ValueInvestor

December 30, 2013

The Leading Authority on Value Investing

INSIGHT
Margins of Safety Inside this Issue
FEATURES
Value investors can err by lowering their business-quality standards in order
Investor Insight: Brown Brothers
to get a bargain price. That’s not a mistake Tim Hartch is likely to make.
Casting a wide net for resilient

A
sk Tim Hartch of Brown Brothers INVESTOR INSIGHT business models and finding them in
Harriman & Co. to describe a fa- Schlumberger, Fuchs Petrolub, TGS-
vorite stock and the conversation Nopec and Sanofi. PAGE 1 »
will go on for some time before there’s any Investor Insight: Mario Cibelli
mention of the share price and valuation.
Looking for winners in secularly
“We’re buying a business, not a model,” changing markets and finding them
says Hartch. in Outerwall, Shutterfly, Green Dot
This business-first approach has paid off and Blackhawk Network. PAGE 1 »
handsomely for investors in the $20 bil-
Strategy: Michael Porter
lion (assets) BBH Core Select strategy that
The dean of competitive strategy
Hartch has co-managed since 2005. Over
has been thinking a lot about inves-
that time, it has earned a net annualized tors and investing. PAGE 18 »
10.2%, vs. 7.1% for the S&P 500. Brown Brothers Harriman & Co.
Though they’re finding bargains relative- (l to r) Tim Hartch, Regina Lombardi and Uncovering Value: Dream
ly hard to come by, Hartch and co-manager Michael Keller A representative inexpensive idea
Michael Keller do see opportunity today in Investment Focus: Seek companies with from “the most overlooked stock
sustainable positions in attractive markets market in the world.” PAGE 21 »
such areas as oil services, industrial lubri-
when short-term or low-impact problems
cants, wireless technology, pharmaceuticals are overly discounted in the share price. Editors’ Letter
and seismic data. See page 2 Reflecting on the past year with a

Disruptive Behavior
focus more on what’s gone wrong
than what’s gone right. PAGE 22 »

Mario Cibelli’s favorite stocks have tended to produce a lot of controversy INVESTMENT HIGHLIGHTS
and volatility – and, in his hands, a long-term record of spectacular returns. INVESTMENT SNAPSHOTS PAGE

A
s might be expected from someone Blackhawk Network 16
INVESTOR INSIGHT
who trained under investing icono- Dream Unlimited 21
clasts such are Mario Gabelli and Fuchs Petrolub 7
Bob Robotti, Mario Cibelli isn’t one to Green Dot 15
bounce ideas off a network of hedge-fund Outerwall 12
buddies. “I’m an introvert when it comes to Sanofi 6
research,” he says. “I don’t think you can Schlumberger 5
get true insights any other way.” Shutterfly 14
Cibelli’s independent streak has result- TGS-Nopec 8
ed in outsized returns for his Marathon
Partners L.P. investors. Since its launch in Other companies in this issue:
1997, the fund has earned a net annualized Automatic Data Processing, Baxter, Bec-
Mario Cibelli 17.0%, vs. 7.3% for the S&P 500. ton, Dickinson, Bed Bath & Beyond, Dow
Cibelli Capital Management Targeting companies whose prospects Chemical, EOG Resources, Facebook,
Investment Focus: Seeks companies are frequently under vociferous debate, he’s Microsoft, Nestle, Netflix, Novartis, Novo
selling products that disrupt the competi- currently finding long-term upside in such Nordisk, Occidental Petroleum, Praxair,
tive status quo, allowing strong growth areas as self-service kiosks, photo com- Qualcomm, Sally Beauty, Southwestern
regardless of economic conditions.
merce, money transfer, prepaid debit cards Energy, Twitter, Western Union
and prepaid gift cards. See page 10

www.valueinvestorinsight.com
 S T R A T E G Y : Michael Porter

Fundamental Purpose
Without peer as an expert on industry dynamics and competitive strategy, Harvard Business School’s Michael
Porter has also been thinking a lot about investors and investing – not all of which is particularly flattering.

