MA enterprise value: $30.8 billion.

MA 2010 est. EBITDA: $2.8 billion.
MA 2011 est. EBITDA: $3.3 billion.

Est. 2010 closing EV/EBITDA ratio: 10.5X
Est. 2011 closing EV/EBITDA ratio: 8.5X

Mastercard's global growth rates seem to be unappreciated by North American investors.

Q1, 2010 revenues came in a $1.31 billion, up by 13.1%. This surpassed the highest view of $1.28 billion for Q1 and the analyst consensus of $1.27 billion. Earnings came in at $3.46 US per share, ABOVE the highest view of $3.40, ABOVE the whisper number of $3.35 per share and 10% above the consensus estimates of $3.14 per share for the quarter.

EBITDA in the quarter was $735 million, or 55.8% of net revenues, a record since inception. Net liabilities fell by $568 million in the quarter.

click here to download the company's press release

click here to see the transcript of the company's earnings call

Mastercard has little respect from a "US centric" North American analyst community.

Mastercard became a publicly traded company in May 2006. At year-end 2005, the firm reported total revenues of $2.937 billion and EBITDA of $592.4 million, a margin of 20.1%.

At the end of fiscal 2010, Mastercard revenues may exceed $5.75 billion, with EBITDA surpassing $2.8 billion, a margin of 48.7%. Should this be proven correct, on an absolute basis, EBITDA will grow by approximately 472%, on revenue gains of 96%, during a five year period.

EBITDA increases of this magnitude occur at companies with largely fixed costs. Mastercard has proven an ability to keep costs in check throughout the past five years, while expanding revenue at a 14.5% compounded annual clip.

Despite a share price gain of more than 540% since issue, Mastercard is selling for roughly the same forward relative valuation, as in 2006. EBITDA growth has risen, virtually lock-step, with share price appreciation. The balance sheet improvements are equally notable. At the end of 2010, Mastercard's balance sheet will have moved from a position of net liabilities, in the range of $2 billion, to what looks to be a totally debt free position and a modest net cash balance. 4 million outstanding shares will have been retired through share repurchase since IPO.

Subsequent to IPOissue, MA has beaten analyst views on revenues and earnings EACH and EVERY quarter, sometimes by amounts sufficiently high, so as to call into question, the modelling systems adopted by various analysts. Q1 2010 proved, yet again, that analysts do not seem to be able to accurately compile various components of the international revenue streams. Visa, the larger competitor, did not beat consensus expectations on revenues and earnings by analysts. This represents a paradox for analysts. One can easily and logically conclude a confirmation bias exists in favour of Visa, and against Mastercard.

Mastercard is a larger issuer of credit cards than debit cards. Analysts are bullish on the outlook for debit, less so for credit. Mastercard's historic emphasis on credit, rather than debit, represents another point of contention with analysts. Many are of the opinion that Mastercard will not be able to fully participate in a secular trend towards debit.

Analysts and individual investors alike often report that Visa is more than 2X the size of Mastercard in the US, and extrapolate this market share on a global basis. Such a view represents a fallacy. Globally, Mastercard's business is roughly 67% the size of Visa.

Mastercard derives more than 55% of revenues outside of the United States, and has key strengths in emerging markets such as Brazil, Asia and Mexico. 66% of the total number of cards, carrying the various Mastercard brands, are outside of the United States. 60% of gross dollar volumes (GDV) processed by Mastercard are generated outside of the United States.

http://phx.corporateir.net/External.File?item=UGFyZW50SUQ9MjY5NTMzOHxDaGlsZElEPTM2ODM5MHxUeXBlPTI=&t=1

The Asia Pacific region is Mastercard's fastest growing market. In Q1, 2010, GDV in this region represented 22% of total volumes, up by 20.9% year over year. In 2009, Asia Pacific GDV represented 18.7% of the total.

http://phx.corporateir.net/External.File?item=UGFyZW50SUQ9Mjk3NzAyOXxDaGlsZElEPTM4MDQxNHxUeXBlPTI=&t=1

Latin America GDV accounts for 7.8% of Mastercard's total. A year ago, Latin American GDV was 6.7% of the total.

In aggregate, Asia and Latin America are Mastercard's second largest overall market, ahead of Europe and behind the US. Should present trends continue, by mid- 2011, Asia and Latin America will become Mastercard's largest market, as measured by GDV.

While Visa and Mastercard represent a de-facto duopoly in global credit/debit, there is a substantial difference in valuation, between the two firms.

Visa (V-NYSE, $83) has 737 million shares outstanding on a fully diluted basis and currently has net liabilities of $3.52 billion. This represents an enterprise value of $64.9 billion. Visa should report 2010 EBITDA of $4.7 billion. Visa has currently made a dilutive purchase (Cybersource) to be completed later this year; total liabilities should remain unchanged through the 2010. Visa's 2010 year end EV/EBITDA looks to be in the range of 13.9X.

Mastercard has a current enterprise value of $30.8 billion and should report 2010 EBITDA in the range of $2.8 billion. The year-end EV/EBITDA ratio looks to be 10.5X.

Mastercard generates less than 67% the revenue of Visa and produces 62% of Visa's EBITDA. As an offset, Mastercard sells for roughly 44.6% of Visa's 2010 year end EV/EBITDA ratio.

Both Mastercard and Visa are well positioned to capture the secular global move to a cashless society.

As processors, Mastercard and Visa remain immunized from direct credit risk. They generate revenues from license fees, cross border assessments and a modest percentage of the interchange fee charged to merchants who rely on their global payment systems.

There has been periodic upheaval in the share price of Mastercard throughout the years 2008-2010. At first, criticism was levied regarding the earnings reliability throughout the global slowdown in 2008-2009. Such fears of earnings compression proved to be wholly unfounded.

In the case of Mastercard, revenues have grown by a solid 25.3% from 2007 to year-end 2009. Processed transactions were up 19.5% over the same period. Operating expenses have not changed significantly in the last several years. Almost all of the increase in revenues fell directly to EBITDA, and subsequently to the bottom line.

Capital expenditures to support and grow the Mastercard network have approximated $162 million per annum, for the last 3 years. This is approximately 3% of annual revenues.

The initial fixed costs of setting up competing businesses are extremely high, which is a key barrier to entry. Fees paid to processors are miniscule on a per transaction basis. Economies of scale are therefore almost impossible to achieve for new entrants to the business, which represents the other barrier to entry. For these reasons, I do not own the smaller processors, which include American Express and Discover. Visa and Mastercard produce some of the highest non-cyclical profit margins on the planet. With fixed costs in check and rapidly declining interest charges, future revenue gains may produce disproportionately high bottom line profits. Frankly, they both operate terrific businesses that are virtually impossible to replicate, in scope and scale.

Two banks are attempting to set up a credit and debit processing partnership in Brazil, which will report start up assets in the range of $8.5 billion, before adding in debts. The partnership hopes to generate roughly $600 million of total profits in the next five years, ($120 million per year), a modest 1.4% annual return on invested capital. Such a start-up cost certainly reinforces the current value of highly profitable businesses operated by Visa and Mastercard.

Visa is certainly more advanced in the debit card market.

US consumers completed more debit transactions than credit transactions in 2009. Analysts reported this as a tipping point. Whether or not the emphasis on the use of debit vs credit can be considered a permanent trend remains to be seen. It is my contention that at least a portion of the debit increase in the US, and to a lesser extent Canada, is largely cyclical. Should the US economic recovery continue, it is my belief that credit trends will revert to the norm. Debit usage will continue to increase, but credit could recover very quickly.

Globally at Visa, debit card use accounted for approximately 57% of gross dollar volume

http://finance.yahoo.com/news/Visa-Inc-Posts-Strong-Fiscal-prnews-1476842592.html?x=0&.v=1

Mastercard's perceived current weakness in US markets are not nessarily reflective of a global trend.

Insofar as debit is concerned, Mastercard's international operations represented 17% of gross dollar volumes for Q1. Total debit (including US) represented 33.7% of gross dollar volumes for the quarter. As with Visa, Mastercard also reported US that debit usage surpassed the use of credit in Q1, 2010.

Internationally, Mastercard reported debit volumes were up by 33.2% in Q1. On an absolute basis, Mastercard debit is smaller both domestically and globally, than Visa. However, Mastercard's growth rates in debit are quite comparable to that of Visa.

http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MzgwNDA5fENoaWxkSUQ9MzgwMzc1fFR5cGU9MQ==&t=1

Recent criticisms impacting Mastercard's share price, as well as that of Visa, reflect the possibility of interchange fees moving towards a regulated structure, in the US.

Retailers continue to try to have US congress cap the interchange fees. The implication put forth by mainstream media is that the lobby group of Visa and Mastercard is weaker than the lobby groups of retailers, and will therefore lose out in some sort of regulatory end run.

http://www.reuters.com/article/idCNN0511837420100505?rpc=44

http://www.gao.gov/new.items/d1045.pdf

What media outlets fail to take into account, is that a full 85% of interchange assessments go to the member banks of the credit and debit card systems. Almost $40 billion of total interchange fees were paid to the issuing banks in 2009. Retailers are really fighting banks. Mastercard and Visa, as partners with the banks, are certainly exposed, but represent more peripheral players.

Banks and financial services presently account for more than 2X the amount of US GDP, when compared to retailers. Banks are an incredibly powerful lobby group (some argue too powerful) and will neither willingly give up either current fees, nor will they give away potential fee growth, without a fight. Both banks, V and MA argue that assessments are made against merchants, not consumers; the issue in their mind is one of "business to business" and need not be regulated.

http://online.wsj.com/article/SB10001424052748704905704574622722184163510.html

In a worst case scenario for Visa and Mastercard, any potential cap on interchange fees could, in all likelihood, simply be replaced by a new type of fee which would be levied, so as to offset interchange caps. Such a fee could be similar to the dreaded "system access fees" consumers pay for mobile cell services in certain parts of the world.

What businesses are doing, essentially, is attempting to shift the burden of the interchange payments off of their backs, and directly to the backs of consumers. There is no free lunch. Consumers are already indirectly paying the interchange fees; merchants build into merchandise selling prices an amount equal or greater than, the current assessments. In the event that interchange fees are capped or reduced, it is highly doubtful that merchants will then reduce product prices by an amount equal to interchange fee reductions. What is attempting to be accomplished, is simply a lateral transfer of profit away from card issuers to merchants.

Since the earnings report of May 4th, 2010. Mastercard shares have fallen by 12.1%, far greater than the average decline of US equity markets as a whole.

Visa shares have also fallen by approximately 12.5% since the release of their last quarterly financial report. It would appear that a portion of the pullback may be attributable to the potential for some regulatory fee cap being imposed at a congressional level. Whether or not this comes to pass, or whether it will have an impact on the business remains to be seen. Interchange fees are now regulated in Australia; according to financial reports ay Visa and Mastercard, no material challenges to the business model or profitability in that market occurred. Many of Mastercard's primary markets already carry higher degrees of regulation than the US. With a larger US business, Visa will be potentially impacted to a greater degree than Mastercard, should punitive regulations go into effect.

Investment markets have generally been weakened by a key national issue coming from Europe.

The current risks of a default in the national debts of Greece are cause for concern but are possibly very overblown. Greece is not a substantial economic power. With a population of just 10.8 million persons, Greece is the 34th largest economy on the globe, but is the 17th largest external debtor. It is a government heavy nation; more than 40% of GDP comes from public sector employment. Some government employees are paid bonuses simply for showing up to work on time. Direct EU aid represents about 3.3% of Greek GDP per annum. GDP is about 2/3 per capita that of leading Eurozone nations. National tax policies are lax, collections are uneven and the cash economy is rampant.

https://www.cia.gov/library/publications/the-world-factbook/geos/gr.html

Through direct subsidy, Greece has been effectively "propped up" by EU aid for many years now, and will continue to be afforded substantial aid in the future.

A country of 10.7 million people is simply is too small to have meaningful negative impacts upon forecast global growth. However, investors are now becoming preoccupied with a fear that Greek "contagion" will spread to other nations in the EU. Three nations have come under increased scrutiny of late, Spain, Portugal and Italy.

Spain has a 20% official unemployment rate, to be sure. This is not a new phenomenon; in fact Spanish unemployment rates have been structurally high for more than 20 years.

http://www.allbusiness.com/public-administration/national-security-international/524124-1.html

High unemployment rates in Spain are a more or less permanent paradox. Many of the officially unemployed in Spain are actually "double dipping"; they generate tax free cash incomes in Spain's large underground economy, while simultaneously obtaining tax assisted government benefits, or "Paro". It is widely assumed that the black market economy now equals 25% of reported Spanish GDP per year.

Portugal has a more diversified economy, a lower budget deficit and workers willing and able to be work for wages roughly 2/3 that of Greeks. Spain, Italy and Portugal are less dependent upon EU aid, and are not in the same leaky boat as Greece.

Italy has the largest black market, or "shadow" economy in all of Europe.

http://www.theflorentine.net/articles/article-view.asp?issuetocId=1262

In my view, the risks of a Greek domestic capital crisis spreading throughout the rest of Europe are as likely today, as was the likelihood of the swine flu becoming a true pandemic last year; not likely. However, a common underlying thread of Italy, Portugal, Spain and Greece is the absolute size of their underground cash economies. Reform is required to "out" these substantial shadow economies, so that tax revenues can be paid. Some external shock is required to affect the changes, as their domestic governments refuse to do so. Hopefully, this is presently underway.

http://finance.yahoo.com/news/Stocks-slide-anew-but-its-apf-4109518464.html?x=0&sec=topStories&pos=1&asset=&ccode=

A greater blow to the credibility of North American markets recently came about from the VERY recent disclosure of Goldman Sachs discussing an SEC settlement on their mortgage securitization issuance activities.

http://online.wsj.com/article/SB10001424052748704370704575228232487804548.html#articleTabs%3Darticle

Such a settlement, if reached, will confirm long held suspicions by investors at large that we operate at a considerable disadvantage to a select number of financial institutions.

It is equally important to note that true financial reform cannot occur, when those who are supposedly overseeing the financial firms, find themselves in a position to earn outsized financial benefits by trading on material non-public information.

http://finance.yahoo.com/tech-ticker/congress-refuses-to-outlaw-insider-trading-for-lawmakers-478701.html?tickers=^dji,^gspc,^ixic,brk-a,brk-b,gs,xlf&sec=topStories&pos=9&asset=&ccode=

Key government officials have clearly demonstrated their abilities to drive down the shares of Mastercard and Visa by more than 6%, over and above normal market fluctuations. This was effectively accomplished simply through discussing the placing of an addendum to a bill. Competing bank lobby groups will now go to work on lawmakers. Nevertheless, negative media attention has been generated. Unfortunately for investors holding securities other than Visa and Mastercard, such negative government pronouncements for index stocks created a ripple effect one that spilled over into other securities. So long as officials are also in a personal position to sell shares short, without the requirement of disclosure, their motivations for spreading rumour may certainly be called into question. I estimate that more than $8.6 billion of the market cap decline in Visa and Mastercard is directly attributable to potential interchange proposal. Quis Custodiet ipsos custodes?

http://rightsoup.com/insider-trading-illegal-for-you-but-not-for-congress-hr-682/

Trading volumes and selling pressures for Visa and Mastercard spiked VERY dramatically for 2 days, immediately prior to the announcement that a government official is considering adding an interchange fee amendment, to a forthcoming bill.

Pundits may shortly discuss potential negative impacts of a spending slowdown in the Mediterranean Eurozone nations.

