The Ideas Report For Serious Investors

Market SuperStarS SecretS of canada’S top Stock pickerS Stock dealing in nightmares, not dreams tiM Mcelvaine Stock Market Superstars | 1 Dealing in Nightmares, Not Dreams “I make Homer Simpson look active because there’s not that much excitement happening in my office.” As the ex-chief investment officer for Peter Cundill’s company, Tim McElvaine is all about deep value investing. If you wondered what the definition of deep value investing is, it is buying the equity of companies that are beaten up, unwanted, and unloved. Even hearing their name will sometimes make you cringe. As Tim says, “We deal in nightmares, not dreams.” So why would you buy nightmares, you say? Well, because if you pick the right ones, you get a great bargain on the purchase price, and this is how Tim says he makes his money. With a 20 percent annualized return (16 percent net to investors) for the last ten years until December 31, 2007, “nightmares” have turned into dreamy performance for Tim’s investors. As a value investor who is strict in his style, he will build up the cash when he can’t find bargains. Surprisingly, he has been able to achieve these returns while holding a lot of cash over the years. In 1997, the average cash position in the fund was 59 percent, and at various times over the last decade, the fund has averaged 20 percent-plus in cash. What even makes the performance more remarkable is that there are hardly any resource stocks that have accounted for the performance. Chances are, you won’t have heard of many of the com- Tim McElvaine panies that Tim has owned over the years. Buying stocks with a margin of safety can also help to reduce your downside and can result in amazing consistency. Tim is one of only a couple of managers I can think of who have not had a down year in the last ten years. Other than a drop during 2002, and the recent drop at the beginning of 2008, the chart for the McElvaine Investment Trust has generally been a nice upward sloping line over the last ten years with very few bumps along the way. Even in 2007, in which many “value managers” were beaten up, he squeezed in a positive return by the tightest of margins. The style has been pretty easy on the nerves over the years, and it proves repeatedly that to make a lot of money over time, you just need to avoid the big drops during the bad times. Known for his witty and self-deprecating humour, it is always fun to chat with Tim. Putting yourself down in a fun way I think actually helps people to stay humble, which is one of the traits of the most successful investors. I actually had to convince him that he should be included in this book. When I asked him why he developed a value philosophy, he said, “I am not as bright as growth managers, so it was logical for me to do this.” When asked why he tends to hold stocks for so long, he says, “Because it takes so long for them to go up,” referring to the fact that many value managers get into stocks a bit early. I first met Tim in 2006 after doing some research on value managers. The McElvaine Investment Trust had one of the best and most consistent return profiles going, and upon further examination, I found the results and process to be very repeatable. I called his office in Vancouver and arranged a meeting to sit down and talk about his philosophy. We had to book a meeting a couple of weeks out because Tim is only in Vancouver every so often, living full time in the beautiful city of Victoria, B.C. What I love about many of the Stock Market Superstars profiled in this book is that most have small unassuming offices. Tim is no exception. With only a few people working at the firm, including Kim and Di, who Tim constantly praises in his updates, the office in downtown Vancouver is very small. We chatted the first time in Tim’s office, which was about as plain as could be, with simply a laptop on his desk. I interviewed him a second time in his room at the Four Seasons Vancouver in May 2008 just after one of the more brutal drubbings for value stocks in years. 2 | Tim McElvaine Bob: You were the CIO at Cundill. How did that come about? Stock Market Superstars | 3 Tim: At the time, I was working in Bermuda for the Bank of Butterfield taking my CFA. I wanted to get more involved in the investment business, and I went through a list of people who I view as mentors. John Templeton was on the list, Peter Cundill was on the list, and someone from Trimark, what was his name? Robert Krembil? Krembil was on the list. This was in 1989, 1990, which was not a great time for stocks and not a great time for hiring. Out of them, Peter showed the most interest, so I hounded him. He had to either change his fax number or hire me. Thankfully, he hired me, so I moved to Vancouver and started working with him, and that would have been in March of ‘91. Nothing like persistence, then? Nothing. Yeah, persistence. Companies get lots of resumes, but people who send resumes who obviously know a little bit about what you do I think is so important. So when people say they’re looking for a job these days, if they can tailor the package they’re sending to the person they’re sending it to, it goes a long way. Mark Holowesko used to run the Templeton Growth Fund. He called Templeton at 27 years old, or 25, and said, “I want to work for you,” and Templeton said, “Go get your CFA and then talk to me.” He went back a few years later with his CFA—three years later or whenever he finished it—Templeton said, “Sure.” I think he gave Mark the Templeton Growth Fund at 27 years old, right? The people at Cundill today are fairly young when you look at them. Is that something that Peter did, is he’ll bring somebody young in with not a lot of experience and say, “I’ll teach you the value way”? Or did you have a lot of experience before you went and saw Peter? No, but Pete’s a value investor. They’re cheap that way. Right, right. So they run their businesses that way too. No, I didn’t. What I did do is send Peter a lot of very specific ideas, so I think he had an idea of how I thought. Then when I went to start to work with him, it was kind of just working, how I always approached stuff and how he approached stuff. How long did you work for him before you were a CIO? It was pretty quick, wasn’t it? The advantage was there were only two of us, so [laughs] I didn’t have to climb to the top of a ladder. We had fifteen people in the firm, but there were only two on the investment side. 4 | Tim McElvaine How much money did the firm manage? Probably about $300 million, give or take a little bit, and going down because it was 1991, so things weren’t going too well. My accountant who’s a CA told me this. He said, “What do accountants use for birth control?” I said, “What?” He said, “Their personalities.” [Laughs] That came from my accountant. That wasn’t me. Obviously, you said you sent Peter some ideas. You were a value guy before you met Peter Cundill. How did you evolve into that, rather than a growth investor? Well, partially given that I was a CA, I obviously had low self-esteem, You have an accounting degree and a CFA. A lot of people have CFAs and a lot of people don’t have either one and do fine. So which one do you think was better, as far as helping you with what you do? I didn’t have the personality to do your job, so that meant I became a CA. It’s a language thing. A CA is like learning French—there’s nothing magical there, but it makes you quite comfortable with the lingo and mostly with the BS that people toss out. Then it also makes you understand how divorced accounting sometimes is from the reality of the situation. So you’re not in awe of it; you say, “Well, that’s crap.” What they’re doing for accounting is whatever the CAs or CPAs want, but that’s not what’s happening in the economics of the business. The CFA—and God bless the CFA because as long as they keep that program, there won’t be very many people doing my thing in the business. So the CFA was interesting to me because it’s where I wanted to go, but there’s an awful lot of stuff in it that doesn’t apply to what you or I would do on a day-to-day basis. and when you have low self-esteem, you work towards value stocks. If I really thought I was that smart, maybe I would have been a growth guy. That’s kind of what got me towards it. In the ‘80s, I had read a lot of stuff about Buffett and Ben Graham and John Templeton. I had been to a number of John Templeton AGMs in Toronto in the early ‘80s, so it felt like a better fit to how I thought about the world. Stock Market Superstars | 5 Do you remember the first stock business experience or when you became interested in the stock market, or when you started buying stocks? My first experience—other than the lemonade-stand-on-the-side-of-theroad-type stuff? My first experience in business was probably when I was about 12. We lived on a farm. I decided, with certainly my parents’ “encouragement” so to speak, to produce eggs and sell them to the neighbours. I ended up getting twenty chickens or something like that. We built a coop. My dad put up the capital cost and lent me the money to build a chicken coop and the wiring to buy the chickens. Then my theory was the chickens would lay the eggs, and I’d sell the eggs to the neighbours, and we’d pay my dad and then make some money for myself, and this would be my enterprise. So I had visions of being the chicken king of Kingston, Ontario. Well, you know, agriculture is a tough business. First of all, the chickens’ eggs kept breaking, so I had to change their feed. Then the foxes came by and ate the odd chicken, which doesn’t do very good for production. Then winter came and the eggs would freeze before I came home. Finally, for the poor egg that made it from the chicken into my fridge, sometimes my mom took them without telling me. I quickly moved into bankruptcy in my chicken business. We ended up selling them to the farmer across the road, and he slaughtered them. After that, I decided I didn’t want to do anything in agriculture, and picking stocks seemed a heck of a lot easier than taking care of chickens, so I kind of worked towards that. You had seen a business go through a rough time, so you’re familiar with that. As well as the liquidation value; I was quite familiar with it. You were a value trap, weren’t you? Yeah. Yeah. You wouldn’t buy your business even at a cheap price? No, it was not a good business, but I think like my early stocks, like everyone else, I was kind of lurching around trying to figure out how to do this. I looked at technical analysis. I tried to think about growth stuff. I think I had some Wardair and some Pop Shoppes International at one stage, and I think Wardair made some money and Pop Shoppes went to zero. Sometime around that area I kind of bumped into Buffett and then Ben Graham and I thought, “Okay, well, that makes sense. Here’s more of a framework that makes sense to me.” Your personality has a lot to do with how you invest money a lot of times. Some of these growth guys that are out there, they’re cocky. You could look at somebody and say, “That’s going to be a growth investor.” Somebody else can say, “That’s going to be a value investor,” because value investors seem to be more conservative in their personal lives. They’re softer spoken. Yeah. Yeah, I guess so, meaning if you want to party, find a growth guy. I think that’s what you’re saying. Yeah, maybe. But none of the growth guys are as funny as you are, and you don’t even know it. Now, were there some lessons that you learned from Peter? Yeah. The two biggest things are, when you have the courage of your convictions—if you’re right—then don’t worry about what other people think. The second thing is it always takes longer than you think for stuff to work out. That would be the two I recall at this moment. 6 | Tim McElvaine Your average holding period is a long time with stocks, right? Yeah. We own stocks for a long time quite simply because it takes a long time for them to go up. If they went up quickly, I’d love to have high turnover and sell them quickly, but it’d take a long time to go up. There was a poster that you saw a long time ago that you read … Oh, yeah. Yeah. How did that affect you? A lot of people who come into the business want to do something. They like the activity, I think it comes a little bit from—our business today is like Xbox on steroids, right? You can get the game in front of you, you see the lights flashing, you can hit a button and buy and hit another button and sell. There’s lots of adrenalin; it’s exciting. So for me, I kind of operate at a completely different spectrum. I make Homer Simpson look active because there’s not that much excitement happening in my office. I can go to the bathroom and not worry that I missed making a million dollars because of a portfolio decision. So my sister had this poster up that said, “Sometimes I sit and think, and sometimes I just sit.” That kind of summarizes a day at the office for me. In other words, if there’s nothing to do, nothing to buy, then don’t spend the money. Then don’t do it. Yeah. Stock Market Superstars | 7 One of the best hedge fund managers of all time, George Soros, the big macro guy, said exactly the same thing. He said, “I sit there…I do nothing…until if I see a big pile of money in the corner, then I’ll go pick it up, and I’ll bring it over.” And then he said, “I’ll sit and do nothing for a long time until I find another big pile of money.” It’s interesting because he has a totally different philosophy from what you do, but he was really saying the same thing. Yeah, it’s kind of like.… You don’t feel the need to always be busy. Yeah, Buffett talks about how you don’t have to swing at every pitch. It’s kind of like value investing. Certainly, maybe investing in general is really boredom with moments of pure panic in between. A lot of time there’s nothing to do, and then all of a sudden there’ll be those moments where there’s something to do. You need to make sure that in the boredom times, you are getting yourself ready to act when you need to. But you don’t need to do everything every minute. I think that’s the most important thing I learned. Do you think most people have the ability to be as patient as you need to be? It certainly doesn’t seem like it because you have to be extremely patient. You’ve owned stocks for years before they go up, and then they’ll go up 50 percent in three months. It’s helpful to be somewhat challenged, so time passes and I’m still think- ing well of stuff. I think if you’re confident with what you’re doing and you see the value building over time, then you don’t mind waiting at all. It’s a lot easier to do than you think. The important thing is not to get distracted by greener fields, because every day you come in there’ll be something over there that looks like it might be more interesting. It’s kind of like with a girlfriend or a boyfriend, and for sure if you’re on a diet you can look at the menu, but you’d better not go and start sampling unless you’ve decided you’re no longer on the diet. Same thing with investing, for me at least. It’s fine to go and look at all these other stocks to see because they look interesting. To actually make the purchase and sale decision, you have to be really careful because the only thing we control in this business is when you buy and when you sell. That’s the only one thing I can do. I can’t make the stock go up or down. Frank Mersch said the one thing he could do better is to be more patient. He said that he owned 30 percent of Canadian Natural Resources, of the entire company, at $0.10 a share. He said that he got bored with it and sold it. He said, “Can you imagine?” I had over 10 percent of Denison Mines at one stage. It went up a little bit, and I thought, “Wow! Ooh, ain’t I bright?” So I think I sold it for $0.15 or whatever. The interesting thing too is quite often the ideas you’re most focused on will languish and the one that you’ve kept in the portfolio because you think it’s cheap but you’re not expecting anything out of it this year…suddenly something happens. So, yeah, it’s kind of funny that way. You start a year and you never know exactly where your gains are going to come from, at least in my case. 8 | Tim McElvaine What are the three things that you look for when you assess a stock? There are actually like three and a half, and the half thing I’m a little bit reluctant to talk about because most people think I’m dumb when I mention it, but, regardless, I will. First thing is, “Does it trade for less than it’s worth?” which you know every person will say that. So you figure out what you think the company is worth, and we go through a four-step process to do that. We look at liquidation value. We look at kind of a break up value. What would a private market buyer pay for it? We also look at what happens if things go the way we think. I try and model out three years. I don’t try and go out a long period, but try and go out a couple of years and say, “This is where I think they’re going, and if they’re going in that direction, what does it mean the company will look like in three years?” What will happen to cash primarily? Not so much worried about earnings, but what will happen to cash over that period? A fourth one is a kind of discounted cash flow, but there are so many things you can play around with when you go out longer term. I’m really careful not to let the Excel spreadsheet rule me. In fact, I much prefer analysis that you can do with a pencil and a piece of paper to one that’s very elaborate with multiple spreadsheets. That’s the first thing. Does it trade for less than you think it’s worth? The second thing is, “How volatile is that estimate of what it’s worth?” Think of the story of “The Three Little Pigs.” If you take an example of a straw hut, at the first sign of difficulty, the first time a wolf comes around, it’ll get blown down. Then, perhaps a comparison to that is Nortel. When Nortel was a hundred bucks, the winds came up and the company blew up essentially, and the valuation was way too high. So that’s a straw hut. I kind of look for brick houses in the three little pigs lingo, and what I mean there is you feel like you have a strong foundation in what you’re buying. Because I’m a value investor, your brick house won’t look like a beautiful waterfront property on Lake Muskoka or West Vancouver. The roof might be damaged, the window might be missing, it might need a paint job, but “the bones” in real estate lingo are good, and then that gives you your foundation. We owned shares of a company called Sun-Rype many years ago, and even if Sun-Rype may be no money for a number of years, I felt comfortable that its presence, its position in the marketplace, had an intrinsic value, that no matter what I could get our money back. So that’s what I mean in having a firm foundation. Going back a step, the first thing was, “Does it trade for less than it’s worth?” How volatile is that estimate? The volatility you want is on the upside and not on the downside. The third thing is to determine whether management is for or against you. Basically, are they in the same boat as you, the management and the board? Many times, a good board has saved us from a difficult situation. The half, as I call it, the three and a half thing, is I try and look for situations where the sellers don’t care about price. What I mean there is when you’re buying a stock, if the seller is thinking carefully about whether or not they ought to sell, then it’s a tougher decision to buy because you’re basically betting the buyer is wrong. I prefer situations where people just want out, and that can happen. There are a couple of reasons. One is it’s an area people don’t want to be involved in, meaning there’s really bad news. It can be specific to Stock Market Superstars | 9 That was the situation with TELUS bonds a few years ago. TELUS was the same thing. I actually didn’t end up buying them, so I missed that one, but I looked at them, that’s for sure. They went down to $0.50 on the dollar. Yeah, yeah. a stock or it could be an industry. An example might be newspapers these days. People just don’t want to be involved in newspaper stock, so they sell them. That’ll lead to depressed valuations. A second reason is if there’s some type of constraint that prevents them from buying the stock. For example, with a bond, because I do distressed too, I would ask if there was a bankruptcy filing, then you might have someone sell the bonds because they can’t own those shares in their portfolio, or those bonds in their portfolio. The third reason, and the one I tend to use the most, is a corporate event. For example, a spinout, a rights issue, something happens like that. An example there is we own some shares in a company called Citadel Broadcasting, the third largest radio broadcaster in the U.S. It suffers from two things: one, people don’t like radio, so they’re not particularly interested. Secondly, it existed before, but primarily a large portion of it’s float, or a large portion of the shares that are currently outstanding came in June of last year when they acquired ABC Radio from Disney. They gave Disney shares in Citadel, and Disney then spun those shares out to Disney shareholders. So very roughly speaking, if you had $5,000 in Disney, today you’d have about $40 in Citadel stock. The inclination then is I don’t even want to look at the Citadel. I’ll just sell it because Disney is the company I bought. That’s what I mean as a spinout, someone just wants to get rid of the security without thinking about price, and that’s when we like to get involved. 10 | Tim McElvaine When did you take over the Cundill LP? Is that what it was called at the time? At that time, I was living in Ontario. I came back to Vancouver to work with Peter on Value Fund. I acquired Cundill Capital Limited Partnership at that time and changed the name. Peter, he had a lot of his own money in it at that time. Does he still? No, Peter has been very generous with me, not only allowing me to set up my own business many years ago, but also being a large investor of mine over the last eight years in the case of the LP or twelve years in the case of the trust. He owned part of my management company for a number of years, but when he sold his business to Mackenzie, they had a non-compete, so I bought him out of that. In typical Peter fashion, he did it on a generous basis to me. I find it incredible that Peter Cundill, one of the gods of value investing, entrusts his net worth to you. He obviously must have a tremendous amount of confidence in what you’re doing for him. Maybe he has a tremendous amount of money too. [Laughs] He says, “Aw, I can afford to give him a little bit.” What is the difference between the trust and the other fund? Yeah, it’s now a corp. Stock Market Superstars | 11 Right. It’s the same now? Yeah. On investments, I always believe strongly in simplicity. For example, if you hire an MBA or a CA or even just someone off the street and say, “Can you tell me ten reasons to buy a stock?” It’s easy to come up with ten reasons. It’s hard to say instead, “Can you tell me the three key drivers that we should be thinking about, but only the top three?” That’s a lot tougher, so it is the same thing with valuations. It’s actually very easy and comforting to do a big Excel model because you feel like you’re active, you have all of these numbers, and it feels good that you’re putting something together. It’s very hard to sit there with a pencil and say, “What do I really think? Define how this company should be valued.” The same thing with my business—I try and keep everything simple. We outsource as much as we can to RBC Dexia, as far as doing valuations, record keeping, and trade settlement. We try and do all of that outside so that the people inside are focused on client relations and investment. We had two funds. To the extent that I can get them together and make it one fund, I’d be happy with that and keep everything very basic, very simple. I don’t want a family of sixteen different funds. I think one of them was more foreign? Yeah, originally it was set up to be foreign. I ended up getting a lot of calls from people. Someone would come to me as an investor, and they don’t come because they think I have a brand or they want my Far East Asian Fund or my mining fund or something like that. They come because they like the fact that I have all my money in our funds, and they want to be a partner. So having two funds actually complicated that process because instead of saying, “We’re interested in the foreign fund or Canadian fund,” just said, “Well, I don’t care. Where does Tim have his money?” Right, right. That was part of the impetus behind combining everything, keeping our business very simple, and keeping my focus very simple. 12 | Tim McElvaine What funds at Cundill did you run? I ran Cundill Security Fund from June ‘92 until June ‘99. Then I was involved in Cundill Value Fund from 1999 to 2004. I co-managed Value Fund with Pete, and I managed Security Fund by myself, primarily out of Ontario where I was living at that time. I came back to Vancouver to work with Peter on Value Fund in ‘99 or 2000. Cundill has been kind of famous in the last few years for having a massive amount of the fund in Japan. A lot of people just didn’t see what you saw in Japan. I think the Japanese market was going down and down and down, but you were doing great. I think the stocks, generally speaking, were doing fine. We had a good group of research guys at Cundill on Japan, but I think it suffered. Even if you look at the period from 2000 onward, it was a pretty good period for value investors in North America. You had a lot of stuff in Japan that had bad balance sheets but high valuations, so that stuff just kept going down. You had stuff with good balance sheets and low valuations, and that kind of percolated up a little bit, so it was a little bit of a two-tiered market. Have you ever shorted stocks? Peter did, I think. Yeah, we used to short indexes for a little while. I bought puts on stocks in 2000, and in typical fashion, the puts expired. I had puts on GE, CIBC, and some others as well, but they expired in January of 2000. Then I didn’t renew them because I was so tired of losing money, and then all hell broke loose in March of 2000. So other than a good tale, I can’t say I profited from it, but that’s about the closest I ever got to shorting. Last year in Omaha, Nebraska, somebody asked Buffett about silver. He said, “Oh, yeah, we owned a lot of silver, and we bought it way too early, and we sold it way too early, and we never made any money. But that’s what we always do, so that’s okay.” So he said to Charlie Munger, “Well, what do you have to say about silver, Charlie?” Charlie said, “That’ll just about cover our expertise in commodities.” How is running what you run now different from the funds that you ran at Cundill? I think one of the things I’m thinking about here is size. I think it helps to be smaller generally. When I got involved with Peter in ‘91, the Value Fund had 400 stocks. I think it shrunk down to about 150, 100, 125 when I got involved in Value Fund again in 1999 or 2000, and then we worked it down to about 30 stocks after that. I think my predisposition has always been to have a more concentrated portfolio than maybe the average traditional value guy. I think Ben Graham certainly espoused having a large number of securities, and that’s been Tweedy’s approach as well. Templeton’s got a ton of stocks too. I’d say that’s a difference. The second thing is I do sometimes get involved in the securities, for example, go on the Board. That would be different from Cundill. Finally, I don’t mind looking at small stocks or big stocks, and when you’re running a large mutual fund, as much as you’d like to, you can’t spend your time working on small companies. Stock Market Superstars | 13 Do you look for stocks a lot of times that are undercovered by analysts, or analysts don’t even cover them at all? There are two ways that they get undercovered. One, of course, is if they’ve collapsed. There’s a certain…I don’t want to be cynical about it, but you see it happen with some regularity where a stock may be $20, and a broker will have a buy on it with a target of $30. The stock falls to $10, and a broker will go to a hold, and then the stock falls to $5, the broker will go to a sell. The stock falls to $4, and the research analyst will suddenly no longer be working there. That is, I’d say, not an unusual pattern of some of the stocks we get involved with. Then over time, the analysts will come back in and they’ll get covered again, or sometimes the stocks just weren’t really covered from the beginning. That is the case with even something like Citadel Broadcasting, which used to be a billion dollar type company, but now is maybe $300 or $400 million in market cap. Because of all of the changes over the last year, there’s a very limited amount of analyst coverage, and that works to our advantage, of course. Right. It creates the inefficiencies. Yeah, it creates inefficiencies, so I agree. An undercovered stock $15something that we’re quite happy to get involved with. 14 | Tim McElvaine I think a value investor believes that the market is very inefficient in the short run, but you’re banking on the fact that it’s efficient in the long run or else you’re never going to realize the value that you think you should have. Is that true? Yeah, for sure. I joke that there are two types of investors out there. There are the people who approach life saying, “I’m smarter than everyone else because I think I can figure out,” and this is my comment about that. I think that’s great. They think I can figure out why the stock is cheaper and therefore will go up more than people realize. That would typically be a type of growth manager because he’s saying, “My cousin’s best friend’s housekeeper works also for the CEO of Research in Motion. They tell me the number of units shipped is going up; therefore, I think I have an inside edge, and I want to buy that stock.” Once again, their analysis is all based on the fact that they think they know something the market doesn’t, or they think the market is wrongly valuing it. On a value basis, I suggest that value managers are much dumber than growth managers, but at least they know they’re dumb. When I’m buying a stock, I don’t think about all the wonderful things that could go wrong. I just try and think about all the things that are going wrong and whether or not they’re really serious, so that means a couple of things. First, it means if the market thinks things are worse than they are, then you’ll get appreciation— the relief, so to speak—because things weren’t as bad as they thought. The second thing is it usually takes some time for the stock to turn around, so that’s why your holding period is a little bit longer. A lot of stocks that you own are very illiquid, but you own big chunks of the company. How do you get the liquidity you need to either buy or sell when they trade 500 shares a day? What always happens is you see a stock and you say, “I like that idea,” and I try and have my positions between 5 and 10 percent. Let’s assume I buy a 5 percent position in a stock, and the broker says, “Tim, this is part of a cleanup. This is a guy who had a million shares, and he can’t get a bid on this somewhat illiquid stock, and there’s bad news on it. Are you interested?” So I’ll end up buying some, and I’ll think, “All right, we got a somewhat illiquid position but it has a good story.” The stock will promptly fall by a third and then, lo and behold, if the broker doesn’t phone back and say, “Actually, it wasn’t a cleanup. There’s another block of a million shares available. Are you interested?” I end up saying, “Yes.” Then, over time, I end up with these relatively large positions in stocks that don’t trade all the time. The situation usually changes a little bit, and either there’s a takeover or pick up of research coverage, and we’re able to sell into that. So you got liquidity? So we get liquidated that way. You have to be a little bit careful, and I’m guilty of this a couple of times. When the liquidity comes in on some of these stocks, it’s usually because there’s good things happening. It would be easy, then, to say, “Oh, maybe I should hang onto this for a lot longer because maybe I was too pessimistic.” When you see liquidity start to come in, one of the things I’m very conscious of is, I make the easy decisions when there’s no hope, and then it gets some hope. The person who’s coming in and trying to value how much that hope is worth has a much tougher job, and I’m better off to sell to them and take my money and go and find another hopeless situation. Stock Market Superstars | 15 I don’t know if you ever read this, but I found it very interesting. Benjamin Graham set up his office down the hall from Tweedy Browne, and they were the broker, and they’d accumulate the stock that nobody wanted and then he’d buy it. Tweedy Browne looked and said, “Well, he’s actually doing pretty well on these crappy stocks, the ones that we’re dumping off to him.” So they became a value money management firm themselves. Many great stock pickers have a team of analysts working for them. I’ve been to your office in Vancouver here, and it was an empty office with a laptop. How do you find ideas when you don’t have a bunch of people looking around for you? The first thing is, I worked with a good group at Cundill, and without a doubt, a lot of them were brighter than I. The important thing in the investment business is that you have someone who the buck stops with—so someone who feels responsible for the fund or for the portfolio. When you have a lot of peo- ple working with you, you can spend a lot of time getting into elaborate discussions over what you should and shouldn’t be doing. That can be quite helpful, but it can also be quite distracting. I get involved in messy situations, so I feel quite comfortable with how I’m approaching it. It can be good to have a sounding board. 