INVESTOR INSIGHT surprise, he also had plenty on his mind costs, differentiation, broad or narrow
about investing in general, and value in- set of customers. Over time, I deepened
vesting in particular. the principles for thinking about creating
a unique and sustainable position, start-
Your “five forces” framework for analyz- ing with the value chain. That was partly
ing industries – Threat of New Entrants, motivated by the #1 question I had got-
Bargaining Power of Buyers, Threat of ten about the generic strategies, which is,
Substitutes, Bargaining Power of Suppli- “Can’t you be both low-cost and differen-
ers, Rivalry Among Firms – is an impor- tiated at the same time?” This conundrum
tant part of many fundamental investors’ let to the distinction between operational
research process. Has your thinking on it effectiveness and strategic positioning.
evolved over the years? Operational effectiveness is about assimi-
lating best practices. Strategic position-
Michael Porter
Harvard Business School Michael Porter: While the original frame- ing is about making choices and tradeoffs
work was introduced many years ago, in about what customers a company is going
On investors’ role: “Directing capital
to companies that can use it productively 2008 I wrote an article in the Harvard to serve, the particular needs it is trying to
is ultimately the most profound benefit Business Review that reexamined and re- meet, and ultimately the value proposition
investors can have on society.” flected on the application of the concept of a company relative to competitors.
over time. My basic conclusion is that the I have been focused on the timeless, un-
Editor’s Note: Harvard Business School five forces are still the five forces. There varying fundamentals that underlie com-
Professor Michael Porter needs no intro- have been various nominations for a sixth petition. There’s no question that condi-
duction to any serious student of busi- force, such as technology or the influence tions change and that change is relentless
ness. His seminal work on the competitive of government, but my view is that those and impacts industries and companies.
dynamics that determine industry profit- are best understood in terms of how they But I have always tried to understand the
ability and on the strategies companies affect the five fundamental forces that ul- principles that never change, and use them
can employ to positively impact their timately drive the division of value among to understand the consequences of change
competitive positions – laid out initially industry participants. For example, gov- and the implications for companies and
in the books Competitive Strategy and ernment policy can raise barriers to entry managers in setting direction. Those prin-
Competitive Advantage – revolutionized or lower barriers to entry. New technol- ciples have stood the test of time.
managerial thinking. So articulate was ogy can intensify the rivalry among firms
his framework for thinking about strat- or decrease it. Broadly speaking, would you say the rate
egy and competition that it passed quickly Industry structure is profoundly rel- of change in industry structures and com-
into accepted wisdom. As he recently told evant to investment analysis, but too petitive positions has increased?
Fortune, “The highest compliment, I’ve much of the analysis looks at industries in
come to understand, is, ‘Oh, that’s obvi- a simplistic way, say whether the industry MP: We don’t have any real proof, but the
ous.’ I used to take that as criticism, but is growing or shrinking, or whether it’s a general feeling is that things are chang-
now I understand that’s the goal – to take down cycle or an up cycle. The fundamen- ing faster. I believe that everyone always
a complex problem and make it seem clear tal investor that uses the five forces to un- thinks that their period of history is one
and obvious.” derstand what determines the fundamen- where things are changing faster.
Now 66 and busier than ever writing, tal economic value creation in an industry Information technology, however, has
teaching and advising, Porter continues and how it is changing gains a huge edge. clearly been a big disrupter and a speed
to take on a succession of massively com- accelerator. I would also say the aggres-
plex problems, from reviving inner cities, Do you think your strategy prescriptions siveness with which management is shut-
to making countries more competitive, to for creating competitive advantage have ting things down and cutting costs has
transforming the value of healthcare de- equally stood the test of time? definitely gone up over the last 10 or 20
livery. We caught up with him recently to years. That is partly due to the fact that
discuss his latest thinking on competitive MP: My original work looked at the broad capital markets are more transparent and
dynamics and corporate strategy. To our positioning choices in an industry – low investors are more demanding. But on

