Columbia Business School

Columbia Business School AT THE VERY CENTER OF BUSINESS Inside this issue: CSIMA Confer- ence & Pershing Square Challenge John Phelan Alex Magaro Adam Wyden '10 Marc Cohodes Pershing Square Challenge Ideas P. 3 P. 4 P. 14 P. 25 P. 33 P. 44 Editors: Brendan Dawson MBA 2016 Scott DeBenedett MBA 2016 Anthony Philipp MBA 2016 Brandon Cheong MBA 2017 Eric Laidlow, CFA MBA 2017 Benjamin Ostrow MBA 2017 Visit ut>'t• wwwcsimainfn HeilbrunnCenter for Graham&Dodrt I CCCCC I NO csima COLUMBIA STUDENT INVESTMENT MANAGEMENT ASSOCIATION Marc Cohodes Alex Magaro Graham & Doddsville An investment newsletter from the students of Columbia Business School Issue XXVII John Phelan Spring 2016 John Phelan of MSD Capital Mr. Phelan is Co-Managing Partner of MSD and Co-Founder of the firm. Prior to forming MSD, he was a Principal from 1992 to 1997 at ESL Investments, a Greenwich, Connecticut based investment firm. At ESL, Mr. Phelan was responsible for ESL's Special Situation Investments and helped grow the firm from $50 million to over $2.0 billion in assets under management. Prior to ESL, Mr. Phelan was Vice President in charge of Acquisitions (Western Region) for the Zell-Merrill Lynch Real Estate Opportunity Funds. Mr. Phelan began his career at Goldman, Sachs & Co. where he (Continuo:Ian page 4) Alex Magaro of Meritage Group Alex Magaro is a Co-President of Meritage Group, a fundamentally - oriented investment firm, managing approximately $10B primarily on (Conenued 00 page (4) Adam Wyden Adam Wyden '10 of ADW Capital Adam Wyden founded ADW Capital in January 2011 and acts as sole portfolio manager to the Fund. The Fund is focused on maintaining a concentrated portfolio of high-quality and high- (Continued on page 25) Marc Cohodes formerly of Rocker Partners/Copper River Marc Cohodes is a former General Partner of Rocker Partners/ Copper River from 1985-2009. He began his career at the Northern Trust Company in 1982 after graduating Babson College with a BS in Finance. He has been profiled in the books; Reckless Endangerment, Selling America Short ,The Most Dangerous Trade. He was the subject of a Harvard Business School Case study on his efforts to expose Mortgage Fraud at Novastar. He resides in Cotati, California, where he runs Alder Lane Farm. (Continued on page 33) EFTA00300965 Page 2 Welcome to Graham & Doddsville Meredith Trivedi, the Heilbrunn Center Director. Meredith skillfully leads the Center. cultivating strong relationships with some of the world's most experi- enced value investors, and treating numerous learning opportunities for students interested in value invest- ing. The classes sponsored by the Heilbrunn Center are among the most heavily demanded and highly rated classes at Columbia Busi- ness School. Professor Bruce Greenwald. the Faculty Co-Director of the Heilbrunn Center. The Center sponsors the Value Investing Program. a rigor- ous academic curriculum for particularly committed stu- dents that is taught by some of the industry's best practi- tioners. I Icilbrunn( cnter Graham &Dodd . T — csima ilWESTMENT MANAGOAINT ASS0CLATI0N We are pleased to bring you the 27th edition of Graham & Doddsville. This student-led In- vestment publication of Colum- bia Business School (CBS) is co- sponsored by the Heilbrunn Center for Graham & Dodd Investing and the Columbia Stu- dent Investment Management Association (CSIMA). In this issue, we were fortunate to speak with four investors who offer a range of perspec- tives based on their unique paths to and careers in investing. John Phelan of MSD Capital discusses lessons learned over decades of investing with men- tors such as Richard Rainwater, Sam Zell. Eddie Lampert. and Michael Dell. John offers Insights into the development of MSD Capital as well as his own devel- opment as an investor and PM, while shedding light on challeng- es he sees today in the invest- ment management industry. Alex Magaro of Meritage Group discusses his many expe- riences. from running a business as an owner-operator to invest- ing in early stage companies, which led him to co-manage Meritage Group. Alex talks to about long-term invest-ment horizons across asset classes and the return potential of businesses with durable competitive advantages. Adam Wyden '10 of ADW Capital discusses the influence of an entrepreneurial spirit on his firm and investment pro- cess. Adam walks through past ideas such as IDT and Investor Restaurant Group (IRG.TO) as well as current theses on Fer- rari (RACE) and Fiat (BIT:FCA). Mark Cohodes shares his experiences from a lifetime of short-selling. He offers his per- spective on the discipline and temperament required as well as the intellectual rewards of a career in short-selling. Marc discusses ideas such as Home Capital Group (HCG) and Tempur Sealy (TPX). This issue also highlights pho- tos from the 19th annual CSIMA Conference as well as the 9th annual Pershing Square Challenge. Lastly, we are proud to include in this issue finalist pitches from current students at CBS who competed in this year's Per- shing Square Challenge. When we Inherited Graham & Doddsville as editors last year. we wanted to continue the tradition of providing our read- ership with high quality inter- views and investment ideas. We sought to provide diversity of thought and experiences via our Interviews. We hope we have lived up to those objec- tives. We are honored and privileged to have continued the Graham & Doddsville legacy, and we look forward to reading the next generation of issues, helmed by three outstanding individuals in Brandon Cheong '17, Eric Laidlow '17. and Ben Ostrow '17. We want to thank Brandon. Eric, and Ben for their commitment and dedica- tion to Graham & Doddsville over the last year. As always. we thank our interviewees for contributing their time and insights not only to us, but also to the invest- ment community as a whole. and we thank you for reading. - G&Dsville Editors Howard Marks from Oaktree, pictured here giving the keynote talk at the