investing in undervalued value stocks - value investor...

Investing in Undervalued Value Stocks

WHITNEY TILSON is the founder and Managing Partner of T2 Partners LLC and the Tilson Mutual Funds. The former (www.T2PartnersLLC.com) manages three value-oriented private investment partnerships, while the latter is comprised of two value-based mutual funds, Tilson Focus Fund and Tilson Dividend Fund (www.tilsonmutualfunds.com). Prior to launching his investment career in 1999, Mr. Tilson spent five years working with Harvard Business School Professor Michael E. Porter studying the competitiveness of inner cities and inner-city-based companies nationwide. He and Professor Porter founded the Initiative for a Competitive Inner City, of which Mr. Tilson was Executive Director. Mr. Tilson also led the effort to create ICV Partners, a national for-profit private equity fund focused on minority-owned and inner-city businesses that has raised nearly $500 million. Before business school, Mr. Tilson was a founding member of Teach for America, the national teacher corps, and then spent two years as a consultant at The Boston Consulting Group.

Mr. Tilson received an MBA degree with High Distinction from the Harvard Business School, where he was elected a Baker Scholar (top 5% of class), and graduated magna cum laude from Harvard College, with a bachelor’s degree in Government.

M O N E Y M A N A G E R I N T E R V I E W

R E P R I N T E D F R O M A U G U S T 2 3 , 2 0 1 0

SECTOR – GENERAL INVESTINGTWST: If you can start with an overview of T2 Partners

and your investment philosophy.Mr. Tilson: We manage hedge funds and mutual funds. We

manage three hedge funds as one pool of capital, long-short primarily US equity, and then we have two mutual funds. The Tilson Focus Fund, which my partner Glenn and I manage, is a long-only strategy so it’s similar to our hedge funds on the long side, but doesn’t have a short com-ponent. Then we also have the Tilson Dividend Fund, which is managed by our friend, Zeke Ashton at Centaur Capital in Dallas. There is a sub-advisory arrangement there so we don’t manage it directly, but it falls under our umbrella. Three hedge funds managed virtually identically and then two mutual funds with slightly different investment strategies -- that’s T2.

We manage about $150 million in our hedge funds and about $38 million in the two mutual funds. All of the funds are managed with a value investing approach. We simply apply the timeless principles of Graham and Dodd, practiced today most notably by Warren Buffett and Charlie Munger. We consider these great investors our guides in this busi-ness. What does that mean? It means we’re generally not trying to make big macroeconomic prognostications or trying to figure out if a company is going to beat earnings by a penny this quarter and trade around that, but

rather we try to calculate the intrinsic value of businesses and then com-pare that to the value that the stock market is applying to the business in terms of its stock price – and then we seek to buy when there are very large valuation discrepancies.

Most of our activity is on the long side, meaning we look for undervalued stocks: the proverbial 50-cent dollars. In our hedge funds, we also look for 10-dollar dollars to short: things that are massively over-valued, fads, frauds, that kind of thing.

Our original hedge fund started on January 1, 1999 and has only trailed the S&P 500 in two of those eleven-and-a-half years. We’re way above the S&P this year, so it looks like this will be the tenth year out of 12 that we beat the market. In our original hedge fund, net to investors, we have more than tripled our investor’s money versus basically a flat S&P 500, including reinvested dividends, over that eleven-and-a-half year period.

On the mutual fund side, the Tilson Focus Fund is the #1 fund in its category this year and over the past 12 months, is in the 98th percentile over the past two years, and is in the 94th percentile since inception just over five years ago. The Tilson Dividend Fund is the #1 fund in its category over the past two and three years, and is #2 over the past five years.

Overall, we have a very strong investment track record that we are proud of – but also aim to improve upon.

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MONEY MANAGER INTERVIEW ——————— INVESTING IN UNDERVALUED VALUE STOCKS

TWST: What is your outlook of the economy and markets going forward?

Mr. Tilson: We consider ourselves bottom-up stock pickers and our forte is company and industry analysis. However, we learned an im-portant lesson in 2008: if the world goes to hell in a bucket, you can throw your company and industry analysis out the window because everything correlates, so it’s good to have an idea if that might happen. As a gen-eral rule, we follow Buffett’s time-less principle: “Be fearful when others are greedy and greedy when others are fearful.” One of the ways we built a strong investment track record is being very defensive dur-ing periods of market euphoria, namely the Internet bubble in 2000 and then again at the peak of the housing/debt bubble in 2007. We were able to escape those downturns with substantially lower losses than the overall market in our hedge funds because while we didn’t fully anticipate the magnitude of the chaos in the markets, we knew enough to be defensive when others were euphoric and the, when other investors were panicking in late 2008 and early 2009, we were ag-gressively buying.

While the core of what we do and the positions in our portfolio are based on company and industry specific analysis, how we position the portfolio overall, how aggressive we are on the long side, how big we make our short book and therefore what our net exposure is can change quite dramatically depending on our view of the world. We are playing defense today. We are not in maximum defensive position, but we are on the defensive side of the spectrum. If you take our gross long exposure, subtract our gross short exposure, that leaves you with net long exposure.

For example, today we are approximately 100% long in our hedge funds and we’re about 60% short. We are fully invested on the long side and then we’ve sold 60% of our capital short as well and so in hedge fund terminology, that’s 40% net long. Our net long exposure has ranged from a high of 90%, which was 120% long, 30% short in March of 2009. That’s net 90% net long, which is maximum aggressive posi-

tioning for us, to a couple of months ago, when we were 90% long and 70% short, which is 20% net long. You can see there is a very wide range of exposure, though we have never been net short.