December 30, 2013 www.valueinvestorinsight.com Value Investor Insight 18

 S T R A T E G Y : Michael Porter

many other dimensions of competition, for the printing industry was non-existent MP: In the U.S. economy, the single big-
I’m not so sure the rate of change is that because print is being substituted for by gest opportunity that will have ripple ef-
much faster. electronic media. But declining industries fects across many industries is the new en-
Every year or two over the past 20 can be highly profitable if capacity leaves ergy situation. This is certainly not a secret
years somebody has written an article say- the market and barriers to entry rise. De- and has already had significant impact on
ing strategy is no longer relevant because mand can hold up in less-price-sensitive oil and gas producing regions and on the
the world is changing too quickly and the segments. I’m not making the case for ev- railroads and pipelines that transport all
imperative is to stay one step ahead by eryone to run out and buy printing com- the new production. The next-order ef-
changing feverishly. I don’t know many panies. But if you look deeply enough, fects, which are just beginning, will be on
CEOs who actually believe this. Just you may have even greater economic op- industries where oil and gas are important
about every company I’ve ever come in portunities in some declining industries feedstocks or inputs, such as in chemicals
contact with recognizes it needs a strategy. than you do in growth industries where and plastics where U.S. production now
It needs to understand who it is and how has a competitive advantage where it has
it’s going to create distinctive value. That’s ON SHARED VALUE: had a disadvantage. Further down the
what allows companies and managers to line, other energy-intensive industries and
make choices about how to deal with all We’re starting to understand companies will benefit.
the trends, versus just imitate the next guy. Another area on which I spend a lot of
that worrisome societal prob-
my time today is around the idea of cre-
Elaborate on your earlier comment that lems represent the greatest ating shared value. This gets at the rela-
investors’ industry analysis can often be business opportunities. tionship between business and important
simplistic. societal issues such as health, education,
poverty and the environment. Historically
MP: Industry trends and today’s growth everyone is rushing to get in. Look at the companies have addressed social issues
rates are easy to see. What’s more subtle stock price of R.R. Donnelley [RRD] over through corporate philanthropy, which
is to understand how the five forces are the past year. is detached from the business and, some
changing, and what that means for where would say, spends shareholders’ money.
the overall value lies. You mentioned that investors have be- More recently, corporate responsibility
For example, a very important trend come more demanding. Do you consider initiatives have led to much reporting and
working its way through many manu- that an unalloyed good? focus on reducing social harms – again,
facturing industries is that products with tangential to the business.
embedded sensors are getting “smart” and MP: Net-net, I would say capital mar- But the real power of a business in so-
“connected” to manufacturers and users kets have made it harder for companies ciety is in being a business – meeting needs
via the Internet. Smart connected prod- to actually have a strategy and make the at a profit. We’re just starting to under-
ucts can have a variety of impacts up and investments that address the true funda- stand that the worrisome societal prob-
down the value chain. For example, by mentals of their industry structure and lems we face represent the greatest busi-
transforming the nature of after-sale ser- their competitive position. We’ve seen a ness opportunities.
vice, where there is a shift toward more rise in gaming around guidance and deliv- The pharmaceutical industry is a great
preventative and efficient maintenance ering quarterly earnings surprises. There’s example. It was built largely to serve a
versus a traditional break-and-fix model. also a tendency for investors to latch on to half billion people living primarily in
But the trend is neither good nor bad. It one company that seems to be doing well rich countries with established healthcare
all depends on how it’s going to impact the and push for everyone else in the indus- systems and relatively high incomes. But
five forces in a particular industry. Does try to imitate it. Analysts tend to evalu- another 6.5 billion people are out there
it impact barriers to entry? Does it create ate competitors on the same metrics even whose needs are largely unmet. Compa-
switching costs for the customer? Does it though different metrics are appropriate nies like Novartis and Novo Nordisk are
create new business models focused on for different strategies. All of this encour- starting to address those 6.5 billion people
selling the use of the product rather than ages convergence, which is the enemy of profitably with new kinds of products,
the product itself, rebalancing customer strategy. The worst mistake in strategy is pricing models and distribution systems.
power? Taking the trends and then work- for a company to compete with rivals on The potential to create shared value is
ing them through the five-forces frame- all the same things. huge and applicable to virtually every in-
work is where the insight comes. dustry and sector.
Another example is that an industry Given all your work with companies and
doesn’t have to be growing to be interest- industries, are there any secular trends Can you give some other examples of
ing. A year or two ago investor enthusiasm you’d suggest investors examine? companies creating shared value?

