TROJAN March 3, 2008 Issue 1 - Volume 1

INVESTING NEWSLETTER
Welcome to the Trojan Investing Newsletter!
Inside This Issue
Through issues distributed at the beginning of Trend Analysis
each month, the Trojan Investing Newsletter hopes to Think Global, Invest Global, Be Global .. p.2
bring ideas together that stimulate new ways of thinking
The Dry Shipping Sector ........................ p.3
to benefit you as an investor. Through critically analyzing
economic and sector/industry trends as well as individual Investment Analysis
securities, we hope to provide you with new insight into Losing Its Shine - AAPL .......................... p.5
how to view the world as a place to invest.
Stability in a Volatile Market - RIG ......... p.6
We are affiliated with the Trojan Investing Soci-
ety, the premier finance and investing club at USC. The
Passing on Higher Costs - TIF ................ p.8
weekly TIS meetings are a great place to come to express Cashing in on Turbulence - FFH ......... p.10
your opinions on the articles written; and where the con- Shorting the 10-year Treasury ............... p.12
tributors of those articles will have a chance to answer any Buying Quality - AEO ......................... p.12
questions you have. Being allowed access to a variety of Biting the Dust - FINL ......................... p.13
investing ideas through this forum has given our first issue Listen to Me! - PRAA ........................... p.14
depth and breadth that we would otherwise be unable to
afford our readership. We hope to further add to this va- Book Review
riety through the inclusion of book reviews, guest articles, You Can Be A Stock Market Genius ..... p.15
and interviews. Commentary
Although our first issue has a number of intricate Financial Illiteracy ................................. p.16
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 dif-
ficult subjects and sources for additional self-research. Market Performance Snapshot
This first issue is the culmination of many hours of 1-Feb 29-Feb Return
toil on the part of our numerous supporters and contribu-
Dow Jones 12,743.19 12,266.39 -3.74%
tors. The staff would like to thank everyone for pitching in
and seeing this project through fruition. We sincerely hope S&P 500 1,395.42 1,330.63 -4.46%
that you find our newsletter to be interesting, informative NASDAQ 2,413.36 2,271.48 -5.88%
and most of all, enjoyable. S&P 400 823.43 788.51 -4.24%
Russell 2000 730.5 686.18 -6.07%
“How many millionaires do you know who have become 10-Year T-Bill 3.60% 3.53% -1.94%
wealthy by investing in savings accounts? I rest my case.”
-Robert G. Allen
Contributors:
Danny Kisch, Alexander Muhr, David J. Namdar,
-Trojan Investing Newsletter Staff 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 gen-
eration faces different challenges, has unique experiences,
and creates more new opportunities than all of the previ-
ous 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, sleep-
ing, 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 com-
puters/cell phones and driving cars. There are billions of
people doing the same things every single day. It is es-
sential 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 indi-
viduals; it is also a key characteristic of the most success-
ful 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.
Embrace this generation’s unique experience: think glob-
To use everyone’s favorite social networking example, Fa- ally, invest globally, and be global.
cebook initially was a website for college students at Har-
vard and then became used by students across the US by
focusing on the niche networks of each university
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 high-
lighted 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 cap-
ital 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 gen-
eration. 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 legiti-
mate 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?
Dry Shipping, Dead in the Water?
By Jordan Ohama Recommendation: Hold
The shipping industry is historically a cyclical industry. the owners of these vessels and create revenue by leasing
The dry bulk sector is part of this overarching category out their use. Therefore their performance is positively
and has many of the same attributes of the broader indus- correlated with the movement of shipping rates. These
try. This sector tends to be stronger in the fall and winter companies include the likes of Dryships (DRYS), Diana
months with the anticipation of increased coal and other Shipping (DSX), Excel Maritime (EXM), and Eagle Bulk
good consumption during winter. The dry shipping sec- Shipping (EGLE).
tor is also cyclical in the more general sense in that it fares
well when there is global growth, but does not fare as well Pricing Trends
when the global economy stagnates. The Baltic Dry Index (BDI) is a measure for spot ship-
ping rates. It measures the average spot rates for 22 ship-
In the past few years, the dry bulk shipping sector has ex- ping lanes worldwide. In Figure 1, it is clear that there
perienced a boon from increased worldwide demand for has been a bull market in this sector for the past couple of
raw materials as undeveloped countries build up infra- years, with a recent correction at the beginning of 2008
structure and increase their manufacturing capabilities. and then continued upward movement.
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 Figure 1: Spot Shipping Rates from March 2003 to March 2008
• Grain Source: www.dryships.com, 2008