Some have already concluded that Greece will fall into a period of economic malaise that will require a decade or more to recover. More worry that Italy, Spain and Portugal will soon follow suit. An inference might be made that conclude Mastercard and Visa will experience sharp reductions in European processing. This is unlikely.

What the mass media will inevitably fail to take into account, and what this article has pointed out earlier, are that Italy, Greece, Spain and Portugal represent the four largest "cash" economies in the EU. Even should all four nations fall into an economic recession, payment processing rates are likely to be unaffected. Those who pay with cash don't generate a dime of revenue for V and MA. Credit and debit volumes, according to Visa and Mastercard, in Q1,2010, grew by rates significantly above that of the US. Most of this growth came from the northern and central regions of Europe. Recent declines in the Euro will make these nations, which are the key "producing" economies of Europe, even more competitive going forward. In fact, there may be longer term unintended benefits of PIGS (Portugal, Italy Greece and Spain) reform for V and MA. Any substantial reforms in these cash economies will create more non-cash processing, down the road.

Mastercard represents one part of a duopoly presently benefitting from one of the planet's defining secular trends; a move from cash to electronic payments.

The business model of Mastercard and Visa proved itself out during a period of below average global growth. At less than 10X my 2011 forward EV/EBITDA estimate, shares of Mastercard now look to be about as cheap, on a forward basis, as they were shortly after the IPO.

I feel that Mastercard has significant earnings leverage, should credit use increase in a more broadly based economic recovery. The secular trend towards increased debit use will continue; Mastercard seems well positioned to grow the debit business as well.

After several years of holding shares of Mastercard, without either buying or selling, RMG#1 has recently moved to add some shares of Mastercard to the account.

At the current price, it is my view that Mastercard is presently valued as a broken growth stock. Mastercard is the more international investment in the card processing market, as compared to Visa. In about a year, Asian and Latin American processing by Mastercard will surpass that of the US.

Mastercard's growth story, which never abated during the economic slowdown, is likely to accelerate in the near to mid-term. Interchange fees improve for Mastercard and Visa when average ticket size increases. Purchases on credit are historically much higher than purchases on debit. Mastercard's revenue stream is credit oriented. Only modest growth in the use of credit cards is necessary in order to produce a material revenue "shock" to the top line.

By the end of 2010, even using my conservative determination of EV, Mastercard should boast a net cash balance. Significant forecast net cash balances, in the years to come, may be used to repurchase stock, raise the dividend and be invested for organic growth.

Opportunities to invest in a strong, highly profitable and non-cyclical company, for less than 9X 2011 EV/EBITDA, generally only present themselves during bouts of fear. The Dow Jones Industrial Average is now down for the year, as of the close of business on Friday, May 7th, 2010. Clearly, this appears to be such a time.

Visa is also currently selling for a valuation well below its growth rates in revenue, EBITDA and earnings. I consider the shares of Visa to be attractively valued. Visa has recently increased their merchant assessment rates, to be effective July, 2010. Q3, 2010 earnings for Visa could surprise to the upside. I will seek to increase the RMG#1 position in Visa shortly.

On Friday, May 7th, 2010, I added to my personal position in Mastercard.

Brazil's #2 and #1 Appliance and Electronics Retailers Merge: Transformative for Compania Brasiliera De Distribuciao (CBD-NYSE, $72.15)

Compania Brasiliera De Distribuciao (CBD), a holding of RMG#1, and a business recently profiled, has announced the largest joint venture in its corporate history.

Management has announced the intention to merge the recently purchased white goods retailer, Ponto Frio, into Casas Bahias, a privately held company.

CBD will add all of Ponto Frio's retail stores, all corporate real estate of CBD and shares. After this non cash consideration has been paid, CBD will own a modest control position (51%) of Brazil's largest appliance and electronics retailer.

Casas Bahias is the 800 pound gorilla of appliance and electronics retailing in Brazil. In 2008, the total white goods and electronics market in Brazil was estimated to be $38.8 billion US. Casas accounted for 27.6% of this market, or $10.6 billion US. Ponto Frio, CBD's appliance retailer, was a very distant #2 in the market, with 2008 sales estimated to be $1.5 billion. On a pro forma basis, combined estimated 2009 sales of the two companies may be in the range of $15 billion US.

The market for appliances and electronics in Brazil is forecast to grow, by North American standards, at what would be considered to be explosive rates.

By 2013 the total white goods and electronics market is estimated to reach sales of $77 billion, vs. $38.8 billion in 2008. This is a potential CAGR of 14.8% per annum.

As a private company, Casas Bahias does not make its financial records available to the public. However, CBD notes that synergies from the combination of the two firms may amount to more than $696 million per year, when all integration is complete. It seems easy to determine where the savings will occur. As a private firm, Casas Bahias did not have access to the relatively lower cost credit enjoyed by CBD. There will be major purchase savings, as well as substantial savings on administrative costs. EBITDA margins on the combined firms should rise.

To place this accretion into perspective, I had previously forecast that CBD, on a stand alone basis, would have the potential to generate roughly $790 million in 2009 EBITDA. As the deal is being done with both real estate as well as stock, current shareholders should benefit a dramatic improvement in EBITDA per share, on a go forward basis. Purchases of private entities are generally far cheaper than purchased of publicly traded firms. I do not know the total stock consideration to be paid in the deal as yet, but potential EBITDA enhancement could be as high as 20%, in the near term, for existing shareholders.

There is a compelling strategic motive for the purchase.

CBD, by taking a 51% holding in Brazil's largest appliance retailer, has eliminated a potential tie-up of Casas Bahias with either Wal-Mart or Carrefour, CBD's two largest rivals. The chairman of Casas Bahias, Samuel Klein, is 77 years old. He is often called "Brazil's Sam Walton". Casas Bahias has built a dominant market share in Brazil, by extending credit to lower income buyers, when traditional banks would not.

Such a joint venture makes sense, if one believes the following.

1. Brazil, as a nation, may benefit from lower overall credit expenses in the future. In the past, Brazil has suffered through periods of extremely high interest rates. However, a growing global recognition of Brazil's forecast GDP growth rate, coupled with the strength of their national balance sheet, could mean that the country's national credit rating will result in a gradual decline in their cost of borrowing. This could flow through to both banks and non bank entities.

Should this prove to be the case, the combined Ponto Frio and Casas Bahias may stand to generate increased credit spreads on their financing plans, in the future. Such a benefit would be incremental to the current forecast synergies.

2. Brazil, as a nation, will grow in stature as an investment market. The country has few publicly traded stocks available as ADR's to foreign investors. Most of these are already represented in institutional accounts. I referred to this in my earlier write-up on CBD, using the term "herding".

After the deal closes, CBD will have a commanding lead over Wal-Mart and Carrefour in Brazil, in terms of market share. There is every possibility that CBD, a little known firm to foreign institutional investors, will quickly become part of the institutional "herd". Prior to institutional purchases, it is common for a flurry of glowing research reports, on both a buy side and sell side, to occur. Having quite recently moved from mid cap to a very small large cap stock, CBD clearly has the potential to become a mid sized large cap company in the years ahead. Institutions need large caps for liquidity purposes, and CBD will soon fall squarely into their sights.

The deal catapults CBD into a completely different league.

The government of Brazil has recently announced a two year $20 billion US plan to encourage low income families to own a home. A key plank of this plan has been the tax cut on stoves, refrigerators and washing machines. The macro outlook greatly improves in both the long term for CBD, as well as the short term.

http://www.brazillandinvest.com/index.php?option=com_content&view=article&id=219:brazil-planning-to-cut-taxes-to-stimulate-domestic-consumption&catid=1:latest&Itemid=30 <http://www.brazillandinvest.com/index.php?option=com_content&view=article&id=219:brazil-planning-to-cut-taxes-to-stimulate-domestic-consumption&catid=1:latest&Itemid=30>

On the heels of big recent move in the share price, some retail investors will be temped to take profits.

My analysis of the accretion potential suggests that the price increase in CBD is fully justified, and will continue to hold the shares.

I seldom report twice on a business.

My personal philosophy is this; a correct initial thesis has absolutely NO need to trumpet results that turn out in line with forecasts. Some investors are accustomed to flurries of weekly updates from buy side research houses, daily updates on blogs from private investors, or perhaps a plethora of reports from analysts lacking conviction in their calls and needing to justify ownership.

Retail investors requiring voluminous reports, on a regular basis, will not benefit from my investment systems and model.

My body of work is dull in comparison. I am a perpetually terrified investor and do not find the process of business ownership to be at all fun. It merely represents a means to an end. Accordingly, inordinate time is spent at the front end of the research process. The objective is to ensure, as best I can, that my selection in large caps turns out to be the best possible company in its sector, consistent with my long term objectives. Therefore, if a business performs as planned, I simply breathe a sigh of relief. Should my initial research report prove to be correct, the business in question generally won't be reported on, until sold.

In the case of CBD, however, such an accretive purchase should be mentioned to existing investors. It's a VERY big deal for a smallish large cap company. In the next several years, the new joint venture has the potential to obliterate my mid term EBITDA and revenue forecasts.

click here to download the company's press release

BOYD GAMING: Betting on a Cyclical Recovery

"When experience is not retained, infancy is perpetual. Those who cannot remember the past are doomed to repeat it" - George Santayana

Does the technical end of the US recession equal a near term bull market?

To answer that question, perhaps we should compare the current US recession to the previous recession.

According to the National Bureau of Economic Research, the US last experienced a recession that started in March 2001. An end date of November 2001 was declared but remains controversial. While the period of negative growth was described as being brief, the impacts were felt in the United States until 2003.

The previous recession was characterized by massive layoffs, outsourcing and a jobless recovery. Many formerly highly paid manufacturing and professional employees were forced into much lower paid service positions. The Dow Jones Industrial average fell from 11,722 points on January 10th 2000, to 10,367 points at the start of March 2000, the official start date of the recession. By September 2003, the DJIA fell to 7,528 points, 2.5 years after the official start date, and well into the onset of the economic recovery phase.

This equity contraction represented a broadly based decline of more than 34.5% from the economic peak. By the end of 2003, the DJIA had only rebounded back to 10,409, still down 9.5% from the previous peak.

It should be noted that in 2003, the first year in four that produced GDP growth in excess of 2%, the DJIA index was still 11.2% below the peak of 2000. It was only in October 2006 that the Dow Jones average surpassed the peak of 2000. Recovery of broadly based capital, from the prior economic peak, took more than six years.

Despite the broadly based index underperformance, if one was both patient, and had no aversion to owning cyclical stocks in the economic setback of 2000-2002, selected categories performed very well in the up cycle.

The casino industry, as a whole, provided investors with above average returns until the current recession. At the start of 2000, two months prior to the official "kick-off" of that US slowdown, investors could have purchased shares of Boyd Gaming for a price of $5.50 per share. Just six months beforehand, shares of Boyd sold for $7.375 per share. Going into that slowdown, investors at $5.50 probably would have felt that they were getting in at bargain prices.

For the fiscal year ending 2000, BYD Gaming generated revenues of $1.131 billion. EBITDA was $.27 billion, or a margin of 23.4%. The EBITDA to interest expense ratio was 3.4X.

In the year 2001, Boyd's top line reflected a slowdown in consumer spending brought on by the recession. Revenues fell to $1.1 billion and EBITDA fell to $.215 billion, a margin of 19.6%. The EBITDA to interest expense ratio fell to 2.9X.

In 2002, the first real year of moderate recovery from the recession, Boyd's revenues rebounded to $1.22 billion; EBITDA grew to $.254 billion, still below the level achieved in 2000. The EBITDA margin recovered from the trough of 2001, but at 20.8% was still below peak, despite revenues that were now above peak. EBITDA to interest expense ratio rose to 3.5X.

Investors that purchased shares of Boyd Gaming, in late 1999, immediately prior to the stock market peak, would have endured a paper loss, going into that economic turn, of more than 56%.

Boyd shares fell from $7.375 in the second quarter of 1999 (immediately prior to the economic peak), to $3.25 per share (shortly after the formal end of the recession) in 2001.

The drop occurred, based on an absolute EBITDA decline of $55 million. The EBITDA decline equalled a 3.8% lower margin, on a revenue reduction of $31 million. In the recession, expenses rose to maintain customer counts, but were inadequate to wholly maintain gaming revenues. This is consistent with cyclical businesses.

When any investment drops by 50%, individuals, particularly market timers, sometimes lose objectivity. On occasion, they might then tout the purported merits of the "50% loss" adage, in an attempt to rationalize the paper loss and opportunity cost. The saying goes like this:

"An investment that falls by 50%, will subsequently have to recover by 100%, just to break even."

This statement implies that investors should cut their losses when down, because it may take an inordinate amount of time (2X +) to get back to being ahead, when debating as to whether or not to hold a money losing stock.

In a nutshell, those who subscribe to the 50% loss rule assume that stock market gains take place at exactly the speed of losses.

Such a notion represents an interesting conversation starter at a cocktail party. However, it is patently wrong. More ominously, it can produce a false dilemma for investors:

"either I sell and switch to something else after a sharp drop, or I will never recover my capital".

The dilemma is false, because it implies that just 2 logical approaches exist to addressing a money losing investment. What proponents of market timing neglect to note is a host of other possibilities that exist along the continuum. An abrupt takeover offer for an attractive price might occur. There may be a meaningful recovery of share capital based on changing market sentiment. A positive transformational change might take place at the firm in question. None of these aforementioned possibilities, to name just a few, can generally be anticipated.

There is absolutely NO fundamental reason that any stock cannot rise every bit as fast as it drops, or even faster. In the case of cyclical companies, this rule of 50% becomes even less applicable, when compared to non cyclical businesses.

To demonstrate the opportunity cost for those who endorse such views (ie market timers), consider the case of shareholders with stock in Boyd Gaming, in the year 2002. Remember that BYD shares bottomed out in 2001 at $3.25, supposedly well after the recession had technically ended.

If one had set up some sort of formal or informal stop loss program on the shares, and sold out of Boyd at any point on the way down; for example at 25% of the loss from $7.375 per share, the buyer at $7.375 would have received about $5.53 per share.

Perhaps that same investor would have steeled themselves up for further short term pain, and ultimately sold out at a 50% loss from peak purchase price, they would have received $3.68 per share.

However, from the second quarter of 2001 to the 2nd quarter of 2002, BYD shares appreciated from a low of $3.25 and hit $16.85, a gain of more than 500% off of the bottom. There was absolutely NO fundamental reason for this explosive gain to have occurred. In 2002, Boyd was still producing lower EBITDA than in 2000. All that changed during the interval was an intangible, a change in market sentiment.

For the investor who purchased BYD at the peak in 1999 and maintained patience and discipline through the bottom, Boyd would have still proved out to be a 2.2X bagger from the top. On the other hand consider the plight of the professed long term investor, who in fact turned out to be nothing more than a short term speculator; not only did he/she lose 25%-50% of their initial capital, they also missed out on the powerful run up.

Further compounding the error in judgement, resulting from adherence to the "rule of 50%" lay in the fact that Boyd Gaming's share price recovery took place while broadly based stock market indexes continued to fall. Those who DID sell BYD at that bottom, in all probability (based on index returns) would have placed their money into something "safer" (ie larger cap or less cyclical). Sadly, the majority of US stocks continued to drop for an additional year. It would have been logical to assume that the realized loss on Boyd would have turned into yet another loss, on the reinvestment. Adherence, in this case, to the 50% adage, resulted in opportunity cost in the magnitude of 400%. It seems reasonable to estimate that the total opportunity cost could have exceeded as much as 420% over four years.

In the case of Boyd Gaming, over the course of 2 years, the shares fell by slightly more than 50%. It took less than one year into the recovery for the shares to climb by 400%.

