Trojan Investing Newsletter - Volume 1 Issue 1

TROJAN

March 3, 2008 Issue 1 - Volume 1

INVESTING NEWSLETTER

Welcome to the Trojan Investing Newsletter! Through issues distributed at the beginning of each month, the Trojan Investing Newsletter hopes to bring ideas together that stimulate new ways of thinking to benefit you as an investor. Through critically analyzing economic and sector/industry trends as well as individual securities, we hope to provide you with new insight into how to view the world as a place to invest. We are affiliated with the Trojan Investing Society, the premier finance and investing club at USC. The weekly TIS meetings are a great place to come to express your opinions on the articles written; and where the contributors of those articles will have a chance to answer any questions you have. Being allowed access to a variety of investing ideas through this forum has given our first issue depth and breadth that we would otherwise be unable to afford our readership. We hope to further add to this variety through the inclusion of book reviews, guest articles, and interviews. Although our first issue has a number of intricate ideas, our analyses cater to anyone interested in investing – whether a newcomer to the markets or someone who is already experienced in investing – with extra notes on difficult subjects and sources for additional self-research. This first issue is the culmination of many hours of toil on the part of our numerous supporters and contributors. The staff would like to thank everyone for pitching in and seeing this project through fruition. We sincerely hope that you find our newsletter to be interesting, informative and most of all, enjoyable. “How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.” -Robert G. Allen -Trojan Investing Newsletter Staff

Inside This Issue

Trend Analysis

Think Global, Invest Global, Be Global .. p.2 The Dry Shipping Sector ........................ p.3

Investment Analysis Losing Its Shine - AAPL .......................... p.5

Stability in a Volatile Market - RIG ......... p.6 Passing on Higher Costs - TIF ................ p.8 Cashing in on Turbulence - FFH ......... p.10 Shorting the 10-year Treasury ............... p.12 Buying Quality - AEO ......................... p.12 Biting the Dust - FINL ......................... p.13 Listen to Me! - PRAA ........................... p.14

Book Review

You Can Be A Stock Market Genius ..... p.15

Commentary

Financial Illiteracy ................................. p.16

Market Performance Snapshot 1-Feb Dow Jones 12,743.19 S&P 500 1,395.42 NASDAQ 2,413.36 S&P 400 823.43 Russell 2000 730.5 10-Year T-Bill 3.60%

29-Feb 12,266.39 1,330.63 2,271.48 788.51 686.18 3.53%

Return -3.74% -4.46% -5.88% -4.24% -6.07% -1.94%

Contributors:

Danny Kisch, Alexander Muhr, David J. Namdar, Jordan Ohama, Reid Petersen, and Matthew Riley Disclaimer: Any of the views expressed in this newsletter are not those of the University of Southern California, but the author’s own. Any buy/sell/hold recommendations are made by students, not financial professionals - so you should do any due diligence before investing. The main purpose of the newsletter is to facilitate discussion.

Think Global, Invest Global, Be Global By David J. Namdar Life is a continuously changing process and every generation faces different challenges, has unique experiences, and creates more new opportunities than all of the previous ones. Every generation goes through many turning point, when they step back and look at the world in front of them –transforming before their eyes – and they see changes they never imagined would take place. Many of these occur before they even realize it. Well the current generation has been going through many such turning points and has failed to truly grasp just how amazing the transformation has been.

Globalization is a term that has been thrown around for decades and is losing its significance. While there still is considerable economic, political and cultural growth that will be accomplished in the future, for all intensive purposes globalization has been achieved. Travel to any country in the world and more often than not it will be a challenge to find an experience completely unique from one in any other part of the world. Life is universal in its simplest aspects – eating, sleeping, mating, aging – and increasingly the more complex ones are being universally shared on a global level. Think about everything that you do and encounter on a daily basis: from brushing teeth, getting dressed, using computers/cell phones and driving cars. There are billions of people doing the same things every single day. It is essential to realize the extent of that statement and how the exact same thing can be done anywhere in the world at any point in time. Thinking globally is not just something done by individuals; it is also a key characteristic of the most successful companies. The greatest businesses no longer open and close, and are not limited to certain markets or by geographical boundaries. Instead, they transcend every obstacle thought to be a constraint and seamlessly grow their businesses.

and high school. Yet the university experience was not one unique to Americans which allowed the company to expand internationally: its success in doing so is highlighted by the fact that non-US users jumped from 24% to 65% of total users in 2007 alone. And the business is set up to continue its relentless global expansion since it has a renewable source of core users as children grow into and participate in the universal high school and college experience. Investing globally is realizing the possibility to move capital anywhere in the world and to invest in the businesses that are embracing global opportunities and shaping the world. An individual’s workday generally consists of 8-12 hours in an office, but as mentioned before, it can really be done at any time and anywhere. Someone can work from California and participate in a business in New York, Europe, or Asia simply by working a different shift in their 24-hour day. Investors can “day trade” in any stock market in the world through the middle of their night and 24 hours a day. And soon enough, investors will be able to invest everywhere in the world and in the next great global businesses wherever they are created. Being global is the essential piece of achieving the ability to think globally and grasping the opportunity to invest globally. It entails embracing the now-globalized world head on and seeing the universal experience as one that has created more opportunities than in any previous generation. Great investors know their businesses inside and out and get to know how and why the products are used. If the best businesses are the ones that are succeeding on a global level, the greatest investors are the ones that go around the world to see which opportunities are legitimate and where growth will occur. Does it make sense to invest in Chinese or Indian real estate if you’ve never been there? How about Brazilian ethanol plants, Turkish manufacturers, or Middle Eastern banks?

