Lee Cooperman— “Buying Straw Hats in the Winter”

Fall 2011

Leon “Lee” Cooperman ’67, CFA, began his post- business school career in 1967 with Goldman Sachs. In addition to holding a number of key positions within the firm, Mr. Cooper- man was founder, Chairman and Chief Executive Officer of Goldman’s Asset Manage- ment division. In 1991, he left the firm to launch Omega Advisors, Inc., a value-oriented hedge fund which now manages roughly $5.5 billion. Mr. Cooperman earned his B.A. in Science from Hunter College and his M.B.A. from Columbia Busi- ness School. Mr. Cooper- man and his wife are signa- tories of Warren Buffett’s “Giving Pledge”.

G&D: After graduating from Columbia Business School, you began your very successful career at Goldman. What drew you to the sell-side following business school?

LC: Something that I should mention, before addressing my time at Columbia and Goldman, was my decision to not pursue a dental education. This was the most difficult decision I had made in my life up to that point. Back in 1963, if you completed your undergraduate major and minor in three years, you could count your first year of dental or medical school toward your fourth year of college and receive a separate degree. I finished my science major in the summer of 1963, which enabled me to enroll in dental school. After being in dental school for about eight days, I wasn't sure that was the direction I wanted to go. This became quite a traumatic situation. I had to go to the dean of the dental school and tell him I wanted to matriculate back into the undergraduate school to complete my fourth undergraduate year unencumbered. The dean put me on a great guilt trip, telling me that I had deprived the 101st applicant of a dental education, that the school would be losing revenues for the next four years and that I couldn‘t possibly know what I wanted to do after eight days. The only person who really appreciated the significance of my decision was the dean of Hunter College. I went back to Hunter and, since I had finished my major during the summer, took 10 elective courses in economics and received 10 A‘s. That furthered my interest in business.

Upon graduation I went to work for Xerox up in Rochester, NY as a quality control engineer. After about 15 months I decided I wanted to get an MBA to advance my credentials. I wanted to stay in the New York area and I was interested in finance, so Columbia was a natural fit. With great modesty, I would say that I was an attractive package coming out of Columbia Business School. I was Beta Gamma Sigma, had straight A‘s, a 6 month old child and was a serious person. Wall Street was hiring with abandon, a lot of which had to do with the market cycle. I was interviewing in 1966, which was a year in which the market was peaking, though no one knew that. I accepted an offer with Gold- man Sachs, which at the time was not what it would become a decade or two later. This was fortunate because I was able to contribute, in a small way, to the firm‘s later success. I got my MBA on January 31, 1967. I had a six month old child and I had no money in the bank so I was not in the position to take the obligatory trip to Hawaii or Australia.

I started as an analyst at Goldman the next day. I then spent close to 25 glorious years with the firm. I had a number of different roles in the company. For example I was made Partner in charge of research in 1976 and, at the same time, I was Chairman of the firm‘s investment policy committee. For a number of years, I had been telling Goldman management that we were making a mistake not being in the asset management business. The firm, being a brokerage house, was strongly opposed to what they considered competing with their client base. Every brokerage firm at the time was largely in this business. Once Salomon Brothers and some others announced their launching of an asset management business, Goldman leadership asked me to establish one of their own. I left research at that time and became Chairman and CEO of Goldman Sachs Asset Management.

This was the beginning of my exit from the firm. They wanted to capture as many assets as possible because they wanted to build the business to a scale that would be relevant to a firm like Goldman Sachs. On the other hand, my motivation was the proper performance of the assets in my control. I realized after a short time I didn't want to be on the road every week, introducing a new product and sourcing new funds. I wanted to spend my time visiting companies and finding new mispriced stocks. I wanted to manage money in such a way that my interests and the clients‘ interests were 100% aligned. I did not want to build a big business like Goldman Sachs wanted me to. I have the highest respect for Goldman, but it was the firm‘s reluctance to go into the hedge fund business that led to me start Omega.

My last day at Goldman was November 30th, 1991 and I started Omega the very next day. Over the past twenty years I‘ve been raising the money, hiring the people, running the money and setting up the infra- structure. It‘s kind of been non-stop. I‘m getting older but I‘m still handling it okay.

G&D: Did anyone or any investing class at Columbia Business School have a particularly significant influence on you?

