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B

rian Rogers was only three years into


his tenure at T. Rowe Price when he
was tapped in 1985 to launch its val-
ue-oriented Equity Income Fund. I raised
my hand, but to be honest, he says, this
was mostly a growth-stock organization
then and not many other hands went up.
Still at the helm 28 years later, Rogers
$29 billion (assets) fund has earned a net
annualized 11.0% since inception, vs. 9.4%
for the Lipper Equity Income Fund Index.
Since 2004 he has also served as T. Rowe
Prices Chief Investment Ofcer, and in 2007
was named its Chairman.
Rarely lacking for ideas on which to take
a contrarian stance, hes nding investment
opportunity today in such diverse areas as
consumer electronics, energy, department
stores and cruise lines. See page 2
T
hat most of his Wasatch Advisors
colleagues are growth investors
doesnt bother Jim Larkins in the
least. Our core competence as a rm is
identifying great growth stories, he says.
I just wait to pick them off if they become
value priced.
His eye thus far has proven reliably
sharp. The Wasatch Small Cap Value Fund
Larkins has managed or co-managed since
the beginning of 1999 has earned a net an-
nualized 12.5% since then, vs. 7.5% for the
Russell 2000 Index.
Pursuing ideas that growth investors
are leaving and value investors have yet
to nd, hes seeing opportunity today in a
variety of places, including biotechnology,
energy, apparel retailing, enterprise soft-
ware and mattresses. See page 9
ValueInvestor
INSIGHT
September 30, 2013
The Leading Authority on Value Investing
Righting the Ship
Badly lagging market sentiment can reect a companys past far more than its
future. When that happens, Brian Rogers is often there to take advantage.
Inside this Issue
FEATURES
Investor Insight: Brian Rogers
Looking beyond choppy waters to
calmer sailing ahead for companies
such as Apache, Apple, Carnival
and Kohls. PAGE 1
Investor Insight: Jim Larkins
Stepping in when fair-weather in-
vestors step out in such companies
as Questcor, Select Comfort, Ebix,
Comstock and Chicos. PAGE 1
A Fresh Look: J.C. Penney
Pondering whether the relentless
decline in the beleaguered retailers
stock has gone too far. PAGE 17
A Fresh Look: Tesco PLC
Is this value-investor favorites less-
than-smooth journey to recovery
still on the right track? PAGE 18
Editors Letter
Warren Buffett on what to look for
in a money manager. PAGE 19

INVESTMENT HIGHLIGHTS
Other companies in this issue:
Amgen, Avon, Body Central, Carbo
Ceramics, ConAgra, DXP, Energizer,
Ingersoll-Rand, Joy Global, JPMorgan
Chase, Microsoft, Polypore, Skullcandy,
SLM, Thermo Fisher Scientic, TriState
Capital, Whirlpool, Yes Bank
www.valueinvestorinsight.com
I NVESTOR I NSI GHT
Jim Larkins
Wasatch Advisors
Investment Focus: Seeks companies
whose growth prospects appear largely
unappreciated due to a recent fall from
grace, relative obscurity, or both.
Scenic Detours
So-called fallen angels often never really rise back up. Jim Larkins over
time has shown an impressive knack for identifying the ones that will.
INVESTMENT SNAPSHOTS PAGE
Apache 5
Apple 6
Carnival 7
Chicos FAS 13
Comstock Resources 15
Ebix 12
J.C. Penney 17
Kohls 8
Questcor Pharmaceuticals 11
Select Comfort 14
Tesco PLC 18
I NVESTOR I NSI GHT
Brian Rogers
T. Rowe Price
Investment Focus: Seeks companies
trading at low relative valuations for cyclical
or company-specic fundamental reasons
that are expected to mean-revert.
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 2
Describe the early thinking behind T.
Rowe Prices Equity Income Fund, which
you launched in 1985 and still manage.
Brian Rogers: T. Rowe Price through the
1970s was primarily a growth-stock orga-
nization, with a small and growing xed-
income business. That positioning wasnt
the greatest in the 1973-74 bear market or
in the late 1970s, and the company went
through some tough times.
In the early 1980s the equity market
environment was very challenging, but
the company made the strategic decision
that to insure its success going forward,
it needed to introduce a number of new
value-oriented and conservative portfolios
that would appeal to the 401(k) investor.
In 1985 the Equity Income Fund became
an important part of that effort. The idea
was to focus on somewhat tarnished blue
chips with contrarian appeal and attrac-
tive dividend yields. We ended up invest-
ing in a higher-yielding, lower-P/E basket
of mostly U.S. equities thats basically
what weve done ever since.
The perfect investment for us has faced
a cyclical, sector or company-specic chal-
lenge, has encountered some controversy,
has low visibility in terms of what ana-
lysts are expecting and has lagged perfor-
mance-wise. That can create a situation in
which the companys earnings, cash ow
and dividend stream are mispriced relative
to the market. My philosophy in a nut-
shell is if you invest in a company selling
at an anomalously low valuation level,
have condence in its ability to improve
its fundamental performance, and have a
long-enough time horizon, you can win
from a pattern of mean reversion.
How do you zero in on high-potential
prospects?
BR: We have a scoring system that ranks
companies based on how their share
prices trade relative to the S&P 500 over
time on four measures: price-to-earnings,
price-to-sales, price-to-book and dividend
yield. In simple terms, a relative P/E today
of 0.8x the market versus a long-term av-
erage of 1.2x, say, would suggest todays
valuation could be attractive. From there,
our research is focused on trying to get
our arms around the conditions necessary
for the company to improve its underlying
nancial performance and the likelihood
of those conditions prevailing. We make
earnings and protability projections two
to three years out and estimate how the
earnings and dividends streams may be
valued at that time. Then we look at the
gap between todays market value and the
potential future value. If its attractive, we
buy it. Nothing fancy.
As an example, one of the easy invest-
ments of all time was Home Depot [HD]
about ve years ago. The stock had gone
from $40 to $20, the P/E went from 18x
to 10x and the dividend yield went from
1.5% to 3.5%. Nothing had particularly
changed in terms of the companys com-
petitive situation. If you assumed 2008
wouldnt repeat itself any time soon, you
could make a mean-reversion assumption
and conclude the stock a couple years out
was worth at least $50. [Editors Note:
HD shares hit $50 in early 2012 and now
trade at $76.]
Absent overall market routs, were assum-
ing company-specic problems more often
attract your attention.
BR: There is very often an inverse rela-
tionship between recent stock-price per-
formance and valuation appeal as we
gauge it. So invariably were looking at
companies that have been under pressure.
A representative example of that would be
Carnival [CCL], the cruise-ship company.
The problems started when its Costa Con-
cordia cruise ship capsized off the coast
I NVESTOR I NSI GHT : Brian Rogers
Investor Insight: Brian Rogers
T. Rowe Prices Brian Rogers describes when hes willing to bet on mean reversion, why Home Depot ve years ago was
one of the easy investments of all time, why his portfolio is as diversied as it is, his tactic for trying to add value at
his rm during the nancial crisis, and why he sees unrecognized value today in Apple, Apache, Carnival and Kohls.
Brian Rogers
Keeping Talent In-House
Investment management was hardly a hot
eld when Brian Rogers was looking to join
it in 1982 upon graduation from Harvard
Business School. An ination-wracked
economy was struggling and the S&P 500
for 15 years had been bumping along at
around 100. There was a contrarian ele-
ment to my career choice, he says.
His timing couldnt have been better. He
joined T. Rowe Price in the summer of
1982, eight weeks before the biggest bull
market in history started its nearly 18-year
run. In 1985 he was named portfolio man-
ager of the T. Rowe Price Equity Income
Fund, a position he still holds in addition to
serving as the rms Chairman and Chief
Investment Ofcer.
Rogers tenure at T. Rowe Price is indica-
tive of one of the rms strengths: keeping
talent in-house. Theres no magic to that,
he says, but its not an accident either.
People ask why I never left. Its a func-
tion of being given new challenges at key
points in my career, working in a decen-
tralized structure where you own your own
destiny, always feeling very well-treated
nancially and working with people I like.
Good investors attract other good inves-
tors, which is why strong investment cul-
tures can be self-perpetuating.
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 3
I NVESTOR I NSI GHT : Brian Rogers
of Italy in January 2012 and then last
winter there were additional self-inict-
ed wounds from high-prole engine and
water-system failures on a couple of their
ships. To buy Carnival which we rst
did about a year ago we had to conclude
that the damage to its brand was xable
and that its management was capable of
xing it. We accept the premise that it can
pay to invest in good companies with bad
psychology.
Negative psychology can extend to an
entire sector. Weve been struck, for in-
stance, by how dramatically conventional
wisdom appears to have shifted around
anything related to commodities. After
years of focus on the commodity super-
cycle, now all you hear about is global
excess capacity. Consequently, the stock
prices of anything related to the sector
have declined pretty sharply, whether its
an actual raw-material company or an
equipment manufacturer that serves the
business like Joy Global [JOY]. Weve
made a small new investment in Joy, but
more generally its an area in which were
doing a lot of work.
You dont appear at all afraid of turn-
around situations. What makes them
more or less attractive in your eyes?
