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Investing in Undervalued Value Stocks

WHITNEY TILSON is the founder and Managing Partner of T2 Partners LLC and the Tilson
Mutual Funds. The former (www.T2PartnersLLC.com) manages three value-oriented
private investment partnerships, while the latter is comprised of two value-based mutual
funds, Tilson Focus Fund and Tilson Dividend Fund (www.tilsonmutualfunds.com). Prior to
launching his investment career in 1999, Mr. Tilson spent five years working with Harvard
Business School Professor Michael E. Porter studying the competitiveness of inner cities
and inner-city-based companies nationwide. He and Professor Porter founded the Initiative
for a Competitive Inner City, of which Mr. Tilson was Executive Director. Mr. Tilson also led
the effort to create ICV Partners, a national for-profit private equity fund focused on
minority-owned and inner-city businesses that has raised nearly $500 million. Before
business school, Mr. Tilson was a founding member of Teach for America, the national
teacher corps, and then spent two years as a consultant at The Boston Consulting Group.
Mr. Tilson received an MBA degree with High Distinction from the Harvard Business School, where he was
elected a Baker Scholar (top 5% of class), and graduated magna cum laude from Harvard College, with a
bachelor’s degree in Government.

SECTOR – GENERAL INVESTING
TWST: If you can start with an overview of T2 Partners
and your investment philosophy.
Mr. Tilson: We manage hedge funds and mutual funds. We
manage three hedge funds as one pool of capital, long-short primarily US
equity, and then we have two mutual funds. The Tilson Focus Fund,
which my partner Glenn and I manage, is a long-only strategy so it’s
similar to our hedge funds on the long side, but doesn’t have a short com-
ponent. Then we also have the Tilson Dividend Fund, which is managed
by our friend, Zeke Ashton at Centaur Capital in Dallas. There is a sub-
advisory arrangement there so we don’t manage it directly, but it falls
under our umbrella. Three hedge funds managed virtually identically and
then two mutual funds with slightly different investment strategies --
that’s T2.
We manage about $150 million in our hedge funds and about
$38 million in the two mutual funds. All of the funds are managed with a
value investing approach. We simply apply the timeless principles of
Graham and Dodd, practiced today most notably by Warren Buffett and
Charlie Munger. We consider these great investors our guides in this busi-
ness. What does that mean? It means we’re generally not trying to make
big macroeconomic prognostications or trying to figure out if a company
is going to beat earnings by a penny this quarter and trade around that, but
rather we try to calculate the intrinsic value of businesses and then com-
pare that to the value that the stock market is applying to the business in
terms of its stock price – and then we seek to buy when there are very
large valuation discrepancies.
Most of our activity is on the long side, meaning we look for
undervalued stocks: the proverbial 50-cent dollars. In our hedge funds,
we also look for 10-dollar dollars to short: things that are massively over-
valued, fads, frauds, that kind of thing.
Our original hedge fund started on January 1, 1999 and has only
trailed the S&P 500 in two of those eleven-and-a-half years. We’re way
above the S&P this year, so it looks like this will be the tenth year out of
12 that we beat the market. In our original hedge fund, net to investors,
we have more than tripled our investor’s money versus basically a flat
S&P 500, including reinvested dividends, over that eleven-and-a-half
year period.
On the mutual fund side, the Tilson Focus Fund is the #1 fund in
its category this year and over the past 12 months, is in the 98th percentile
over the past two years, and is in the 94th percentile since inception just
over five years ago.  The Tilson Dividend Fund is the #1 fund in its category
over the past two and three years, and is #2 over the past five years.
Overall, we have a very strong investment track record that we
are proud of – but also aim to improve upon.