LC: Yes, there was one person who had a profound influence on me. I even have a letter he sent me in 1977 hanging on my wall. His name was Roger Murray, Benjamin Graham‘s successor as the professor of security analysis at Columbia and, in fact, a subsequent editor of the book Security Analysis. Mario Gabelli, a very dear friend of mine, also studied under him and would probably say the same thing. As our value investing professor, he showed a great deal of excitement for the subject matter. I would also say Warren Buffett influenced me tremendously. I‘m an expert in his writings and his views. Finally, Graham and Dodd influenced me as well. Their book Security Analysis is sitting right there on my shelf.

G&D: How has your approach to investing changed to investing changed since 1991?

LC: Not in an appreciable fashion. The bulk of our portfolio is long-term oriented bets. We do a certain amount of trading — a quarter of our portfolio turns over more actively. I think the major change was a result of the drubbing most of us took in 2008. I did not do a good job of controlling losses. I invested a certain amount of responsibility in my associates and they showed, in the end, an inability to sell. So now I‘m more willing to sell when things don‘t look like they‘re going in the right direction.

I would sell a security for one of four reasons. The first reason is the highest quality reason. That is when you buy something with a price objective. When it appreciates to that price objective, and you think it‘s fully valued, you sell it. The second reason is when, based on calls to our companies, their competitors and their suppliers, things are not moving along the originally anticipated lines so you get out before you get murdered. It is very hard in this market, which is choppy and not really going anywhere, to make up for big losses so you have to sell before you get creamed. A third reason we sell is when we find an idea that‘s more attractive than the idea we‘re acting on already. So we‘ll sell something to buy something that we think has a better risk/reward ratio. Finally, the fourth reason we sell something is when our market outlook changes. Since I don‘t tend to buy and sell market futures to an appreciable degree, to effect this macro- driven repositioning, I have to sell specific securities.

So I would say the big change is my willingness to sell. This is very difficult for a value investor because if, for example, you liked Ford Motor at $20, you should like it more at $18 and even more at $15. But there are times when the market has figured out what‘s going on before you, the fundamentalist, have figured it out. Let‘s face it, although not perfect, the stock market is one of the better leading indicators. Some people are wary of the information the stock market is imparting because, they would say, it has priced in 10 out of the last 7 recessions. In my opinion, however, that‘s a better record than most economists.

G&D: What about the de facto value investing motto that if something you‘ve liked goes down, buy more and, if it falls further, just buy more?

LC: Well, there are those times when you‘ve made a fundamental mistake – you‘ve misjudged the company‘s competitive position, you‘ve misjudged the economy, you‘ve misjudged the stock market. I think you just can‘t afford to say, ―I know more than the market. Of course, it depends on the company. There are certain things you can be stubborn on such as when you have a big dividend yield, a big discount to book value, an extremely low valuation. But I think, gen- erally, you have to respect the stock market. If you don‘t, you‘re going to get wiped out.

G&D: How do you personally think about valuation? What types of techniques do you use?

LC: There are a lot of different approaches. We use the dividend discount model to identify undervalued stocks as a screen. Essentially, I know what the financial statistics are for the S&P and as a value investor, I‘m looking for more but for less. I‘m looking for more growth at a lower multiple. I‘m looking for more yield versus what I can get from the S&P. Or, I‘m looking for more asset value.

I‘d say a theme that runs throughout a lot of our portfolio holdings is the concept of public market value versus private market value. About 95% of publicly traded companies have two values. One is the auction market value, which is the price you and I would pay for one hundred shares of a company. The other is the so-called private market value, which is the price a strategic or financial investor would pay for the entire business. So one of the approaches I take is to look for a stock in the public market that is selling at a significant discount to private market value where I can identify catalysts for a potential change. In the last year we had four take-overs in the portfolio.

We try to find some set of statistics that motivate us to act. The analogy I have always used is that when you go into the beer section of the supermarket, you see 25 different brands of beer. There‘s something that makes you reach for one particular brew. In the parlance of the stock market, there‘s some combination of return-on-equity, growth rate, P/E ratio, dividend yield, and asset value that makes you act. We have a diversified group here looking for attractive ideas, and different industries get capitalized in different ways. If you want to be a broad- based investor you have to be willing to embrace different approaches. For example, although we are value- orientated investors typically looking at the traditional valuation metrics, we do have a technology analyst who is studying things like rate-of-change and following Citrix Systems and Apple, which we own.