The core of what we do is almost always on the long side, but we can get very defensive, very close to being market neutral, at times. Today we are not at the bottom end, which was 20% net long, but 40% net long is still

very conservatively positioned and that’s because we think there is a very wide range of potential outcomes for the economy and for the stock market and we’re really not sure how it’s going to play out, but we know that there are many things that could go wrong and that makes us nervous.

We think we have gone through the most difficult economic period in the United States and the world since the Great Depression. We think the worldwide debt bubble -- this was not just a US housing cri-sis or bubble, but a worldwide debt bubble -- was unprecedented in the degree of depravity that took place, in the amount of leverage that built up in the system all over the world, and we’re very skeptical that we have somehow successfully managed our way through the aftermath of that bubble and that everything is rosy now. We think the aftermath of this bubble will be with us for many years and that will continue to cause dis-ruptions and turmoil in various mar-kets. The sovereign debt crisis in Europe is a good example of that just in the past few months; we think the US housing market is already in a

double dip right now, though because there is a lag in the data, most people haven’t yet realized it. We don’t think it’s going to be anything like the first dip, which really took world economy over a cliff, but there are 7 million people not paying their mortgages right now and we have not resolved that

problem and that’s going to continue to be a headwind for our financial system. There are probably six or eight major risk factors, two of which are the sovereign debt issues and the US housing market. These make us very nervous and we don’t know how it’s going to play out (and we’re skeptical that anyone knows how it’s going to play out), so in light of these major problems, we think it’s wise to be prudent.

Highlights

Whitney Tilson co-manages the Tilson Focus Fund, a long-only strategy similar to the firm’s hedge funds on the long side, but doesn’t have a short component. As a value investor, he calculates the intrinsic value of businesses and them compares that to the value that the stock market is applying to the business in terms of its stock price – and then he buys when there are large valuation discrepancies. As the market rallied 80% from trough to peak in just over one year, he made several moves to make the portfolio more defensive. He sold stocks that were rising and hitting his price targets; he oriented the portfolio away from more speculative high-beta volatile stocks into big-cap blue-chip stocks that have pricing power even in a recessionary environment; and he let his short book run against him and even added to it. He thinks cheapness is its own catalyst and if you can be patient, sometimes for a year or two, you will be rewarded. He does in-depth work on the companies and industries in which he invests and he is able to look around in the nooks and crannies of the market and has made spectacular returns on some very small positions. He says it’s a big advantage on the long side being a small firm, but it’s an even bigger advantage being small on the short side.Companies include: Huntsman (HUN); Vistaprint (VPRT); Berkshire Hathaway (BRK.A); Microsoft (MSFT); Anheuser-Busch InBev (BUD); BP (BP); dELIA*s (DLIA).

“To make our portfolio more defensive we oriented it away from more speculative high-beta, volatile stocks like Huntsman into more defensive companies like Berkshire Hathaway, Microsoft, Anheuser-Busch InBev, Kraft, Pfizer, and Intel. They are the kind of companies that even in a lousy economic environment, even in an inflationary environment or deflationary environment, have pricing power.”

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If stock prices are very low and are pricing in a worst-case scenario as they were in March of 2009 for example, we’re very happy to invest aggressively on the long side even in light of tremendous un-certainty as long as we think we’re getting paid for that risk. The problem is that, even after the latest pullback in the US stock market, the S&P 500 is still up nearly 60% from its lows in early March of 2009. We think today the market is still priced for a fair amount of optimism. We’re hopeful that a scenario develops where we get a V-shaped economic re-covery where unemployment falls substantially, in which case stocks today are probably cheap, but I’d say there is only 20% chance of that

scenario. We think there is a 50% chance of a scenario we would call a muddle-through economic situation, where unemployment remains per-sistently high and economic growth is 0% to 2% compounded for the next five years. In this case the stock market’s probably not going any-where for another five years. Finally, we think there’s at least a 20% to 30% chance of a double-dip recession of some magnitude where the stock market could fall another 10% to 20% from here.

TWST: Is that because the market’s not fairly valued enough?

Mr. Tilson: It’s because the market today is assuming at least reasonable economic growth and if that doesn’t materialize, then stocks are going to fall.

TWST: What changes have you made to the portfolio over the last 12 months or so to reflect this current defensive posture?

Mr. Tilson: We’ve made three changes -- nothing dramatic, but steadily in small increments over time from the market bottom in March of 2009 through the recent peak in April of this year. As the mar-ket rallied 80% from trough to peak in just over one year, one of the sharpest market rallies in stock market history, we did three things to make our portfolio more defensive.

Number one is we sold stocks that were rising and hitting our price targets. A good example would be Huntsman (HUN), a specialty

chemical company, a cyclical business, a busted acquisition by Apollo Management, and a company with too much debt. It was the exact kind of company that got obliterated in the downturn. The stock went from $26, near the price Apollo had committed to pay, to $8 as both the economy and the market took a dive. Huntsman’s earnings fell sharply, and people started to worry about whether their debt load could take them under. We started buying at $8 a share thinking it was worth $15 in any kind of normal economy, knowing it might take a few years to get there, but thinking we would double our money eventually. The company also had multibillion dollar lawsuits against Apollo and its bankers for

walking away from the deal at $26.50 a share, so we thought we were also getting a free call option on another $5-10 a share of upside in ad-dition to a 50-cent dollar stock.

