Value-oriented Equity Investment Ideas for Sophisticated Investors

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Investing In The Tradition of Graham, Buffett, Klarman

Year V, Volume II February 2012 When asked how he became so successful, Buffett answered: We read hundreds and hundreds of annual reports every year.

IN MEMORY OF VICTOR P. FASCIANI THE SMALL-CAP VALUE ISSUE

The funnel searching for small-cap ideas 20 companies profiled by MOI research team Proprietary selection of top candidates for investment Plus: Ryan Morris on First Marblehead Plus: Superinvestor holdings update Plus: Favorite stock screens for value investors
Small-cap companies mentioned in this issue include Almost Family, American Equity, Ameristar Casinos, Astex Pharma, ATP Oil & Gas, Aviat Networks, Avid Technology, Axcelis Technologies, AXT, Banco Macro, Benchmark Electronics, BGC Partners, Bridgepoint Education, C&J Energy, Calix, Callaway Golf, Capital Southwest, Career Education, Celadon Group, China Yuchai, Citi Trends, Comtech Telecommunications, Cray, Crexus Investment, Crimson Exploration, CTC Media, Daily Journal, DepoMed, Digital River, Exceed Company, First American, First Marblehead, FormFactor, Fox Chase Bancorp, FXCM, Gleacher & Co., Global Sources, Haverty Furniture, hhgregg, IDT Corp., Imation, Insperity, ITT Educational, KBW, Kindred Healthcare, Korn/Ferry, Life Partners, Majesco, Medifast, Medley Capital, Mesabi Trust, NACCO Industries, Natures Sunshine, NeoPhotonics, Neutral Tandem, Nova Measuring, Office Depot, OmniAmerican Bancorp, OmniVision, Oplink Comms, Pacific Biosciences, PDL BioPharma, PennyMac Mortgage, PetMed Express, Power-One, RadioShack, Rambus, RealNetworks, Rentrak, Rosetta Stone, Rubicon Technology, Skechers, Skullcandy, Spirit Airlines, Stein Mart, Stewart Information, Synaptics, Telular, Tessera Technologies, TransGlobe Energy, TriQuint Semiconductor, Unisys, United Online, Vanguard Health, Veeco Instruments, Vista Gold Corp., Vonage, Winn-Dixie Stores, Winnebago, Xyratex, and more. (analyzed companies are underlined)

Top Ideas In This Report

Capital Southwest
(Nasdaq: CSWC) 36

Rosetta Stone
(NYSE: RST) .. 74

Vonage
(NYSE: VG) 94

Also Inside
Editors Commentary .. 9 Superinvestor Update .. 13 Small-Cap Idea Funnel . 14 20 Small-Cap Value Ideas 24 Presentation on Boyd Gaming ... 102 Ryan Morris on First Marblehead . 106 Favorite Value Screens .. 109 This Months Top Web Links .. 118

About The Manual of Ideas

Our goal is to bring you investment ideas that are compelling on the basis of value versus price. In our quest for value, we analyze the top holdings of top fund managers. We also use a proprietary methodology to identify stocks that are not widely followed by institutional investors. Our research team has extensive experience in industry and security analysis, equity valuation, and investment management. We bring a buy side mindset to the idea generation process, cutting across industries and market capitalization ranges in our search for compelling equity investment opportunities. Visit the Members Area at http://members.manualofideas.com

Copyright Warning: It is a violation of federal copyright law to reproduce all or part of this publication for any purpose without the prior written consent of BeyondProxy LLC. Email support@manualofideas.com if you wish to have multiple copies sent to you. 2008-2012 by BeyondProxy LLC. All rights reserved.