G&D: What are the characteristics of a business that you‘d want to own for a long period of time?

LC: To me, it‘s free cash flow sine qua non because that gives you the ability to intelligently redeploy your money. If you don‘t have the free cash flow, you don‘t have anything. Number two is a business that has a moat around it, where it‘s competitively insulated to some large degree. There are very few businesses that actually have a monopoly position today. Quality of, and incentives for, management are also very important. We look at management ownership to see whether their interests are aligned with the shareholders‘ interests and we look for their compensation levels to be reasonable. The compensation levels in corporate America are ridiculous in my opinion, and this is a big problem today.

Hedge fund guys are over- paid but the good news about that is, you don‘t make the money unless you make the money for the investor. In corporate America, you‘re being paid to fail. A lot of times, guys are kicked out of companies and they leave with $10, $15 or $20 million checks, which I think is ridiculous. Back to free cash flow; I would obviously weigh-in the growth of the company too. I would love to own a company that has great investment opportunities in which it‘s investing a lot of cash. I just want to make sure the money is invested wisely. A company has a number of uses for free cash flow. Management could choose to reinvest in the business through capital expenditures, buy other businesses, reduce debt loads, or pay out dividends. I just want to make sure management is channeling their cash into the right opportunities.

Corporate America has been very busy, particularly in 2008, buying back stock. Most of them have not known what they‘re doing. There‘s been a large amount of money wasted. I gave a presentation at the Value Investing Congress in 2007 where I said a lot of companies were mispricing what they were buying. I washighly critical and provided many examples of this development. Analysts tend to be cheer- leaders for corporate repur- chase programs. In my view, these programs only make sense under one condition – the company is buying back shares that are significantly undervalued. Most management teams have demonstrated the total inability to understand what their businesses are worth. They‘re buying back shares when the stock is up, and have no courage to buy when the stock is down.

G&D: Can you talk about how you construct your portfolio?

LC: My portfolio construction is some combination of top-down and bottoms-up. We try to make money for our investors in a number of different ways. Stocks are high risk financial assets and short term bonds and cash are low risk financial assets.

First, we spend a great deal of time trying to figure out whether the market is going up or going down because that will determine both the predominant performance of our portfolio and how much exposure we want to have to risky assets.

The second way we try to make money is looking for the undervalued asset class. We look at government bonds versus corporate bonds versus high yield bonds. We think about bonds versus stocks, whether in the U.S. or in Europe. We‘re trying to look for the straw hats in the winter. In the winter, people don‘t buy straw hats so they‘re on sale. We‘re basically looking for what‘s on sale. In 1993, we made a great deal of money in non- dollar bonds because we made a play on interest rates that was very right. In 1995 through 1997, we made a great deal of money in the debt of Brazil, Turkey and other emerging markets. In 2002, we made a lot of money in high yield bonds, and the same is true for 2009 and 2010. So we‘re looking for the right asset class. Any study you‘ll read on portfolio returns will tell you that being in the right asset class is more important than being in any individual stock in any one year.

Third, which is the bread and butter business where I spend the bulk of my time, is looking for undervalued stocks on the long side. I have a very value-oriented approach.

Fourth, which has not been particularly productive for us, is finding overvalued stocks on the short side. Finally, we take 2–3% of our capital and invest in macro strategies. We might be long or short the dollar, we might be long or short a commodity. It‘s a small part of what we do but I like the macro strategies. The returns are not necessarily correlated to equities and at times you get a trend of opportunity that you can capitalize on. In my own opinion, the next big trended opportunity — though we haven‘t put the trade on just yet — is being short U.S. government bonds. They don‘t belong at 2%. They‘re just way too low. Historically, the ten year U.S. government bond yield has tracked nominal GDP. If you think we‘re in a world of 2–3% real growth and 2–3% inflation or potentially more, that would give you nominal GDP of 4–6%. So if the ten year government bond yield was in that range of 4–6% that would not be unusual. I would also add that, over the years, our portfolio has on average been 70% net long, though right now we‘re about 80% net long. We tend to be more in- vested than most hedge funds.