Having fallen from $26 to $8, with many positive catalysts, we thought it couldn’t fall any further – yet within five months, the stock was at $2, we’d lost 75% of our money, and the stock was being priced as if the company would soon file for bankruptcy. It was a tiny sliver of equity on top of many billions of dollars of debt.

We did our analysis, focusing on the debt loads — specifically the debt maturity dates, and noted that there were no material maturities until 2013, so we couldn’t see how this company would go bankrupt. Thus, we started buying it at $8, bought more at $6, more at $4, and fi-nally bought a lot at $2 right at the bottom. Within one year, the stock went from $2 to $14. It turned out our initial thesis was exactly right and buying it at $8 was a great investment, but buying it at $2 was a really great investment. We had a number of stocks just like this.

As Huntsman rose from $2 to $14 a share, we trimmed it all the way up because we wanted to manage the position size and because it was approaching our estimate of intrinsic value.

The second thing we did to make our portfolio more defensive is we oriented it away from more speculative high-beta, volatile stocks like Huntsman into more defensive companies like Berkshire Hatha-way (BRK.A), Microsoft (MSFT), Anheuser-Busch InBev (BUD), Kraft (KFT), Pfizer (PFE), and Intel (INTC). All of these are all big-cap blue-chip stocks that we own today. They are the kind of companies that even in a lousy economic environment, even in an inflationary envi-ronment or deflationary environment, have pricing power. If the dollar goes up, if the dollar goes down; it doesn’t matter, these companies earn money in different currencies all over the world.

To the extent you want to own anything in a lousy economic environment, these are the kind of strong-balance-sheet, dominant-mar-ket-position companies with pricing power that you want to own -- as-suming of course that you can buy them at low valuations. The great news today is that high-quality blue-chip stocks as a whole are trading at the lowest valuations we’ve ever seen relative to the market.

In March of 2009, we deliberately positioned our portfolio in some of the riskiest stocks and sectors, like cyclical, heavily indebted companies such as Huntsman and financial stocks because they were

“We started buying Huntsman at $8, bought more at $6, more at $4, and finally bought a lot at $2 right at the bottom. Within one year, the stock went from $2 to $14. It turned out our initial thesis was exactly right and buying it at $8 was a great investment, but buying it at $2 was a really great investment.”

1-Year Daily Chart of Huntsman

Chart provided by www.BigCharts.com

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C O M P A N Y I N T E R V I E W ——————— C O M P A N Y , I N C .

so cheap – we weren’t buying 50-cent dollars, but 10-cent dollars and 20-cent dollars. We were short financial stocks going into the crisis and all the way down, but near the bottom we flipped around and went long a number of blue-chip financial companies like American Express (AXP) and Wells Fargo (WFC) and made many times our money within a year. More recently, we’ve been trimming these kinds of stocks and buying the blue chips.

The third thing we’ve done is let our short book run against us and even added to it. Obviously when we were 120% long and 30% short in March 2009, nearly all of those shorts have risen a lot. We still did much better than the market coming out of the bottom because of our long book, but our short book was obviously a headwind and we needed to decide whether we were wrong about the companies we were short as

the stocks went up -- some of them went up a lot. The answer in most cases we concluded was that we were still right and the market was in-correct in running these stocks up. We maintained our short position in the homebuilders, for example, and even increased it earlier this year. That was the third piece of playing defense and protecting our portfolio.

In some cases, the shorts haven’t worked at all and have hurt us, but in other cases they have worked beautifully. For example earlier this

year, the homebuilders had rallied to the point where they were trading on average at about 1.7 times book value and we were convinced that we were heading into a double dip in the housing market. Two months later, the homebuilders are down roughly 40% on average as it’s become clear to most people that we are in fact experiencing at least some level of double dip and the homebuilders are back to trading at 1.1 times book and probably aren’t a good short anymore and so we’re trimming that short position.

Another category of companies that we’re short today are very richly valued stocks where the underlying business actually might be an okay business and might be doing well, but the valua-tion is simply ridiculous. Lululemon Athletica (LULU), Netflix (NFLX), and our favorite, a company called Vistaprint (VPRT) are examples. Vistaprint is an online printing company, a total com-modity business in our view that was trading north of 30 times earn-

ings. They just announced earnings last night and the last I looked the stock is down 35% today. Vistaprint is one of those shorts that hurt us a lot over the past year until the day they miss earnings. With a richly-valued stock that misses earnings, the pain for the people who own the stock can be severe and the benefits for people who are short the stock can be quick, which is something we’re see-ing today in Vistaprint.


“Another category of companies that we’re short today are very richly valued stocks where the underlying business actually might be an okay business and might be doing well, but the valuation is simply ridiculous. Lululemon Athletica, Netflix, and our favorite, a company called Vistaprint are examples. Vistaprint is an online printing company, a total commodity business in our view that was trading north of 30 times earnings.”

“One of our most successful investments ever was buying McDonald’s in early 2003 after the company had reported something like 24 consecutive months of negative same-store sales. We thought earnings could quickly rise and the multiple on those earnings would rise, as McDonald’s is obviously worth much more than ten times earnings if the business is even stable, much less growing. The stock went from $12 to $60 in a matter of five years.”