CSIMA Conference in January 2016 Columbia Business School students help at registration for the 19th Annual CSIMA Conference EFTA00300966 Page 3 Columbia Business School Events: CSIMA Conference and Pershing Square Challenge Keith Meister of Corvex Management LP delivers his keynote address at the 19th Annual CSIMA Conference Howard Marks of Oaktree with Bruce Greenwald after their keynote interview at the 19th Annual CSIMA Conference 1st Place Finalists Joanna Vu '17, Melody LI '17, and Thais Fernandes '16 pitch Alimentation Couche-Tard at the 9th Annual Pershing Square Challenge Paul Hilal '92 and Bill Ackman listen and Judge student pitches at the 9th Annual Pershing Square Challenge Judges deliberate at the 9th Annual Pershing Square Challenge Bill Ackman and the winning team at the 9th Annual Pershing Square Challenge EFTA00300967 Page 4 John Phelan John Phelan (Continued (ran page () worked as an Analyst in the Investment Banking Division. Mr. Phelan received his . from Harvard Business School and graduated cum laude with distinction and Phi Beta Kappa from Southern Methodist University with a B.A. in Economics and Political Science. Mr. Phelan also holds a General Course degree with an emphasis in Economics and International Relations from the London School of Economics. Graham & Doddsville (Mb: To start off, talk about your background and your path to investing, including mentors and influences along the way. John Phelan OP): My mother was a very big influence on my development as an investor. My father was a doctor and. like most doctors unfortunately, not a very good investor. My mother, on the other hand, came from a real estate background and focused very much on cash flow. My parents gave me a Disney stock certificate for a birthday present when I was five years old. That got me hooked—I was fascinated by numbers and seeing something trade every day. That's what got me into stocks. I initially went into real estate, where my mother taught me quite a bit, including two principles: make sure you can always pay your bills and debt service and the importance of free cash flow for levered assets like real estate. She also encouraged me to go find good mentors. She said one of the things about good mentors is you can learn on someone else's nickel. It's something you don't realize when you're younger. But it struck me at a very early age to try to go find people that were the best in their particular businesses, and I think my mother pushed me towards that. In my real first job, I worked with an uncle rehabbing apartments in New York. I was doing that during college. That was an eye-opening experience that forced me to focus on cash flow every minute of the day. It was a very tough business and I was doing a number of different things. The work ranged from running the numbers to actually doing construction work That teaches you a lot. I also learned I didn't want to break my back doing that for my entire career. I was fortunate enough to get a job with Goldman Sachs. which was really the first big company I worked for. At the time, Goldman was still a private partnership. I learned a ton and I had a number of great mentors at Goldman Sachs. I worked with truly exceptional people there. As great as my experience at Goldman was, it did make me realize that I did not want a career in investment banking. Instead of being the person who is on call 24/7 to serve my client I wanted to be the client. I preferred being a principal as opposed to an advisor. I decided to attend business school and was accepted into Harvard Business School. The summer between my first and second years at business school I worked for Richard Rainwater, and that's where I met Eddie Lampert. Richard introduced me to Eddie. Of those ten weeks that summer. I spent about three or four with Richard and the rest with Eddie. : How did you connect with Richard? JP: I had been hoping to get back to Texas after business school and I wrote Richard a letter. In that letter I told him I would be willing to work for free and one of my professors at Southern Methodist University had suggested I contact him. I told him I just wanted to learn from one of the best and was willing to invest in myself. Richard called me on a Friday at like 4:00pm. He said "Hey John, this is Richard Rainwater." I thought it was one of my classmates playing a joke on me. I used a curse word I shouldn't have and just hung up the phone. A minute later the phone rang again: "I think we got disconnected." thinking. "Oh my God, this is Richard Rainwater. I cannot believe I just hung up on this guy." I said,'. really sorry, but my classmates have been playing jokes on each other, and I thought you were one of them." "Oh that's a pretty good one," he laughed—he was very good about it. I flew down to Fort Worth on my own dime and met with Richard. He said, "Meet with these different guys. You can work with me for a bit and see if one of them will take you as well." I met with Eddie and a couple of other guys who were (Cont'nued on page 5) EFTA00300968 Page 5 John Phelan with Richard at the time. I didn't know a lot about risk arbitrage, but I knew they were analyzing stocks and that was something I really wanted to do. It was a tremendous learning experience. I really enjoyed working with Richard and Eddie that summer, and I fell in love with the risk arbitrage business. One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside. I graduated in 1990—not a very good year to graduate from business school, as you can imagine. The markets were bad, the RTC/bank crisis was accelerating and most money managers were having a bad year. It was a rough year. Eddie said. "Listen, I don't know if going to be in business much less have a job for you. It's not clear. You should go find something." IM Did you end up working with Eddie? JP: I actually graduated without a job. It was depressing because I didn't expect to be jobless. in debt, and living at home with my parents after graduating from Harvard