THE BERMAN VALUE FOLIO

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1 THE BERMAN VALUE FOLIO A Trefis Interactive Portfolio Report Big Value in Big Steel December 2013 CONTENTS Big Value in Big Steel 1 MT: Follow the Money 3 Company Highlights 5 Access interactive Trefis analysis to get the most from the Folio: Apple 5 Pfizer 6 ADP 7 BNY Mellon 8 The Berman Value Folio 9 Test our assumptions Run your own scenarios Read forecast rationale Access Trefis research Analyze company value drivers There are few deeply undervalued sectors anymore. Large cap steel stocks stand alone, a forgotten corner of the market, punished by every macro view: the China slowdown, the Fed taper, and the debt ceiling hangover. But the fundamentals of steel will improve eventually. More to the point, the value is already there. I ve written previously about Leonard Ayre s 1927 blastfurnace index, which advocated buying steel stocks only when they were out of favor and demand was quantifiably low. When over 60% of furnaces were in blast producing pig iron, stock prices were high and bargains scarce. When a low number was in play, prices were cheap and opportunities great. As Warren Buffett says, you pay a dear price for a cheery consensus. The particular blast furnace data point itself is now dated, but the idea remains the same. Like any deeply cyclical stock, you should buy when the economy is slack, prospects poor, and the eventual recovery dim to behold. That time is now. My favorite among the steel stocks is Arcelor-Mittal (MT), the amalgam of the 2006 merger of French steel company Arcelor and Indian competitor Mittal. James Berman I bought MT back in September, 2012 at $ Now at $16.65, it s one of the worst performers in the Folio over the past year. No wholesale recovery in steel is on the horizon. By the time it s clear, though, it will be too late. The Trefis price is $16.56, but I think there s much more value there. James Berman, the president and founder of JBGlobal.com LLC, a registered investment advisory firm (SEC registered), specializes in asset management for high-net-worth individuals and trusts. Mr. Berman is a faculty member in the Finance Department of NYU SCPS. He has appeared on CNBC and the Fox Business Channel and has been quoted and published in a variety of publications, including Barron's, Fortune, Bloomberg, The Huffington Post and CNN Money. Mr. Berman holds a B.A., Magna Cum Laude, Phi Beta Kappa, in English & American Literature from Harvard and a J.D. from Harvard Law School.

2 The Trefis Dow Trefis Ticker Price Market Price AXP BA CAT CSCO CVX DD DIS GE GS HD IBM INTC JNJ JPM KO MCD MMM MRK MSFT NKE PFE PG T TRV UNH UTX V VZ WMT XOM Trefis Market Price Price DOW 16,217 16,088 1% Undervaluation One reason MT s stock has been capped for a year is fear surrounding the company s debt level. MT s leverage is higher than average. The misunderstandings around MT s debt level, however, have eclipsed any valid concerns about MT s financial strength. In August of 2012, S&P cut MT s long-term debt rating to BB+, a notch below investment grade, in other (more expressive) words, to junk. The agencies tend to downgrade ratings long after the stock market has priced it in. Thus, a favorite value strategy is to buy a stock at the moment the debt rating is cut. True to form, MT is up over 10% since the downgrade was announced. The major declines occurred in the six months leading up to the announcement. The market appears to misunderstand two things about MT s debt: (1) The market, as it often does, has trouble distinguishing net income from free cash flow. Since GAAP accounting requires net income to be calculated net of amortization and depreciation, net income can understate true earnings power in years where there are large goodwill write-offs or other non-cash charges. This is exactly so in MT s case, where a net income loss of $3.8 billion in 2012 obscures a $5.3 billion positive operating cash flow and $611 million in free cash flow (FCF) over the same period. There s a not insignificant difference between a business losing $4 billion or making $600 million, especially if you re worried about a default on $2.6 billion on annual debt service. (2) The market worries about MT s violation of its debt covenants, which would trigger further downgrades and could cause a technical default. When a company is close to triggering a technical default by violation of its debt covenants not from any real inability to pay it s more likely to modify the terms of its existing agreements than actually default. If the lender won t comply, it would refinance with a different lender. Legg Mason (LM) (and many others) renegotiated debt covenants in the wake of the financial crisis. Obviously, the revisions to the debt agreement will impose some cost on MT, such as higher interest rates, but the market is pricing in default, not a jot higher payment.