16 | Tim McElvaine It’s kind of like the song by Sony and Cher. Oh, “You’ve got me, babe.” Yeah. With my funds, my name is on the door—You got me, babe, so to speak—and unfortunately, I’m the only one. I’m working now with another guy who’s helping me with some structural stuff as well as the investment portfolio, and it’s a bit of an experience for both of us. I do think that having people working with you that help generate ideas lets you cover more ground. The only question is, how distracting is that to the decision making process? Peter Puccetti told me he has a good friend who just watches what Peter buys. He says, “I’ll just watch what you buy and then two years later, I’ll buy it.” When you get into something, does the news usually get a bit worse? Is it catching a falling knife? Well, I think for sure every time I buy a stock, it tends to go down by a third after we buy it. Every time I buy it, I’m pretty sure this one won’t go down by a third. So the answer to your question is yes. The neat thing about value investing is if you think a company is worth five and you’re paying three, you have a margin of safety. If the stock falls to two, and you still think the company is worth five, it’s actually a better deal. You have a larger margin of safety. Unlike a growth guy, the second the stock may start to go down, they worry that it’s an indication that they’ve missed something in the valuation and the smartest thing to do is sell. Quite often with a value stock, if you’re confident that your analysis is correct, a stock going down is really the opportunity to keep adding money to it. So averaging down is a fact of life, and I think probably the thing that tests your judgment the most is if the stock falls by half, would you still be interested in buying more? If you say yes from the beginning, and you’re able to do that, then I think that says a lot about your discipline as an investor, certainly a value investor. You said once that you tend to own cheap stocks—stocks that everybody agrees are cheap. I think your idea is to take out the but. Yeah, it’s the same thing, I would be a great golfer but for the fact that I can’t hit the ball properly. So that but is a pretty big thing in life. I’d look like Fabio but for the fact that I’m thirty pounds overweight and bald, so but is a pretty big word in stuff, and it’s certainly a big word in investing. So people will say, “You own some shares in….” Let’s take Citadel again because I talked about it, “…but it’ll be a couple of years before they execute on their plan, but it’s in the radio segment, but there are a lot of sellers.” You just look at what’s behind the but and say, “Does that really matter to me? Does it matter that it might take a couple of years?” No. One of the things I think we do as investors is trade time for price. Does it matter that it’s in the radio business? No, because I think the price I’m buying at is attractive enough. So, yeah, we try and take the but out of investing. It sounds like a bad joke, but that’s the way we do it. Stock Market Superstars | 17 If you’re wrong on a growth stock, and you hold it, you can have a permanent loss of capital. If you’re wrong on a value stock, other than being a value trap, you don’t normally get a permanent loss of capital? Yeah, let’s face it, value portfolios look ugly. I think the best example is I remember I used to take my kids to Stanley Park when it had a penguin exhibit. When you were just entering the area, you were maybe a hundred yards away, you’d see the penguin exhibit and all these penguins are splashing and dancing, and you go, “Oh, ain’t that cute?” When you walk up within five feet of a penguin exhibit, it stinks like heck, and you say, “This thing is awful, like let’s get away from here.” So it didn’t matter how picturesque it looked from the distance. My portfolio is like that. From a distance it’s a beautiful work of Right. The other thing that is related is quite often I think people mix up uncertainty and risk. I can say without a doubt all of the stocks I get involved in are uncertain, and by uncertain I mean you don’t know what’s going to happen over the next quarter, over the next six months, maybe even in the next year. But I measure risk as: What’s the chance that we’ll actually lose money on the position? Whether or not it goes up and down in the stock market, whether or not I know what’s going to happen next quarter, isn’t a risk to me. As I said, risk is: What’s the chance in permanent loss of capital? So when someone looks at a stock and says, “I’m uncertain about where it’s going,” I think that’s fine. art. Up close, someone would say, “You own twelve duds.” I guess that’s what I do for a living. Own duds? Own duds. 18 | Tim McElvaine How important is the qualitative side of it? Do you get to know the management? Are these guys honest? Are they going to execute properly? Is that why you get on the board of companies? Well, let’s try and pull that apart. The first thing I think is running the numbers on the stock doesn’t give a reason to buy it. The things I’m looking at are the qualitative stuff. What can go wrong? What can go right? Where are the incentives for the group? What’s in it for the managers? I think that’s a very important part. Of course, it’s always nice to see insider buying. That’s a well-known thing. Sometimes at moments of crisis, though, insiders may be restricted from buying, or they’re unable to for a number of reasons. So you have to be a little bit careful with insider buying. What I look for is, as I said in the beginning, is management in the same boat as you or not, or is their compensation, or preferably, their ownership such that in a moment of crisis when they’re dealing with shareholders’ money, will they make a decision in the best interest of the owners, or will they make it in the best interests of the managers? That’s the main thing I try and think about. What are those crises occurring? How damaging are they to the company? How will management make a decision when they reach that position? Now, in a couple of cases, three in particular, I’ve gone on boards, but I don’t go looking for a fight. I’m a lover, not a fighter, so I don’t like doing activism. I don’t say, “I’m going to buy that stock,” and agitate. That’s not our way. It’s more like I’ve got backed into a corner, and I’ll get involved because I have to be. Once again, in all of those cases, I can say without a doubt I’ve never met a board member who wasn’t honest and had the best intentions, but as a shareowner of a company, you have to try and evaluate whether or not their intentions are really in your interest. An example of that might be where someone is making an acquisition that they believe will make the company stronger in aggregate, but on a per-share basis, it is not. The best example of that would be oil and gas stocks. They may feel that they want to buy more reserves when the price is high because it’ll make the company stronger. If you measured reserves per share, you might figure that it’s a dilutive deal for each of the indi- vidual investors. So that’s what I’m talking about when I say I am trying to figure out where the incentives are. Stock Market Superstars | 19 One of the biggest shareholders of Sun-Rype was the Jim Pattison Group. I think they still are one of the biggest? Well, yeah, I think if you have a choice of investing with a billionaire or investing with a pauper, you’re probably better off investing with the billionaire. The billionaire. There you go. Certainly, we’ve sold a large portion of our Sun-Rype position to the Pattison Group. I was on the board with Mike Korenberg and Don Selman from the Pattison Group. I was always very impressed with their honesty and their integrity but also how they looked at stuff. They were focused on return on capital. They were focused on cash flow; everything that you and I would think about as a value investor, they were doing from a business perspective. I think that’s a tribute to Jimmy and the culture he’s put in place there. Everybody kind of says the same thing about how they look at a stock, but why have you generated 20 percent a year for the past ten years before performance fee and hardly anybody else has? What makes you different? Is it the smaller base of money? Is it the different ways you look at it? The bizarre thing in this business is when you meet someone and they say, “The stock’s going to $30.” You can’t control that part of the business. Where I sit, you really can’t. Sometimes if you get involved in the board, you can do stuff that will further it, but, nevertheless, you can’t control what the market is going to do with the price each day. The only thing you can control is when you can buy and when you can sell. I’ve been fortunate in that I’ve been really involved in a number of hopeless things that became not as hopeless as people thought, and that’s been a large part of the performance. Unlike some of the other investors that you talk about in your book, some people make overall projections and then find stocks that’ll fit in. I have enormous respect for people who do that, but that’s not where I am. I’m really looking for complete despair and protecting the downside and knowing that when the turn comes, it usually comes back, and it’s a lot better than you expect. I think Benjamin Graham said that he would definitely buy a crummy business as long as it was at the best price, whereas other people have said, “I’m going to buy a great business at a good price but I’ll never get a great business at a fantastic price.” What I’ve tried to do is stay away from the really bad stuff and realize that whenever I think a really wonderful business is at a good price, it’s usually me who’s confused about the quality of the business, not the person selling. So what I’ve tried to do is say price is important and cash is important, meaning cash flow. I’ll try and stay away from the stuff that consumes cash. What I ideally like is a mediocre business, so to speak, that each year will be worth a little bit more primarily because of cash flow. If the stock prices stayed the same, your margin of safety over time inches up. That’s where I’ve had the best luck. If we take Sun-Rype, for example, I think we bought our first stock at $2.10 or $2.20 or something like that. We got $1.50 in dividends, and we sold our stock to Jimmy for $11.50. When we bought it, we definitely did not think it was worth $11.50, but over the years, the value kept compounding. The return on invested capital within Sun-Rype was very, very high, and it doesn’t take very many Sun-Rypes in a lifetime to have a good outcome. 20 | Tim McElvaine How do you avoid a value trap? A company is really, really undervalued because it’s going to zero! Have you ever had a situation like that? Well, yeah, sure, you get them all the time. I don’t mind buying situations that are challenging at the moment, but I’m not a dumb contrarian in that I’ll buy situations that there’s no hope of winning. For example, if I go and box against Mike Tyson, I’m not going to win. So if I’m going to get into a fight, which I don’t want to, I want to make sure it’s a fight I can win. Same thing with a business. If it’s losing money, losing cash, and the value is staying constant or declining, you have to be really, really careful what price you pay. The value traps I’ve been stuck in tend to be where the net asset value has stayed about the same over the period and the stock price hasn’t gone anywhere. The best situations for me have been where the value of the company has grown. It can be quite slowly over time so that my margin of safety is getting bigger, and that gives you the large return. I try and avoid stuff where I think it’s going to be stagnant. I’m talking about the underlying value, not the stock price, so I’m really careful about what you pay in those circumstances. You said you’re the only guy in Canada who missed the entire oil and gas run in gas and minerals. Yeah. Stock Market Superstars | 21 Have you had resource stocks? How do you analyze a resource stock versus a retailing company because it’s a totally different business? I’ve been in all of the hottest sectors. I was just, like, five years too early and sold three years too early. We owned real estate, closed-end funds, and sold them before they became very popular. I think we owned some oil and gas trusts, and I owned some gold mining stocks and Teck, which then became Teck Cominco. I owned Denison Mines, I owned oil drillers, and I bought them when there was despair, meaning people felt they didn’t have any hope. Then the stocks go up somewhat and you sell them. I could definitely be faulted on selling early, but that’s okay. What I said before was I try and make the easy decision that things aren’t as bad as people think. I have protection in the price, and when it gets up into the area where you’re debating what type of multiple should be put on it, then I’ll let someone else make that decision. Paraphrasing a little bit the Rothschild quote, “I buy on assets or I buy on intrinsic value; I sell on earnings.” That’s kind of what I do. I don’t try and figure out what the multiple ought to be—that’s someone else’s job—or where the growth rate is going to be. They’re difficult decisions, and I’m happy to leave them to someone else. To give you an example of that, we had a large position about five years ago in a company called Sask Wheat Pool. It actually first was a distressed debt position in that there were some concerns that Sask Wheat Pool was going into bankruptcy, so we bought some debt, and that got resolved. We made some money on the debt and sold it. Then Sask Wheat Pool did a rights issue at about $5, and we stepped in and bought a lot of the rights, which then led to stock. That’s how we got a large part of our Sask Wheat Pool position, or really nearly all of it, is around the rights issue. At the time, people said Sask Wheat Pool had been through a couple of years where there had been not very much production on the prairies, so it was a business that was going to be impacted by global warming. They had too many fixed costs in that business. It Have you ever had resource stocks in a portfolio? Cundill had Canadian Natural Resources for a long time. You know, I never had that. was controlled by the railways because they did all of the shipping, and there was generally despair. Now, today, with the stock almost three times higher and with many, many more shares outstanding, people are setting up agricultural funds to invest in stuff like Sask Wheat Pool, which is now called Viterra, because they feel that the outlook looks bright. Without a doubt, I did not make any prediction when we were buying the stock that agriculture was an important place to invest. I’m not that smart at all. It was just that Sask Wheat Pool was cheap, they were doing some smart stuff, and they had a very important presence in the industry. That’s why we bought it, and, of course, we sold it too early. I think I sold at $10 or $11 or something like that. It worked out very well. We got very high rates of compounding because it came off such a low base, and that’s kind of what’s helped the numbers. A stock like Potash used to be a value stock that nobody in their right mind would ever own. Exactly. I didn’t buy it, but I was aware of it, yeah. 22 | Tim McElvaine Now it’s only growth momentum managers who own Potash. How does the baton get passed when a value manager sells their stock to a growth manager? We buy stocks when they’re burned out, and then they start to go up a little bit, and we sell it to maybe a GARP (growth at a reasonable price) manager who then might sell it to a momentum guy. I don’t know who he sells it to, but he sells it to some poor person, and the stock collapses and comes back. It’s like passing the hot potatoes. [Laughs] Yes. It’s a good thing about getting older in this business. Some of the stocks I used to own come back. It also shows you have to be a little bit careful that you don’t believe that all trees grow to heaven. I’ve heard some value managers say the biggest mistake you can make is extrapolation. They say, “Well, this has happened for the last five years, so if this continues to happen into the next ten years, it’s going to be massive.” It never seems to work that way. I’m also a little bit careful on reversion to the mean. People who say, “Well, they had 30 percent margins two years ago, and they only have 5 percent margins now. If they go back to 30 percent margins, I’ll make this much money.” That’s always a big leap of faith that I think you have to be careful about making. Stock Market Superstars | 23 My dad moved to California in the early 1960s; I always remember this story. There was a weatherman speaking on TV, and the way he said it everybody knew it was a joke. There was a huge influx of people into California at the time, and he said, “Now, I’ve calculated that if this number of people continue to move to California, then twenty years from now everybody in the United States will live in California.” Everybody laughed because everybody is not going to live in California. However, if you extrapolated that, that’s exactly what it would show, right? Yeah. If you’re playing poker and you don’t know who the patsy at the table is, then you’re the patsy. It’s the same thing a little bit in the investment business. If you’re looking around and you don’t know who the sucker is, then it’s probably you. In poker, I think a good poker player will make most of their money on a relatively small number of hands. Is it the same in the stocks? Do you make most of your money on three stocks out of ten that you’ll own? Well, I run a pretty concentrated portfolio, so I agree that I’m always surprised with which of those stocks go up in any year. I think what I also try to do is not make too many bets but just wait until the odds look definitely in your favour, and then bet significantly. As we talked about before, I think it’s human nature to say, “Well, that looks kind of interesting, so I’ll buy some of that. And that one looks kind of interesting, so I’ll buy some of that.” Then you soon end up with a hundred things that look kind of interesting. I much prefer to sit and wait for something that looks really interesting, and then go into it very significantly. Go big or go home. Yeah. So in your poker analogy, you wait until you’ve got a really good hand, and then bet strongly. Now, of course, in poker, when you do that, if you’ve been quiet all of the previous five hands, the second you do that everyone else is going to fold. In the investment business, that doesn’t happen, so that’s a huge advantage you have in our business versus playing with a group of poker players. To get more understanding of your philosophy, let’s go through some individual examples, like Humpty Dumpty Foods. Yeah, we.… 24 | Tim McElvaine That was a criticism people had about Japanese companies. They weren’t shareholder friendly and they didn’t really make a lot of money. Oh, for sure. When I look at a company, there are lots of wonderful companies run by great people. It doesn’t mean that you have to buy them. That’s the great thing about being a value investor. I can benefit from the RIMs of the world who are doing things like the BlackBerry, although I actually don’t have one. That’s too much connection for me. I don’t have to put my money into that type of situation. I wait. When I really think I have an advantage on the investment, on the price, then I act. What attracted you to that stock? How about Indigo? Yeah, the good, the bad, the ugly. We talked about Sun-Rype, and that was clearly a good. A bad one, to some extent, would be Humpty Dumpty. I got involved in it—I don’t remember exactly when—but it was an IPO. They acquired a private brand business, I think, from Cott for chips, so there was a growth idea. They thought it was going to do really well, and I don’t know if it got as high as $10 or $8. Then the stock collapsed to $2 or $3, and that’s when I started to buy it on the basis that they were the second largest potato chip manufacturer east of Winnipeg and their competition was Frito Lay. They had got into a price war with Frito Lay, and management owned a significant amount of stock. I learned a lot from the Humpty Dumpty experience. I eventually ended up going on the board as part of a proxy fight and we replaced management, and then closed the facility and ended up selling the company to Old Dutch, so it came out as a save at best. But I learned a lot about business being on the board, as I did at Sun-Rype, and as I do on Rainmaker. I think that’s made me a better investor. The type of things you think about are a competitive situation and cash flow and business model. In the case of Sun-Rype and Humpty Dumpty, in a different fashion, in the case of Rainmaker, there was a focus on doing volume perhaps at the expense of margins and cash flow. This gets back to my earlier discussion. Even in my own business, I’m just trying to keep things simple. Activity doesn’t equal success or profitability. I think that’s what was a bit of the issue with Sun-Rype and Humpty Dumpty. But Sun-Rype resolved it quite successfully, and Humpty Dumpty, as I said, was at best a save. I’ve always found when stocks go into the index, they’ve already gone up a tremendous amount, so the index is momentum based. Microsoft and Intel were put into the index in 2000, right at the top. Yeah, I think it would be fair to say, because as a value guy, I do look at when the index changes come out. It’s not because I’m thinking about the weighting of my portfolio, but it’s quite simply to see what’s being deleted because, once again, I like ideas where the seller is not caring about price. You get a certain amount of selling after an index deletion that might be interesting, but it hasn’t really been a source of great ideas. But who knows? Maybe tomorrow. Stock Market Superstars | 25 If you look at the past ten years—and it’s been a rough year for value in the past year—you’ve still generated before the performance fee 20 percent a year, 16 percent net to investors, which is right at the top. You’ve had great returns while maintaining pretty high cash positions along the way. I think at the end of ‘97 you had 59 percent cash. You’ve had less cash recently, but I think 25, 27 percent cash has been common. How did you generate those returns with that much cash? This gets back to a comment I made before: I try and only act when I think there’s something to do, and I don’t care what the portfolio looks like relative to the index. If there isn’t anything to do, I’m quite happy to sit on my hands. That’s what cash ends up being. It’s not an asset class in my mind, it’s the residual. If there’s nothing to do, we’ll just sit in cash. If there’s something to do and it’s really good, then let’s spend the money. As I said to you before, when the year ends and you look back and say, wow, I was up whatever this year, sometimes I’m as surprised as the next person. I can’t say how it happened that way. All I know is I try to be disciplined on when to buy, and that’s worked to our advantage. Back to distressed securities. The Loewen Group bond—did that work or not? Yeah, it did. Yeah, I like doing distressed debt. It’s the same thing as buying distressed stocks, really. It’s just a different part of the capital structure. There hasn’t been as much stuff to do recently, although I have to say in the last six months, we’ve started looking at the distressed again, and we’re quite close on at least one idea to buying some of the debt. The advantages to distressed debt are twofold. Sometimes you get a coupon, sometimes not. Secondly, there’s usually an event that comes along—a restructuring, an emergence from bankruptcy, or something like that—that allows the position to turn over naturally. You’re not dependent on waiting for the business to improve or analysts to get coverage or liquidating to come in. There’s usually an event with distress that gives you liquidity. It’s an interesting place to invest. We do not buy bonds unless they’re significantly discounted from face, and that’s the only time we would do it. 26 | Tim McElvaine There was a study done where they gave investment problems to sociopaths in prison, and they did much better than the average population. They had no conscience. They didn’t care. They just made logical decisions without any emotion. At times, my performance has been compared to everything from sociopaths to primates, so if there’s any day you’re feeling like you’re a bright person, don’t worry. You can find someone to tell you you’re not. So it keeps you humble. Why did you make the insignia for your firm a toad with a prince’s crown? Well, I guess all of our stocks have warts on them. We have to kiss a lot of frogs to look for the prince, so quite often I think that if I needed one investment tool in this business, it might be LypSyl and not a calculator. That’s how the frog came into being. Can you pinpoint one thing that has helped you to do well? As I said this to you before, it would be trying to emulate Homer Simpson in my daily investment activity. I’m always amazed with the people who get on television and people ask them stock ideas, and they know something about every stock. My brain can only hold so much information. If it’s not something that I want to focus on, then I’m not going to spend a whole bunch of time thinking about it. If it is something I’m interested in, then I’ll focus on it, and if it’s attractive, I’ll actually do it. So not feeling like I come in every day having to make a decision but being focused on waiting for what I think are the right decisions and being confident when you make them. I think that there’s some advantage to dropping your children on their head at an early age because I think that’s what happened to me. Send them into the investment business if that happens. Does one stock kind of stand out in your mind as being your biggest win and your biggest multi-bagger? Your mind is always drawn to most recent stuff, so Sun-Rype was a great win for us. I probably overstayed by a couple of years. I could have sold it earlier. Glacier Ventures is one of the largest publishers of community newspapers. I think we bought our first stock at $0.70 or so. That management group, Sam Grippo and Jon Kennedy, have been wonderful at creating value over the last five years, and the stock’s roughly $4 give or take a little bit. What I found, is when we look at a stock, I’m not looking for a 20 percent discount to what I think it’s worth. I’m kind of thinking if things go right and we wait three or four years or five years can the stock be a double or triple, or quadruple? Thankfully, we’ve had a number of those and that’s helped the performance a lot. You seem to find a lot of stocks that are under $5. It’s quite often not before I buy them. Stock Market Superstars | 27 Indigo Books, what drew you to that? At the time Indigo was a dog with fleas. I go back to my joke earlier about penguins. It’s certainly like that when you go up and you look close at each individual idea. There’s usually some significant part that stinks. What happened in Indigo was that they bought Chapters, and the stock essentially had collapsed. Heather Reisman was involved. Yeah. Heather Reisman had formed Indigo, but she was the person behind the merger with Chapters, because Chapters had gotten into some difficulty. They were doing a rights issue. I just was scrolling through the paper, and I saw, “Oh, Indigo is doing a rights issue.” As I said before, I try and look for situations where there’s an event going on. Following that up, I noticed that the rights issue was backed by Gerry Schwartz. Now he is Heather’s husband, but he’s also one of the most successful businessmen we have in Canada. I have a partner as well, but I know she’s not going to put money into something that I’m doing, into my fund if she thought it was a losing proposition. I think Gerry approached life the same way. What you had there was essentially insider buying, so that got my interest. I got the documents and said, “Well, what’s interesting about Indigo?” First, they have an important presence in Canada. It would be very hard to come in and compete against them. Chapters and Indigo are a large, large network of stores, both in the malls and the superstores, so they have a competitive position. Whether it’s worth a lot of money or a little bit of money, it’s there. The second thing is the book business is extremely cash generative compared to a lot of retail. The furniture and fixtures are not as significant as you’d expect, so there’s actually a fairly high return on invested capital. The business is seasonal. Thirdly, their margins were significantly below similar companies elsewhere in the world. That was basically the four key things. Gerry was putting in money to backstop it, they had an important presence in the industry, they could produce free cash flow, and there was the opportunity for margin expansion. Then from there, I talked to the company—I tried to figure out what might happen over time, and they worked out okay. You bought it at $4.50? Yeah, something like that. It got as high as $18 and it is now about $12. Having a stock go from $4 to—let’s average those two and say $15 or $16— that’s quite helpful to performance. 