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Investing in Deep-Value Plays

DANIEL G. LYSIK, CFA, is the Founder and Managing Director of Pratt Capital, LLC. Mr. Lysik serves as the Chief Investment Officer and Lead Portfolio Manager. He served as Managing Director, Head of the Fundamental Equity Team, at PNC Capital Advisors formerly Mercantile Capital Advisors. He was the Portfolio Manager of the Fundamental LargeCap Value Strategy, serving institutional and high net worth clients. Prior to joining Mercantile Capital Advisors, Mr. Lysik was a Partner at Brown Investment Advisory, serving as a largecap value Portfolio Manager. Mr. Lysik earned a B.S. degree from Rutgers College and an MBA from Columbia Business School. He received his CFA designation in 1993 and is a member of the Baltimore Security Analysts Society.

SECTOR GENERAL INVESTING TWST: Tell us about Pratt Capital and why you decided to found the firm. Mr. Lysik: The equity market dislocation in 2008-2009 not only looked like a great long-term opportunity to be a value investor but also very timely to start a standalone independent investment firm. Over the previous 10 years, I had been successful as a partner in two local investment firms, founding and developing a deeper value investment strategy. The value strategy effort that I developed in 2000 looked to take advantage of market dislocations by finding out-of-favor stocks that were trading at prices that were at a deep discount to their calculated intrinsic value. The value strategy had success significantly outperforming the S&P 500 Index over most time periods, and I became more skilled as a value investor and also gained valuable experience on how to successfully build a scalable infrastructure. In 2009, Pratt Capital was formed as an independent investment firm to focus solely on value equity investing for clients. At the time, I believed that we could provide a tremendous amount of value to clients focusing the firm on delivering superior long-term investment returns with the highest level of integrity and diligence. Recently, we have expanded the firms offering to also provide a more concentrated deeper value equity strategy
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that we believe is very unique. Both strategies are the opposite of equity index investing. The larger value portfolio only has a 15% weighting overlap with the S&P 500, while the concentrated portfolio overlap is less than 3%. TWST: You mentioned the dislocations in the market at that time. Are we seeing the same kinds of opportunities in the markets now that you saw then? Mr. Lysik: In my opinion, there are always opportunities in the marketplace where a company is being priced at $0.50 to a $1 of intrinsic value. We have seen these opportunities present themselves in all different economic sectors as security prices become mispriced due to excessive investor emotions. Over the past 35 years, there have been several notable academic studies conducted by Fama and French, Lakonishok, Shleifer and Vishny that have provided empirical evidence that investing in securities using value stock selection criteria low price to earnings, low price to cash flow and low price to book has on average done quite well and significantly outperformed the overall market and the most expensive valuation securities glamour stocks. By looking at low-valuation securities in a contrarian fashion, history has shown that investing in these securities following a business owner approach can allow an investor to generate attractive long-term results.
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MONEY MANAGER INTERVIEW INVESTING IN DEEP-VALUE PLAYS However, over shorter time periods, the least expensive investing in the public equity market. The concentrated portfolio or value portion of the market can underperform the overall marholdings are a subset of the larger value portfolio and possess a ket. From the beginning of 2011 through the middle of 2012, the 50%-plus discount to their calculated intrinsic value. These holdenvironment for deep value investing was actually pretty chalings each provide a potential IRR of 20%-plus over a three- to lenging. If you segmented the S&P 500 by price to book into five-year holding period. However, unlike private equity investquintile groups, you would find that the lowest price-to-book ing, the concentrated strategy has no lock-up period, investments quintile dramatically underperformed the are passive in nature, a nominal asset-based market by over 20% and the most expensive management fee of 1% and is invested in Highlights price-to-book quintile by over 30%. There very liquid securities with full transparency were and continues to be incredible opportuof a separate account structure for clients. Daniel G. Lysik provides an nities that are hidden to the marketplace. TWST: You are bottom-up invesoverview of Pratt Capitals investment strategies. It takes a Within economic sectors a pretty wide distors. How do sectors play into that? Are bottom-up approach and focuses persion still exists between individual comsector weights important or are you comon deep-value plays. He panies creating great value opportunities. pletely bottom-up? highlights favorite sectors right TWST: What about specifically in Mr. Lysik: Over the past 10-plus now: education, technology and the large-cap space? What is it about that years, I have continuously enhanced the financials, and a few examples of particular area that you like? investment process to ensure it is systemholdings in each. Mr. Lysik: For our larger value atic, repeatable and measurable. Internal Companies include: Bank of portfolio we are looking for attractive inproprietary screens look at valuation and America (BAC); Citigroup (C); vestment opportunities within the mid to price characteristics of each publicly traded Hewlett-Packard Company (HPQ); large market capitalization portion of the company. The results of these screens narIBM (IBM); Corning (GLW); equity market. Generally, new investment row the investable universe down to a subMarvell Technology Group candidates are companies whose market set of very low-expectation and out-of-favor (MRVL); DeVry (DV); Apollo Group (APOL) and Dell (DELL). capitalizations are greater than $2 billion. securities. We then perform fundamental Our portfolio weighted market cap tends to work focusing on gaining a better underbe significantly lower than the S&P 500 in standing of the asset value and the normalpart because were looking at companies that are 40%-80%ized earnings power of the enterprise over the next three to plus below their recent market price highs. Our investment five years. Focusing on the key drivers of the business model process leads us towards finding great market leading compawe also frame out a reasonable worst-case-scenario to nearnies that have been around for lengthy periods of time, have term profitability. Prior to investment, each new candidates strong market shares, great franchises and given marketplace market price must be no greater than 20% from a calculated concerns, are trading at prices that are a fraction of their calworst-case scenario. We believe that identifying the necessary