Embrace this generation’s unique experience: think globTo use everyone’s favorite social networking example, Fa- ally, invest globally, and be global. cebook initially was a website for college students at Harvard and then became used by students across the US by focusing on the niche networks of each university

Dry Shipping, Dead in the Water? By Jordan Ohama The shipping industry is historically a cyclical industry. The dry bulk sector is part of this overarching category and has many of the same attributes of the broader industry. This sector tends to be stronger in the fall and winter months with the anticipation of increased coal and other good consumption during winter. The dry shipping sector is also cyclical in the more general sense in that it fares well when there is global growth, but does not fare as well when the global economy stagnates.

In the past few years, the dry bulk shipping sector has experienced a boon from increased worldwide demand for raw materials as undeveloped countries build up infrastructure and increase their manufacturing capabilities. The prices for dry bulk ships and shipping rates as well as dry bulk shipper profits have increased beyond historical prices and have been reaching new highs. From 2000 to 2003, dry bulk demand remained in the 3-4% annual growth range. Since 2003 though, demand growth has almost doubled to 5-6% annually. Examples of Dry Bulk Items: • Cement • Coal • Lumber • Ore • Grain Sector Breakdown Within the dry bulk sector there are two major groups that carry out the transportation of goods. There are the owners of the ships who normally lease out their vessels to others, and those that operate these leased vessels to move supplies. The companies that own the vessels have two major options when leasing their vessels: they can 1) trade the usage of their vessels on the spot market or 2) lease out their ships under a time charter. Spot rates are daily rates that are influenced by the changing demand of the marketplace. They fluctuate daily and tend to be higher than time charter rates due to the uncertainty of continued usage. Time charter rates are contracts that create a fixed rate for a given period of time, usually ranging from a few months to a few years.

Recommendation: Hold

the owners of these vessels and create revenue by leasing out their use. Therefore their performance is positively correlated with the movement of shipping rates. These companies include the likes of Dryships (DRYS), Diana Shipping (DSX), Excel Maritime (EXM), and Eagle Bulk Shipping (EGLE). Pricing Trends The Baltic Dry Index (BDI) is a measure for spot shipping rates. It measures the average spot rates for 22 shipping lanes worldwide. In Figure 1, it is clear that there has been a bull market in this sector for the past couple of years, with a recent correction at the beginning of 2008 and then continued upward movement.

Figure 1: Spot Shipping Rates from March 2003 to March 2008 Source: www.dryships.com, 2008

Each line on the above chart represents a different set of shipping routes—each varying in capacity. This chart shows the variability in dry shipping spot rates from January 2003 to the present, but it is clear that since July 2005, spot shipping prices for all ships have been moving significantly higher. This is a trend that has lasted for two years already, and shows no signs of letting up. Even now, the rates are hitting all-time highs. The latest rate runup—which we are currently in the midst of—shows the strength of the demand for dry bulk services, even as the United States credit crunch reaches critical mass.

Trickle-down Effects Trickle-down effects are either external occurrences that affect an industry or internal occurrences that affect Most of the companies listed on the stock exchanges are things outside the industry. Here, the major trickle-down effects connected with the shipping sector are categorized

by inflows and outflows of assets; inflows being factors that increase the demand for dry bulk services and outflows being factors that decrease demand. Inflows: • Global economic growth has created an increased demand for dry bulk goods • A lack of infrastructure in key ports has recently created backlogs, tying up dry bulk vessels • Investments made by mining companies into more distant prospects

Figure 3: China’s Net Exports (1987-2005)

Source: Australian Government: Treasury Department, Medium-term

outlook for global energy and minerals markets, 2005 Outflows: • Decreased activities for other businesses due to China is not the only reason that dry bulk demand is inincreased costs of commodities and raw goods • Expanding operations of mining companies to creasing, but the massive demand from China has helped to exacerbate these effects. For example, the increase in include shipping naval activity has led to congestion in busy ports in AusFollowing is a quick analysis of global economic growth— tralia, forcing both sellers and buyers of dry bulk goods to specifically on the growth of China—and the effect of its look farther a field for those resources. The same goods travel many times more if it travels from Brazil to China demand on the dry bulk shipping sector. as opposed to Australia to China. Mining companies such as Rio Tinto and BHP are “investing tremendous China’s Effect on Dry Bulk Demand China, as a growing economy, has growing needs for raw amounts, not only in Australia and Brazil, but in Afrimaterials such as coal, iron ore, cement, cotton and other ca and that is extending routes.” (Capital Link, 2007) dry bulk goods. It’s important to note that, “iron ore The increased distance from destination to destination and coal, both . . . make up about 25% of total import equates to increased demand for dry bulk capacity. demand. Over the last ten years, Chinese demand has made up about 85% of total iron ore import demand Final Analysis growth and China has been the world’s largest importer China’s demand on dry bulk services is a moving force of iron ore since 2003, currently importing about half in the shipping markets, and the outlook on increasing of the world’s total exports.” (Capital Link, 2007, Dry demand for dry bulk shipping from China appears to reBulk Sector Analyst Virtual Forum) Further, China has main unchanged—even as the United States is on the become “a (net) coal importer the first time this year; verge of recession. Historically though, the economies they brought in 27 million tons from January to June, an of developing countries have slowed when the United increase of 48%, and exports dropped about 28% to 23 States’ economy slows. million tons.” (Capital Link, 2007) Figure 3 shows the clearly increasing demand for dry bulk shipping through All taken into consideration, although demand curboth importing raw materials and exporting finished rently seems to be stable, drops in demand and prices could be on the horizon for dry bulk shippers. At this goods: point, it is difficult to forecast future global growth, but increased capacity—which would facilitate a quick drop in prices—coming online in 2009 does not leave much wiggle room between now and when more economic information comes to light. I am therefore recommending a Hold on this sector.