1-Year Daily Chart of Anheuser-Busch InBev


1-Year Daily Chart of Microsoft


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TWST: What are your investment criteria or valuation metric that you look for in for your longs and shorts?

Mr. Tilson: It really varies by situation. I’ll give you some rules of thumb, based on a dozen years of experience, not necessarily mathematical proof. For typical companies, we are looking at the mul-tiple of what we think are normalized earnings or cash flows. It’s hard for me to think of a single stock we have ever purchased in 12 years that we purchased trading at more than 15 times normalized earnings. I know we have never purchased a stock trading at more than 20 times what we think are normalized earnings for the next 12 months.

What that means is that we have missed some tremendous stocks over the past ten years. For example after Google (GOOG) IPO’d, the stock went under $100 to over $700 in just over three years -- and we missed it all the way up. A lot of value investors who were more comfortable paying up for growth made a lot of money. Another example: shame on us for missing Apple (AAPL) all these years. I love their products, but at any given point in time, it just seemed to be quite richly valued -- but if a company can grow its earnings at 80% a year for five years, it almost doesn’t matter what multiple you pay at the inception, you’re going to do very well with that stock.

But that’s okay, we’re willing to miss some of the high-growth stories like Google and Apple because too often when you pay up for a stock, you end up with a Vistaprint and lose 35% of your money in a day if it misses earnings by a few pennies and that just makes us uncomfortable.

I would say as a general rule for the highest quality businesses in the world, we might pay 15 times earnings. Typically we’re buying companies that have problems, often betting on a turnaround or where the sector is out of favor, in which case we much prefer to buy things at ten times to 12 times earnings for decent businesses with what we be-lieve are short-term problems. We also like buying distressed business at five times earnings where there’s a lot of negativity already built in and if anything goes right, you can double your money pretty quickly.

Let me give you a couple of examples. One of our most suc-cessful investments ever was buying McDonald’s (MCD) in early 2003 after the company had reported something like 24 consecutive months of negative same-store sales. There were documentaries and books coming out like Super Size Me and Fast Food Nation that were blaming McDon-ald’s for many ills, especially obesity. The company had gone through a number of CEOs, had consistently disappointed Wall Street, and we were

able to buy McDonald’s at the bottom at about ten times depressed earn-ings. We thought earnings could quickly rise and the multiple on those earnings would rise, as McDonald’s is obviously worth much more than ten times earnings if the business is even stable, much less growing. The stock went from $12 to $60 in a matter of five years, so this was a case of buying a great business with problems at ten times earnings.

Interestingly, about two years into the turnaround, the com-pany was doing well, had reported a couple of years of positive same-store comps, and the stock had risen to $30, so we’d already doubled our money in two years. Normally, at that point, value investors like us are getting out: the stock was now trading at about 15 times earnings and was popular on Wall Street. But interestingly enough, at that point we looked at McDonald’s with a fresh set of eyes and we saw a business that was firing on all cylinders, with a lot of operating leverage. In other words, 5% same-store sales translate into 20% earnings per share growth and the company was reporting very consistently 5% to 8% same-store sales growth. We knew that as long as they were in the 5% to 8% range, earnings were going to grow at 20% to 25% a year, yet analysts were estimating earnings growth of 12% a year.

For three years in a row, analysts every year just kept predict-ing 12% EPS growth even though we could see very clearly that earnings were going to be at least double that. We held on to McDonald’s for another three years and sure enough earnings grew at 25% a year for three years and we got another double out of the stock from $30 to $60. That would be an example of buying a great business at the high-end of a multiple that we would ever pay, but one where the business was just good enough. 15 times earnings is a below-average multiple for a com-pany that is clearly massively superior to the average American business.

Finally, let me give you a very recent example of buying a distressed turnaround situation at five times earnings: BP (BP). We look for investment situations where we think the sellers are panicked and are selling to us irrespective of any rational calculation of intrinsic value. Of course virtually anything we purchased from October 2008 through March of 2009 fell into that category, but it’s much harder today in this more complacent market. But every once in a while you get a situation where a company encounters severe distress and the stock crashes. Sometimes it’s warranted and the company spirals into bankruptcy and obviously you want to avoid those situations, but sometimes it’s not war-ranted and BP was an classic example of this.


1-Year Daily Chart of McDonald's


1-Year Daily Chart of Vistaprint


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When the Deepwater Horizon Rig blew on April 20th, BP stock was at $60.48. We started buying when the stock fell to $37, know-ing that the headlines would be terrible for at least another month or so until they capped the well. Sure enough, the headlines were terrible and many people were comparing this to asbestos and predicting bankruptcy. We owe them a debt of gratitude because they triggered an investor panic that took more than $100 billion off of BP’s market cap. We bought it all

the way down to its 14-year low under $27 on the thesis that BP would be able to cap the well, that the damages, while severe, wouldn’t be in the $100+ billion range, but instead would be in the $30-50 billion range, and most importantly, that a company with $34 billion a year of operat-ing cash flow would be able to earn its way out of trouble. Allow me to digress a moment and share an important lesson that played out in our BP investment. It has almost never occurred in our investment careers that we have been clever enough to buy a new posi-tion at its very low -- it’s never happened. It is always the case that we start buying something and at some point -- maybe the next day, maybe the next month, maybe the next year -- the stock declines further from our purchase price. The key to successful investing is not being the world’s most clever buyer on day one, it’s what you do with an existing position that is 25% below where you first started buying it.