Over the past year, we have developed a more concentrated deeper-value strategy for clients. We have referred to this 20- to 25-holding portfolio as a private equity-like approach to investing in the public equity market.
culated intrinsic value. The concerns that temporarily depress these securities prices can be related to numerous items. We have typically seen this happen when companies go through product-cycle transitions, experience cyclicality of their end markets or see near-term profitability pressure on a portion of their business. However, its been our experience that the market overreacts to these near-term events, failing to recognize the companys ability to return to a normalized earnings power over the following couple of years. A patient investor has an opportunity to capture a very attractive long-term investment opportunity with a significant margin of safety. Over the past year, we have developed a more concentrated deeper-value strategy for clients. We have referred to this 20- to 25-holding portfolio as a private equity-like approach to purchase price for each investment opportunity provides the appropriate margin of safety and minimizes capital-loss potential. It also provides a reward/risk profile for each holding. A greater emphasis in the portfolios is placed on the investment opportunities with the most attractive reward/risk opportunity, weighting these holdings the highest in the portfolios. The end result of the bottom-up fundamental work has been a mostly diversified portfolio which at times would see out-of-favor sectors weighted higher in the portfolio. If you went back 10 years ago, the utilities and staples sectors would be at significantly higher weights. A couple years ago health care sector weightings would have been higher, and today there is a greater exposure to financials, technology and consumer discretionary sectors.

MONEY MANAGER INTERVIEW INVESTING IN DEEP-VALUE PLAYS TWST: Tell me about some of your specific picks right now and why you like them. Mr. Lysik: I think some of the leading companies in the financial sector provide great long-term investment opportunities. During the market dislocation of 2008-2009, the financial sector saw significant financial stress as near-term profitability was impacted by increasing reserves, rising chargeoffs, weaker loan growth and net interest margin compression. In addition, an accounting change accelerated asset write-downs, increasing the cyclicality of the sector. The industry went through a series of valuation multiple compressions, from a multiple of earnings to book value to tangible book value to a discount of tangible book value, as the marketplace became concerned on with liquidity and potential dilutive capital raises. U.S. households. Citigroup has a unique global footprint with extensive banking infrastructure in some of the worlds fastest growing economies. Both companies are still incredibly attractive securities with current market prices below their tangible book value. It may take some time for the market to fully understand the franchises earnings power, but in the meantime both companies will see further book value growth with decreasing legal and financial risk. Both franchises can still generate normalized return on equity of at least 10% as they successfully right-size their cost structures. We believe the companies will continue to show operating efficiency improvement as they move closer towards a normalized 1% level. As of the latest earnings report, Bank of Americas tangible book is $13, their book value is greater than $20 and we believe their normalized earnings over the next couple of years is

With the headwinds shifting to tailwinds, the financial sector earnings should continue to surprise the marketplace and move towards normalized earnings power over the next couple of years.
1-Year Daily Chart of Bank of America

greater than $2 per share. Citigroups tangible book is $51, their book value is greater than $60 and we calculate their normalized earnings potential as greater than $7. Looking out over the next three to five years, both companies possess intrinsic values that are significantly higher than current market prices.
1-Year Daily Chart of Hewlett-Packard Co.