Sector Breakdown
Within the dry bulk sector there are two major groups Each line on the above chart represents a different set
that carry out the transportation of goods. There are the of shipping routes—each varying in capacity. This chart
owners of the ships who normally lease out their vessels shows the variability in dry shipping spot rates from Jan-
to others, and those that operate these leased vessels to uary 2003 to the present, but it is clear that since July
move supplies. The companies that own the vessels have 2005, spot shipping prices for all ships have been moving
two major options when leasing their vessels: they can 1) significantly higher. This is a trend that has lasted for two
trade the usage of their vessels on the spot market or 2) years already, and shows no signs of letting up. Even now,
lease out their ships under a time charter. Spot rates are the rates are hitting all-time highs. The latest rate run-
daily rates that are influenced by the changing demand up—which we are currently in the midst of—shows the
of the marketplace. They fluctuate daily and tend to be strength of the demand for dry bulk services, even as the
higher than time charter rates due to the uncertainty of United States credit crunch reaches critical mass.
continued usage. Time charter rates are contracts that
Trickle-down Effects
create a fixed rate for a given period of time, usually rang-
ing from a few months to a few years. 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 out-
flows 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
Outflows: outlook for global energy and minerals markets, 2005
• Decreased activities for other businesses due to
increased costs of commodities and raw goods China is not the only reason that dry bulk demand is in-
• Expanding operations of mining companies to creasing, but the massive demand from China has helped
include shipping to exacerbate these effects. For example, the increase in
naval activity has led to congestion in busy ports in Aus-
Following 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
demand on the dry bulk shipping sector. travel many times more if it travels from Brazil to China
as opposed to Australia to China. Mining companies
China’s Effect on Dry Bulk Demand such as Rio Tinto and BHP are “investing tremendous
China, as a growing economy, has growing needs for raw amounts, not only in Australia and Brazil, but in Afri-
materials 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 re-
Bulk 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 cur-
both importing raw materials and exporting finished rently seems to be stable, drops in demand and prices
goods: could be on the horizon for dry bulk shippers. At this
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 in-
formation comes to light. I am therefore recommending
a Hold on this sector.
Apple Inc. - Losing Its Shine
By Jordan Ohama Recommendation: Sell (Short)
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.
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 pro-
vides marginal benefits to a very few.

Why Short-Term Weakness? Although the aforementioned products help to position

When there is uncertainty, there is weakness in the price AAPL as a leader in certain areas in the distant future,
of the stock. For AAPL this uncertainty pertains to both they have little financial benefit to the company now.
its ability to continue to create innovative products as
well as the health of the overall US economy. Risks that The only product that has been talked about recently is
AAPL faces include: 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. His-
Recently, 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 compa-
at 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 larg-
that 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 sig-
nificantly 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 reces-
sion.