December 30, 2013 www.valueinvestorinsight.com Value Investor Insight 19

 S T R A T E G Y : Michael Porter

MP: Becton, Dickinson is a medical-device cutting jobs and incomes, the U.S. is not In the same way companies need to define
company whose recent growth is being truly competitive. We’re finding that the their purpose, you’ve said the same thing
driven by addressing public health needs U.S. has serious structural competitiveness about investors. Explain that.
– like risks from needle-stick infections problems, which leads us to believe that
– working collaboratively with govern- the country is likely to face slow economic MP: I believe the fundamental purpose
ments and non-governmental organiza- and job growth for years to come. of investing is to deploy capital to pro-
tions to do so. Dow Chemical created a Everyone seems to understand the mac- ductive uses in the real economy. It’s the
“Breakthroughs to World Challenges” roeconomic problems we face. But our ability of businesses to use capital well to
program, tasking each of its business work suggests that we also have a number meet needs at a profit and grow that cre-
units to find business solutions to a range of serious microeconomic problems that ates all the wealth in society. Government
of global problems. One big hit was the are just as important. and NGOs don’t create wealth, they uti-
development of Omega-9 canola and sun- lize taxes and donations to meet societal
flower seeds that produce cooking oil with ON ECONOMIC VALUE: needs. Directing capital to companies that
no trans fats and low saturated fats. The can use it productively to create economic
seeds yield for farmers twice the oil per The concern is that it seems value, and thus wealth, is ultimately the
hectare than soybeans, and the oils have most profound benefit investors can have
the vast majority of energy
longer shelf and usage lives for customers. on society.
It’s also become one of Dow Chemical’s and effort in investing has Beyond allocating capital, investors
biggest-selling product lines. This is creat- become about other things. also play a vital role in monitoring what
ing shared value. companies are doing, pushing for trans-
It’s crucial for every enterprise to un- parency, and intervening to catalyze
derstand its fundamental purpose in so- While the U.S. retains core strengths in change if the capital employed isn’t gen-
ciety. Lately we’ve been saying that our things like entrepreneurship, innovation, erating the economic value it should. All
fundamental purpose is to make money science and higher education, we’ve let of this raises the fundamental wealth that
– maximize shareholder value. But this some of the basics slide. We need to sim- is being created, and this kind of wealth
definition of purpose is uninspiring and plify and streamline regulation affecting creation does not come at the expense of
even risky. Companies also define purpose business to focus on outcomes rather than other investors.
in terms of the product they produce. But impose costly reporting, compliance and The concern is that it seems like the
purpose ought to be about the fundamen- delays. Our legal system is inflicting high vast majority of energy and effort in in-
tal needs in society a company meets. If costs on U.S. businesses, as is our health- vesting has become about other things.
Nestle thinks of itself as just a food com- care system. Roads, bridges and ports are It’s about indexing. It’s about momentum.
pany, it might think that the goal is to get in disrepair, and our communications and It’s about program trading to capitalize
people to eat more. But if Nestle thinks of energy infrastructure does not match the on tiny movements in share prices. It’s
itself as a nutrition company, it has aligned world’s best. about locating your servers closer to the
its purpose around meeting a fundamental The corporate tax system is disastrous exchange so you can trade in and out a
societal need. That opens up optionality for U.S. competitiveness, with the highest little faster. I’m all for price discovery and
and opportunity for Nestle to differenti- statutory rates in the OECD and disincen- liquidity, but improvements here have di-
ate itself and innovate in ways that create tives to repatriate foreign profits back to minishing returns for fundamental wealth
shared value. the U.S. At the same time, the system has creation. One investor’s gain is often an-
so many complex exclusions and deduc- other investor’s loss.
You’re helping to lead a multi-year Har- tions that the U.S. ends up collecting low- As more investors walk away from
vard initiative on U.S. competitiveness. er taxes than many other countries. fundamental investing, the need and the
What would you highlight as key insights Our public-education system, crucial to opportunity grows for value investors
from that effort so far? the ability of workers to compete and to who focus on understanding companies,
maintain their incomes, continues to fall industries and competition. Such investors
MP: This starts with the definition of further behind, especially with respect to can do well for themselves, for their own
competitiveness. In our definition, the middle-level skills involving some techni- investors, and for society. This is creating
United States is competitive to the degree cal training. Overall, skill development is shared value. I’d like to see more inves-
that companies operating here can com- broken, leading to unfilled jobs and high tors with that sense of purpose, and more
pete successfully in global markets while unemployment. What troubles us is that rules, regulations and incentives put in
simultaneously maintaining and increas- the U.S. has not been willing and able to place that lead investing in these direc-
ing wages and living standards for the reach consensus, pass legislation, and ad- tions rather than those that create limited
average American. If business succeeds by dress any of these problems in decades. societal returns. VII