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

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

TWST: What is your outlook of the economy and markets tioning for us, to a couple of months ago, when we were 90% long and
going forward? 70% short, which is 20% net long. You can see there is a very wide range
Mr. Tilson: We consider ourselves bottom-up stock pickers and of exposure, though we have never been net short.
our forte is company and industry analysis. However, we learned an im- The core of what we do is almost always on the long side, but we
portant lesson in 2008: if the world goes to hell in a bucket, you can throw can get very defensive, very close to being market neutral, at times. Today we
your company and industry analysis out the window because everything are not at the bottom end, which was 20% net long, but 40% net long is still
correlates, so it’s good to have an very conservatively positioned and
idea if that might happen. As a gen- that’s because we think there is a very
Highlights
eral rule, we follow Buffett’s time- wide range of potential outcomes for
less principle: “Be fearful when Whitney Tilson co-manages the Tilson Focus Fund, a long- the economy and for the stock market
others are greedy and greedy when only strategy similar to the firm’s hedge funds on the long and we’re really not sure how it’s
others are fearful.” One of the ways side, but doesn’t have a short component. As a value going to play out, but we know that
we built a strong investment track investor, he calculates the intrinsic value of businesses and there are many things that could go
record is being very defensive dur- them compares that to the value that the stock market is wrong and that makes us nervous.
ing periods of market euphoria, applying to the business in terms of its stock price – and We think we have gone
namely the Internet bubble in 2000 then he buys when there are large valuation discrepancies. through the most difficult economic
and then again at the peak of the As the market rallied 80% from trough to peak in just over period in the United States and the
housing/debt bubble in 2007. We one year, he made several moves to make the portfolio world since the Great Depression.
were able to escape those downturns more defensive. He sold stocks that were rising and hitting We think the worldwide debt bubble
with substantially lower losses than his price targets; he oriented the portfolio away from more -- this was not just a US housing cri-
the overall market in our hedge speculative high-beta volatile stocks into big-cap blue-chip sis or bubble, but a worldwide debt
funds because while we didn’t fully stocks that have pricing power even in a recessionary bubble -- was unprecedented in the
anticipate the magnitude of the environment; and he let his short book run against him degree of depravity that took place,
chaos in the markets, we knew and even added to it. He thinks cheapness is its own in the amount of leverage that built
enough to be defensive when others catalyst and if you can be patient, sometimes for a year or up in the system all over the world,
were euphoric and the, when other two, you will be rewarded. He does in-depth work on the and we’re very skeptical that we have
investors were panicking in late companies and industries in which he invests and he is somehow successfully managed our
2008 and early 2009, we were ag- able to look around in the nooks and crannies of the way through the aftermath of that
gressively buying. market and has made spectacular returns on some very bubble and that everything is rosy
While the core of what we small positions. He says it’s a big advantage on the long now. We think the aftermath of this
do and the positions in our portfolio side being a small firm, but it’s an even bigger advantage bubble will be with us for many years
are based on company and industry being small on the short side. and that will continue to cause dis-
specific analysis, how we position Companies include: Huntsman (HUN); Vistaprint (VPRT); ruptions and turmoil in various mar-
the portfolio overall, how aggressive Berkshire Hathaway (BRK.A); Microsoft (MSFT); Anheuser- kets. The sovereign debt crisis in
we are on the long side, how big we Busch InBev (BUD); BP (BP); dELIA*s (DLIA). Europe is a good example of that just
make our short book and therefore in the past few months; we think the
what our net exposure is can change US housing market is already in a
quite dramatically depending on our view of the world. We are playing double dip right now, though because there is a lag in the data, most people
defense today. We are not in maximum defensive position, but we are on haven’t yet realized it. We don’t think it’s going to be anything like the first
the defensive side of the spectrum. If you take our gross long exposure, dip, which really took world economy over a cliff, but there are 7 million
subtract our gross short exposure, that leaves you with net long exposure. people not paying their mortgages right now and we have not resolved that

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

For example, today we are approximately 100% long in our
hedge funds and we’re about 60% short. We are fully invested on the
long side and then we’ve sold 60% of our capital short as well and so in
hedge fund terminology, that’s 40% net long. Our net long exposure has
ranged from a high of 90%, which was 120% long, 30% short in March
of 2009. That’s net 90% net long, which is maximum aggressive posi-
problem and that’s going to continue to be a headwind for our financial
system. There are probably six or eight major risk factors, two of which are
the sovereign debt issues and the US housing market. These make us very
nervous and we don’t know how it’s going to play out (and we’re skeptical
that anyone knows how it’s going to play out), so in light of these major
problems, we think it’s wise to be prudent.