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 Recommendation: Buy
In extremely volatile markets, investors look for stable in-
larger problem in oil prices though, relates to demand.
vestments that can provide them with financial security. From 2000 to 2006, U.S. oil consumption increased
While bonds and C/D’s may be a safe play, those looking 5% due to a rising population and an increasing num-
for more than single digit return will find these undesir- ber of automobiles on the road. Worldwide, demand for
able. Specifically, given its low risk, Transocean (RIG) oil is growing at an even faster rate. China’s GDP grew
is attractive given the current market conditions. The 10% in 2007 and is expected to grow at an annual rate
firm operates as an offshore oil-drilling contractor and isof 8% for the next 2 years. Additionally, Chinese auto-
headquartered in Houston, TX. mobile 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 com-
to 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’ esti-
mate 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 prof-
its. 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 Ul-
tra-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. Trans-
ocean currently has 8 of these Ultra-Deepwater Float-
ers 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 indus-
try average of 20 times earnings. I am therefore recom-
mending RIG as a Buy.
Tiffany & Co. - Passing on Higher Costs
By Jordan Ohama Recommendation: Hold
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 busi-
ness 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 substan-
tially 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:
• 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.
• Changes in consumer spending 4 10K is the name of the SEC’s mandatory Annual Report.
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.
through TIF’s latest 10-Q3 (third quarter) report of op-
erations 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 stim-
ulated by fears of a weakening economy and inflation.
Because it has become more difficult to finance invest-
ment real-estate for most non-institutional/money-man-
agement 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 Bal-
tic 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 increas-
ing 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
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 (mea-
sured 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, decreas-
According to TIF’s 10-Q though, 70% of TIF’s inventory ing costs of investment transactions and increasing inter-
is 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 in-
accounted 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 oc- Table 1: Net Sales (YTD – 3Q 2007)
curred and also subtract decreases in the LIFO Reserve
in 000’s Percent
from the gross earnings.
US Retail 946,692 50.2%
In its most recent 10-Q filing, TIF has maintained a rela- International 777,875 41.3%
tively steady Gross Margin at 55.3% as compared to 56% Retail
a year ago. This means that as of October 2007, TIF has Direct Marketing 104,772 5.55%
successfully been able to pass on the higher costs of com- Other 56,275 2.98
modities. Significant fluctuations in the Gross Margin in TOTAL 1,885,614 1
the future could mean that TIF is no longer able to pass
on this cost, a sign of a slowdown in demand. More in- Approximately 50% of “International Retail” is based in
formation is given in the footnotes of the report, which Japan. This means that a total of 70% of its net sales
are summarized on finance.yahoo.com under “Gross comes from Japan and the United States. A good deal of
Margin.” Also found in the footnotes is the LIFO Re- sales revenue from Europe comes from London, who is
serve—which was $120,940,000 at the end of the most also a close trading partner with the US. If the economy
recent quarter. If this number drops significantly it could continues to slow in the United States, Japan and the UK
mean that TIF is selling off old inventory which has risen are also likely to be affected considering the strong trade
in value since it was bought.7 This type of gain is not sus- relationship between these countries. If there is a reces-
tainable and therefore should be discounted when look- sion in the US, this may slow spending on luxury goods
ing at the Gross Profit. in TIF’s major markets, forcing TIF to either cut prices
(lowering the gross margin) or to lose revenue.
Changes in Consumer Spending
Publishers of a few articles I have read recently have been Although a company’s financial statements may show a
pointing to the fact that in past recessions the most lux- healthy company, there are definitely risks investing in
ury brands are not significantly affected. One difference any stock. For TIF, I feel that the downside risks offset
of past recessions is that people in the “way back when”, any potential for gains and am therefore recommending a
would buy jewelry because they felt that gold and other Hold for TIF until the Q4 and 10K reports are released.
real assets would be a good investment. Although this
6 LIFO (last in, first out) is a way of inventory accounting. Be-
cause 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.
Fairfax Financial - Cashing in on Turbulence
By Alexander Muhr Recommendation: Buy
The world is coming to an end! These days in the finan-
cial 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 com-
pany’s assets in case financial markets begin to deteriorate
drastically. With the markets in turmoil since last sum-
mer, these bets are not only protecting their assets but
also paying off handsomely making FFH a great invest-
ment, 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. Coun-
trywide, 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 de-
fault 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 mar-
ket 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 com-
parison. The reason that the CDS market became so big
is that it is unregulated and there are limitless possibili-
ties 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-
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 fac-
ing 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 hap-
pen 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 share-
holders, 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, ac-
cording to Tom MacKin-
non 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 Fair-
2003 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 mil-
Since 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 portfo-
are 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. Accord-
ing 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 mon-
the banks that issue them and the insurance companies ey is not only very well protected but also still has a po-
that 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 Fair-
the 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 Recommendation: Sell (Short)
The Federal Funds Rate1 is currently at 3.3 percent and
Ben Bernanke stated last week in his testimony to Con-
gress that we are coming to the end of the rate cuts that
have been supporting stock prices to some extent. Ad-
ditionally, 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 tradi-
tionally used to meet minimum capital requirements for banks
and financial institutions set by the government.
American Eagle - Buying Quality
By Alexander Muhr Recommendation: Buy
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 in-
vestment, 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.
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.
a back seat to the CDO crisis, the 10-year treasury has
become overvalued.
If the Fed2 stops raising rates and begins to recognize in-
flation as a key concern, the 10-year Treasury bond yield
(currently at 3.51%) could easily rise above the five per-
cent 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.
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 invest-
ments, 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 long-
term 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 re-
tail segments. Whichever one of these concepts survives,
management is calculating that the spending now should
bring in the new cash and earnings to reward sharehold-
ers.
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. ness, we need take a look at FINL’s most recent quarter’s4
Its stores operate under the brands The Finish Line, Man 10-Q report. This quarterly report compares the finances
Alive and Paiva. Each one focuses on specific product from the quarter ending December 2007 with those end-
types and demographics. The Finish Line, for example, ing November 2006. The first number that stands out
specializes mainly in selling sporting goods. from the Statement of Operations, is the Operating Loss
for the thirteen weeks ending December 1, 2007, which
Retailers are being hit hard by the slowing economy right was $23 million. The second number that stands out
now, and those with weak financial stability are getting is the $22.3 million in Net Cash Used in Operations.
hit the hardest. FINL is no exception. With a market I place emphasis on operating numbers because those
cap1 of just under $190 million, it is a small-cap2 compa- numbers deal directly with the core business operations.
ny, making it especially susceptible to such a slowdown. This means that by using these numbers we are able to
look directly at the business rather than include its auxil-
On March 3, 2007, Finish Line was in the news for fail- iary operations.
ing at a bid to buyout its larger rival Genesco (GCO).
This boosted FINL’s stock price upwards of 40% in one From the comparison of the two periods on the Cash
day. Although the possibility of being crushed by nearly Flow Statement, we are able to see that even after spend-
$1.5 billion in debt that the buyout deal would create for ing $28 million more on Property, Plant and Equipment
FINL is now gone, its own operations and balance sheet in 2006, the Net Decrease in Cash and Cash Equivalents
still show significant risks of bankruptcy. For example, in in 2007 is still $14 million higher. Table 1 explains the
its third fiscal quarter of 2007, FINL was forced to shut first half of this problem.
down its 15 Paiva stores.
4 Most recent quarter can also be written MRQ.
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 weak-
1 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 in-
dicative of the current weakness in sales that both FINL and GCO
are currently facing.
 Table 1: Store Openings (Closings) Although the 2006 and 2007 comparisons from the
Thirteen weeks ended Cash Flow Statement look similar, they do not necessar-
1-Dec-07 25-Nov-06 ily include analysis of the current situation. In 2006 the
Number of Stores: company was growing rapidly and was spending a lot of
Finish Line money on building new stores and growing its brand.
Beginning of Period 697 672 Currently, the retailer is closing more stores than it is
Opened 7 21 opening and is losing money doing it.
Closed -3 -1
End of Period 701 692 In all, because of FINL’s small size and the fact that in
Man Alive lieu of building up its financials, it spent what it earned
Beginning of Period 95 76 while expanding, it may now go bankrupt. FINL’s epic
Opened 1 12 struggle to survive was epitomized through its attempt
Closed - - and failure to buy out its larger rival GCO. Now, with
End of Period 96 88 nothing more than its own sales weakness weighing the
Paiva
stock price down, I am recommending to Sell this stock
Beginning of Period 15 6
short…to zero.
Opened - 6
Closed -15 -
End of Period - 12
Total
Beginning of Period 807 754
Opened 8 39
Closed -18 -1
End of Period 797 792