Value-oriented Equity Investment Ideas for Sophisticated Investors

REMEMBERING VICTOR P. FASCIANI

Dear readers, If you have been an attendee of Ciccios Value Investing Seminar, you certainly would have met and heard from Victor Fasciani who passed away last week. By some strange stroke of fate, this was the very week that we were getting ready to publish an interview with Victor Fasciani. While we cannot bring Victor back to life, we can send the message loud and clear to Raquel, his surviving wife, and to his daughters, Gabby and Julia that we, his professional colleagues and friends, are not neutral bystanders. Vitaliy Katsenelson has set up a benevolent fund for Victors surviving children. In addition to words from Tony Contrucci (reproduced below), we have received expressions of regret from Guy Spier, Aaron Edelheit, Vitaliy and Alex Katsenelson, Ken Shubin Stein, Marcelo Lima, and others. Sincerely, John Mihaljevic

Message from Vitaliy Katsenelson: Victor left behind two daughters Gabby 9 and Julia 5. There is nothing we can do about Victors untimely passing but we can help his kids. We set up a benevolent fund for Gabby and Julias education. You can contribute to this fund by going to this website http://bit.ly/fascianifamily (this link will take you to the PayPal website where you will have an option to contribute using your PayPal account or a credit card). Victor always valued education, and we know that he would be very touched and appreciative that his friends and colleagues participated in the educational journey of his daughters. I keep going over in my head through conversations I had with Victor over the years. I keep remembering a smart, funny, thoughtful, modest, compassionate human being who was always there to cheer you up. Victor will be dearly missed!

Words from Anthony Contrucci: It is with deep sadness that I write to inform you of the untimely passing of my dear friend Victor P. Fasciani. Victor fell victim to what is believed to be a fatal heart attack on Thursday, January 19th. He is survived by his wife Raquel and two daughters, Gabby and Julia. Victor was an amazing man, husband, father, friend and brother. His intellect was only surpassed by that of the size of his heart. He lived life like a true Roman, one of passion, honor, and integrity and was never afraid to be himself or fight for a just cause. Victor meant more to me than words can describe. He was a mentor, business partner, and friend, whom I always called my brother. I love him very much and know he is in a better place. Victor was a student of Roman History and of Marcus Aurelius. He once shared with me an excerpt that he found, one that I believe truly embodies how Victor lived his life:
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Value-oriented Equity Investment Ideas for Sophisticated Investors

HOW TO ACT Never under compulsion, or out of selfishness, without forethought, or with misgivings Dont fancy up your thoughts No surplus words or unnecessary actions Let the spirit within you represent a man, an adult, a citizen, a Roman, a ruler. Taking up his post like a soldier and patiently awaiting his recall from life; needing no oath or witness Cheerfulness; without requiring other peoples help to achieve it, nor serenity supplied by others To stand up straight, not to be straightened Marcus Aurelius

Tonys funeral oration for Victor: I know my dear friend Victor is here with us today looking down from Heaven and both eagerly awaiting how long I will speak for and how, as he put it, flowery I will make it. However, I will honor him, his memory, and his teachings today by utilizing his favorite acronym actually probably one of the only acronyms he liked EOM = Economy of Motion And in this case, a slight variation, Economy of Words In my last conversation with Victor just a couple of weeks ago, after catching-up for a while, I for some reason felt a need to thank him again for everything he has done for me, taught me, and for how much he always believed in me. I went on to apologize for not always being the best student and told him that I loved him. He said, and I quote, If all I ever taught you was economy of motion and words then that would be enough. Victor taught me many things. And it was an honor and a privilege to be a part of his life. He was a great man! He was intelligent, honest, and loving. He had an uncanny ability to share his vast knowledge on a variety of subject matters while remaining humble and sincere. He detested hubris and always strived to be the best version of himself that he could be regardless of what he was doing. Victor was driven and led by example. He was full of passion passion for knowledge, for food, for life, bust most importantly passion for his family, for his wife Raquel and beautiful daughters Gabby and Julia. He was passionate about wanting to make a difference in the world and to work on projects that mattered. What I hope he did not fail to notice was that he did make this world a better place. He touched the lives of so many, always lending a helping hand when possible and being a friend when needed. You could not but help to feel he was a man of integrity, character and honesty. I owe so much of who I am today to him. He has helped mold me into the man that stands before you today and I will continue ahead with both Victor in my heart and his many cherished lessons in my mind. I know that Victor is in a better place and that we will all be together again some day. Only God knows the why and only God himself could have taken him from his beautiful family for he loved them more than words can say.
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Value-oriented Equity Investment Ideas for Sophisticated Investors