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 MONEY MANAGER INTERVIEW ——————— INVESTING IN UNDERVALUED VALUE STOCKS
If stock prices are very low and are pricing in a worst-case
scenario as they were in March of 2009 for example, we’re very happy
to invest aggressively on the long side even in light of tremendous un-
certainty as long as we think we’re getting paid for that risk. The problem
is that, even after the latest pullback in the US stock market, the S&P 500
is still up nearly 60% from its lows in early March of 2009. We think
today the market is still priced for a fair amount of optimism. We’re
hopeful that a scenario develops where we get a V-shaped economic re-
covery where unemployment falls substantially, in which case stocks
today are probably cheap, but I’d say there is only 20% chance of that
“We started buying Huntsman at $8, bought more at $6, more at $4, and finally bought a lot at $2 right
at the bottom. Within one year, the stock went from $2 to $14. It turned out our initial thesis was exactly
right and buying it at $8 was a great investment, but buying it at $2 was a really great investment.”
1-Year Daily Chart of Huntsman
Chart provided by www.BigCharts.com
scenario. We think there is a 50% chance of a scenario we would call a
muddle-through economic situation, where unemployment remains per-
sistently high and economic growth is 0% to 2% compounded for the
next five years. In this case the stock market’s probably not going any-
where for another five years. Finally, we think there’s at least a 20% to
30% chance of a double-dip recession of some magnitude where the
stock market could fall another 10% to 20% from here.
TWST: Is that because the market’s not fairly valued
enough?
Mr. Tilson: It’s because the market today is assuming at least
reasonable economic growth and if that doesn’t materialize, then stocks
are going to fall.
TWST: What changes have you made to the portfolio over
the last 12 months or so to reflect this current defensive posture?
Mr. Tilson: We’ve made three changes -- nothing dramatic,
but steadily in small increments over time from the market bottom in
March of 2009 through the recent peak in April of this year. As the mar-
ket rallied 80% from trough to peak in just over one year, one of the
sharpest market rallies in stock market history, we did three things to
make our portfolio more defensive.
Number one is we sold stocks that were rising and hitting our
price targets. A good example would be Huntsman (HUN), a specialty
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chemical company, a cyclical business, a busted acquisition by Apollo
Management, and a company with too much debt. It was the exact kind
of company that got obliterated in the downturn. The stock went from
$26, near the price Apollo had committed to pay, to $8 as both the
economy and the market took a dive. Huntsman’s earnings fell sharply,
and people started to worry about whether their debt load could take
them under. We started buying at $8 a share thinking it was worth $15 in
any kind of normal economy, knowing it might take a few years to get
there, but thinking we would double our money eventually. The company
also had multibillion dollar lawsuits against Apollo and its bankers for
walking away from the deal at $26.50 a share, so we thought we were
also getting a free call option on another $5-10 a share of upside in ad-
dition to a 50-cent dollar stock.
Having fallen from $26 to $8, with many positive catalysts, we
thought it couldn’t fall any further – yet within five months, the stock
was at $2, we’d lost 75% of our money, and the stock was being priced
as if the company would soon file for bankruptcy. It was a tiny sliver of
equity on top of many billions of dollars of debt.
We did our analysis, focusing on the debt loads — specifically
the debt maturity dates, and noted that there were no material maturities
until 2013, so we couldn’t see how this company would go bankrupt.
Thus, we started buying it at $8, bought more at $6, more at $4, and fi-
nally bought a lot at $2 right at the bottom. Within one year, the stock
went from $2 to $14. It turned out our initial thesis was exactly right and
buying it at $8 was a great investment, but buying it at $2 was a really
great investment. We had a number of stocks just like this.
As Huntsman rose from $2 to $14 a share, we trimmed it all
the way up because we wanted to manage the position size and because
it was approaching our estimate of intrinsic value.
The second thing we did to make our portfolio more defensive
is we oriented it away from more speculative high-beta, volatile stocks
like Huntsman into more defensive companies like Berkshire Hatha-
way (BRK.A), Microsoft (MSFT), Anheuser-Busch InBev (BUD),
Kraft (KFT), Pfizer (PFE), and Intel (INTC). All of these are all big-
cap blue-chip stocks that we own today. They are the kind of companies
that even in a lousy economic environment, even in an inflationary envi-
ronment or deflationary environment, have pricing power. If the dollar
goes up, if the dollar goes down; it doesn’t matter, these companies earn
money in different currencies all over the world.
To the extent you want to own anything in a lousy economic
environment, these are the kind of strong-balance-sheet, dominant-mar-
ket-position companies with pricing power that you want to own -- as-
suming of course that you can buy them at low valuations. The great
news today is that high-quality blue-chip stocks as a whole are trading at
the lowest valuations we’ve ever seen relative to the market.
In March of 2009, we deliberately positioned our portfolio in
some of the riskiest stocks and sectors, like cyclical, heavily indebted
companies such as Huntsman and financial stocks because they were
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so cheap – we weren’t buying 50-cent dollars, but 10-cent dollars and
20-cent dollars. We were short financial stocks going into the crisis and
all the way down, but near the bottom we flipped around and went long
a number of blue-chip financial companies like American Express
(AXP) and Wells Fargo (WFC) and made many times our money
within a year. More recently, we’ve been trimming these kinds of
stocks and buying the blue chips.
year, the homebuilders had rallied to the point where they were trading on
average at about 1.7 times book value and we were convinced that we were
heading into a double dip in the housing market. Two months later, the
homebuilders are down roughly 40% on average as it’s become clear to most
people that we are in fact experiencing at least some level of double dip and
the homebuilders are back to trading at 1.1 times book and probably aren’t
a good short anymore and so we’re trimming that short position.

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

Another category of companies that we’re short today are

1-Year Daily Chart of Anheuser-Busch InBev
very richly valued stocks where the underlying business actually
might be an okay business and might be doing well, but the valua-
tion is simply ridiculous. Lululemon Athletica (LULU), Netflix
(NFLX), and our favorite, a company called Vistaprint (VPRT) are
examples. Vistaprint is an online printing company, a total com-
modity business in our view that was trading north of 30 times earn-

1-Year Daily Chart of Microsoft

Chart provided by www.BigCharts.com

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

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

the stocks went up -- some of them went up a lot. The answer in most
cases we concluded was that we were still right and the market was in-
correct in running these stocks up. We maintained our short position in
the homebuilders, for example, and even increased it earlier this year.
That was the third piece of playing defense and protecting our portfolio.
In some cases, the shorts haven’t worked at all and have hurt us,
but in other cases they have worked beautifully. For example earlier this
ings. They just announced earnings last night and the last I looked
the stock is down 35% today. Vistaprint is one of those shorts that
hurt us a lot over the past year until the day they miss earnings.
With a richly-valued stock that misses earnings, the pain for the
people who own the stock can be severe and the benefits for people
who are short the stock can be quick, which is something we’re see-
ing today in Vistaprint.