Apple Inc. - Losing Its Shine By Jordan Ohama AAPL is a strong long-term play, but for the short-term I do not see it outperforming the markets—which I feel have not yet hit bottom. I agree with many of the other analyses out there that AAPL has 1) a strong following/ brand 2) super growth levels in keys markets (specifically PC’s) and 3) solid products. I do not, however, agree that the stock has hit bottom and has become a screaming buy.

Recommendation: Sell (Short)

Why Short-Term Weakness? When there is uncertainty, there is weakness in the price of the stock. For AAPL this uncertainty pertains to both its ability to continue to create innovative products as well as the health of the overall US economy. Risks that AAPL faces include:

Although the aforementioned products help to position AAPL as a leader in certain areas in the distant future, they have little financial benefit to the company now.

sumer. Even with its most recent update, there is still a lot to go on this product. The AAPL Air, AAPL’s most recent addition to its family of products is also a bit ahead of its time. Although AAPL is making a good bet with WiFi, not including CD or DVD slots and little connectivity beyond wireless, it provides marginal benefits to a very few.

The only product that has been talked about recently is AAPL’s plan for a 3G iPhone. This product has a limited market because it is still probably going to be limited to • Increasing competition—lower pricing and margins AT&T (T), and most people that want an iPhone al• Weak new product lines ready have one. Because it has only been a short time • Trouble maintaining strategic partnerships since the iPhone’s release, unless there are significant up• Overall Economic Weakness grades in the 3G version, most people will not be willing to spend another $600 or more to upgrade from their old I will be discussing these topics in the following qualita- iPhones. tive analysis of AAPL. Until more rumors about a potentially “game-changing” Increasing Competition product begins circulating, I am going to sit tight. HisRecently, there has been news of increasing competition torically, if you had the insight to invest in the stock even to the iPod and a number of AAPL’s other goods and ser- shortly after these hit products were newly released, you vices. For example, although competitors like the Zune still realized some pretty hefty gains. have not necessarily seen large sales increases, the fact that AAPL has recently cut its prices on its iPod Nano line Strategic Partnerships on the Rocks means that the mp3 player market is aging. Even iTunes AAPL has been unable to come to agreements with many is facing the music from increased competition. distributors in many product channels in its attempt to maintain its brand and the quality associated with that Weak New Product Lines brand. Recently though, AAPL seems to be making The new AAPL laptops are offering few incentives to buy moves that will hurt its relationships with other compaat a time when consumers’ wallets are being hit by in- nies without realizing any brand or revenue benefit. For creases in food and gas. Although they boast moderately example, its inability to cut a deal with China Mobile faster processors and memory increases, the main feature (CHL) is helping to keep AAPL out of one of the largthat AAPL is marketing is the new built-in multi-touch est markets for PDA devices in the world. Although the trackpad. specifics about the deal were not released, seeing how AAPL demanded a significant revenue cut from AT&T The AAPL TV was dead on arrival. Although some AAPL (T), AAPL may have been a little too snooty for its own fans feel that its compatibility with the computer make good on this deal. it unique, it does not provide any features that are significantly different or advantageous to the ordinary con- AAPL also recently had a minor brush with Adobe

(ADBE) over not having Flash Player installed into the iPhone. Adobe is a software powerhouse and there is no reason that AAPL should not help one of its strategic partners. A Consumer Led Recession The other major reason that there will be continued weakness in the price of this stock is because of overall economic weakness in the coming months. Consumers make up 70% of the GDP in the United States and a higher percentage in AAPL’s sales numbers. This really has nothing to do specifically with the stock, but because AAPL has a niche for high-end PC’s and accessories. AAPL may be forced to cut prices (not likely as it will diminish AAPL’s shine as a trendy brand), but will more likely be hit harder than other PC makers by this recession. Another reason it has the potential to get hit harder than other PC makers is because businesses generally do not use Macs. Congress has attached tax breaks for businesses in its most recent stimulus package. If most businesses purchase cheaper PC’s, it may be years before many of them begin to replace their computers again, keeping them out of the AAPL market for some time. Overall, I am recommending a Sell on AAPL until the markets shape up and the economic outlook begins to brighten.

Transocean - Stability in a Volatile Market By Matthew Riley

In extremely volatile markets, investors look for stable investments that can provide them with financial security. While bonds and C/D’s may be a safe play, those looking for more than single digit return will find these undesirable. Specifically, given its low risk, Transocean (RIG) is attractive given the current market conditions. The firm operates as an offshore oil-drilling contractor and is headquartered in Houston, TX.

Recommendation: Buy

larger problem in oil prices though, relates to demand. From 2000 to 2006, U.S. oil consumption increased 5% due to a rising population and an increasing number of automobiles on the road. Worldwide, demand for oil is growing at an even faster rate. China’s GDP grew 10% in 2007 and is expected to grow at an annual rate of 8% for the next 2 years. Additionally, Chinese automobile makers are entering the market in response to a 22% increase in new car sales for 2007 when compared The Economics with 2006. China’s industrialization and its population’s First and foremost in any economic analysis, the relation- trend towards consuming oil-reliant vehicles is putting a ship of supply and demand in the given market must be great amount of upward pressure on worldwide demand understood. Crude Oil closed just shy of $102 a barrel in for oil. trading Friday (February 29th), representing one of the highest levels that prices have ever been. Instability in Taking Advantage of the Situation the Middle East and Venezuela are giving rise to supply As an offshore drilling contractor, Transocean is able to constraint fears, and OPEC’s heavy regulations are trying capitalize on this high demand for Crude Oil. The comto keep supply increases from its member countries. The pany’s success is not correlated to the actual price of oil,

