Praise for Applied Value Investing “Calandro’s clever application of value investing principles to corporate decision-making could transform how businesses operate and what business school students are taught This thoughtprovoking work takes value investing to the next level.” —Seth A Klarman, president, The Baupost Group, L.L.C.; lead editor of Graham and Dodd’s Security Analysis, Sixth Edition; and author of Margin of Safety “After seventy-five years, Graham and Dodd remains the true North Star for those seeking the Rosetta Stone to unlock values Professor Joseph Calandro adopts Graham and Dodd’s fundamental premises and uses them to focus on new dynamics.” —Mario J Gabelli, CFA, chairman and CEO, GAMCO Investors, Inc “Calandro’s application of Graham and Dodd principles outside the traditional realm of value investing involves multi-disciplinary thinking, a necessary skill for constructively framing and reframing the investment landscape in today’s chaotic world Particularly interesting is Calandro’s chapter on the relationship between Graham and Dodd’s discussion of the market valuation cycle of greed and fear, and the top down macro ideas of George Soros In essence, Calandro shows how Mr Market’s bipolar psychology can be linked to Soros’ concepts of reflexivity and feedback between conditions on Wall Street and Main Street Given the wild downward oscillations we have experienced over the last year, every value investor should be able to weave these two investment approaches together to understand when and why a cycle develops, and where market behavior diverges significantly from the fundamentals.” —Mitchell R Julis, co-chairman and co-CEO, Canyon Partners, L.L.C “Joseph Calandro’s Applied Value Investing is the most important business book of our time Today our global economy is in the throes of major readjustment, and this book’s analysis is a critical navigation tool to help executives and investors find and create value Calandro extends the classic work of Graham and Dodd to evaluate mergers and acquisitions, catastrophe-based alternative investment, and most importantly integrates it with a strategic framework for managers to determine if they are truly creating value above their cost of capital, risk adjusted It is also well written, practical, and an enjoyable read.” —Dr John J Sviokla, vice chairman, Diamond Management & Technology Consultants, and former associate professor of Harvard Business School “For anyone interested in the interface between strategy and finance— CEOs, CFOs, operations executives, planners, investors, analysts, and risk managers—Applied Value Investing by Joseph Calandro, Jr offers two key lessons that are potentially extremely rewarding One is that business leaders can find new sources of competitive advantage if they learn to think like highly successful investors The other is that investors and analysts can gain valuable insights if they study how a company achieves the creative interaction of strategy, resource allocation, performance management, and risk management In other words, investors should learn to think like astute business leaders Calandro’s groundbreaking book integrates these two lessons into a holistic and practical business framework, which can be used to either assess or manage a business.” —Robert M Randall, editor, Strategy & Leadership, and coauthor of The Portable MBA in Strategy “This is an extremely smart book The three chapters on M&A alone are worth the price of admission If executives will adopt the discipline that Joseph Calandro lays out, they will avoid many, many costly mistakes.” —Paul B Carroll, coauthor of Billion-Dollar Lessons: What You Can Learn from the Most Inexcusable Business Failures of the Last 25 Years “Joseph Calandro successfully applies the modern approach to Graham and Dodd’s investment valuation The book is a ‘must read’ for all Graham and Dodd followers, and valuation practitioners.” —Patrick Terrion, principal, Founders Capital Management, and author of The Company You Keep: A Commonsense Guide to Value Investing “A useful addition to every value investor’s library.” —Bruce Greenwald, Robert Heilbrunn Professor of Finance and Asset Management, Columbia Business School “You will enjoy learning from real world cases how to apply the investment principles of the legendary Benjamin Graham and Warren Buffett Because of outstanding writing and some fascinating corporate and financial history, this book is an excellent way to learn how to be a successful investor.” —Dr Thomas J O’Brien, professor of finance, University of Connecticut, and author of International Finance: Corporate Decisions in Global Markets APPLIED VALUE INVESTING APPLIED VALUE INVESTING THE PRACTICAL APPLICATIONS OF BENJAMIN GRAHAM’S AND WARREN BUFFETT’S VALUATION PRINCIPLES TO ACQUISITIONS, CATASTROPHE PRICING, AND BUSINESS EXECUTION JOSEPH CALANDRO, JR Copyright © 2009 by Joseph Calandro, Jr All rights reserved Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher ISBN: 978-0-07-162819-8 MHID: 0-07-162819-3 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-162818-1, MHID: 0-07-162818-5 All trademarks are trademarks of their respective owners Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark Where such designations appear in this book, they have been printed with initial caps McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs To contact a representative please e-mail us at bulksales@mcgraw-hill.com This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, futures/securities trading, or other professional service If legal advice or other expert assistance is required, the services of a competent professional person should be sought —From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc (“McGraw-Hill”) and its licensors reserve all rights in and to the work Use of this work is subject to these terms Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited Your right to use the work may be terminated if you fail to comply with these terms THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE McGraw-Hill and its licensors not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting there from McGraw-Hill has no responsibility for the content of any information accessed through the work Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise For Terilyn, Forever CONTENTS Preface Acknowledgments hapter | The Basics and Base-Case Value Introduction Base-Case Valuation Conclusion hapter | Base-Case Value and the Sears Acquisition Introduction The Rise and Fall of Sears Valuing Sears Postacquisition Performance hapter | Franchise Value and the GEICO Acquisition Introduction GEICO Valuing GEICO Postacquisition Performance Appendix: Estimating GEICO’s Discount Rate hapter | The Gen Re Acquisition and Franchise Risk Introduction Gen Re and the Business of Reinsurance Valuing Gen Re Postacquisition Performance Conclusion Appendix: Assessing the Risk of M&A hapter | Macroanalysis, Opportunity Screening, and Value Investing Introduction Business/Boom-Bust Cycles The Eight Stages of a Business Cycle Recovery The “New Economy” Business Cycle New Economy Recovery Post New Economy Business Cycle Activity Conclusion Appendix –Warren Buffett and Efficient Market Theory Appendix –A Practical, Reflexive Fundamental Proxy Appendix –Enron hapter | A Graham and Dodd–Based Approach to Catastrophe Valuation Introduction Background Valuation Postmortem and Guidelines Conclusion and a Word on Catastrophe Bonds hapter | Financial Strategy and Making Value Happen Introduction Strategy Formulation Resource Allocation Performance Management Risk Financial Strategy Conclusion onclusion Introduction Screening Initial Valuation NAV Adjustments EPV Assumptions Franchise Validation Growth Valuation Final Valuation * I discuss discount rate estimation in the appendix to Chapter * The Conclusion addresses this in some detail * An exception is firms in distress, which exhibit a different value profile Distress-based investing is outside the scope of this book For a superb introduction, see J Ezra Merkin, “Blood and Judgement,” in Benjamin Graham and David Dodd, Security Analysis, 6th ed (New York: McGraw-Hill, 2008 [1934]), pp 265–288 * Franchise value and growth value are covered in Chapters and of this book * The Conclusion presents a process for accomplishing these types of activities * See Chapter for more information on the “new economy” boom and bust * Another point of friction pertains to market behavior Graham and Dodd practitioners universally reject the efficient market theory of financial economics I comment on this further in Chapter * The Conclusion addresses the subject of the investment opportunity screening process * The reasons for using the DJIA are discussed in appendix to this chapter * I have been advised by several people familiar with this deal that my valuation is “very close” to the actual price paid by PepsiCo, which was derived at odds of in 1,000 * Buffett rarely receives accolades for his strategic abilities, but I would argue that strategy is actually his core competency; valuation, investment, and M&A are simply the logical outputs of his strategic insights * Buffett rarely receives accolades for his strategic abilities, but I would argue that strategy is actually his core competency; valuation, investment, and M&A are simply the logical outputs of his strategic insights * From the popular, and deceptively simple, SWOT (or strengths, weaknesses, opportunities, and threats) strategic framework * For clarification purposes, I was not eavesdropping on this conversation; however, as I was directly across from these individuals, it was impossible not to hear their conversation, given how loud they were speaking * This is the same Eddie Lampert who purchased Sears, the valuation of which was the topic of Chapter ... approach and to say that in the case of Company X the fair value of the shares is the same as its book value because the earnings, dividends, and prospects support the book value Benjamin Graham and. .. variation on the value investing theme, it adopts the modern Graham and Dodd approach and applies it in a variety of unique and practical ways Specifically, the modern Graham and Dodd approach is applied. .. O’Brien, professor of finance, University of Connecticut, and author of International Finance: Corporate Decisions in Global Markets APPLIED VALUE INVESTING APPLIED VALUE INVESTING THE PRACTICAL APPLICATIONS