Interview with Victor Fasciani: On December 27th, Victor Fasciani sent us the following responses to our interview questions. By publishing the questions and answers below, we honor the memory of Victor and remain forever indebted to him for his willingness to share and teach. The Manual of Ideas: Tell us about the genesis of your firm. What goals did you have at the outset, and what principles have guided you since then? Victor Fasciani: As is the case with many managers, I began by managing my own capital and soon after included family and friends. Initially, my goal was to manage the small portfolio while I continued to perform my work in emerging markets, primarily Eastern Europe. Id been investing in equities on my own for several years, and value investing appealed to me from the beginning. I was spending a lot of time working with private companies and business-like investing made the most sense. Ive generally maintained the same operating principles since; Id rather look at a few companies and learn as much as I can about them than dilute my efforts. The circle expands a bit each year; and I firmly believe that we, as investors, should always be learning and maintaining our intellectual curiosity. MOI: When it comes to stock selection, what are the key criteria you look for in potential investments? Fasciani: Im primarily interested in a history of strong cash flow generation (and a low price to FCF), or, in the case of E&P companies, a propensity to acquire core assets that have the likelihood of producing strong cash flows. Strong balance sheets (total debt to current asset ratio of one or less is ideal), significant insider ownership, seasoned management with a strong track record. Those are my primary criteria, beyond that there is more to be done in terms of valuing assets, assessing qualitative information, etc. Sometimes stocks are cheap for a good reason. MOI: How do you generate investment ideas? Fasciani: I generate ideas in several ways. Some are typical (screens, Value Line, and other high-quality sources). I have the privilege of communicating with some great investors Ive gotten to know over the years (too many to mention, dont want to leave anyone out, but I value their input immeasurably) a valuable resource. Perhaps more atypically, I read a lot of industry journals and websites (e.g. Oil Drum, Rigzone, etc), and more general publications such as The Economist and FT. These provide me with a 30K-meter view of things. From there I can identify themes and ideas that are worthy of closer study. MOI: You have discussed Contago Oil & Gas as an investment in the past. What is your current view of natural gas exploration and production companies, and do you have an updated thesis on Contango? Fasciani: Since I presented Contango in the past, we have witnessed how far oil and gas drilling technology has come. Difficult formations to develop, such as the Barnett Shale in Texas and Marcellus in the Northeastern U.S., have become productive due to advancements in fracking and horizontal drilling. The pace of this activity has been astounding, and has clearly kept a lid on natural gas prices. This relatively new supply of North American natural gas is clearly good news for end users, but producers, onshore and offshore, face the challenge of operating their businesses in a well supplied market. Contango Oil & Gas is no different in this regard. What they do have going for them is their unique operating structure:
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Value-oriented Equity Investment Ideas for Sophisticated Investors