28 | Tim McElvaine When you take a stock on, is it always less than 10 percent of the portfolio at cost? Yeah, it’s like say 5 to 10 percent. In the case of Indigo Books, I think it was like a 7 or 8 percent position, or something like that. If it doubles, it’s extremely accretive to performance; if it doesn’t, that’s where it’s painful. That’s why I try and only invest in stuff I feel confident in, because when you have a 5 percent position in the portfolio or a 7 percent position in the portfolio, you hate to make a mistake on the easy stuff. There’s always going to be stuff out of the blue that hits you, but you hate to make a basic unforced error, as Warren Buffett would call it, on the analysis. There’s a difference between patience and delusion. The important thing for me in Indigo was hearing that management thought margins could expand and seeing some progress towards expanding margins. If that didn’t happen, then you have to get out of the position because it’s not becoming what you thought it would. I think that’s important to understand. You have to be patient for stuff to happen, but you also have to be realistic where you think they’re going and test the company against that. How much money do you manage now? About $160 million give or take a little bit. I enjoy my goal in this business: to make my partners a respectable return and enjoy the relationships with them and have fun. Although I’m an accountant, so it’s not the same as a growth guy, as I said before. My objective isn’t to have a $10 billion fund. My objective is not to have a family of funds. My objective is over time to compound at a respectable amount of money. I have all my money in the funds, so I can look people in the eye and say, “I’m in the same boat as you.” How many investors do you have approximately? Probably about 500, give or take a little bit. Stock Market Superstars | 29 I think you try to treat them, like you said, as partners. You did something a few years ago where you got their pictures? Yeah, what I said to people was, “Why don’t you send us your picture— you doing something fun, not your passport photo. With 500 people, it’s unrealistic to know all of them. The people broke into three categories: those who just didn’t respond, those who sent pictures of themselves doing fun things, and those who just thought I was some psychopath wacko who wanted a picture of them to post on my bathroom wall. Didn’t they get bonus points if they were holding products? Yeah, if they sent a picture holding a product of a company we owned in the portfolio. Now at the time, we had Loewen bonds, which was a funeral home, so I wasn’t really looking for someone sending that along. We had Molson too, so if they sent a picture, drinking Molson or eating Humpty Dumpty chips or Sun-Rype, that was fine. As I said, not an insignificant number of people thought I was some type of warped psycho. We haven’t done that recently. What’s your biggest mistake? Is there something that stands out that you just wish you hadn’t have done? I make a fair number of them. The one that I make consistently is buying too big a position too quickly. Every time I do that, I vow next time I won’t, and then I do it again. That’s always one of those kind of “I should have known better” things. It doesn’t mean that I think I was wrong with the initial position. It was just I went in too early, thinking this time it won’t go down by a third or half or more, and then they always do. So one of these days I’ll figure that out, but I haven’t yet. What did you learn from your biggest mistake? Well, I was hoping to learn. 30 | Tim McElvaine You haven’t learned it yet, but you’re still working on it? [Laughs] I think that’s getting into my brain. The other thing is, if I kind of look back over the ten years, it always takes a little bit longer than you think in a value stock. You get in there and you think that it’s a two-year turnaround, and it ends up being a three- or four-year turnaround. Sometimes it can take more money that you think, but sometimes it goes up more than you think. I never once thought that Indigo would ever see $18 when we bought it. The second thing is being invested with good people has always made a difference to me. I’ve been fortunate enough to understand the incentives or where people are coming from. I’m talking about primarily the board here. That’s bailed me out of many a difficult situation. I think more about that now than I perhaps did when I first started in the business in ‘91. Management is the key? Not so much management; it’s having directors. I’ve seen companies with the largest compliance manuals on earth, but I’d rather take a director with common sense and $200,000 worth of stock over the best compliance follower in the world. I think having some skin in the game makes a real difference at the board level because the board then sets the goalposts for management. I think sometimes you have warning labels on your reports. What are those all about? You always say, “What I did yesterday doesn’t mean that I can do it again tomorrow,” so that’s a big thing in the investment business. Conversely, I would say that if you invest with someone, whether it’s Eric Sprott or Warren Buffett or George Soros or whomever, the first thing you want to do is understand how they invest and whether or not you’re comfortable with it. Then, from time to time, check and make sure they’re still investing the same way they said they would invest. People are going to have good times and they’re going to have bad times, but I think the best investors have been ones who are disciplined and consistent in their approach. I think that’s why a lot of these guys that I’ve interviewed for the book work for themselves, because they can be free thinkers. You can afford to think outside the box when you work for yourself. What you do is you get people who come in and say, “You shouldn’t own this, you shouldn’t own that, you shouldn’t own this,” so you end up succumbing to the pressure from others. With your own business, you answer to your investors, of course, but also to yourself at the end of the day. A lot of my investors are friends or family or people I can put a face to, which means I do feel quite a responsibility to them with every decision I make. My reputation is really all I have, so without a doubt I can make mistakes, but I’m not going to do anything that disadvantages my investors. Stock Market Superstars | 31 32 | Tim McElvaine 1. 2. 3. 4. 5. The McElvaine Investment Trust (“The Trust”) Highly satisfactory longer-term performance can be achieved by focusing on companies selling below net asset value. Given the size of the Canadian market, a small investment fund has a significant competitive advantage. The purpose of an investment vehicle is to make money, not to own stocks. This is an important distinction because it means the Trust will only invest when presented with an attractive situation. As there are few good ideas, there are times when concentration may be helpful. An incentive fee structure rewards performance, not asset growth. STOCK MARKET SUPERSTARS In these absorbing interviews with twelve of the greatest money managers in Canada, Bob Thompson explores the mechanics and psychology behind the key characteristics that IRWIN MICHAEL make these managers great. How do the country’s top stock pickers make millions of dollars in the markets? That’s the quesALLAN JACOBS tion Thompson answers in interviews with these money-making superstars. This book highlights the common traits of some of ROHIT SEHGAL the best money managers in the country. It will help average investors increase their skills by having the money managers, in ERIC SPROTT their own words, explain how their strategies, styles, and success have developed over the years. In this entertaining book, investors will see the insights, personalities, foibles, outlooks, TIM MCELVAINE and misgivings of some of the brightest minds in the investment world here in Canada. It will help make investors aware of their WAYNE DEANS own strengths and weaknesses. Learn what it takes to be a great investor! FRANK MERSCH At Canaccord Capital, Bob Thompson holds the title of Associate Portfolio Manager and Alternative Investment StratePETER PUCCETTI gist, and manages discretionary portfolios on behalf of clients of Canaccord Capital. Thompson is a regularly featured finanNORMAND LAMARCHE cial columnist in the National Post, writing specifically on alternative investments. He is a recognized authority on RANDALL ABRAMSON alternative investing in Canada, and maintains a select clientele of high-net-worth investors and institutions. Thompson is a frequent guest on the Business News NetJOHN THIESSEN work and has written and advised on articles for the Globe and Mail, Canadian Business, Investor’s Digest, Canadian Hedgewatch, Benefits Canada, and others. He is a popular guest speaker at international investment conferences on portfolio strategy, and in particular, alternative investments. For additional information about the managers in this book and a unique portfolio managed by Bob Thompson comprising the strategies of many of Canada’s top stock pickers, please visit: www.stockmarketsuperstars.com TOM STANLEY by Bob Thompson INSOMNIAC PRESS 

Second Quarter Review | July 20, 2009 Despite maintaining a cautious view as evidenced by our cash position and well-hedged portfolio, we are pleased to report a Q2 return of 8.55%. Our top performers for the quarter were our auto finance bank debt positions – specifically Chrysler Financial, Ford Motor Credit, and GMAC. These credits were the most compelling corporate distressed opportunities we have seen so far in this cycle. The market was pricing in losses in each company’s retail and wholesale loan portfolios well in excess of our most bearish scenarios. Despite retail losses running between 2% - 4% and dealer losses being negligible, market prices appeared to be discounting losses of 25% - 50% depending on the specific security. Each of these companies faced distinct challenges and was tethered to automotive companies of varying health. These positions were all profitable during the quarter despite the bankruptcy filings of both Chrysler Automotive and General Motors. A critical component of Chrysler’s bankruptcy plan involved GMAC taking the place of Chrysler Financial to provide financing for new Chrysler vehicles. In essence, Chrysler Automotive will continue manufacturing vehicles with retail customers and dealers financed by GMAC – thereby leaving Chrysler Financial in run-off mode. Despite the disruptions at Chrysler Automotive, Chrysler Financial’s results have remained solid with losses remaining low while the company generates significant cash flow as the portfolio quickly shrinks. We still have a large position in Chrysler Financial first and second lien bank debt, and despite significant price appreciation, we believe that the market continues to underestimate yields by not fully pricing in how quickly par recoveries may be achieved. An investment in Rite Aid bonds was also profitable during the quarter. Rite Aid is the third largest drugstore chain in the country, which, a few years ago purchased the U.S. operations of Jean Coutu, a Canadian pharmacy chain. The significant challenges of integrating a large acquisition made with considerable leverage at a time when the economy was in freefall created a near perfect storm and the entire capital structure sold off significantly. Last fall new management was brought in to oversee this integration and improve operating performance. Since their arrival, cash management has strengthened, expenses are decreasing, margins are improving, and the acquired stores are performing better. Rite Aid has also refinanced its balance sheet which has served to push the next maturity out for several years giving them adequate time to fix the business operations. These bonds traded up significantly and we have reduced our position. During Q2, we built a position in E*Trade bonds. E*Trade operates 2 primary businesses, an online brokerage and a bank. While the brokerage side of the company was performing well, E*Trade Bank was struggling to remain well-capitalized due to its mortgage portfolio. Despite this concern, we found the bonds attractive for several reasons. First, we believed the size of the bank’s capital hole to be manageable and small relative to the Company’s true enterprise value. Second, all parties involved including management, the financial sponsor, bondholders and most importantly its primary regulator were incentivized to ensure the Company remained a going concern. Third, we did not believe E*Trade had an imminent liquidity situation, especially as its brokerage business continued to thrive. Finally, we found the event-driven nature of the situation with an identifiable, near-term positive catalyst very attractive. On June 17th, E*Trade announced a capital plan that included a large debt-for-equity exchange and equity offering to satisfy regulators and solidify its capital base at both E*Trade Bank and the parent, driving bond prices across the capital structure significantly higher. Consequently, we sold our bonds that will not be exchangeable into equity. We also participated in the Debtor-In-Possession (DIP) financing for General Growth Properties (GGP) and made profitable investments in several parts of the capital structure. GGP filed for bankruptcy with an agreement to receive DIP financing from its largest shareholder on what can only be described as egregious terms. The Company and their advisors reportedly had difficulty finding more attractive DIP terms. However, public disclosure of the original DIP proposal resulted in a two week competitive bidding process. In the end our group prevailed with a creative structure that provides us significant coverage, a good base case rate of return, and some interesting optionality. After the bankruptcy filing, we invested in bonds and bank debt of various GGP entities. During the quarter the entire capital structure traded up significantly and we reduced some exposure. The fund begins Q3 with a 10% exposure to Residential Mortgage Backed Securities (RMBS). This portfolio was also profitable for the quarter. We added to our mortgage position in March and through April. The prices of RMBS securities have risen substantially to levels where we are no longer adding aggressively but continue to maintain our position. We believe that despite tepid signs of stabilization, the housing and mortgage markets remain under significant stress and we expect there to be continued attractive opportunities in the space. However, we were positively surprised by the amount of principal repayments in our portfolio. Additionally, as the commercial real estate and consumer sectors continue to deteriorate, we have been preparing ourselves to take advantage of what are likely to be very attractive distressed opportunities in those structured credit markets. Our sovereign CDS position was the biggest detractor for the quarter on a mark to market basis. Notwithstanding the IMF and EU bailouts of the Baltics, spreads tightened throughout Q2. We expect the credit profile of European sovereign governments to continue to deteriorate and accordingly we feel that owning protection at current levels offers a compelling risk/reward opportunity. We still believe this credit cycle will take several years to resolve. First, we expect that commercial real estate is still in the very early stages of a prolonged downturn. The performance of most property types continues to be stressed. As debt on properties matures, we expect that repayment will be unlikely in many cases. Therefore, debt will need to be rescheduled or restructured. The size of this opportunity is very large and we believe that our capital will potentially be able to generate excellent returns in this space. Second, corporate debt maturities will be very heavy in the next three years. Similarly, some percentage of this debt will not be repaid and will need to be restructured. We are already observing higher default rates in Q2. Several large companies such as Extended Stay, Six Flags, General Motors, and General Growth Properties recently filed for bankruptcy and we anticipate this trend will continue. We increased our equities exposure slightly in Q2 by adding selectively to positions such as Dell and Humana. At its lows in March, Dell was an $8 stock with roughly $4 in net cash per share. Based upon an aggressive cost-cutting program, we believed that the worst case EPS for 2009 would be higher than $1 which provided us with a large margin of safety on the investment. Our enthusiasm for the name was bolstered by the potential for a corporate hardware upgrade cycle with the launch of Microsoft’s new operating system this fall. Dell reported a strong first quarter and the stock traded up in June as the magnitude of the costcutting activities became evident to the street. We also believe that our positions in the managed care sector represent compelling opportunities given the fears surrounding the new administration's potential healthcare reform policies. In our opinion the healthcare insurers will be key participants in the reform, and while these companies will clearly be impacted, the situation will not be nearly as dire as their stock prices reflected in March. The reinsurance sector also remains a significant part of the equity book. At the start of Q2, reinsurers were, on average, trading at a greater than 15% discount to Q1 book value. With average leverage of approximately 3x and significantly more conservative investment portfolios than other financial stocks, this discount seems unwarranted. Additionally, given the stresses on insurance industry balance sheets in 2008, as well as the inability to access capital markets, prices for hurricane protection have increased materially this year. In light of this, we helped capitalize a reinsurance sidecar this quarter, covering Florida wind exposure. We continue to run a well hedged portfolio in Asia. We grew our allocation to Tier 1 and Tier 2 hybrid bank paper of a small group of Asian and Australian banks during the first two months of the quarter and these positions contributed meaningful profits. We also benefited from our exposure to leveraged loans in the region and participated in a few recapitalization transactions in Australia that performed well. Although we decreased our credit exposure during the last few weeks of the quarter, we are hopeful that we will get another opportunity during the second half of the year as foreign banks, particularly in Australia, will be focused on reducing their exposure to highly levered entities. Several years ago we made the decision to empower a number of portfolio managers – primarily in the equity area – to allocate silos of capital to distinct industries subject to specific risk controls. This approach had some success at the outset but never fully met our expectations – both in terms of performance and the organization. In the summer of 2007 we decided to downsize our equity business and further build up our credit group. Our goal was to restructure the investment process to reflect a single pool of opportunistic capital without any specified industry or strategy constraints. As a result of the changes that took place, we believe our investment process is currently operating at a significantly higher level than it has over the past several years and that 2009 year-to-date performance reflects our improved agility. Our longevity and successful 21 year track record reflects our institutional approach to management and diligent investment process. For the majority of our history, we have managed money as a single pool of capital with dollars flowing to the best ideas with a focus on event-driven equity and credit situations. During the last credit cycle, our ability to deploy significant amounts of capital in a timely manner while conducting rigorous due diligence resulted in some excellent investment opportunities. Similarly, we anticipate an increase in the number of businesses experiencing financial stress, and we are poised to act as an alternative provider of capital for these companies by participating in DIPS and other rescue financings. The team remains committed to pursuing investment management with rigor and discipline. The primary goal of the Firm continues to be producing uncorrelated returns across different securities, industries, and geographies. As always, your thoughts and comments are welcome. Please feel free to contact Jamie Parrot at (212) 583-4088/ jparrot@perrycap.com or Harlan Saroken at (212) 583-4059/ hsaroken@perrycap.com to further discuss any of these developments. Past performance is not a guarantee of future results. There can be no assurance that these or comparable returns will be achieved by Perry Partners’ investments, either individually or in the aggregate. All returns shown above reflect the reinvestment of dividends and interest and the deduction of all fees and expenses. Although we believe that the performance goals set out in this letter are realistic, it is possible that they will not be achieved and that you could even lose a substantial portion of your investment. The information contained in this letter represents neither an offer to sell nor a solicitation of an offer to buy any securities. Securities in this fund will only be offered through a current offering memorandum and appropriate subscription documents. Copies of the offering memorandum may be obtained from Jamie Parrot (jparrot@perrycap.com) or Harlan Saroken (hsaroken@perrycap.com) in our New York office and will be made available upon request. Offers will not be made in any jurisdiction in which the making of an offer or the acceptance thereof would not be in compliance with the laws of such jurisdiction. Investors should read the Confidential Private Offering Memorandum carefully, especially the “Risk Factors” section, before making a decision to invest in Perry Partners. Additional information is available through our password protected website (www.perrycap.com). June 30, 2009 Estimate Exposure Report Non-Side Pocket Composite MTD Performance QTD Performance YTD Performance Performance Attribution by Strategy Equities North America Latin America / Other Europe Asia North America Latin America / Other Europe Asia North America Latin America / Other Europe Asia North America Latin America / Other Europe Asia 1.53% EST 9.61% EST 9.51% EST Total Fund Composite 1.25% EST 8.55% EST 7.71% EST MTD 0.32% 0.01% 0.02% 0.05% 0.40% 0.82% 0.01% 0.01% 0.16% 1.00% 0.09% -0.04% -0.30% 0.02% -0.23% 0.22% 0.00% -0.07% 0.09% 0.24% -0.06% -0.10% 1.25% S&P 500 (Total Return) 0.20% 15.93% 3.16% QTD 0.57% -0.10% 0.02% -0.24% 0.25% 10.35% 0.03% 0.13% 0.44% 10.95% 0.08% -0.09% -2.09% -0.31% -2.41% 0.41% 0.00% -0.06% 0.15% 0.50% -0.02% -0.72% 8.55% Barclays HY Credit Index 2.86% 23.07% 30.43% YTD -0.43% -0.09% 0.07% -0.33% -0.78% 11.07% 0.03% 0.13% 0.50% 11.73% -0.25% -0.09% -1.99% -0.28% -2.61% -0.08% -0.13% -0.01% 0.11% -0.11% -0.22% -0.30% 7.71% Credit Credit Derivatives Private/Real Estate Legacy Sidepocket Global Macro Total Performance Attribution Performance attribution relates to the total fund composite return Portfolio Exposure by Strategy (as a % of Capital) Equities North America Latin America / Other Europe Asia North America Latin America / Other Europe Asia North America Latin America / Other Europe Asia North America Latin America / Other Europe Asia Long 18% 0% 0% 3% 21% 35% 0% 1% 4% 40% 1% 0% 1% 0% 2% ** 8% 1% 2% 1% 12% 5% 0% 80% $1,533 EST $6,648 EST 18.24% -28.47% Short -11% 0% 0% -3% -14% -1% 0% 0% 0% -1% -2% 0% -55% -7% -64% ** -1% 0% 0% 0% -1% 0% 0% -80% Number of Strategies* 20 0 2 8 30 27 1 2 4 34 4 1 4 5 14 12 2 2 2 18 Credit Credit Derivatives Private/Real Estate Legacy Sidepocket Global Macro*** Total Portfolio Exposure**** Fund Capital (in millions) Firmwide Capital (in millions) Top Exposure Top 5 Long Positions (as a % of Capital) Top 5 Short Positions (as a % of Capital) 2 98 The fund maintains a 11% position in Treasury money market funds which it considers to be cash & cash equivalents and are therefore excluded from the above analysis. For purposes of this report, long equity options are valued off of premium, short equity options at delta adjusted notional value and option combinations, where the exposure is limited to the difference in strike prices, are adjusted to reflect the net delta exposure. * The strategy count includes only those strategies that are at least 15 basis points of the portfolio. ** Please note this is a non risk-adjusted notionalized number which costs the fund approximately $10 million annually to maintain. In addition, this report does not reflect the market value of those positions in which the firm is both the buyer and seller of protection on the same reference obligation even if such positions are held at different counterparties. *** Includes net option premiums at risk on currency hedges for the following currencies: Swiss Franc, Korean Won, Japanese Yen, and Taiwanese Dollar. The net delta adjusted short currency position represents a notional 3% of capital. **** In addition to the above, the firm hedges exposures to certain macro-economic related risks. These include, but may not be limited to, fixed income products and currencies. These positions augment our portfolio hedges and add diversification benefits to the overall firm. 

View the full PDLI chart at Wikinvest

View the full SWIR chart at Wikinvest

DOWNSIDE PROTECTION REPORT With Edited by the Research Team of “Confronted with the challenge to distill the secret of sound investment into three words, we venture the motto: Margin of Safety.” —Ben Graham  August 30, 2009 Dear Fellow Idea Seekers, So far we have focused on finding good stocks to buy and bringing them to you on t hese p ages. We h ave a ssembled a por tfolio o f i deas t hat has t rounced t he broader m arket ( see s corecard o n p age 8 ). A s o ur f eatured i deas h opefully make money for you, the question of when to sell becomes increasingly important. Knowing when to sell a stock that has outperformed is no small task. The danger is dual: We can either sell too early, foregoing future gains; or we can sell too late, giving back the gains we have enjoyed on paper. There are additional wrinkles that complicate the decision to sell, including taxes and broader portfolio considerations. Selling t oo ear ly is a co mmon “m istake” o f value i nvestors. W hile we make money o n undervalued stocks t hat b ecome l ess undervalued, w e also f requently “leave money o n t he t able.” Avoiding t his p redicament i s d ifficult, perhaps e ven impossible — for i t’s t he same value-driven m indset that ge ts us t o buy an undervalued company and to sell it when it trades closer to fair value. If we could hold onto a stock as it rises in price from fairly valued to overvalued, we might lack the mindset that allows us to buy the same stock at a bargain price in the first place. Selling too late is rarer among value investors, but the danger exists nonetheless. We have a t endency t o ha ng onto s omething t hat’s b een g ood t o us — a winning stock falls into this category. We may become emotionally attached or view a stock as our idea. The pain of selling and then seeing someone make more money from our idea might be too much to bear, influencing us to hold onto a company too long. There’s also the danger of keeping losers around merely because we want to break even. Facts, rather than “mental accounting,” should dictate the timing of a sale. This brings us to two companies that we’re putting on the sell list this month — PDL BioPharma (PDLI) and Sierra Wireless (SWIR). Whether or not to sell is a “good p roblem” i n each cas e, as P DLI s hares h ave g ained 1 5% s ince we f eatured them in our July 13th issue, while SWIR has gained 192% since March 23rd. In the case o f P DLI, while o ur a nalysis r emains intact, o ne o f t he ke y va lidations o f o ur work is no longer in place: Seth Klarman’s i nvestment. W hen a superinvestor like Seth Klarman of The Baupost Group sells a company we own, the question must be, “How confident are w e t hat w e either know more t han K larman, o r t hat o ur judgment is superior to his, or that he was selling for non-fundamental reasons?” In the case of PDLI, prudence requires us to take our gain and move on. In the case of Sierra W ireless, we have o bviously en joyed a s trong gain in a s hort ti me, and we hope you have as well. We simply cannot make a no-brainer valuation-driven case for Sierra any longer, even as the company has many other things going for it. Finally, just as with buying a stock, the decision to sell must be driven by your own p articular circumstances. T here may b e tax o r o ther c onsiderations that make holding onto a stock the correct decision, even if the valuation gap has narrowed. Sincerely, John Mihaljevic, CFA Managing Editor, The Manual of Ideas john@manualofideas.com Stocks We’re Buying This Month (Nasdaq: (Nasdaq: ……………… p. 2 ………………… p. 4 Also Inside Downside Protection Screens Top 10 companies trading below net cash ……… p. 6 trading below tangible book … p. 7 buying back their own stock … p. 7 See how we’re doing …………… p. 8 Scorecard About Downside Protection Report Our mission is to uncover stocks with a large margin of safety and bring them to you once a month. John Mihaljevic, editor, is a fund manager, former banker and analyst. He is a member of Value Investors Club, an exclusive community of top money managers, and has won the Club’s prize for best investment idea. John is a trained capital allocator, having studied under Yale chief investment officer David Swensen and served as research assistant to Nobel laureate James Tobin. John holds a BA in Economics, summa cum laude, from Yale and is a CFA charterholder. He resides in New York City with his wife and two kids. Stock Market Cheapness Snapshot % of U.S. stocks All MV> trading for less than… stocks $1bn …net net current assets 3% 0% …net cash 4% 1% …tangible book value 20% 6% …5x trailing EPS 3% 1% Data as of August 28, 2009. DOWNSIDE PROTECTION REPORT is published monthly by BeyondProxy LLC, P.O. Box 1375, New York, NY 10150. Website: www.manualofideas.com. Email: support@manualofideas.com. Please email or call if you have any subscription questions. Managing Editor: John Mihaljevic. Subscription $149 per year. © Copyright 2009 by BeyondProxy LLC. All rights reserved. Photocopying, reproduction, quotation, or redistribution of any kind is strictly prohibited without written permission from the publisher. This newsletter bases recommendations and forecasts on techniques and sources believed to be reliable in the past and cannot guarantee future accuracy and results. BeyondProxy’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. John Mihaljevic, Chairman of BeyondProxy, is also a principal of Mihaljevic Capital Management LLC (“MCM”), which serves as the general partner of a private investment partnership. MCM may purchase or sell securities and financial instruments discussed in this newsletter on behalf of the investment partnership or other accounts it manages. It is the policy of MCM and all Related Persons to allow a full trading day to elapse after the publication of this newsletter before purchases or sales of any securities or financial instruments discussed herein are made. Use of this newsletter and its content is governed by the Terms of Use described in detail at www.manualofideas.com/terms.html. SCORECARD Performance of Past Monthly Picks versus S&P 500 * On this page, we provide a quick update on past featured investments and let you know if it’s time to sell. (sorted by date of initial write-up) Featured Price Greenlight Capital Re / GLRE HOLD Valuation gap has narrowed, but we continue to like David Einhorn's investment strategy and portfolio. EchoStar / SATS HOLD Tivo litigation increases downside risk, but shares remain cheap. Microsoft / MSFT BUY Trades at discount to sum-of-parts valuation of business units. Capital Southwest / CSWC BUY Trades at wide discount to estimated fair value of investment portfolio. K-Swiss / KSWS BUY Trades close to tangible book value, despite good normalized economics and excellent management. Harvest Natural Resources / HNR BUY Shares trade at material discount to estimated fair value. Gravity Co. / GRVY BUY Shares trade below net cash despite major profitability inflection point. MI Developments / MIM BUY Shares trade at steep discount to fair value of real estate holdings. WellCare Health Plans / WCG BUY Shares trade close to net cash despite profitable operations. Kenneth Cole Productions / KCP BUY Shares trade at discount to estimated fair value. KHD Humboldt Wedag / KHD BUY Shares trade close to adjusted net cash; business is nearly “free.” Contango Oil & Gas / MCF BUY Trades at big discount to PV-10 valuation using NYMEX strip pricing. Closed Out Positions: Featured Price Date Crawford (CRD-A, CRD-B) (pair trade) Sierra Wireless (SWIR) SELL Gap to fair value has narrowed materially, adversely affecting the riskreward tradeoff of holding the shares. PDL BioPharma (PDLI) SELL Klarman’s sale makes us more cautious on the outlook for royalties and legal challenges to PDLI’s patents. $2.89** 2/9/09 Closed Out Price Date $1.02** 6/28/09 Price Change Absolute Annualized +65% +271% S&P 500 Change Abs. Ann. +6% +15% $10.85 Date 12/5/08 Latest Price as of 8/28/09 $18.37 Price Change +69.3% S&P 500 Change +17.6% $14.84 $19.71 $87.69 1/16/09 1/16/09 2/9/09 $19.27 $24.68 $77.53 +29.9% +25.2% -11.6% +21.5% +21.5% +18.9% $7.80 3/20/09 $9.97 +27.8% +34.8% $3.51 $0.95 $8.64 $19.04 $7.00 $8.28 $40.80 4/14/09 4/14/09 5/21/09 5/21/09 6/26/09 6/26/09 7/13/09 $5.24 $1.70 $13.66 $25.09 $10.02 $9.78 $45.48 +49.3% +78.9% +58.1% +31.8% +43.1% +18.1% +11.5% +22.6% +22.6% +15.9% +15.9% +12.6% +12.6% +14.7% $2.89 3/20/09 $8.45 8/28/09 +192% +1,039% +35% +97% $7.88 7/13/09 $9.06 8/28/09 +15% +203% +15% +198% * We measure the performance of the S&P 500 Index by the price changes of the S&P Depositary Receipts (SPY), which is an investable vehicle for the S&P 500. ** Represents spread rather than market price. Percentage return represents percentage narrowing of arbitrage spread. DOWNSIDE PROTECTION REPORT — August 30, 2009 Edited by the Research Team of The Manual of Ideas www.manualofideas.com 8 FREQUENTLY ASKED QUESTIONS Some of your top picks fell sharply in price before you picked them. How can you assert that a stock that has fallen precipitously has strong downside protection? Our assessment is based on protecting your capital from this point forward. It is quite unlikely that we would have recommended the same stock a year ago, as it may not have passed our stringent downside protection criteria. At higher prices, the shares most likely did not offer the “margin of safety” they provide today. The price decline has lowered investment risk rather than increased it. Are you saying that the stock price will not decline from this point forward? No. While we expect the stock to exhibit below-average downside, almost anything is possible in the stock market in the short term. As a result, you should never lever up to buy a stock, even if we judge it to have strong downside protection. We use the latter term to refer primarily to the risk that your capital will be permanently impaired. While our analysis gives us high conviction that you will not suffer permanent loss, our judgment will not always be correct. What criteria do you use to determine that a stock has “superior downside protection”? First and foremost, we want the stock to trade at a large discount to our appraisal of fair value. Such appraisal can be based either on the value of the company’s assets, including cash and real estate, or on the present value of estimated future cash flows, or both. Each situation is different—how we arrive at an estimate of fair value will reflect the peculiarities of each situation. Once we estimate fair value, we ask a number of questions that help us build conviction that current value will be safeguarded and, in fact, increased over time. For example, we want management that is capable, properly incentivized and likely to treat fellow shareholders fairly. We also favor companies that have authorized a plan to repurchase their own shares when they are available at a discount to fair value. Repurchases not only provide short-term support for the stock price but, more importantly, boost per-share intrinsic value and signal management’s willingness to return cash to shareholders. Finally, we want companies with strong and liquid balance sheets, enabling their executives to steer through—and take advantage of—difficult economic conditions. You include some stock screens in this report. Are you saying that the companies passing those screens are also good investment opportunities? Not necessarily. We provide three downside protection stock screens in order to identify companies that may represent good investments. We provide the screen results as a starting point from which you may do more research into specific companies. What are the other benefits of subscription in addition to receiving this report? As a subscriber, you have access to the members-only section of manualofideas.com. The section includes an archive of past reports and access to other subscriber-only content. WE’VE BEEN CALLED MANY THINGS. BUT WE’RE NOT COMPLAINING. “INVALUABLE.” “IMPRESSIVE.” “INCREDIBLE.” “TREASURE TROVE.” “WINNER.” “The Manual of Ideas is a tremendous effort and very well put together.” —MOHNISH PABRAI, MANAGING PARTNER, PABRAI INVESTMENT FUNDS “Invaluable tool for the serious investor.” —TIM DAVIS, MANAGING DIRECTOR, BLUESTEM ASSET MANAGEMENT “We do similar work ourselves.” —GLENN GREENBERG, MANAGING DIRECTOR, CHIEFTAIN CAPITAL MGMT “Outstanding.” —JONATHAN HELLER, EDITOR, CHEAP STOCKS “The best institutional-quality equity research to come along in a long time.” —PAVEL SAVOR, ASSISTANT PROFESSOR OF FINANCE, THE WHARTON SCHOOL “One of my must-read sources.” —CORY JANSSEN, FOUNDER, INVESTOPEDIA.COM “Wonderful.” —TOM GAYNER, CHIEF INVESTMENT OFFICER, MARKEL CORPORATION FIND OUT WHAT THE BUZZ IS ABOUT. WWW.MANUALOFIDEAS.COM 