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TWST: What are your investment criteria or valuation
metric that you look for in for your longs and shorts?
Mr. Tilson: It really varies by situation. I’ll give you some
rules of thumb, based on a dozen years of experience, not necessarily
mathematical proof. For typical companies, we are looking at the mul-
tiple of what we think are normalized earnings or cash flows. It’s hard
for me to think of a single stock we have ever purchased in 12 years that
we purchased trading at more than 15 times normalized earnings. I know
we have never purchased a stock trading at more than 20 times what we
think are normalized earnings for the next 12 months.
1-Year Daily Chart of Vistaprint
Chart provided by www.BigCharts.com
What that means is that we have missed some tremendous
stocks over the past ten years. For example after Google (GOOG)
IPO’d, the stock went under $100 to over $700 in just over three years
-- and we missed it all the way up. A lot of value investors who were
more comfortable paying up for growth made a lot of money. Another
example: shame on us for missing Apple (AAPL) all these years. I love
their products, but at any given point in time, it just seemed to be quite
richly valued -- but if a company can grow its earnings at 80% a year
for five years, it almost doesn’t matter what multiple you pay at the
inception, you’re going to do very well with that stock.
But that’s okay, we’re willing to miss some of the high-
growth stories like Google and Apple because too often when you
pay up for a stock, you end up with a Vistaprint and lose 35% of
your money in a day if it misses earnings by a few pennies and that
just makes us uncomfortable.
I would say as a general rule for the highest quality businesses
in the world, we might pay 15 times earnings. Typically we’re buying
companies that have problems, often betting on a turnaround or where
the sector is out of favor, in which case we much prefer to buy things at
ten times to 12 times earnings for decent businesses with what we be-
lieve are short-term problems. We also like buying distressed business at
five times earnings where there’s a lot of negativity already built in and
if anything goes right, you can double your money pretty quickly.
Let me give you a couple of examples. One of our most suc-
cessful investments ever was buying McDonald’s (MCD) in early 2003
after the company had reported something like 24 consecutive months of
negative same-store sales. There were documentaries and books coming
out like Super Size Me and Fast Food Nation that were blaming McDon-
ald’s for many ills, especially obesity. The company had gone through a
number of CEOs, had consistently disappointed Wall Street, and we were
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able to buy McDonald’s at the bottom at about ten times depressed earn-
ings. We thought earnings could quickly rise and the multiple on those
earnings would rise, as McDonald’s is obviously worth much more than
ten times earnings if the business is even stable, much less growing. The
stock went from $12 to $60 in a matter of five years, so this was a case
of buying a great business with problems at ten times earnings.
Interestingly, about two years into the turnaround, the com-
pany was doing well, had reported a couple of years of positive same-
store comps, and the stock had risen to $30, so we’d already doubled our
money in two years. Normally, at that point, value investors like us are
getting out: the stock was now trading at about 15 times earnings and
was popular on Wall Street. But interestingly enough, at that point we
looked at McDonald’s with a fresh set of eyes and we saw a business
that was firing on all cylinders, with a lot of operating leverage. In other
words, 5% same-store sales translate into 20% earnings per share growth
and the company was reporting very consistently 5% to 8% same-store
sales growth. We knew that as long as they were in the 5% to 8% range,
earnings were going to grow at 20% to 25% a year, yet analysts were
estimating earnings growth of 12% a year.
1-Year Daily Chart of McDonald's
Chart provided by www.BigCharts.com
For three years in a row, analysts every year just kept predict-
ing 12% EPS growth even though we could see very clearly that earnings
were going to be at least double that. We held on to McDonald’s for
another three years and sure enough earnings grew at 25% a year for
three years and we got another double out of the stock from $30 to $60.
That would be an example of buying a great business at the high-end of
a multiple that we would ever pay, but one where the business was just
good enough. 15 times earnings is a below-average multiple for a com-
pany that is clearly massively superior to the average American business.
Finally, let me give you a very recent example of buying a
distressed turnaround situation at five times earnings: BP (BP). We look
for investment situations where we think the sellers are panicked and are
selling to us irrespective of any rational calculation of intrinsic value. Of
course virtually anything we purchased from October 2008 through
March of 2009 fell into that category, but it’s much harder today in this
more complacent market. But every once in a while you get a situation
where a company encounters severe distress and the stock crashes.
Sometimes it’s warranted and the company spirals into bankruptcy and
obviously you want to avoid those situations, but sometimes it’s not war-
ranted and BP was an classic example of this.
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When the Deepwater Horizon Rig blew on April 20th, BP
stock was at $60.48. We started buying when the stock fell to $37, know-
ing that the headlines would be terrible for at least another month or so
until they capped the well. Sure enough, the headlines were terrible and
many people were comparing this to asbestos and predicting bankruptcy.
We owe them a debt of gratitude because they triggered an investor panic
that took more than $100 billion off of BP’s market cap. We bought it all
and do nothing, or sell. Making the correct call at that point is much
more important than the price at which you initially purchased the stock,
and there is no clear rule of thumb. Sometimes you want to buy a lot
more, like in the case of BP; sometimes terrible things have happened,
your investment thesis is in tatters, but the stock price reflects it and you
just want to hold and do nothing; and sometimes you’ve made a terrible
mistake and you should sell immediately. It is very difficult to make the