Business School. I knew I did not want to go back to banking, so I did not do that. Luckily a couple of the guys I had worked with at Goldman in Chicago left the firm to go work for Sam Zell. Bob Lurie had died and he was really Sam's right-hand man— they were partners. Sam hired Randy Rowe, who was the main person I worked with at Goldman in Chicago. Randy was kind enough to offer me a job. Sam had just raised his second distressed real estate investment fund and was one of the few people who had capital. It was a good time to have capital. The RTC was formed after a number of S&L's failed, there were a lot of distressed loans, the trading market for loans was just starting to develop, and the illiquidity was incredible. Having capital at that time and being a liquidity provider to the banks was a unique and good place to be. "...my mother taught me quite a bit, including two principles: make sure you can always pay your bills and debt service and the importance of free cash flow for levered assets like real estate. She also encouraged me to go find good mentors." If you go back and study the great investors throughout history—the Medicis, the Morgans, the Rothschilds, and recently Buffett—these great investors with terrific records share a common trait: they were always in a position to be liquidity providers. Each was willing to hold cash until someone was in distress or under duress, and they could provide liquidity at very attractive prices. We have run our firm without leverage and have only been 100% invested once in our 18 year history. the first quarter 2009. I actually consider cash to be an asset class. About nine months into the job, Zell through his Zell- Chilmark fund started taking a hard look at Executive Life, which had a large junk bond portfolio. I was asked to work on credits that had large real estate components: RiteAid (RAD). Carson Pirie Scott. Charter Medical—any company that had a big real estate component to it. We were trying to value both the real estate and going concern value as that was what the debt was secured by and the real estate provided your downside protection. We lost the Executive Life auction to Apollo. It was a fascinating experience and I really learned a lot. I remember looking at Charter Medical debt which was secured by a large number of hospitals. I called Chase Manhattan and said. "Hey. we see you guys are the lead bank on this." They said, "We've got plenty of debt for sale. we can sell you at 20-30 cents on the dollar." We came to the conclusion we could've sold four or five hospitals and gotten all our money back at that price. That's how bad and illiquid the market was. Understanding where you are in terms of seniority in the capital structure and identifying the fulcrum security was critical, so I started auditing a bankruptcy class at University of Chicago because I wanted to learn bankruptcy law. I thought it was an important aspect of the work I was doing. I put together a business plan (Continued on page 6) EFTA00300969 Page 6 John Phelan Pershing Square Challenge runners-up with Paul Hilal '92 (from left to right: Chris Andreola '16. Bran- don Cohen '16, Paul Hilal '92. and Daniel Rudyak '17) on the side, while I was still working at Zell. I pitched Sam on the idea of setting up a junk bond operation to buy the debt of distressed companies. We had done a lot of work on over 100 companies. Exec Life owned only pieces of the debt, so there was a big opportunity to make a lot of money. Sam got up and slapped me on the back and said. "You know what, congratulations. I wish you a lot of luck—this is a fantastic idea. I think this is great." I asked, "Did I just get fired?" He said. "No, you don't have to leave. But you're going to leave. I already know it. This is a great idea. I don't want to do this because I want to own and control companies.. not interested in owning pieces of companies anymore. I actually want to buy and control them. But you've got a great idea and I think you should go pursue it." I called Richard. but he had also taken a run at Executive Life and already had a team in house. So I called Eddie. I sat down with Eddie and gave him my business plan and pitch. He said. "Well why don't you come on in and do it." I did that with Eddie and ended up working with him a little over seven years. I started off basically doing distressed, risk arbitrage—all special situation- type of investing. Then I got involved in the emerging markets debt crisis in 1994. I did quite a bit in that area with Eddie. That's how learned my stripes. I've been very fortunate to have really great mentors at Goldman. as well as Sam. Eddie. and Michael Dell. whose private investment firm I now co-manage with my partner Glenn Fuhrman. All those guys have been very influential for me. And they all have very different approaches. They all go about things very differently, but I've tried to take nuggets from each one of them and incorporate what I've learned from each of them into my thinking process. "If you go back and study the great investors throughout history—the Medicis, the Morgans, the Rothschilds, and recently Buffett— these great investors with terrific records share a common trait they were always in a position to be liquidity providers. Each was willing to hold cash until someone was in distress or under duress, and they could provide liquidity at very attractive prices." Could you talk more about working with Sam Zell through the real estate cycle? How has he been able to avoid mistakes and be opportunistic when others can't? JP: I think Sam is one of the really great macro thinkers out there. He's very good at looking at excesses and thinking through the implications of them before they happen, when they happen, and then after. He's really adept at connecting the dots. He's a much more top- down guy than someone like Eddie. who also has a great nose for investments but is more bottoms up. I have a funny story with Sam. He spoke during my first year at the Goldman