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11 LP August 2009 J MARKETS AT A GLANCE Eric Sprott David Franklin Beyond the Stimulus Are you stimulated yet? We hope you are, because we’ve just witnessed the largest economic stimulus in the history of the world. Never before have so many government dollars been thrown at the economy to prevent a depression. When added together, the combined financial, monetary and fiscal stimuli in the US are more than the cost of the two World Wars and “The New Deal” combined.1 Stimulus spending worldwide has taken the form of a combination of tax cuts, transfer payments (free money) and infrastructure investments on roads, schools, railroads etc. In the US, the financial and stimulus contributions have been especially impressive in scale. According to CNN’s bailout tracker, the various US government departments have committed to stimuli worth $11 trillion dollars and have issued cheques totaling $2.8 trillion dollars thus far in 2009.2 Neil Barofsky, the Special Investigator General for the TARP program, has estimated that the total cost to the US taxpayer could be as high as $23 trillion.3 The vast majority of this stimulus has been directed at the financial sector - a complete waste of money in our opinion, supporting a segment of the economy that never deserved to be bailed out. Nonetheless, the US taxpayer has spent massive sums, committed to promises worth even more and may ultimately owe debt in the double-digit trillions when all is said and done. Nice of them to spend so generously, wouldn’t you say? Although the stimulus has been fantastic for the stock market, it has generated very little benefit for “Main Street”. To make matters worse, the effects of the stimulus packages have already started to wear off. To explain why, we must mention the American Recovery and Reinvestment Act of 2009 (ARRA), which was specifically directed at stimulating the real economy as opposed to “saving Wall Street”. ARRA calls for a total spend of $787 billion, which breaks down into $287B in tax breaks, $192B in direct aid and $308B in discretionary spending. According to Christina Romer, a White House economic advisor, 70% of this stimulus will be spent by the end of September 2010. CHART A The Moment of Truth for Stimulus Contribution to real GDP growth 4% 3% 2% 1% 0% Q1 09 -1% Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10 Sprott Asset Management LP Source: Moody's Economy.com, Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com What impact will this stimulus have on the economy? Chart A presents results from Moody’s that is representative of several private forecasts that we have reviewed.4 The chart Inflation adjusted in 2008 dollars; the cost of World War I is $312 billion, World War II is $3.6 trillion, “The New Deal” which was legislation to aid the US during the Depression is $500 billion. These and other costs can be found at: http://www.ritholtz.com/blog/2008/11/big-bailouts-bigger-bucks/ 2 CNNMoney.com's bailout tracker. Retrieved on August 16, 2009 from: http://money.cnn.com/news/storysupplement/economy/bailouttracker 3 Kopecki, Dawn and Dodge, Catherine (July 20, 2009). U.S. Rescue May Reach $23.7 Trillion, Barofsky Says. Retrieved on August 16, 2009 from: http://www.bloomberg.com/apps/news?pid=20601087&sid=aY0tX8UysIaM 4 Zandi, Mark (June 22, 2009). U.S. Fiscal Stimulus Revisited. Retrieved on August 16, 2009 from: http://www.economy.com/dismal/article_free.asp?cid=116000&src=economy-hp-dismal-article 1 1 illustrates the ARRA’s impact on real GDP by quarter, and reveals that right now, in Q3 2009, the US is experiencing the maximum impact of the Obama stimulus package. That’s right - this is as good as it gets. The majority of the Act consists of tax cuts and transfer payments to citizens, the impact of which was felt within the first two quarters of being received.5 By the end of September 2009 this stimulus will have worn off, and along with it will vanish the greatest marginal impact of the entire stimulus package itself. According to economic forecasters like Moody’s, by 2010 the net impact of the stimulus package to real GDP will be barely over 1%. This is not good news for “Main Street”, especially considering the dramatic increase in unemployment that we’ve witnessed recently. If the effects of stimulus wear off as quickly as they were injected, we could be in for a very difficult Fall (no pun intended). To make matters worse, this scenario is not limited to the US alone - it could potentially impact any of the other large economic powers who have instituted their own massive stimulus packages, most notably China, resulting in a simultaneous global economic decline that would make 2008 look pleasant in comparison. China deserves special mention here, because on a percentage of GDP basis, they are far and away the greatest stimulator of all. While the US has made significant commitments, their $2.8 trillion capital deployment to date only represents a mere 20% of their 2008 GDP. Chinese government spending (combined with Chinese bank lending), on the other hand, is completely unprecedented in the history of banking, and far outweighs the US stimulus in scale and scope. The Chinese have deployed 4 trillion yuan in stimulus spending through to 2010.6 In concert with this stimulus, the Chinese central bank has scrapped its national lending quotas in order to jump start their economic engine. In the first half of 2009, Chinese bank lending hit a record high of 7.37 trillion yuan.7 Assuming their stimulus package is evenly split between 2009 and 2010, it equates to 8.37 trillion yuan of fiscal spending and lending by Chinese banks. For perspective, the Chinese economy generated 13 trillion yuan in the first half of 2008.8 So in effect, the Chinese have injected a stimulus equivalent to 64% of their first half 2008 GDP in the first half of 2009. Please understand us when we tell you that this is unprecedented. The Chinese government has effectively spent and lent enough in six months to buy 122 Ford Class aircraft carriers at US$8.1 billion a piece. It is akin to the US government injecting (and US banks lending) almost $4.5 trillion USD to its citizens and businesses before July 2009…an ungodly sum that would impact every asset class under the sun. Is it any wonder then that the Shanghai stock exchange has more than doubled from trough to peak since its November lows? What is perhaps even more surprising, however, is the fact that the Chinese stimulus has had a seemingly lackluster impact on the Chinese economy. Despite its massive size, the stimulus program has only generated a 7.9% increase in their 2009 GDP. For perspective, this represents a mere 1 trillion yuan return on a 9.37 trillion yuan stimulus - not a good return on investment. So if the money hasn’t generated GDP growth, where did it go? It’s gone everywhere. Their government-induced liquidity flood has “soaked” virtually every speculative asset class in China. Copper, nickel, steel, Chinese equities, Chinese real estate - they’ve all appreciated in spite of the obvious and acknowledged weakness in the global The Congressional Budget Office (CBO) reviewed the impact of the 2001 and 2008 tax rebates under the Bush Administration which would concur with economic model estimates that impact is felt very quickly. This can be found at: http://www.cbo.gov/ftpdocs/96xx/doc9617/06-10-2008Stimulus.pdf 6 (November 11, 2008). World markets buoyed by massive Chinese stimulus plan. Retrieved on August 17, 2009 from: http://news.xinhuanet.com/english/2008-11/11/content_10341108.htm 7 Wang, Aileen (August 11, 2009). INSTANT VIEW 5 - China's July lending and money growth slows. Retrieved on August 17, 2009 from: http://www.forbes.com/feeds/afx/2009/08/11/afx6763394.html 8 (July 17, 2009) China's GDP up 10.4 percent in first half of year. Retrieved on August 17, 2009 from: http://english1.people.com.cn/90001/90776/90884/6452204.html 5 Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 2 economy. It’s been great in the short-term - but this money was LENT OUT remember, and must eventually be paid back. It is not a sustainable long-term growth model, and in the words of Wu Xiaoling, a previous deputy governor of the Chinese central bank, “will sow bad seeds for [China’s] economic adjustment.”9 It is our view that the world’s combined government stimuli have completely distorted the global economy in the short term, and have encouraged a false sense of hope in the stock market. While the market has rallied, the real economy continues to struggle, and is notably worse in many areas. Rates of employment, corporate revenues, US housing prices and retail sales all continue to decline in the face of ‘shock and awe economics’. In our assessment of recent economic data, there are only two possible explanations for the recent market rally. Either investors are discounting an incredible economic recovery that is just around the corner (hard to believe), or the extra liquidity injected into the economy has found its way into the stock market. We’re leaning towards the latter alternative. So what happens next? Will the Keynesian miracle take hold? Will the recovery be strong enough to pay back the increased debt load that was needed to jolt the economy back to life? It seems unlikely. On July 29th two Chinese banks announced that they would limit loans in the second half of 2009. Since the announcement, Chinese stocks have reversed into a considerable down trend. This is reflected in the chart of CSI 300 stock index, which tracks the performance of the largest and most liquid stocks traded on the Shanghai and Shenzhen stock exchanges (see CHART B). Now that the excess stimulus liquidity has been removed, all asset classes that previously benefited will begin to fall. The CSI 300 suggests this process is well underway. CHART B The CSI 300 Stock Index 4000 Chinese Banks Cut Lending 3500 3000 Market Breaks 2500 2000 3/1/2009 6/7/2009 7/5/2009 3/15/2009 3/29/2009 4/12/2009 4/26/2009 5/10/2009 5/24/2009 6/21/2009 7/19/2009 8/2/2009 8/16/2009 8/30/2009 9/13/2009 Source: Bloomberg, Sprott Asset Management LP Sprott Asset Management LP Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com The Federal Reserve has embarked on its own monetary injections, called quantitative easing, by buying $1.745 trillion dollars worth of debt issued by Fannie Mae, Freddie Mac and treasury bills issued by US government. On August 12, 2009 the Federal Reserve provided guidance on their plans to ease the program. Interestingly enough, they extended the completion date from September to October 2009 in order to keep the option of boosting purchases later this Fall. If the Chinese experience is an early lesson, removing the stimulus liquidity from the market could be a dangerous proposition. We have already proven there are not enough buyers of US debt to support the budget deficit this year (please see “The Solution…is the Problem”), and we suspect that much of the US monetary stimulus used to purchase debt issued by Fannie and Freddie has actually made its way into the new US Treasury auctions - thereby supporting the record US budget deficit in 2009. This two step debt monetization process is a complicated topic that we will address in a future MAAG. In the world of government stimulus, the size and speed of the injections are critical to their impact. Once the taps are turned on full bore, any reduction to the stimulus will have almost the same negative impact as removing it entirely. We are now seeing this reduction on three fronts: the Federal Reserve threatening to close the window on its 'quantitative easing’ program; the tax cuts and transfers already paid out to US citizens; and the Chinese banks 7 Garnaut, John (August 12, 2009). China pulls back on bank-credit throttle. Retrieved on August 16, 2009 from: http://business.smh.com.au/business/china-pulls-back-on-bankcredit-throttle-20090811-egzv.html 9/27/2009 3 now reining in their excessive lending. In trader terms - we will soon have no "dry powder" left to burn. In their 2008 annual report, the Bank for International Settlements (BIS) recently reviewed previous banking crises and suggested that a sustainable recovery would require the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuild capital bases. The BIS concludes that “these conditions are not being met and any stimulus will therefore only lead to a temporary pick up in growth followed by protracted stagnation.”10 We agree wholeheartedly, and have seen nothing yet to suggest that the real problems plaguing the world’s banking system are being addressed. In our view, the threat of a double dip recession remains real. When the stimulus effects wear off there will be nothing left to replace the artificial demand they have induced. Investors should be prepared for what awaits us beyond the stimulus. Sprott Asset Management LP The opinions, estimates and projections (“information”) contained within this report are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. The information contained herein does not constitute an offer or solicitation by anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction. Royal Bank Plaza South Tower 200 Bay Street Suite 2700, P.O Box 27 Toronto, Ontario M5J 2J1 T: 416 943 6707 F: 416 943 6497 Toll Free: 888 362 7172 www.sprott.com 10 Bank for International Settlements, Annual Report 2008/09 (June 29, 2009). Retrieved on August 16, 2009 from: http://www.bis.org/publ/arpdf/ar2009e6.pdf 4 

Emerging Value Capital Management, LLC July 2009 letter to investors 152 West 57th Street Floor 46 New York, NY, 10019 Tel1: 312-363-8599 Tel2: 212-277-5607 Fax: 212-974-1850 Dear Partners and Shareholders, Following is our tenth monthly letter to investors. As always, I am happy to speak with partners (and potential new partners) so please do not hesitate to call me with any questions, thoughts or comments. Fund Performance: During July 2009, EVCM Fund returned an estimated +5.3% (net to investors). During this same time period, the S&P500 (SPY) returned approximately +7.5%, and the MSCI All Country World Index (ACWI) returned approximately +9.4%. Since inception (10/15/2008), EVCM Fund returned an estimated +27.8% (net to investors). During this same time period, the S&P500 (SPY) declined approximately -1.0%, and the MSCI All Country World Index (ACWI) returned approximately +6.5%. The stock market rally continued in full force in July. EVCM fund had a nice return, but lagged the markets due to our defensive positioning. We remain very defensively positioned with lots of cash and bonds, high quality stocks, a few shorts and hedges, and disciplined position sizes. When stock markets decline again (and sooner or later they will) our risk aversion should help protect our capital. As before, I caution investors not to focus on monthly returns (monthly results are mostly random and should not be extrapolated). Rather, I hope you will evaluate my performance over a multiyear period. July 2009 EVCM – Net to Investors S&P500 (SPY) MSCI All Country World Index (ACWI) +5.3% +7.5% +9.4% 2009 YTD +22.3% +9.5% +16.4% Since Inception (10/15/2008) +27.8% -1.0% +6.5% *Please note that individual investor net returns will vary due to the timing of one's investment. The results reported above are unaudited estimates and may be subject to change. Page 1 / 4 Value of $1000 invested at inception: EVCM Fund $1,400 $1,300 $1,200 $1,100 $1,000 $900 $800 $700 SPY ACWI 09 09 09 09 09 /20 /20 /20 /20 1/ 2 0 8/ 2 0 1/ 2 0 0/ 2 0 1/ 2 0 09 0/ 2 0 7/3 10 / 14 10 / 31 11 / 30 12 / 31 1/3 2/2 3/3 4/3 5/3 Stock market rally continues: The stock market rally continued in full force in July. For both the economy and for individual companies, anything less than a terrible news report was viewed as a bullish sign. Many corporations reported something along the lines of: “the rate of decline is slowing”. Dusting off my old college calculus book, I figured out this statement seems to mean that the second derivative of sales with respect to time is positive. But why stop at the second derivative? I suspect it is only a matter of time before we go to the third derivative of sales and some company reports the “great news” that: “the rate of the rate of decline is slowing”. ☺ Like with most other rallies, there is a “story” being told to justify the bullishness. The current story is that the crisis of 2008 has caused corporations to dramatically reduce their expenses and employee counts so that they are now ultra lean and efficient and will post great results once the economy recovers. While this story may have a kernel of truth to it, it makes me wonder how inefficiently these corporations must have been running prior to 2008. Reducing unnecessary costs and increasing operational efficiency is part of the ongoing job of every manager. It should not be undertaken only in response to a crisis. As far as I can tell both the macroeconomic and company specific data remain weak. At best we can say that the economy and corporate results are, on average, less weak than we expected. Stock prices ultimately follow corporate earnings and it is difficult to see corporate earnings increasing significantly given the strong macro economic head winds we still face. While I am continuing to see some attractive investment opportunities, our overall portfolio positioning remains defensive and conservative. I am unwilling to risk our capital by chasing this market rally. Just a few months ago it seemed like there was no limit to how low stocks could go. Every day was a new opportunity to sell and no “buy” decision went unpunished. It was difficult to imagine what would break the cycle and cause stocks to rise again. A few months have passed and all is Page 2 / 4 6/3 1/ 2 0 09 08 08 08 08 forgotten. Every day is a new opportunity to buy and stocks just keep going higher. This positive sentiment can and will turn on a dime. I don’t know when or what the catalyst will be, but I know that stocks are now pricing in a fairly rosy recovery and could decline significantly if investor sentiment shifts from greed back to fear again. Analysis of results to date: EVCM Fund has completed 10 months of operation. While this is far too short a time frame from which to draw any firm conclusions, I believe that a brief analysis of our results to date is warranted. Since EVCM funds inception, we have outperformed our benchmarks by a wide margin. Looking at the chart above and the table below, you will notice that most of our outperformance has come in months where the markets declined (Oct 2008, Nov 2008, Jan 2009). We usually lagged behind the markets on strong up months (Mar 2009, Apr 2009, and July 2009). This is exactly how it should be. Our investment process is focused first and foremost on capital protection and risk management. We invest conservatively and constantly worry about how not to lose money. In the future, you should expect this pattern to continue. We are likely to lag the market in up months (hopefully by only a small margin) and we will attempt to avoid large declines in down months. The end result over a long term market cycle should (we hope) lead to significant outperformance verses our benchmarks. Investment Analysis: Morgan Stanley Emerging Markets Domestic Debt Fund: The Morgan Stanley Emerging Markets Domestic Debt Fund (EDD) is a “global macro” investment that EVCM fund holds. EDD is a closed end investment fund that mostly holds government bonds of emerging market countries. The fund currently trades at a 16% discount to the net value of its assets (NAV), has little leverage (about 20% - 25% leverage) has a dividend yield of 7.5% and an internal yield to maturity of over 10%. It is a low-risk way to diversify out of the US dollar while earning a nice yield. EDD currently has an overweight in Mexico, Brazil, Turkey, and Indonesia government bonds. Default risk for these bonds is low since governments rarely default on local currency bonds (they can always print more local currency). The average duration for the portfolio is 4.25 years and the portfolio is positioned to be more or less interest rate neutral. The government bonds that EDD holds are mostly very liquid, with small bid/ask spreads, so calculated NAV for EDD is a reliable number. Clearly, owning EDD is a big bet against the US dollar and the Euro. As I have discussed before the financial situation of the US (and also Europe) is not good with government debt reaching records levels not seen since World War II. The US dollar rallied in 2008 and early 2009 as investors perceived it to be a safe haven. But with financial markets slowly returning to normal, the long term economic problems of the US and Europe will likely continue to pressure down the value of their currencies. Page 3 / 4 EDD’s assets yield over 10% (yield to maturity). It holds about $1.25B worth of government bonds. I estimate that annual operating costs + interest costs = $25M. So annual yield is about: $1.25B X 10% - $25M = $100M. Dividing $100M by 73M EDD shares outstanding gives us an internal yield of about $1.37 per EDD share. The Current share price is $13.25 so EDD’s internal annual yield is over 10%. Some of this yield is being kept by the fund to grow its NAV, so the funds dividend yield is only 7.5%. The 16% discount to NAV that EDD trades at is a bonus. It magnifies our yield and also provides downside protection. I do not know if or when this discount will close, but in general, bond funds (unlike stock funds) should trade at narrow discounts to NAV. I think that owning this fund is a good alternative to holding non US Dollar cash. Instead of holding a basket of foreign currencies and getting almost zero income, we can hold these intermediate term fixed rate government bonds. The 16% discount to NAV and the fairly high yield make this a better holding than a basket of cash. Conclusions: EVCM Fund remains conservatively positioned with capital preservation being our top priority. We continue to search for and find mispriced investment opportunities that offer a compelling risk reward balance. At EVCM, we always remember that many of you (including myself) have a large part of your life savings invested in the fund. We strive to treat our partners and shareholders the way we would like to be treated were our positions reversed. Please feel free to share this letter with prospective new partners and with other interested investors. Also, thank you for the referrals! Sincerely Yours, Ori Eyal Portfolio Manager Disclosure: 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. 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. An investment in the Fund may be deemed speculative and is not intended as a complete investment program. It is designed only for sophisticated persons who are able to bear the risk of the substantial impairment or loss of their investment in the Fund. The Fund is designed for investors who do not require regular current income and who can accept a certain degree of risk in their investments. Prospective investors should carefully consider the risk factors specified in the Offering Memorandum before making a decision to invest in the Fund. Page 4 / 4 