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

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

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

the way down to its 14-year low under $27 on the thesis that BP would
be able to cap the well, that the damages, while severe, wouldn’t be in
the $100+ billion range, but instead would be in the $30-50 billion range,
and most importantly, that a company with $34 billion a year of operat-
ing cash flow would be able to earn its way out of trouble.
Allow me to digress a moment and share an important lesson
that played out in our BP investment. It has almost never occurred in our
investment careers that we have been clever enough to buy a new posi-
tion at its very low -- it’s never happened. It is always the case that we
start buying something and at some point -- maybe the next day, maybe
the next month, maybe the next year -- the stock declines further from
our purchase price. The key to successful investing is not being the
world’s most clever buyer on day one, it’s what you do with an existing
position that is 25% below where you first started buying it.
At that point, you can only do three things: buy more, sit there
Every element of our thesis is now coming true. At the time we
were buying it, there was at least 10% chance of a very severe adverse
outcome – namely bankruptcy -- that would probably wipe out the share-
holders. Today, with the well capped and the environmental damage
much less than people feared, we think that risk is now 1% or less and
therefore, we continue to hold a large position. We think eventually the
stock’s going to be at $50 within a year or two so we’re still holding on.
TWST: That’s very interesting about BP and good fortune
to you.
Mr. Tilson: Let me give you one other example for your read-
ers who don’t have the stomach for BP: Microsoft: If you net out its
cash, it’s trading at less than ten times trailing earnings right now and it
has one of the world’s strongest balance sheets: it’s drowning in cash and
has virtually no debt. The immediate reaction we always get is, “Yes, but
stock has been dead money for ten years and isn’t Google or some other

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competitor going to take away their business, and wasn’t that little phone
they had, the Kin, a bust, and they seem to spend a lot of time and money
on things that lose money and don’t seem to get much traction?” Every-
one knows the bear case on Microsoft.
But what we see is one of the greatest businesses in the history
of the world in terms of margins, in terms of market share in its core
businesses, in terms of the profits and cash flows that it generates.
The real knock against Microsoft is that there is just no growth
and if it’s a no-growth cash cow, it’s probably only worth ten times earn-
ings. But the key is to understand that Microsoft only earns profits in
three areas: Windows, Office, and Server software, which collectively
account for more than 100% of its profits and everything else is irrele-
So, all three drivers of Microsoft’s profits have new products,
offering the prospect of substantial growth -- and you don’t even have to
bet that the growth might come. The evidence is clear, the only question
is how much growth and how quickly. Microsoft just reported quarterly
earnings, and revenue was up 22% year-over-year and earnings per share
were up 50% year-over-year. I’ll give you a wild guess how much ana-
lysts are expecting profits from Microsoft to grow in the next 12 months.
The answer, of course, is 13% because that’s all analysts are capable of
projecting apparently, regardless of all evidence to the contrary.
We think earnings are virtually certain over the next 12
months to grow 20-25%, which we think is conservative in light of the
fact that they just grew earnings per share 50% last quarter. By buying

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

vant. It doesn’t matter that they lose a few hundred million dollars a year
-- or even $1-2 billion a year -- on Bing and other new ventures. It just
doesn’t matter.
The only thing that matters for Microsoft is those three fran-
chises -- the three greatest franchises in history, in our opinion -- and the
beauty of it is that they have new products launching in all three of those
areas. Windows 7 is taking off like a rocket to rave reviews and Corpo-
rate America is adopting it. Many end users shunned Windows Vista and
are still running Windows XP, which is now a very dated system so ev-
erybody is now upgrading to Windows 7.
Microsoft Office has 94% market share of office suites, a
number that has been stable for the last five or ten years. The idea that
Google apps are going to put Microsoft Office out of business is beyond
ludicrous. That might happen five or ten years from now, but it is abso-
lutely not happening today or in the next year. Microsoft Office just
launched a new version, which I’m now using. It’s nothing revolutionary,
but it entrenches Microsoft’s monopoly for another few years.
the stock today at ten times earnings net of cash, a year from now earn-
ings are going to be 20-25% higher, which means if the multiple stays
at ten times earnings, you make 20-25% owning the stock plus a 2%
dividend on top of that.
The only thing that could mess up this investment, assuming
the earnings are there, is the multiple on the earnings contracts. Micro-
soft is only trading at ten times earnings, near the lowest multiple the
stock has ever traded at. We actually think if they start to show nice earn-
ings growth for a few more quarters that the multiple investors will place
on those earnings is much more likely to go up rather than down. A busi-
ness of Microsoft’s quality should trade at 15-20 times earnings not ten
times earnings.
If we’re right about that, you could have a much more substan-
tial return on the stock. In fact, with the stock today around $25, we are
looking for the stock to be in the $35 to $40 range a year from now. Most
importantly, given our defensive nature, is we think that that earnings
growth is going to be there almost no matter what happens to the world