real estate conference. He looked in the room and said. "I want all you to know that, within three years. half of you will no longer be working in this department. There is going to be a major blow up." This was in the summer of 1987. He was dead on the money. Sam is very good that way. He's also a very smart deal structurer. He understands leverage points and knows how to negotiate very well particularly in complex situations. He's a consummate deal maker. When did you start thinking about launching your own fund? Why did you ultimately decide to join Michael Dell instead? JP: In late 1997, I decided to leave ESL. It was a personal decision. My mother had passed away very unexpectedly. It was a very tough thing for me, and it was especially difficult on my dad. I decided to take some time off. been working like a machine with Eddie, those seven years were like dog years. He was a demanding guy to work for but also a very smart guy. I enjoyed it. and learned an incredible amount. (Continued on par 7) EFTA00300970 Page 7 John Phelan but I needed some balance and I needed to help my father. After a few months. I started getting itchy trying to figure out what I was oing to do. At the same time, made a decent amount of money and didn't feel rushed to have to do anything. I decided I was going to write a business plan for a multi- strategy investment firm, similar to ESL. I met with a number of different successful investment people. Some of them I knew. Some of them I did not. I said. "I just want 30 minutes of your time, and I have just one simple question. Tell me why you've been successful and how do you sustain it?" Richard as well as David Bonderman were two of the people kind enough to indulge me. I basically interviewed different successful hedge fund and private equity managers. From those interviews I came away with what I call the three Cs. which is what I thought were really the keys to success in the investment business: Capital. Connections, and Culture. These were the drivers I was able to identify. They're probably drivers in just about any business. I was out raising my own fund and had raised a decent amount of money. While I was raising the fund both Dan Stern and Richard Rainwater gave me a call and said, "You should go meet with Michael Dell." I said, "Michael's an investor of Eddie's. I don't know that I really want to do that." Richard and Dan both said. "Just shut up and go do it." I met with Michael and he asked me what I was trying to build. I walked him through my business plan and he said, "That's interesting. El trying to hire a guy similar to Richard to do something like that for me. Would that be of interest to you?" I said. "No. probably not. I've got some good investors and I am not sure I want another partner at this time." He said. "I got it. okay no problem." I said, "By the way, happy to give you my business plan. It might help you think through what you want for your investment office." "I came away with what I call the three Cs, which is what I thought were really the keys to success in the investment business: Capital, Connections, and Culture. These were the driven I was able to identify. They're probably driven in just about any business." I gave him my business plan. He called me about a week later and said. "You know. I was reading through your business plan, and I have a question for you. just puzzling on it. curious how you're better off under the three Cs by yourself than you are with me. I have capital. In pretty connected. And you get to build the culture." That stopped me in my tracks and I said. "Now that's an interesting question. I didn't really think about that." He said. "MI like you to think about that." I met with Michael a few more times. At the end of the day it was trust on both of our parts, and it worked. He's been a phenomenal partner. II make the same decision again anytime. It's been a great partnership with him and Glenn. Michael was the one that introduced me to my partner, Glenn Fuhrman. He was very good at matching us up. It was a hard thing for me to do because Michael was partnering me up with somebody I didn't know. Although we both came from Goldman—and were there at the same time—we didn't know each other. It became very apparent when Glenn and I first met that we had very complementary skill sets which is really important to a successful partnership. We both came from the same Goldman mold: teamwork. hard work intelligent, humble and ethical behavior. It just worked. I think, to his credit. Michael saw that it was going to work and he knew. unbeknownst to us, that this was probably going to be bigger than what we thought it was going to be when we first started. Glenn has been a tremendous partner and friend and we owe this to Michael. : Could you talk about the evolution of MSD as an investment firm as well as the evolution of your role? JP: It definitely has evolved a lot. I used to jokingly say that never be more than I S (ConCoved on page 8) EFTA00300971 Page 8 John Phelan people. Then when we got to 20. and said, "There's no way we're going to more than 30 people." Today we're 124 people. Initially. when it was just the two of us. Glenn and I were involved in every decision. The firm evolved by us working closely with our PMs before we really let them loose. Distinguishing a good PM from a good analyst is not that easy. We were on top of them in the beginning and over time we established enough confidence in them that we could step back. We knew that they were quite capable. They didn't need the same sort of continued oversight, and we wanted them to focus on building the business just as we were. We felt that creating diversification by strategy and having people who were focused on their individual businesses was the right way to build our overall business. If you look at why most managers get frustrated in the investment industry it's because, as you get bigger and as you scale, you move from picking securities to running the business. That can