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
one company that takes that to heart. debt coming down the pipeline – due primarily to bad
loan and borrowing practices.
Portfolio Recovery Associates is a company that purchas-
es 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 op-
and 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 environ-
The rest came from auto, medical, utility and installment ment have created improved opportunity for debt buying
loans. with prices improving somewhat and supply growing. –
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 It’s also a positive sign that the trouble that PRAA faced
in its most recent quarter was that they were unable to
One tiny blemish: get their new call center (what they mainly use to make
“…higher borrowing cost and our increased leverage collections) up fast enough to meet their collection de-
have resulted in higher interest expense, which is in large mand! Mr. Fredrickson mentioned that the supply (how
part responsible for our fourth quarter performance on much bad debt is coming their way) was coming faster
the bottom line.” than even he, an industry veteran, anticipated. They have
been able to improve productivity at this new call center
The upside to this dilemma is that as PRAA begins to col- already to take advantage of that supply.
lect 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 im-
prove, 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 sepa-
rates 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 sharehold-
ers. 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 Re-
business 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 under-
writing assumptions and insufficient collection capabili-
ties.”

They were prepared:

“With our annual credit line we can take greater advan-
tage 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 in-
vestment partnership. Between 1985 and 1995 his annu-
al 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 bank-
rupt 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 The key to becoming a more financially literate country
various statistics, my eyes fell upon, quite possibly, one lies in establishing the fundamentals of economics and
of the most troublesome pieces of information I have finance in the minds of children at an early age. Too long
ever seen. No it was not another analyst’s evaluation of has our public education system suffered from a deficien-
our economy’s looming threat of recession, nor was it the cy in teaching the practical knowledge that every person
now triple-digit price of oil. Instead, and almost surpris- needs to know (but might not know), whether it be fi-
ingly, my sudden anxiety had been caused by the latest nancial literacy or how to properly care for your car.
figures on financial illiteracy.
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 finan-
recent 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 educa-
only 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 fi-
nancial decision-making… [and] in particular, math and
economics training.”