Chart provided by www.BigCharts.com

Now we are seeing the opposite take place for the industry. Capital levels have been restored, asset quality trends continue to improve, loan growth is accelerating, net interest margins are starting to stabilize and companies are aggressively adjusting their cost structures to match the lower-revenue environment. With the headwinds shifting to tailwinds, the financial sector earnings should continue to surprise the marketplace and move towards normalized earnings power over the next couple of years. Over the past 12 months, financial company stock prices have started moving higher in some cases from deep discounts to liquidation value up to tangible book value. While the marketplace may continue to experience short-term worries over the European financial system we believe the revaluation process still has a long way to go to get from tangible book to the appropriate multiple of book value and normalized earnings. Two opportunities within the sector today would be Bank of America (BAC) and Citigroup (C). Bank of America has the largest U.S. retail deposit market share serving one in every two

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We also think there are great value opportunities in the technology sector today, with strong global franchises being priced in the market at single-digit price to earnings multiples. For example, Hewlett-Packards (HPQ) stock price is down 75% over the last two years. At current prices, Hewlett has a price to cash flow multiple below three, a forward price to earnings multiple below five and a free cash flow yield over 20%. Current valuation levels are at 30-year lows, and significantly below where they should be for a company with the franchise and market-leading positions as Hewlett-Packard. So why is that? When you take a step back, there are a lot of similarities between Hewlett-Packard today and IBM (IBM) in the early 1990s. In

MONEY MANAGER INTERVIEW INVESTING IN DEEP-VALUE PLAYS my opinion, over the past couple of years Hewlett-Packard focused too much on cost reduction, failing to fully integrate acquisitions and starved the organization of necessary R&D innovation. With the recent management changes, they are now making the right decisions, integrating assets, right-sizing the cost structure, focusing on new product innovation, reinvesting back into the business and strengthening the companys balance sheet. The market continues to be concerned with Hewletts personal computer exposure. Looking at a sum of the parts, that business segment is currently carrying a negative value in the companys market price. Given the significant valuation compression, Hewlett-Packards market price provides an investor with numerous free call options personal systems group division, corporate margin improvement, new product innovation, balance sheet improvement. Hewlett-Packard generates a tremendous amount of operating cash flow in excess of $10 billion a year or more than $5 per share. With more than $20 billion in cash and long-term investments, as the company continues to reduce debt, there will be a significant opportunity over the next couple of years to return more cash to shareholders through share repurchases and increased dividends. I believe Hewlett-Packard has normalized earnings power closer to $5 per share as the company sees resumption of revenue growth and steady operating margin improvement. We believe Hewlett-Packards intrinsic value is north of $40, and its hard for me to see why the stock would ever be below $20, let alone as it currently stands in the midteens.
1-Year Daily Chart of Corning

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Corning (GLW) is another technology company that we like a lot today. A market leader and low-cost producer, Corning provides durable glass for smartphones, tablets and televisions. The company is well positioned to be a beneficiary of strong market trends within the technology sector, increased global growth of smartphones, tablets and using touch-screen technology to enhance corporate and consumer interactions. Cornings stock price has fallen 50% over the past 18 months, as the markets been concerned about product cycle shifts within the television marketplace and weak industry pricing that is temporarily weighing on gross margins.

In our opinion, the market is missing a couple important things with Corning. First, the company has a pristine balance sheet, more than $5 per share of net cash and long-term investments, 40% of the current market price. Market participants are overly concerned with near-term margins compression as the stock price is also currently trading below liquidation value. Third, investors are missing the companys manufacturing advantage over their competition. Corning has been able to free up manufacturing capacity as new products Gorilla Glass are able to be manufactured at current facilities providing the company with significant incremental profits. With ample capacity, capital expenditures will fall by 30% over the next year or two, providing significant free cash flow generation that will be used for greater share repurchases and dividend payments. With the stock trading below tangible book value, share repurchases will be very accretive. Over the next couple of years, Corning should see margins improve, revenue growth re-accelerate, and we believe the companys share price will move overtime towards its intrinsic value, which is north of $20. With the current share price near $12, we believe Corning is a great value investment with a significant margin of safety. Finally, a smaller technology company, Marvell Technology (MRVL), looks like a very attractive investment today. Marvell is a leading semiconductor company servicing wireless, storage and networking markets. Over the past three years, Marvells stock price is down over 60%, as the market has been concerned with their wireless segment, a recent patent challenge and operating margins that have been under pressure as the company has seen gross margin compression and ramped up incremental R&D spending. Marvell is an industry-leading innovator, spending nearly 30% of its revenue on research and development. The company has a pristine balance sheet, no debt, and cash and long-term investments in excess of $2 billion or nearly $4 per share. More than 40% of the current market price is the cash and investments on the balance sheet. Rarely do you see an innovation leader with annual research and development spending be more than 40% of their current market price, in essence providing investors with a free call option on the companys future innovation. Marvells current market price, ex cash and investments, is less than three times its normalized earnings power, providing, in our opinion, a wonderful long-term opportunity. TWST: You mentioned the education space. Who do you like there? Mr. Lysik: Another industry currently going through dramatic change and dislocation is the education industry. Its been our historical experience when volatility is at its highest, thats usually because the marketplace is struggling to determine the appropriate valuation for securities, which has more often than not provided us with great long-term value opportunities. Even in the midst of uncertainty, market-leading companies tend to have valuable assets that are temporarily