end up taking 30% - 40% of your time. Guys like us, who like to look at stocks and companies. don't like reviewing the HR policy. the vacation policy. compensation system, etc. But those are all things you have to deal with: your interviewing policy, your training policy, and all those operational issues. Today with all the regulation and compliance it can be a full time job in its own right. We want to find really good investors and remove the distraction of running the business from them, so all they have to do is focus on the investment side. That's really what we've tried to create at the firm today. I would say our roles have evolved to more of a chief risk officer/chief investment officer. We oversee the portfolios, we oversee the teams, but they're really running independent businesses, and they're making the decisions to buy and sell. If there's something in there we don't like we will have a call. happy to pick up the phone and say. "Walk me through this and tell me why we've got this position and what's there." because we're trying to risk manage the firm, so we're kind of a second layer of risk management to their own risk management. "It all depends on your own DNA. Self- awareness is a really important quality to have, as is humility." Today we have ten strategies. We sit on the investment committees for our private equity and real estate strategies. Any illiquid-type investments need to go through an investment committee process. We spend a lot of time today on our investment research process and how to improve it. How do we improve our decision making? How do we do better with data management? What's going on in the markets right now and how are we positioned for it? Are we too exposed in one sector? Are there any hedge overlays we should put on? What do we see across our platform that is concerning? We have a great vantage point because we get to see everything across the firm. not as deep in the weeds as I was when we started. That's partly due to the fact that we have highly capable people who don't need my direct oversight. We do still have very robust conversations around investments and process. We focus a lot on our process. I would say I probably spend more time now on culture building and on trying to develop the firm and our next generation of talent. In reality, for a firm to be successful you have to create these virtuous circles. We're very disciplined. We have a good team. We have good culture. We have great investors. We've been investing for the long term. All this stuff has been built up over time, and it's self-reinforcing. But you also have to adapt constantly. I look at the markets today and I look at the sheer amount of information that's thrown at us. I look at all this algorithmic trading and the impact that has on the market. You better be very aware of what's going on and how it's going to change and what the implications are for you and your business. Those are issues we talk about a great deal. : One element of the MSD philosophy that comes through in a lot of your interviews and writings is a certain contrarian streak. Are there sectors or areas of the investment world where you (Continued an page 9) EFTA00300972 Page 9 John Phelan feel like you have a contrarian view currently? JP: I like to call it independent thinking as opposed to contrarianism. We really try to be as independent in our thought as possible. I don't want to get into a lot of specific investments and what we're doing right now—that is for paying customers —but we try to look for big dislocations. We try to look for places that other people are running from or people don't like. Zell used to always say. "I like to look for trouble." I think that's something we try to do. as well. We try to think about the long term implications of things and how they're going to turn out. That's something that we spend a lot of time on. Take, for example. the sustainability of a company or business model. Today, competitive moats are getting smaller and smaller and competition tougher and tougher. Trying to find really good businesses that can continue to compound at high levels is really hard. You have to really think through all the risks out there and their implications. That's what I mean by independent thinking. Is there a company or business immune from technology risk? Maybe railroads, cement? Think about it. I think there could be some pretty good opportunities in energy as that is a space which has been decimated. We have been analyzing debt securities in a number of energy. metals, and mining companies. We're also trying to understand the knock-on effects of the energy downturn. In energy-heavy markets you're going to see real estate get hit. What will be the flow through in office, multi-family. and industrial? You want to look into where there's a lack of liquidity or mispricing. Is part of the recent equity market volatility due to Middle East Sovereign Wealth Funds taking their money out of equities? On the topic of good businesses, when Rainwater asked you what was the best business ever seen you answered parking garages in New York City. With the benefit of 20-plus years of investing now, would you change your answer? JP: Well at that time I didn't know a lot about companies and businesses. I just hadn't looked at that many. But it's really not that hard of a business when you think about it. It's pretty defensible and you get the benefit of an increased value in real estate over time, similar to car dealers, for example. There's a lot of inherent value in the real estate there. I would probably answer the same way again. I've seen some other great businesses, but when you're put on the spot like that you have to think on your feet pretty quickly, and that's the one that occurred to me at that time. Could you talk about investments that you've been involved with at MSD that would qualify? JP: We've had a number of investments that have gone extremely well. Because I am a big believer in pattern recognition and