BR: Companies in need of a turnaround
tend to have the valuation characteristics
we like to see, but the decision to buy into
one often comes down to a bet on whether
management can deliver improved per-
formance. If you conclude the business
model is broken or the balance sheet is too
stretched, thats less likely. But if you dont
believe the business has fundamentally
changed, turnarounds can offer a very at-
tractive risk/reward. The low expectations
built into the share price mean there can
be substantial upside, while at the same
time the downside is limited.
Avon Products [AVP] is one in-process
turnaround we own. We believe Sheri Mc-
Coy, who took over as CEO 18 months
ago after 30 years at Johnson & Johnson,
is doing the right things to improve the
balance sheet, re-size the cost structure
and address operating problems in key
markets. That probably wouldnt mat-
ter enough if you thought the companys
direct-sales model was beyond repair, but
we dont believe thats the case. The shares
have done fairly well since the beginning
of the year, mostly a function of perfor-
mance metrics moving off the bottom, but
there is still plenty of room for continued
improvement.
On the subject of turnarounds, you have
been a big proponent in recent years of de-
partment-store operator Kohls [KSS], but
not of J.C. Penney [JCP]. What explains
the distinction?
BR: Part of it is a function of experience
we have a long heritage with Kohls and
consider it very well managed. We have
also considered it a higher-quality compa-
ny with a better competitive position and
consistently better nancial performance.
Thats not to say it isnt without its mer-
chandising and product-mix challenges,
but on the whole we consider those to be
more short term and xable than what
Penney has been dealing with.
Id also say that when Ron Johnson
came to Penney from Apple, as success-
ful as hed been, it wasnt obvious to me
his experience would be that transferable.
These were two very different businesses,
almost like taking a star from the Balti-
more Ravens and having him play NHL
hockey. Being a great athlete isnt always
enough.
I dont own J.C. Penney today, but I
have to admit it deserves some attention.
Retail is one of those sectors, like technol-
ogy, where betting on mean reversion can
be tricky, but as with Home Depot and
Lowes ve years ago, it can work out very
well. Penney clearly has its work cut out
for it and its not something that would
look attractive in our valuation rankings,
but any time I see a stock-price chart like
it has for a company that has been in busi-
ness for more than 100 years, I will want
to take a second look.
Does your funds asset size now around
$29 billion limit how diversied you can
be in terms of cap size?
BR: Weve always had a large-cap orienta-
tion, but it gets a little tougher to have the
exposure I might prefer to less-than-$10-
billion market caps. We generally have a
smaller average market cap than that of
the Russell 1000 Value Index, but roughly
85% of the portfolio is in companies with
market caps of more than $10 billion.
Most of what we invest in is very liquid.
How many positions do you typically
hold in the Equity Income Fund?
BR: Weve generally been in the 110 to
125 range. Going back to our original
mission and customer base, weve always
considered it important not to make big
bets by sector or individual holding.
Ive observed too many cases in my
career in which very large bets have hurt
investors, including such prominent ex-
amples as being heavily overweight tech-
nology in early 2000 or nancials in mid-
2008. I suspect the next great market
crisis will involve something other than
what caused the last one. Broader diversi-
cation makes sense to us.
Describe generally how you think about
selling.
BR: We tend to have a low-turnover ap-
proach. Were trying to buy when some-
thing is trading at unusually low levels of
valuation relative to the market and sell
when that relative valuation is at aver-
age to above-average levels. It can happen
more quickly, but its generally at least a
two- to three-year process.
Were humble about our ability to pre-
cisely time these things. We tend to buy
gradually, acknowledging that we may
ON NEGATIVE PSYCHOLOGY:
Weve been struck by how
dramatically conventional
wisdom appears to have
shifted around commodities.
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 4
I NVESTOR I NSI GHT : Brian Rogers
average down, and we tend to sell gradu-
ally, acknowledging that well probably
start selling prematurely. But if a stock
performs relatively well versus the mar-
ket and that leads to its relative valuation
appeal sufciently declining which, for
example, might mean its P/E or Price/
Book goes from a long-term average of
110% of the market to 130% we start
to sell.
If things work out, were selling when
the markets appreciation of a companys
performance has gone from below the
norm to well beyond it. In the second
quarter of this year we considered that the
case for companies such as Thermo Fish-
er Scientic [TMO], Whirlpool [WHR],
Amgen [AMGN], Ingersoll-Rand [IR],
ConAgra [CAG], Energizer [ENR] and
SLM [SLM].
To pick one, Ingersoll-Rands prospects
have clearly improved from ve years ago,
as has the visibility of the economic envi-
ronment. But to our way of thinking, the
stock advanced from the mid-$20s to the
$60s and has gotten ahead of the com-
panys fundamentals. Well cycle out of
such investments into others facing more
uncertainty and investor concern.
Some of your holdings, such as Chevron
[CVX], ExxonMobil [XOM] and AT&T
[T], have been in the portfolio since the
1980s. How does that happen?
BR: If a companys earnings and divi-
dends compound at attractive rates but its
stock never sells at a particularly expen-
sive valuation, it may look attractive to us
on a relative basis for a very long time.
These can still be very solid investments
over time.
What about those cases where things
dont appear to be working out. Are you
quick to cut your losses?
BR: If something hasnt performed well,
well revisit what we were thinking and
try to assess if our timing was off or if we
just didnt know what we were doing. A
big red ag for me is if theres a steady
deterioration in the companys balance-
sheet position that often encourages us
to move on. But generally I have a ten-
dency to be a bit stubborn, so if we think
our investment thesis is still valid and our
valuation analysis is still ballpark correct,
we will hang in there.
With Microsoft [MSFT], what conclu-
sions have you made on the-timing-is
off versus didnt-know-what-we-were-
doing question?
BR: We have slightly trimmed our expo-
sure to Microsoft in 2013. There are so
many moving parts right now. The com-
pany is very strong nancially, but the
industry headwinds seem increasingly
problematic. All in all, the whole situation
is more uncertain than I viewed it at the
beginning of this year. Were okay holding
what we have, but would expect to reeval-
uate the position closely after the naming
of the new CEO.
Describe what attracted you to Apache
Corp. [APA], one of your favorite energy-
related ideas.
BR: Within an energy sector that has not
been a particularly strong performer over
the past 18 to 24 months, Apache has been
notably weak. Its an independent explo-
ration and production company with a
strong long-term record and recently was
trading at only 10x earnings. Im attract-
ed to a company selling at 10x earnings
when there is a lot of activist activity in
the sector. If you look at Hess earlier this
year and Murphy Oil before that, you see
that sometimes good things happen to in-
expensive stocks, and we consider Apache
one of the cheapest independent oil and
gas companies in the market.
What would explain that?
BR: The company has a geographically
and geologically diversied mix of assets
that includes mature reserves generating
strong cash ow as well as high-potential
prospective developments. The primary
issue with the stock has been a large expo-
sure to Egypt. That operation accounts for
around 20% of the rms production and
the market has been concerned about its
value with all the political turmoil there.
While that uncertainty hasnt gone away,
just last month Apache announced it was
selling one-third of its Egyptian business
to Chinas Sinopec Group for over $3 bil-
lion. That seemed to put a solid oor on
the value of those assets, and the share
price did move up a bit in response.
Are you counting on activism to push
things along?
BR: We look at it more as a free option. If
youre into pattern recognition, it would
not be surprising for Apache to become
the focal point of activist activity. It has a
wide range of assets in a wide variety of
places, providing plenty of opportunity to
realize value that doesnt appear reected
in the market price.
That said, the Egypt sale to us signals
that the company is serious about address-
ing the value gap in the stock. This is an
experienced and smart management team
stronger than at either Murphy Oil or
Hess and theyre as frustrated as anyone
with the pattern of undervaluation. Excel-
lent assets and capable, motivated man-
agement make a very good combination.
With the stock currently at $86.25, what
upside do you see here?
BR: On almost any valuation measure rel-
ative to peers, Apache stands out as inex-
pensive. Earnings estimates for 2013 are
$8.15 per share, resulting in a P/E of less
than 11x. The net asset value, based on
proven and probable reserves at current
energy prices, is around $125 per share.
With that kind of upside and a downside
absent a collapse in energy prices that
ON MICROSOFT:
Were okay holding, but
would expect to reevaluate
the position closely after the
naming of the new CEO.
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 5
we have a hard time seeing below $75,
thats a reasonable bet.
Do you build in a view on energy prices?
BR: We generally assume prices are go-
ing to be at. The record of investors in
aggregate in terms of forecasting oil and
gas prices is dismal. Our approach is es-
sentially to buy companies in the sector
when theyre inexpensive on a price-to-
asset-value basis and then wait. When
theyre expensive on a price-to-NAV basis,
you sell. That sounds very basic, but it has
tended to work for us over time.
You have in the past expressed some ti-
midity about investing in the technology
sector. Why have you overcome that with
Apple [AAPL]?
BR: My timidity about technology is a
function of it being, in my experience,
a tough sector in which to bet on mean
reversion. Theres a higher probability
in fast-changing businesses that things
wont revert to the mean. Weve had our
successes, but have also made plenty of
mistakes over a long history, like buying
Lucent Technologies two-thirds of the
way down. Or buying Hewlett-Packard
two years ago. As a generalization, I think
technology is just a tougher eld for the
value investor.