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

Finally, the Server business, which nobody pays any attention
to, has been suffering from depressed margins over the past couple of
years as Microsoft has invested heavily in developing new products.
Because Microsoft’s accounting is very conservative, they expense all of
their software development costs and that’s been depressing margins in
that area. They now are launching new products, the development ex-
penses are going down, and the revenues and profits from the launch of
the new products are going up so we think the Server software business
is going to show an enormous growth in profitability over the next year
or two.
economy or the US economy or GDP growth. We think in the event of a
declining stock market and general investor bearishness or panic, inves-
tors will flee to companies with very strong balance sheets and that can
grow even in the face of a weak economy. We view Microsoft as both
an extremely good defensive stock, but also one that offers you a very
good prospect of nice upside in the next year or two.
TWST: What about the risk management at these value
and deep value stocks? How do you incorporate that within your
process?
Mr. Tilson: It’s a very important factor, but it depends on the

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situation. For example, we think that Anheuser-Busch InBev, which is
another one of our big-cap blue chips, is trading at less than ten times
free cash flow and that it has nice growth prospects ahead of it, so there-
fore we’re going to win as earnings grow and as the multiple on those
earnings expands. One of the reasons we like that business so much is
because we think it has one of the best management teams out there.
Berkshire Hathaway is one of our largest positions because we have so
much confidence in Warren Buffett given his 50-year track record and
also have studied him more closely than anyone we have ever studied.
In the case of tainted management, certainly BP and Tony Hay-
ward fall into that category. We correctly anticipated that he would get
canned and that they’d bring in somebody better and we’re delighted that
of the largest companies in the world -- and also owns something as tiny
as dELiA*s. But this is an important point to make about our portfolio
today: where we are finding opportunity is like a barbell. On one end of
the barbell are mega caps, in most cases big-cap blue chips with the oc-
casional out-of-favor big-cap like BP-. Then on the other end of the
barbell are quite a few special situations and microcaps like dELiA*s
where we take advantage of our small size and find opportunities by
poking around the nooks and crannies of the market. dELiA*s hasn’t
worked yet, as the company has not produced very good results – it’s on
a breakeven EBITDA basis right now – but it has a pile of cash and no
debt and the entire market cap of the company is equal to their pile of
cash. Thus, you get the whole business for free.

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

1-Year Daily Chart of dELIA*s

Bob Dudley is now running BP. That’s the good thing about bad manage-
ment: they can always be replaced. Lastly, since we were just talking about
Microsoft, there have been calls for Steve Ballmer’s ouster. In the ten
years that Steve Ballmer has been running Microsoft, revenues have tri-
pled and profits have doubled. It’s not his fault that he became CEO when
investors had much too high a multiple on Microsoft’s stock.
Another pillar of the bearish thesis on Microsoft is that the
company is going to take $40 billion of its cash and squander it via a
stupid acquisition or investment. We don’t have that concern. It’s possi-
ble, but we don’t think it’s very likely. Microsoft has actually returned
over $100 billion to shareholders over the past decade, did a $30 billion
one-time special dividend, repurchased a lot of stock, reducing the share
count substantially, and is now paying a 2% dividend. We don’t be-
grudge Microsoft investing money in small acquisitions and trying to
compete with Google with its Bing search engine, which by the way last
month took market share from Google (albeit from a very small base).
Frankly we don’t think Google should be too worried about Bing. But
it’s okay in our opinion for Microsoft to spend a few hundred million,
even a couple of billion, to invest in new technologies and maybe de-
velop another new franchise. We have a much more sanguine view of
Microsoft’s capital allocation over the last ten years than the rest of the
market appears to, and we are not calling for Steve Ballmer’s ouster.
TWST: What other ways do you look for to prevent the
individual security level to prevent them becoming value money
traps for example?
Mr. Tilson: We have plenty of experience with value traps. We
have a number in our portfolio today, in fact, where we bought them re-
ally cheap, but where the businesses just haven’t done very well and the
stocks remain cheap; maybe we haven’t lost much money, but we’ve tied
capital for a few years and it hasn’t gone anywhere.
I’ll give an example of a micro-cap that we own almost 10%
of called dELiA*s (DLIA). It’s a specialty retailer selling to teenage
girls with over 100 stores in nice malls all over the country plus a catalog
and web business that’s about half of their revenues. The stock today
trades for about $1.40, so it has a $45 million market cap.
Incidentally, it’s very unusual to find a fund like ours that owns
things like Berkshire Hathaway, BP, Microsoft, and AB InBev -- some
Chart provided by www.BigCharts.com
The question is, is the business worth something? The com-
pany generates about $225 million of revenue, but because it’s such a
small business, the overhead, the salaries for management, the cost of
being a public company in the era of Sarbanes–Oxley, for example, suck
up a lot of what would otherwise be profits. This is a business that should
not be public at its current size and would make a nice little bite-size
acquisition for any number of larger retail/apparel-oriented companies
that could strip out the cost of being public and it would immediately
become a profitable business. This business is clearly worth more as part
of a bigger company than as an independent company. Thus, it didn’t
surprise us when one of the largest shareholders recently wrote a letter to
the company calling on it to find a buyer.
The stock continues to languish and may continue to do so until
someday somebody buys the company for $3 a share or more. It’s been a
value trap and will remain one until one day the stock doubles because the
company is acquired. We can make a very good argument for why there
are any number of buyers for whom purchasing this company at $3 a share
would be a very good deal for them because they could immediately
pocket the $1.40 a share in cash. Let’s say the acquirer pays $50 million
above the cash to own a business with $225 million of sales and a good
little niche business. They’d be buying this business for less than 25% of
sales, and many mall-based specialty retailers trade for one times sales.