we have made investments in the same company multiple times over different years. Let me focus on a private deal we did. We're one of the big investors in IndyMac Bank now called OneWest which was recently sold to CIT (CIT). In 1990. when 1 was with Zell. we were looking at RTC banks, and I remember the Basses made a fortune on American Savings. IndyMac/OneWest was an investment we did phenomenally well on. and 1 think that was a combination of good underwriting, good management, and a compelling risk/reward. Buying a bank in the first quarter of 2009 was not a really easy thing to do. We're looking for very good businesses with strong management teams and very defensible moats. Eddie Lampert is famous for using case studies and studying historically successful investments to develop pattern recognition. Were you part of this effort at ESL and did any investments that you made rely on this pattern recognition? JP: Yes, I was. Pattern recognition can mean different things to different people. The bottom line is this: good companies, just like managers. have to experiment. You have to constantly test new things. Sometimes that 30% probability case shows up and you lose $0.25 of earnings or you make a bad investment and people just kill the stock. It doesn't mean your business or the company is dead or that it's a bad business. When I was at ESL I can think of four or five companies that we bought two or three times over the years. Kmart was something that originally came out of a distressed investment we IConbnued on page 10/ EFTA00300973 Page 10 John Phelan made. We made a big investment in their mortgage bonds when they were in bankruptcy the first time. We modeled out every single store and even had a plan for alternative uses of the spaces. That was a company we did a lot of work on before Eddie ended up buying it. When Dominos first introduced thin crust pizza the market did not react well which presented a good opportunity as our research indicated this would be very successful. I think that history and understanding why companies are successful is really important. I think you can learn different things about different businesses and apply them really well to other situations. That's something we were able to do. It seems like part of building your own moat as an investment firm, to build up your own intellectual capital and property. JP: That's what you're trying to do. We are very focused on process. as I believe you should focus on process not outcomes. Process is the key to proper risk management. There is a big difference between a wrong decision and a bad decision. A wrong decision is picking door #1 when the prize is actually behind door #2. It's a lousy result but the fault lies with method. A bad decision is launching the space shuttle Challenger when the engineers predicted a nearly 100% chance of catastrophe. The distinction is important because it separates outcomes which you can't control from process which you can. What are your thoughts on the broader hedge fund industry, what the future may hold, and whether or not it's a good place to start a career these days? JP: If you applied Porter's Five Forces to the hedge fund industry right now.. not sure that analysis would suggest you should go running in. You've got massive fee pressure, so revenues are "We are very focused on process, as I believe you should focus on process not outcomes. Process is the key to proper risk management. There is a big difference between a wrong decision and a bad decision." coming down. You have huge regulatory costs and burdens plus IT expenses which seem to go up every year. so your costs are going up. You could argue the barriers have gotten bigger because of the expense of starting. but when you look at the number of hedge funds each year that seem to start and go out of business, even post-2008. you would have thought there would be a significant drop in the number of firms and assets. But we did not see that. When I compare the number of firms today run by smart people compared to when I started, it is mindboggling. I also think you have a massive asset-liability mismatch caused by institutional investors, making it that much harder to succeed long term. If you look at what investors want today I call it the Holy Grail: liquidity, transparency. high returns, low volatility, and group validation. The question is this: Is this goal achievable? Does it make sense? The only person I can think of who consistently gave you this is Madoff. Today it's hard to scale. Unless you become a large firm fast. you're not going to get proper service from any of the banks. Unless you're going to be a big client, it's going to be really hard for you. I could argue that running less money may be an advantage, candidly, but it definitely makes it harder right now. There are a lot of trends going on now that make the business very tough. You've had a lot of smart people come into it. making it much harder to find opportunities. You need to determine what your real competitive advantage is. When I look at the industry— and we look at it from a lot of different ways—I've not found a lot of people who make money shorting. I think long/ short is to some extent just a way to run leverage long. I think that it's a tough business. With the advent of electronic. HFT, and algorithmic trading. many smart people believe machines are going to put guys like me and firms like ours out of business. It's going to be machine to machine. My own view is the machines are going to put the machines out of business. But the question is when. This may last for a very (Continued on pore I 0 EFTA00300974 Page I I John Phelan long time. We're seeing a lot of interesting anomalies in trading. We're seeing interesting things in stocks that get beat up. I think this whole movement to passive and ETFs combined with the electronic trading and the "Holy Grail" I mentioned earlier that investors want today is making it really hard to invest actively on fundamentals. When