outsourced geological/exploration/recovery services, a debt-free balance sheet, high insider ownership, $100 million stock buyback. With low natural gas prices and a relatively slow recovery in industrial demand, it is critical to be a low-cost producer. Contango is profitable and generates a 15% ROE (versus industry average of 11%), even in this low price environment. Thus, the thesis has changed a bit based on lower natural gas price assumptions, but I still believe it represents a solid investment in the natural gas sector; even more so once natural gas demand improves and prices revert more toward the mean (about $6 per MMBtu at Henry Hub). MOI: How do you assess the quality and incentives of management, and what CEOs do you admire most? Fasciani: Track record and longevity of management is one of the best ways to assess their effectiveness. Their ability to stay focused on the business and achieve attainable goals is invaluable. Incentives are quite powerful, as Charlie Munger has discussed in great detail, and are best evaluated by an investor in terms of how the incentives align with measurable improvements in the companys performance. Some of the CEOs I most admire include Peter Rose of Expeditors International, Ken Peak of Contango Oil & Gas, and Menderes Akdag of PetMed Express. MOI: In investing, good ideas are only one piece of the success equation. Skilled portfolio management is indispensable. What are the biggest challenges you face as a portfolio manager? How do you manage risk? Fasciani: One challenge we face is the ability to adapt to conditions we may never have encountered before. Few managers have been around long enough to have seen it all. I was around for the dot com bust, but never experienced anything like 2008, for example. We, as value investors, tend to be a bit dogmatic about simply picking companies that are significantly undervalued, hopefully with some catalyst that will allow them to appreciate in value. At the same time, we must try to be aware of what environment we are investing in. That can work fine much of the time, but in a period such as 2008, it basically becomes irrelevant. The economic environment became so fraught with peril that few stocks were immune, as we all experienced to one degree or another. I do not believe we can become market prognosticators or technical analysts (nor should we), but we can be mindful of economic conditions and how they could affect our portfolio. This requires time and experience and the ability to analyze our own mistakes as objectively as possible; so managing risk comes down to paying some attention to the forest, not just the trees. MOI: To what extent do you employ short-selling? Fasciani: I have always employed short-selling. It can be a valuable tool when employed properly. Thats often easier said than done. Theoretically, of course, a short has unlimited loss potential. Momentum stocks are especially difficult to short, because they can not only maintain an irrationally high price for an extended period of time, but can climb even higher. There is a hedging element to shorting that can be quite valuable and cant be ignored. In selecting shorts, I try to stick to companies that are suffering from severe impairment, extreme competitive pressures, combined with excessive valuation. I do not short a stock based purely on excessive valuation. During rare extremes (2000, for example), I was as much as 40% net short. Typically that percentage would be closer to 20% net short. MOI: How has market volatility over the past three years affected your investment process, and have you tweaked your approach in any way as a result?

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Value-oriented Equity Investment Ideas for Sophisticated Investors

Fasciani: Ive looked at data (its one data point, but very interesting) that shows that market volatility has increased over the last six decades (and clearly over the last three!). I believe it becomes more of a distraction than anything as far as long-term returns are concerned. I still believe a stock will approach its intrinsic value over a reasonable time period. The key is patience. Volatility clearly benefits short-term traders. With high frequency trading becoming all too common, I would expect volatility to be with us for the foreseeable future. Where it becomes a factor for value investors, who tend to prefer more concentrated portfolios, is the appearance of lumpier returns. If the investor can live with that, I think its less of an issue. Thus, although Im mindful of volatility, I havent really tweaked anything to counter it. It does affect me in terms of my preference for small- and mid-cap equities, but thus far over a rather short period of time. MOI: What is the single biggest mistake that keeps investors from reaching their goals? Fasciani: In my view, the biggest mistake investors make is to deviate from their original plan. This is not to say that one mustnt diligently monitor their investments to determine if anything significant has changed within their holdings, or re-examine their thesis if they have made a mistake. However, in a world with a 24-hour news cycle, multiple outlets for news and information, including the Internet (websites, blogs, videos), it has become more important than ever to discipline oneself to tune out the noise. MOI: What books have you read in recent years that have stood out as valuable additions to your investment library? Fasciani: One that stands out recently is The Billion Dollar Mistake: Learning the Art of Investing Through the Missteps of Legendary Investors by Stephen Weiss. I happen to agree with the axiom that we learn more from our mistakes than from our successes, and this book provides valuable insights into the investment mistakes of otherwise highly successful investors. Another is The Quest: Energy, Security and the Remaking of the Modern World by Daniel Yergin. Despite the somewhat overwrought title (and over 800-page length), this book provides some much needed context in terms of understanding global energy markets/production and changing geopolitical factors.

To contribute to a benevolent fund for Victors two surviving children: http://bit.ly/fascianifamily

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