It took until 2004, for Boyd's absolute EBITDA to surpass the peak of 2000.

The company added some properties, took on additional debts to make capital improvements, and worked diligently to become a more sizeable gaming company. In 2004, EBITDA margins stalled out at 20.5%, still below the peak. Only in 2005, a full 5 years after the previous economic peak, were Boyd's EBITDA margins restored to 23.4%.

From 2004-2006, US GDP was optimal. This produced benefits for all companies in consumer discretionary industries.

The domestic casino industry in general, benefited from this period of expansion. Specific to Boyd, EBITDA margins peaked at 26.2% of revenues in 2006. The largest publicly traded casino operator in North America, MGM Grand, more than 4x Boyd's size, reported peak EBITDA margins of 33.2% in that same year.

Then the next economic contraction started, and the cycle repeats.

So called "smart money", including Kirk Kerkorian (MGM Grand), Sheldon Adelson (Las Vegas Sands) and Steve Wynn (Wynn Resorts Ltd), have each lost billions on paper in the past 24 months. Mr. Kerkorian's paper loss in MGM is estimated at $13.4 billion from peak.

http://finance.yahoo.com/news/The-Biggest-Bet-in-bizwk-415670022.html?x=0&.v=1

Every one of these large casino investors understands full well the cyclical nature of the business. They take comfort from the 20%+ EBITDA margins being generated by their companies, at what is likely to be the bottom of this economic cycle. Kirkorian, Adelson and Wynn are very old hands in casino investment, having experienced decades of ups and downs.

Unfortunately for many retail investors, media pundits and investment banks built up image of casinos as being recession proof, or at least recession resistant. This fallacy was carefully crafted over the last economic upswing, and promoted gaming patrons to be largely hard core junkies. In reality, casino companies are lumped into the category defined as "consumer discretionary". Most people who gamble do so as a form of entertainment, utilizing spare cash. When cash is tight, they gamble less. When cash is more plentiful, they gamble more. The casino industry, simply put, is cyclical.

After a decade of industry rollup and the taking private of many public casino operators, the US sector now has just 5 other good sized public operators, in addition to Boyd.

MGM Grand (MGM-NYSE, $9.25) sells for about 13.5X my 2009 forecast EV to EBITDA ratio. Kirk Kerkorian's Tracinda Corp. is a major shareholder. MGM is the 800 pound gorilla of the industry. 2009 revenues may exceed $5.9 billion and casino EBITDA margins, at the trough, are still better than 27.5%. MGM has rolled up much of the industry, and added significant debt in doing so.

In 2006, MGM EBITDA peaked at 33.3% of revenues. In the 4th quarter of 2007, the MGM share price peaked at $100.50 per share. Since that time, on the heels of a potential 23.4% drop in revenues (2007-2009), and a 32% drop in net EBITDA over that same period, MGM shares have fallen by more than 90.7% from the 2007 peak.

Analysts are currently uniformly bearish on MGM at present. I believe this to be consistent with "cyclical bottom thinking". Consensus expectations suggest that revenues in 2010 will fall from 2009 estimates. Shares of MGM Grand are selling for roughly the same price paid by investors in August 1993.

Las Vegas Sands (LVS-NYSE, $15.09) is the gaming vehicle of Sheldon Adelson and sells for about 16.6X my 2009 forecast EV to EBITDA ratio. 2009 Revenues could touch $4.7 billion. Consensus estimates are for 2010 revenues to average $6 billion. EBITDA margins are presently about 23%.

In 2007, revenues of Las Vegas Sands were $2.95 billion, and EBITDA was $.532 billion, or 18% of revenues. 2007 EBITDA was impacted by preopening expenses on a new casino. Peak EBITDA margins were touched in 2006, at 29.2%. So, current EBITDA margins are down by 21% from peak. In the 4th quarter of 2007, LVS shares touched $148.76. The share price is down 89.9% from the peak. LVS went public on December 15th, 2004.

Wynn Resorts (WYNN-NASDAQ, $54.22) is the creation of Steve Wynn. 2009 Revenues are forecast to be $3 billion, and EBITDA margins are roughly 22.1%. The shares sell for roughly 16X my forecast 2009 EV to EBITDA ratio.

In 2007, revenues of Wynn Resorts were $2.69 billion. EBITDA was $.649 billion, or 24.1% of revenues. Current EBITDA margins are off 8.3% from peak. Shares of Wynn are down from a high of $176.14 touched in the 4th quarter of 2007. The stock is down 69.2% from the peak.

Penn Gaming (PENN-NASDAQ, $25.13) is a widely held public casino operator operating in the US. The company does not have operations in the city of Las Vegas. 2009 revenues are forecast to be roughly $2.4 billion. EBITDA margins are currently in the range of 22.5%. The shares sell for roughly 11.9X my forecast 2009 EV to EBITDA ratio.

In 2007, revenues of Penn Gaming were $2.44 billion and EBITDA was $.636 billion, or 26% of revenues. Current margins are off 13.5% from 2007. In 2006, EBITDA margins peaked at 31.2% of revenues. In the second quarter of 2007, shares of Penn Gaming touched $63.68. The share price is down 60.5% from peak.

Isle of Capri Casinos (ISLE-NASDAQ, $7.75) is a widely held public casino operator operating in the US. No ISLE facilities exist in Las Vegas. 2009 revenues are forecast to be roughly $1 billion. EBITDA margins are presently about 19% of revenues. The shares sell for 9.1X my 2009 forecast EV to EBITDA ratio.

In 2007, ISLE revenues peaked at $1.122 billion. EBITDA (factoring out unusual charges) was $.185 billion in 2007, for a margin of 16.4%. Record EBITDA margins of 22.4% were achieved in 2004. Currently EBITDA margins are roughly 15.2% off of peak. In the first quarter of 2007, ISLE shares touched $33.01. Shares are presently down 76.5% from peak.

Boyd Gaming (BYD-NYSE, $7.36) is a widely held public casino operator in the US. The Boyd family controls 36% of the shares. The majority of facilities exist in Las Vegas, although the firm does have some regional exposure. Boyd Gaming and MGM Grand also operate a joint venture in Atlantic City which owns the "Borgata" Casino.

2009 revenues are forecast to be $1.62 billion. Excluding all joint venture contributions from Borgata, I forecast EBITDA to be in the range of $.340 billion, or 21% of revenues. The shares sell for about 11.6X my 2009 forecast EV to EBITDA ratio.

In 2007, BYD revenues were $1.98 billion. EBITDA was $.437 billion (excluding the contribution from Borgata), or 22% of revenues.

Record EBITDA margins of 23.4% were touched in 2006. These peak margins were also demonstrated by other casino operators.

In the 3rd quarter of 2007, shares of Boyd touched $54.22. On a 19% decline in revenues, a 10% decline in EBITDA margins and an absolute 23% decline in EBITDA, shares have fallen by 86% from the peak.

Of the 6 publicly traded operators in my peer sample, I have chosen BYD to be my cyclical recovery vehicle.

Boyd Gaming shares have fallen almost in line with the two most highly leveraged operators, MGM and Las Vegas Sands.

Boyd receives my investment attention, over MGM or LVS, for the following reasons.

1. Boyd's balance sheet is stronger, by far, than MGM or LVS. BYD's EBITDA is currently more than 1.96X annual interest charges. This excludes the sizeable contribution from Borgata. If the 50% Borgata EBITDA was consolidated, EBITDA coverage would rise to more than 2.5X. Boyd has completed the majority of its capital expenditures for the foreseeable future. Absent an acquisition of operating assets, free cash flow should gradually reduce total liabilities. I do not add Borgata's EBITDA in Boyd's income statement, as the firm lacks the ability to readily access Borgata cash.

In comparison to BYD, MGM's EBITDA to interest coverage was just 1.5X in Q2. MGM's EBITDA coverage includes the contribution from Borgata, and excludes a very sizeable interest charge presently being capitalized.

LVS' EBITDA to interest and preferred share coverage was 1.88X in Q3. LVS also capitalizes a considerable interest amount. If reflected on the income statement, the interest and dividend coverage ratio would be reduced considerably.

Not only is the balance sheet at BYD better than the two most depressed casino equities, the quality of the balance sheet and income reporting at Boyd, in my view, is heads and tails above the two peers noted. While MGM and LVS are throwing in everything but the kitchen sink to improve their debt coverage ratios, BYD's interest coverage, at what may be the bottom of the market, appears to be more than adequate to ride out further economic malaise, without straining the boundaries of credulity.

Wynn Resorts currently has the strongest balance sheet among the 4 large publicly traded Las Vegas operators. The EBITDA to interest coverage ratio, by my calculation, is currently 3.5X. This ratio makes Wynn one of the few casino operators that have garnished the praise of Wall Street.

2. Boyd is prepared to make acquisitions during a time of depressed valuations. It is now cheaper to buy an existing casino, than it is to build a "greenfield" operation. Management has made offers to purchase some or all of the facilities operated by Station Casinos. Station, presently in reorganization, has rebuffed the proposal. However, the willingness of BYD to come up with a cash offer of $950 million for Station properties, and without requiring a major equity underwriting to come up with cash, provides me with confidence that management is prepared to make accretive acquisitions for the benefit of existing shareholders.

http://www.reuters.com/article/marketsNews/idCNBNG34826720091102?rpc=44

A potential purchase price of producing assets would be funded through a $2 billion standby revolving line of credit, now unused, that was provided for Echelon development. This revolver comes up for renewal in 2012. The interest rate is no more than LIBOR +1.625% (2.86% currently).

If management could add existing assets with EBITDA margins similar to existing properties, ANY purchase could prove to be highly accretive for existing shareholders.

For example, let us assume that the Station Casino properties produce similar returns as Boyd. Station's problems arose from an inability to service $6 billion + dollars in high cost debt, not based on the quality of the portfolio. If Boyd was to buy existing operations, for a cost of $950 million, producing EBITDA margins of perhaps 18%-20%, and was to finance the purchase from the revolver; net EBITDA accretion would be roughly $143 million to $163 million per annum. Allowing for an 8.9X to 11.9X EV/EBITDA multiple on a $950 million potential acquisition, and the net result is a potential market cap swing of $3.70 per share to $11.37 per share.

If the Station assets are not purchased, a number of other prime properties could be available. MGM might be persuaded, in its current financial state, to part with the remaining 50% of Borgata. Perhaps another strategic casino might have to go on the chopping block. LBO firms were also keen purchasers of casinos in recent years, and may need to rationalize certain properties.

A $2 billion credit line buys a WHOLE lot of casino revenue in the current environment. Boyd Gaming is one of the few casino firms in business with access to low cost credit. In a credit challenged environment, firms with credit are king.

Many are praying for a speedy economic rebound in Las Vegas. I would argue that the Boyd family might be hoping for things to get just a bit worse, and for a little while longer. Only then might recalcitrant creditors, or competitors on shaky footing, perhaps currently holding out for high dollars, be more easily persuaded to part with good assets for fire sale prices.

3. Boyd's drop in revenue and EBITDA, from peak levels in 2006, is almost entirely due to the sale and closure of 3 Las Vegas properties.

The Stardust Casino and Hotel, across from the Steve Wynn's flagship resorts, was long considered to be an underdeveloped property on the Las Vegas Strip. Boyd engaged in a feasibility study to determine the most appropriate use for the acreage. Ultimately, the decision was made to close and demolish the Stardust. The Stardust entered into runoff mode in 2005, was closed on November 1st, 2006, and was demolished in March 2007. In order to secure the land adjacent to the Stardust and maintain an adequate balance sheet for the potential building of a mega property, to be named "Echelon", Boyd sold a casino for $401 million cash plus 3.4 million common shares. They further exchanged a smaller casino for the 24 acres of land adjacent to the Stardust.

With these disposals, 192,000 square feet of casino floor and 2460 hotel rooms, carrying average rack rates of $61 per night, ceased to make contributions to the BYD's top and bottom lines in 2006. In aggregate, $387.8 million of annualized revenues, and $76 million of annualized EBITDA was removed from the portfolio.

At the conclusion of the sales, demolitions and swaps, Boyd owned a total of 87 acres of raw land on Las Vegas Boulevard, one of the largest continuous holdings on the strip.

4. The deferral of Echelon removed a substantial amount of value from the company, but also removed project execution risk. On August 1st, 2008, management placed construction of Echelon on hold, until such time as Las Vegas conditions recover. Boyd executives have recently indicated that they don't envision restarting the project for a minimum of 3-5 years. Capital costs, initially envisioned to be about $3 billion dollars, had escalated to a potential $4.8 billion. These increased costs would have certainly reduced the EBITDA potential of the project. I'm comfortable waiting until a later date, if it improves the economics of the project.

In the meantime, the 87 acres sit idle, earning zero return for shareholders. In addition to the foregone revenues on the casinos sold and bulldozed, Boyd has thus expensed about $125 million of cash on the project. This is also generating a return of zero. The delay is expensive, but one that I don't dispute as unnecessary. At a total projected capital outlay of up to $4.8 billion, Echelon would have been one of the most ambitious projects in Las Vegas. Going ahead with construction would have certainly placed Boyd on precipitous financial footing, in a US recession.

This acreage won't remain idle forever. It sits across the street from 2 of Las Vegas' most attractive properties (Wynn and Encore). In a normalized Las Vegas real estate market, a project with piles in the ground, architectural plans drawn up and approvals granted, might suggest that this property is still worth the land value of up to $1.2 billion. Should Boyd fail to develop this project in an economic upswing, their hand may be forced. To put the potential value of the raw land into perspective, keep in mind that the entire market cap of BYD is currently just $635 million.

5. The Borgata joint venture with MGM, represents, in my view, an extremely undervalued asset. Since inception, BYD has made investments and advances of $405.9 million to the partnership, equalling $4.67 per share.

The Borgata is a 140,000 square foot casino and 2000 room hotel in Atlantic City. Opened in 2003, the project has made continuous investments to build on its status as the pre-eminent casino in AC. The venture has completed an 800 hotel room expansion in late 2008, named the Water Club, which carried a capital investment of more than $400 million. Boyd's share of the total joint venture presently carries total long term debt of $595 million, which includes $200 million recently invested in the Water Club. With 2009 forecast revenues in the range of $800 million, and EBITDA of as much as $228 million, Borgata generates EBITDA margins in the range of 28.5%, the highest in the Boyd portfolio. As this is a private joint venture, it is my view that the market is attributing little real value for Boyd shareholders. If one assumes that Borgata is worth a 20% discount to the publicly traded firm with the lowest EV/EBITDA ratio in the peer group (ISLE), this would imply a value, net to BYD, of $2.50 per share in value. Such a discount seems excessive, considering that Borgata generates EBITDA margins 50% above ISLE, has the leading market share in Atlantic City and has recently opened a hotel property offering accretion potential as it matures. Borgata remains a prize, even in an increasingly competitive region.

A more appropriate valuation, in my view, is to price Borgata at 10X EV/EBITDA in a private transaction. This produces a value, net to Boyd, of $6.30 per share, or 85% of BYD's current market value.

On a "sum of parts" basis, Boyd Gaming looks to be quite undervalued at the current price.

If Borgata is truly worth somewhere in the range of $2.50 per share to $6.30 per share for Boyd, and the 87 acres of raw land on Las Vegas Boulevard retain a value of $7.5 million per acre ($7.50 per BYD share), this implies a potential value of $10 to $13.8 per share, for just these two assets. If the raw land ever does command a value of $15 million per acre and Borgata can be unlocked at my $6.30 per share estimated value, these two assets become worth as much as $21.3 per share.