you look at stocks like we do as owners of a business as opposed to pieces of paper to be traded, it's a difficult environment today. That doesn't mean you shouldn't go into the business. but the attractiveness of the industry has declined significantly from when I started. If you're an incumbent and you've got a lot of assets, you're in a pretty good place. If you think about how much risk a new manager needs to take to really make it, it's quite high. They may make it. but even then all it takes is one bad quarter or a bad year. If you don't have five to ten years under your belt, if you have a bad quarter, the fund will see significant redemptions. With pension funds and institutional investors—the whole ecosystem. really—moving to passive, you're going to see this big movement to quantitative trading. and, if that lasts for a long time, I think long-biased guys like us are going to be very challenged in that type of environment. You've got to make sure you've got the capital. the wherewithal, the strategy, and the ability to wait for that to end, because I do think it will end. I don't think it's going to end in a pleasant fashion. But hopefully it'll be a good opportunity. For a student, the amazing thing today is the number of new companies that are starting up. The barriers to starting a new company today are so much lower. Google is what, a IS year old company? It took Coca Cola over 100 years to have the brand recognition Google has. Think about it. You can become a global brand in ten years or less. That's unbelievable. I think that unless you're really passionate about this business. unless this is what you want to do every day. you're better off starting a business today. Find a dislocation and start a business. It seems like MSD is doubling down in some ways on the hedge fund business by actually growing and taking outside capital. JP: I don't know that we're doubling down. We don't think of ourselves as a hedge fund. We think of ourselves as an investment firm. For us. it's not doubling down. We're not guys who run long/short. We don't use any of the Greek alphabet numbers that everyone loves to bandy about. I still can't get anyone really to explain to me what market neutral means; yet, everybody uses it. It's fascinating to me. One of the things I have observed during my investment career that I think is interesting is that the basics of investing do not change only the terminology or lexicon seems to. VAR, sharpe ratio, Market Neutral—whatever that means—tail risk, black swans, Sortino ratio. To me there just seems to be some perverse human characteristic that likes to make easy things difficult. There are a couple things driving our decision to take outside capital. One was a question of whether we were going to continue to get capital from Michael. It was pretty clear that we had gotten to a stage where that was probably not going to occur anymore Second, we had a number of people we had worked with on investments and they always asked us if they could invest with us, but we declined because we didn't take outside capital. We started to find that actually started bothering people. I remember we called one person up whom we worked with on two different situations. He said. "You know John, El love to work with you guys. but I can never invest with you. Obviously, I can go buy the stock or whatever, but you guys are really on top of it. rather really be able to do that." We started to realize that our network was inhibited by the fact that we didn't take outside money. The other thing we found is when someone invests money with you. they help you out a lot more. One of the things we did while I was at ESL was to target a strategic group of investors. ESL had a very good group of investors. We're trying to build the same thing at MSD. We want to find people who have got good industry experience and are like minded. We have a lot of ex-CEOs. big families, and a small group of sophisticated institutions that are investors. They have great industry knowledge and expertise. We want to take advantage of that. be able to rely on those partnerships, and create our own ecosystem. Look at what Buffett has done with (Continued on page I 2) EFTA00300975 Page 12 9th Annual Pershing Square Challenge judges. John Phelan Berkshire and his shareholder base. I don't think a lot of managers engage with their LPs much. It's more "thanks for the money. now let me do my job." We're trying to include them whenever we think they can be helpful. We're trying to build an investment firm which is different than a hedge fund. We will not just take anybody's money. We're long term, fundamental, concentrated guys. If you want to start talking volatility equals risk. sharpe ratios, beta and gamma. the Greek alphabet. we're not a good match for you. It's funny, Buffett in his 2009 annual report said. "Don't get taken by formulas. Investors should be skeptical of history based models instructed by a nerdy sounding priesthood, using esoteric terms such as beta, gamma, sigma. and the like. These models tend to look impressive. Too often. though. investors forget to examine the assumption behind the symbol. Our advice is to beware of geeks bearing formulas." Same thing applies for investors. We're not formulaic. We're making bets on things that we think are going to happen over time, and I think that's really, really important. When you think about how you create good rates of return and how you are going to make a successful investment, the truth is that it's made by positioning your capital where your view is subsequently adopted and acted upon by others. You need to be in front of them. Are there funds whose approach to investing resonates with yours at MSD? What should students be doing to prepare themselves for this competitive environment to create value? JP: I think it all depends on your own DNA. Self- awareness is a really important quality to have, as is humility. If you're someone who is comfortable being in a place "When you