G&D: So you‘re optimistic about the general outlook for the market?

LC: We‘re more optimistic than most. We don‘t believe that we‘re going into a recession but rather an environment of slow growth. We don‘t think we‘re an- other Japan. That‘s our opinion as well as Jeff Immelt‘s and Warren Buffett‘s. Recent auto sales and recent chain store sales suggest a decent economic environment. I also assume that the ECB will do for European financial institutions what the Fed did for U.S. institutions. In the end, they have no choice and I think they‘ll do it. They need to ring-fence Greece though, and make sure the mess doesn‘t spread to Spain and Italy. One of the biggest concerns I have is social unrest. The labor force in America grows 1% per annum. Productivity of the labor force grows 2% per annum. So you need 3% growth to keep the unemployment rate flat and we‘re not growing at that rate. The global unrest and global demonstrations — ―Occupy Wall Street,‖ the demonstrations in Zuccotti Park, the Arab Spring, are all about unemployment. The frustration over the lack of economic opportunity, particularly by the youth, is understandable. People are looking for a scapegoat. I had hoped that Obama would move more to the center and soften his anti- wealth and anti-business stance. He doesn‘t seem capable of doing that and his election underscores the unrest I‘m referring to. The largest country in the free world chose as its leader a 48-year-old man who was a community organizer and had never worked in the business world. His election was a clear result of the frustration of the populace.

G&D: Is your technique for shorting mostly valuation driven?

LC: It‘s valuation driven or it‘s driven by a belief that the company‘s competitive position is in the process of changing. But if you look at the sources of our returns, short selling has not been an important part. The bulk of our returns have come from undervalued equities on the long side.

G&D: What have you learned from the market collapses of 2000–2001 or 2008–2009?

LC: We made money in 2000 and 2001 because we stuck with value. You only got creamed if you were buying these 100x revenues technology companies. So it was really 2008 that was a rough patch for us and it was very simple. We misjudged the significance of Lehman. As I mentioned, 2008 was transformative for me because, at the time, I allowed my people to hold onto their positions when I should‘ve started kicking them out well before we got into the hole. One thing nice about the investment business is that, even though I‘m 68, I continue to learn. You learn something every month and every quarter.

G&D: Could you describe the process your team goes through to generate investment ideas at the company level?

LC: When I hire an analyst, we put together a FactSet universe of companies that are within their sphere of expertise and those are the companies they follow. I monitor and judge their performance by how well they do penetrating the opportunities that Mr. Market has presented. The way it works is that the analyst proposes an idea. The stock selection commit- tee, which consists of four or five senior people at the firm, and me, dispose and debate the idea. This process represents about 75% of the activity of the firm. For example, this afternoon, we‘re discussing an apparel company that my analyst is strongly recommending we buy. He submitted his re- port for our review this afternoon. I ask these analysts, who are experts in particular areas, to find things that are going to out-perform the market. Later, we‘ll have a meeting about the New York Stock Ex- change, which the associated analyst is also recommending. Periodically, we‘ll operate with a shorter term timeframe because we think we‘ve developed some in- formation that other people don‘t have and we want to act on it before it becomes commonly known.

G&D: How do you evaluate management teams prior to making an investment?

LC: Benjamin Graham, in The Intelligent Investor, said you evaluate management twice in the decision-making process. Once, through the face-to-face interrogation. You ask them questions and they respond and you make a judgment about the quality of their responses. In addition, the quality of management also manifests itself in the numbers: in ROE (absolute and relative to competitors), return on total capital, growth rate, industry position, trend of market share, and profit margins.

G&D: Regarding the importance of management, with the unfortunate passing of Steve Jobs, how do you see Apple — one of your favored picks — impacted going forward?

LC: You can‘t replace a guy like Steve Jobs. At the end of the day, they have a pipeline of products already in place that could probably last several years and they generate something like $15-$20 billion a year in free cash flow on top of $80 billion in cash and market- able securities. No rational person would criticize Jobs but I will criticize the company for their financial management. There is no basis for sitting on $80 billion in cash and not paying a dividend and not buying back stock. They‘re projecting, in my opinion, temporary success. They‘re saying we don‘t know where the business is heading long term and we want to have this financial powerhouse. I‘m told by people close to Jobs that he wanted to do a con- tent acquisition, such as Disney if it had not been in the theme park business.