Then, one must estimate a value for the remaining 808,200 square feet of gaming space and 7250 hotel rooms in the Boyd portfolio. They appear to be fully capable of generating $340 million of EBITDA in an adverse time. BYD generates EBITDA margins roughly in line with PENN, despite having thrown away $125 million in the last several years on preconstruction costs at Echelon; to value the casino assets at 11.9X EV/EBITDA seems reasonable. This produces a value of $8.27 per share.

Since 2000, Boyd has made capital investments of $1.23 billion, net of write downs, on its portfolio of properties. This represents an investment, on existing properties, of roughly $14.15 US per share.

An addition source of potential accretion lies on the balance sheet. On September 30th, 2009, Boyd's total long term debts were recorded on the balance sheet at their full carrying amount of $2.65 billion. However, the estimated fair market value of this debt might be a full $519 million, or $5.97 per share, below the carrying amount. In the first 9 months of 2009, Boyd repurchased $82.4 million face value, at a total cost of $70.14 million, or 85.2% of par value. Over the next several years, should Boyd prove opportunistic, management may be able to add further shareholder value, via discounted debt purchases. With only sustaining capital expenditures planned for the short term, BYD would appear to have an ability to accelerate such purchases over the next year or so.

In total, my sum of parts estimated value for BYD, without a revenue producing Echelon casino, is approximately $18.27 to $29.57 per share. Whatever discounted debt purchases may be made could be incremental to my estimate.

In an economic recovery, it could seem reasonable to suggest that BYD's EBITDA may rise, potentially enhancing the value. Please do NOT assume that a sum of parts calculation represents my future share price estimate. It is merely an expression of potential value, under certain conditions, should a motivated party seek to bust up the firm.

Finally, all of this assumes the Echelon remains on hold. Should the project be revived, such a mega project could prove to be a game changer.

Does Boyd's 23% decline in EBITDA justify an 86% decline in share price?

I think not. However, the decline appears to be wholly consistent with the pessimism experienced by casino operators, off the previous economic low of 2001. The market reaction was extreme then, and appears to be more so now. Admittedly, the current US economic malaise is more severe than the 2000-2002 period. In my view, a portion of the BYD share price decline is likely a sympathetic reaction to the current woes of MGM and LVS.

Differing from all three of the major casino peers in Las Vegas, (WYNN, LVS and MGM) Boyd has felt little need to dilute shareholders with equity underwritings. In fact, a modest open market repurchase program recently took place. I would NOT anticipate more stock purchases. Management has stated their willingness to pay up to $950 million in cash for some or all of the Station Casino assets. Such a cash deal, through a court appointed reorganization, produces nothing in the way of M&A revenues for Wall Street. In short, the business model of Boyd has little appeal to Wall Street. BYD is a self financing, fully funded casino operator. They have finished several years of major capex and are presently using excess cash to retire debt at discounts. The company is, frankly, a terrible investment banking prospect.

Normalized EBITDA actually, according to my methodology, surprised to the upside. I was not anticipating normalized EBITDA to exceed $320 million in 2009. With stringent cost controls in place, even a mild US economic recovery could restore lustre to the Boyd and for that matter the sector in general.

Each casino operator has some knock against it from Wall Street, save for Wynn. I acknowledge the validity of each bear thesis on each and every stock in this sector. However, Wynn is currently selling for a forward EV/EBITDA ratio that makes my nose bleed, and has nothing that I would consider to be a hidden asset on the books. This is not to imply that Wynn shares won't produce excellent performance in the next up cycle. I believe that all of the casino companies in my peer sample, should the US economy recover even modestly, may prove to be cyclical darlings once again.

The contrarian's argument on US equity allocation, at this time, can best by summed up with my own views.

I'm a global bull, but a US bear. On a relative basis, it is my view that many developed global markets offer far greater return potential in the long term. In contrast, I consider the US economy to be somewhat past the plateau of a generational bull market. Few important US driven secular trends benefit the entire economy. The one notable trend, a move from cash to non cash payments, is already represented in my account, through holdings in Mastercard.

Those who disagree with such a view have little support in the form of economic data. In the last 9 years and 10 months, the US economy will now have produced more months of negative or subpar GDP growth (below 2%) than optimum GDP growth (3% or higher). The US is now clearly a cyclical market. Accordingly, so as to obtain maximum potential benefit from a US recovery, I must, by default, consider owning a cyclical investment. It makes me uncomfortable to do so.

And THAT is exactly the reason that I'm going all in on Boyd Gaming, with a view to build up an equal portfolio weight. As a global "everyman", I must discount my bias and consider a middle ground, as being possible, for the US economy. My emotional responses to current negative investor sentiment, are attempting to override, what should be considered a logical and rational investment for small cap cyclical accounts, in a potentially improving economic cycle.

Off the bottom of every cyclical market, investors can come up with thousands of reasons NOT to own a well run firm that has been beaten up. When these same cyclical investments rise fivefold, tenfold or twentyfold, everybody suddenly wants in.

As for those who have written off Boyd completely (hence the washout), I wonder why they no longer consider BYD to be capable of outperforming in a potential economic advance. After all, from US economic "peak to peak" (1999-2006), BYD represented a 7.3 bagger. Those who patiently purchased the shares off the bottom of the last economic cycle, when the cycle had already turned for the better, generated a 16.6 bagger going into economic high. Certainly, the shares are nowhere near that today. However, we are now comparing "peak to trough" performance. Appraise ANY cyclical sector or stock on peak to trough, and you will almost always feel queasy.

The company now sells for a discount to other Las Vegas peers on a trailing EV/EBITDA ratio. Considering that Boyd has a stronger balance sheet than all save Wynn Resorts, has suffered minimal EBITDA contraction as compared to peers, and is deleveraging its balance sheet without diluting existing shareholders, this seems unwarranted.

While ISLE and PENN have been proposed by some as being the better "values" in the market, this appears to have been arrived at largely based upon their lower degrees of share price decline. If the global economy is improving, and the US economy will continue to be the weak link among developed nations, a relatively weak US dollar might result in an international tourism "pick up" in the mid term. Regional casino operators will not benefit from an influx of foreign tourists, despite their vociferous protests to the contrary. Las Vegas remains a world class tourist destination, and I want to participate in any potential recovery of that market. Unless ISLE and PENN establish a meaningful presence in Las Vegas, I will continue to have limited interest in their businesses.

RMG1 made an initial underweight purchase of Boyd Gaming at an price of $36 + dollars in 2006, based upon the EBITDA prospects for a completed Echelon casino. Based upon my mid term view for recovery in Las Vegas casino operators, I am delighted that an opportunity exists to buy additional shares at the current price of $7.36. In my view, this price represents a capitulation value.

RMG2 VC recently opened a brand new investment position, based upon cap weight.

The shares may continue to be volatile from here. Perhaps I may even be presented with a further opportunity to buy more shares below this price. So long as my total allocation to Boyd remains underweight in the portfolio, the possibility of averaging down further does not present me with undue concern. As dividends flow through to the account, further purchases may be reported. I am NOT investing in Boyd for the potential of earning a mere 20%-30% return on my cyclical capital.

The global economy in 2008 was NEVER as badly off as North American media portrayed it to be.

In 2008, global GDP increased by a respectable 3.8% over 2007. This data flies squarely in the face of those who were boldly tossing around the words "global depression".

It is true that mature cyclical economies such as Canada and the US showed GDP declines. However, it is equally true that China, Brazil and France either failed to receive notice of a global recession, or didn't experience anything more than a four month slowdown. Some of the preliminary data has already been revised for the better. I believe that it may ultimately be determined that neither Brazil nor France met the technical definition of economies in recession.

The statistics speak volumes. If the US, Canada and several other European countries (which in total account for about 35% of global output) showed a reduction in GDP, yet the global economy grew at such a solid rate, it stands to reason that the MAJORITY of countries posted positive GDP growth in 2008.

"Harrumph" goes the naysayers. "Of course China was in a recession". Their economy slowed from 13% GDP growth in 2008, to what looks to be just 9% this year. For China, that is a recession".

No. Calling China's 9% forecast rate of GDP growth in 2009 recessionary, is analogous to saying that Lance Armstrong, holding a commanding a 1 hour lead over all other riders in a Tour de France, and slowing down for a couple of minutes to battle some headwinds, is now going to lose the race. The headwinds also affect the peloton, not just Mr. Armstrong. He's likely still going to win the race by a landslide.

As the media becomes aware of the magnitude of their gaffe, the hyperbole is diminishing.

Now, rather than calling the reduction in global economic growth a "depression", the mass media has softened their tone. Now, it is just "the worst recession since the 1930's".

No. The 1980 recession made this slowdown seem like a cakewalk. Unemployment in the US peaked at 10.8%. US unemployment rates are a full 10% below that recorded level. This is by no means the worst recession since the 1930`s. It is not even close.

"Harrumph" goes the naysayers. "The unemployment rate is likely to rise, and will surpass that peak. Therefore, things are going to get worse".

Unlikely. Unemployment is a lagging indicator. And, North Americans are fixated upon US statistics, which accounts for just 20% of the global economy. Employment growth tracks GDP growth. As global growth was highly satisfactory in 2008, there is ample inferential evidence to suggest that globally, employment rose. Evidence is now starting to pile up which confirms the long held view of this author; the recession was primarily driven by a cyclical slowdown in the US. It spilled over into countries that derive significant trade with the US. The recession was neither global, nor was it severe. Regretfully, media, being concentrated in the US, took what was happening on a local basis, and reached an incorrect conclusion.

If there was NO global recession, the harrumphers proclaim, why did global equities fall lockstep with US equities?

Equity values will fall for a variety of reasons. One key reason was that the global growth rate abated. Equities do represent a call on future profit growth. A more slowly growing global economy inevitably results in a reduction of future expectations.

Equities on a global basis corrected, to reflect the reality that global GDP was no longer growing at 5.1% from 2007 and dropped to 3.8% in 2008.

In any event, a meaningful cyclical turnaround may soon be underway in North America. If true, it will be driven by consumer spending, based upon more disposable income due to lower commodity prices. While oil prices have recently increased, natural gas prices have continued to fall in 2008, which has helped reduce costs for both homeowners and manufacturers alike.

While the media remains fixated upon extricating themselves from an intransigent position, THE important macro story of 2008 was the ascension of Brazil into the world's economic elite.

In 2008, Brazilian GDP leapfrogged over Canada, and became the world's 10thth largest economy. Based upon reported growth rates in the first half of 2009, Brazil has since overtaken Spain, and now stands at 9th place globally. I believe that the Brazilian economy appears poised to overtake Russia in 2010. The economies of Italy and the UK could be smaller than Brazil by 2015. In 2020, I predict that Brazil may be the 5th largest on the planet.

Brazil is lumped into the BRIC (Brazil, Russia, India and China) group of emerging markets, and is therefore a bit more noteworthy than before. Goldman Sachs came up with the moniker. Nevertheless, despite the name recognition, North American investors still don't appear to have anything other than a passing interest in Brazil.

It is my opinion that inclusion into the group known as BRIC has actually HURT the image of Brazil with investors. Being lumped into a category of countries plagued by financial scandals, partial foreign exchange controls, bureaucratic governments, high levels of protectionism and kleptocratic businessmen (Russia and India); does little to enhance the status of Brazil.

This is moderately left of center, pro business country. It features low corporate taxes, a better national balance sheet than 9 of the top 10 economies globally and a superb macro outlook. My views are considerably more optimistic than consensus. When I work through Brazil's economy and prospects, I see a nation featuring China's growth potential, but without China's problematic lack of strategic natural resources.

The Brazilian economy has surprising parallels to Canada. Both nations have core competencies in agricultural output, automobiles and aerospace. However, rather than viewing Canada as a peer, I consider Brazil to be one of Canada's main competitors on the global stage. Key structural advantages, such as a motivated low cost workforce, lower corporate taxes and complete control over almost all aspects of the supply chain, have allowed Brazil's economy to dominate Canada in key industries. The proof is in the pudding. Canada's industrial output fell by about 1% in 2008, while Brazil's grew by 4%. In value added areas such as commercial passenger jet production, Canada fights with Brazil repeatedly. Several times in the past decade, Canada has filed trade disputes, claiming that Brazil exports goods globally at prices below that of Canadian exporters. Upon careful reflection, the WTO (World Trade Organization) generally indicates that Brazil is simply the lower cost producer. If you can read into the nature of the complaints, cries of foul play are actually a sort of offhanded compliment, in support of the Brazilian business model.

With only 2% of Brazilian GDP coming about via exports to the US, there appears to be limited economic correlation between Brazil and North America.

I consider Brazil to be the most balanced economy among the global top 10. The nation has a fast growing consumer market to sop up increasing industrial output. This might provide portfolio managers with some potential for a natural hedge, in an increasingly globally correlated marketplace. When I think of Brazil, I see the South American equivalent of Canada, minus Canada's uncomfortably high dependence upon the US for exports.

Canada generated approximately 29.3% of its GDP, or $459.1 billion US, through exports to foreign markets in 2008. Of this amount, a whopping 77.7%, or $356 billion, was exported to the US. US exports directly account for 22.8% of Canadian GDP. Canada has negligible export business with China. Brazil, on the other hand, reports that China is poised to overtake the US, as their largest trading partner and export market, by 2010.

Despite a strong economic showing for the better part of a decade, and accompanying equity buoyancy, I still consider Brazil to be relatively undervalued for investors.

The proof comes from a simple comparison of GDP to stock market valuations.

In 2008, Brazil's GDP was $1.67 trillion US, or roughly 2.4% of global GDP. In contrast, the market value of all Brazilian publicly traded shares was just $1.37 trillion, or 2% of the aggregate market value of global equities, at year end 2008.

In 2008, Canada's GDP was $1.56 trillion US, or 2.2% of global GDP. The aggregate market value of all publicly traded Canadian shares was $2.2 trillion, or 3.3% of the aggregate market value of global equities, at year end 2008.

In simplistic terms, the Brazilian economy is 7% larger than that of Canada. However, Brazil's stock market is just 62% the value of Canada's. I believe that in the years to come, this gap will diminish, and potentially reverse.

Brazilian equity undervaluation appears even more pronounced when the impact of foreign manager "herding" is considered.

At the end of 2008, 10 of the 439 publicly traded stocks on the Brazilian stock exchange accounted for more than half of the country's total public capitalization. Those who prefer to invest passively in Brazil, via ETF's, index products or mutual funds might find that various package offerings are largely identical. Most packages seem to feature the same ten large cap stocks, just in different weightings.

Ex these institutionally driven holdings, the average market cap for the remaining 429 companies was $1.58 billion US. Brazil is a now large cap economy, primarily run by companies selling for small cap valuations. Veritable cornucopias of intriguing companies exist, outside of the tightly clustered investment coverage herd.

Critics point out that Brazil has low GDP per capita, and that the consumer market is in its infancy.

I respond by indicating that the absolute size of the Brazilian middle class is larger than that of Canada. Brazil's economy in the past twenty four months has expanded by $139 billion. The magnitude of growth is such, that many companies appear well positioned to increase revenues significantly, without fighting each other for market share.

In contrast, Canadian GDP has grown by an anaemic .8% per annum for the past two years. This was about $20 billion of net increase. In such a weak economy, business must be wrestled away from competitors to gain market share. Absent a US led recovery, Canada's domestic economy appears to be very much a zero sum gain market.

Bears are quick to note that the Brazilian economic miracle needs to be tempered against an inflationary backdrop.