PORTFOLIO MANAGER’S REVIEW A Monthly Publication of BeyondProxy LLC  www.manualofideas.com  editor@manualofideas.com  August 21, 2009 When asked how he became so successful, Buffett answered: “we read hundreds and hundreds of annual reports every year.” Edited by the Manual of Ideas Research Team “If our efforts can further the goals of our members by giving them a discernible edge over other market participants, we have succeeded.” THE SUPERINVESTOR ISSUE ► Snapshot of 100 companies owned by superinvestors ► 22 companies profiled and analyzed ► Proprietary selection of Top 3 candidates for investment ► Plus: Latest holdings of top investors ► Plus: Exclusive Interview with Brian Bares ► Plus: Exclusive Notes from Value Investing Seminar, Italy Top Ideas In This Report Contango Oil & Gas (NYSE: MCF) …………………. p. 54 Exterran Holdings (NYSE: EXH) ………………… p. 57 Pfizer (NYSE: PFE) ……………………p. 60 Also Inside Editor’s Commentary ……………. p. 5 Portfolios with “Signal Value” …. p. 6 Interview with Brian Bares …….. p. 29 100 Superinvestor Stocks ……… p. 34 Value Investing Seminar Notes p. 116 About Portfolio Manager’s Review Our goal is to bring you equity investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary screening methodology to identify opportunities that are not yet widely followed by institutional investors. John Mihaljevic, managing editor, is a fund manager, former banker and analyst. He is a member of Value Investors Club, an exclusive community of top money managers, and has won the Club’s prize for best investment idea. John is a trained capital allocator, having studied under Yale chief investment officer David Swensen and served as research assistant to Nobel laureate James Tobin. John holds a BA in Economics, summa cum laude, from Yale and is a CFA charterholder. He resides in New York City with his wife and two kids. Superinvestor companies mentioned in this issue include Abbott Labs, Abercrombie & Fitch, Alleghany, Allegheny Energy, Allergan, Alliance One, Allied Healthcare, Allstate, AmeriCredit, Apollo Group, Aspen Insurance, Automatic Data, AutoNation, Bank of America, Becton, Dickinson, Bel Fuse, BioFuel Energy, Brookfield Prop., Burlington Northern, Campbell Soup, Capital Southwest, CapitalSource, Cardinal Health, CF Industries, Coca-Cola Company, Comcast, Contango Oil & Gas, Coventry Health, Crosstex Energy, Dell, DIRECTV Group, Discovery Comms, DreamWorks Animation, EMC Corp., Exterran Holdings, Fairfax Financial, Forest City, General Electric, Genworth Financial, Health Net, Hertz Global, Hewlett-Packard, Humana, Intelligent Systems, International Assets, International Coal, Jefferies Group, Johnson & Johnson, Leucadia National, Level 3 Comms, Liberty Acquisition, Liberty Entertain., Lockheed Martin, Magna International, Market Leader, McDonald's, MI Developments, Microsoft, ModusLink Global, Monsanto Company, Nabors Industries, News Corp., Northrop Grumman, Odyssey Re, Omnicom Group, Overstock.com, Pfizer, Philip Morris, POSCO, Potash Corp., Procter & Gamble, Republic Airways, SAP, Sears Holdings, Smithfield Foods, Spirit AeroSystems, St. Joe, Stanley Furniture, Strayer Education, Sun Microsystems, Sycamore Networks, TAL International, Target, Tejon Ranch, Theravance, Transatlantic, TravelCenters, tw telecom, U.S. Bancorp, United Am. Indemnity, Varian Medical, Visa, VistaPrint, Wal-Mart, Walt Disney, WellCare Health, Wells Fargo, Wyeth, Yahoo!, Yum! Brands, and more. (profiled companies are underlined) Copyright Warning: It is a violation of federal copyright law to reproduce all or part of this publication for any purpose without the prior written consent of BeyondProxy LLC. The Copyright Act imposes liability of up to $150,000 per issue for such infringement, and violators will be prosecuted to the full extent of the law. See inside for subscription information, including having multiple copies sent to you. © 2008-09 by BeyondProxy LLC. All rights reserved. Table of Contents EDITOR’S COMMENTARY ............................................................................ 5  PORTFOLIOS WITH “SIGNAL VALUE” ....................................................... 6  BILL ACKMAN, PERSHING SQUARE ............................................................................................... 7  ZEKE ASHTON, CENTAUR ............................................................................................................ 8  BRUCE BERKOWITZ, FAIRHOLME .................................................................................................. 9  WARREN BUFFETT, BERKSHIRE HATHAWAY ............................................................................... 10  IAN CUMMING & JOE STEINBERG, LEUCADIA .............................................................................. 11  DAVID EINHORN, GREENLIGHT ................................................................................................... 12  BRIAN GAINES, SPRINGHOUSE................................................................................................... 13  TOM GAYNER, MARKEL GAYNER................................................................................................ 14  GLENN GREENBERG, CHIEFTAIN ................................................................................................ 15  MASON HAWKINS, SOUTHEASTERN ............................................................................................ 16  CHRIS HOHN, CHILDREN’S INVESTMENT FUND ........................................................................... 17  CARL ICAHN, ICAHN PARTNERS.................................................................................................. 18  SETH KLARMAN, BAUPOST ........................................................................................................ 19  EDDIE LAMPERT, RBS PARTNERS ............................................................................................. 20  DAN LOEB, THIRD POINT ........................................................................................................... 21  STEVE MANDEL, LONE PINE ...................................................................................................... 22  MOHNISH PABRAI, PABRAI FUNDS.............................................................................................. 23  RICH PZENA, PZENA INVESTMENT MANAGEMENT ....................................................................... 24  KEN SHUBIN STEIN, SPENCER CAPITAL ...................................................................................... 25  PREM WATSA, FAIRFAX ............................................................................................................. 26  WALLY WEITZ, WEITZ FUNDS .................................................................................................... 27  MARTY WHITMAN, THIRD AVENUE.............................................................................................. 28  EXCLUSIVE INTERVIEW WITH BRIAN BARES ........................................ 29  SNAPSHOT OF 100 SUPERINVESTOR-OWNED COMPANIES ............... 34  IN ALPHABETICAL ORDER .......................................................................................................... 34  BY MARKET VALUE ................................................................................................................... 36  BY SECTOR ..............................................................................................................................38  STOCK PRICE PERFORMANCE ................................................................................................... 40  FREE CASH FLOW ..................................................................................................................... 42  P/E MULTIPLES ......................................................................................................................... 44  LATEST QUARTERLY EPS SURPRISES ....................................................................................... 46  REVENUE AND EPS GROWTH .................................................................................................... 48  PERCENTILE RANK WITHIN INDUSTRY ......................................................................................... 50  INSIDER BUYING AND OWNERSHIP ............................................................................................. 52  TOP THREE SUPERINVESTOR SELECTIONS ......................................... 54  CONTANGO OIL & GAS (MCF) – SELLERS , SHUBIN STEIN  ................................................. 54  EXTERRAN HOLDINGS (EXH) – KLARMAN , ZELL..................................................................... 57  PFIZER (PFE) – BERKOWITZ , EINHORN , LOEB , WHITMAN  ........................................ 60  NEW OR INCREASED SUPERINVESTOR HOLDINGS ............................. 64  CF INDUSTRIES (CF) – LOEB  .............................................................................................. 64  COCA-COLA COMPANY (KO) – BUFFETT , GAYNER , HOHN , MANDEL  ...................... 67  FAIRFAX FINANCIAL (FFH) – GAYNER , HAWKINS , PABRAI  ............................................... 70  HERTZ (HTZ) – BERKOWITZ ................................................................................................... 72  PROCTER & GAMBLE (PG) – BUFFETT , GAYNER , WEITZ  .............................................. 75  SPIRIT AEROSYSTEMS (SPR) – BERKOWITZ ........................................................................... 78  TAL INTERNATIONAL (TAL) – BERKOWITZ  .............................................................................. 81  WELLS FARGO (WFC) – BUFFETT , PABRAI , WATSA ....................................................... 84  YAHOO! (YHOO) – ASHTON , ICAHN , LOEB  .................................................................. 87  UNCHANGED SUPERINVESTOR HOLDINGS........................................... 90  INTERNATIONAL ASSETS HOLDING (IAAC) – BARES, CUMMING/STEINBERG  ............................ 90  MARKET LEADER (LEDR) – GAINES  ...................................................................................... 93  © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 3 of 126 REDUCED OR ELIMINATED SUPERINVESTOR HOLDINGS................... 96  ABERCROMBIE & FITCH (ANF) – MANDEL  ............................................................................ 96  COVENTRY HEALTH CARE (CVH) – GAINES  ........................................................................... 99  HEALTH NET (HNT) – GAINES , ROSENSTEIN .................................................................. 101  MAGNA INTERNATIONAL (MGA) – PZENA , WATSA  ............................................................ 104  MODUSLINK GLOBAL (MLNK) – GAINES  ............................................................................... 106  NEWS CORP. (NWS.A) – KLARMAN  ..................................................................................... 108  VISA (V) – ACKMAN , HOHN , MANDEL  ......................................................................... 110  YUM! BRANDS (YUM) – ACKMAN , HAWKINS  ................................................................... 113  NOTES FROM VALUE INVESTING SEMINAR IN ITALY, JULY ............. 116  CICCIO AZZOLLINI, CATTOLICA PARTECIPAZIONI ....................................................................... 116  VICTOR FASCIANI, PRAETORIAN VALUE FUND .......................................................................... 117  DON FITZGERALD, TOCQUEVILLE VALUE EUROPE ..................................................................... 118  ALVARO GUZMAN DÉ LAZARO MATEOS, BESTINVER.................................................................. 119  MAX OTTE, FACHHOCHSCHULE WORMS................................................................................... 120  GUY SPIER, AQUAMARINE CAPITAL MANAGEMENT.................................................................... 121  ROBERT VINALL, RV CAPITAL .................................................................................................. 122  JOSH TARASOFF, GREENLEA LANE CAPITAL ............................................................................. 123  © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 4 of 126 Portfolios With “Signal Value” Revealing the Top Ideas of Top Investors “Signal value” as opposed to “noise.” We present the holdings of some of the world’s top investors. We look for investors who have amassed impressive track records over long periods of time. We choose these investors carefully to avoid the noise inherent in most 13F-HR filings. MOI Signal Rank answers the question, “What are this investor’s top ten ideas right now?” Rather than simply presenting each investor’s largest holdings as of the recently filed quarter end, the MOI’s proprietary methodology ranks the companies in each investor’s portfolio based on the investor’s current level of conviction in each holding, as Top investors included in this section:                       William Ackman, Pershing Square Zeke Ashton, Centaur Bruce Berkowitz, Fairholme Warren Buffett, Berkshire Hathaway Ian Cumming & Joe Steinberg, Leucadia David Einhorn, Greenlight Glenn Greenberg, Chieftain Brian Gaines, Springhouse Tom Gayner, Markel Gayner Mason Hawkins, Southeastern Chris Hohn, Children’s Investment Fund Carl Icahn, Icahn Seth Klarman, Baupost Eddie Lampert, RBS (ESL) Dan Loeb, Third Point Steve Mandel, Lone Pine Mohnish Pabrai, Pabrai Funds Rich Pzena, Pzena Investment Kenneth Shubin Stein, Spencer Prem Watsa, Fairfax Wally Weitz, Weitz Funds Marty Whitman, Third Avenue Missing your favorite superinvestor? Let us know at editor@manualofideas.com. judged by the MOI. Our proprietary methodology takes into account a number of variables, including the size of a position in an investor’s portfolio, the size of a position relative to the market value of the corresponding company, the most recent quarterly change in the number of shares owned, and the change in the stock price of a position since the most recent quarterly filing date. For example, an investor might have the most conviction in a position that is only the tenth-largest position in such investor’s portfolio. This might be the case if an investor invests in a small company, resulting in a holding that is simply too small to rank highly based on size alone. On the other hand, such a holding might represent 19.9% of the shares outstanding of the subject company, suggesting a high level of conviction. Our estimate of the conviction level would rise further if the subject company has a 20% poison-pill threshold, thereby suggesting that the investor has bought as much of the subject company as is practically feasible. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 6 of 126 Bruce Berkowitz, Fairholme Bruce Berkowitz, manager of The Fairholme Fund, has been one of the most successful value-oriented investors of the past decade. From inception on December 29, 1999 through December 31, 2008, The Fairholme Fund has delivered a cumulative return, net of expenses, of 153.92%, versus a return of -27.83%, before expenses, for the S&P 500 Index. MOI Signal Rank™ – Top Current Ideas of Fairholme Market Value ($mn) 1,912 3,029 4,511 1,049 2,283 309 5,885 156,589 156,589 Latest Date 13.67 32.74 11.02 24.85 17.19 10.00 34.69 101,400 3,329 Price ($) Filing ∆ Since Date Filing 13.74 -1% 26.49 24% 7.99 38% 18.49 34% 13.55 27% 10.90 -8% 32.26 8% 90,000 13% 2,896 15% Shares Owned Latest ∆ Since Filing 3/31/09 22,155,838 17% 24,751,543 34% 58,817,361 38% 8,399,763 3% 32,307,322 no change 2,724,862 12% 9,537,400 41% 847 >100% 25,707 new position Holdings as % of Co. Fund 21% 4% 27% 9% 16% 7% 20% 2% 24% 6% 9% 0% 6% 4% 0% 1% 0% 1% 1 2 3 4 5 6 7 8 Company Spirit Aerosystems St Joe Hertz Global WellCare Health Plans AmeriCredit TAL International Humana Berkshire Hathaway Berkshire Hathaway Ticker SPR JOE HTZ WCG ACF TAL HUM BRK/A BRK/B Top Holdings of Fairholme – By Dollar Value Market Value ($mn) 106,434 9,247 3,029 4,511 8,308 24,793 2,283 6,302 5,885 1,912 Latest Date 15.77 77.10 32.74 11.02 27.54 52.19 17.19 25.86 34.69 13.67 Price ($) Filing ∆ Since Date Filing 15.00 5% 66.52 16% 26.49 24% 7.99 38% 25.11 10% 50.89 3% 13.55 27% 21.09 23% 32.26 8% 13.74 -1% Shares Owned Latest ∆ Since Filing 3/31/09 87,182,848 -1% 13,576,439 -5% 24,751,543 34% 58,817,361 38% 18,147,244 -10% 8,710,710 -13% 32,307,322 no change 18,008,803 -1% 9,537,400 41% 22,155,838 17% Holdings as % of Co. Fund 1% 18% 11% 13% 27% 9% 16% 7% 6% 6% 2% 6% 24% 6% 8% 5% 6% 4% 21% 4% 1 2 3 4 5 6 7 8 9 10 Company Pfizer Sears Holdings St Joe Hertz Global Forest Laboratories WellPoint AmeriCredit Leucadia National Humana Spirit Aerosystems Ticker PFE SHLD JOE HTZ FRX WLP ACF LUK HUM SPR New Positions Berkshire Hathaway (B Shares) (BRK/B) Meritor Savings Bank (MSVP) RSC Holdings (RRR) Sold Out Positions Calumet Specialty Products (CLMT) Canadian Natural Resources (CNQ) Markel (MKL) Portfolio Metrics Portfolio size Top 10 as % of portfolio Median market value Average market value Median price to earnings Median price to book $7 billion 73% $6 billion $31 billion 9x 1.3x Sector Weightings Consumer, Non‐cyclical Financial Industrial Consumer, Cyclical Diversified Communications Energy 0% 0% 5% 13% 13% 20% 49% © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 9 of 126 David Einhorn, Greenlight David Einhorn is the founder of Greenlight Capital, a value-oriented, research-driven investment firm with a market-beating long-term track record. He is also author of Fooling Some of the People All of the Time. MOI Signal Rank™ – Top Current Ideas of Greenlight Market Value ($mn) 11,846 62,734 106,434 22 208 2,032 571 4,339 3,110 227 Latest Date 32.90 46.99 15.77 0.65 12.91 24.47 12.21 12.49 46.86 6.60 Price ($) Filing ∆ Since Date Filing 30.55 8% 45.39 4% 15.00 5% 0.63 4% 8.65 49% 22.34 10% 7.59 61% 13.87 -10% 43.33 8% 6.53 1% Shares Owned Latest ∆ Since Filing 3/31/09 3,971,173 new position 2,860,000 100% 11,987,000 >100% 7,542,104 no change 10,733,469 no change 4,140,000 74% 5,655,235 no change 17,400 new position 325,000 new position 3,382,800 no change Holdings as % of Co. Fund 1% 4% 0% 5% 0% 6% 32% 0% 67% 3% 5% 3% 12% 2% 0% 0% 0% 0% 10% 1% 1 2 3 4 5 6 7 8 9 10 Company Cardinal Health Wyeth Pfizer BioFuel Energy Einstein Noah Restaurant Aspen Insurance MI Developments US Natural Gas ETF Transatlantic Republic Airways Ticker CAH WYE PFE BIOF BAGL AHL MIM UNG TRH RJET Top Holdings of Greenlight – By Dollar Value Market Value ($mn) 106,434 3,954 4,656 62,734 11,846 4,448 4,279 30,674 208 2,032 Latest Date 15.77 47.54 27.10 46.99 32.90 39.21 25.25 15.17 12.91 24.47 Price ($) Filing ∆ Since Date Filing 15.00 5% 49.52 -4% 23.43 16% 45.39 4% 30.55 8% 37.82 4% 25.65 -2% 13.10 16% 8.65 49% 22.34 10% Shares Owned Latest ∆ Since Filing 3/31/09 11,987,000 >100% 3,194,924 -28% 6,205,017 -10% 2,860,000 100% 3,971,173 new position 3,200,000 no change 4,154,200 -4% 7,244,000 -43% 10,733,469 no change 4,140,000 74% Holdings as % of Co. Fund 0% 6% 4% 6% 4% 5% 0% 5% 1% 4% 3% 4% 2% 4% 0% 3% 67% 3% 5% 3% 1 2 3 4 5 6 7 8 9 10 Company Pfizer URS Teradata Wyeth Cardinal Health Gold Miners ETF Allegheny Energy EMC Einstein Noah Restaurant Aspen Insurance Ticker PFE URS TDC WYE CAH GDX AYE EMC BAGL AHL New Positions ATP Oil & Gas (ATPG) Cardinal Health (CAH) Endurance Specialty (ENH) Transatlantic (TRH) US Natural Gas ETF (UNG) Sold Out Positions American Eagle Outfitters (AEO) Brandywine Realty (BDN) Cadence Design (CDNS) Carpenter Technology (CRS) CommScope (CTV) Con-way (CNW) Corning Inc (GLW) Discover Financial (DFS) Dow Chemical (DOW) Focus Media Holding (FMCN) Hess (HES) JA Solar (JASO) Jones Apparel (JNY) Patriot Coal (PCX) Rohm and Haas (ROH) SPDR Gold ETF (GLD) Sunstone Hotel (SHO) SUPERVALU (SVU) Target (TGT) Western Digital (WDC) Williams-Sonoma (WSM) Portfolio Metrics Portfolio size Top 10 as % of portfolio Median market value Average market value Median price to earnings Median price to book $2.8 billion 65% $2 billion $9 billion 10x 1.0x Sector Weightings Funds Consumer, Non‐cyclical Technology Financial Industrial Energy Consumer, Cyclical Utilities Communications Basic Materials 0% 1% 4% 6% 6% 12% 11% 11% 19% 29% © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 12 of 126 Exclusive Interview with Brian Bares We are pleased to bring you an interview with Austin, Texas-based investor Brian Bares this month. Bares started his investment firm, Bares Capital Management, in 2000, focusing initially on micro-cap public companies. The firm launched a small-cap institutional strategy in 2001 and now manages assets in two valueoriented strategies. Bares Capital Management Brian Bares is quite unique in the institutional asset Bares Capital Management, Inc. management world, as it has adhered to a disciplined business strategy, limiting the growth of assets under management to benefit investment performance. Both of Bares’s institutional strategies have beaten their respective benchmark indices by wide margins since inception. “Our competitors have a difficult time running a strategy like ours because success creates profit motives that tend to move them up the market cap spectrum or into excessively diversified portfolios…” MOI: Since starting your firm nearly ten years ago, you have focused on investing in small public companies. What prompted this focus, and has your approach changed at all in light of the fact that many large companies have looked inefficiently priced recently? Brian Bares: There are really two reasons for our focus on small companies. The first is that small companies are more likely to be inefficiently priced. Our investment process mandates a comprehensive understanding of our portfolio companies. It is much more likely that we can profit from this understanding in small caps, where information scarcity allows for opportunity. We also cap assets to maintain our focus on small companies. Our competitors have a difficult time running a strategy like ours because success creates profit motives that tend to move them up the market cap spectrum or into excessively diversified portfolios in order to accommodate a larger asset base. The second reason is structural. Our firm manages money in replicated separate accounts, and our relationships are largely direct with foundation and endowment clients. These clients employ many specialist managers in a number of different niche areas. They understand that our value to them is our area of competence — small-company common stocks. And they pay for our best ideas as we typically hold between 10 and 20 positions. Our clients allow us to do this because they have other managers looking at mid- and large-caps, international, commodities, real estate, etc. So we have really absolved ourselves of making many difficult macro and asset allocation decisions. Instead, we simply hunker down and focus on our little corner of the market. Our success is judged against small company benchmarks. The only time we think about what is happening with large-caps, international stocks, and other asset classes is when factors affecting these could affect the underlying business performance of the companies we own. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 29 of 126 Snapshot of 100 Superinvestor-Owned Companies In Alphabetical Order Recent Company / Ticker Abbott Laboratories / ABT Abercrombie & Fitch / ANF Alleghany Corp. / Y Allegheny Energy / AYE Allergan / AGN Alliance One / AOI Allied Healthcare / AHCI Allstate / ALL AmeriCredit / ACF Apollo Group / APOL Aspen Insurance / AHL Automatic Data / ADP AutoNation / AN Bank of America / BAC Becton, Dickinson / BDX Bel Fuse / BELFB BioFuel Energy / BIOF Brookfield Prop. / BPO Burlington Northern / BNI Campbell Soup / CPB Capital Southwest / CSWC CapitalSource / CSE Cardinal Health / CAH CF Industries / CF Coca-Cola Company / KO Comcast Corp. / CMCSA Contango Oil & Gas / MCF Coventry Health / CVH Crosstex Energy / XTXI Dell / DELL DIRECTV Group / DTV Discovery Comms / DISCA DreamWorks Animation / DWA EMC Corp. / EMC Exterran Holdings / EXH Fairfax Financial / FFH Forest City / FCE.A General Electric / GE Genworth Financial / GNW Health Net / HNT Hertz Global / HTZ Hewlett-Packard / HPQ Humana / HUM Intelligent Systems / INS International Assets / IAAC International Coal / ICO Jefferies Group / JEF Johnson & Johnson / JNJ Leucadia National / LUK Level 3 Comms / LVLT Industry Major Drugs Retail (Apparel) Conglomerates Electric Utilities Biotechnology & Drugs Tobacco Healthcare Facilities Property & Casualty Insur. Retail Financial Services Schools Property & Casualty Insur. Business Services Retail (Specialty) Money Center Banks Medical Equipment Electronic Instruments Chemical Manufacturing Real Estate Operations Railroads Food Processing Misc. Financial Services Regional Banks Biotechnology & Drugs Chemical Manufacturing Beverages (Non-Alcoholic) Broadcasting & Cable TV Oil & Gas Operations Health Insurance Natural Gas Utilities Computer Hardware Broadcasting & Cable TV Broadcasting & Cable TV Motion Pictures Computer Storage Devices Oil Well Services Property & Casualty Insur. Real Estate Operations Conglomerates Life Insurance Health Insurance Rental & Leasing Computer Hardware Health Insurance Software & Programming Investment Services Coal Investment Services Major Drugs Conglomerates Communications Services Notable Shareholders Tom Gayner Steve Mandel (sold out) Zeke Ashton Einhorn, Shubin Stein Dan Loeb Seth Klarman Brian Gaines Rich Pzena Berkowitz, Leucadia Wally Weitz David Einhorn Bill Ackman Eddie Lampert Dan Loeb Warren Buffett Marty Whitman Einhorn, Loeb Mohnish Pabrai Buffett, Watsa Tom Gayner Cumming/Steinberg Seth Klarman Einhorn, Pzena Dan Loeb Buffett, Gayner, Hohn Greenberg, Weitz Mark Sellers Brian Gaines (sold out) Greenberg, Shubin Stein Greenberg, Hawkins Mason Hawkins Hawkins, Mandel Zeke Ashton Ackman, Einhorn Seth Klarman Gayner, Hawkins Marty Whitman Gayner, Watsa Eddie Lampert Brian Gaines (sold out) Bruce Berkowitz Mandel, Loeb Bruce Berkowitz Wally Weitz Cumming/Steinberg Prem Watsa Cumming/Steinberg Buffett, Watsa Berkowitz, Pabrai Hawkins, Watsa Price ($) 44.36 34.25 264.82 25.25 54.38 3.79 2.50 28.55 17.19 65.73 24.47 38.48 18.49 17.39 66.39 17.12 0.65 10.15 82.63 30.60 78.31 3.84 32.90 82.87 48.47 14.81 44.82 22.60 3.86 14.20 24.64 24.77 31.25 15.17 17.24 343.90 7.68 13.92 8.28 14.67 11.02 44.09 34.69 1.10 17.01 3.21 22.45 60.08 25.86 1.19  to 52-Wk Low High ($) ($) -7% -60% -33% -20% -47% -48% -62% -52% -83% -27% -45% -20% -79% -85% -12% -49% -62% -60% -38% -20% -32% -77% -16% -54% -23% -38% -29% -65% -81% -45% -54% -60% -45% -46% -31% -39% -58% -59% -92% -50% -86% -42% -46% -50% -69% -66% -64% -23% -60% -52% 37% 63% 55% 87% 13% 51% 16% 68% 4% 37% 32% 19% 15% 127% 34% 82% 185% 118% 33% 33% 87% 284% 71% 86% 15% 52% 81% 74% 765% 83% 17% 5% 5% 4% 190% 3% 427% 118% 141% 96% 9% 12% 46% 224% 78% 234% 29% 21% 89% 201% Market Value ($mn) 68,577 3,010 2,387 4,279 16,535 338 113 15,314 2,283 10,102 2,032 19,303 3,292 150,451 15,893 197 22 3,970 28,096 10,720 293 1,242 11,846 4,016 112,326 42,502 710 3,380 179 27,747 24,080 6,984 2,710 30,675 1,077 6,274 1,201 147,926 3,587 1,524 4,511 105,210 5,885 5 155 495 3,874 165,569 6,302 1,945 Website www.abbott.com www.abercrombie.co.uk www.alleghany.com www.alleghenyenergy.com www.allergan.com www.aointl.com www.alliedhealthcare.com www.allstate.com www.americredit.com www.apollogrp.edu www.aspen.bm www.adp.com www.autonation.com /www.bankofamerica.com www.bd.com www.belfuse.com www.bfenergy.com www.brookfieldproperties.com www.bnsf.com www.campbellsoup.com www.capitalsouthwest.com www.capitalsource.com www.cardinal.com www.cfindustries.com thecoca-colacompany.com www.comcast.com www.contango.com www.coventryhealthcare.com www.crosstexenergy.com www.dell.com www.directv.com discoverycommunications.com www.dreamworksanimation.com www.emc.com www.exterran.com www.fairfax.ca www.forestcity.net www.ge.com www.genworth.com /www.healthnet.com www.hertz.com www.hp.com www.humana.com www.intelsys.com www.intlassets.com www.intlcoal.com www.jefferies.com www.jnj.com www.leucadia.com www.level3.com [Portfolio w 100 companies ● Top100_browser ● MOI_macros_100.xls, MOI100A, then MOI100B, then MOI100C, then MOI100D] © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 34 of 126 In Alphabetical Order (continued) Recent Company / Ticker Liberty Acquisition / LIA Liberty Entertain. / LMDIA Lockheed Martin / LMT Magna International / MGA Market Leader / LEDR McDonald's / MCD MI Developments / MIM Microsoft / MSFT ModusLink Global / MLNK Monsanto Company / MON Nabors Industries / NBR News Corp. / NWSA Northrop Grumman / NOC Odyssey Re / ORH Omnicom Group / OMC Overstock.com / OSTK Pfizer / PFE Philip Morris / PM POSCO / PKX Potash Corp. / POT Procter & Gamble / PG Republic Airways / RJET SAP / SAP Sears Holdings / SHLD Smithfield Foods / SFD Spirit AeroSystems / SPR St. Joe / JOE Stanley Furniture / STLY Strayer Education / STRA Sun Microsystems / JAVA Sycamore Networks / SCMR TAL International / TAL Target / TGT Tejon Ranch / TRC Theravance / THRX Transatlantic / TRH TravelCenters / TA tw telecom / TWTC U.S. Bancorp / USB United Am. Indemnity / INDM Varian Medical / VAR Visa / V VistaPrint / VPRT Wal-Mart / WMT Walt Disney / DIS WellCare Health / WCG Wells Fargo / WFC Wyeth / WYE Yahoo! / YHOO Yum! Brands / YUM Industry Misc. Financial Services Broadcasting & Cable TV Aerospace and Defense Auto & Truck Parts Real Estate Operations Restaurants Real Estate Operations Software & Programming Computer Services Chemical Manufacturing Oil Well Services Broadcasting & Cable TV Aerospace and Defense Property & Casualty Insur. Advertising Retail (Online) Major Drugs Tobacco Iron & Steel Non-Metallic Mining Household Products Airline Software & Programming Retail (Dep't & Discount) Food Processing Aerospace and Defense Real Estate Operations Furniture & Fixtures Schools Computer Hardware Communications Equipment Rental & Leasing Retail (Dep't & Discount) Real Estate Operations Biotechnology & Drugs Health Insurance Retail (Specialty) Communications Services Money Center Banks Property & Casualty Insur. Medical Equipment Retail Financial Services Business Services Retail (Dep't & Discount) Broadcasting & Cable TV Health Insurance Regional Banks Major Drugs Business Services Restaurants Notable Shareholders Dan Loeb Hawkins, Klarman Glenn Greenberg Watsa, Pzena Brian Gaines Ackman, Gayner David Einhorn Gayner, Weitz Brian Gaines Steve Mandel Marty Whitman Seth Klarman Pzena, Ashton Watsa, Ashton Rich Pzena Prem Watsa Berkowitz, Einhorn Hohn, Mandel Marty Whitman Pabrai, Weitz Buffett, Gayner, Weitz David Einhorn Chris Hohn Lampert, Berkowitz Steve Mandel Bruce Berkowitz Bruce Berkowitz Marty Whitman Mandel, Weitz Dan Loeb Marty Whitman Bruce Berkowitz Bill Ackman Marty Whitman Seth Klarman Einhorn, Loeb Cumming/Steinberg Mason Hawkins Buffett, Greenberg Rich Pzena Glenn Greenberg Hohn, Mandel Steve Mandel Tom Gayner Hawkins, Gayner Berkowitz, Shubin Stein Buffett, Watsa, Pabrai Einhorn, Loeb Icahn, Loeb, Ashton Mason Hawkins Price ($) 9.30 27.84 74.59 47.93 1.99 55.27 12.21 23.69 7.11 81.24 17.70 10.94 47.37 48.30 35.34 12.62 15.77 46.62 95.87 95.75 52.37 6.60 46.92 77.10 11.93 13.67 32.74 10.99 213.68 9.16 3.09 10.00 42.03 25.74 14.66 46.86 2.93 11.39 22.49 6.19 36.80 67.80 43.83 51.79 25.86 24.85 27.73 46.99 15.04 34.94  to 52-Wk Low High ($) ($) -16% -66% -23% -59% -37% -17% -73% -37% -77% -22% -53% -55% -29% -35% -43% -50% -26% -31% -58% -50% -16% -38% -38% -65% -55% -48% -56% -49% -33% -72% -35% -45% -41% -29% -71% -44% -67% -61% -64% -40% -26% -38% -73% -11% -41% -75% -72% -40% -41% -38% 0% 3% 61% 30% 47% 18% 93% 19% 75% 49% 114% 33% 52% 13% 26% 79% 28% 20% 20% 95% 40% 138% 26% 41% 114% 74% 30% 7% 12% 19% 21% 170% 42% 50% 27% 51% 19% 43% 88% 185% 79% 14% 6% 23% 35% 84% 61% 1% 38% 15% Market Value ($mn) 1,203 14,430 28,669 5,398 48 60,319 570 211,112 324 44,350 5,028 28,601 15,069 2,824 10,983 289 106,434 90,185 29,761 28,316 152,643 227 56,670 9,247 1,713 1,928 3,029 114 2,990 6,836 878 312 31,618 438 926 3,110 49 1,700 43,001 374 4,620 57,394 1,876 201,806 48,062 1,049 129,544 62,734 21,107 16,302 Website libertyacquisitionholdingsinte www.libertymedia.com www.lockheedmartin.com www.magna.com www.marketleader.com www.mcdonalds.com www.midevelopments.com www.microsoft.com www.moduslink.com www.monsanto.com www.nabors.com www.newscorp.com www.northropgrumman.com www.odysseyre.com www.omnicomgroup.com www.overstock.com www.pfizer.com philipmorrisinternational.com www.posco.com www.potashcorp.com www.pg.com www.republicairways.com www.sap.com www.searsholdings.com www.smithfieldfoods.com www.spiritaero.com www.joe.com www.stanleyfurniture.com www.strayereducation.com www.sun.com www.sycamorenet.com www.talinternational.com www.target.com www.tejon.com www.theravance.com www.transre.com www.tatravelcenters.com www.twtelecom.com www.usbank.com www.uai.ky www.varian.com www.visa.com www.vistaprint.co.uk walmartstores.com disney.go.com www.wellcare.com /www.wellsfargo.com www.wyeth.com www.yahoo.com www.yum.com [MFI100 ● Top100_browser ● MOI_macros_100.xls, MOI100A] © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 35 of 126 By Market Value Recent Company / Ticker Microsoft / MSFT Wal-Mart / WMT Johnson & Johnson / JNJ Procter & Gamble / PG Bank of America / BAC General Electric / GE Wells Fargo / WFC Coca-Cola Company / KO Pfizer / PFE Hewlett-Packard / HPQ Philip Morris / PM Abbott Laboratories / ABT Wyeth / WYE McDonald's / MCD Visa / V SAP / SAP Walt Disney / DIS Monsanto Company / MON U.S. Bancorp / USB Comcast Corp. / CMCSA Target / TGT EMC Corp. / EMC POSCO / PKX Lockheed Martin / LMT News Corp. / NWSA Potash Corp. / POT Burlington Northern / BNI Dell / DELL DIRECTV Group / DTV Yahoo! / YHOO Automatic Data / ADP Allergan / AGN Yum! Brands / YUM Becton, Dickinson / BDX Allstate / ALL Northrop Grumman / NOC Liberty Entertain. / LMDIA Cardinal Health / CAH Omnicom Group / OMC Campbell Soup / CPB Apollo Group / APOL Sears Holdings / SHLD Discovery Comms / DISCA Sun Microsystems / JAVA Leucadia National / LUK Fairfax Financial / FFH Humana / HUM Magna International / MGA Nabors Industries / NBR Varian Medical / VAR Industry Software & Programming Retail (Dep't & Discount) Major Drugs Household Products Money Center Banks Conglomerates Regional Banks Beverages (Non-Alcoholic) Major Drugs Computer Hardware Tobacco Major Drugs Major Drugs Restaurants Retail Financial Services Software & Programming Broadcasting & Cable TV Chemical Manufacturing Money Center Banks Broadcasting & Cable TV Retail (Dep't & Discount) Computer Storage Devices Iron & Steel Aerospace and Defense Broadcasting & Cable TV Non-Metallic Mining Railroads Computer Hardware Broadcasting & Cable TV Business Services Business Services Biotechnology & Drugs Restaurants Medical Equipment Property & Casualty Insur. Aerospace and Defense Broadcasting & Cable TV Biotechnology & Drugs Advertising Food Processing Schools Retail (Dep't & Discount) Broadcasting & Cable TV Computer Hardware Conglomerates Property & Casualty Insur. Health Insurance Auto & Truck Parts Oil Well Services Medical Equipment Notable Shareholders Gayner, Weitz Tom Gayner Buffett, Watsa Buffett, Gayner, Weitz Dan Loeb Gayner, Watsa Buffett, Watsa, Pabrai Buffett, Gayner, Hohn Berkowitz, Einhorn Mandel, Loeb Hohn, Mandel Tom Gayner Einhorn, Loeb Ackman, Gayner Hohn, Mandel Chris Hohn Hawkins, Gayner Steve Mandel Buffett, Greenberg Greenberg, Weitz Bill Ackman Ackman, Einhorn Marty Whitman Glenn Greenberg Seth Klarman Pabrai, Weitz Buffett, Watsa Greenberg, Hawkins Mason Hawkins Icahn, Loeb, Ashton Bill Ackman Dan Loeb Mason Hawkins Warren Buffett Rich Pzena Pzena, Ashton Hawkins, Klarman Einhorn, Pzena Rich Pzena Tom Gayner Wally Weitz Lampert, Berkowitz Hawkins, Mandel Dan Loeb Berkowitz, Pabrai Gayner, Hawkins Bruce Berkowitz Watsa, Pzena Marty Whitman Glenn Greenberg Price ($) 23.69 51.79 60.08 52.37 17.39 13.92 27.73 48.47 15.77 44.09 46.62 44.36 46.99 55.27 67.80 46.92 25.86 81.24 22.49 14.81 42.03 15.17 95.87 74.59 10.94 95.75 82.63 14.20 24.64 15.04 38.48 54.38 34.94 66.39 28.55 47.37 27.84 32.90 35.34 30.60 65.73 77.10 24.77 9.16 25.86 343.90 34.69 47.93 17.70 36.80  to 52-Wk Low High ($) ($) -37% -11% -23% -16% -85% -59% -72% -23% -26% -42% -31% -7% -40% -17% -38% -38% -41% -22% -64% -38% -41% -46% -58% -23% -55% -50% -38% -45% -54% -41% -20% -47% -38% -12% -52% -29% -66% -16% -43% -20% -27% -65% -60% -72% -60% -39% -46% -59% -53% -26% 19% 23% 21% 40% 127% 118% 61% 15% 28% 12% 20% 37% 1% 18% 14% 26% 35% 49% 88% 52% 42% 4% 20% 61% 33% 95% 33% 83% 17% 38% 19% 13% 15% 34% 68% 52% 3% 71% 26% 33% 37% 41% 5% 19% 89% 3% 46% 30% 114% 79% Market Value ($mn) 211,112 201,806 165,569 152,643 150,451 147,926 129,544 112,326 106,434 105,210 90,185 68,577 62,734 60,319 57,394 56,670 48,062 44,350 43,001 42,502 31,618 30,675 29,761 28,669 28,601 28,316 28,096 27,747 24,080 21,107 19,303 16,535 16,302 15,893 15,314 15,069 14,430 11,846 10,983 10,720 10,102 9,247 6,984 6,836 6,302 6,274 5,885 5,398 5,028 4,620 Enterprise Value ($mn) 185,411 239,051 164,467 184,834 