing P/E 21.0 18.3Forward P/E Est. 11.2 15.3


200

300

400

500 Close0.00.20.40.60.81.0

TSCO PRICE HISTORY

NEW BOTTOM LINEDespite providing a rocky ride thus far, Foster Corwith says the company’s shares re-main attractive due to progress with its home-market turnaround and a still-low valu-ation. His target share price on his next fiscal year’s 33-pence EPS estimate: £4.20.

ORIGINAL BOTTOM LINE – February 29, 2012Operating leverage as a needed U.K. store-investment program winds down and as international operations mature should “work its way nicely through the company’s income statement in future years,” says Harry Hartford. At 11x his earnings estimate for the year ending in February 2014, the shares two years’ out would trade at £4.20.


VII, February 29, 2012

2011 2012 2013

5.00

4.00

3.00

2.00

5.00

4.00

3.00

2.00



E D I T O R S ’ L E T T E R

Warren Buffett has long described the challenge money managers face in beating the market as their assets under management rise – notwithstanding the fact that he has continued to do just that while managing more money than anyone. We were reminded recently of his think-ing on this subject in a letter he wrote in 1975 to the Washington Post Co.’s Katha-rine Graham about pension-fund manage-ment. (To see the full letter, click here.)

In one section of the letter – titled “Is There Hope?” – Buffett highlights the dif-ficulty of finding poised-to-outperform in-vestment managers in light of the fact that the best records tend to attract “massive” money flows:

For openers, there is the one huge, ob-vious pitfall. I am virtually certain that above-average performance cannot be maintained with large sums of managed money. It is nice to think that $20 billion managed under one roof will produce fi-nancial resources which can hire some of the world’s most effective investment tal-ent. Surely $50 million annually of fees on $20 billion of managed assets will allow (a) an array of industry special-ists covering minute-by-minute develop-

ments affecting companies within their purview; (b) top-flight economists to study the movement of the tides; and (c) nimble, decisive portfolio managers to translate this wealth of information into appropriate market action.

It just doesn’t work that way. Down the street there is another $20 billion getting the same input. Each organization has its own group of bridge experts cooperating on identical hands – and they all have read the same book and consulted the same computers. Furthermore, you just don’t move $20 billion or any significant fraction around easily or inexpensively – particularly not when all eyes tend to be focused on the same current investment problems and opportunities. An increase in funds managed dramatically reduces the number of investment opportunities, since only companies of very large size can be of any real use in filling portfolios. More money means fewer choices – and the restriction of those choices to exactly the same bill of fare offered to others with ravenous financial appetites.

He does later offer one option for choosing managers, namely focusing on

those “handling smaller amounts whose record has been good for the right rea-sons.” He then describes a potential “right” reason:

The good results have been accomplished by a single individual or, at most, a few, working in fairly specialized areas in which the great bulk of investment mon-ey simply had no interest. It has been very difficult to out-think the pack on General Motors, IBM, Sears, etc. Rather, the unusual records – and there are few that have been maintained – have been achieved by those who have worked rela-tively neglected fields in which competi-tion was light.

If you find such a manager, he then of-fers one further piece of advice: “Hope that no one else finds him.” VII

Standing Apart

Value Investor Insight™ is published monthly a www.valueinvestorinsight.com (the “Site”), by Value Investor Media, Inc. Co-Founder and Chairman, Whitney Tilson; Co-Founder, President and Editor-in-Chief, John Heins. Annual subscription price: $349.©2013 by Value Investor Media, Inc. All rights reserved. All Site content is protected by U.S. and international copyright laws and is the property of VIM and any third-party providers of such content. The U.S. Copyright Act imposes liability of up to $150,000 for each act of willful infringement of a copyright.

Subscribers may download Site content to their computer and store and print Site materials for their individual use only. Any other reproduction, transmission, display or editing of the Content by any means, mechanical or electronic, without the prior written permission of VIM is strictly prohibited.

Terms of Use: Use of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com. See a summary of key terms on the following page of this newsletter.

Contact Information: For all customer service, subscription or other inquiries, please visit www.valueinvestorinsight.com, or contact us at Value Investor Insight, 2071 Chain Bridge Road, Suite 400, Vienna, VA 22182; telephone: 703-288-9060

Subscribe now and receive a full year of Value Investor Insight – including weekly e-mail bonus content and access to all back issues – for only $348.That’s less than $30 per month!

Subscribe Online »

Mail-In Form »

Fax-In Form »

Want to learn more? Please visit www.valueinvestorinsight.com

Always on the lookout for better investment ideas?

Or call toll-free:866-988-9060


http://www.scribd.com/fullscreen/160301289%3Faccess_key%3Dkey-zcgkzjhsy2fzhxnoh%25E2%2580%25A6





https://secure.valueinvestorinsight.com/subscribe/

http://www.valueinvestorinsight.com/download/SubscribeMailForm/

http://www.valueinvestorinsight.com/download/SubscribeFaxForm



Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the “Site”) by Value Investor Media, Inc. Use of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse. For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

No Investment AdviceThis newsletter is 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. This newsletter is distributed for informational purposes only and should not be construed as investment advice or a recom-mendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financ ial situations, or needs of individual investors. The price and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this newsletter may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.

DisclaimersThere are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this newsletter. Value Investor Media will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this newsletter, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this newsletter.

Related PersonsValue Investor Media’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter.

Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, a registered investment adviser. T2Partners Management, LP may purchase or sell securities and financial instruments discussed in this newsletter on behalf of certain ac-counts it manages.

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

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

General Publication Information and Terms of Use

E D I T O R S ’ L E T T E R



www.valueinvestorinsight.com/misc/termsofuse

Documents

2013.09.30 - Value Investor Insight