They report that Brazil's inflation rates are higher than that of Canada, and imply that Canada is therefore a safer place to invest. In reality, investors in Brazil have had far better success, adjusted for inflation, than have Canadians. Canadian GDP growth has LAGGED inflation by approximately 1.7% per year since 2007. In contrast, Brazil's inflation was only .3% higher than GDP growth for the same interval.

While inflation bears throw up a fearful talking point, their objections fail to pass even cursory scrutiny. Both countries are commodity exporters. A mild dose of inflation has helped their economies in the past, at the expense of import oriented nations. Brazilians and Canadians alike would prefer a global economy with rising input costs.

Finally, certain investors point out that the Brazilian equity market is dominated by just a handful of publicly traded companies. The worry about the marketplace effects, should just a couple of the top ten firms disappoint, on an earnings front.

This is valid, but becomes less worrisome providing that economic growth continues. I acknowledge the risk by seeking to hold an appropriate portfolio weight in Brazil. As the Brazilian economy is 2.4% of the global economy, and is growing 40% faster than the planet as a whole, I'm currently comfortable with about 3.5%-4% of my entire account allocated in Brazilian equities.

The macro case for Brazil might be augmented in the next decade, through the development of substantial offshore oil resources.

Petrobras, the largest oil company in Brazil, forecasts that oil output in Brazil will grow from 2.2 million bpd, to as much as 5.7 million bpd, by 2020. At $70 oil, and factoring in a multiplier of 2, oil development alone may add 2.5% to annual Brazilian GDP growth, for an entire decade. Output from the massive Tupi fields should initially commence at the end of 2010.

I consider the long term outlook for Brazilian equities to be very appealing.

And, I always put my money where my mouth is. Today, I complete the building of a portfolio position in Compania Brasileira de Distribucio (CBD-NYSE, $53.41). CBD is my choice to potentially benefit from rising consumer incomes in Brazil.

This is the largest grocery and general goods retailer in Brazil, holding about 13.2% of the entire Brazilian food market. The company operates both conventional grocery stores as well as the popular hyper mart formats. Half of CBD's 2008 revenue came from hyper marts, and the company increased its total number of hyper mart stores by 12% vs. 2007.

CBD's 2008 revenues were $9.62 billion US and EBITDA was $538 million. With a very recent acquisition of a white goods retailer, valued in the purchase at 5.6X 2008 EBITDA, 2009 revenues could touch $12 billion US. EBITDA could reach $780 million US.

The firm operates 1279 stores in Brazil. In the first half of 2009, sales were up 10.7%. Of particular interest, the revenue growth rate accelerated in Q2, which should have been the global trough in retailing. EBITDA was up 15.7% year over year. EBITDA margins (a key measure of operating profits) were 6.9% in the first half of the year. US and Canadian food retailers are generally pleased with margins half that level, and get absolutely ecstatic when margins surpass 5%. With $4.1 billion of total liabilities (I am more stringent in my definition than the street), and $6.1 billion of market cap, CBD has an enterprise value of $10.2 billion. This prices the company at roughly 13.2X my 2009 estimated EV/EBITDA ratio.

CBD only recently broke through the $5 billion market cap, which justifies inclusion into large cap accounts. In light of global market volatility, CBD's movement into the new cap weight may have slipped by the screens of some institutional managers.

Collectively, the top 3 food retailers, CBD (#1), Carrefour (#2), and Wal-Mart (#3) account for about 39% of the total Brazilian market. The next largest 2 food retailers account for less than 3% of the market. The top 3 firms appear to have organic growth potential, without having to continually embark upon food price wars experienced in the US and Canada. CBD has continued to maintain its fair share of the food market, despite a decade of competition with Wal-Mart.

I believe that a major improvement in the Brazilian economy will commence in 2011.

Individual investors are always on the hunt for future 10 baggers. This search becomes easier when powerful secular drivers exist. My forecast is that the Brazilian economy will soon have such tailwinds.

Initial revenues from new offshore oil production will start to trickle down to the consumer economy around 2011. Until then, the domestic economy of Brazil will show normalized levels of economic growth, plus a modest capital expenditure multiplier based upon the field development.

Tupi oil revenues, and the attendant economic multipliers, have yet to be felt by national economy. If oil prices remain at current levels, forecast rising output from Tupi could dramatically accelerate Brazil's growth rates.

As the largest retailer in the country, CBD is poised to obtain the lion's share of rising consumer incomes in Brazil. If the nation can produce 5% annual GDP growth rates through 2020, and if CBD can maintain its present market share of the food market, total revenues at CBD could increase from my forecast of $12 billion in 2009, to as much as $36 billion by 2020, a potential revenue increase of 300%. Such top line growth could produce EBITDA growth in the range of 500%.

Bears will respond with a hearty guffaw, at the thought of 5% annual GDP growth for a decade. If offshore oil output meets projections, I on the other hand, consider this very achievable.

I believe that that CBD's premium valuation, when compared to largest food retailers in Canada and the US, is fully warranted by the Brazilian retailer's superior top and bottom line growth rates. CBD has a balance sheet that is at least as strong as North American peers. CBD currently sells for a 41% premium to Wal-Mart (WMT-NYSE, $51.68). It also sells for a 49% premium to the largest retailer in Canada, Loblaws (L-TO, $32.86 Can). However, I scooped up shares on the cheap, during a time of investor distress. On April 24th 2009, RMG#1 initiated a position in CBD at a price of $31.31 per share. The portfolio averaged up throughout the period ending September 16th 2009, and now has a blended average cost base of $41.66 per share.

The blended average cost for RMG#1 is 10.1X my estimated EV/EBITDA ratio for CBD. This is a far more reasonable premium to Wal-Mart and Loblaws; in the range of 13% and 16% respectively.

I believe that that CBD deserves a valuation that is superior to the largest food retailers in Canada and the US, based upon top and bottom line growth rates. CBD has a balance sheet that is at least as strong as North American peers.

There are some great secular themes, crying out for investor participation, across the globe. Some, like growth in China, are well understood. Others, like the growth of Brazil, still appear to be overlooked. It is my opinion that Brazil is on the verge of larger scale investor acceptance. In addition to having purchased more shares of CBD for the large cap RMG#1 portfolio last week, I have purchased more shares personally.

The mantra of efficient market proponents is that all known information regarding a corporation becomes quickly priced into a stock price.

Such disciples suggest one cannot consistently outperform, based upon information that the market already knows, except by luck.

I believe that there are two basic flaws in the efficient markets premise. The first issues lies in the fact that statistical analysis and forecasting cannot ably handle uncertainty.  Accordingly, analysts prioritize or triage information, largely based on short term valuation models.  A minor development in the near term carries infinitely greater weight for most analysts, as compared to a longer term development.  Secondly, efficient markets theorists tend to focus quite narrowly upon company specific information.  Unintended benefits or consequences from external sources, even if already in the public domain, generally fail to be taken into account.  Until such developments are conclusively linked to a specific company, external news will have virtually NO impact on statistical investment modelling.

However, on occasion, some investors correctly determine the impact of external developments on a corporation and its competitors. This flash of insight, completely overlooked by analysts and the investing public at large, is sometimes referred to as a "Eureka Moment".  It is my opinion; that the highly prized, greatly sought after, yet seldom found "10 bagger", arises from a Eureka Moment.

I believe that for Kansas City Southern Railroads (KSU-NYSE, $17.50); a Eureka Moment occurred in August 2008.

In a nutshell, a series of little known and relatively unreported tax changes, imposed by the government of California in 2008, may eventually result in wholesale change to the flow of imports throughout western and central United States.

In the long term, California's actions could result in some very detrimental unintended consequences for Burlington Northern (BNI-NYSE, $74.55) and Union Pacific Railroads (UNP-NYSE, $56.54).  My prediction is that the single greatest unintended beneficiary of the change in trade flows will be Kansas City Southern. A secular windfall could accrue in the longer term, for new shareholders of KSU.

Who is Kansas City Southern Railroads?

KSU is the smallest of the 7 class one railroads now operating in the North America.  Roughly 1/10 the size of Burlington Northern, Kansas City Southern is sometimes referred to as the free trade railroad.  Most of the major class one railroads operate a continental operation, traversing east to west. KSU, in contrast, runs their tracks from Mexico into the mid continental United States.

The company has been investing heavily to increase its Mexican-US freight business.

Capital expenditures of more than $1.26 billion have been made in the past 3 years.  As a percentage of revenues, this is almost 2X that of larger peers.

The average age of KSU's locomotive fleet is just 10.9 years, and is considered to be the most modern in the industry.  At year end 2008, KSU owned 5584 pieces of rolling stock, up by 86.5% since 2004. The rolling stock has been modernized, and is now among the youngest among railroads.

Total liabilities have risen sharply since 2004.  However, based upon all important ratios, it seems clear that Kansas City Southern has invested this capital to improve the long term competitiveness of the business.  KSU continues to grow its inventory of owned equipment, vs. leased. 

Other rails have had to allocate major capital to address chronically under funded pensions.  In contrast, KSU reports just a $28 million healthcare/pension shortfall, at year end 2008.

A major capital project is now turning to sales.

The Rosenberg line is now operational.  Completed for an estimated capital cost of $170+ million, the refurbished 70 mile line eliminates the need for KSU to use 160 km of heavily congested track owned by Union Pacific.  An estimated $18 million per annum in right of way charges and fuel savings will be generated.  Shippers will benefit from reduced transit times, which management anticipates will lead to increased business.  Full utilization of the line should reduce total annual operating expenses by about 1.2%. (Source)

A second major capital expense will be completed by 2010.

70% owned by Kansas City Southern, the 320 mile Meridian Speedway line is now in the latter stages of a $300 million refurbishment and expansion. The expansion capital is being fully funded by Norfolk Southern Railroad (NYSE-NSC, $36.54), in exchange for a 30% interest in the line.

By 2010, the Meridian line should be able to accommodate 45 trains per day, almost double the present amount.  Transit times by shippers throughout the south-central US will be reduced by about 7 hours.      KSU will not only save millions in operating expenses on their trains, it is possible that other class one rails will increase their use of the Meridian line, creating substantial right of way fees.

Completion of the major projects should reduce KSU's future annual capex by more than half.

After a four year period (2005-2009) where KSU invested an average of $350 million per year in capex, management now anticipates about $150 million per annum to sustain the business.  Any incremental spending in the future could be considered as potentially accretive for the top and bottom lines.

The recession cast aside certain views that railroads were positioned to manage the swings of the economic cycle.

Perhaps this would have been true during a soft landing, but the US economy recently experienced the largest economic dislocation since the recession of 1980.

All railroads were impacted.  Kansas City Southern was the hardest hit of all.  Investors who purchased KSU late in the last cycle suffered from a serious bout of unbridled enthusiasm.  Analysts placed far too much emphasis on the long term the free trade story, and ignored competitive forces in the transport sector.  It appears that they completely forgot about the cyclical nature of the business.

With greater financial leverage than larger peers, and a major capital works program in mid stream, KSU fell from a $5.5 billion market cap, all the way down to a small cap, within the past 52 weeks. The market cap reduction of more than $3.7 billion seems to have removed all but the most intrepid of shareholders.  Large cap mutual funds were forced to divest the shares based upon cap weight restrictions.  Mid cap funds were going through massive redemptions and could not add the stock to their portfolio lists.  Retail investors were largely overwrought.

Analysts have belatedly remembered the cyclical issues, and now appear to have discounted KSU as a cyclical recovery pick.

Just 15 months ago, KSU management was anticipating as much as $2.8 billion of annualized revenues in 2012.    EBITDA was anticipated to be as high as $1.17 billion in that year.  EBITDA margins were forecast to grow to almost 42%, up from the 30% level achieved in 2008. (Source)

Intermodal growth was forecast to be the main driver of revenue.  With the expansion of a key container port (Lazaro Cardenas) scheduled for the end of 2010, KSU was anticipating intermodal revenues to grow by almost $500 million through 2012.

Now, in the tail end of the current recession, KSU is now looking to generate possibly just $1.4 billion of revenues for 2009.  EBITDA might fall to as little as $400 million.

While existing KSU shareholders remain in shock, new investors may have a remarkable opportunity.

Business has fallen off by less than 25% since 2008.  EBITDA seems to have fallen off by about 30%.  By way of contrast, Kansas City Southern share values have declined by more than 68% from their 52 week high. The share price decline appears excessive.

With 90.75 million shares currently outstanding, KSU has a market cap of $1.58 billion.  Add to this the estimated total liabilities (less short term cash) of $3.1 billion, $216 million of preferred shares and the result is a current enterprise value of roughly $4.9 billion.

Kansas City Southern now has a "Made in California" secular benefit, to add to the cyclical recovery story.

1.  A sea change in the international shipping industry occurred in August 2008.

Little known to the general investing public, the State of California passed a series of levies and taxes.  The intended victims are Asian producers and shippers of consumer goods to the United States.  A series of new fees are now applied against international shippers.  Port charges again these shippers have gone up by 160% in California.

State port taxes and levies now add an extra $160 per TEU, to the basic container handling charge in California.

Until recently, Asian exporters had few cost effective alternatives to getting goods into the United States.  Consequently, California is earning taxation revenues that would be classified as confiscatory, and possibly illegal, by trading partners in other countries.  Expressed as a percentage of the cargo values, port fees, dwell fees and taxes at California ports now exceed 5%, a global high.

Domestic shippers and outbound freight are largely exempted from the new tariffs and fees, and have remained very quiet about the tax changes.  In the eyes of the legislative assemblies, this robbery appears to be a victimless crime.

2.  To add insult to injury, the Longshoreman's union is doing to the west coast port industry, what the automotive unions did to the domestic auto business.

Average cash wages for the typical West Coast longshoreman exceeded $138,000 in 2008.  This is the highest paying blue collar job in the world.  Over and above the exorbitant wages, benefits are second to none.  The union boasts full health care coverage without deductible, fully paid by the employer.  In total, the average wage and benefits package per full time longshoreman exceeded $179,000 in 2008. (Source 1, Source 2)

In order to pay such ridiculous sums, a total of 9000 containers per employee, per annum, must be processed. With net margins on container handling at ports average about 20% globally, it appears that the most recent longshoreman's contract will push the two ports into the red, when container volumes drop below 15 million TEU.

Based upon the extraordinarily high cost of labour at California ports, it appears that insufficient funds will remain for future modernization and expansion of Long Beach and Los Angeles.

The failure to reign in longshoremen's wages coupled with sharply increased shipping charges; has effectively priced California out of the international container business.

Unlike ports, vessels are mobile.  The great shipping conglomerates of Asia can and will change where they will ultimately unload freight, as soon as an alternative port becomes available.  Most of the Asian ships heading to the US come with fully loaded containers, and leave with empty containers.  They are no ties to keep the shipments flowing through the US west coast, if a viable alternative may be found.

All that shippers require is a deepwater facility with direct access to roads and rails, and California will stand to lose every bit of container freight that can't be directly consumed within the state.  More than 65% of total container volumes are at long term risk of displacement.

The long term economic risk to California cannot be understated.  1 million California jobs are directly and indirectly tied to the international shipping industry.

Highly efficient, cheap and modern port competition is now being built, due south of California.

Located on the Pacific coast of Mexico, Lazaro Cardenas is well positioned to become a key competitor to west coast container ports. The facility is managed by Hong Kong based Hutchison Port Holdings.  Hutchison has strong ties to both the shipping industry in general and Chinese exporters specifically.  Both moral suasion as well as preferred customer discounts can be applied, should Hutchison choose to divert freight from Los Angeles to their facility.

TEU charges are estimated to be $235 US at Lazaro.  This compares very favourably to the $901 per TEU total charge levied at Long Beach.

The average longshoreman at Lazaro Cardenas earns less than 1/10th the total pay and benefits package, as the typical California longshoreman.