but rather the demand for it. Because the demand for oil is so great, companies like Royal Dutch Shell and BP have an incentive to increase production. To do so, they must go through a company such as Transocean since they do not own the equipment required to extract the oil themselves. The demand for Transocean’s products is thus increased which pushes the prices it is able to charge for its services upwards – billed in daily rates. For the quarter ended Dec. 30th, 2007, the company reported earnings of $2.79 per share, beating Bear Stearns’ estimate by $.51 per share – an earnings surprise of 22%! Future Prospects Currently, 93% of jackups, 97% of semi-submersibles and 100% of all drillships are fully contracted with very few new offshore rigs scheduled to be introduced in 2008. Rising demand with unchanged supply will cause daily rates to rise and Transocean to take in larger profits. Beyond the company’s positive earnings surprise, its outlook is that of continued growth. In its 2007 Annual Report, Transocean’s management conveys that all of the firm’s oil rigs are fully committed in 2008 and only a small number have availability for 2009. The company is focusing on expanding its operations by providing Ultra-Deepwater Floaters, allowing oil to be extracted from previously untapped supplies. This gives oil companies the ability to drill where they were unable to drill before and Transocean will be in a position to charge a premium for bring the only company in this niche market. Transocean currently has 8 of these Ultra-Deepwater Floaters under construction placing it in a position to be one of the first drilling contractors to make them available. With a price/earnings ratio of 9 times for 2008 earnings Transocean remains undervalued compared to the industry average of 20 times earnings. I am therefore recommending RIG as a Buy.

Tiffany & Co. - Passing on Higher Costs By Jordan Ohama Tiffany and Co. was founded in New York in 1837 and is in the business of selling fine jewelry and time pieces. Although its retail side is the largest portion of its business and best known, the company also runs a wholesale diamond business, direct selling operations and business to business operations. Risk Assumptions Risk assumptions for companies in times of significant change are very important. If one of these assumptions is violated, it could spell disaster for the company. For TIF, some of the items on its list of assumptions in its most recent quarterly report caught my attention: • That low or negative growth in the economy or in the financial markets, particularly in the U.S. and Japan, will not occur and reduce discretionary spending on goods that are, or are perceived to be, “luxuries”; • That consumer spending does not decline substantially during the fourth quarter of any year; • That sales in Japan will not decline substantially; • That there will not be a substantial adverse change in the exchange relationship between the Japanese yen and the U.S. dollar; • That Mitsukoshi and other department store operators in Japan, in the face of declining or stagnant department store sales, will not close or consolidate stores which have TIFFANY & CO. retail locations; • That the Company is able to pass on higher costs of raw materials to consumers through price increases; These risk factors raise some interesting questions about material changes to TIF’s outlook that may occur if there is still a significant downside to the US economy. These can be summarized into a few points, which are:

Recommendation: Hold

through TIF’s latest 10-Q3 (third quarter) report of operations ending October 30, 2007. As a note, TIF’s Q4 and annual 10K4 reports should be due around the end of March. Increasing Commodity Prices The cost of gold in recent years has been skyrocketing. At the end of 2006, gold futures were trading for over $600/oz and today are trading for nearly $940/oz. More recently, the price of platinum has also been skyrocketing as South Africa suffers from power shortages. Platinum contracts have recently closed over $2,100/oz. Movement of money into real assets can be further stimulated by fears of a weakening economy and inflation. Because it has become more difficult to finance investment real-estate for most non-institutional/money-management investors, gold and other commodities would be much more appealing and easier to purchase. If inflation continues to increase as it has in January, the price of gold and other commodities that TIF may depend on to make its products will rise dramatically. Dry shipping costs have also been increasing and the Baltic Dry Index5 which measures spot charter rates is back on the rise after taking a big dip at the beginning of the year. Dry shipping has been one of the fastest increasing expenses for miners and companies that need the raw materials that dry shippers move. Passing Higher Prices onto Consumers TIF does not disclose the breakdown of its inventory as far as asset weights. Even if an investor could break the inventory down, diamonds and certain other commodity markets are very opaque, making it extremely difficult for an investor to accurately calculate the value of such inventory items. These issues prevent an accurate margin analysis through the analysis of changes in market prices

• Increasing commodity prices (COGS1 for TIF) • The ability to pass these higher prices onto consumers (Gross Margin2) 3 10-Q is the name of the SEC’s mandatory Quarterly Report. 4 10K is the name of the SEC’s mandatory Annual Report. • Changes in consumer spending I will be hitting on these points in the following analysis 1 COGS stands for Cost of Goods Sold. 2 Net Sales – COGS = Gross Profit; Gross Profit / Net Sales = Gross Margin.

5 The Baltic Dry Index is a compilation of spot prices for of the most traveled routes by dry-shippers and is calculated daily. Spot prices are the prices charged for a given amount of tonnage (measured in dwt or dead-weight tons) and fluctuate daily. Although time charters are available—which lock in charter prices for a given period of time—the long-term trends of the spot prices are highly correlated with the charter rates.