With hadnt been involved with Apple
at all during its spectacular run. I remem-
ber being on CNBC in May of 2011 and
the host making note that, Brian, youre
just about the only fund manager in
America who doesnt own Apple. We ob-
viously would have loved to have bought
it at $80, or $120 or $200, but it just
never t our prole. Then starting late last
year as the top-line and earnings momen-
tum slowed down somewhat, we watched
it go from an over-hyped, institutionally
over-owned stock to one that everyone
was tripping over themselves to get out
of taking the share price from $700 to
below $400 in relatively short order. The
P/E went to 10x, the dividend yield went
to 3%, and there was far more cash on
the balance sheet than they could possibly
spend. It very much t our prole of an
attractive stock. It was one of our largest
purchases in the second quarter.
What assumptions are you making about
the business?
BR: At todays valuation we dont believe
the investor has to make aggressive as-
sumptions about the businesss trajectory.
Id argue, in fact, that at the current price
theres very little growth expectation built
in. But we still consider Apple a creative
company with a great global brand that
is very well positioned in rapidly grow-
ing sectors of the market. Its not going to
grow like it has, but can it grow at 10-
15% a year? Wed argue yes.
How are you looking at valuation with
the shares recently at around $483?
BR: The company is expected to earn
close to $40 per share for the year ending
this month, and we think $42 to $45 is a
reasonable range for scal 2014. That re-
sults in a forward multiple of around 11x,
without backing out the roughly $160 per
share in cash on the balance sheet.
We were buying 60 points ago, so we
start out earning 3% on the dividend.
I NVESTOR I NSI GHT : Brian Rogers
Apache
(NYSE: APA)
Business: Exploration, development and
production of oil and natural gas, with as-
sets located in the U.S., Canada, Egypt,
Australia, Argentina and the U.K.
Share Information
(@9/27/13):
Price 86.25
52-Week Range 67.91 89.17
Dividend Yield 0.9%
Market Cap $33.59 billion
Financials (TTM):
Revenue $16.63 billion
Operating Prot Margin 38.8%
Net Prot Margin 15.6%
Valuation Metrics
(@9/27/13):
APA S&P 500
P/E (TTM) 13.4 18.3
Forward P/E (Est.) 10.7 15.3
EV/EBITDA (TTM) 3.9
Largest Institutional Owners
(@6/30/13):
Company % Owned
Capital Research Global Inv 5.8%
T. Rowe Price 5.0%
Vanguard 4.6%
State Street 4.3%
Franklin Templeton 2.9%
Short Interest (as of 8/30/13):
Shares Short/Float 2.0%
I N V E S T ME N T S N A P S H OT
APA PRICE HISTORY
THE BOTTOM LINE
Its large exposure to Egypt has led to a persistent pattern of undervaluation in the com-
panys stock that isnt warranted by the quality and diversity of its assets, says Brian
Rogers. If the gap between its current market value and its $125-per-share net asset
value remains wide, he wouldnt be surprised by activist-investor efforts to help close it.
Sources: Company reports, other publicly available information
60
90
120
150
Adj Close
0.0 0.2 0.4 0.6 0.8 1.0
2011 2012 2013
150
120
90
60
150
120
90
60
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 6
I NVESTOR I NSI GHT : Brian Rogers
Then were willing to bet the company can
grow EPS at a 10% or so rate, giving us
a simple return of 13% per year. Theres
nothing wrong with that, but we also re-
tain an upside option that a small sentiment
change could have a big impact on the valu-
ation and share price. That could be helped
along if the company continues to be on
the offensive in terms of returning capital
to shareholders, which we think it will.
Does Steve Jobs absence give you pause?
BR: Apple under Steve Jobs was an incred-
ibly innovative company, but everyone
didnt leave when he died. I dont buy into
the notion that the untimely departure of
one person has altered the companys abil-
ity to innovate forever.
From consumer electronics to vacation
cruises, describe your investment thesis
for Carnival.
BR: After the Costa Concordia capsized,
we asked two analysts to research all past
signicant consumer product and service
disasters think Tylenol or Jack in the
Box and determine how long it took for
the brand in question to be restored. The
conclusion was that customers do forgive,
but it typically takes two to three years
from the initial incident. We took our po-
sition in Carnival realizing the impact on
the business wouldnt go away immedi-
ately, then the stock got hit again by the
engine and sanitation issues on a couple
of the companys ships last winter. After
reassessing our work, we added to the po-
sition earlier this year.
The crux of our thesis is that custom-
ers eventually forgive, that the company is
doing the right things in responding to the
problems, and that it has both the market
position and nancial wherewithal to ride
out a tough period.
Describe the competitive position and the
companys response to its troubles.
BR: Carnival is the largest cruise-line op-
erator with 100 ships in service and pas-
senger capacity of around 200,000. It has
10 global brands targeting just about ev-
ery relevant demographic, but its primar-
ily a middle-market line. Its not an easy
business to enter and Carnival along with
Royal Caribbean [RCL] control nearly
75% of the global market.
On the operating front, founder Mick-
ey Arison stepped aside as CEO, which
we consider a positive given that hes of-
ten appeared more interested in his non-
Carnival activities than in running the
business. The new CEO, Arnold Donald,
has been almost exclusively focused on
rebuilding the companys brand image,
starting with an overhaul of maintenance
and emergency-response procedures.
Hes also spending heavily on marketing,
which depresses earnings, but is necessary
to help the brand recover.
Is the cruise business generally a good
business?
BR: Its not a high-return, high-margin
business. Its cyclical, driven by consumer
disposable income, and is highly capi-
tal intensive. On the other hand, it has
some positive demographic tailwinds and
has benetted by the success of Disney in
building its cruise operation. Theyve le-
Apple
(Nasdaq: AAPL)
Business: Design, manufacture, marketing
and sale of a range of personal comput-
ers and mobile communication and media
devices such as the iPhone and iPad.
Share Information
(@9/27/13):
Price 482.75
52-Week Range 385.10 676.75
Dividend Yield 2.6%
Market Cap $438.58 billion
Financials (TTM):
Revenue $169.40 billion
Operating Prot Margin 29.5%
Net Prot Margin 22.3%
Valuation Metrics
(@9/27/13):
AAPL S&P 500
P/E (TTM) 12.0 18.3
Forward P/E (Est.) 11.3 15.3
EV/EBITDA (TTM) 7.1
Largest Institutional Owners
(@6/30/13):
Company % Owned
Vanguard 4.9%
State Street 4.1%
BlackRock 3.8%
Fidelity Mgmt & Research 3.4%
Northern Trust 1.5%
Short Interest (as of 8/30/13):
Shares Short/Float 1.9%
I N V E S T ME N T S N A P S H OT
AAPL PRICE HISTORY
THE BOTTOM LINE
Brian Rogers believes the market is overreacting to a slowdown in the companys growth
and is undervaluing its still-enviable position in rapidly growing global technology sectors.
From earnings growth and dividends he expects an average annual return of some 13%
on the stock, with further upside from even a small deserved change in market sentiment.
Sources: Company reports, other publicly available information
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Value Investor Insight 7
I NVESTOR I NSI GHT : Brian Rogers
gitimized the cruise as a family vacation,
broadening the market beyond just people
who are 21 or 71.
How attractive do you consider Carnivals
shares, trading recently at just under $33?
BR: We like that theres balance-sheet sup-
port on the downside, with a $31 book
value that appears solid. The big ques-
tion is how quickly the companys earn-
ings power can recover. We estimate EPS
of only $1.55 for the scal year ending
in November, rising to $2 next year and
maybe $3 or so in scal 2015. To frame
that, EPS in 2011 prior to the high-pro-
le problems was just over $2.40.
If were right, two years out at what
we consider a reasonable 15x multiple for
this type of business, youd have a $45
share price. On top of that youre earning
nearly 3% per year from dividends.
Risks?
BR: Im quite condent well see no oper-
ating problems this season, but one clear
way for this to be a bad investment is if
we see news footage of another stranded
Carnival ship with plumbing problems
this January. Then the likely assumption
of investors and customers perhaps cor-
rectly will be that this is the gang that
cant shoot straight.
Kohls shares have been in a funk for some
time. Why are you condent that can
change?
BR: This is a company that for many
years was universally well regarded by the
market, but which has lost some of that
goodwill after a fairly drawn-out period
of weak same-store-sales and margin com-
parisons. The key question is whether its
problems are a few missed fashion cycles
and not having enough of the right hot
brands, or if theres something more fun-
damentally wrong with its competitive
position and customers are just shopping
elsewhere. In owning the stock, weve ob-
viously concluded theres nothing wrong
with its position and we have condence
in managements ability to get the opera-
tions back on track.
How would you describe its market
position?
BR: The company has 1,100 or so stores
in the U.S., targeting the middle-income
and value-focused customer with moder-
ately priced apparel, footwear and home
goods. The stores generally have a wider
selection of brand-name apparel than a
competitor like Target, and are in more-
convenient stand-alone locations than one
like J.C. Penney. One historical strength
has been a greater focus on private-label
and exclusive-label merchandise, which
account for more than 50% of total sales
and have driven better-than-average gross
and operating margins.