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We think something good will happen and there is a catalyst in
place with a shareholder being an activist, but in the meantime we just
sit and there’s not much we can do. We don’t buy the stock as we’re al-
ready approaching the 10% limit and even if we wanted to sell it, which
we don’t, we probably couldn’t because it trades by appointment and we
own so much of it.
Mr. Tilson: In addition to the two I mentioned earlier, sover-
eign debt issues and the U.S. housing market, the single biggest concern
I have is that governments around the world are adopting austerity mea-
sures too early. We had the Great Recession, but things could have been
much worse. The only reason we avoided it is governments around the
world printed a lot money and stepped into the breach caused by busi-

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

TWST: What other factors that differentiate your invest-
ment approach from that at other peer companies? What other
things do you bring to the table that other firms might not?
Mr. Tilson: There are a couple of things. One is we built our
business with investors who share our value orientation and long-term
investment philosophy, so we have a very stable base of capital and we
can invest without worrying about whether the stock is going to work for
us this month or this quarter or even this year. Sometimes the cheapest
situations are the ones that everyone agrees are cheap, but there’s no
catalyst. We think cheapness is its own catalyst and if you can be patient,
sometimes for a year or two, you’ll be rewarded. Our patience and the
investor base we built that allows us to be patient is a big advantage.
Secondly, we do in-depth work on the companies and indus-
tries that we invest in that is rivaled by very few other investment firms.
Even though we’re a small firm, my partner, Glenn Tongue, and I have a
lot of experience. The average hedge fund and mutual fund is run by a
manager who has been running that fund for only a few years, whereas
we have a nearly 12-year track record. We’ve endured two of the biggest
market busts in history and not only lived to tell about it, but thrive.
Our third big advantage is our size. Most of the very successful
investors with decade-long successful track records are managing $5
billion to $50 billion and we are managing $150 million. We can look
around in the nooks and crannies of the market, and have made spec-
tacular returns on some very small positions. For example, we were
buying SPAC warrants in late 2008 and early 2009 at $0.20 that are today
worth more than $3; we bought General Growth Properties at $1 a
share a little more than a year ago and today it’s our largest position
around $13.50 a share. Being small allows us to be nimble and to invest
in material size in special situations and micro caps where one can make
enormous percentage returns.
Our size also gives us a huge advantage on the short side. The
best short ideas are often in the $500 million to $1 billion market cap
range. If you’re running a $5 billion hedge fund, you cannot get enough
borrow to establish a large enough short position in something with $500
million market cap to make a difference. So it’s a big advantage on the
long side being small, but it’s an even bigger advantage being small on
the short side.
TWST: Looking ahead for the rest of this year for inves-
tors, what are the challenges or headwinds that you foresee that
people should be wary of?
nesses and consumers pulling back, which was creating a self-reinforc-
ing vicious cycle that would have plunged the entire world into
something like 20%+ unemployment instead of the 10% unemployment
we have. It was massive coordinated government action that avoided a
repeat of the Great Depression.
A year later, we appeared to have staved off another Great
Depression, but I believe both the US and European economies are much
more feeble than is generally believed by policymakers. Unemployment
still remains around 10% in the United States and it is possibly a very
serious mistake to be cutting back government spending and to focus on
deficit reduction with the world economy so weak. Eventually the gov-
ernments need to cut back and stop running such large deficits, of course,
but the key is when. I could be wrong and hope I’m wrong, but I suspect
it’s happening too early and that the withdrawal of government stimulus
done prematurely could tip the world back into a double-dip recession of
some sort.
We are keeping a very close eye on various basic, obvious fac-
tors that would indicate whether the economy is just taking a little bit of
a breather or whether we’re heading back into a double-dip recession. If
that happens, profits are going to get hit because businesses, which have
managed to maintain their profits surprisingly well by cost cutting, will
likely not be able to do much more cost cutting.
For most businesses to continue to grow their profits, they
need general economic growth, which we’re not sure will occur. There-
fore, we are looking to own business that we think can grow even in the
absence of any kind of general economic growth -- ones like Microsoft,
Anheuser-Busch InBev and Berkshire Hathaway where the businesses
are strong enough or have unique things happening like new products in
the case of Microsoft or cost cutting in the case of Anheuser-Busch
InBev that will allow them to show growth even in the absence of a
tailwind from the economy.
TWST: Thank you. (PS)
WHITNEY TILSON
T2 Partners LLC
145 East 57th Street Tenth Floor - 1100
New York, NY, 10022
(212) 386-7162