In total, the total estimated costs to move freight from Lazaro to Chicago appear to be exactly 50% of the current charges being levied just by the ports in California.  Fees assessed by BNI and UNP to transport containers to end markets, widen the differential.  In the world of logistics, shippers will move business to generate a 1 or 2% net saving.  A 50% net saving represents an irresistible pull. (Source)

Lazaro's expanded operation will be highly automated.  It will also be considerably more efficient than any US West coast port.  Dwell times are now almost non existent at Cardenas, while ships may wait 3-6 days at Long Beach to unload freight.

Over and above the compelling cost advantage, Cardenas also offers many strategic advantages over Los Angeles.  At 60 feet of depth, Lazaro Cardenas is the deepest port on the Pacific Ocean.  Being 7 feet deeper than the port of Los Angeles, this Mexican port is better able to handle the newest generation of container vessels.  (Source)

Cardenas is ideally situated to capture Asian goods destined for the US Midwest and south, such as Chicago, Kansas City and Houston. 

The port is quite new, and just in the first stages of start-up. In 2005, the port handled just 150,000 TEU.  Current volumes are running at 220,000 TEU per annum.

The first expansion will allow for a total of 2.2 million TEU per annum to be processed.  At full capacity over 4 million TEU annually may be handled. (Source 1, Source 2, Source 3)

California risks becoming an "also ran" in international trade.

While confronted with incontrovertible and irrefutable logic supporting large scale shipment diversions out of California, US detractors of Lazaro Cardenas remain dismissive.  They note that Lazaro Cardenas has been operating for a few years now, and hasn't pulled much freight away.  In reality, Lazaro was simply constrained by size.  The limitations will be removed in late 2010.

Status quo arguers further fail to acknowledge the economics of dropping containers into California have deteriorated, on a more or less permanent basis.  West coast ports have been unable to wrestle down longshoreman costs, which have now spiralled out of control.  Refusing to acknowledge the economic rationale for shippers changing ports won't stop it from happening.

And what makes things worse, is that a cash strapped government is no longer working to preserve the strong monopoly position of Long Beach/Los Angeles.  The state has actually put into action, a series of taxes that will ensure an increase in competition.  Everyone with a vested interest in preserving the ports appear to be working towards their demise.

Asian shippers are pragmatic.  Rather than complain to deaf ears, they will simply work to bypass California completely.  When Lazaro Cardenas and Punta Colonet (another proposed Mexican port) are fully operational, international shipping companies will save billions of dollars annually.

Lazaro Cardenas will benefit, as will all of Mexico.  So too, will Kansas City Southern Railway.

I have gently probed industry sources for several months, and have determined that the investment industry is completely apathetic to California's actions.

Not a single analyst has publicly questioned Kansas City Southern management since August 2008, regarding the change in California port charges.  Also, to my knowledge, after having listened to the many conference calls held by BNI and UNP since that time, it appears that not a single buy or sell side analyst has queried the competition about the development.

I have also spent some time diligently assessing the average retail railroad investor for their opinions, and found that they were:

a. Uniformly unaware of the tax changes.
b. Largely disinterested as to the long term ramifications.

Perhaps the largest potential driver of future revenue growth at KSU appears to be virtually unknown, and largely scoffed at, by those who should be highly attuned to the industry.  As a long term investor, I couldn't be more excited by the collective inattention.

If Kansas City Southern can increase its intermodal revenues from the Mexican port, revenues and EBITDA could soar.

In 2008, a whopping $2.5 billion, or 14% of 2008 Burlington Northern's total revenues, came from international container freight transport.  When combined with domestic container movements, BNI generated almost 34% of total revenues from container and auto hauling in 2008.

In 2008, roughly $1.3 billion, or 7% of UNP's total revenues came from international container freight transport.  When combined with domestic movements, Union Pacific generated 18% of revenues from container transport.  A further 8% of UNP revenues were earned through automotive transport.

In sharp contrast, Kansas City Southern generated just 9% of 2008 revenues from container transport.  Automotive transport accounted for just 6% of 2008 revenues. In 2008, container and auto intermodal revenues at KSU totalled $266.2 million

Should my long term thesis prove to be correct, roughly $2.5 billion of BNI and UNP's international container freight volumes could be displaced, in the next decade.  This is more than 25X KSU's current international container revenues. Kansas City Southern may not get all of my forecast revenue displacement, but they should certainly obtain some.

The woes of the auto industry also may have some unintended benefits for KSU.

In the near term, auto hauling is down sharply throughout North America.  This is due to declining sales.  I consider this purely temporary. At some point, sales should recover.

A long term windfall may accrue for railroads that specialize in moving imports. An estimated 1900 auto dealer franchises will be cut loose by the big 3 domestic producers.  GM, Ford and Chrysler "hope" these dealers will simply close up shop.  I consider this to be a naive assumption.  If the domestic big 3 thought that cutting loose a highly sophisticated network of dealers was a good thing, they will be sadly mistaken. 

A likelier event; at least half or more of these dealers will simply switch nameplates.  Penske Auto Group for example, has purchased 350 dealers to maintain the Saturn brand.  Penske now wants to add a foreign product (products) to build out the Saturn name. China has been looking for entry to the United States with their many car brands.

In years to come, I predict that the big 3 will dearly regret the decision to simply pull franchises, rather than buy them out and close them down.  The most logical outcome of the planned dealership reductions is that a host of inexpensive foreign products will be unleashed on North American shores soon.  The Chinese needed a distribution network, and many are now available.  North American dealers are used to a great deal of service revenue, so they will have no problem selling cars with perceived low initial vehicle quality.

Chinese autos will be low cost, so the shipping costs need to remain low.  Los Angeles and Long beach has priced themselves out of the Chinese market with their recent moves.  Mexico, with port charges just 26% that charged by the US west coast, seems to be the only logical choice.

Anecdotal evidence of the foreign car growth potential is already in the markets.  KSU has just announced a new venture with Nissan.  The goal is to beef up the flow of imports to the US. (Source)

My belief is that we are now in the nascent stage of a new economic cycle.

Market opinions are divided, as they should be. When investors are uniformly bullish or bearish, this is a sure sign of trouble. Currently, many consider the stabilization of a deteriorating US economy to be just a double dip.  Alternatively, some consider the stimulus packages to be the priming of the pump.

According to my data, the economic downturn was exacerbated by machinations of financial service firms, and would have conceivably been quite an ordinary recession at best...perhaps even a soft landing.  Therefore, the upside in the mid term could be pretty impressive, should consumers regain confidence.

I am not a market timer, and always run the risk of overpaying in the short run.

In the earliest part of a new economic upswing, deeper cyclicals tend to produce their absolute worst fiscal results.  Accordingly, these companies often look historically expensive, and therefore miss the numerous value screens now in use by retail investors.  The second quarter now ended could be the trough for rails, which will make the entire industry look more expensive than at any time in the last 5 years.  However, when compared to the last economic bottom, I consider this entry point to be cheap.

It is my intention is to increase Kansas City Southern to a core weight holding in RMG#1

While the balance sheet of KSU is the most leveraged among class one railways, liabilities have gone towards went towards building a better railroad, not paying out legacy retiree benefits.  The benefits of aggressive capital spending will be enjoyed in the next up cycle. With one of the newest engine and rolling stock fleets in the industry, and cost savings starting now on completed capex, KSU would potentially generate more than $650 million of EBITDA in 2012.  If the markets eventually value KSU at a 10X EV/EBITDA multiple in that year, shareholders could potentially double their money from here. 

A three year potential double, based upon a cyclical recovery in North America would be adequate compensation for my time.  If the secular trend does start to play out as planned, potential revenue and EBITDA growth could be far more dramatic.

By 2015, KSU could certainly generate the $2.8 billion of revenues originally forecast by management for the 2012 period.  If, by 2015, EBITDA surpasses $1.17 billion, a 9X EV to EBITDA multiple could value the shares at $75.

RMG#1 is a predominantly large cap, globally themed portfolio seeking to benefit from global secular trends.  A very small initial position was started in KSU a few months ago, while I began assessing the potential impact of the Californian tax decisions.  After considerable reflection, I will be comfortable increasing the holding to a 3%-5% market weight position.  I also own shares of Kansas City Southern personally.

We've all heard the saying, "invest in what you know". This saying, coined by Peter Lynch, refers to the hope that good investments might be found at your very doorstep.

The mantra should be accompanied with a pharmaceutical "black box" warning, or at the very least a caveat. Investing in familiar names, by default, implies that we overweight in local or domestic companies. This creates the possibility of a "false confidence". In order to stay within our comfort zone, a very real risk exists that we wind up owning highly ordinary (or less than ordinary) companies. A confirmation bias is created for domestic firms at the expense of foreign firms. Such a view has been borne out by a host of academic research. One seminal paper "Familiarity breeds Investment," by Gur Huberman at Columbia University, is worth a read. (click here to download the article)

Perhaps it is time to put the notion of investing in what we know aside. False confidence is no substitute for fundamental investment research and thorough peer analysis.

Nowhere has this "invest in what you know" premise been more of a failure than in large cap US pharmaceuticals.

Long term investors piled in almost a generation ago. The lure was pie charts full of favourable demographic data on drug use. After all, companies produce a pill for every real (or imagined) need. And as we age, don't we all consume more drugs? The business model was touted as being recession proof.

This confirmation bias has produced a decade or more of disappointment. Investors bought into demographic trends while ignoring balance sheets, global competition and government regulation. Consider how investors would have done had they held the big three US drug companies based on enterprise value. These are Johnson and Johnson (JNJ-NYSE, $56.12), Pfizer (PFE-NYSE, $15.17) and Merck (MRK-NYSE, $26.21).

A dinner party to honour the outcome of these three purchases would be a "bleak tie affair" indeed. If JNJ was purchased back in September 24th, 2001, one has just broken even (before dividends). If Pfizer had been purchased way back on January 2nd, 1997, investors are now roughly even before dividends. Based on a purchase of Merck 14 years ago (July 1995), investors are STILL not even, before dividends.

Those who are bullish on US large pharma blithely explain away a decade of lost returns on the current recession and global market selloff.

However, they fail to explain why such so called "recession proof" US companies are acknowledging potential revenue and profit declines for the next several years. Bulls further fail to address how it can be that US large cap pharma firms are doing so poorly on a business basis, whereas European and Asian large pharma are quietly reporting record sales and earnings.

The latest tool in the corporate finance divisions of large pharma is to merge the weak.

Merck has agreed to buy Schering-Plough (SGP-NYSE, $23.76). SGP is forecasting flat to declining 2009 revenues and profit. Pfizer has agreed to merge with Wyeth (WYE-NYSE, $44.59). Once again, Wyeth is forecasting revenue and profit declines in 2009.

I personally fail to see how merging four firms into two solves the revenue decline issue. If Pfizer and Wyeth sales are dropping, combining these firms achieves nothing. If Merck sales are dropping and Schering sales are dropping, an acquisition of Schering with a healthy cash payout does not address the coming round of patent expirations.

It also remains to be seen how leveraging up the balance sheets of Merck and Pfizer does anything more than add capital risk for shareholders. I consider the recent wave of weakness mergers in the US to be acts of corporate finance desperation.

Sophisticated investors evidently don't buy the premise either. Bleak near term industry prospects for the US industry have compressed valuations. The median EV/EBITDA ratio for the top 7 drug companies globally has fallen to the lowest average level in more than a decade.

Investors should not assume that the global pharmaceutical industry is in the same leaky boat as US drug firms.

Three of the top seven global firms based upon enterprise value are based in Europe. Roche (ROG-Zurich, $131.5), Sanofi-Aventis (SNY-NYSE, $30.99) and Novartis (NVS-NYSE, $40.47) are forecasting revenue growth in 2009 and beyond. All three companies posted record 2008 fiscal results. All raised their 2009 dividend payouts. All suggest that new drug approvals and existing product growth may more than offset patent expiries through 2012.

The compression of large pharma valuation ratios has made these successful firms look incredibly cheap on a historic basis

The European giants are doing just fine. Clearly all are differentiated from US peers in a number of important areas. Capital ratios are much stronger, with lower levels of debt than US peers. In contrast to US counterparts, European firms already operate under widespread price controls for many drugs. Like US firms, the big three in Europe grow by acquisition. To the benefit of their existing shareholders, these firms generally pay with cash rather than dilutive stock. The companies are geographically closer to key emerging markets in Asia and Eastern Europe. And finally, European firms tend to be "asset heavy", with an emphasis upon building new pharmaceutical plants. They have made substantial inroads into China and emerging markets with major capital investments.

My personal choice as a GARP investor, among the three European names mentioned above, is Sanofi-Aventis.

With 2.62 billion ADRs outstanding, SNY is the world's 3rd largest pharmaceutical company on a global basis by revenues. Sales were $36 billion for 2008, and should surpass $40 billion US in 2009, primarily from pharmaceutical products. EBITDA could exceed $16.1 billion in 2009. The company generates more than 69% of its revenues outside of the US. In the current quarter, the US dollar has fallen rather sharply against the global currency basket. At Sanofi, this should be of benefit. Recent currency moves should also assist Roche and Novartis in 2009.

SNY is the world's leading producer of vaccines. The Sanofi-Pasteur division holds 21% of the global market, and is increasing share. Management has determined this division to be a major driver of revenue and earnings growth. Accordingly, significant capital is being invested to double global vaccine output in the next five years. Of major significance is the potential commercialization of a Dengue fever vaccine. SNY hopes to bring this product to market in 2014. A $475 million plant in France is now being built to produce the vaccine. Second only to malaria in terms of commercial potential, this vaccine could post sales in excess of $1 billion US.

Sanofi also has core strengths in the diabetes market. On a global basis, SNY is #2 behind Novo Nordisk (NVO-NYSE, $52.28). Both firms have been capturing market share from Eli Lilly (LLY-NYSE, $34.77). SNY forecasts its forecast 2009 diabetes revenues ($4.5 billion) to virtually double by 2013. The global diabetes market has the potential to become a de facto duopoly.

Sanofi makes acquisitions. Existing shareholders are well served, since SNY pays cash (not stock) for small bolt on purchases. Thus far in 2009, three emerging markets generic drug makers have been acquired just off the market lows. Over one full fiscal year of operations, these acquisitions will add $1.2 billion of revenues.

On the basis of all key metrics, Sanofi-Aventis appear to be a bargain vs. peers.

At forecast EBITDA and revenues, Sanofi would appear to deserve a top three enterprise value on a global basis. The company is only valued as the 7th best in the peer group. Sanofi sells for a 2009 EV/EBITDA ratio that I forecast to be 6.8X, well below the industry average of 8.9X.

SNY's sheet is the strongest among the top #7 global peers, and by far. Only Novo Nordisk (another current holding of RMG#1) boasts a better balance sheet.

Profit and dividends are likely to grow in the near term.

In 2009, management of Sanofi anticipates revenue growth rate of about 7%, tops among large companies.

The current dividend payment provides for a gross yield of 4.9% and is just 34% of forecast 2009 profit. On an absolute basis, the dividend payment has grown by 83% since 2004

The dividend growth rate contrasts to large cap US peers, most of which have produced limited dividend growth since 2004. PFE has recently slashed its dividend in half. Merck's dividend payout is touching 50% of forecast earnings, and is unlikely to increase in the near future. JNJ's payout ratio appears to be almost 45% of forecast 2009 earnings, and is unlikely to be increased substantially in the near term.

A lack of research coverage may account for the limited number of Sanofi shareholders in the US.

Only 4 US firms provide coverage. 1 firm rates SNY as a buy, 1 as a hold, and 2 as a "sell". I find this inexplicable.