We meet twice a year with Kevin Man-
sell, who has been with the company for
more than 30 years and was named CEO
in 2008, and theres no question that hes
focused on rejuvenating the merchandis-
ing organization and getting the product
mix back on track. That doesnt guarantee
success, of course, but we dont need mir-
acles for the stock to perform well from
todays price.
Carnival
(NYSE: CCL)
Business: Worlds largest cruise-ship
operator, with more than 100 ships operat-
ing under such brand names as Carnival,
Holland America, Cunard and Costa.
Share Information
(@9/27/13):
Price 32.88
52-Week Range 32.06 39.95
Dividend Yield 2.7%
Market Cap $25.48 billion
Financials (TTM):
Revenue $15.33 billion
Operating Prot Margin 12.3%
Net Prot Margin 9.8%
Valuation Metrics
(@9/27/13):
CCL S&P 500
P/E (TTM) 17.0 18.3
Forward P/E (Est.) 19.1 15.3
EV/EBITDA (TTM) 11.0
Largest Institutional Owners
(@6/30/13):
Company % Owned
Northern Trust 7.9%
T. Rowe Price 6.5%
Barrow, Hanley, Mewhinney & Strauss 4.3%
Capital World Inv 3.6%
Vanguard 3.4%
Short Interest (as of 8/30/13):
Shares Short/Float 5.0%
I N V E S T ME N T S N A P S H OT
CCL PRICE HISTORY
THE BOTTOM LINE
While its high-prole mishaps will not be overcome quickly, Brian Rogers believes the
company is doing the right things in response and that it has the market position and
nancial wherewithal to win customers fully back. At 15x his scal 2015 earnings-per-
share estimate of $3, the shares would return to their early-2011 level of around $45.
Sources: Company reports, other publicly available information
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Value Investor Insight 8
I NVESTOR I NSI GHT : Brian Rogers
How cheap do you consider the shares at
todays $52?
BR: If we assume same stores sales do a
little better, operating margins expand
a little bit and we have reasonable retail
consumer spending, we think the compa-
ny can earn around $5 per share next year.
Put a 12x multiple on that and youd have
a $60 stock a year from now and would
have earned 2.7% from the dividend. That
would be a 17-18% total return, which in
todays market is quite attractive.
Theres also an important capital-return
story here. The company has continued to
increase its dividend and has bought back
more than 25% of its total shares over the
past four years. Theres no reason to be-
lieve that wont continue.
T. Rowe Price recently publicly resisted
Michael Dells buyout offer for Dell. Do
you expect to do more of that?
BR: We believe activism is a constructive
force and enhances shareholder value. But
most of the time were not that vocal. If
we have a large stake in a company and
have material concerns, we will invari-
ably have extensive conversations with
management and will sometimes reach
out directly to the board. Earlier this year
you probably didnt read much about our
involvement, but we played an active role
in the conversations between Elliott Asso-
ciates and Hess, which had a very positive
outcome for shareholders. In the case of
Dell, the LBO proposal was such a one-
sided, stacked game that we just felt like
we had to say something publicly.
Much activism revolves around balance-
sheet structure and capital allocation.
What do you tell companies when they
ask for advice?
BR: We like to invest in companies that
have a balanced, intelligent nancial strat-
egy. That means not buying back stock at
any price. That means not taking on heavy
leverage or pursuing unsound dividend
policies. All of this is particularly impor-
tant today because of the well-document-
ed buildup of cash on corporate balance
sheets. Theres no one-size-ts-all response
companies should evaluate every arrow
in the quiver to build shareholder value.
Do you have any general market views that
impact what youre buying and selling?
BR: We dont usually invest based on
macro views. Occasionally, however, it
can be necessary to have a view in extreme
environments. For example, one of the
most helpful things I did during the nan-
cial crisis was constantly remind people
around here that the world doesnt end
that often, and that we should be focused
on how best to come out the other side.
Today I have a view that interest rates
can only go up. As the global economy
grows it only makes sense that central
banks become less accommodative. But
that view doesnt make me like the stock
of JPMorgan Chase [JPM] more or less.
What makes me like JPMorgan is its rela-
tive valuation appeal. What will make me
like it less is when the stock outperforms
and sells at $60. I believe we can do a bet-
ter job for our investors by focusing on
individual opportunities than by trying to
play investment strategist.
VII
Kohls
(NYSE: KSS)
Business: Owner and operator of U.S. de-
partment stores that sell moderately priced
apparel, accessories, footwear, soft home
goods and housewares.
Share Information
(@9/27/13):
Price 52.03
52-Week Range 41.35 55.25
Dividend Yield 2.7%
Market Cap $11.30 billion
Financials (TTM):
Revenue $19.32 billion
Operating Prot Margin 9.7%
Net Prot Margin 5.0%
Valuation Metrics
(@9/27/13):
KSS S&P 500
P/E (TTM) 12.2 18.3
Forward P/E (Est.) 11.1 15.3
EV/EBITDA (TTM) 5.6
Largest Institutional Owners
(@6/30/13):
Company % Owned
T. Rowe Price 11.9%
State Street 5.2%
JPMorgan Chase 4.4%
Vanguard 4.3%
Franklin Templeton 3.4%
Short Interest (as of 8/30/13):
Shares Short/Float 10.6%
I N V E S T ME N T S N A P S H OT
THE BOTTOM LINE
The key question around the company is whether its problems are a few missed fashion
cycles or if theres a fundamental problem with its competitive position, says Brian Rog-
ers. Having concluded the former, he expects better same store sales and operating
margins to drive $5 in EPS next year. At a 12x multiple, the shares would trade at $60.
Sources: Company reports, other publicly available information
KSS PRICE HISTORY
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Value Investor Insight 9
An important part of your strategy is in-
vesting in fallen angels. Why is that a
worthy cohort for ideas?
Jim Larkins: I look for successful, grow-
ing small-cap companies that have a hit
a bump in the road that causes growth
and momentum investors to bail because
their growth and momentum criteria are
temporarily not being met. At the same
time, these ideas dont hit value investors
screens because the company still prob-
ably looks expensive on book value and
earnings, which have just taken a hit. The
overall dynamic can create inefciency in
share prices that we try to exploit.
We have an added institutional advan-
tage because Wasatch is more of a growth
shop than a value shop. We often already
have extensive research done that can help
inform whether a company is hitting a
bump in the road or coming to the end
of the road. If we conclude it is a bump,
we can pounce quickly. Probably my best
source of new ideas is the most-down list
among our internal holdings.
Youve said your ideal investment has
three distinct stages of performance. What
are they?
JL: The rst leg is what I call the intrinsic-
value stage, where the price increases back
to some average historical valuation level.
Were trying to buy below those average
levels on metrics such as EV/Sales or Price/
Book, and the return to average usually
comes from the market realizing the com-
pany is a going concern with relatively in-
tact earnings power.
The second stage comes from earnings
improvement as the company gets back on
its feet and starts to perform again. At that
point the stock should at least move in line
with earnings, which we typically are ex-
pecting to grow 10-15% per year over the
intermediate term. The nal leg, if weve
chosen well, comes from multiple expan-
sion. If the growth is there, its likely the
market again falls in love with the stock.
Describe a real-time example or two of
your fallen angels.
JL: Carbo Ceramics [CRR] would be a
representative one. The company primar-
ily makes ceramic proppant that is used
in uids that are blasted into rock forma-
tions during fracking operations to extract
oil and gas. The company has a long track
record of excellent nancial performance,
but it really took off a few years ago when
the use of fracking in the U.S. signicant-
ly increased. Then Chinese competition
came in, natural-gas prices collapsed and
gas drilling was sharply curtailed. That re-
sulted in a glut of proppant inventory that
had to be worked through, putting a huge
dent in Carbos growth story.
The question to answer as the share
price fell from $180 in the summer of
2011 to the low-$60s a year ago was
whether the companys problem was a
cyclical one that would correct itself over
time or whether the Chinese competition
was a game-changer. We concluded that
the science and data support the fact that
the uniform, high-quality ceramic prop-
pant that Carbo makes, while more ex-
pensive upfront, will over the life of a well
produce more oil and gas and a better ROI
for drillers. If were right, the companys
earnings power as a supplier to a thriving
global market for shale drilling is intact.
With the stock now at nearly $100, which
stage of performance do you think its in?
JL: The panic is out of the shares, so the
valuation is almost back to historical lev-
els. What we need to see now is the num-
bers to turn, so that we can capture the
revenue and earnings growth and perhaps
a bit of multiple expansion.
I NVESTOR I NSI GHT : Jim Larkins
Investor Insight: Jim Larkins
Jim Larkins of Wasatch Advisors explains the three stages of performance he expects from his ideal stock, the category
of catalyst on which he most often counts, his picks and shovels alternative to market darling Tesla Motors, and why
he believes Questcor Pharmaceuticals, Ebix, Comstock Resources, Chicos and Select Comfort are mispriced.
Jim Larkins
Fertile Ground
Soon after earning an MBA from Brigham
Young University and joining Wasatch Ad-
visors as a growth-stock analyst in 1996,
Jim Larkins noticed somewhat of a discon-
nect between his investing nature and that
of many of his colleagues. It was often
hard for me to make the valuation math
work in high-quality small caps, he says.
I found myself getting interested when
a growth story would blow up, which is
when the growth guys would peel out.