At that point, you can only do three things: buy more, sit there

and do nothing, or sell. Making the correct call at that point is much more important than the price at which you initially purchased the stock, and there is no clear rule of thumb. Sometimes you want to buy a lot more, like in the case of BP; sometimes terrible things have happened, your investment thesis is in tatters, but the stock price reflects it and you just want to hold and do nothing; and sometimes you’ve made a terrible mistake and you should sell immediately. It is very difficult to make the

right decision analytically and it’s compounded by the fact that there are very strong emotional factors that cause people to make bad decisions. One of the most expensive mistakes that investors can make is buying a stock at $37, watching it go down to $27, but having the entire invest-ment thesis in tatters and they would never buy the stock at $27 if they didn’t already own it. But they decide, “Wow, I’ve really made a terrible mistake and I really don’t want to own this, but I don’t want to take a loss so therefore I’m going to wait until the stock goes back to $37 and then I’ll sell it.” That kind of thinking is pervasive -- and deadly. We were buying BP at $27 completely irrespective of the fact that we already owned it or that we purchased it $10 higher; instead, we were buying it at $27 because we were convinced the market was wrong and it was worth $50 -- that was the only reason we were buying it at $27. Thanks to aggressively averaging down, our average cost is under $30.

Every element of our thesis is now coming true. At the time we were buying it, there was at least 10% chance of a very severe adverse outcome – namely bankruptcy -- that would probably wipe out the share-holders. Today, with the well capped and the environmental damage much less than people feared, we think that risk is now 1% or less and therefore, we continue to hold a large position. We think eventually the stock’s going to be at $50 within a year or two so we’re still holding on.

TWST: That’s very interesting about BP and good fortune to you.

Mr. Tilson: Let me give you one other example for your read-ers who don’t have the stomach for BP: Microsoft: If you net out its cash, it’s trading at less than ten times trailing earnings right now and it has one of the world’s strongest balance sheets: it’s drowning in cash and has virtually no debt. The immediate reaction we always get is, “Yes, but stock has been dead money for ten years and isn’t Google or some other

“At the time we were buying BP, there was at least 10% chance of a very severe adverse outcome – namely bankruptcy -- that would probably wipe out the shareholders. Today, with the well capped and the environmental damage much less than people feared, we think that risk is now 1% or less and therefore, we continue to hold a large position. We think eventually the stock’s going to be at $50 within a year or two so we’re still holding on. ”

“Microsoft: If you net out its cash, it’s trading at less than ten times trailing earnings right now and it has one of the world’s strongest balance sheets: it’s drowning in cash and has virtually no debt. The key is to understand that Microsoft only earns profits in three areas: Windows, Office, and Server software, which collectively account for more than 100% of its profits and everything else is irrelevant.”

1-Year Daily Chart of BP



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competitor going to take away their business, and wasn’t that little phone they had, the Kin, a bust, and they seem to spend a lot of time and money on things that lose money and don’t seem to get much traction?” Every-one knows the bear case on Microsoft.

But what we see is one of the greatest businesses in the history of the world in terms of margins, in terms of market share in its core businesses, in terms of the profits and cash flows that it generates.

The real knock against Microsoft is that there is just no growth and if it’s a no-growth cash cow, it’s probably only worth ten times earn-ings. But the key is to understand that Microsoft only earns profits in three areas: Windows, Office, and Server software, which collectively account for more than 100% of its profits and everything else is irrele-

vant. It doesn’t matter that they lose a few hundred million dollars a year -- or even $1-2 billion a year -- on Bing and other new ventures. It just doesn’t matter.

The only thing that matters for Microsoft is those three fran-chises -- the three greatest franchises in history, in our opinion -- and the beauty of it is that they have new products launching in all three of those areas. Windows 7 is taking off like a rocket to rave reviews and Corpo-rate America is adopting it. Many end users shunned Windows Vista and are still running Windows XP, which is now a very dated system so ev-erybody is now upgrading to Windows 7.

Microsoft Office has 94% market share of office suites, a number that has been stable for the last five or ten years. The idea that Google apps are going to put Microsoft Office out of business is beyond ludicrous. That might happen five or ten years from now, but it is abso-lutely not happening today or in the next year. Microsoft Office just launched a new version, which I’m now using. It’s nothing revolutionary, but it entrenches Microsoft’s monopoly for another few years.

Finally, the Server business, which nobody pays any attention to, has been suffering from depressed margins over the past couple of years as Microsoft has invested heavily in developing new products. Because Microsoft’s accounting is very conservative, they expense all of their software development costs and that’s been depressing margins in that area. They now are launching new products, the development ex-penses are going down, and the revenues and profits from the launch of the new products are going up so we think the Server software business is going to show an enormous growth in profitability over the next year or two.

So, all three drivers of Microsoft’s profits have new products, offering the prospect of substantial growth -- and you don’t even have to bet that the growth might come. The evidence is clear, the only question is how much growth and how quickly. Microsoft just reported quarterly earnings, and revenue was up 22% year-over-year and earnings per share were up 50% year-over-year. I’ll give you a wild guess how much ana-lysts are expecting profits from Microsoft to grow in the next 12 months. The answer, of course, is 13% because that’s all analysts are capable of projecting apparently, regardless of all evidence to the contrary.