of related commodities, changes in inventory and sales may or may not have been a significant group, it should numbers. be basically non-existent today. Due to the release of gold tracking ETF’s, decreasing costs of information, decreasAccording to TIF’s 10-Q though, 70% of TIF’s inventory ing costs of investment transactions and increasing interis run on a LIFO6 model, making it possible to assume est in investing, investing in gold companies, gold futures that the majority of their volatile commodities are being or gold ETF’s would probably appear as much better inaccounted for in this way. This assumption means that vestments to this group. Again, this may or may not be the ability to pass on higher costs of goods to consumers a significant factor in driving people to buy jewelry, but would be reflected relatively accurately through changes this is an example of how times are changing and past in the Gross Margin (GM). Using the given Gross Margin recessions may actually have been different in significant is always risky because companies can always manipulate ways. this number, but in this situation, it is the best number that we have. To increase the accuracy of our estimate of Sales of TIF as seen in Table 1 below, are based heavily in this margin, we can look at the footnotes in the 10-Q the United States. report pertaining to the reasons why changes in GM ocTable 1: Net Sales (YTD – 3Q 2007) curred and also subtract decreases in the LIFO Reserve in 000’s Percent from the gross earnings. In its most recent 10-Q filing, TIF has maintained a relatively steady Gross Margin at 55.3% as compared to 56% a year ago. This means that as of October 2007, TIF has successfully been able to pass on the higher costs of commodities. Significant fluctuations in the Gross Margin in the future could mean that TIF is no longer able to pass on this cost, a sign of a slowdown in demand. More information is given in the footnotes of the report, which are summarized on finance.yahoo.com under “Gross Margin.” Also found in the footnotes is the LIFO Reserve—which was $120,940,000 at the end of the most recent quarter. If this number drops significantly it could mean that TIF is selling off old inventory which has risen in value since it was bought.7 This type of gain is not sustainable and therefore should be discounted when looking at the Gross Profit. Changes in Consumer Spending Publishers of a few articles I have read recently have been pointing to the fact that in past recessions the most luxury brands are not significantly affected. One difference of past recessions is that people in the “way back when”, would buy jewelry because they felt that gold and other real assets would be a good investment. Although this 6 LIFO (last in, first out) is a way of inventory accounting. Because inventory is kept at the book value or the cost of materials, older items may have gains or losses in market value while kept in the inventory account. This discrepancy is known as the LIFO Reserve. 7 This increases the Gross Profit by the difference between the LIFO Reserve amounts minus further increases in the prices of items in its inventory.

US Retail International Retail Direct Marketing Other TOTAL

946,692 777,875

50.2% 41.3%

104,772 56,275 1,885,614

5.55% 2.98 1

Approximately 50% of “International Retail” is based in Japan. This means that a total of 70% of its net sales comes from Japan and the United States. A good deal of sales revenue from Europe comes from London, who is also a close trading partner with the US. If the economy continues to slow in the United States, Japan and the UK are also likely to be affected considering the strong trade relationship between these countries. If there is a recession in the US, this may slow spending on luxury goods in TIF’s major markets, forcing TIF to either cut prices (lowering the gross margin) or to lose revenue. Although a company’s financial statements may show a healthy company, there are definitely risks investing in any stock. For TIF, I feel that the downside risks offset any potential for gains and am therefore recommending a Hold for TIF until the Q4 and 10K reports are released.

Fairfax Financial - Cashing in on Turbulence By Alexander Muhr The world is coming to an end! These days in the financial markets, investors are losing money left and right with few exceptions. Fairfax Financial Holdings run by Chairman and Chief Executive Officer Prem Watsa is one of those exceptional companies. Through a simple bet called a Credit Default Swap, Mr. Watsa (below) has been able to hedge – meaning to protect – all of the company’s assets in case financial markets begin to deteriorate drastically. With the markets in turmoil since last summer, these bets are not only protecting their assets but also paying off handsomely making FFH a great investment, even in this volatile market.

What in the world is CDS? The “bet” which we’re going to look into are Credit Default Swaps (CDS), which simply stated, is a wager between two parties on whether or not a company will default on its bonds. Many different institutions make these wagers (by selling these contracts), but it’s mostly a way for seemingly high-grade companies (i.e. Countrywide, Ambac, and MBIA – all currently facing pretty hard times) to receive some extra cash flow. Investors on the buying side pay the companies a certain amount per year to pay down the debt, and if there is any hint of default by the selling company, the price of the contract will increase drastically. When and if the company actually defaults – stops paying down its debt – on their bonds, they have to pay out the full value of those bonds. You may not have heard of the CDS market, but its market value stands at about $45 trillion, which is 2-times the market value of all U.S. stocks, and 10-times the value of the entire treasury market! Back in the year 2000, the whole market was worth a measly $900 billion in comparison. The reason that the CDS market became so big is that it is unregulated and there are limitless possibilities for these bets to be made. Anyone can make them, as long as they have enough money. Another problem is that it’s very difficult to track who is responsible for pay-

Recommendation: Buy

ing up and there is very little liquidity – meaning there are very few transactions taking place. (Check out the image on the following page from The New York Times.) The major problem that the CDS market is currently facing is the perception that companies aren’t going to pay their debts. This is creating significant increases in the volume of transactions. Because the market is so illiquid, people don’t know fast enough who is responsible to pay whom. There can be multiple derivatives of just one CDS and the act of one person in the chain not being able to pay up can disrupt the whole system. What would happen if you had a contract with someone and they just sold it to some bum on the street? Those are the types of deals happening in the CDS market right now, over and over again. On the Right Side Fortunately, for Prem Watsa and Fairfax Financial shareholders, they are on the good side of the CDS monster. The current portfolio cost $343 million to take but the “notional value” – which is when the whole value of the bonds must be paid – is $18.5 billion! All bets reaching that level is not likely, but the point is to have protection in bad times. And if a market crash doesn’t happen, the company can still make money. According to filings by Fairfax’s Odyssey Re subsidiary they have CDS on bond insurance companies such as Ambac Financial, MBIA Inc and on mortgage insurance companies like MGCI Investment, Radian Group, and PMI Group. All these companies have had their risk of default increase many times over, and this is contributing to the earnings of Fairfax. The main concern for opening CDS positions has been on Mr. Watsa’s mind for a few years already. In the 2005 annual report he writes, “Animal spirits are alive and well and downside risks have been forgotten … we see all the signs of a bubble in the housing market currently.” He goes on to comment about how buying a house is “viewed as a sure shot investment” and that credit spreads – the differences between safe and risky bonds – were historically extremely low. These concerns can be seen in reports and management discussions – published in the