The following year Larkins helped launch
a new fund, the Wasatch Small Cap Value
Fund, set up in large part to take advan-
tage of just such broken-growth stories.
He was named a co-portfolio manager in
1999 and has been running the fund solo
since 2008.
When not tending to his portfolio, Larkins
in is spare time is an avid gardener, par-
tial to growing fruit, tomatoes and even
the occasional mega-pumpkin, including
an award-winning 650-pound specimen a
few years back. I realize its a bit corny,
but there really are parallels between gar-
dening and investing, he says. You put
in a lot of work upfront, do all you can to
make sure everythings healthy, and you
wait. The end result isnt always perfect,
but when it is, its extremely satisfying.
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 10
I NVESTOR I NSI GHT : Jim Larkins
Another classic fallen angel that is still
one of our top holdings is Polypore In-
ternational [PPO]. The company makes
membranes that create in batteries an
ion-exchange barrier that allows the pro-
duction of electricity. These membranes
are highly engineered, based on exacting
requirements from battery manufacturers,
but theyre not a big component of the
overall cost. Its a nice consumable-prod-
uct, recurring-revenue business.
Polypores stock did extremely well as
the economy recovered after the crisis, ris-
ing from $3 a share in March 2009 to over
$70 in mid-2011. But the company built
out too much capacity to supply large-
format lithium batteries used in electric
vehicles, so when demand for electric cars
came in lower than expected, a lot of air
came out of the stock. Then we had a real-
ly warm winter a year and a half ago and
traditional lead-acid batteries didnt sell,
which hit the shares further. We think the
stock today [at $41] is attractively priced
just on the core, lead-acid-battery busi-
ness. Any future homerun from electric
vehicles we get for free.
Give an example in another favored idea
category, the undiscovered gem.
JL: These types of ideas are more in line
with what other small-cap managers say
theyre looking for high-quality com-
panies below Wall Streets radar and un-
dervalued relative to their prospects. One
we added to the portfolio in the second
quarter was TriState Capital Holdings
[TSC], a regional, business-focused bank
that came public in May. The company
is following the type of branchless, rela-
tionship-focused strategy that weve seen
succeed very well in previous holdings by
our growth managers such as Signature
Bank [SBNY] but it came public and still
trades at only 1.2x to 1.3x book value, vs.
the closer to 2x book at which comparable
banks trade. If it grows like we believe it
can and the story is better known, its hard
to imagine that valuation gap persisting.
Are there any themes informing your in-
vestment interest today?
JL: One thing weve been doing a lot of
work on is how the advent of horizon-
tal drilling and well fracking is likely to
bring more stability to the domestic oil
and gas market and the businesses that
service it. With the ability to more eas-
ily shift shale-deposit production between
oil, with more-stable prices, and gas, with
less-stable prices, were expecting steadier,
less-cyclical ups and downs in the energy-
services sector.
The stock has already done extremely
well, but one of our plays in this area
is DXP Enterprises [DXPE], which is a
maintenance, repair and overhaul supplier
of products and equipment to industrial
end users, the largest number of which are
in oil and gas. In DXP we own a business
that by its nature is fairly stable selling
replacement parts and which is becom-
ing more so as its end users face less cycli-
cality. As the market recognizes the lower
cyclicality, these types of businesses can be
re-rated.
How active are you outside the U.S.?
JL: We have less than 10% of the portfo-
lio in non-U.S. stocks, but the fallen-angel
concept works as well outside the U.S. as
in it. With stocks getting clocked in India,
for example, I just bought into a pharma-
ceutical company with a strong export
business that will benet from the cheap
currency. I cant name that one because we
havent disclosed it yet publicly, but anoth-
er Indian name weve owned for a while
is Yes Bank [YES:IN], which is one of the
new, leading-edge private-sector banks in
India that we believe have a long runway
for growth as Indias credit culture grows
along with the economy. Weve added to
our position recently as the whole banking
sector has gotten hit over concerns about
the economy and currency.
How generally do you approach valuation?
JL: We think of ourselves as value inves-
tors off the income statement, but in iden-
tifying ideas the current P/E often isnt
ON INVESTING THEMES:
One is the potential for more
stability in the domestic oil
and gas market and for the
companies that service it.
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Value Investor Insight 11
I NVESTOR I NSI GHT : Jim Larkins
meaningful because earnings have just
gone down for some reason. So as a rst
pass were looking for stocks trading at
a discount to historical price-to-book or
enterprise-value-to-sales.
As we dig in further we come up with
price targets, based on earnings power
two years out at what we consider an ap-
propriate multiple for the earnings growth
prole in the three to ve years after that.
We try to nd stocks we expect to return
at least 20% per year, but in todays mar-
ket 12-15% is an acceptable return.
Are you looking for particular catalysts?
JL: Were basically looking for the re-
versal of whatever it was that made the
stock go down. In many cases, earnings
have stalled or fallen and were expecting
growth to resume. Or it could be a regu-
latory issue that works itself out. Well
talk later about Questcor Pharmaceuticals
[QCOR], but one reason the stock got in-
teresting last year was an announcement
that the U.S. government was investigat-
ing certain marketing practices going back
two to three years. Could they nd some-
thing? Yes. Is it likely Questcor has im-
proved compliance and addressed what-
ever was the problem already? Yes. If we
conclude the headline event will have little
to no impact on the underlying operations
of the company going forward, that de-
valuation catalyst can work to our ben-
et when it reverses.
On the subject of Questcor, describe in
more detail your investment case for it.
JL: The companys main product is H.P.
Acthar Gel, a biologic drug developed in
the 1950s to treat a variety of disorders
that have an inammatory component. As
steroids became the more popular stan-
dard of care in such situations, Acthar
was almost forgotten and abandoned,
kept alive by its efcacy in treating sick
babies with infantile spasms. The market
was very small, so in 2007 the company
to survive had to dramatically increase the
products price, which insurance paid be-
cause it saved lives.
As Questcor got protable, it began to
look for other applications for the drug.
It had originally been approved for more
than 50 indications, but in 2010 the com-
pany went back to the FDA to get a new la-
bel, this time approved for 19 indications.
The strategy since has been to roll out new
treatments typically for second-line use
generally when steroids arent working
for multiple sclerosis, nephrotic syndrome
and rheumatic diseases.
What we like about the business model
is that growth is primarily a function of
identifying an already-approved target
market and then putting a sales and mar-
keting effort behind it. There isnt the un-
certainty and cost associated with trials.
The multiple indications and that Acthar is
a second-line treatment also mean theres
no one knockout punch competitively
against it. All in all, we think the company
can grow on both the top and bottom lines
by 20% per year over the next year or two
and at a mid-teens rate beyond that.
Sounds wonderful. Why isnt the market
recognizing all that?
JL: There seem to be two primary con-
cerns. One is around insurance-company
Questcor Pharmaceuticals
(Nasdaq: QCOR)
Business: Development and sale of bio-
pharmaceuticals; primary drug treats several
conditions, including multiple sclerosis,
nephrotic syndrome and infantile spasms.
Share Information
(@9/27/13):
Price 56.90
52-Week Range 17.60 74.76
Dividend Yield 1.8%
Market Cap $3.35 billion
Financials (TTM):
Revenue $620.6 million
Operating Prot Margin 55.0%
Net Prot Margin 36.4%
Valuation Metrics
(@9/27/13):
QCOR S&P 500
P/E (TTM) 15.3 18.3
Forward P/E (Est.) 9.8 15.3
EV/EBITDA (TTM) 9.2
Largest Institutional Owners
(@6/30/13):
Company % Owned
Fidelity Mgmt & Research 14.6%
BlackRock 8.1%
Vanguard 5.7%
Broadwood Capital 5.5%
LSV Asset Mgmt 3.3%
Short Interest (as of 8/30/13):
Shares Short/Float 21.7%
I N V E S T ME N T S N A P S H OT
THE BOTTOM LINE
The markets concerns over insurance reimbursement and an ongoing investigation into
the companys past marketing practices have excessively obscured the fundamental
strength of its business and growth prospects, says Jim Larkins. At a roughly small-cap
market multiple on his 2014 EPS estimate, the shares would trade at around $100.
Sources: Company reports, other publicly available information
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September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 12
I NVESTOR I NSI GHT : Jim Larkins
reimbursement. The drug is very expen-
sive and typically needs pre-approval for
any of the indications other than infantile
spasms. But theres nothing new in that,
and the company over the years has seen a
roughly 80% acceptance rate by insurance
companies for Acthar use. In fact, we be-
lieve one of Questcors core competencies
is its ability to get payment approval by
walking doctors and insurance companies
through how the drug saves lives or im-
proves the quality of life.
The second big concern is around the
government investigation. Again, while it
was a really bad headline, our conclusion
after speaking at length with management
is that even if a rogue salesperson or two
ran afoul of the rules a few years ago,
the company today has made signicant
strides in all aspects of training and com-
pliance, so that any nding might involve
a ne but wont impact the operation go-
ing forward.
With the shares having recovered from last
years debacle, at todays price of $56.90
how are you looking at valuation?
JL: The stock trades at only 12.2x our
$4.65 EPS estimate for this year. Thats
a signicant discount to the median P/E
multiple for my small-cap universe today
of about 17x.