Regrettably, for the world and for him, he‘s not around to execute that ambition. I think Apple will do fine for a few years and we‘ll have to see after that. Right now, the major plus in Apple is the valuation. It seems ridiculously low for a company growing at its rate. Based on all of the checking I do, the users of the equipment at corporations are making purchasing decisions and the users all want iPads. They have a phenomenally high market share of a growing business that has very high profit margins. I‘m sure one day, Apple will have issues but for the next few years it looks like clear sailing. Jobs left behind a financial powerhouse.

Maybe one change that could be constructive is the better use of their cash. So you think eclectically. Apple has no dividend and no re-purchase program but they generate gobs of free cash flow and they‘re in the right business.

G&D: Many in the value investing community say that Apple is not a true―value stock. How would you respond?

LC: I think their definition of ―value‖ has to be broadened. It‘s not just about trading below book value. To me, ―value means the value proposition that is being offered. A lot of companies Warren Buffett owns would not be considered value in the classical sense. A company can be growing at an extremely high rate but happens to be trading at a very reasonable multiple. Or that same company can be giving you your return through a fat dividend. My analyst thinks Apple can earn $40 per share next year, which is 9.4x earnings. When this was printed, the S&P was at 11x earnings. So is Apple a growth company or is it a good value proposition?

What you want is some combination of financial statistics that yell, ―Buy me. It could be an unusually high growth rate at a proper multiple or it could be a return upfront with modest growth. I‘m very eclectic as an investor. In the 70s, the dominant investing institution was JP Morgan U.S. Trust, which espoused a philosophy of the ―nifty fifty. They only wanted to be in the best growth companies but had no regard for what they paid. They didn‘t care if they paid 60x or 70x earnings.

During the eventual recession which fol- lowed a surge in interest rates, the prices of these stocks declined 50% or more. The multiples were all wrong. Their philosophy was ―only the right stock at any price‖ whereas my philosophy is ―any stock or bond at the right price.

G&D: It would be great if we could discuss a couple of specific stocks that you find compelling today.

LC: Well, I like KKR Financial (ticker: KFN), where the debt management arm has the ingredients that I look for. Right now their dividend yield is 9.75% in a world of zero interest rates and the dividend is covered twice by earnings. They earn about $1.50-1.60 per share and they‘re only paying $0.72, so they can grow the business over time. The real book value is somewhere around $10 and the stock is $7.75. So I‘m buying something 20% below book, yielding in the high 9% range – which is competitive with the equity market‘s return annually, with motivated management that own a decent amount of stock in a decent business. KKR Financial is a mezzanine lender and they have the advantage of being on the KKR platform, which sees a lot of interesting deals.

Another one I like is Sallie Mae (ticker: SLM). Roughly 81% of their loans are guaranteed by the U.S. government and the bulk of the remaining loans are co- signed by the student‘s parent. So I think the quality of these assets is not bad. I think they‘ll earn $1.80 this year and the stock is $13, so half of the market multiple. The yield is about 3.5% and they‘re buying back 5% of their stock annually through the repurchase program and we think the assets are worth $20 per share. The company is a consolidator of FELP loans. FELP loans are shrinking part of all bank balance sheets and therefore will slowly be sold as they‘re not worth the effort to hold. Sallie Mae is one of the few natural buyers in the market and is able to achieve attractive double digit IRR‘s on these purchases. In addition, the ―sins‖ of Sallie Mae‘s past are burning off quickly. The amount of non-standard credit entering repayment is drop- ping very quickly. 2010 had $572 million enter repayment, 2011 has $320 mil- lion, and next year only $112 million. With 40-50% loss ratio on these ―non- standard‖ loans, credit at SLM will naturally improve. The company is shareholder friendly. As the FELP port- folio generates cash, we expect the company to complete the previously announced $300 million repurchase program this year, and repurchase $500 million in 2012. As financial institutions struggle for as- set growth, SLM could be- come a nice niche acquisition target for any large bank over the next several years in the low $20s range.

G&D: Could you walk us through other ideas that you find interesting today?