of Fairfax’s CDS portfolio is starting to appreciate rapidly. Printing Money In the third quarter, according to Tom MacKinnon of Scotia Capital, the CDS portfolio increased in value to $540 million, which represents $10 per annual reports – going all the way back to 2004 in the share in earnings, or two-thirds. Just a few days ago Fair2003 Annual Report. fax released fourth quarter and fiscal year 2007 earnings, and they turned out to be stellar. For the fourth quarter We’ve seen this before alone, net gains from the CDS portfolio were $705 milSince Fairfax is in the insurance business, it has an idea lion, and $1.145 billion for all of 2007. This is really or two about disasters. The hurricanes in 2005 (Katrina, amazing because 61% of their gains from investments for Rita, etc.) all took a huge bite out of the company, but it the whole year were in just one quarter! If you have been has survived due to conservative business practices and a keeping track, based on the cost of the portfolio, it has well managed balance sheet. The same goes for the next already returned 230%! few years as the U.S. economy will likely suffer, but why not make some money while preserving your invest- Investment Potential ments? The increasing possibility that a major negative market event could happen is exactly why Prem Wasta has been How does Mr. Watsa think the possibility of default on so worried. Just like a freak hurricane can make your the financial companies is going to happen? The ratings business suffer, so can a financial crisis. Fairfax has no on the asset-backed bonds (based on home loans, car exposure to any of the toxic CDOs that were issued in loans, etc.) they have issued and supported are declining the past few years (keyword: subprime) and has shifted in value – that’s why you see major financial institutions their investments to about 75% in stable government making big write-downs lately. “These asset-backed bonds bonds. Their only stock exposure is 15% of their portfoare rated based on their historical loss experience record lio, which is also hedged by a large short position on the which will likely be very different in the future.” In other S&P 500. When you include the CDS portfolio, all their words, when the ratings agencies (Moodys, Standard & assets are extremely well protected, and if nothing major Poors, and Fitch) downgrade these assets, it will bring the happens, they got off cheap – maybe even making some solvency of the company into question. That will in turn money in the process. Not a bad deal! make it difficult for these companies to raise new cash, refinance debt, and any loans the company is able to get If you are looking for an investment in a public company will be at much higher interest rates. right now, the main criteria should be survival. According to Whitney Tilson, managing partner of T2 Partners, In the past year, the predictions of a more volatile and the only recession-proof companies he can think of are hazardous market have come true. Higher default rates on McDonalds, Berkshire Hathaway and Fairfax Financial. CDOs (Collateralized Debt Obligations; packaged loans) When the markets get ugly the best place to put your have sent down their price drastically. This has brought money is in these types of investments, where your monthe banks that issue them and the insurance companies ey is not only very well protected but also still has a pothat guarantee them into question. Will they be able to tential upside. back their enormous obligations? Or will they also need to default on their own debt? Many people don’t think Therefore I am recommending a resounding Buy on Fairthe companies will be able to, and that is why the value fax Financial Holdings.

Shorting the 10-Year Treasury: A Safe Move Amidst Market Uncertainty By Reid Petersen The Federal Funds Rate1 is currently at 3.3 percent and Ben Bernanke stated last week in his testimony to Congress that we are coming to the end of the rate cuts that have been supporting stock prices to some extent. Additionally, inflation is becoming more of an issue, as was apparent in the last Fed meeting. Because of extensive rate cuts and the way that the inflation issue has taken 1 The Federal Funds Rate is the rate at which banks can lend money to each other. This is a very short-term loan and is traditionally used to meet minimum capital requirements for banks and financial institutions set by the government.

Recommendation: Sell (Short) a back seat to the CDO crisis, the 10-year treasury has become overvalued. If the Fed2 stops raising rates and begins to recognize inflation as a key concern, the 10-year Treasury bond yield (currently at 3.51%) could easily rise above the five percent level within the next two years. Even if you believe that the bond’s yield will fall further, shorting the bond is none-the-less a good play in this uncertain environment, because it is an excellent inflation hedge. 2 The Fed refers to the Federal Reserve which is currently led by Fed Chairman Ben Bernanke.

American Eagle - Buying Quality By Alexander Muhr Weakness as Opportunity The recent economic weakness, specifically in retailers, is presenting good buying opportunities for companies that have a great product. Whenever looking for an investment, it’s a good idea to look for those which have a “durable competitive advantage,” as Warren Buffett likes to put it. So, what is AEO’s? Any time you see a retailer that can sell an item cheaper than it’s competitors and still make the same kind of margins, that seems like an advantage to me. If we compare AEO to ANF, we can see in times of economic hardship, people are more likely to spend their money at an affordable retailer that still has stylish and appealing clothing. Companies like ANF even though they have a very successful brand - will not do well when consumers are strapped for cash.

Recommendation: Buy

stabilize and business picks up again, you own more of them and that helps share prices. Rock-Solid Balance Sheet The company is very financially stable. With 14% of their market cap, or $3/share in cash and short term investments, they are an attractive candidate for buy-outs and increased dividend payments. Currently they also pay an attractive yield of about 2%. AEO also has zero longterm debt and an EV/EBITDA ratio of 5.4 (versus 6.6 for ANF, and 7.4 for GPS). Future Growth AEO is expanding into different market segments and age groups. Most of their capex2 is being spent on M+O (Martin + Osa geared towards the 28-40 crowd), aerie (which is supposed to be similar to Victoria’s Secret’s Pink), and 77kids (targeting kids aged 2-10). With the main brand focused towards the 15-25 group, in all, AEO will have a collection of brands to cover many retail segments. Whichever one of these concepts survives, management is calculating that the spending now should bring in the new cash and earnings to reward shareholders.

Capable People AEO ir run by extremely capable managers that have the shareholder interests in mind because they themselves are also large shareholders. Recently top managers have made large stock purchases, in the open market no less, which is a sign that they believe the long-term prospects for their company are not as dire as the market perceives. Also, they have a stock repurchase program running, which in the last reported quarter has shrunk the share count by 1%, with millions more shares on the way to retirement1. So all in all, this is a great time to start getting into a What does that mean for shareholders? When earnings company with a phenomenal track record, an appealing 1 Buying back its own stock as Treasury Stock or using them to make a bonfire.