Given the companys competitive posi-
tion and growth runway, wed argue that
theres a signicant opportunity to benet
both from higher earnings and a higher
multiple. If you put an 18x multiple on
our 2014 earnings estimate of around
$5.50, the shares would trade at $100. If
the market falls in love again, the upside is
much better. Alexion [ALXN], which has
a biologic drug that the market adores,
currently trades at 35x estimated 2014
earnings.
Sticking with controversial ideas, describe
your interest in Ebix, Inc. [EBIX]
JL: Ebix sells software and services that
primarily facilitate the secure exchange of
information between insurance brokers
and insurance companies. One straight-
forward application would be in providing
the front-end system for a life-insurance
agent, say, to enter all of a potential cus-
tomers information and then to electroni-
cally elicit bids on the policy from multiple
carriers. The companys products cover a
variety of tasks in the insurance ecosystem,
from sales and the binding of transactions,
to customer relationship management and
compliance. Its a toll-booth kind of busi-
ness and the track record in terms of mar-
gins, free cash ow and long-term revenue
and earnings growth is exceptional.
The CEO, Robin Raina, doesnt have
the greatest public persona. The company
over the years has been acquisitive both in
the U.S. and internationally, and is known
to be fairly ruthless in cutting costs as
businesses get integrated. We talked to one
business owner who sold his company to
Ebix and the rst thing he said was how
aggressive it was in cutting costs, and the
second thing he pointed out was that they
didnt lose any clients. So while it all seems
to work, theres often an element of ill will
created.
The bigger controversy, however, was
the announcement in June that the U.S.
attorney for northern Georgia the com-
pany is headquartered in Atlanta was
Ebix
(Nasdaq: EBIX)
Business: Provider of software and
e-commerce systems primarily used by bro-
kers and underwriters in the sale of a broad
range of insurance and annuity products.
Share Information
(@9/27/13):
Price 9.85
52-Week Range 8.21 24.35
Dividend Yield 3.0%
Market Cap $374.0 million
Financials (TTM):
Revenue $211.4 million
Operating Prot Margin 34.4%
Net Prot Margin 32.0%
Valuation Metrics
(@9/27/13):
EBIX Russell 2000
P/E (TTM) 5.7 86.3
Forward P/E (Est.) 6.2 19.4
EV/EBITDA (TTM) 5.0
Largest Institutional Owners
(@6/30/13):
Company % Owned
Fidelity Mgmt & Research 7.2%
BlackRock 6.3%
Vanguard 5.4%
Bank of Montreal 5.0%
Wedge Capital 4.2%
Short Interest (as of 8/30/13):
Shares Short/Float 51.7%
I N V E S T ME N T S N A P S H OT
THE BOTTOM LINE
The companys toll-booth business model and exemplary long-term performance receives
little weight today from a market concerned by an inquiry into its accounting, says Jim
Larkins. If resolution of the investigation doesnt fundamentally alter the companys pros-
pects, as he expects, he believes the shares can double over the next 12 to 18 months.
Sources: Company reports, other publicly available information
EBIX PRICE HISTORY
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Value Investor Insight 13
I NVESTOR I NSI GHT : Jim Larkins
investigating Ebixs accounting and re-
porting practices. Very little detail has
been disclosed, but as best we can tell the
inquiry probably revolves around inter-
company transfers between various sub-
sidiaries and potentially aggressive tax
positions taken by the company. That in-
quiry caused Goldman Sachs which had
already completed months of due diligence
on Ebix to pull a $20-per-share buyout
offer it made for the company in May, and
the stock promptly fell below $10. We
knew the company and had owned the
stock before, and ended up taking a new
position after that fall.
How do you get past the risk of the gov-
ernment investigation?
JL: We dont know any specics, nor does
anyone else whos not directly involved.
But there have been very few times in my
career when someone has deliberately
tried to defraud in a way that can end up
sinking the company. It can certainly hap-
pen, but there are two main reasons I think
its unlikely here. One, concerns over the
companys accounting have been around
for years and nothing has ever happened,
which argues that the most controversial
issues have been vetted. Two, the compa-
ny generates real cash. It pays a nice divi-
dend and despite making several acquisi-
tions over the years still has roughly the
same share count it did in 2008. Its hard
to fake cash.
What do you think the shares, now at
$9.85, are more reasonably worth?
JL: The company earned roughly $60 mil-
lion in free cash ow in the past 12 months,
which at todays market value translates
into a free cash ow yield of about 16%.
We estimate earnings will come down a
little bit this year, to $1.75 per share, but
can a year from now be back in the $1.90
or so range. At even a 10x multiple, that
would get us back to near what Goldman
was willing to pay.
The obvious catalyst on the upside
would be a positive resolution of the gov-
ernment inquiry. The company has also
not been shy about the potential for more
acquisitions to consolidate and extend its
position in existing lines of business. The
more the market incorporates a business-
as-usual outlook for the stock, the better
its likely to perform.
What do you see in apparel retailer Chi-
cos [CHS] that the market doesnt?
JL: The markets perception of Chicos
today seems to be driven by negativity
toward apparel retailing in general and
by concern about the companys weak
same-store-sales performance last quarter.
As value investors were always pointed
toward what people dont like at the mo-
ment, and this is a good example.
Our basic premise is that neither of
the markets worries reects fundamental
problems with the companys business and
that its long-term growth story is intact.
The company now has four distinct con-
cepts, Chicos, Soma, White House|Black
Market and Boston Proper. Chicos is the
core brand, differentiated by serving a
more-mature customer, a segment of the
market that isnt as hyper-competitive as
retailing to young women, especially now
that other stand-alone concepts like Ann
Chicos FAS
(NYSE: CHS)
Business: Specialty retailer primarily of
womens apparel through four store con-
cepts: Chicos, White House|Black Market,
Soma Intimates and Boston Proper.
Share Information
(@9/27/13):
Price 16.66
52-Week Range 15.27 19.95
Dividend Yield 1.3%
Market Cap $2.61 billion
Financials (TTM):
Revenue $2.61 billion
Operating Prot Margin 10.3%
Net Prot Margin 6.4%
Valuation Metrics
(@9/27/13):
CHS Russell 2000
P/E (TTM) 16.4 86.3
Forward P/E (Est.) 13.3 19.4
EV/EBITDA (TTM) 6.1
Largest Institutional Owners
(@6/30/13):
Company % Owned
Vanguard 5.7%
Blue Harbour Group 5.0%
Fidelity Mgmt & Research 4.3%
State Street 3.6%
BlackRock 2.9%
Short Interest (as of 8/30/13):
Shares Short/Float 3.5%
I N V E S T ME N T S N A P S H OT
THE BOTTOM LINE
With store growth, a modest uptick in same-store sales and 200 basis points in extra
operating margin, Jim Larkins believes the company can grow earnings at a 20% annual
rate potential he does not at all consider built into the current share price. At even a
below-market multiple on his 2015 EPS estimate, the shares would trade at $24.
Sources: Company reports, other publicly available information
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Value Investor Insight 14
Taylor, J. Jill and Talbots have tried to go
younger. Among the other brands, Soma is
proving to be a big hit, an intimates con-
cept that looks to take over for more ma-
ture women where Victorias Secret leaves
off. Its still relatively small, with 235
stores at the end of the second quarter, but
thats up from 200 a year ago. Overall, to-
tal-company stores are growing at around
8% per year.
We think multiple concepts provide a
more-stable platform for growth and also
make us less worried about the company
running into a big ditch from a fashion
perspective though we dont see Chicos
as a super-aggressive fashion story any-
way. We also see signicant opportunity
to expand margins as the company lever-
ages shared-service costs for things like IT,
warehousing and marketing across mul-
tiple concepts. With store growth, modest
improvement in same-store sales and 200
basis points in incremental operating mar-
gin within ve years, we think the com-
pany can grow earnings at a 20% annual
rate for many years.
How do you see that translating into up-
side for the shares, now at around $16.70?
JL: The stock trades at less than 17x trail-
ing earnings, in line with todays small-cap
market multiple. Being conservative be-
cause theyre struggling a bit on the fash-
ion side, Im using a 15x multiple on our
2015 EPS estimate of $1.60 to arrive at a
target price of $24. If they get same-store
sales back on track and earnings grow as
we expect, there could be nice additional
upside from multiple expansion.
Select Comfort [SCSS] has given share-
holders a wild ride over the years. Why is
now a good time to be on board?
JL: We often return to ideas weve owned
in the past and this is one, as you say, that
has provided some interesting entry points.
In general we like the business, which is
built around Sleep Number brand mat-
tresses that have separate air bladders on
each side of the bed and a remote control
that allows people to adjust the rmness
as desired. Its a unique product concept
that addresses a key sleep-related problem
partners who dont like the same kind of
mattress and the company has typically
marketed it very well.
Theyve also built an excellent nan-
cial model. They manufacture the beds
and mostly sell them in their own stores,
capturing the manufacturing, distribution
and retail margins for themselves. Theres
also very little working capital required,
as they only build and ship the beds af-
ter getting paid upfront. That results in
healthy cash ows that can then be used
to self-fund growth.
So what caused the share-price swoon this
past Spring, taking the stock from $28 to
less than $18 in a matter of weeks?