nm nm nm 115,829 95,427 110,974 101,657 77,392 58,304 69,159 53,092 56,275 58,628 45,596 nm 71,488 49,016 26,461 28,886 29,802 36,350 31,947 37,450 20,119 27,595 17,229 17,780 16,639 19,566 16,030 21,305 17,881 15,582 14,151 13,028 13,241 9,305 11,150 10,121 5,390 7,717 7,306 1,554 4,060 8,063 4,180 LTM EBIT/ EV 11% 10% 10% 9% 2% 2% 4% 7% 10% 9% 10% 8% 12% 9% 4% 7% 9% 7% 3% 10% 9% 5% 17% 16% nm 8% 10% 13% 9% 0% 10% 5% 7% 10% nm 0% nm 14% 12% 9% 13% 4% 13% nm nm 23% 89% nm 5% 11% LTM EBIT/ Capital >99% 0-25% 50-99% 50-99% 0-25% 0-25% 0-25% 50-99% 0-25% >99% >99% 25-50% 25-50% 25-50% >99% >99% 25-50% 25-50% 0-25% 25-50% 0-25% 50-99% 25-50% >99% nm 25-50% 0-25% >99% 25-50% nm >99% 50-99% 25-50% 25-50% nm nm nm 25-50% >99% 50-99% >99% 0-25% >99% nm nm >99% 50-99% nm 0-25% 50-99% [MFI100 ● Top100_browser ● MOI_macros_100.xls, MOI100A] © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 36 of 126 By Market Value (continued) Recent Company / Ticker Hertz Global / HTZ Allegheny Energy / AYE CF Industries / CF Brookfield Prop. / BPO Jefferies Group / JEF Genworth Financial / GNW Coventry Health / CVH AutoNation / AN Transatlantic / TRH St. Joe / JOE Abercrombie & Fitch / ANF Strayer Education / STRA Odyssey Re / ORH DreamWorks Animation / DWA Alleghany Corp. / Y AmeriCredit / ACF Aspen Insurance / AHL Level 3 Comms / LVLT Spirit AeroSystems / SPR VistaPrint / VPRT Smithfield Foods / SFD tw telecom / TWTC Health Net / HNT CapitalSource / CSE Liberty Acquisition / LIA Forest City / FCE.A Exterran Holdings / EXH WellCare Health / WCG Theravance / THRX Sycamore Networks / SCMR Contango Oil & Gas / MCF MI Developments / MIM International Coal / ICO Tejon Ranch / TRC United Am. Indemnity / INDM Alliance One / AOI ModusLink Global / MLNK TAL International / TAL Capital Southwest / CSWC Overstock.com / OSTK Republic Airways / RJET Bel Fuse / BELFB Crosstex Energy / XTXI International Assets / IAAC Stanley Furniture / STLY Allied Healthcare / AHCI TravelCenters / TA Market Leader / LEDR BioFuel Energy / BIOF Intelligent Systems / INS Industry Rental & Leasing Electric Utilities Chemical Manufacturing Real Estate Operations Investment Services Life Insurance Health Insurance Retail (Specialty) Health Insurance Real Estate Operations Retail (Apparel) Schools Property & Casualty Insur. Motion Pictures Conglomerates Retail Financial Services Property & Casualty Insur. Communications Services Aerospace and Defense Business Services Food Processing Communications Services Health Insurance Regional Banks Misc. Financial Services Real Estate Operations Oil Well Services Health Insurance Biotechnology & Drugs Communications Equipment Oil & Gas Operations Real Estate Operations Coal Real Estate Operations Property & Casualty Insur. Tobacco Computer Services Rental & Leasing Misc. Financial Services Retail (Online) Airline Electronic Instruments Natural Gas Utilities Investment Services Furniture & Fixtures Healthcare Facilities Retail (Specialty) Real Estate Operations Chemical Manufacturing Software & Programming Notable Shareholders Bruce Berkowitz Einhorn, Shubin Stein Dan Loeb Mohnish Pabrai Cumming/Steinberg Eddie Lampert Brian Gaines (sold out) Eddie Lampert Einhorn, Loeb Bruce Berkowitz Steve Mandel (sold out) Mandel, Weitz Watsa, Ashton Zeke Ashton Zeke Ashton Berkowitz, Leucadia David Einhorn Hawkins, Watsa Bruce Berkowitz Steve Mandel Steve Mandel Mason Hawkins Brian Gaines (sold out) Seth Klarman Dan Loeb Marty Whitman Seth Klarman Berkowitz, Shubin Stein Seth Klarman Marty Whitman Mark Sellers David Einhorn Prem Watsa Marty Whitman Rich Pzena Seth Klarman Brian Gaines Bruce Berkowitz Cumming/Steinberg Prem Watsa David Einhorn Marty Whitman Greenberg, Shubin Stein Cumming/Steinberg Marty Whitman Brian Gaines Cumming/Steinberg Brian Gaines Einhorn, Loeb Wally Weitz Price ($) 11.02 25.25 82.87 10.15 22.45 8.28 22.60 18.49 46.86 32.74 34.25 213.68 48.30 31.25 264.82 17.19 24.47 1.19 13.67 43.83 11.93 11.39 14.67 3.84 9.30 7.68 17.24 24.85 14.66 3.09 44.82 12.21 3.21 25.74 6.19 3.79 7.11 10.00 78.31 12.62 6.60 17.12 3.86 17.01 10.99 2.50 2.93 1.99 0.65 1.10  to 52-Wk Low High ($) ($) -86% -20% -54% -60% -64% -92% -65% -79% -44% -56% -60% -33% -35% -45% -33% -83% -45% -52% -48% -73% -55% -61% -50% -77% -16% -58% -31% -75% -71% -35% -29% -73% -66% -29% -40% -48% -77% -45% -32% -50% -38% -49% -81% -69% -49% -62% -67% -37% -62% -50% 9% 87% 86% 118% 29% 141% 74% 15% 51% 30% 63% 12% 13% 5% 55% 4% 32% 201% 74% 6% 114% 43% 96% 284% 0% 427% 190% 84% 27% 21% 81% 93% 234% 50% 185% 51% 75% 170% 87% 79% 138% 82% 765% 78% 7% 16% 19% 47% 185% 224% Market Value ($mn) 4,511 4,279 4,016 3,970 3,874 3,587 3,380 3,292 3,110 3,029 3,010 2,990 2,824 2,710 2,387 2,283 2,032 1,945 1,928 1,876 1,713 1,700 1,524 1,242 1,203 1,201 1,077 1,049 926 878 710 570 495 438 374 338 324 312 293 289 227 197 179 155 114 113 49 48 22 5 Enterprise Value ($mn) 13,736 8,394 3,099 17,642 6,389 nm 3,362 4,296 3,474 2,962 2,620 2,900 2,457 2,431 2,312 11,700 1,563 7,661 2,575 1,761 4,582 2,612 1,574 5,924 1,194 9,809 3,486 108 924 163 672 689 872 402 210 1,351 157 1,527 283 280 2,353 82 1,555 203 101 84 -31 -9 267 5 LTM EBIT/ EV nm 9% 31% 5% nm nm 12% nm 0% nm 4% 5% 20% 9% 1% 6% 9% 3% 9% 3% nm 4% 11% nm 0% 4% nm nm nm nm 20% nm 2% nm nm 16% nm 13% 4% nm 9% nm 1% 12% nm 17% 17% >99% nm nm LTM EBIT/ Capital nm >99% >99% 0-25% nm nm >99% nm >99% nm 0-25% >99% >99% >99% >99% 0-25% >99% 0-25% 0-25% 25-50% nm 0-25% >99% nm nm 0-25% nm nm nm nm 25-50% nm 0-25% nm nm 0-25% nm 0-25% >99% nm 0-25% nm 25-50% 50-99% nm >99% nm nm nm nm [MFI100 ● Top100_browser ● MOI_macros_100.xls, MOI100A] © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 37 of 126 Health Net (HNT) – Gaines , Rosenstein  Financial: Insurance (Accident & Health), Member of S&P MidCap 400 Trading Data Price: $14.67 (as of 8/14/09) 52-week range: $7.38 - $28.78 Market value: $1.5 billion Enterprise value: $1.6 billion Shares out: 103.9 million Ownership Data Insider ownership: 3% Insider buys (last six months): 0 Insider sales (last six months): 0 Institutional ownership: 95% # of institutional owners: 555 Consensus EPS Estimates Latest $0.62 0.69 2.19 1.82 1.93 Month Ago $0.62 0.67 2.17 1.95 2.04 # of Ests 12 11 14 14 6 5 Woodland Hills, CA, 818-676-6000 https://www.healthnet.com/portal/ho… Valuation P/E FYE 12/31/08 P/E FYE 12/31/09 P/E FYE 12/31/10 P/E FYE 12/31/11 EV / LTM revenue EV / LTM EBITDA EV / LTM EBIT 17x 7x 8x 8x 0.1x 7x 9x This quarter Next quarter FYE 12/31/09 FYE 12/31/10 FYE 12/31/11 LT EPS growth 8.4% 10.0% Latest Quarterly EPS Surprise Date 8/4/09 Actual $0.49 Estimate $0.53 P / tangible book 1.5x Greenblatt Criteria LTM EBIT yield LTM pre-tax ROC 11% n/m Operating Performance and Financial Position ($ millions, except per share data) Revenue Gross profit EBIT Net income Diluted EPS Cash from ops Capex Free cash flow Cash & investments Total current assets Intangible assets Total assets Short-term debt Total current liabilities Long-term debt Total liabilities Preferred stock Common equity EBIT/capital employed 12/31/02 10,195 1,580 352 226 1.86 414 45 368 833 0 784 3,461 0 0 399 2,160 0 1,300 n/m 12/31/03 11,065 1,758 517 234 2.73 380 55 325 861 0 749 3,549 0 0 399 2,255 0 1,294 n/m Fiscal Years Ended 12/31/04 12/31/05 12/31/06 11,646 11,941 12,908 1,305 1,716 2,073 67 376 479 43 230 329 0.38 1.99 2.78 (55) 191 278 48 49 73 (103) 143 205 722 743 705 0 0 0 746 742 795 3,653 3,941 4,297 0 0 200 0 0 0 398 388 300 2,380 2,352 2,518 0 0 0 1,273 1,589 1,779 n/m n/m n/m 12/31/07 14,108 2,038 359 194 1.70 606 65 541 1,007 0 861 4,933 35 0 510 3,058 0 1,876 n/m 12/31/08 15,367 1,901 147 95 0.88 (159) 96 (255) 668 0 843 4,816 27 0 652 3,064 0 1,752 n/m LTME 6/30/09 15,635 1,949 168 116 1.11 (21) 31 (52) 566 0 835 4,803 118 0 498 2,977 0 1,827 n/m FQE 6/30/08 3,842 528 118 77 0.71 (81) 60 (141) 761 0 853 4,921 26 0 661 3,137 0 1,784 n/m FQE 6/30/09 4,014 503 64 40 0.38 (54) 5 (59) 566 0 835 4,803 118 0 498 2,977 0 1,827 n/m Ten-Year Stock Price Performance and Trading Volume Dynamics $70 $60 $50 $40 $30 $20 $10 $0 Jul 00 Jul 01 Jul 02 Jul 03 Jul 04 Jul 05 Jul 06 Jul 07 Jul 08 Jul 09 © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 101 of 126 BUSINESS OVERVIEW Health Net provides managed care in two segments: Health Plan Services operates commercial, Medicare (including Part D) and Medicaid health plans; health and life insurance firms; and behavioral health and pharma services. Government Contracts includes government-sponsored managed care plans through the TRICARE program and other health care-related government contracts. The company’s operations are the result of a 1997 merger of Health Systems International (HSI) and Foundation Health. SELECTED OPERATING DATA FYE December 31 2004 2005 2006 2007 5% 3% 8% 9%  revenue 5% 0% 9% 10%  health plan premiums -4% -5% 6% 1%  plan membership 8% 9% 3% 8%  plan PMPM 1 Revenue ($bn) 11.6 11.9 12.9 14.1 % of revenue by type: Health plan premiums 82% 80% 80% 81% Government contracts 17% 19% 18% 18% Net investment income 0% 1% 1% 1% % of health plan services premium revenue by line of business: Commercial premiums 73% 71% 67% 65% Medicare premiums 16% 17% 22% 24% Medicaid premiums 11% 12% 11% 10% Health plan services MCR by type: 2 Commercial (incl. ASO) 3 88% 83% 83% 86% Medicare 92% 89% 83% 85% Medicaid 82% 82% 81% 83% Gov’t-related cost ratio 4 95% 96% 94% 92% G&A expense ratio 5 9% 10% 11% 11% Selling costs ratio 6 3% 2% 2% 3% Pretax income margin 7 1% 3% 4% 3% Health plan services membership by segment (‘000): Commercial 2,603 2,380 2,251 2,225 ASO 3 80 116 109 68 Medicare (ex. Part D) 172 174 499 615 Medicaid 832 830 840 846 Health plan PMPM ($) 216 236 244 264 Plan costs PMPM ($) 191 199 202 225 Net income ($mn) 43 230 329 194 Diluted EPS ($) 0.38 1.99 2.78 1.70 -4% 1% 2% -3%  shares out (avg) 2008 9% 8% -1% 5% 15.4 81% 18% 1% 63% 28% 9% 86% 90% 84% 95% 10% 3% 1% 2,024 44 840 812 278 241 95 0.88 -4% 1H09 3% 1% -15% 6% 7.9 79% 20% 1% 61% 30% 9% 86% 88% 88% 95% 11% 3% 1% 1,999 38 284 878 296 255 62 0.59 -4% INVESTMENT HIGHLIGHTS   Strong position in California, with 2.3 million members enrolled in commercial, Medicaid and Medicare (ex. Part D) programs. To sell Northeast operations to UnitedHealth for $510-630 million, with ultimate proceeds dependent on renewal rates of commercial customers. The operations have tangible book of $450 million, 578,000 members, and ‘09E revenue of $2.7 billion. The deal should be “modestly accretive” to EPS. CEO Jay Gellert (55) joined HSI, a predecessor, in 1996 and became CEO in 1998. Chairman Roger Greaves (71) founded a predecessor of the company in 1990. Joe Capezza (54), CFO since 2007, was previously CFO of Harvard Pilgrim Health Care. Guiding for adjusted EPS of $2.25-2.35 in 2009, up from $1.85 in 2008 but down from $3.66 in ‘07. Strong balance sheet, with $1 billion of tangible book value and virtually no net debt. Repurchased $1.3 billion of stock at $34 per share over the years, with another $103 million authorized at the end of Q2. The company has not bought back shares this year due to a review of strategic options. Shares trade at 7x ‘09E EPS, 1.5x tangible book.     Source: Gridstone Research, Company filings, Manual of Ideas analysis. 1 PMPM stands for “premiums per member per month” and is calculated based on total at-risk member months (ex. “admin. services only” member months). 2 MCR = medical care ratio = health plan expense (ex. D&A) / premiums. 3 ASO refers to “administrative services only” members. 4 Calculated as government contracts cost divided by associated revenue. 5 Computed as G&A expenses divided by the sum of health plan services premium revenue and administrative services fees and other income. 6 Computed as selling expenses divided by health plan services premiums. 7 Computed as GAAP income before taxes divided by total revenue.   COMPARABLE PUBLIC COMPANY ANALYSIS MV ($mn) UNH WLP WCG HNT 32,620 24,790 1,050 1,520 EV ($mn) 36,180 32,570 110 1,570 EV / Rev. .4x .5x .0x .1x P / T. Book n/m 74.8x 1.5x 1.5x This FY P/E 9x 9x 9x 7x Next FY P/E 9x 9x 11x 8x INVESTMENT RISKS & CONCERNS Declining membership in commercial segment, the company’s largest value driver. Membership has fallen steadily over five years, but declines have slowed due to new sales in Western health plans. Lost TRICARE North contract in July, affecting vast majority of government contracts revenue. The latter accounted for 20% of revenue in 1H09, with a cost ratio in the mid-90s. Unless revised, the deal is scheduled to conclude at the end of Q1 2010.  RATINGS VALUE Intrinsic value materially higher than market value?  MANAGEMENT Capable and properly incentivized?  FINANCIAL STRENGTH Solid balance sheet?  MOAT Able to sustain high returns on invested capital?  EARNINGS MOMENTUM Fundamentals improving?  MACRO Poised to benefit from economic and secular trends?  EXPLOSIVENESS 5%+ probability of 5x upside in one year?  MAJOR HOLDERS CEO Gellert 2% | Other insiders 1% | JANA 2% THE BOTTOM LINE Health Net is refocusing managed care operations on the Western region, comprised of California, Oregon and Arizona. In July, the company agreed to divest the roughly breakeven Northeast operations to UnitedHealth for a modest premium over tangible book value. With adjusted EPS estimated at $2.25-2.35 in 2009, Health Net shares appear quite cheap, but the lack of growth and unpredictable regulatory environment make it difficult to gain comfort regarding long-term earning power. If the new Western strategy can produce sustainable growth, Health Net would create significant shareholder value. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 102 of 126 …additional insight into HNT: SLIDES FROM COMPANY PRESENTATION, MAY 2009 © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 103 of 126 Notes from Value Investing Seminar in Italy, July The Manual of Ideas’ Oliver Mihaljevic attended the Seminar in Molfetta, Italy from July 14-15. Here are his notes. For speaker biographies, visit http://www.valueinvestingseminar.it/pages/eng/speakers_2009.asp Ciccio Azzollini, Cattolica Partecipazioni Ciccio Azzollini’s presentation was entitled, Surviving: The Name Of The Game. Ben Graham’s three timeless ideas for investing:  Evaluate stocks as part-ownership in the business  Make Mr. Market your friend by taking advantage of prices he quotes you when these prices deviate substantially from fair value  Invest with a “margin of safety”  build a bridge able to withstand 15,000 pounds if you’re going to drive a 10,000 pound truck across it Investment-related observations:  Equity markets around the world show disappointing 10-year track records with U.S. and Europe down 30-50%  Now a good time to look for investments and review value investing toolkit  Ciccio favors “investing with flexibility,” i.e., in undervalued stocks, risk arbitrage, special situations, distressed securities  all can have different risk/reward and time horizon profiles but value investing basis for investing is the same (look for situations with motivated sellers and missing buyers leading to large price dislocations) Understand your edge when making an investment:  Information?  Analysis?  Psychology?  Time horizon? Do a few things well when evaluating an investment:  Understand the business  Understand the people running the business  Get safety from the price paid  Concentrate on best ideas  Discipline, rationality and patience are key Investment Idea: Banco Popolare (Milan: BP)  4th largest Italian commercial bank with market share of approx. 10% in 6 regions of northern Italy  Network of approx. 2,200 branches  Business model focused on retail banking  Sound balance sheet and liquidity: loan/deposit ratio of 0.91 as of 3/31/09; funding needs covered until 2011  Asset base is low-risk: focus on local domestic market (where no real estate bubble); merchant banking portfolio valued at market; strong diversification and strict loan provisioning  No investments in toxic assets: no exposure to subprime mortgage sector or structured products  Ciccio estimates intrinsic value per share of €8.5-11 (based on 10-12x normalized EPS of €0.85-0.95 assuming €1.4B of pre-tax, pre-provision earnings, €300-400M of losses, 45% tax rate and 640M shares outstanding) vs. current market price of ~€5 and tangible book value of €7 per share © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 116 of 126 Victor Fasciani, Praetorian Value Fund Victor Fasciani presented an investment case for Contango Oil & Gas (MCF). Praetorian Value Fund – Investment Philosophy  Understand every detail of business (financials, management, industry, competition)  “leave nothing to chance”  Market volatility and irrationality present opportunities across all market caps (traditional small/mid-cap focus)  Diversification is not risk management Praetorian Value Fund – Selected Investments Long (as of 4/30/09): Alliance Grain Traders (AGT.UN-V.TSX): company in commodity business without commodity-like characteristics; American Express (AXP); Contango Oil & Gas (MCF); Cresud (CRESY); Gigamedia (GIGM); Transocean (RIG); Vulcan Materials (VMC) Recent Short: Dollar Thrifty (DTG) - over-levered year-to-date outperformer that should come crashing down Investment Idea: Contango Oil & Gas (MCF)  Company focuses on highest ROI part of the value chain: exploration  Founded by CEO Ken Peak in 1999 with $30 million of capital (stable share count since 2001)  Buffett-like philosophy: give smart people capital, large incentives for doing well, and then let them do their thing  Leanest operation: seven employees in Houston (everything except planning and idea generation is outsourced)  Underfollowed by sell-side: no analyst coverage  Robust balance sheet: no long-term debt  Motivated and incentivized management: CEO owns 20% of company Compelling valuation:  $1.3B or $78/share intrinsic value of proved reserves only (based on net present value of after-tax income assuming $7 per Mmbtu natural gas price and $70 per barrel of oil)  Reserves in place for last ~50 million years and not going away  Other assets and free options add up to $30-40/share (MCF bought 70+ lease blocks in the Gulf at $35 million cost basis; may be worth $100 million because of seismic data and company’s 67% successful drill track record) Catalysts:  Continue drilling in the Gulf potentially converting probable into proved reserves  Company for sale in summer 2008 – received offers of $70-80 but CEO would not sell as prices viewed as fire-sale  Assets remain in play and CEO is 65 years of age  Company has $100M stock buyback in place Reasons for mispricing:  Natural gas stocks trade partly based on spot or front-month natural gas futures price movements  as 12-month forward curve significantly higher than spot, market seems to ignore the implied increase in prices  Market won't pay for optionality value of assets in oil & gas, especially in current environment  Market doesn't give enough credit to good management teams in this industry Why Natural Gas Stocks Present Opportunities  Assets can be easily converted into cash and non-perishable inventory  Currently reserves are cheaper on Wall Street ( M&A) than in the ground  Ratio of oil to natural gas prices at 16:1 vs. 10:1 historically  Victor convinced of reversion to mean and thinks this will happen by natural gas prices rising from their recent lows in the $3.50 range (thinks long term floor for natural gas prices is around $6 for companies to achieve 10% ROE  if prices fall below that for long, higher cost onshore wells are shut reducing supply and eventually leading to higher prices again, as happened in fall of 2006) © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com August 21, 2009 – Page 117 of 126 About PORTFOLIO MANAGER’S REVIEW © 2008 by BeyondProxy LLC. All rights reserved. All content is protected by U.S. and international copyright laws and is the property of BeyondProxy and any thirdparty 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. PORTFOLIO MANAGER’S REVIEW is published monthly by BeyondProxy. Subscribers may download content to their computer and store and print 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 BeyondProxy is strictly prohibited. Terms of use: Use of this newsletter and its content is governed by the Terms of Use described in detail at www.manualofideas.com. See a summary of key terms below. 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PORTFOLIO MANAGER’S REVIEW A Monthly Publication of BeyondProxy LLC www.manualofideas.com editor@manualofideas.com July 31, 2009 When asked how he became so successful, Buffett answered: “we read hundreds and hundreds of annual reports every year.” Edited by the Manual of Ideas Research Team “If our efforts can further the goals of our members by giving them a discernible edge over other market participants, we have succeeded.” INFLATION PROTECTION SERIES – PART II: BUSINESSES WITH PRICING POWER AND LOW CAPITAL INTENSITY ► For-Profit Education Firms ► Companies Providing Human Capital Services ► Other Interesting Businesses ► Also Inside: Exclusive Interview with Guy Spier Top Ideas In This Report McGraw-Hill Companies (NYSE: MHP) …………………. p. 36 Princeton Review (Nasdaq: REVU) ……………… p. 40 Sotheby’s (NYSE: BID) …………………… p. 42 Companies mentioned in this issue include: 51job, Acxiom, Administaff, Alliance Data Sys., Ambassadors Group, American Public Education, AMN Healthcare, Apollo Group, ATA, Automatic Data, Barrett Business Services, Bridgepoint Education, Burlington Northern, Capella Education, Career Education, CDI, China Distance Education, China Education, Chinacast Education, ChinaEdu, Coca-Cola Company, COMSYS IT Partners, Corinthian Colleges, Corporate Executive, Cross Country Health, DeVry, Diageo, Dice Holdings, Dr Pepper Snapple, Dun & Bradstreet, Eaton Corp., Eli Lilly & Co., Energizer Holdings, Equifax, Exterran Holdings, Fair Isaac, Foster Wheeler, Franklin Covey, GlaxoSmithKline, Global Payments, GP Strategies, Grand Canyon, H&R Block, Harley-Davidson, Harte-Hanks, Heartland Payment, Heidrick & Struggles, Hershey, Hewitt Associates, infoGROUP, Intuit, ITT Educational Services, Johnson & Johnson, K12, Kelly Services, Kenexa, Kforce, Kimberly-Clark, Korn/Ferry, Learning Tree, Lincoln Educational, Inside: Lorillard, Manpower, McGraw-Hill, Merck, Microsoft, Monster Worldwide, Moody's, MPS Group, New Oriental Education, Noah Education, Nobel Learning, Novartis, Novo Nordisk, On Assignment, Paychex, PepsiCo, Exclusive Interview with Pfizer, Princeton Review, Procter & Gamble, Resources Connection, Guy Spier, founder and CEO Reynolds American, Robert Half International, Sanofi-Aventis, Sotheby's, of Aquamarine Capital Spherion, SPSS, Starbucks, Strayer Education, Taleo, Ticketmaster, Management Total System Services, Travelzoo, TrueBlue, Universal Technical, Valassis Comms, Volt Information, Walt Disney, Washington Post, Watson Wyatt,, and more. Also Inside Editor’s Commentary ……………. p. 4 Interview with Guy Spier ……….. p. 6 For-Profit Education Companies .. p. 46 Human Capital Services Firms … p. 77 Other Interesting Businesses ….. p. 88 About Portfolio Manager’s Review Our goal is to bring you equity investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary screening methodology to identify opportunities that are not yet widely followed by institutional investors. John Mihaljevic, managing editor, is a fund manager, former banker and analyst. He is a member of Value Investors Club, an exclusive community of top money managers, and has won the Club’s prize for best investment idea. John is a trained capital allocator, having studied under Yale chief investment officer David Swensen and served as research assistant to Nobel laureate James Tobin. John holds a BA in Economics, summa cum laude, from Yale and is a CFA charterholder. He resides in New York City with his wife and two kids. With compliments of The Manual of Ideas (profiled companies are underlined) Copyright Warning: It is a violation of federal copyright law to reproduce all or part of this publication for any purpose without the prior written consent of BeyondProxy LLC. The Copyright Act imposes liability of up to $150,000 per issue for such infringement, and violators will be prosecuted to the full extent of the law. See inside for subscription information, including having multiple copies sent to you. © 2008-09 by BeyondProxy LLC. All rights reserved. Exclusive Interview with Guy Spier Guy Spier of Aquamarine Capital is a noted value investor and speaker on investment management. Guy’s willingness to share his insights with fellow value investors reminds us of Buffett’s penchant for sharing his wisdom with those eager to benefit from it. Last November, Guy spoke on global value investing at the Darden Value Investing Conference in Charlottesville, Virginia.1 This past May, he was at the Value Investing Congress in Pasadena, California,2 making a case for global for-profit education providers Estácio (Brazil: ESTC3)3 and Raffles Education (Singapore: E6D).4 Earlier this month, Guy presented at the Value Investing Seminar in Molfetta, Italy, highlighting an opportunity in London Mining (Oslo Axess: LOND).5 His speech was entitled, Navigating Between Fear & Greed Using Checklists.6 On The Investment Process… MOI: Your fund has outperformed the market indices by a wide margin since inception, posting a cumulative net return of 115% from September 1997 through June 2009, compared to cumulative returns of 9% for the Dow Jones Industrial Average, 0% for the S&P 500 Index and -13% for the FT 100. Do you use short-selling or leverage in the portfolio and how concentrated is your fund typically? The trend of the market is up, not down. Shorting stocks puts you against that trend… Guy Spier on short selling: I do not use short selling. The fund has not shorted a stock since the 2002 to 2003 time frame. At that time I did short three stocks, on which I broke even on two and made money on one of them. The experience taught me that I was not going to be using short selling going forward for a slew of reasons. The first is the straightforward logic of the matter. The trend of the market is up, not down. Shorting stocks puts you against that trend and thus makes it more difficult to make money. Other than a time period like the one we’ve gone through, short selling will tend to be a difficult strategy to make money with. Second, the mathematics of shorting – when you short something and it goes down, it becomes a bigger and bigger part of your portfolio, thus creating increasing risk as things go against you, making it an unbalanced and unstable thing to manage. By contrast, when you go long something and it goes against you, it becomes a smaller and smaller proportion of the portfolio, thus reducing its impact on the portfolio. So there is a tendency for long positions to selfstabilize in a certain way – they have a stabilizing effect on the portfolio, whereas short positions have a destabilizing effect on the portfolio. Watch Guy’s speech at http://manualofideas.com/blog/2008/12/tom_russo_and_guy_spier_on_glo.html Read our notes from Guy’s presentation at http://manualofideas.com/blog/2009/05/vic_live_blogging_guy_spier.html The investor relations website of Estácio may be accessed at http://www.estacioparticipacoes.com (English language version available) 4 The investor relations website of Raffles may be accessed at http://www.raffles-education-corporation.com (available in English) 5 The investor relations website of London Mining may be accessed at http://www.londonmining.co.uk/investors.asp 6 Read our notes from Guy’s presentation at http://manualofideas.com/blog/2009/07/guy_spier_live_blogging_the_va.html. To download the full presentation, visit http://www.manualofideas.com/files/content/guy_spier_presentation_2009-07.pdf 2 3 1 © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 This results in two things. First, it means that if you are going to short, you have to make each short position a small proportion of the portfolio. Most of the people I respect who do short make their short positions no more than 1% or 2% of the portfolio, which means that in order to derive advantages from it, you need to short a lot of stocks. The other effect is that you have to be super vigilant. When you have shorts in your portfolio, you have to be watching them all the time, looking for indications of something that will cause the stock to go up on you many multiples and thus eat away much of the value in your portfolio. That is not the way that I want to run money. What I found when I was short the three stocks was that I was doing things, and having to pay attention in ways that I don’t think my brain is wired for. As you know, and many of your readers know, much of investing is finding a way to invest successfully to play the odds which are in tune and in congruence with the way your own nervous system is wired. I think that there are some people out there who have nervous systems that are wired to do shorting very well. I take my hat off to them, but I am not one of those people. I would also add that short selling falls into a category of trade that Nassim Taleb has described very well in Fooled by Randomness. It has been described as picking up pennies in front of a steamroller. There are many trades that appear to be profitable on a cash basis, meaning that one can go for years picking up the pennies, showing an income, while pretending to one’s self, or one’s risk managers, or investors that the risk of a loss on that trade is minimal to zero. The practical reality is that one can go for long periods of time on those trades and can do just fine until a big bath happens that eats away all of the previous profits that were gained. I would argue that short selling is one of those kinds of trades and the big bath is exemplified by the experience that people had in the recent Volkswagen/Porsche pair trade. The price of VW went up many, many, many times and resulted in a huge loss for the people who were in that position, potentially wiping out many years of shorting gains. I see a lot of these kinds of opportunities, and the right thing to do is just to say “no.” I think one of the hard things about these types of trades is that they are extremely attractive. They are dressed up to look extremely sexy for the kinds of people that are thinking about investing in funds like mine. I think that often investment managers consider doing them not because they believe in the trade themselves, but because they know it will be attractive to certain types of investors who perceive the trade as being smart. I think that the best thing to do is walk away from them. Guy Spier on leverage: I was actually levered to 110% of the value of equities, so 10% levered in 1998, as I purchased more securities during the Asian crisis. I was very lucky, because everything worked out for me and I made a little bit more return as a result. Since then, the fund has never been leveraged for a very good reason. Most of the people that you and I know, the readership of your fine publication, will be in trades that will make them money provided they can play out their hands. …short selling falls into a category of trade that… has been described as picking up pennies in front of a steamroller. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 We know that leverage can prevent you from playing out your hand because exactly the time when markets go into crisis is when your credit gets called. I am aware of funds that had their credit lines pulled at the most inconvenient times and suffered catastrophic losses which would not have been suffered had their credit not been pulled. It is worth saying that except in the case of a very large fund that can arrange for some kind of long-term loan from their broker, the loans tend to be overnight. You get money overnight and the trades can usually be liquidated within a very short period of time. Good investment ideas usually take months, if not years, to play out. I would argue that levering up an investment portfolio, even if it is composed of liquid securities, is a profound mismatch of assets and liabilities. I think that the experience of Bear Stearns and Lehman Brothers exemplifies this case. They were borrowing money short-term and the investments they were making were liquid, so from the perspective of the lender they were not bothered because they knew they could force the brokerage firm to liquidate in order to pay their short-term funding. The reality was that the bets that they were making needed time to play out and to the extent that those firms didn’t have the time to let those bets play out, they suffered insolvency, and that is not something that I am about to do for my investors. Guy Spier on concentration: The portfolio was extremely concentrated in that about six positions were as much as 85% of the total value of the fund. I think that part of the reason for my substantial decline in 2008 was the fact that risks that I was not aware of cropped up in the portfolio and impacted some positions substantially. If I were able to go back in time and look at the information I had, I am not sure I would not have owned the things that I owned. However, I think that one of the ways I could have protected my investors from such a substantial decline is to have less concentrated positions. Going forward a 5% position will be a full position. An idea will have to be something absolutely extraordinary to become a 10% position and many positions in the portfolio are currently 2-4%. …leverage can prevent you from playing out your hand because exactly the time when markets go into crisis is when your credit gets called. MOI: When it comes to stock selection, you have talked about the importance of checklists. Why are they so crucial, and what are some of the key items on your checklist? Guy Spier: Those readers who have seen my two or three presentations know that I have talked about checklists. All of these ideas have emerged from conversations with Mohnish Pabrai, who noticed an article by Atul Gawande in The New Yorker with profound implications for investors. I'll share the basic insight that I have had as a result of these conversations: I think that we just have to acknowledge that there are some individuals out there — I think Warren Buffett in the investment world is one, Ajit Jain in the insurance world is another — who have a very particular ability to rationally analyze a situation in spite of crazy things going on in the world. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 Most of us do not have that specific wiring. In spite of that, we can still improve our decision-making an awful lot by using checklists. The main way that I see it is that the investment world, either by design or by nature — and I think it is a combination of the two — throws up plenty of information that is designed to trigger one of two areas in the brain. One is the threat detection fear mechanism, which throws up a very primeval response that has evolved within us for a very long time. It is one of the oldest parts of our brain — the fight-or-flight response. When we see something that makes us fearful, and we don’t have time to act, analyze and make weighted judgments, we have to decide either to run or to stay. We all know days in the market where that part of an investor’s brain is dominating and in which share prices can move around rather dramatically when compared to what appears to be very small amounts of news. So that is one sort of mode that the markets can be in, which is really the psychological mode of the majority of the participants in the market. Then there is another side, which is irrational exuberance, as Alan Greenspan has described it, where the part of the brain that is being triggered is, as I’ve seen it described in various articles, the pleasure center of the brain. It turns out that the part of the brain we stimulate by the expectation of future profits is not that far away or dissimilar to the part of the brain that is stimulated, or lights up in CAT scans, when cocaine addicts either contemplate or are taking cocaine. These are very powerful centers. Whether it is the fight-or-flight or the expectation of pleasure centers, the effect of both is to short-circuit rationally considered thoughts. They undermine the path of the brain that can make weighted, careful judgments about probabilities and about expectations. My perception is that it is the rational neocortex from which flow the very best investment decisions. Unfortunately, the world in which we operate is a minefield of opportunities to get caught up either by the fight-or-flight or by the pleasure center. So to the extent that somebody will talk about an investment being good when one is trembling with greed – I would not subscribe to that because trembling with greed implies that your greed and pleasure mechanisms in the brain are dominating the rational side. I think that somebody like Warren Buffett is naturally wired not to be in either of those two extremes and spends his time in the happy middle. I think that what the rest of us human beings can do to train ourselves to be in that happy middle is use checklists. A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes. So that is the basis for checklists. The example I have given in talks is an airplane that is crashing. There is no question that checklists have been extremely helpful in reducing airplane accident rates. What it does is it brings the brain back to the place where one can make rational decisions. A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 MOI: What advice would you give other investors on building an effective checklist? Is it primarily a product of past investment experience, i.e., mistakes — and if so, how does one differentiate between mistakes that should go on the checklist versus others that are simply unavoidable? Guy Spier: Obviously, in terms of building checklists, there is no question that the place to go is past mistakes. Not only one’s own past mistakes, but also to look at other investors’ past mistakes and see what those mistakes were. It seems to me, and it is a process that I am still going through, that the more specific the checklist item is the better. I can give an example of an investment that I made where the CEO of the corporation was going through a divorce — a long, protracted and bitter divorce. In retrospect, when I look at what went wrong in that investment, I can see very clearly that the fact that he was going through this divorce meant that the CEO was much less able to focus both on the needs of the business and on capital allocation decisions. His whole investment, in fact, would have gone to his former wife if she had won the lawsuit. The whole company would not have belonged to him. So his emotional ties to the company were predicated on the outcome of the court case. His desire to make money for the company’s shareholders would have been hugely diminished if his wife had ended up controlling the company. So one of the items in my checklist is whether the CEO is going through major divorce proceedings, in which case I would tend to weigh that very heavily. To give an example of checklist items that don’t come from individual or personal mistakes is the example of Coca-Cola and its ownership by Berkshire Hathaway. There was a period earlier this decade when Coca-Cola was trading at a multiple which was as high as 40 to 45 times earnings. We all know that Warren Buffett did not sell. I think that there is at least one statement in the public domain where he said that if given the chance to revisit that decision, he would have sold Coca-Cola. I ask myself to what extent he was unable to make that choice at the time and execute a sale because he had already made public statements in the annual reports and elsewhere that Coca-Cola was an inevitable and permanent holding of Berkshire Hathaway. Making such a public statement is a very powerful driver of commitment consistency bias, which may have affected his ability to make rational decisions. So what would go on the list? You would ask yourself the question, “Have I made public statements about this?” Obviously, the note to self is, don’t make public statements about positions you own that will predispose you towards owning them or not owning them or being able to sell them or not. There is another example from Berkshire Hathaway, which is the acquisition of Cort Furniture, which did not turn out to be the phenomenal acquisition that some commentators suggested it was. It seems that one of the reasons is that Cort was in the business of renting furniture to people who had a temporary need. Cort benefited dramatically from the Internet bubble in which many companies were setting up offices that needed to be furnished rather quickly and had large amounts of money to spend. In the aftermath of the Internet bubble, the demand from that portion of the market was extremely attenuated and Cort’s earnings power was diminished significantly. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 …in terms of building checklists, there is no question that the place to go is past mistakes. …checklists are not wish lists. The basic insight that seems to have not been applied in the Cort acquisition, which has gone onto my checklist, would be, “Am I investing in an industry or a company that is benefiting from another industry that has just experienced a dramatic boom?” Another way of saying the same thing would be, “Am I investing while looking in the rear view mirror rather than looking at the road ahead?” Whether they are yours or somebody else’s, I think that mistakes are the most fruitful place to look for checklist items. It is important to note that checklists are not wish lists. Obviously, we are looking for certain kinds of businesses and certain types of investment. That is what we are navigating for. The checklists are very specific items that are designed to bring our brains away from the influence of greed and fear. I would argue that I am not sure a mistake that is unavoidable is a “mistake” in terms of your question. I think that there are so many ways where one can go wrong. In retrospect we can see what we should have known. It is hard to control for the unknowable, because it is by definition unknown. The more one can throw onto an investment checklist, the better. It is worth pointing out that no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up the issues that one should be focused on. Then an investor can try to weigh them to decide if they negate the benefits of the investment or not. One of the things that the checklist has done for me is to bring up the basic question: “Are we stretching to make the investment?” In this way investing is very similar to golf. In golf, one never hits a good shot if one is stretching or pushing oneself. The best golf shots come when we are acting well within our capacity. To that extent, a term that I do not think should apply to investing is, “I spent time getting comfortable.” The investment should leap out to you. If you are trying to get comfortable with something or it takes too long for you to get comfortable with it, then it is probably not a good investment. You shouldn’t have to get comfortable. That implies to me that I would be stretching. …no investment is going to pass every single investment checklist item. What the investment checklist will do is to throw up issues that one should focus on MOI: What is the single biggest mistake that keeps investors from reaching their goals? Guy Spier: The biggest mistake is when we as investors stop thinking like principals. I think that when we think as principals, when we apply Ben Graham’s maxim that we should treat every equity security as part ownership in a business and think like business owners, we have the right perspective. Most of the answers flow from having that perspective. While thinking like that is not easy, and most of the time the answers are not to invest and to do nothing, the kind of decision-making that flows from that perspective tends to be good investment decision-making. I’ll just give you examples from my own life and from people close to me of the ways in which that perspective can be deformed by the environment and circumstances. It can be deformed by having the wrong investors — investors who see you, the investment manager, as a proxy for their desires. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 I had an experience with an investor who was admonishing me for holding too high much cash. The investor claimed that they were not paying me to hold cash balances. Well, that created a pressure on me to get fully invested. The person making the investment wanted me to show that cash was being put to work. I was responding to the situation rather than to the logical and rational dictates of having a prudent amount of cash. I was responding to the actual demand of the client. To the extent that I did respond to that pressure, I was acting less like a principal and more like somebody that was putting together a marketing story. In another example, to the extent that I have been associated with the for-profit education industry, I have received questions as to why I don’t market my fund as a global education fund. Again, if I were to do so, I would no longer be acting as a principal trying to maximize the return on investment for my shareholders, but I would be seeking to market the fund by appealing to a particular niche audience. That could result in some substantial misallocations of capital. I think that this mistake comes in varied forms and it influences all of us. When we talk about creating the best environment for making investment decisions — a lot of that entails investing within the right structure, the right incentive structure. It also comes from having the right investors as partners and aggressively moving away from and not engaging with people who show themselves to be the wrong type of partner because they are focused on the wrong thing. I think that everything falls from having a principal’s perspective. MOI: How do you generate investment ideas? … whenever something in Seth Klarman’s portfolio is trading below the price that he paid for it, it is worthy looking at. Guy Spier: My answer is “all of the above.” The nature of a good investment idea is that it puts together new facts in old ways or old facts in new ways. You need to have the mental flexibility and creative ability to see something new and see why it fits together in a certain way. I think that the answer in my case is to look at everything, to do everything in a certain way, and to reserve a lot of time for thinking. I read other managers’ letters. I look at the positions they own. The lists of portfolio securities that other managers own are very useful because it means the investment has already passed a very important filter. I think that whenever something in Seth Klarman’s portfolio is trading below the price that he paid for it, it is worthy of looking at, and at the same time, it performs another function. To get better at investing you want to study the moves of the masters. I also read a number of industry publications. The publications vary at any time depending on the particular industries that I am interested in and what subscriptions I have decided to subscribe to. One subscription that I have right now is to The Nilson Report on the credit card industry. Based on my interest in following the U.S. banking sector I recently subscribed to The American Banker. I also recently subscribed to The Oil and Gas Journal. These are all interesting journals that don’t necessarily throw up investment ideas per se, but they throw up background information. While a lot of this information is available on the web, it is very nice to look at it in the form of a publication. www.manualofideas.com © 2009 by BeyondProxy LLC. All rights reserved. July 31, 2009 So, wide reading, including the daily newspapers, is important. I like to screen for companies, but increasingly I have found that your service and other people present me with screens that perhaps provide a shortcut. Having said that, it is also worth saying that I don’t think there is any shortage of ideas for anyone who is interested in investing. It doesn’t take a moment of browsing on the Internet before you have 30 ideas to look at. The real question is, as I look at the ideas, why am I discarding them and what personal biases am I engaging in as I discard them? I think something I have seen in a number of portfolios, including my own, is that the contents of the portfolio are a reflection of the particular biases of the person running the portfolio. To the extent that those biases or the model of the world that person has is faulty, it can lead to either phenomenal returns if the stars are aligned or it can lead to very bad returns if the stars do not align. As I look at other people’s portfolios, I look to understand what their biases are and what particular chinks in their armor they may have. They may have a predilection for small-cap stocks or they may have a predilection for niche companies with niche ideas. Ultimately, what I can say for myself, I have had a bias towards low-capital invested, high-ROE businesses. In general, that is a bias that has probably been very productive. However, there are environments, particularly the one that we have just been through over the past 18 months, where that has probably hurt the portfolio more than it has helped the portfolio. So the way in which we go about generating ideas is obviously both important and critical and I think that ultimately it is a journey to explore our own personal biases. On Global For-Profit Education… MOI: Please share with us your thesis on global for-profit education. Which countries are particularly good places to invest in this growing trend? Guy Spier: The thesis on the global for-profit education business is a very simple one. We have an educational infrastructure whose legacy was the industrial revolution. This has been valid whether we talk about China, Brazil, the United States, or Western Europe. The basic outlook was that the vast majority of people being educated would go to work in factories. They didn’t need more than a certain level of education. These educational systems would then skim off the very best who would go off to be lawyers, doctors, and accountants – white-collar suited pen pushers. The IT and post-industrial revolution that we have been through and continue to go through over the last 30 years has been one in which the need for relatively low skill levels has attenuated and the need for people with high skill levels has grown dramatically. Whether it is people who can do research into biochemistry and biotechnology or whether it is people who are developing gaming software for the gaming industry. Obviously the people who design computer chips or computer programmers need to achieve a certain skill level. … the need for relatively low skill levels has attenuated and the need for people with high skill levels has grown dramatically. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 In every growing part of the global economy, you have the need for highly skilled workers, and the infrastructure is just not set up to generate the number of people we need. For various reasons, the private and the state sector are very slow in responding to those needs. What has jumped in to fill the gaps are the for-profit institutions, which are very responsive to the needs of people who need to improve their skill sets and to prove their marketability in the workforce. That creates the demand for education. I should add that in emerging markets the demand is dramatically heightened by the fact that these economies are trying to grow at a rapid rate, and most of the growth comes from the sectors which require skilled people. I would argue that in places such as China and Brazil there is a dramatic shortage of skilled people. Then we come to the supply side. It turns out that the supply of educational services is profoundly constrained for a number of reasons. I think that this relates to the work that I did in the credit rating business, and there is much that is similar. First of all, the education business tends to be highly regulated. In most countries around the world, you cannot just go and set up a post-secondary college and expect to be allowed to stay in business. There are regulatory requirements which have to be met, and the tendency in all regulated businesses is that the leaders and the largest companies tend to dominate the regulatory process. There is a good aspect to the regulatory process in that it raises standards in the industry and it ensures that you do not have charlatans and fly-by-night companies engaging in the industry. At the same time, it has an anti-competitive effect. Now, from the consumer perspective, that is not good. From the perspective of an investor in those industries it is very good. The other side of the story, which is not regulatory, is equally important. There is a reputational and branding effect which takes place when an educational institution has been around for some time, in which the very fact that you have attended and studied at a certain place gives you credibility in the marketplace. There are a limited number of brands that people can carry in their heads. We all know that when it comes to the United States, it is extremely unlikely that any university would displace Harvard, Yale, or Princeton. This branding effect also extends to the kinds of colleges that are offering for-profit degrees in that when they establish a brand, it becomes very marketable. The students who are going for higher education to improve their skill sets are not going to attend any institution. They are going to attend an institution with a good brand. There are two final elements to the thesis. First, the return on investment to the student is extremely high. This is something that has been studied across economies and has been shown to be the case across many different economies. The payback of any degree, even if you spend $20,000 to $30,000 per year on a two-year degree — which is not as effective as a four-year degree — is usually within two years. Somebody earning $50,000 will end up, after they have finished their degree, earning $60,000 or $70,000. Thus, they can pay off the cost of the education very quickly. [Regulation] raises standards in the industry and ensures that you do not have charlatans and fly-by-night companies engaging in the industry. At the same time, it has an anticompetitive effect. From the consumer perspective, that is not good. From the perspective of an investor in those industries it is very good. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 The ROI on a degree has not been definitively studied, but I estimate to be well in excess of 50%, and the institution is only capturing a small proportion of that return on investment. Then when it comes to the institutions themselves, it turns out that you can have very high operating leverage, very high returns on invested capital, and very high returns on equity in these businesses because your customers benefit and because there are barriers to entry, both regulatory and other. That means that if you are established in the business, you can make very high returns. The key is to buy these companies at reasonable valuations and to buy companies that don’t run into regulatory problems — that have a long hill to slide down. …the international markets have been wide open for [non-U.S.] companies to pursue. MOI: Do U.S. giants such as Apollo Group have a chance of becoming leaders in overseas markets, or do you expect “locally grown” companies to dominate? Guy Spier: I should say that I have not been particularly focused on the U.S. for-profit education sector, even though it is the most developed in the world, because my perception is that the companies have had extremely rich valuations. I also think that since the U.S. market is so large and so full of opportunity, the majority of companies have focused, probably rightfully, on the domestic market. The result has been that the international markets have been wide open for other companies to pursue. I can think of at least one non-U.S. company that has a substantial chance of becoming the dominant player in the for-profit industry over the next 20 or 30 years. But there are some very good United States-based companies that I believe will do extremely well. I have visited the operations of Laureate Education [taken private in CEO-led buyout in 2007] in a number of different countries. They do an outstanding job of running a campus and they also have a global vision. I think that another company that is developing steadily internationally is Kaplan of the Washington Post [WPO], although they have been slower than Laureate to move internationally. The Kaplan testing service exam preparation service is already very international, so they have a good basis upon which to expand their operations. A third company, DeVry [DV], has started to gingerly expand into international markets. They recently bought a company in Brazil and they have had their international medical school, Ross University, which is based in Dominica. They also have means for exploring expansion through Becker Review. The guy who runs international development is named Sergio Abramovich, who is a very interesting guy to get to know. So they are developing, but I would still argue that all those companies, except for Laureate, are very much American in their focus and that creates great opportunity for non-American companies to pursue international opportunities. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 MOI: For-profit education providers have enjoyed significant pricing power despite the fact that many companies derive a majority of revenue directly or indirectly from government-supported loan programs. Do you expect tuition price increases to continue to outpace inflation? Guy Spier: It is true that the for-profit education providers have enjoyed significant pricing power. It is worth saying, as an aside, that education is a fantastic example of a Giffen good. Those of us who are economists will know that a Giffen good is something where the higher the price goes, the more we want of it. Examples usually given are luxury goods such as a Rolls Royce or a Rolex watch. Warren Buffett, in his own inimical way, has described this as when you go and buy a diamond ring for your fiancée. You don’t want to come home and say, “Honey, I took the low bid.” That is true when it comes to certain brands of chocolates, it is true in the case of high-end jewelry, it is true in the case of certain luxury goods, and it is also true for education. It is true in any place where price becomes an indicator of value. Where someone is engaging in a purchasing decision where there is a huge amount of uncertainty, they don’t know much about the product they are buying, and they very much want to get it right. Price becomes one of the ways in which you discern that a purchasing decision is a good thing. This creates an incredibly strong business advantage for companies and enterprises that are leaders in their field. I have absolutely no doubt that the “Harvard Business Schools” of the world will continue to lead the industry in terms of price increases. As more and more people get rich around the world, they will all want elite educations. So as long as there is an increase in demand for their services, as there is today, the “Harvard Business Schools” of the world will be able to increase their prices at a greater rate than the rate of inflation. Those elite private universities create the pricing umbrella for the for-profit industry to move underneath. So if Harvard is raising its prices 10% per year, it is perfectly possible for a for-profit university to raise its prices 5% or 6% per year, and I absolutely expect them to do that. It is true that much of the revenues in the United States come from government-supported programs, but ultimately the decision to take on the debt and the decision to attend an institution is taken on by the student themselves. If the companies were pricing their education above the value that their educational services would deliver to the student, then one could expect that the price rises would not continue, but that is not the case at all. In fact, studies would suggest that the value of an education is going up, not down. One of the statistics you can look at to support this is to look at different economies and look at their salaries per degree. What is the salary of the non-college graduate workers? What is the salary of a college graduate? What is the salary of a master’s degree graduate? The gap between educated and non-educated is increasing. In a knowledge-based world, degrees which help you work with knowledge become more valuable because you can add more value in the workplace. Therefore, the people who are offering these degrees can charge higher prices. I don’t expect that process to end any time soon. …for-profit education providers have enjoyed significant pricing power. […] education is a fantastic example of a Giffen good. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 On International Investing… MOI: You have invested globally for a long time — what are the main pitfalls to global investing and how big a role do transaction costs play when investing locally in emerging markets? Guy Spier: I have been investing internationally for a very long time – since I started investing. The main insight I would pass along is that I try to see the world as borderless. I think this is a better way to see things. I am not too concerned as to where a company is based. I am more concerned to find the business qualities that I need to find in order to make an investment. While it is easier in the United States, I think that an investor is crazy to stop the search for great investments at the borders of the country that they happen to be living in. I think that the most profound pitfall and thing that one has to get over when investing beyond your borders is not to take the conditions that exist in the home investing country and assume that the same conditions exist in the country where the investment is being made. I have seen that going both ways. From the United States investing out, there are assumptions that investors have made about how the managers of the foreign company will allocate capital. There are also assumptions about what kind of standard managers hold themselves to. Not all managers of companies want to be remembered for being the best capital allocators. In some countries, being rapacious and greedy is considered a normal standard. Russia might be an example of that. At the same time, there are some countries such as Switzerland, where I would argue the ethics of drawing a modest salary and really acting for best interest of the shareholders are possibly even higher than the very high standards that already exist in the United States. The reverse is also true. For example, Korean investors think that the United States is a very risky place to invest because they make assumptions about the way Americans act. I think that the key danger is that we make many assumptions that have to be checked and revised. One of the ways to do that is to spend some time in the country where the investments are being made. One of the rules that I have is that I want to be able to read the source documents in the language in which they are produced. I think there is a lot of subtlety that is missed when one reads a translation. Transaction costs in international markets have been going down over time, so I don’t think that they should be a big concern. I have been a buy-andhold investor, and my average holding period is in excess of three years. To the extent that the transaction costs a bit higher, it has not been a deterrent for me. …investors are crazy if they stop the search for great investments at the borders of the country they happen to be living in. MOI: Is globalization irreversible? Guy Spier: The global economic downturn has made protectionism more popular. We absolutely know that. We see that in a number of different ways, and we all know as free traders that this is unfortunate but true. The antiglobalization and the anti-world trade movement is a strong movement. People who feel like their jobs have been lost and their livelihoods have been lost to workers from other countries have a specific and very genuine grievance which is something that all globalizing economies have to deal with. © 2009 by BeyondProxy LLC. All rights reserved. www.manualofideas.com July 31, 2009 To deal with it doesn’t mean to ignore it. To deal with it means to find a way to buffer the effects of the jobs of these people going overseas. Of course, in theory a laid-off autoworker can become a creative web designer. However, the truth is that a laid-off auto worker may only be good at making cars. I have absolutely no doubt in my mind that this is one of the reasons why we pay taxes — to ensure that people who are laid off through globalization have opportunities to retrain and have opportunities to go into new professions and new jobs and be productive human beings. In terms of whether globalization is irreversible, I would argue that it is absolutely irreversible in the same way that the phone created irreversible changes, and the Internet created irreversible changes. I would argue that much of what is driving globalization is actually the implementation of these new communications technologies around the world. …globalization is irreversible… in the same way that the phone created irreversible changes, and the Internet created irreversible changes. One great example that I heard was of the remote Indian village in which there are no telephones. One day you install one telephone and the effect of that telephone is profound even though there is only one. Suddenly farmers can phone hundreds of miles away and discover the prices for their produce at markets. Suddenly, middlemen have a much diminished opportunity to engage in taking middleman profits. Farmers are able to discover weather patterns and storm fronts and thus plan when they plant and how they manage their fields. It is the subject of a talk that I have given. Once you have that convenience, you are not going to give it up at almost any price. Once you have lived in a concrete and steel constructed house, you are not going want to go back to living in a mud hut. Once you have had the benefits of speaking on the telephone to your loved ones, you are not going to want to go without that. I would argue that globalization is inevitable and irreversible. It is similar to thinking that southern Manhattan once had fields and crops planted there. Over time there was an increased concentration of offices and residential activity in southern Manhattan, and the fields moved away from Manhattan such that you don’t have any planted fields within at least a ten-mile radius of Manhattan, let alone southern Manhattan. The process by which southern Manhattan developed was inevitable and irreversible. Much as the probability that southern Manhattan would be ploughed over and turned into fields is extremely low, I would argue that the probability that globalization is reversible is equally as low. And Finally… MOI: What books have you read in recent years that have stood out as valuable additions to your investment library? Guy Spier: I sent Alice Schroeder’s book7 out to a bunch of investors. I think that it is a very valuable book to read. I know that it has been controversial, but setting that aside, I think that Alice probes into aspects of Warren Buffet’s mind and psyche to reveal more of his personality with all of the foibles of the human being behind Warren Buffet. 