December 30, 2013 www.valueinvestorinsight.com Value Investor Insight 20

 EDITORS’ LETTER

Taking Stock
As readers, we’ve never gotten a ($1,220,000), your portfolio as of Decem- during the year, those cited before the
great deal out of investment-oriented pub- ber 26 would have $43,000 more than one activist went public, such as Air Products
lications’ “How did we do this year?” that had invested the same amounts in the and Oil States International, performed
types of stories. While we appreciate the Russell 3000. That represents an 18.8% far better than those mentioned after the
effort to be accountable for what’s ap- gain, vs. 15.3% for the market. (In com- activist angle became well known, such as
peared in their pages, there tends to be a paring this to the market’s 2013 perfor- Agrium and Ashland.
lot of back-slapping over great calls, the mance, remember that the ideas tracked Timing has also been an issue with
recitation of which doesn’t provide a tre- only contribute for the time held, which technology companies Internap Network
mendous amount of value after the fact. for the ideas in our November issue, for Services and Symantec. While both have
We regularly track how the stocks rec- example, amounted to just one month.) seen their shares fall since being men-
ommended in VII perform, specifically No fewer than five stocks – Quiksilver, tioned, the investment cases for each rests
the “focus” ideas in interviews that are Manpower, Crosstex Energy, iGate and on business transformations that haven’t
accompanied by Investment Snapshots, Leap Wireless – more than doubled. yet borne the fruit that their recommend-
as well as the one-off ideas in Uncovering Were there commonalities among the ers expect. Each was a “time arbitrage”
Value, Uncovering Risk or A Fresh Look handful of unsuccessful ideas so far? Two idea for which insufficient time has passed
features. The challenge is defining a time stand out. Bottom fishing among gold to accurately judge success or failure.
frame over which to look. Most of those miners, namely Coeur Mining and Allied One idea from our pages for which time
we interview credibly cite their ability to Nevada Gold, has decidedly not worked has been relatively unkind: British grocery
look beyond the short-term focus of most out. Nor, unsurprisingly, have most of the giant Tesco PLC. It has been recommend-
investors as a competitive advantage, so short ideas recommended, most promi- ed three times in the past two years, most
rating their ideas after a year or less seems nently Herbalife, German utility RWE and recently in our September issue, and the
unproductive and a bit unfair. Vera Bradley. In a horrible year for short- share price has essentially gone nowhere.
But as the end of the year is a good time sellers, kudos go to Solas Capital’s Tucker Maybe our pointing it out now is a sign
to reflect, we’re happy to do so – but with Golden for his negative thesis on Krispy that the tide is about to turn.
a twist, focusing more on what has so Kreme Doughnuts in our August issue – Here’s wishing you all a happy, peace-
far gone wrong than right. Not that a lot its shares have fallen 14% over a period ful and prosperous 2014! VII
didn’t go right: Had you invested $10,000 in which the market is up more than 12%.
in each of the 122 ideas mentioned in While many ideas recommended at-
depth in VII over the past 12 months tracted high-profile activist investments

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