In contrast, 15 US analysts provide coverage on Merck. 13 report on Pfizer. 17 cover JNJ. Despite the fact that the three US peers are faced with the prospect of declining revenues and earnings in 2009, not a single US analyst in the bunch will dare to publish a sell.

It seems clear that a North America confirmation bias exists. US large cap pharmaceuticals are praised, irregardless of investment merit. Taking into account the lack of coverage on Roche (1 analyst), Sanofi (4 analysts) and Novartis (4 analysts), it also seems clear that a negative confirmation bias exists for international large pharma.

An analyst buy rating seems unnecessary to confirm my investment case here.

Sanofi's industry leading growth rate, world class business model, best in class balance sheet and high, sustainable and potentially growing dividend are all the validation I require.

The shares appear undervalued by 20%-32% to the peer group in the near term. My view is that this gap will close in the years ahead. If success in the vaccine and diabetes franchise continues, SNY may ultimately deserve a premium valuation. I consider Sanofi-Aventis to be a core holding in a globally themed large cap portfolio and own shares personally.

RMG #1 has recently initiated a position in Sanofi. This holding will be gradually increased to a core weight as funds permit.

The corporate website may be found here: http://en.sanofi-aventis.com/

Guangshen Railroad: (GSH-NYSE: $17.29)

All amounts, unless stated otherwise, are expressed in US dollars. Amounts are converted from Chinese Yuan at the rate of $.1463. Estimates are my own, and may differ materially from analyst reports.

ADR Shares Outstanding: 141.67 million.
Total liabilities cash (09/30/08): $724 million.

Estimated EBITDA for 2008: $434 million.
Estimated EBITDA for 2009: $503 million

Estimated 2008 year end EV/EBITDA ratio: 7.4X
Estimated 2009 year end EV/EBITDA ratio: 6.3X

Guangshen Railway's 9 month revenue reports provided the first indications in 2008, of normalized traffic flows

Primarily a passenger railroad, GSH revenues are heavily front loaded to the 1st quarter of the fiscal year. This coincides with the January spring festival holiday travel period. Accordingly, as much as 30% of the total years' revenues, and up to 35% of annualized EBITDA are earned in the first quarter of each fiscal year.

In 2008, massive snowfalls in the transport basin resulted in a complete shutdown of rail transport for much of the spring festival. Travellers did not choose alternative transport, as all roads were closed. The Chinese government simply advised migrant workers to stay put during the holiday period.

The cessation of holiday travel produced a reduction in 1st quarter revenue growth, as well a drop in 1st quarter EBITDA. 2nd quarter revenues and EBITDA demonstrated improvement, but were not sufficient to overcome the 1st quarter drop.

The 3rd quarter has proved to be more indicative of GSH potential. My estimated 9 month EBITDA has now surpassed that earned in the first nine months of 2007.

While modest, it now appears that GSH has the potential to increase 2008 total EBITDA by up to 6% above 2007 numbers. Revenues could be roughly 17% above 2007 year end figures.

GSH has now completed its major purchases of rolling stock in the near term

The firm completed the most significant expansion of its history. Between 2004-2007, Guangshen purchased a major trunk line and completed a $450 million high speed rail line expansion.

Rolling stock purchases were the focus of capital spending in 2008. Most of the equipment purchases have now been delivered, and are producing planned revenue growth. Net liabilities have increased by more than $258 million in 2008. Only two more train sets are scheduled for 2009 delivery. I anticipate a steady reduction in total indebtedness from here.

Guangshen appears to be setting up for a robust 2009

Based on my current EV/EBITDA ratio, the investing public seems to have lost complete faith in the Chinese secular growth play. Analysts too, appear to be extrapolating the current lack of economic growth, well beyond any reasonable time frame for historic global slowdowns. In short, I consider the consensus view to be too sceptical, by far.

$65-70 oil will revitalize the global economy much faster than policy initiatives ever will. I consider the current economic slowdown to be a major buying opportunity for the next economic cycle.

The 3rd quarter report for GSH confirms that EBITDA growth has turned for the better. To the chagrin of current holders, recent market volatility has temporarily trumped positive fundamental news.

As to mid term outlook for Guangshen Railroad, it appears bright. With additional rolling stock, the new high speed rail line will be more fully utilized. This should prove highly beneficial to both the top and bottom lines.

Based on my forecast, Guangzhou Railroad now appears to be selling for the lowest EV/EBITDA ratio in almost 10 years. With a major capital expenditure program now completed, the focus for 2009 will turn to revenue growth and margin expansion.

GSH traditionally sells for a premium to North American rails, due to better secular growth trends and less emphasis on commodity hauling. This is one of the few instances that I have seen, where this Chinese passenger line sells for discount to North American commodity hauling peers. I believe that the shares are too cheap by far.

Novo-Nordisk (NVO-NYSE: $53.51)

Shares outstanding (fully diluted as of 09/30/08: 618.6 million.
Total liabilities- short term cash as of 09/30/08: $1.68 billion.
Enterprise Value: $34.78 billion.

Revenue forecast for 2008: $9.1 billion.
Revenue forecast for 2009 $10.1 billion.

EBITDA margin forecast for 2008: 30%
EBITDA margin forecast for 2009: 32%

EBITDA estimate for 2008: $2.7 billion.
EBITDA estimate for 2009: $3.2 billion.

In an investment world plagued with companies reporting earnings disappointments, reduced guidance or balance sheet blowups due to credit markets, it is refreshing to find world class companies that have INCREASED their guidance. Novo Nordisk is one of just a handful of firms on a global basis to have done so.

http://biz.yahoo.com/ap/081030/earns_novo_nordisk.html?.v=2

Novo Nordisk is the world leader in diabetes pharmaceuticals

NVO has a 52% market share of the worldwide insulin market. This market share has been growing consistently over time. The firm has worked diligently to produce better and safer insulins over the past 20 years, which have been well received by patients. The company has demonstrated considerable success in the modern insulin market as of late, capturing a 44% global market share of this fast growing market. The diabetes division accounted for 73.5% of total revenues in the first 9 months of 2008

Major global competitors include Eli Lilly and Sanofi Aventis.

The firm also has considerable strengths in hormone therapies and haemophilia pharmaceuticals

Novo produces human growth hormones and coagulation products. Revenues continue to grow at double digit rates.

Novo has a superb balance sheet

Using the conventional model that is employed by analysts at most firms, NVO would be considered completely debt free and carry a liquid balance of 1.7 billion US.

http://www.novonordisk.com/images/investors/reports/interim_reports/2008/PR081030_9M_UK.pdf

Analysts generally lump all short term assets into models employed at major brokerage firms, when producing their Enterprise Value (EV) estimates. My valuation models are more stringent. I consider inventory to be a permanent part of the capital structure. Without inventory, a company cannot produce any product. A failure to include inventory in investment analysis represents an admission that a business is not a "going concern".

My EV calculations only include true "cash and short term assets" and exclude inventory, accounts receivable and marketable securities. As we are all now intimately aware, marketable securities sometime become "unmarketable".

Using my model, NVO reported net liabilities of $1.68 billion on 09/30/08. This works out to be less than 9 months of 2008 operating cash flow.

The firm has a near term diabetes product in the pipeline, with blockbuster potential

Liraglutide may be approved by the FDA as early as 2009. This drug is designed to compete with an Eli-Lilly/Amylin Pharmaceuticals product known as Byetta. According to comprehensive phase 3 testing, Liraglutide has the potential to become the industry standard in this newer class of diabetes compounds. Adverse side effects are much less pronounced in Liraglutide than Byetta, and patient tolerance is considerably higher. Novo does not factor in any revenues from this drug in 2009 revenue estimates.

Of greater interest is a "Category Killer" insulin now heading for phase III trials

NN5401 and NN1250 have the indications to completely redefine the conventional treatment of diabetes. Novo had kept this development under wraps until quite recently. Now, it appears that management is highly confident of their potential to better the lives of diabetics globally. These two innovative, next generation insulins will commence phase 3 testing in the latter half of 2009. Both are long lasting insulins (more than 24 hours), and appear to be both safe and very well tolerated. Instead of daily injections, patients would only require 3 injections per week.

Novo is the only company worldwide, with a new generation of insulin in full clinical development. Now that details are more fully disclosed, it appears that NVO might have caught Eli Lilly and Sanofi Aventis napping. Either of these products may serve to completely change the dynamics of the marketplace. If approved, NN5401 and NN1250 could steal enormous market share from competing products.

The global market for conventional insulins (modern and human) is estimated to be larger than $11.2 billion, and is growing at almost double digit annual rates. While NN5401 and NN1250 would cannibalize Novo's own sales, commercialization of either of these insulins could potentially add incremental sales by at least 10% per annum, commencing in 2012.

In terms of market potential, a 3 injection per week insulin, considered much safer than conventional products, with weight loss potential, would reshape the playing field. Novo appears to have as much as a 5 year window over potential competition. If successful, these insulin's could hit the market as early as 2012. While this sounds ridiculous, the potential exists for Novo to capture 100% of the remaining market share

A game changing drug could also be a game changer for Novo investors

At a 7% annual growth rate for conventional diabetes products, the market share that Novo does not have, may grow to $7.4 billion in five years. The operating margins on insulin sales approach 76%. EBITDA margins for this division approach 40%.

Total market share could add an incremental $3 billion of EBITDA for Novo shareholders by 2016. Novo's current product portfolio seems to offer the potential for 15% annual EBITDA growth, for some years to come. Commercialization of NN5401 or NN1250 would make NVO the fastest growing large cap pharmaceutical firm on the planet.

In ten years, if either insulin is approved, NVO appears to offer "five bagger" potential from here.

Unlike many peers, Novo carries little pharmaceutical liability

If a drug does not have the potential to be an industry standard, NOVO management won't run it through the clinical trial basis. The firm also has no reservation about scrapping drugs in the early testing phase. This has been proven again. In the most recent quarter, a promising compound was dropped.

When a drug company cancels a research project in the testing phase, this results in an immediate expense against the current years earnings. This is generally punished by analysts. Perversely, legal settlements are often considered to be "one time" items, and are therefore ignored by analysts.

NVO has demonstrated that it is willing to take the ethical high road. Accordingly, the company's litigation docket is the lightest of any major pharmaceutical firm that I follow.

On a historic basis, the shares are inexpensive

Novo is a quiet global success story. According to Yahoo, only 2 Wall street firms now report on NVO. Yet, in the past five years, investors have almost tripled their investment value, when dividends are added to the total return. That said, the shares are presently selling at the same EV/EBITDA ratio as in 2003. This is because the company's sales and EBITDA have grown proportionately.

Eli Lilly and/or Sanofi-Aventis may ultimately be forced to launch a takeover bid

I don't normally comment on the potential for takeover with any stock, as they seldom come to fruition.

In the short term, potential commercialization of Liraglutide appears to place Lilly at a clear disadvantage. In the mid term, NN5401 and NN1250, if successful, could totally destroy the high profit insulin franchises of Novo's competitors. Lilly, in particular, has lost considerable market share in the past decade. Without a competitive product, the only defense against a category killer, is a high cost friendly takeover.

The quarter ending September 30th, 2008 was certainly a tumultuous time. Irregardless of whether a "long only" manager maintained a value philosophy, a growth philosophy or growth at a reasonable price methodology, the outcome was the same; a down quarter.

It also made very little difference as to whether one was in large cap or small cap. The only differentiation between portfolios was based upon the percentage loss incurred in the quarter. Global investors, both personal and professional, went into net redemption mode.

RMG#1 has a global focus. The portfolio posted a loss of 14.3% for the quarter ending 09/30/08, and was down by 19.36% YTD.

I appraise the relative success, or lack thereof, against similarly configured publicly available mutual funds with a global theme, in similar cap weights. These peers include:

Trailing Returns as of 10/1/08 (17.98%)

Ticker	Fund Name	3 Mo. Return	YTD Return	1 Year Return	3 Year Annualized	5 Year Annualized
CWGIX	American Funds Capital World G/I A	(15.05%)	(24.04%)	(24.81%)	4.56%	11.11%
AEPGX	American Funds EuroPacific Gr A	(26.91%)	(26.88%)	4.29%	11.34%
ANCFX	American Funds Fundamental Invs A	(15.77%)	(22.07%)	(23.79%)	2.68%	8.92%
TWWDX	Thomas White International	(20.80%)	(27.62%)	(29.03%)	6.03%	14.22%
ABIYX	American Funds Capital World G/I A	(20.80%)	(27.62%)	(29.03%)	6.03%	14.22%
DODFX	American Funds EuroPacific Gr A	(17.56%)	(28.10%)	(29.35%)	2.45%	12.61%
SAHMX	American Funds Fundamental Invs A	(16.87%)	(30.79%)	(33.39%)	2.25%	11.05%
DODGX	Thomas White International	(12.63%)	(26.49%)	(30.98%)	4.95%	8.90%
RMG1	Value Oriented Growth	(15.75%)	(24.18%)	(19.13%)	14.26%	33.26%

Returns assume reinvestment of dividends and distributions. Performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

1. All returns as of October 1, 2008
2. Mutual fund returns from Morningstar
3. RMG1 returns are from a model portfolio managed at www.marketocracy.com using virtual money. Returns include virtual transaction fees of 5 cents per share and virtual annual operating expenses of 1.95%

Among global portfolios with a larger cap focus, Morningstar reports that the representative fund in their coverage universe lost 27.72% YTD, as of September 30th, 2008. The Morgan Stanley Capital International Index, known as MSCI EAFE (developed) was down 29.26% YTD on that date.

The larger cap portfolio RMG#1 has maintained its #1 status among peers YTD. I am quite certain that none of the managers, me included, are impressed with the absolute negative returns posted year to date. Most of the managers in this class have exhibited minimal turnover of their holdings, since the end of the last quarter. This seems to imply that they are very much standing pat with their investment selections, as am I.

During periods of market volatility, investors can sometimes second guess themselves, and fall prey to panic, or media hype. The media has a 100% track record in reacting to events. However, the media's interpretation of such events, and predictive ability for the future, is not nearly so clear.

I believe that economic recessions have one great virtue. During periods such as now, truly world class companies become abundantly obvious to all. Poorly run firms, ordinary firms and many fine firms don't meet EBITDA and revenue expectations during downturns. Sometimes, earnings are met, but only with an * being attached to their financial statements, which is every bit as bad as a miss. However, there are companies in each and every economic cycle, which beat targets, and sometimes raise them.

At times such as now, I look to identify these corporations, potentially for inclusion in a portfolio. Businesses capable of beating expectations during tough times often become multi-baggers when economies revert to growth.

Here is a summary of the top three investment position in RMG#1 with my long term outlook. In addition, I am including a quick layout of what I feel are the key criticisms that generally represent the bearish thesis on each company.

Mastercard Inc (nyse: MA)

A. Mastercard (MA-NYSE $171.34). I consider Mastercard to be a global company, as more than 50% of its revenue is derived outside of North America. The company earns fees for processing transactions on its system, and has no direct exposure to bad debts or credit collections.

There are roughly 131 million shares outstanding, and the company had net liabilities on June 30th, 2008 of $3.04 billion. This produces an EV of $25.5 billion.

Mastercard, in my view, is a cash generating machine unlike few in the world today. The company has sustaining capital expenditures which appear to be less than $100 million per year. EBITDA for 2008 could exceed $1.7 billion, which prices the stock at 15X the current years EV/EBITDA ratio. Provided that the secular trend continues, MA could generate as much as $2.1 billion of EBITDA in 2009, for a ratio of 12X my 2008 estimate.