think about how you create good rates of return and how you are going to make a successful investment, the truth is that it's made by positioning your capital where your view is subsequently adopted and acted upon by others. You need to be in front of them." where you may only make a few investments each year and you're not actively trading every day—it's not noisy and you're not whipping stuff around the trading floor— that's a value place. We're a shop like that. Baupost is a shop like that. I also have a ton of respect for AKO in Europe. They are a very good firm and do a very similar thing. They're a little more active but really disciplined, buy and hold type investors. If you're someone who wants to focus on macro or you want to trade or you want to do long/short, that's a totally different environment. Nothing wrong with it, but you're going to be doing different things and constructing different trades and thinking about your process differently. You've got to decide as a student what you're good at and what you're not good at. I always say to people who come in to see me that you have to realize in our business a really, really good person is wrong 30% of the time. That's a world class investor. Are you comfortable being wrong 30% of the time? By the way. you can't be wrong in a massive way. I think you have to be someone who thinks in terms of probabilities. Finding the right environment for you is super important. I came from the school of thought where we are all generalists. I think that's a huge advantage. With many hedge funds today, you're slotted into a sector: you're the tech guy, you're the media guy, you're the industrials guy. or you're the chemicals guy. and you're going to learn everything about the companies in that industry. They've all specialized. We still use a generalist model. We need to go figure out what ponds we're going to fish in. I believe that 80% of the game is figuring out what to work on. We've created our firm to be very good at figuring out what to work on. You can look at the newspaper today, or any day. and find four or five things you might want to look at. Which one you look at and why is really (Continued on pate I?) EFTA00300976 Page 13 John Phelan important. You're manufacturing ideas. You have a set amount of time each day. week etc. and the market's going to give you opportunities over certain periods of times. What stocks you follow and why, which ones you keep an eye on and why, which ones you actually buy and why, which ones you pass on and why, that's really important stuff. I think certain people have the mental capacity to be disciplined and do that and not need action. Other people need action. If you need action, that's a different firm. I also believe that the more businesses you look at and can compare the better investor you will become. This is why we like the generalist versus specialist model. We are confident we can get to 80% - 85% of the knowledge base any specialist has. We can go buy the other 15%. We can go hire a consultant or whatever we need to get up to speed. If we're monitoring the wrong stocks, if we're not identifying the right things to work on, because we have small teams. it's going to be very difficult for us. We force our team to get good at figuring out what to work on and how to spend our time well. That's what our system tries to do. That's one of our views and one of our competitive advantages. : This was great. Thanks again for your time and insights. We really enjoyed it. JP: Thank you. I really enjoyed it and hope you find my comments useful. "For a student, the amazing thing today is the number of new companies that are starting up I'm] I think that unless you're really passionate about this business, unless this is what you want to do every day, you're better off starting a business today. Find a dislocation and start a business." EFTA00300977 Page 14 Alex Magaro Alex Magaro (Continued (ran page 0 behalf of current and former principals of Renaissance Technologies. Prior to joining in 2003, he spent ten years investing in private equity and running a small company. He graduated from Harvard College in 1993. Alex currently lives in San Francisco, CA with his wife and three children. Graham & Doddsville (=): Can you discuss your path to investing? Alex Magaro (AM): I recognized early that I would be a horrible employee for somebody someday. for two reasons. First, I really lacked any political skill to speak of, and second, I never really did well with authority—if I didn't agree with it. Those two things are almost certainly related. Working backwards from that. I started to ask myself, "What can I do to make a living that doesn't rely heavily on political ability?" I initially concluded that meant pursuing either an academic or an entrepreneurial career. While being an academic probably suited my personality a bit better, once I got to college. I realized that road actually did require a reasonable amount of political ability. In thinking about the entrepreneurial path I wanted to try to avoid the high death rate of start-ups. If most businesses fail in the first 5 years, then avoid the first 5 years, so it seemed to me the better move was to buy a small business and run it. During college. I worked for a small private equity shop that was basically a fundless sponsor—they would find companies and raise money for each deal as they went. I decided to work with them after graduation. but we had an agreement that I could look for companies below a certain size to buy for my own account. I gave myself two years to find something before going back to graduate school. I went through hundreds of businesses for sale and went down the road with a couple. On one. I pulled the plug because the sellers tried to extract an "n+ l" at the last minute. Almost at the end of the two years. I came across a staffing business. In the mid I 990s, staffing had some pretty good tailwinds—and that really surprised me. so I ended up buying it. "There's a