MONEY MANAGER INTERVIEW INVESTING IN DEEP-VALUE PLAYS underappreciated by the marketplace. If we can find opportunities where the industry is near trough profit margins and trough valuation multiples, an investor can benefit over time from the industry, returning to normalized margins or expanding valuation multiples. Sometimes we get lucky and both of those events begin to happen at the same time. will now have a greater convenience to take classes outside of the classroom setting. In addition, Apollo is teaming up larger corporations to help reduce the current skills gap that is challenging these companies. With the market price below $19, Apollos stock price is down 75% over the last 18 months. The marketplace has been

Rarely do you see an innovation leader with annual research and development spending be more than 40% of their current market price, in essence providing investors with a free call option on the companys future innovation. Marvells current market price, ex cash and investments, is less than three times its normalzied earnings power, providing, in our opinion, a wonderful long-term opportunity.
In the middle of 2012, we became very interested in DeVry (DV) as the stock price fell to $20 from a high near $70 back in the beginning of 2011. Over the past 20 years, DeVry has smartly put together leading educational offerings in business technology, medical and health care. As a result, DeVry leads the industry with strong job placements results and starting salaries north of $43,000 for graduates. Like everyone in the industry, recent enrollment trends have been hurt by becoming less dependent on third-party channels and cyclically weak demand due to the economy and weakening consumer sentiment toward higher education. To help offset enrollment challenges, DeVry has focused on generating incremental cost-savings, which could add close to $1 per share in earnings over the next two years. We believe as enrollment improves over the next couple of years, DeVry could generate $4 per share of normalized earnings. The company has a pristine balance sheet with $4 per share net cash. At time of purchase, DeVrys market price, ex-cash, was approximately four times normalized earnings and a normalized earnings free cash flow yield of 25%. Even if it took three to five years for DeVrys share price to reach its intrinsic value of more than $40, in our opinion, purchasing shares at $20 provided a very attractive holding period return. More recently, weve become interested in Apollo Group (APOL) within the education space. Apollo has been the online market leader, owning the University of Phoenix brand. The company has also been well-known as the technology leader with roughly 1,000 technology employees, a third of them in the Bay Area. Recently the company was awarded a patent that should allow Apollo to further benefit from the evolution of the industry. Apollo has developed a way to make the online education space even more portable by combining multiple applications to provide services to students through laptops, smartphones and tablets. Students
1-Year Daily Chart of Apollo Group

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very concerned with Apollos weak enrollment trends and stepped up investment on new technologies and marketing, which is weighing on near-term earnings. In addition, the market is concerned with an ongoing Higher Learning Commission peer review, which could lead to short-term fines and incremental costs to alleviate any issues that could affect University Phoenix accreditation. We think Apollos cost-reduction program, eliminating redundant physical facilities and excess infrastructure costs, will generate significant savings starting in 2013 and continue through 2014. The company still generates a very attractive return on equity of more than 20%. With capital expenditures, only 3% of revenues, Apollos annual free cash generation is significant. The company has a pristine balance sheet with $9 per share of net cash and long-term investments. We believe if you look out a couple of years, as expenses come down, Apollos earnings should recover from $2-$2.50 range to normalized level closer to $4 per share. Apollos current market price, ex-cash, is currently only two times normalized earnings and has a normalized free cash flow yield greater than 40%.