LC: I also like Boston Scientific (ticker: BSX). The company generates $1 billion a year in free cash flow, so you‘re getting a free cash flow yield of about 17–18%. They just achieved an investment grade credit rating so they‘re now in a position to take that cash flow and buy back stock or do tuck-in acquisitions to accelerate growth. Management seems very motivated to follow- through. Of course, the opportunity to buy cheaply is a result of their deal from hell, that being the acquisition of Guidant for nearly $30 billion. Now we think they‘re on the way back. Due to the past issues, investors seem unwilling to look at the value of the business objectively. Old management is gone. BSX‘s private market value is much greater than public market valuation. Financial buyers could easily pay $9.50/share. If the company was broken up and sold off in pieces or if a strategic buyer were to step in, BSX could fetch $13/per share based on public comps or transactions done in the past 24 months. It is a highly regulated business, and as it gets more regulated, it means that the costs of entering these businesses increase. Utilization will continue to increase with demographics and with healthcare reform, we will likely see more people coming into the system. In spite of pricing pressure, margins are still very attractive. The new management is shifting its focus on creating share- holder value in the near term, rightsizing cost structure improving profitability, selling non-core assets and buying back stock. Multiple new product cycles are coming in core franchises (stents, defibrillators, women‘s health), that will drive 500+ bps of operating margin improvement in the next few years.

We also like Transocean (ticker: RIG). The stock is currently around $50 and we believe there is significant upside to it. RIG is trading at a very low P/E, P/ CF, and EV/EBITDA multiples, and at a substantial discount to NAV and Tangible BV. The offshore drilling market is fast improving, especially in the ultra-deep water where RIG has the largest fleet. The overhang of legal issues from the 2010 BP―Macondo‖ disaster may start to be resolved over the next six months. RIG has a $3.16 dividend (6.7% current yield) that we believe is sustainable for years, so investors are being paid to wait. Long-term con- tracts on its deepwater fleet will recover most construction costs and reduce the basic risk of RIG‘s business. RIG‘s 2011 EPS reflects low―revenue efficiency: contracted rigs are out of service for replacement of Blow-Out Preventers. This process will continue through 2011 but then end, so ―revenue efficiency will return to historical 90%+ level, from 82% now. Many Wall Street analysts don‘t have higher ―revenue efficiency in their projections. We believe consensus 2012 EPS could rise by $1.00- $1.50.

G&D: Which personal attribute has contributed the most to your success over the years?

LC: I would attribute my success to hard work, surrounding myself with good people, and a fair amount of luck. I remind my team of this proverb often: ―Every morning in Africa, a gazelle wakes up; it knows it must run faster than the fastest lion or it will be killed.

Every morning a lion wakes up; it knows it must outrun the slowest gazelle or it will starve to death. It doesn‘t matter whether you are a lion or a gazelle. When the sun comes up, you‘d better be running. In the parlance of my business, I like to put this proverb in my own terms. There are roughly 10,000 mutual funds that will manage your money for 1% or less and there are roughly 10,000 hedge funds that have the audacity to ask for 1–2% management fees and 20% of the profits. Our clients have a right to expect more because they‘re paying more. So what that means is that when the market‘s high, I have to figure out how I can get hedged and when the market‘s low, I have to figure out how I can get leveraged to the opportunity. You‘re constantly on the balls of your feet. There‘s no relaxing. You come to work with a total commitment to the clients‘ interests or you go to work in a different industry.

G&D: What are the most common errors that you see analysts make?

LC: Misjudging a company‘s competitive position would be one. Making valuation judgments that are wrong is another. Then there are macro mistakes, such as underestimating the degree of discontent with the banks following the credit crisis, which is leading to higher capital charges and an inability for their earnings to grow. In every sector it‘s different. In technology, you may have overestimated the company‘s competitive position and underestimated the competitive threat from somebody else. You can‘t standardize the error.

G&D: Any parting words of wisdom for our readers?

LC: The best advice I can give anyone is exemplified by the following Andrew Carnegie quote: ―Here lies a man who was wise enough to bring into his service men who knew more than he. Always try to surround yourself with the very best people. Don‘t feel threatened by good people. You should feel that having them around is to your advantage. Lastly, no matter how rich you become, arrogance is not a luxury you can afford.

G&D: Thank you very much, Mr. Cooperman.