We think earnings are virtually certain over the next 12 months to grow 20-25%, which we think is conservative in light of the fact that they just grew earnings per share 50% last quarter. By buying

the stock today at ten times earnings net of cash, a year from now earn-ings are going to be 20-25% higher, which means if the multiple stays at ten times earnings, you make 20-25% owning the stock plus a 2% dividend on top of that.

The only thing that could mess up this investment, assuming the earnings are there, is the multiple on the earnings contracts. Micro-soft is only trading at ten times earnings, near the lowest multiple the stock has ever traded at. We actually think if they start to show nice earn-ings growth for a few more quarters that the multiple investors will place on those earnings is much more likely to go up rather than down. A busi-ness of Microsoft’s quality should trade at 15-20 times earnings not ten times earnings.

If we’re right about that, you could have a much more substan-tial return on the stock. In fact, with the stock today around $25, we are looking for the stock to be in the $35 to $40 range a year from now. Most importantly, given our defensive nature, is we think that that earnings growth is going to be there almost no matter what happens to the world

economy or the US economy or GDP growth. We think in the event of a declining stock market and general investor bearishness or panic, inves-tors will flee to companies with very strong balance sheets and that can grow even in the face of a weak economy. We view Microsoft as both an extremely good defensive stock, but also one that offers you a very good prospect of nice upside in the next year or two.

TWST: What about the risk management at these value and deep value stocks? How do you incorporate that within your process?

Mr. Tilson: It’s a very important factor, but it depends on the


“Anheuser-Busch InBev, which is another one of our big-cap blue chips, is trading at less than ten times free cash flow and that it has nice growth prospects ahead of it, so therefore we’re going to win as earnings grow and as the multiple on those earnings expands. One of the reasons we like that business so much is because we think it has one of the best management teams out there.”

“Sometimes the cheapest situations are the ones that everyone agrees are cheap, but there’s no catalyst. We think cheapness is its own catalyst and if you can be patient, sometimes for a year or two, you’ll be rewarded. Our patience and the investor base we built that allows us to be patient is a big advantage.”

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situation. For example, we think that Anheuser-Busch InBev, which is another one of our big-cap blue chips, is trading at less than ten times free cash flow and that it has nice growth prospects ahead of it, so there-fore we’re going to win as earnings grow and as the multiple on those earnings expands. One of the reasons we like that business so much is because we think it has one of the best management teams out there. Berkshire Hathaway is one of our largest positions because we have so much confidence in Warren Buffett given his 50-year track record and also have studied him more closely than anyone we have ever studied.

In the case of tainted management, certainly BP and Tony Hay-ward fall into that category. We correctly anticipated that he would get canned and that they’d bring in somebody better and we’re delighted that

Bob Dudley is now running BP. That’s the good thing about bad manage-ment: they can always be replaced. Lastly, since we were just talking about Microsoft, there have been calls for Steve Ballmer’s ouster. In the ten years that Steve Ballmer has been running Microsoft, revenues have tri-pled and profits have doubled. It’s not his fault that he became CEO when investors had much too high a multiple on Microsoft’s stock.

Another pillar of the bearish thesis on Microsoft is that the company is going to take $40 billion of its cash and squander it via a stupid acquisition or investment. We don’t have that concern. It’s possi-ble, but we don’t think it’s very likely. Microsoft has actually returned over $100 billion to shareholders over the past decade, did a $30 billion one-time special dividend, repurchased a lot of stock, reducing the share count substantially, and is now paying a 2% dividend. We don’t be-grudge Microsoft investing money in small acquisitions and trying to compete with Google with its Bing search engine, which by the way last month took market share from Google (albeit from a very small base). Frankly we don’t think Google should be too worried about Bing. But it’s okay in our opinion for Microsoft to spend a few hundred million, even a couple of billion, to invest in new technologies and maybe de-velop another new franchise. We have a much more sanguine view of Microsoft’s capital allocation over the last ten years than the rest of the market appears to, and we are not calling for Steve Ballmer’s ouster.

TWST: What other ways do you look for to prevent the individual security level to prevent them becoming value money traps for example?

Mr. Tilson: We have plenty of experience with value traps. We have a number in our portfolio today, in fact, where we bought them re-ally cheap, but where the businesses just haven’t done very well and the stocks remain cheap; maybe we haven’t lost much money, but we’ve tied capital for a few years and it hasn’t gone anywhere.

I’ll give an example of a micro-cap that we own almost 10% of called dELiA*s (DLIA). It’s a specialty retailer selling to teenage girls with over 100 stores in nice malls all over the country plus a catalog and web business that’s about half of their revenues. The stock today trades for about $1.40, so it has a $45 million market cap.

Incidentally, it’s very unusual to find a fund like ours that owns things like Berkshire Hathaway, BP, Microsoft, and AB InBev -- some

of the largest companies in the world -- and also owns something as tiny as dELiA*s. But this is an important point to make about our portfolio today: where we are finding opportunity is like a barbell. On one end of the barbell are mega caps, in most cases big-cap blue chips with the oc-casional out-of-favor big-cap like BP-. Then on the other end of the barbell are quite a few special situations and microcaps like dELiA*s where we take advantage of our small size and find opportunities by poking around the nooks and crannies of the market. dELiA*s hasn’t worked yet, as the company has not produced very good results – it’s on a breakeven EBITDA basis right now – but it has a pile of cash and no debt and the entire market cap of the company is equal to their pile of cash. Thus, you get the whole business for free.