MONEY MANAGER INTERVIEW INVESTING IN DEEP-VALUE PLAYS TWST: How does the large amount of data available today impact your operations? Mr. Lysik: Information today gets into the marketplace much quicker than it used to. I believe the ability to share information instantaneously from multiple devices is driving the marketplace to focus that much more on near-term news or events. This in turn is creating a greater amount of volatility in individual securities compared to 15 years ago. With our disciplined investment approach we understand that market prices are not equal to value, providing us with greater opportunity to take advantage of the increased volatility by getting aggressive when others are fearful. holdings today versus the historical performance for the value strategy. From the beginning of 2009 through the end of January 2013, the larger value portfolio has a cumulative total return of 130% versus the S&P 500 Index of 80%. However, while the S&P 500 Index may be reaching new price highs, our current value portfolio holdings are collectively 70% below their 2007 price levels. Over the past four years, we have made successful investments that have generated 40% to 60%-plus holding period returns, and those companies have been sold and redeployed into new opportunities that have market prices that are 40%-50% below their intrinsic value. In fact, today the value portfolio holdings are collectively still near their 2009 price levels.

Since inception, the portfolio has experienced low holding turnover of 25%, four-year-average investment holding period, versus the industry, which averages 85% turnover or slightly more than one year. Since Pratt Capital started in 2009, we have not eliminated a holding for a loss.
However, what I think is worth watching is whether market participants will try to limit the future investment returns of some value opportunities. Dell (DELL) is a great recent example. The market became fearful of weakening personal computer sales and technology spending late last year, and as a result Dells market price traded below $10. We were holders of Dell with the belief that their intrinsic value is more than $20 based upon several different valuation approaches. Therefore, with the price weakness, we became aggressive adding to our holdings, making the company one of our largest holding in both of our portfolios. However, Dells senior management also recognizes the tremendous value of the company, and as a result is in the process of taking the company private at a price 40% higher than its price at the end of last year, but unfortunately for us at still a 50%-plus discount to its long-term fundamental value. Hopefully, this experience doesnt become the norm, and value investors are allowed to fully benefit in a companys revaluation to their intrinsic value. TWST: You mentioned you hold for the long term. What makes you sell or take another look at your holdings? Mr. Lysik: Since inception, the portfolio has experienced low holding turnover of 25%, four-year-average investment holding period, versus the industry, which averages 85% turnover or slightly more than one year. Since Pratt Capital started in 2009, we have not eliminated a holding for a loss. Having said that, we do hold securities today that are at lower market prices than where we first purchased those securities. We remain very disciplined bringing holdings into the portfolio that are only additive to overall portfolio valuation and have valuation measures that are usually 50% lower than a portfolio elimination. One of the ways we show clients that we, hopefully, practice what we preach is if one were to look at the portfolio Also, the value portfolios valuation characteristics remain at a deep 30%-80% discount to the S&P 500 Index. When the portfolios valuation is at current levels it has been a good leading indicator of strong investment performance over the next couple of years. While we continue to be excited about the value portfolio, we are even more excited about the new concentrated portfolio. The concentrated portfolio since inception late September 2012 through the end of January has a cumulative return of 24.35%, versus the S&P 500 of 4.78%. The portfolios current holdings are collectively not only below 2009 price levels but close to 1995 price levels. The concentrated portfolios current characteristics are also at an even deeper 40% to 90% valuation discount to the market. Current valuation levels are near their 30-year absolute valuation lows for the portfolio holdings price to cash flow less than four times, price to sales less than 0.25 times, price to book less than 0.9 times, trailing price to earnings less than eight times and price to normalized earnings less than six times. With a normalized earnings yield of 13% plus a dividend yield close to 2.5%, the concentrated portfolio total yield is more than 15%, significantly greater than the overall market. TWST: Tell us about your background. Mr. Lysik: Im the first individual in my family to pursue a career in the investment field. I first became enlightened with value investing in my mid-20s when I attended Columbia Business School. Bruce Greenwald, Director of Columbia Business Schools Heilbrunn Center for Graham & Dodd Investing, has done a tremendous job over the past 20-plus years in updating and enhancing the core teachings of Benjamin Graham and David Dodd that started at Columbia in the 1920s. Graham and Dodd were the pioneers of security analysis and

MONEY MANAGER INTERVIEW INVESTING IN DEEP-VALUE PLAYS value investing, and its why Columbia Business School is regarded as the birthplace of value investing. In 2000, at a local investment firm, I started a value strategy with an investment process that traces its roots back to some of the same core principals provided by the late Benjamin Graham. So for the past 15 years, Ive been fortunate to have had success running a value strategy as part of a larger institution and now also part of an independent firm. At Pratt Capital, we look forward to the next 15-plus years and continuing our mission on delivering superior long-term investment returns for our clients with the highest level of integrity and diligence. TWST: Thank you. (LMR) DANIEL G. LYSIK, CFA Founder & Managing Director Pratt Capital, LLC 111 S. Calvert St. Suite 2700 Baltimore, MD 21202 (410) 385-5220 (866) 366-3439 FAX www.prattcap.com

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