7 Alice Schroeder: The Snowball: Warren Buffett and the Business of Life. www.manualofideas.com July 31, 2009 © 2009 by BeyondProxy LLC. All rights reserved. For those of us that are big Buffett fans, that is a huge advantage. It helped me to understand why I am different than Warren Buffett. I think it is a valuable read in that regard. It helps to place his mind in the center of the decisions he has made. The book lets you look at the kind of emotional life that Buffett had growing up. I do not think his phenomenal track record could have come about without that emotional makeup. There are three books that I have read not so long ago on complexity theory. I think that they are extremely valuable. One is by John Gribbin.8 Even though I studied economics and I felt I had a good grasp of the kind of economics taught academically, I feel that the study of complexity theory as applied to the global economy is actually a much better model for understanding how the global economy evolves. …by placing an area to play bridge right outside of Borsheim’s, Buffett is saying that bridge is more than just a great game — it is something that has really helped him develop his mind. One of the books is by Benoit Mandelbrot 9 who is famous for the Mandelbrot set. He also wrote a book about the fractal nature of financial markets. Mandelbrot is obviously a very modest guy because his fractal approach to financial markets predicts that sooner or later something like what happened over the last 18 months was going to happen. Unlike other commentators, who get in front of the TV cameras and say “I told you so,” he has not done that. He is a true scientist. Lastly, an investor of mine gave me one of the two books by Atul Gawande who is focused on the very small things that make hospitals better. One of the books is actually called Better. The other book is called Complications. Atul Gawande gives a sense of how you can be extremely knowledgeable and totally focused on the right outcomes and still fail by a wide margin to get close to the ideal that you would like. Of course, this has massive lessons for investors. I recently took up bridge, so I have been reading a lot of bridge books. I am looking forward to going outside Borsheim’s at the next Berkshire Hathaway meeting and playing bridge with whoever is willing to play me. I don’t think that it is a coincidence that Buffett chose to put an area to play bridge outside of Borsheim’s rather than chess or table tennis or any one of a number of other things. It is not just that Buffett likes bridge. He likes an awful lot of things. I think that he is sending a message, in his inimical way, which is not to force it down anyone’s throat. But by placing an area to play bridge right outside of Borsheim’s, Buffett is saying that bridge is more than just a great game, it is something that has really helped him, I believe, develop his mind. I think it can develop all of our minds in a way which is helpful to investing. MOI: Guy, thank you very much for taking the time to interview with us. We remain indebted to David M. Kessler for transcribing the interview. Guy Spier has been running Aquamarine Capital Management since 1995. Investors include friends and family, high net worth individuals, and private banks. The fund has market-beating returns, and has received mentions by Lipper and Nelson’s world’s best money managers. The investees can be obscure or they can also be very well known. The fund has also done well owning the shares of less understood, but very high quality, cash generative businesses. 8 9 John Gribbin: Deep Simplicity: Chaos Complexity and the Emergence of Life (Penguin Press Science). Benoit B. Mandelbrot: Fractals and Scaling In Finance: Discontinuity, Concentration, Risk. www.manualofideas.com July 31, 2009 © 2009 by BeyondProxy LLC. All rights reserved. The Manual of Ideas research team is gratified to have won high praise for our investment idea generation process and analytical work. “I highly recommend MOI — the thoroughness of the product coupled with the quality of the content makes it an invaluable tool for the serious investor.” —TIM DAVIS, MANAGING DIRECTOR, BLUESTEM ASSET MANAGEMENT “We do similar work ourselves.” —GLENN GREENBERG, MANAGING DIRECTOR, CHIEFTAIN CAPITAL MANAGEMENT “The Manual of Ideas is a tremendous effort and very well put together.” —MOHNISH PABRAI, MANAGING PARTNER, PABRAI INVESTMENT FUNDS “Outstanding.” —JONATHAN HELLER, CFA, EDITOR, CHEAP STOCKS “Your reports provide serious investors with a plethora of bargain stocks and sound advice. I highly recommend them.” —MIGUEL BARBOSA, EDITOR, SIMOLEON SENSE “Very impressive.” —SHAI DARDASHTI, MANAGING PARTNER, DARDASHTI CAPITAL MANAGEMENT “It’s little surprise MOI is a winner. When you start with superior stock screening and combine it with good judgment, you put yourself in a great position to outperform.” —MARKO VUCEMILOVIC, FOUNDER AND MANAGING DIRECTOR, ALKAR GLOBAL “This is the best institutional-quality equity research to come along in a long time. It not only unearths companies with compelling risk-reward profiles but also analyzes them with a clear understanding of business economics and competitive dynamics.” —PAVEL SAVOR, ASSISTANT PROFESSOR OF FINANCE, THE WHARTON SCHOOL “I am (as always) impressed with your work.” —MARK SPROULE, SCOPIA CAPITAL “Keep up the great work, you are quickly becoming one of my must-read sources.” —CORY JANSSEN, FOUNDER, INVESTOPEDIA.COM FIND OUT WHAT THE BUZZ IS ABOUT. WWW.MANUALOFIDEAS.COM 

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THE FAIRHOLME FUND A NO-LOAD CAPITAL APPRECIATION FUND FAIRX FAIRHOLME Ignore the crowd. SEMI-ANNUAL REPORT FOR THE SIX MONTHS ENDED MAY 31, 2009 FAIRHOLMEFUNDS.COM 866.202.2263 VALUE OF $10,000 INVESTED AT INCEPTION (UNAUDITED) THE FAIRHOLME FUND VS. THE S&P 500 INDEX Fairholme Fund $40,000 38,000 36,000 34,000 32,000 30,000 28,000 26,000 24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 04 11 /3 0/ 20 00 02 06 7 /2 9/ 19 99 11 /3 0 31 30 /2 00 8 /2 00 9 11 / 5/ 01 03 05 0/ 20 0/ 20 30 0/ 20 0/ 20 0/ 20 0 /2 0 /2 0 S&P 500 $28,461 $7,430 /3 11 / 11 /3 11 /3 /3 The chart above covers the period from inception of The Fairholme Fund (the “Fund”) (December 29, 1999) to the end of the most recent fiscal semi-annual period (May 31, 2009). The following notes pertain to the chart above as well as the performance table included in the Management Discussion and Analysis that follows the Portfolio Manager’s Report. Performance information in this report represents past performance and is not a guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate, so that an investor’s shares when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted within. Any questions you have, including obtaining the latest month-end performance, can be answered by calling the Fund at 1-866-202-2263 or by visiting the Fund’s website at www.fairholmefunds.com. Data for both the S&P 500 Index and the Fund are presented assuming all dividends and distributions have been reinvested and do not reflect any taxes that might have been incurred by a shareholder as a result of Fund distributions. The S&P 500 Index is a widely recognized, unmanaged index of 500 of the largest companies in the United States as measured by market capitalization and does not reflect any investment management fees or transaction expenses, nor the effects of taxes, fees or other charges. 12 11 11 11 /3 THE FAIRHOLME FUND PORTFOLIO MANAGER’S REPORT For the Six Months Ended June 30, 2009 This Portfolio Manager’s Report is based on calendar year performance and precedes a more formal Management Discussion & Analysis. Opinions of the Portfolio Manager are intended as such, and not as statements of fact requiring attestation. All references to portfolio investments are as of the latest public filing of the Fund’s holdings at the time of publication. Mutual fund investing involves risks including loss of principal. Performance information quoted herein represents past performance and is not a guarantee of future results. The investment return and principal values of an investment in the Fund will fluctuate, so that an investor’s shares when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance information quoted within. The Fund imposes a 2% redemption fee on shares held less than 60 days. Performance data does not reflect the redemption fee, which if imposed, would reduce returns. Any questions you have regarding the latest month-end performance can be obtained by calling shareholder services at 1-866-202-2263 or by visiting the Fund’s website at www.fairholmefunds.com. Additional information regarding the risks of investing in the Fund may be found in the Fund’s current Prospectus and Statement of Additional Information. The S&P 500 Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the U.S. equity market in general. Investors cannot invest directly in an index. Please refer to the back cover of this document for additional important disclosures. July 29, 2009 To the Shareholders and Directors of the Fairholme Fund: Below is a comparison of the Fund’s unaudited performance (after expenses) with that of the S&P 500 Index (before expenses), both with dividends and distributions reinvested, for the period ending June 30, 2009: Performance to 6/30/09 Six Months One Year Three Years Five Years Since Inception 12/29/1999 ———— ———— ——— ——— ——— ——— ——— ——— ——— ——— ——— ——— Cumulative: The Fairholme Fund S&P 500 Index Annualized: The Fairholme Fund S&P 500 Index 16.21% 3.16% -13.18% -26.21% -13.18% -26.21% -1.65% -22.70% -0.55% -8.22% 44.21% -10.72% 7.60% -2.24% 195.07% -25.55% 12.06% -3.06% The Fund’s Expense Ratio at May 31, 2009 is 1.00%. In the Fund’s current prospectus dated March 17, 2009, the Fund’s Expense Ratio is 1.02%. 1 THE FAIRHOLME FUND PORTFOLIO MANAGER’S REPORT (Continued) For the Six Months Ended June 30, 2009 In the first half of 2009, The Fairholme Fund earned a total return of 16.21% versus the S&P 500 Index return of 3.16%. This was a period of sharp market moves to say the least. From the end of December to early March, the S&P 500 sank 25%. Then, from March 9 through June 12, the index surged 40%. The index then declined in the last two weeks of June, leaving the index slightly positive for the six-month period. We were able to outperform in the past six months as well as in the trailing one- , three- , and five-year periods because our policy is always to keep adequate cash on hand. Cash is defensive when the market goes into a tailspin. Cash also allows us to be opportunistic in snapping up stocks that get unfairly battered. When panic sets in, as it did many times over the last year, some market participants are forced to sell without regard to price. Cheap stocks are not necessarily good investments. A cheap stock can become cheaper, as was proven over and over again over the past twelve months. Many once-unassailable blue-chip stocks were brought to their knees. World-class banks and financial companies required government assistance to weather the maelstrom. General Motors went through bankruptcy, which would have been unthinkable a decade ago. Successful investing is about getting much more cash over time than you give. Buying cheap relative to expected cash flows is half the battle. Today, even though the market is up significantly from the March lows, the investments we own appear undervalued reflecting the market’s hangover from years of irrational exuberance. For sure, it will take a long time to repair the damaged balance sheets of individuals, corporations and entire nations. Still, we are hopeful that the global economy is on the mend. One of our canaries in the economic coal mine is Hertz Global Holdings. In a June 25 interview on CNBC, Hertz CEO Mark Frissora said “we’ve seen continuous improvement every single week for the last 10 weeks in the US rent-a-car space on improving demand for the summer season. We’ve been buying a lot of cars the last eight weeks…. We’re scrambling to buy as many cars as we can.” Others are beginning to chirp, but are less sanguine. At this time, healthcare and defense remain significant sectors for the Fund. We believe many companies in these sectors are undervalued as they offer essential services and products, have few if any substitutes and have strong cash flows. What’s more, their margins are high enough to assure a steady stream of profits but not so high as to draw in competitors. We believe they are in the sweet spot. 2 THE FAIRHOLME FUND PORTFOLIO MANAGER’S REPORT (Continued) For the Six Months Ended June 30, 2009 Since our start about nine and a half years ago through June 30, 2009, the Fund has appreciated at an average annualized rate of 12.06% compared to an average annualized loss of 3.06% for the S&P 500 Index. A $10,000 investment at The Fairholme Fund’s inception has grown to $29,507 after expenses while $10,000 invested in the S&P 500 Index for the same period has shrunk to $7,445 before expenses. The Fund’s tenets are as always: Vigilance, Focus, Commitment and Value. Numerous shareholders have entrusted the Fund with much of their long-term investments and defending this principal against permanent loss remains our number one priority. To hammer this home, the Managing Member of Fairholme Capital Management, LLC has the lion’s share of his family’s long-term investments in The Fairholme Fund on the same terms and conditions as all the other shareholders. In September, Fairholme will hold a semi-annual conference call and webcast for shareholders. Please visit www.fairholmefunds.com for the details. Thank you for your continued support and trust, FAIRHOLME CAPITAL MANAGEMENT, LLC 3 THE FAIRHOLME FUND MANAGEMENT DISCUSSION & ANALYSIS For the Six Months Ended May 31, 2009 At May 31, 2009, the end of the second fiscal quarter of 2009, the unaudited net asset value (“NAV”) attributable to the 331,990,660 shares outstanding of The Fairholme Fund (the “Fund”) was $24.48 per share. This compares with an audited NAV of $20.95 per share at November 30, 2008, and an unaudited NAV of $33.54 per share at May 31, 2008. At June 30, 2009, the unaudited NAV was $25.38 per share. Performance figures below are shown as of the end of the Fund’s second fiscal quarter at May 31, 2009 and do not match calendar year figures for the period ended June 30, 2009 cited in the Portfolio Manager’s Report. Performance to 5/31/09 Six Months One Year Three Years Five Years Since Inception 12/29/1999 ———— ———— ——— ——— ——— ——— ——— ——— ——— ——— ——— ——— Cumulative: The Fairholme Fund S&P 500 Index Annualized: The Fairholme Fund S&P 500 Index 19.84% 4.05% -25.14% -32.57% -25.14% -32.57% -5.24% -22.75% -1.78% -8.24% 39.17% -9.16% 6.83% -1.90% 184.61% -25.70% 11.74% -3.10% For the six months ended May 31, 2009, the Fund outperformed the S&P 500 by 15.79 percentage points while over the last year the Fund outperformed the S&P 500 by 7.43 percentage points. From inception, the Fund outperformed the S&P 500 Index by an average annual rate of 14.81 or, on a cumulative basis, by 210.31 over nine years and five months. In the opinion of Fairholme Capital Management, LLC (“Manager” or “Management”), performance over short intervals is likely to be less meaningful than a comparison of longer periods. Further, shareholders should note that the S&P 500 Index is an unmanaged index incurring no fees, expenses, or tax effects and is shown solely to compare the Fund’s performance to that of an unmanaged and diversified index of 500 large U.S. corporations. The following charts show the top ten disclosed holdings by issuer and top ten disclosed holdings’ categories of the Fund at May 31, 2009, listed by their percentage of the Fund’s net assets. Portfolio holdings are subject to change without notice. 4 THE FAIRHOLME FUND MANAGEMENT DISCUSSION & ANALYSIS (Continued) For the Six Months Ended May 31, 2009 Top Ten Holdings by Issuer* (% of Net Assets) Pfizer, Inc. Sears Holdings Corp. Hertz Global Holdings, Inc. The St. Joe Co. AmeriCredit Corp. Forest Laboratories, Inc. WellPoint, Inc. United Rental, Inc. Spirit Aerosystems Holdings, Inc., Class A Leucadia National Corp. 14.3% 8.8% 6.8% 6.7% 5.5% 4.6% 4.3% 3.3% 3.2% 3.0% Top Ten Categories (% of Net Assets) Pharmaceuticals Cash and Cash Equivalents** Managed Health Care Aerospace & Defense Commercial Services & Supplies Retail Department Stores Consumer Finance Real Estate Management & Development Diversified Holding Companies Oil & Gas Drilling 18.9% 17.2% 11.1% 10.4% 10.0% 8.8% 8.7% 6.7% 3.0% 2.3% —— —— —— —— —— —— —— —— —— —— —— —— 60.5% 97.1% * Excludes cash, money market funds, and U.S. Treasury Bills ** Includes money market funds and U.S. Treasury Bills During the first six months of the 2009 fiscal year, the Fund initiated positions in the following disclosed investment: Loan Participations and Assignments Spanish Broadcasting System, Inc. Tranche B Loan 2.970%, 06/10/2012 The Fund also increased and decreased existing portfolio holdings. Such changes may not appear obvious due to additions or withdrawals of capital as a result of Fund share purchases or redemptions. During the first six months of the fiscal year, the Fund materially disposed of holdings in the following investments: Common Stocks Canadian Natural Resources Ltd. DISH Network Corp. EchoStar Corp. Mueller Water Products, Inc. Jefferies Group, Inc. Corporate Bonds FMG Finance Pty Ltd. 10.00%, 09/01/2013 5 THE FAIRHOLME FUND MANAGEMENT DISCUSSION & ANALYSIS (Continued) For the Six Months Ended May 31, 2009 Not all dispositions or additions to the portfolio are material, and, while the Fund and its Manager have long-term objectives, it is possible that a security sold or purchased in one period will be purchased or sold in a subsequent period. Generally, the Fund’s Manager determines to buy and sell based on its estimates of the absolute and relative intrinsic values and fundamental dynamics of a particular corporation and its industry, and not on short-term price movements. However, certain strategies of the Manager in carrying out the Fund’s investment policies may result in shorter holding periods. Investors are further cautioned not to rely on short-term results, both with respect to profits and losses on any individual investment in the Fund, as well as with respect to Fund shares themselves. Securities whose market value increases significantly affected the Fund’s overall portfolio value (including realized and unrealized gains) for the first six months of the fiscal year included holdings in the following investments: Common Stocks American Express Co. AmeriCredit Corp. Ensign Energy Services, Inc. Hertz Global Holdings, Inc. Northrop Grumman Corp. Sears Holdings Corp. Spirit Aerosystems Holdings, Inc. The St. Joe Co. UnitedHealth Group, Inc. WellPoint, Inc. Corporate Bonds The Hertz Corp. 8.875%, 01/01/2014 United Rentals, Inc. 7.750%, 11/15/2013 Securities whose market value declines significantly affected the Fund’s overall portfolio value (including realized and unrealized losses) for the first six months of the fiscal year included holdings in the following investment: Common Stocks Mueller Water Products, Inc. The fact that securities decline in value does not always indicate that the Manager believes these securities to be less attractive — in fact, the Manager believes that some price declines present buying opportunities. However, shareholders are cautioned that it is possible that some securities mentioned 6 THE FAIRHOLME FUND MANAGEMENT DISCUSSION & ANALYSIS (Continued) For the Six Months Ended May 31, 2009 in this discussion may no longer be owned by the Fund subsequent to the end of the fiscal period and that the Fund may have made significant new purchases that are not yet required to be disclosed. It is the Fund’s general policy not to disclose portfolio holdings other than when required by relevant law or regulation. The Manager invests Fund assets in securities to the extent it finds reasonable investment opportunities and the Fund may invest a significant portion of its assets in liquid, low-risk securities or cash. The Fund’s Manager views such liquidity as a strategic asset and may invest a significant portion of its cash and liquid assets in other more risky securities at any time, particularly under situations where markets are weak or a particular industry’s securities decline sharply. At May 31, 2009, the Fund’s liquidity (consisting of cash, money market funds, and U.S. Treasury Bills) represented 17.2% of Fund assets. It should be noted that since inception, the Fund has held, on average, a significant percentage of assets in liquid low-risk securities or cash without, in the opinion of the Manager, negatively influencing performance, although there is no guarantee that future performance will not be negatively affected by the Fund’s liquidity. The Fund’s Management, Board, and Manager are aware that large cash inflows may adversely affect Fund performance. However, Management of the Fund, after consulting with the Fund’s Manager, does not believe that inflows have negatively affected performance. To the contrary, the Manager believes that such cash inflows have helped the Fund make opportunistic investments. Management and the Board monitor cash inflows and outflows and intend, after consultation with the Fund’s Manager, to take appropriate actions if they believe future performance is likely to be negatively impacted by net inflows. As of the date of this report, no such actions are contemplated. The Fund transacts in non-U.S. securities and securities of corporations domiciled outside of the United States. It is the intent of the Fund to have the Manager employ a consistent value-based investment philosophy which may expose the Fund to risk of adverse changes resulting from foreign currency fluctuations or other potential risks as described in the Fund’s Prospectus and Statement of Additional Information. The Fund is also considered to be “non-diversified” under the Investment Company Act of 1940 (the “1940 Act”), which means that the Fund can invest a greater percentage of its assets in fewer securities than a diversified fund. The Fund may also have a greater percentage of its assets invested in particular industries than a diversified fund, exposing the Fund to the risk of unanticipated industry conditions as well as risks specific to a single corporation. 7 THE FAIRHOLME FUND MANAGEMENT DISCUSSION & ANALYSIS (Continued) For the Six Months Ended May 31, 2009 The independent Directors of the Board continue to believe that it is in the best interests of the Fund’s shareholders to have Mr. Berkowitz serve as Chairman of the Board given: his experience, commitment, and significant personal investment in the Fund; the present constitution of the Fund’s Board and policies; and current rules and regulations. At May 31, 2009: a majority of the Board is by statute independent of the Manager; no stock option or restricted stock plans exist; Officers receive no direct compensation from the Fund; and Directors who are also employees of the Manager receive no compensation for being Directors. The Officers and Directors (and their affiliates) of the Fund continue to have a significant and increasing personal stake in the Fund, holding an aggregate 3,513,000 shares with a value of $85,998,240 at May 31, 2009. While there is no requirement that Officers and Directors own shares of the Fund, the Officers and Directors believe that such holdings help to align the interests of the Fund’s Management and the Board with those of the Fund’s shareholders. Since inception, the Fund has been advised by Fairholme Capital Management, LLC. Certain Directors and Officers of Fairholme Funds, Inc. are also Members and Officers of Fairholme Capital Management, LLC or FCM Services, Inc., a wholly owned subsidiary of Fairholme Capital Management, LLC. For more complete information about the Fund, or to obtain a current prospectus, please visit www.fairholmefunds.com or call 1-866-202-2263. 8 THE FAIRHOLME FUND EXPENSE EXAMPLE May 31, 2009 (Unaudited) As a shareholder of the Fund, you incur two types of costs: direct costs, which may include, but are not limited to, transaction fees at some broker-dealers, custodial fees for retirement accounts, redemption fees (on shares redeemed within 60 days of purchase), and wire transfer fees. As a shareholder, you also incur indirect costs, such as the management fee paid to the Manager of the Fund. The following example is intended to help you understand your indirect costs (also referred to as “ongoing costs” and measured in dollars) when investing in the Fund and to compare these costs with the ongoing costs of investing in other mutual funds. This example below is based on an investment of $1,000 invested in the Fund at December 1, 2008 and held for the entire six month period ending May 31, 2009. Actual Expenses The first line of the table on the following page provides information about actual account values and actual expenses. You may use the information in this line, together with the amount you had invested at the beginning of the period, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During the Period” to estimate the expenses you paid on your Fund holdings during this period. Hypothetical Example for Comparison Purposes The second line of the table provides information about hypothetical account values and hypothetical expenses based on the Fund’s actual expense ratio and an assumed rate of return of 5% per year before expenses, which is not the Fund’s actual return for the period presented. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses that you paid for the period presented. However, you may use this information to compare ongoing costs of investing in the Fund with the ongoing costs of investing in other funds. To do so, compare this 5% hypothetical example with the 5% examples that appear in the shareholder reports of other funds. 9 THE FAIRHOLME FUND EXPENSE EXAMPLE (Continued) May 31, 2009 (Unaudited) Please note that the column titled “Expenses Paid During the Period” in the table below is meant to highlight your ongoing costs only. Therefore, the second line of the table is useful in comparing ongoing costs only, does not reflect any direct costs, and will not help you determine the relative total costs of owning different funds. In addition, if these direct costs were included, your total costs would be higher. Expenses Paid During the Period* December 1, 2008 Through May 31, 2009 —————————— ————————— Beginning Account Value December 1, 2008 —————————— Ending Account Value May 31, 2009 Actual Hypothetical (5% return before expenses) $1,000.00 $1,000.00 $1,198.40 $1,019.95 $5.48 $5.04 * Expenses are equal to the Fund’s annualized expense ratio of 1.00%, multiplied by the average account value over the period, multiplied by 182 days/365 days (to reflect the one-half year period). The Fund’s Ending Account Value on the first line in the table is based on its actual total return of 19.84% for the six-month period of December 1, 2008 to May 31, 2009. 10 THE FAIRHOLME FUND SCHEDULE OF INVESTMENTS May 31, 2009 (Unaudited) Shares ——— DOMESTIC EQUITY SECURITIES — 70.1% 2,078,100 4,863,000 18,808,600 5,327,800 AEROSPACE & DEFENSE — 10.4% General Dynamics Corp. Northrop Grumman Corp. Spirit Aerosystems Holdings, Inc., Class A (a) The Boeing Co. $ 118,243,890 231,576,060 258,618,250 238,951,830 847,390,030 COMMERCIAL SERVICES & SUPPLIES — 4.4% Hertz Global Holdings, Inc. (a)(b) United Rentals, Inc. (a)(b) Value —————— 46,371,900 8,197,518 317,647,515 38,938,211 356,585,726 5,882,750 31,814,670 CONSUMER FINANCE — 6.8% American Express Co. AmeriCredit Corp. (a)(b)(c) 146,186,338 404,364,456 550,550,794 11,893,274 DIVERSIFIED HOLDING COMPANIES — 3.0% Leucadia National Corp. (a) MANAGED HEALTH CARE — 11.1% Humana, Inc. (a) UnitedHealth Group, Inc. WellCare Health Plans, Inc. (a)(b) WellPoint, Inc. (a) 248,331,561 7,793,900 8,642,400 4,218,200 7,430,900 244,182,887 229,887,840 80,145,800 346,057,013 900,273,540 15,888,800 76,483,000 PHARMACEUTICALS — 18.9% Forest Laboratories, Inc. (a)(b) Pfizer, Inc. 376,405,672 1,161,776,770 1,538,182,442 The accompanying notes are an integral part of the financial statements. 11 THE FAIRHOLME FUND SCHEDULE OF INVESTMENTS (Continued) May 31, 2009 (Unaudited) Shares ——— REAL ESTATE MANAGEMENT & DEVELOPMENT — 6.7% The St. Joe Co. (a)(b) RETAIL DEPARTMENT STORES — 8.8% Sears Holdings Corp. (a)(b) Value —————— 21,360,902 $ 545,557,437 12,514,971 711,476,101 TOTAL DOMESTIC EQUITY SECURITIES (COST $6,711,155,287) FOREIGN EQUITY SECURITIES — 3.4% AUSTRALIA — 1.1% 42,452,337 METALS & MINING — 1.1% Fortescue Metals Group Ltd. (a) CANADA — 2.3% 12,104,100 OIL & GAS DRILLING — 2.3% Ensign Energy Services, Inc. (b) UNITED KINGDOM — 0.0% DIVERSIFIED FINANCIAL SERVICES — 0.0% JZ Capital Partners Ltd. 5,698,347,631 89,079,867 184,153,058 4,325,926 3,006,543 TOTAL FOREIGN EQUITY SECURITIES (COST $364,140,539) FOREIGN RIGHTS — 0.0% UNITED KINGDOM — 0.0% DIVERSIFIED FINANCIAL SERVICES — 0.0% JZ Capital Partners Ltd., expire 06/16/09 (a)(d) 276,239,468 10,093,827 0 TOTAL FOREIGN RIGHTS (COST $0) 0 The accompanying notes are an integral part of the financial statements. 12 THE FAIRHOLME FUND SCHEDULE OF INVESTMENTS (Continued) May 31, 2009 (Unaudited) Principal ———— ASSET BACKED SECURITIES — 1.4% $ 50,645,000 72,581,000 CONSUMER FINANCE �