2 Capital Expenditures - Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment

product that makes tons of money and is being priced at about 10x this year’s earnings. There might be more weakness in the economy, which could drag AEO down further in the short term, but overall this company should perform very well over the next few years. Therefore AEO is a Buy.

The Finish Line, Inc. - Biting the Dust By Jordan Ohama

Recommendation: Sell (Short)

Finish Line Inc. runs a set of mall based specialty retailers. Its stores operate under the brands The Finish Line, Man Alive and Paiva. Each one focuses on specific product types and demographics. The Finish Line, for example, specializes mainly in selling sporting goods.

ness, we need take a look at FINL’s most recent quarter’s4 10-Q report. This quarterly report compares the finances from the quarter ending December 2007 with those ending November 2006. The first number that stands out from the Statement of Operations, is the Operating Loss for the thirteen weeks ending December 1, 2007, which was $23 million. The second number that stands out is the $22.3 million in Net Cash Used in Operations. I place emphasis on operating numbers because those numbers deal directly with the core business operations. This means that by using these numbers we are able to look directly at the business rather than include its auxiliary operations.

Retailers are being hit hard by the slowing economy right now, and those with weak financial stability are getting hit the hardest. FINL is no exception. With a market cap1 of just under $190 million, it is a small-cap2 company, making it especially susceptible to such a slowdown. On March 3, 2007, Finish Line was in the news for failing at a bid to buyout its larger rival Genesco (GCO). This boosted FINL’s stock price upwards of 40% in one day. Although the possibility of being crushed by nearly $1.5 billion in debt that the buyout deal would create for FINL is now gone, its own operations and balance sheet still show significant risks of bankruptcy. For example, in its third fiscal quarter of 2007, FINL was forced to shut down its 15 Paiva stores. Another bit of bad news: by not going through with the acquisition, FINL has incurred massive breakup fees. Even splitting the $170 million break-up fee shared with UBS3 (the bank that was supposed to finance the deal), will cost FINL dearly. Further, as of December 1, 2007 FINL’s Cash and Cash Equivalents account stood at $14 million. In addition to the $170 million GCO is slated to recieve 12% of FINL’s outstanding stock as part of the breakup fee. To fully understand the extent of FINL’s financial weak1 A measure of the size/value of a firm found by multiplying: Stock Price*Number Outstanding Shares 2 Small cap – about $100M < Market Value < $500M 3 UBS issued a statement noting that if it did finance the merger and it did go through, the new company would be unable to pay down its debt and quickly become insolvent. This is strongly indicative of the current weakness in sales that both FINL and GCO are currently facing.

From the comparison of the two periods on the Cash Flow Statement, we are able to see that even after spending $28 million more on Property, Plant and Equipment in 2006, the Net Decrease in Cash and Cash Equivalents in 2007 is still $14 million higher. Table 1 explains the first half of this problem. 4 Most recent quarter can also be written MRQ.

Table 1: Store Openings (Closings) Thirteen weeks ended Number of Stores: Finish Line Beginning of Period Opened Closed End of Period Man Alive Beginning of Period Opened Closed End of Period Paiva Beginning of Period Opened Closed End of Period Total Beginning of Period Opened Closed End of Period

1-Dec-07

25-Nov-06

697 7 -3 701

672 21 -1 692

95 1 96

76 12 88

15 -15 -

6 6 12

807 8 -18 797

754 39 -1 792

Although the 2006 and 2007 comparisons from the Cash Flow Statement look similar, they do not necessarily include analysis of the current situation. In 2006 the company was growing rapidly and was spending a lot of money on building new stores and growing its brand. Currently, the retailer is closing more stores than it is opening and is losing money doing it. In all, because of FINL’s small size and the fact that in lieu of building up its financials, it spent what it earned while expanding, it may now go bankrupt. FINL’s epic struggle to survive was epitomized through its attempt and failure to buy out its larger rival GCO. Now, with nothing more than its own sales weakness weighing the stock price down, I am recommending to Sell this stock short…to zero.

Source: Third Quarter 2007 10-Q Report

PRA, Inc. - Listen to Me! A Conference Call By Alexander Muhr

Recommendation: Buy

The market is tanking, what are you going to do about it? rent market environment as a major opportunity for the When others are fearful, we must be greedy, and there is company to take advantage of the huge amount of bad debt coming down the pipeline – due primarily to bad one company that takes that to heart. loan and borrowing practices. Portfolio Recovery Associates is a company that purchases portfolios of defaulted consumer receivables – these On the fourth quarter: are unpaid obligations of individuals to credit originators “While some may look at our fourth quarter numbers . Basically, if you have a loan on anything besides a house with disappointment … I think you’ll agree that the opand stop paying, PRAA will come knocking on your door portunity ahead is exciting and well worth some short to wring as much money out of you as possible. In the term sacrifice to make sure we can capitalize upon it.” fourth quarter alone, PRAA bought 84 portfolios from 24 different sellers, the majority of which was a combi- They have a competitive advantage: nation of Visa/MasterCard and private label credit cards. “…the weakening economy and tighter credit environThe rest came from auto, medical, utility and installment ment have created improved opportunity for debt buying with prices improving somewhat and supply growing. – loans. but only for the experts.” Current Market Environment = Ka-Ching! Stephen Fredrickson, the CEO of PRAA, sees the cur- PRAA’s expertise lies in being able to price these complex

assets, and employ seasoned collectors One tiny blemish: “…higher borrowing cost and our increased leverage have resulted in higher interest expense, which is in large part responsible for our fourth quarter performance on the bottom line.”