The question is, is the business worth something? The com-pany generates about $225 million of revenue, but because it’s such a small business, the overhead, the salaries for management, the cost of being a public company in the era of Sarbanes–Oxley, for example, suck up a lot of what would otherwise be profits. This is a business that should not be public at its current size and would make a nice little bite-size acquisition for any number of larger retail/apparel-oriented companies that could strip out the cost of being public and it would immediately become a profitable business. This business is clearly worth more as part of a bigger company than as an independent company. Thus, it didn’t surprise us when one of the largest shareholders recently wrote a letter to the company calling on it to find a buyer.

The stock continues to languish and may continue to do so until someday somebody buys the company for $3 a share or more. It’s been a value trap and will remain one until one day the stock doubles because the company is acquired. We can make a very good argument for why there are any number of buyers for whom purchasing this company at $3 a share would be a very good deal for them because they could immediately pocket the $1.40 a share in cash. Let’s say the acquirer pays $50 million above the cash to own a business with $225 million of sales and a good little niche business. They’d be buying this business for less than 25% of sales, and many mall-based specialty retailers trade for one times sales.


“An example of a micro-cap that we own almost 10% of called dELiA*s. It’s a specialty retailer selling to teenage girls with over 100 stores in nice malls all over the country plus a catalog and web business that’s about half of their revenues. The stock today trades for about $1.40, so it has a $45 million market cap. ”

1-Year Daily Chart of dELIA*s


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We think something good will happen and there is a catalyst in place with a shareholder being an activist, but in the meantime we just sit and there’s not much we can do. We don’t buy the stock as we’re al-ready approaching the 10% limit and even if we wanted to sell it, which we don’t, we probably couldn’t because it trades by appointment and we own so much of it.

TWST: What other factors that differentiate your invest-ment approach from that at other peer companies? What other things do you bring to the table that other firms might not?

Mr. Tilson: There are a couple of things. One is we built our business with investors who share our value orientation and long-term investment philosophy, so we have a very stable base of capital and we can invest without worrying about whether the stock is going to work for us this month or this quarter or even this year. Sometimes the cheapest situations are the ones that everyone agrees are cheap, but there’s no catalyst. We think cheapness is its own catalyst and if you can be patient, sometimes for a year or two, you’ll be rewarded. Our patience and the investor base we built that allows us to be patient is a big advantage.

Secondly, we do in-depth work on the companies and indus-tries that we invest in that is rivaled by very few other investment firms. Even though we’re a small firm, my partner, Glenn Tongue, and I have a lot of experience. The average hedge fund and mutual fund is run by a manager who has been running that fund for only a few years, whereas we have a nearly 12-year track record. We’ve endured two of the biggest market busts in history and not only lived to tell about it, but thrive.

Our third big advantage is our size. Most of the very successful investors with decade-long successful track records are managing $5 billion to $50 billion and we are managing $150 million. We can look around in the nooks and crannies of the market, and have made spec-tacular returns on some very small positions. For example, we were buying SPAC warrants in late 2008 and early 2009 at $0.20 that are today worth more than $3; we bought General Growth Properties at $1 a share a little more than a year ago and today it’s our largest position around $13.50 a share. Being small allows us to be nimble and to invest in material size in special situations and micro caps where one can make enormous percentage returns.

Our size also gives us a huge advantage on the short side. The best short ideas are often in the $500 million to $1 billion market cap range. If you’re running a $5 billion hedge fund, you cannot get enough borrow to establish a large enough short position in something with $500 million market cap to make a difference. So it’s a big advantage on the long side being small, but it’s an even bigger advantage being small on the short side.

TWST: Looking ahead for the rest of this year for inves-tors, what are the challenges or headwinds that you foresee that people should be wary of?

Mr. Tilson: In addition to the two I mentioned earlier, sover-eign debt issues and the U.S. housing market, the single biggest concern I have is that governments around the world are adopting austerity mea-sures too early. We had the Great Recession, but things could have been much worse. The only reason we avoided it is governments around the world printed a lot money and stepped into the breach caused by busi-

nesses and consumers pulling back, which was creating a self-reinforc-ing vicious cycle that would have plunged the entire world into something like 20%+ unemployment instead of the 10% unemployment we have. It was massive coordinated government action that avoided a repeat of the Great Depression.

A year later, we appeared to have staved off another Great Depression, but I believe both the US and European economies are much more feeble than is generally believed by policymakers. Unemployment still remains around 10% in the United States and it is possibly a very serious mistake to be cutting back government spending and to focus on deficit reduction with the world economy so weak. Eventually the gov-ernments need to cut back and stop running such large deficits, of course, but the key is when. I could be wrong and hope I’m wrong, but I suspect it’s happening too early and that the withdrawal of government stimulus done prematurely could tip the world back into a double-dip recession of some sort.

We are keeping a very close eye on various basic, obvious fac-tors that would indicate whether the economy is just taking a little bit of a breather or whether we’re heading back into a double-dip recession. If that happens, profits are going to get hit because businesses, which have managed to maintain their profits surprisingly well by cost cutting, will likely not be able to do much more cost cutting.

For most businesses to continue to grow their profits, they need general economic growth, which we’re not sure will occur. There-fore, we are looking to own business that we think can grow even in the absence of any kind of general economic growth -- ones like Microsoft, Anheuser-Busch InBev and Berkshire Hathaway where the businesses are strong enough or have unique things happening like new products in the case of Microsoft or cost cutting in the case of Anheuser-Busch InBev that will allow them to show growth even in the absence of a tailwind from the economy.