The shares were initially floated to the public at a ridiculously low valuation. MA rose quickly as investors became aware of the growth potential based upon the secular trend towards debit/credit usage vs. cash.

Mastercard shares have come down rather hard in the last quarter. The bearish case centers on the credit crisis, and valuation. In terms of the crisis, discussion centers on the possible slowdown in the growth of credit and debit card transactions by consumers. European, Asian and South American use expanded at anywhere from 15%-20% in the first half of 2008. In the US, volume growth was much lower. Should volume growth slow, EBITDA growth will also slow. This might result in further compression of the share price (valuation).

While I understand the bear case, even detractors can't see volumes NOT growing. Bears and bulls simply disagree as to the rate of future volume growth.

My ONE key concern is the possibility of some short term collateral damage, should Visa come up short on their forecast. Visa generates a far greater percentage of revenues from the US than does Mastercard. Visa also generates a very high percentage of volumes from California, which might be harder hit than other markets from the credit crisis.

Myself, I estimate that by 2018, at a 10%-12% rate of annual volume growth, MA could generate as much as $7 billion of EBITDA in that year. If the market continues to value the stock at 12X- 15X EBITDA, MasterCard could have an enterprise value of $84 billion-$105 billion at that time. I forecast up to $39 billion of EBITDA may be earned in that entire period, which greatly exceeds the market cap. In short, I believe that MA has the potential to be a multi-bagger for patient investors.

Novo-Nordisk A/S (nyse: NVO)

Novo-Nordisk (NVO-NYSE $52.91) is the world's leading pharmaceutical firm specializing in the treatment of diabetes. Headquartered in Denmark, NVO has a 53% (and growing) market share of the worldwide insulin market. In the US, Novo's market share is 42%. Diabetes care products accounted for roughly 73% of 2007 sales. The firm also has core strengths in hormone replacement therapy, haemostasis and growth hormones. Revenue could touch $9 billion in 2008 and $10 billion in 2009.

There are 623.5 million shares outstanding, for a market cap of $33 billion. NVO has net liabilities of just $1.25 billion, which produces an EV of $34.25 billion. I forecast that NVO may generate more than 2.8 billion of EBITDA in 2008. This may rise to $3.2 billion in 2009. This prices the shares at 10.7X my 2009 EV/EBITDA ratio, a four year low.

US sales of insulin products were up by an impressive 21% in the first half of 2008, a rising US dollar could materially bump revenues and earnings for the better. Novo generates roughly 53% of total revenues from North America. In local currencies, revenues were up by more than 13% in the first half of 2008. This reduced revenue growth somewhat for the first half of the year. However, for the quarter ending September 30th, 2008, the US dollar appreciated vs. the Danish krone. In early August, NVO raised earnings guidance by almost 10%, over their prior forecast. Since that time, the dollar has strengthened further.

EBITDA margins now exceed 30%, and have been rising year over year for quite some time. Novo has a potential diabetes blockbuster drug, Liraglutide, awaiting FDA approval, which may materially add to revenue and profit.

Bears, of which there appear to be few, tend to focus somewhat upon valuation. NVO has a flawless balance sheet, with little of the litigation that dogs most large pharmaceutical firms. Accordingly, the shares have tended to trade for a modest premium to peers in the marketplace. Detractors also appear concerned about difficulties experienced by a competitor, with an existing drug in the same class as Liraglutide.

I consider the modest premium valuation to be well deserved. Corporate governance is world class. NVO historically has quickly scrapped products that don't appear to be safe and effective, in the testing phase. This is why litigation is so light. I see few reasons to doubt management' current assertion; that Liraglutide is safer and more effective than the current standard. NVO seems to have gone above and beyond in its testing process. When/if the FDA clears Liraglutide for US sale, 2009 and 2010 earnings will need to be bumped up rapidly. If I am wrong, a company growing revenues by 10% + per annum, featuring 30%+ EBITDA margins still seems an impressive value at the current price.

Guangshen Railway (nyse: GSH)

Guangshen Railway (GSH-NYSE $26.03), is my top pick on the infrastructure and transport growth story in China. Guangshen operates high speed and normal freight rail lines in a heavily industrialized region of China. In mid 2007, GSH completed a major expansion of their high speed rail lines. In January 2007, management also purchased a sizeable trunk line from the Chinese government. The effective price was less than 8X EV/EBITDA. This purchase added a significant freight hauling business as well as long distance passenger revenue. Shares were sold to Chinese investors on the Shanghai stock exchange in December 2006, to raise the cash for the railway acquisition.

By my calculations, GSH had invested more than $450 million in the past 4 years to build its new high speed rail lines. This was paid for with internally generated cash flow. With the lines completed in 2007, management needed to purchase rolling stock to utilize the additional capacity. GSH added $375 million of debt in the last year, for the purchase of new train sets. Most of these were placed into service in early 2008.

There are 141.7 million shares outstanding, which creates a market cap of $3.7 billion. On June 30th, 2008, GSH had total net liabilities of $446.5 million. This produces an EV of $4.1465 billion. I estimate that GSH may generate $477-$500 million of EBITDA in 2008, and $515-$540 million of EBITDA in 2009. This effectively values the company at 8.7X the 2008 ratio, and less than 7.4X-7.8X my 2009 ratio.

The bearish sentiment on GSH comes from a sector dislike of China, coupled with the potential for additional competition from rails and bus in China.

I would note that as the Chinese stock market is off a whopping 65% from the 52 week high, there can't be many foreigners left in this sector. With GSH down by roughly 24% on the year, the shares have held up relatively well.

As to competition, with Chinese growth in both traffic and freight seeming to be a clear secular trend, there appears to be plenty of market share for all. In the next year, as the train set purchases are paid down, Guangshen should find itself with a very healthy cash flow to pay for more rail line assets, should they become available.

This is the only publicly traded railway in China with shares listed overseas. As I intend to benefit from the long term secular trend, Guangshen is the obvious choice.

At the current price, American investors are effectively paying less for GSH, than $27.45 US price paid per share by Chinese nationals in the secondary issue of almost 2 years ago. The shares now sell for a discount to North American peers, on a forward EV/EBITDA basis.

In closing, the media would have us in the throes of a pending great depression. This is exactly the same talk that I heard in the last several recessions. Recessions, while unwelcome, represent an inevitable part of the investment cycle. At their worst, recessions typically DELAY, but do not cancel, the progression of clearly defined secular trends.

In the weeks to come, I intend to provide my thesis on other holdings within the account, so as to bring investors up to speed with my approach and methodology. I look forward to sharing these views with you.

Regards,

Randolph

When selecting a manager, we always look at their largest positions, particularly when they represent a large portion of their portfolio. We like to know what their track record is with those stocks: how they've traded them, whether it is in their "performance zone" or not and what they see in the stock.

mFOLIO Master, Randolph McDuff's two largest positions are Mastercard Inc (nyse: MA) and Novo-Nordisk A/S (nyse: NVO) currently representing about 30% of the portfolio. Randolph writes about these two stocks, along with his third largest position, Guangshen Railway (nyse: GSH) in his Q3 Review above.

Below is a chart which details McDuff's trading of Mastercard since he started buying it just after its IPO in May 2006. You'll see that to keep MA from becoming too large a position as it skyrocketed to a six bagger, McDuff has made astute sells on jumps in the price including right near the all-time high. But as MA has dropped in price with the credit crisis - losing more than half of its value, McDuff has held on. This is very much in keeping with his investment style and you'll see from his interview in MarkeTalk and in his Q3 Review why he continues to like Mastercard and expects to keep it as a long-term position in his portfolio.

In the chart above, the stock price of Mastercard is shown as a BLUE line with the prices shown on the far right vertical axis. The number of Mastercard shares owned by McDuff in RMG1 is shown as a RED line with the values shown on the far left vertical axis. The GREEN Shaded vertical bars represent the dates when McDuff was BUYING more shares of Mastercard and the RED Shaded vertical bars represent the dates when McDuff was SELLING shares of Mastercard.

All amounts are quoted in US. The conversion rate from Columbian Pesos to US dollars on September 29th, 2008 was $.0004784. 1 US dollar =2090.5 COL pesos

Shares outstanding: 1.55 billion
Total liabilities short term cash on 12/30/2007: .71 billion.
Enterprise Value: 09/29/2008: $37.35 billion.

EBITDA generated in 2007: 9.6 billion.
Trailing 2007 EV/EBITDA ratio: 3.9X

Forecast 2008 EBITDA: $13 billion
Est. 2008 EV/EBITDA ratio: 2.8X

Forecast 2009 EBITDA: $11 billion.
Est. 2009 EV/EBITDA ratio: 3.X

American Depository Receipts of Ecopetrol (EC) have recently been listed on the NYSE. Each ADR represents 20 underlying shares of Ecopetrol common shares, which trade on the Columbian stock exchange. The shares were issued to Columbian citizens pre-market at $13.40 US. Since listing, the underlying EcoPetrol shares have traded in a 52 week range of $20.20-$33.00 US. The ADR of Ecopetrol started trading in North America on September 18th, 2008

Previously a government enterprise, Ecopetrol shares were floated to the public on November 28th, 2007 on the Columbian stock exchange. Each Columbian was limited to about $700 of initial investment at the time. The Columbian government still holds more than 89.9% of the total capitalization.

Ecopetrol was listed on the NYSE to provide a more liquid market than the Columbian stock exchange could offer. The company intends to create an international profile in line with companies such as Petrobras. Ecopetrol reports 1.45 billion barrels of 1P oil equivalent reserves (1.8 billion barrels including 2P). Other assets include 2 refineries with the capability of processing 270,000 bpd, 8400 km of pipelines and petrochemical facilities. Oil and natural gas production averaged 399,000 boepd in 2007.

http://www.ecopetrol.com.co/documentos/41350_Presentacion_19_Congreso_Petrolero_Mundial__julio_02-2.pdf

Ecopetrol is virtually debt free, reporting just $708 million of net liabilities on 12/31/07. Among oil companies its size, ECO has arguably the strongest balance sheet in its class.

Management intends to boost oil production from 399,000 boepd in 2007, to 1 million boepd by 2015.

All oil companies tend to talk up strong production growth potential, which is seldom realized. For a major to forecast an 18% plus annual production growth rate in the next 8 years seems almost absurd.

Ecopetrol however, has a unique operating advantage over many oil companies in South America. The firm can back into almost any new discovery made in Columbia, to a potential 30% holding. This trigger can occur when EC pays all costs incurred to the point where a discovery is declared commercial. Columbia boasts a low royalty regime (5%-25% of production). Corporate taxes are currently 33%, and have declined sharply in Columbia for the past 5years. This attractive fiscal regime has sparked renewed interest in this oil prone country. Too, Columbia has large heavy oil deposits which are likely to be exploited in the years ahead. The geography is quite similar to Venezuela, which has substantial heavy oil deposits.

The attractive fiscal regime, heavy oil potential and development initiatives underway in key oil basins, give me confidence that EC is likely to grow production materially in the years to come. A 150% increase does seem to be a stretch, but review of the field potential does suggest a potential doubling of production over the forecast period.

Thus far, as a public company, Ecopetrol has made good on their goals. In the first half of 2008, output rose to 438,000 boepd. This compares to the 399,000 boepd produced in 2007, a gain of 9.8%.

http://www.ecopetrol.com.co/english/documentos/41492_Ecopetrol_en_cifras_Junio_08-ingles.pdf

Management intends to boost recovery factors from existing fields using improved technologies. Too, Ecopetrol intends to take a more active interest in exploration and development, in and around, key underexploited fields. It does not seem unreasonable to suggest that 2P reserves might grow to almost 3 billion barrels by the end of 2015.

Refinery capacity and petrochemical output is forecast to grow dramatically in the next 7 years.

Management intends to double refined output by 2015. Petrochemical production growth of almost 475% is planned in this period.

Provided that oil remains in the $90-$100 bpd range for the next 7 years, internally generated cash flow should pay for this expansion.

A better known peer, Petrobras, intend to increase output by about 1/3 in the next 7 years, but might need about $250 billion of external capital to meet this goal. Ecopetrol intends to spend about $60 billion in the next 7 years, with a view towards more than doubling in size. This will be less than forecast EBITDA, which suggests minimal need for external capital funding.

The shares seem very inexpensive on an EBITDA basis.

Ecopetrol generated $8.99 billion of EBITDA in the first half of 2008, up from $5.1 billion in the same period of 2007. Oil prices have moderated since Q2, but are still higher than in 2007. Should oil prices remain in the $90-$100 per barrel range for the balance of 2008, EC may generate as much as $13 billion of EBITDA in 2008.

The balance sheet appears to be improving. Capital expenditures are forecast to range from $4.1-$4.6 billion for 2008. As this is less than half of forecast EBITDA, EC may report a positive net cash balance at the end of 2008.

It clearly appears that the windfall profits from high commodity pricing are over for the industry.

Most global oil companies grew EBITDA rapidly in the last 24 months based on extraordinary pricing of oil. Production growth in large caps was largely stagnant. Now that oil pricing has moderated, the majority of large cap exploration and production companies will begin to post declining quarter over quarter comparisons. In short, the market will now start to become highly selective.

Companies that look capable of outperforming their peers will need to be low cost producers, in lightly taxed jurisdictions, with clearly defined growth prospects. Ecopetrol seems to fit my criteria nicely. Columbia, while virtually unknown to investors, boasts a declining corporate tax rate (33% for 2008) and royalty rates of 5%-25%. I believe that the Columbian economy has excellent macro potential overall.

While EC will not match 2008 EBITDA forecasts in 2009, the shares seem awfully inexpensive on all valuations. Oil prices are such that conventional producers will make strong profits. Shale oil and shale gas producers, with their extremely high capital costs and low productivity, will not be so lucky.

Spotting a potential multi-bagger early always invites the wrath of sceptics.

The company looks like an early version of Petrobras (PBR), which I purchased way back in the 1990's. Then, I took plenty of flack from the professional investment community, for purchasing shares of a third world oil company operating in a leftist country. Considering my country of origin, this seems deeply ironic.

Now, PBR is an integral part of most international oil portfolios and Brazil has a larger economy than Canada. Many of these experts who refused to acknowledge the thesis early on, now feel quite comfortable calling PBR a buy, at prices more than 15X above my initial purchase price.

Ecopetrol is NOT a suitable investment on a stand alone basis.

The shares are completely unknown to the public, and are not liquid at present. 89.9% of the stock is tied up in government hands. At best, a further 9.9% of the shares might come to market someday. Further, the stock started trading at a precipitous period in the markets. Improved institutional attention will NOT be forthcoming in the near term. As the firm should require minimal capital from external sources, brokerage firms will not pay any attention to the ADR.

Ecopetrol should only be considered as an extremely long term investment and should be no more than a modest portion of a well diversified global account. That said, I predict Ecopetrol will one day be a widely held investment in oil accounts, much like Petrobras. I will be happy for broadly based markets to inevitably arrive at my conclusions, and will be soon adding shares for the Marketocracy large cap account.

My 7 year forecast hold period might be made more comfortable with a decent dividend. Based upon 2007 results, EC paid out a basic dividend of $.80 US per share, a 3.3% dividend rate. Provisions exist for a bonus payout annually, which added a further $.60 US per share, or 2.5%, to the 2007 amount.

Plenty of oil companies pay dividends far above this rate. However, the cushion of safety at most is inadequate, when oil is $90 per barrel and gas is $7 per mcf. With a highly conservative balance sheet, Ecopetrol's basic rate could grow steadily over time.

The corporate website, in English, may be found by linking here:

http://www.ecopetrol.com.co/english/