It’s also a positive sign that the trouble that PRAA faced in its most recent quarter was that they were unable to get their new call center (what they mainly use to make collections) up fast enough to meet their collection demand! Mr. Fredrickson mentioned that the supply (how much bad debt is coming their way) was coming faster than even he, an industry veteran, anticipated. They have been able to improve productivity at this new call center already to take advantage of that supply.

The upside to this dilemma is that as PRAA begins to collect from its portfolio of the defaulted debt, these interest expenses will be offset and future interest expenses from There are some other hugely positive catalysts for PRAA. these assets will be eliminated. The first is that there are many investors selling the stock short, to the point where a “short squeeze” will occur – this I love the way Mr. Fredrickson thinks! is when a rush of short sellers needs to buy back stock to “Importantly, market conditions continued to improve close their positions, creating major positive stock moves slightly in the quarter, with increase in supply and some- on pretty low volume. The “short ratio” – the amount of what softer pricing.” days it would take to cover all shorts based on historic volume – is a whopping 18. That means it would take 18 He is happy that the market is soft, and sees opportunity, days of non-stop buying to cover all the shorts, and this just like we should be acting right now in times of weak- creates massive pressure to the upside. ness. Some more… “weakening economic environment is clearly driving the improved market conditions.” Another catalyst is that, when economic conditions improve, PRAA will have an easier time collecting. Due to They know that they are doing: their ability to buy up large amounts of this bad debt “We feel as though our enormous database of accounts in weak times, the company will practically print money and payment histories combined with our well refined when we head for clearer skies. sophisticated statistical underwriting techniques separates us from our competitors in terms of our ability to The last important piece of information you need to appropriately price portfolios.” know is that management is fully aligned with shareholders. They actually have it mandated that managers own Blocking out the competition: a certain amount of stock. This makes them much more “Further impacting the market place is the tighter credit likely to act in everyone’s favor. environment. This has raised the bar for capital making it harder for some of our competitors in the debt buying All of these factors lead me to recommend Portfolio Rebusiness to take advantage of the increased supply we are covery Associates as a Buy. seeing. Many of these competitors find themselves with underperforming portfolios, purchased with poor underwriting assumptions and insufficient collection capabilities.” They were prepared: “With our annual credit line we can take greater advantage of this buying environment than can others. We have in essence planned for this market turn by putting a larger credit line in place, as well as investing to build the capacity necessary to handle collections on increased buying.”

You Can Be A Stock Market Genius - A Review By Alexander Muhr

Joel Greenblatt is the founder of Gotham Capital, an investment partnership. Between 1985 and 1995 his annual return to investors (after costs, but before the general partners’ incentive allocation) was an astounding 50%. If you had invested just $1,000 you would have ended up with $51,970 in just 10 years! Even though the book was written in 1996, more than 12 years ago, the topics covered are still very important for investors who want to achieve above-average returns. In the book he basically outlines the methods he uses to find those returns, which are called special situations: - Spin-offs - Mergers - Bankruptcies - Restructurings - Rights Offerings - Risk Arbitrage - Merger Securities - Recapitalizations Greenblatt methodically walks the reader through all of these special situations and explains specific trades where he made money and, of course the ones where he lost money too. This book should be very useful for those who have not read it yet because now that “cheap money” has virtually left financial markets there will be less leverage buyouts, and more of these special situations. There will be more companies trying to realize value for their shareholders through mergers, spin-offs and rights offerings – at the same time there will be a lot of companies going bankrupt when the economy turns sour. Overall this is a great book for beginners and experienced investors alike because of its simplicity in writing (easy to read) and the depth of analysis on the trades Greenblatt discusses. The book belongs in every investor’s library.

Financial Illiteracy:

What did you learn in your middle school P/E class? By Danny Kisch

As I was perusing my daily dose of financial news and various statistics, my eyes fell upon, quite possibly, one of the most troublesome pieces of information I have ever seen. No it was not another analyst’s evaluation of our economy’s looming threat of recession, nor was it the now triple-digit price of oil. Instead, and almost surprisingly, my sudden anxiety had been caused by the latest figures on financial illiteracy.

The key to becoming a more financially literate country lies in establishing the fundamentals of economics and finance in the minds of children at an early age. Too long has our public education system suffered from a deficiency in teaching the practical knowledge that every person needs to know (but might not know), whether it be financial literacy or how to properly care for your car.

It is about time for academic curricula nation-wide to In a survey conducted by the Harvard Business School, incorporate a new P/E class that focuses on P/E ratios, Dartmouth College professors, and TNS, and cited in a ROIs, banking, investing, and how to achieve the finanrecent article from CNNMoney.com, 1,000 individuals cial independence that everyone wants to experience. were asked basic questions about the debt they carried and how long they estimated that debt to double. While What this country needs is a massive overhaul in educaonly 35.9% of respondents could accurately tell when tion so that we can empower the average investor to take the debt they owed on their credit cards would double, control of his or her financial situation. 31.9% over-estimated the time frame, and a whopping 18.2% had no idea how to respond. Get ready Warren Buffett, because the entire United States of America is eager and waiting to show that they Though I don’t expect the average person to carry around too can become a homegrown success! a pocket calculator to compute the amount of debt they owe at a moment’s notice, when 1 in 5 Americans do not have a solid grasp of their own financial situation let alone the debt they owe, you know that there is a disaster waiting to happen. By itself, this information might seem harmless, but it becomes significantly more disquieting given the current state of the economy and the declining value of the dollar. With the far-reaching effects of the sub-prime mortgage bubble combined with a credit-crisis in full swing, aside from an economic miracle, there is little to look forward to in terms of the mitigation of consumer debt. Or is there? As Senior Economist and Manager of the Federal Reserve Bank of St. Louis, William R. Emmons, described in his paper on financial literacy, “The [primary] obstacle to widespread financial literacy is the underdevelopment… of the basic technical and emotional skills needed in financial decision-making… [and] in particular, math and economics training.”