3 MT: Follow the Money The extraordinary divide between free cash flow and net income doesn t usually loom this large. If we look at the operating cash flow statement, we can see the 2012 reconciliation of net income to free cash flow from the cash flow statement: If we look at the 2012 operating cash flow (bottom, circled in red), we can see the $5.294 billion result. Whenever looking at the divide between operating cash flow and net income, you have to understand what s causing it. Ignoring the cause is just as bad as ignoring the cash flow statement itself. There could be real reasons why the net income is more indicative than the cash flow. It always depends on the cause of the discrepancy. Here, the two big add-backs are depreciation and impairment charges. The biggest adjustment is a $5.035 billion impairment charge (top, circled in red). If we look at the notes to the financial statement, we ll find the breakdown of impairment charges, including the $4.3 billion attributable to reduction of goodwill on prior acquisitions:

4 MT: Default? Really? No, not really. Because MT is actually making $600 million, not losing billions. The goodwill impairment charge is non-cash and doesn t impact free cash flow. Of course, an impairment charge is no good thing. It means that MT overpaid for prior acquisitions at the very least a sign of poor timing, at worst a sign of management s incompetence. An impairment charge also means that asset values which were once recognized as such no longer exist, tainting debt to equity ratios and impacting MT s ongoing efforts to realize value from continued sales and dispositions. For debt service, however, what counts are real ongoing cash flows net of capital expenditures. As you can see from the Trefis estimate of FCF over the next seven years (which are based on conservative growth and margin estimates), MT is likely to generate significant amounts of cash going forward: To put this all in personal finance terms, no bank would really care if your home s value declined so long as you continued to make mortgage payments. The day you didn t make that payment, well, different story. But MT s position would have to worsen dramatically, beyond even another worldwide recession, for debt payments to go uncovered. Where I depart from the Trefis analysis is the discount rate as measured by the weighted average cost of capital. I feel it should be 12% (not 13%) across all divisions, which leads to an intrinsic value of nearly $21 per share. I think MT is a great buy at the current price.

5 COMPANY HIGHLIGHTS Apple Berman s Take: Apple s (AAPL) stock has recovered over the past few months, but I agree with Trefis that it s worth more: over $600 per share. AAPL has been short on innovation and long on minor tweaks for some time. I don t think this is a bad way to run a business for a limited time: to entrench your basic products and services by improving them incrementally. But if you re in the device business you must eventually reinvent the wheel, or die under it. Fortunately, a $600 intrinsic value per share is exinnovation. In other words, AAPL is worth that price even without a new, new thing. AAPL is not the type to endlessly disappoint. At some moment (of their choosing), they will announce a broad new initiative. Will this rival the iphone in sheer novelty? Unlikely. Will it justify a move beyond $600? Probably. Trefis Key Drivers: Investors have been waiting for some time for Apple to strike a deal with China Mobile, China s largest wireless carrier. While roadblocks have included network incompatibility issues as well as disagreements surrounding subsidies, it is now rumored that the two companies are close to a deal that would make the iphone available to China Mobile s 760 million subscribers. This would open up a huge potential customer base for Apple, and could drive significant sales growth in the next few years. However, it will be interesting to see if Apple launches a sub-$400 iphone for emerging markets (which it has been reluctant to do), or offers any concessions on subsidies to land the deal. Market Capitalization Annual Revenues Dividend/Yield 52 Week Range $500 B $171 B $12.20 / 2.3% $