TWST: Thank you. (PS)


WHITNEY TILSON T2 Partners LLC 145 East 57th Street Tenth Floor - 1100 New York, NY, 10022 (212) 386-7162

© 2010 The Wall Street Transcript, 48 West 37th Street, NYC 10018Tel: (212) 952-7400 • Fax: (212) 668-9842 • Website: www.twst.com

“Our size gives us a huge advantage on the short side. The best short ideas are often in the $500 million to $1 billion market cap range. If you’re running a $5 billion hedge fund, you cannot get enough borrow to establish a large enough short position in something with $500 million market cap to make a difference. So it’s a big advantage on the long side being small, but it’s an even bigger advantage being small on the short side.”

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The investment objective of the funds managed by the Investment Manager, T2 Partners Management, LLC, is to achieve long-term after-tax capital appreciation commensurate with moderate risk, primarily by investing with a long-term perspective in a concentrated portfolio of U.S. stocks. In carrying out the funds’ investment objective, the Investment Manager’s primary strategy is to buy stocks at a steep discount to intrinsic value such that there is low risk of capital loss and significant upside potential. There is no assurance that any securities discussed herein will remain in the portfolio of the funds managed by the Investment Manager at the time you receive this report or that securities sold have not been repurchased. The securities discussed do not represent the funds’ entire portfolio and in the aggregate may represent only a small percentage of the funds’ portfolio holdings. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. All recommendations within the preceding 12 months or applicable period are available upon request. Hedge Funds Disclaimer Hedge fund performance results discussed are for the T2 Accredited Fund, LP and include the reinvestment of all dividends, interest, and capital gains. Returns are presented net of all fees, including a 1.5% annual management fee and a 20% incentive fee allocation. For periods prior to June 1, 2004, the Investment Manager’s fee schedule included a 1% annual management fee and a 20% incentive fee allocation, subject to a 10% “hurdle” rate. In practice, the incentive fee is “earned” on an annual, not monthly, basis or upon a withdrawal from the Fund. Because some investors may have different fee arrangements and depending on the timing of a specific investment, net performance for an individual investor may vary from the net performance as stated herein. The return of the S&P 500 and other indices are included in the interview. The volatility of these indices may be materially different from the volatility in the Fund. In addition, the Fund’s holdings differ significantly from the securities that comprise the indices. The indices have not been selected to represent appropriate benchmarks to compare an investor’s performance, but rather are disclosed to allow for comparison of the investor’s performance to that of certain well-known and widely recognized indices. You cannot invest directly in these indices. Past results are no guarantee of future results and no representation is made that an investor will or is likely to achieve results similar to those shown. All investments involve risk including the loss of principal. This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum.

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Mutual Funds Disclaimer An investor should consider the investment objectives, risks, and charges and expenses of the Tilson Mutual Funds before investing. The prospectus contains this and other information about the Funds. A copy of the prospectus is available by calling the Funds directly at 1-888-484-5766. The prospectus should be read carefully before investing.

Past performance is no guarantee of future results. Investment return and principal value of an investment in the Funds will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance data may be lower or higher than the performance data quoted. To obtain more current performance data regarding the Funds, including performance data current to the Funds’ most recent month-end, please visit www.ncfunds.com.

Investment in the Funds is subject to investment risks, including, without limitation, market risk, management style risk, sector focus risk, foreign securities risk, non-diversified fund risk, portfolio turnover risk, credit risk, interest rate risk, maturity risk, investment-grade securities risk, junk bonds or lower-rated securities risk, derivative instruments risk and real estate securities risk. * The Tilson Focus Fund’s investment advisor (“Advisor”) receives monthly compensation in the form of a variable performance-based incentive fee (“Variable Advisory Fee”). The Variable Advisory Fee is comprised of two separate component fees: (i) a fixed rate fee of 1.50% of the average daily net assets of the Focus Fund (“Fulcrum Fee”) and (ii) a performance incentive fee as set forth below (“Performance Fee”). The Performance Fee functions as an adjustment to the Fulcrum Fee and is based on the Fund’s performance relative to the performance of the Dow Jones Wilshire 5000 (Full Cap) Index, a broad-based, unmanaged index of 5,000 different stocks (“Wilshire 5000 Index”), over a 12-month rolling measuring period (“Measuring Period”), as such performance is presented on the website www.wilshire.com. The Measuring Period operates such that when each subsequent calendar month is added to the Measuring Period on a rolling basis, the earliest calendar month in the previous Measuring Period is dropped. For example, on April 1, 2006, the relevant Measuring Period would be from April 1, 2005 through March 31, 2006 and on May 1, 2006, the relevant Measuring Period would be from May 1, 2005 through April 30, 2006. Thus, the Performance Fee, and in turn the Variable Advisory Fee, will periodically increase or decrease depending on how well the Fund performs relative to the Wilshire 5000 Index for the Measuring Period. See the prospectus section entitled “Management of the Funds – Investment Advisor” for more information on the Tilson Focus Fund’s Performance Fee. Distributor: Capital Investment Group, Inc., P.O. Box 4365, Rocky Mount, NC 27803, 800-773-3863.

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http://www.ncfunds.com/

http://www.wilshire.com/

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