JL: Same-store sales comps took a hit,
which the company attributed to botching
the execution of a turnover of its media-
buying program. They may have under-
spent a bit as well, but they appear to have
made certain changes too quickly and that
just didnt work. Its not an immediate x,
but they say theyve increased oversight
of the process and feel like it is turning
around. This is obviously something were
watching closely, but we have no reason
I NVESTOR I NSI GHT : Jim Larkins
Select Comfort
(Nasdaq: SCSS)
Business: Vertically integrated seller of
adjustable-rmness air mattresses that are
sold primarily in the United States under the
Sleep Number brand name.
Share Information
(@9/27/13):
Price 24.47
52-Week Range 16.62 33.90
Dividend Yield 0.0%
Market Cap $1.36 billion
Financials (TTM):
Revenue $933.0 million
Operating Prot Margin 11.8%
Net Prot Margin 7.7%
Valuation Metrics
(@9/27/13):
SCSS Russell 2000
P/E (TTM) 19.1 86.3
Forward P/E (Est.) 14.5 19.4
EV/EBITDA (TTM) 9.4
Largest Institutional Owners
(@6/30/13):
Company % Owned
State Street 8.0%
Putnam Inv 7.7%
Disciplined Growth Inv 7.0%
William Blair & Co 5.8%
Vanguard Group 5.8%
Short Interest (as of 8/30/13):
Shares Short/Float 11.3%
I N V E S T ME N T S N A P S H OT
THE BOTTOM LINE
The companys unique branded product offer and vertically integrated approach position
it well to prosper as high-end mattresses take a larger share of the overall market, says
Jim Larkins. Assuming 20% bottom-line growth over the next two years and a conserva-
tive 15x P/E on his 2015 earnings estimate, the stock would rise to at least $30.
Sources: Company reports, other publicly available information
SCSS PRICE HISTORY
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Value Investor Insight 15
I NVESTOR I NSI GHT : Jim Larkins
to believe it signals a more intractable
problem.
Assuming it is a temporary glitch, what
are your growth expectations here?
JL: One secular tailwind is that Sleep
Number mattresses address the premium
end of the market, which is taking share
as people see the benets of higher-quality
beds and are willing to pay for them.
The company also still has the ability
to roll out additional stores. It has done
a good job of identifying markets across
the country that it felt had the right demo-
graphic proles and then on a blitzkrieg
kind of basis of taking share by opening
multiple stores and spending heavily on
advertising. Theyre now shifting the store
mix somewhat away from malls, which
they believe will offer them more space to
better merchandise their products. Over-
all we expect the number of stores, now
around 415, to increase at 5-6% per year.
Its early, but we also see potential in
new-product rollouts. For example, they
just launched a line of dual-temperature
mattress pads which work on any kind
of bed. Theyre trying to address another
common sleep issue, one partner liking it
hotter or cooler at night than the other.
Overall, from getting back on track
after the marketing stumble, benetting
from the changing store mix, opening new
stores and rolling out new products, we
think the company can grow prots 20%
annually for the next two years. Growth
likely slows down after that, but we esti-
mate will still be at a low-teens rate.
At $24.50, how inexpensive is the stock?
JL: The shares are up nicely since we start-
ed buying in the second quarter, so the
upside from today to our two-year target
price of $30 15x our $2 per share 2015
earnings estimate isnt overly exciting.
But that would still be a 10% compound
return, which isnt bad for this market. If
earnings pick up as we believe they can
and you get some multiple expansion to
17-18x, you could easily see $30 in a year
rather than two.
Comstock Resources [CRK] has been a
depleting asset for shareholders over the
past ve years. Why do you expect that
to change?
JL: This is a straightforward story, built
on the thesis that the natural gas price
pendulum has swung too far to the cheap
side and is going to swing back to normal.
While its heritage is natural gas ex-
plaining the poor stock performance the
company has a two-pronged approach.
It has a large position in the Haynesville
Shale, one of the most-productive and
lowest-cost U.S. gas basins, but to which
the company isnt directing incremental
capital at $3.50 [per-million-BTU] gas.
Where it is deploying capital is in the Ea-
gle Ford in south Texas, which along with
the Bakken in North Dakota are the two
most-prolic oil-shale plays in the U.S.
The company says it can earn 50%
IRRs in deploying capital at Eagle Ford,
which provides healthy cash ow. But the
real upside comes from cranking up pro-
duction at Haynesville, which will require
gas prices in the $4.50 to $5 range. We
cant know exactly when that happens,
but would expect some return to normal-
cy in gas prices within the next two years.
Comstock Resources
(NYSE: CRK)
Business: Acquisition, development, explo-
ration and production of oil and natural gas,
with assets located primarily in the Haynes-
ville and Eagle Ford formations in the U.S.
Share Information
(@9/27/13):
Price 15.88
52-Week Range 12.83 21.16
Dividend Yield 3.2%
Market Cap $767.2 million
Financials (TTM):
Revenue $440.7 million
Operating Prot Margin (-17.2%)
Net Prot Margin (-1.4%)
Valuation Metrics
(@9/27/13):
CRK Russell 2000
P/E (TTM) n/a 86.3
Forward P/E (Est.) 26.5 19.4
EV/EBITDA (TTM) 4.2
Largest Institutional Owners
(@6/30/13):
Company % Owned
Dimensional Fund Adv 7.5%
Vanguard 5.7%
Wellington Mgmt 5.5%
Capital Research Global Inv 5.2%
GW Capital 4.8%
Short Interest (as of 8/30/13):
Shares Short/Float 16.4%
I N V E S T ME N T S N A P S H OT
THE BOTTOM LINE
Jim Larkins doesnt believe the market is adequately recognizing either the diversity of the
companys assets or the upside it has when natural gas prices move off their lows. The
companys low-$20s per share current net asset value provides solid downside protec-
tion while waiting for a closer to $30-per-share value at $5 [per MMBtu] gas, he says.
Sources: Company reports, other publicly available information
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Value Investor Insight 16
I NVESTOR I NSI GHT : Jim Larkins
Why at rst glance do Comstocks nan-
cials look so lousy?
JL: When shale companies aggressively
drill youll often see high upfront costs
and rapid well depreciation, which im-
pacts reported earnings. The company
also recently sold some assets in the Perm-
ian basin, which while it strengthens the
balance sheet, can make the income state-
ment look a bit messy.
What upside do you see in the stock price
from todays $15.90?
JL: Comstocks net asset value today
based on proven and probable reserves is
in the low-$20s per share. At $5 gas that
number is closer to $30. So we basically
look at this as a solid energy company,
with downside protection from its assets
and a strong balance sheet, that also hap-
pens to pay a 3.2% dividend. If you want
an option on natural gas prices going up
and everybody one day wanting to own a
gas play again, we think this is one of the
better ways to get it.
Talk about a recent investing misstep or
two and any lessons attached.
JL: Two fairly recent mistakes that are top
of mind are Skullcandy [SKUL], which
makes headphones, and Body Central
[BODY], a teen-apparel retailer. In both
cases and Id say this is fairly common
in ideas that havent work out we just
misread how strong the competition was.
Thats a particular challenge in fashion-
oriented businesses you know theyre
competitive but can underestimate that
when a company has historically grown
very well.
For-prot education is an area that has
been showing up on our valuation screens
but that Ive specically avoided because
of the hyper-competitiveness of the mar-
ket. Not only do you have incumbents
ghting over a smaller market pie, but
you also have every strong state college
or second-tier university rolling out online
programs. Theres been a value bounce in
some of the stocks, but I havent partici-
pated in it and dont expect to try.
Whats your gut telling you about the mar-
ket today?
JL: My gut is Im running the highest cash
balance Ive run in a long time were at
high-single-digit cash, which is a lot for
us. It certainly feels like theres more to
sell than to buy.
I really believe success in this business
comes down to patience. One aspect of
that is patience to continue to own things
that are working and have really good fun-
damentals while the market is guring that
out. On the buy side, you often just have
to wait for things to happen. You have
your watch list, you look at your names
every day, you look for whats down, and
youre just waiting for an event that you
can act on. You cant count on when, but
interesting things will happen.
VII
September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 17
A FRESH L OOK: J.C. Penney
In a testament to careful ongoing research vigilance, Advisory Research escaped unscathed from its investment
in ill-fated J.C. Penney. The question for today: Has the relentless punishment of Penney stock gone too far?
Savvy balance-sheet-focused investors
like Chicagos Advisory Research were
naturally drawn to J.C. Penney stock two
years ago. As co-portfolio manager Jim
Langer explained it [VII, October 31,
2011], the companys share price, then
$33, almost exactly matched his rms
estimate of Penneys tangible book value
after adjusting for the value of its owned
real estate. With protected downside, the
upside for the still-protable retailer rest-
ed in the hands of new CEO Ron Johnson,
whose resume rst at Target and then
as architect and leader of Apples retail
strategy was without peer. The value
realization from a successful turnaround
wouldnt happen right away, but was of a
scale to make it more than worth the wait.
We all know how that turned out. John-
son implemented a new strategy focused
on refashioning selling space into branded
stores-within-a-store and on weaning Pen-
ney customers of their seeming addiction
to coupons and price markdowns. As
investment spending took off, customers
revolted, resulting in a sea of red ink that
cost Johnson his job and continues to dev-
astate Penneys share price. Above $40 in
the early part of 2012, the shares at a re-
cent $9 trade where they did in 1986.