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Te l : ( 2 12 ) 9 5 2 - 74 0 0 • Fa x : ( 2 12 ) 6 6 8 - 9 8 4 2 • We b s i t e : w w w. t w s t . c o m
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The investment objective of the funds managed by the Investment Manager, T2 Partners
Management, LLC, is to achieve long-term after-tax capital appreciation commensurate with
moderate risk, primarily by investing with a long-term perspective in a concentrated portfolio of
U.S. stocks. In carrying out the funds’ investment objective, the Investment Manager’s primary
strategy is to buy stocks at a steep discount to intrinsic value such that there is low risk of capital
loss and significant upside potential.

There is no assurance that any securities discussed herein will remain in the portfolio of the
funds managed by the Investment Manager at the time you receive this report or that securities
sold have not been repurchased. The securities discussed do not represent the funds’ entire
portfolio and in the aggregate may represent only a small percentage of the funds’ portfolio
holdings. It should not be assumed that any of the securities transactions, holdings or sectors
discussed were or will prove to be profitable, or that the investment recommendations or
decisions we make in the future will be profitable or will equal the investment performance of
the securities discussed herein. All recommendations within the preceding 12 months or
applicable period are available upon request.

Hedge Funds Disclaimer

Hedge fund performance results discussed are for the T2 Accredited Fund, LP and include the
reinvestment of all dividends, interest, and capital gains. Returns are presented net of all fees,
including a 1.5% annual management fee and a 20% incentive fee allocation. For periods prior
to June 1, 2004, the Investment Manager’s fee schedule included a 1% annual management fee
and a 20% incentive fee allocation, subject to a 10% “hurdle” rate. In practice, the incentive fee
is “earned” on an annual, not monthly, basis or upon a withdrawal from the Fund. Because some
investors may have different fee arrangements and depending on the timing of a specific
investment, net performance for an individual investor may vary from the net performance as
stated herein.

The return of the S&P 500 and other indices are included in the interview. The volatility of these
indices may be materially different from the volatility in the Fund. In addition, the Fund’s
holdings differ significantly from the securities that comprise the indices. The indices have not
been selected to represent appropriate benchmarks to compare an investor’s performance, but
rather are disclosed to allow for comparison of the investor’s performance to that of certain well-
known and widely recognized indices. You cannot invest directly in these indices.

Past results are no guarantee of future results and no representation is made that an investor will
or is likely to achieve results similar to those shown. All investments involve risk including the
loss of principal. This document does not constitute an offer to sell or the solicitation of an offer
to purchase any security or investment product. Any such offer or solicitation may only be made
by means of delivery of an approved confidential offering memorandum.

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

Past performance is no guarantee of future results. Investment return and principal

value of an investment in the Funds will fluctuate so that an investor’s shares, when
redeemed, may be worth more or less than their original cost. Current performance
data may be lower or higher than the performance data quoted. To obtain more
current performance data regarding the Funds, including performance data current
to the Funds’ most recent month-end, please visit www.ncfunds.com.

Investment in the Funds is subject to investment risks, including, without limitation,

market risk, management style risk, sector focus risk, foreign securities risk, non-
diversified fund risk, portfolio turnover risk, credit risk, interest rate risk, maturity
risk, investment-grade securities risk, junk bonds or lower-rated securities risk,
derivative instruments risk and real estate securities risk.
*
The Tilson Focus Fund’s investment advisor (“Advisor”) receives monthly compensation in the form of a variable performance-
based incentive fee (“Variable Advisory Fee”). The Variable Advisory Fee is comprised of two separate component fees: (i) a
fixed rate fee of 1.50% of the average daily net assets of the Focus Fund (“Fulcrum Fee”) and (ii) a performance incentive fee as
set forth below (“Performance Fee”). The Performance Fee functions as an adjustment to the Fulcrum Fee and is based on the
Fund’s performance relative to the performance of the Dow Jones Wilshire 5000 (Full Cap) Index, a broad-based, unmanaged
index of 5,000 different stocks (“Wilshire 5000 Index”), over a 12-month rolling measuring period (“Measuring Period”), as such
performance is presented on the website www.wilshire.com. The Measuring Period operates such that when each subsequent
calendar month is added to the Measuring Period on a rolling basis, the earliest calendar month in the previous Measuring Period
is dropped. For example, on April 1, 2006, the relevant Measuring Period would be from April 1, 2005 through March 31, 2006
and on May 1, 2006, the relevant Measuring Period would be from May 1, 2005 through April 30, 2006. Thus, the Performance
Fee, and in turn the Variable Advisory Fee, will periodically increase or decrease depending on how well the Fund performs
relative to the Wilshire 5000 Index for the Measuring Period. See the prospectus section entitled “Management of the Funds –
Investment Advisor” for more information on the Tilson Focus Fund’s Performance Fee.

Distributor: Capital Investment Group, Inc., P.O. Box 4365, Rocky Mount, NC 27803, 800-773-
3863.

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