In a testament to ongoing research vigi-
lance, Advisory Research actually escaped
unscathed from this debacle. Hinged as the
thesis was to the strategy revamp work-
ing, says co-portfolio manager Matthew
Swaim, his team regularly spoke with
both large and small Penney competitors
to understand what was happening in the
market. As the share price started pushing
$40 at the same time competitors increas-
ingly said they were gaining share at Pen-
neys expense, Advisory Research headed
for the exits. What we saw playing out
was consistent with the idea that its a lot
easier to re a customer than to hire a new
one, says Swaim. At the price we were
able to sell, we thought the execution risk
had gotten too high.
Has the relentless fall in Penney stock
gone too far? High-prole investors such
as Glenview Capital, Soros Fund Manage-
ment, Perry Capital and Hayman Capital
have too early so far all established
or added to large Penney equity positions
in recent months. Swaim reports that
Advisory Research has yet to join them,
although were looking very closely,
he says. The problem is that while there
appears to be asset value supporting the
shares Advisory Researchs estimate of
adjusted tangible book value is in the mid-
teens per share the company has pledged
real estate against certain debt obliga-
tions and may be forced to continue that
practice, to the detriment of shareholders.
The key is liquidity what they have and
what theyll need, he says. Were still
going through the calculations.
VII
Dodging a Bullet
J.C. Penney
(NYSE: JCP)
Business: National department store chain
founded in 1902, selling a broad range of
apparel, footwear and home furnishings
through some 1,100 stores in 49 states.
Share Information
(@9/27/13):
Price 9.05
52-Week Range 8.85 27.00
Dividend Yield 0.0%
Market Cap $2.00 billion
Financials (TTM):
Revenue $12.11 billion
Operating Prot Margin (-14.8%)
Net Prot Margin (-13.3%)
Valuation Metrics
(@9/27/13):
JCP Russell 2000
P/E (TTM) n/a 86.3
Forward P/E (Est.) n/a 19.4
EV/EBITDA (TTM) n/a
Largest Institutional Owners
(@6/30/13):
Company % Owned
Soros Fund Mgmt 9.1%
State Street 8.1%
UBS 6.0%
Perry Capital 5.4%
Evercore Trust 5.1%
Short Interest (as of 8/30/13):
Shares Short/Float 43.7%
I N V E S T ME N T S N A P S H OT
JCP PRICE HISTORY
THE BOTTOM LINE
Having dodged a bullet on his rms investment two years ago in J.C. Penney, Matt
Swaim says he and his partners are looking very closely at whether the relentless fall in
the companys share price has gone too far. The answer to date, not yet. The key is li-
quidity what they have and what theyll need. Were still going through the calculations.
Sources: Company reports, other publicly available information
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Value Investor Insight 18
A FRESH L OOK: Tesco PLC
Following Warren Buffetts lead, many value investors in recent years have been enamored with the turnaround/
international growth story at British grocery chain Tesco. It hasnt been a particularly smooth ride.
British grocery giant Tesco PLC has
been on value investors radar screens for
some time now. Warren Buffetts Berkshire
Hathaway initiated a position in 2006,
which by the end of last year was one of
the insurers top holdings, a 5.2% stake
valued at nearly $2.3 billion. Causeway
Capitals Harry Hartford [VII, February
29, 2012] and Vulcan Value Partners C.T.
Fitzpatrick [VII, September 28, 2012]
both made cases for Tescos stock last year
in interviews, and others would have done
so had we not demurred in order to avoid
repetition.
The basic case for the shares was fairly
consistent. The company had taken its
eye off the ball in the U.K., where it was
the dominant player with a 30% market
share, and was spending heavily to recon-
gure and refresh its store base there. At
the same time, it was making large invest-
ments outside of its home country, primar-
ily in Eastern Europe, Asia and in launch-
ing its Fresh & Easy budget-grocery
concept in the U.S. Trading at 10x or less
what were considered depressed earnings,
the upside from the U.K. back-to-basics
strategy and from increased protabil-
ity as international markets matured was
considered substantial.
It hasnt been a smooth ride. The U.K.
makeover under Philip Clarke, CEO since
early 2011, has moved forward in ts and
starts. After upgrading service and putting
more focus on fresh foods, the company is
now reconguring stores to better utilize
oor space overly cluttered in many cas-
es with high-priced non-food items that
generate revenue but not enough prots.
Outside the U.K., same-store sales have
generally been lower than expected and
the company has announced over the past
18 months that it was exiting both Japan
and the U.S., while putting its loss-making
Chinese operation into a joint venture
with that countrys largest food retailer.
The investment case for Tesco today?
Despite considerable volatility, the stock is
up 14% since Causeways Hartford sung
its praises in early 2012. Causeway has
maintained its stake, says the rms Foster
Corwith, for two primary reasons. One,
hes optimistic that the U.K. revival is on
track. CEO Clarke, who started at Tesco
as a teenager stocking shelves, knows the
business and market inside and out, he
says, and the store restylings that he has
pushed so far still a drawn-out process
have shown largely positive results. With
the U.K. accounting for roughly two-
thirds of the companys overall operating
prot, as goes the domestic operation, so
will go Tesco.
The second key aspect of the story,
says Corwith, remains valuation. The
shares today trade at 11.7x his 31 pence
EPS estimate for the scal year ending in
February, vs. a roughly 14x average P/E
for European food retailers who he argues
arent as close to trough earnings. His tar-
get share price, off his next scal years
33-pence earnings estimate, is 4.20. The
stock also currently pays a nearly 4.5%
dividend yield. The company is paying
down debt for now, says Corwith, but
as it pulls back on empire building, capital
return to shareholders likely becomes even
more important.
VII
The Empire Pulls Back
Tesco
(London: TSCO:LN)
Share Information (@9/27/13):
Price 3.63
52-Week Range 3.06 3.88
Valuation Metrics (@9/27/13):
TSCO S&P 500
Trailing P/E 21.0 18.3
Forward P/E Est. 11.2 15.3
I N V E S T ME N T S N A P S H OT
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300
400
500
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TSCO PRICE HISTORY
NEW BOTTOM LINE
Despite providing a rocky ride thus far, Foster Corwith says the companys shares re-
main attractive due to progress with its home-market turnaround and a still-low valu-
ation. His target share price on his next scal years 33-pence EPS estimate: 4.20.
ORIGINAL BOTTOM LINE February 29, 2012
Operating leverage as a needed U.K. store-investment program winds down and as
international operations mature should work its way nicely through the companys
income statement in future years, says Harry Hartford. At 11x his earnings estimate
for the year ending in February 2014, the shares two years out would trade at 4.20.
Sources: Company reports, other publicly available information
VII, February 29, 2012
2011 2012 2013
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September 30, 2013 www.valueinvestorinsight.com
Value Investor Insight 19
EDI TORS L ET T ER
Warren Buffett has long described
the challenge money managers face in
beating the market as their assets under
management rise notwithstanding the
fact that he has continued to do just that
while managing more money than anyone.
We were reminded recently of his think-
ing on this subject in a letter he wrote in
1975 to the Washington Post Co.s Katha-
rine Graham about pension-fund manage-
ment. (To see the full letter, click here.)
In one section of the letter titled Is
There Hope? Buffett highlights the dif-
culty of nding poised-to-outperform in-
vestment managers in light of the fact that
the best records tend to attract massive
money ows:
For openers, there is the one huge, ob-
vious pitfall. I am virtually certain that
above-average performance cannot be
maintained with large sums of managed
money. It is nice to think that $20 billion
managed under one roof will produce -
nancial resources which can hire some of
the worlds most effective investment tal-
ent. Surely $50 million annually of fees
on $20 billion of managed assets will
allow (a) an array of industry special-
ists covering minute-by-minute develop-
ments affecting companies within their
purview; (b) top-ight economists to
study the movement of the tides; and (c)
nimble, decisive portfolio managers to
translate this wealth of information into
appropriate market action.
It just doesnt work that way. Down the
street there is another $20 billion getting
the same input. Each organization has its
own group of bridge experts cooperating
on identical hands and they all have
read the same book and consulted the
same computers. Furthermore, you just
dont move $20 billion or any signicant
fraction around easily or inexpensively
particularly not when all eyes tend to be
focused on the same current investment
problems and opportunities. An increase
in funds managed dramatically reduces
the number of investment opportunities,
since only companies of very large size
can be of any real use in lling portfolios.
More money means fewer choices and
the restriction of those choices to exactly
the same bill of fare offered to others
with ravenous nancial appetites.
He does later offer one option for
choosing managers, namely focusing on
those handling smaller amounts whose
record has been good for the right rea-
sons. He then describes a potential
right reason:
The good results have been accomplished
by a single individual or, at most, a few,
working in fairly specialized areas in
which the great bulk of investment mon-
ey simply had no interest. It has been
very difcult to out-think the pack on
General Motors, IBM, Sears, etc. Rather,
the unusual records and there are few
that have been maintained have been
achieved by those who have worked rela-
tively neglected elds in which competi-
tion was light.
If you nd such a manager, he then of-
fers one further piece of advice: Hope
that no one else nds him.
VII
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