6 COMPANY HIGHLIGHTS Pfizer Berman s Take: For Pfizer (PFE), Trefis predicts flat-to-down revenue and free cash flow through the next several years. PFE can still be an excellent investment over that time if: (1) poor expectations are already priced into the shares, and (2) a decent dividend yield pays you to wait. PFE passes both tests. With a 7% free cash flow yield and a 3% dividend yield, PFE is a juicy, well-capitalized asset. If the pipeline produces any upside surprise over the next three years, the expected return could exceed the dividend. If not, well, where else can you earn 3%? I like the considerable bearish sentiment that hangs over large pharma. It s all very good from a contrarian point of view. In 1999, with a new drug called Viagra, PFE could do no wrong. With a pitiful 1% annualized return over the past 15 years, PFE can do no right. Even on the heels of a 32% year-to-date return, PFE still looks like the ultimate contrarian buy. Trefis Key Drivers: Pfizer and Wyeth's Indian subsidiaries recently got board approval for a merger which will create the ninth largest pharmaceutical entity in the country. India offers a tremendous growth opportunity for the company, as the country's pharmaceutical industry is forecast to approach $50 billion by the end of the decade, more than twice its current size. Pfizer's revenues from India are below $200 million currently, less than 1% of total revenues. So while this is unlikely to move the needle much for the next few years, it is a logical, and potentially lucrative, move from a long-term standpoint. Market Capitalization Annual Revenues Dividend/Yield 52 Week Range $206 B $56.3 B $0.96 / 3.0% $

7 COMPANY HIGHLIGHTS ADP Berman s Take: Next to Paychex (PAYX), ADP is my favorite business. The recurring revenue, operating leverage, cost-free float, and low capital expenditures of payroll processing make it a terrific mini-sector. The boring, unglamorous nature of payroll transactions attract little competition. High switching costs keep the most dedicated interloper at bay. Companies that try to challenge the PAYX-ADP virtual duopoly (such as banks) have had little success. That said, the market has caught onto the benefits of payroll processors as a hedge against higher interest rates, given their ability to reinvest float at better yields. The payroll companies are no longer cheap. Trefis thinks ADP is worth $73, a full 9% below market price. By revising the discount rate down from 10% to 8% on my assessment of ADP s risk, I get a $90 fair value. But if ADP continues to rise, I may have to downgrade it to a hold, or even a sell even if it is one of the world s best businesses. Trefis Key Drivers: Despite a mixed macroeconomic environment and persistently high unemployment, ADP has managed to generate solid revenue growth, with weakness in client fund interest more than offset by strong Payroll Processing results. While the job market has gotten marginally better, which directly impacts the Payroll Processing business, the company has also done a good job of retaining clients. The company should be very well positioned to benefit from an eventual macro recovery, with reduced levels of unemployment and an eventual rise in interest rates both having a direct impact on earnings. Market Capitalization Annual Revenues Dividend/Yield 52 Week Range $38.5 B $11.5 B $1.92 / 2.4% $

8 COMPANY HIGHLIGHTS BNY Mellon Berman s Take: BNY Mellon (BK) is perhaps the best-capitalized bank in the world. As the leading custodian bank, BK is more of a transaction processor and software company. Of course, BK lends money and manages assets, but their bread and butter is Asset Servicing, the steady job of collecting nickels by holding money for others and keeping track of where it goes. I love this business model long-term. Unlike large money center banks who careen from cycle to cycle, dependent on prop trading results, BK has always enjoyed greater stability. Low interest rates, however, have crimped BK s revenues for some time, lowering revenues on securities lending and money market fees. As I believe rates will rise eventually, I see BK as a hedge against this cruel inevitability. Trefis Key Drivers: Aided by a continued focus on expense management and steady inflows of assets into its Investment Management and Investment Services segments, BNY Mellon has done a good job navigating through a difficult environment. The bank s net interest margins have been squeezed from a high of almost 1.9% in early 2010 to 1.16% in the third quarter. To put this in perspective, if the NIM figure for Q3 was 1.9% instead of the 1.16% it witnessed, its net interest revenues for the period would have been roughly $1.25 billion - a good 60% higher than the actual figure reported. As economic conditions normalize, the bank s profitability should see a significant boost. Market Capitalization Annual Revenues Dividend/Yield 52 Week Range $38.7 B $15.1 B $0.60 / 1.8% $

9 PORTFOLIO CHANGES No changes this month, but I reiterate: MT at the current price is a great buy. THE BERMAN VALUE FOLIO As of December 1, 2013 Ticker Name Basic Materials Buy Hold Sell Purchase Date Purchase Price Market Price Total Return Since Purchase Date Trefis Estimate AA Alcoa Buy 12/21/2011 $8.87 $ % $7.22 DOW Dow Chemical Hold 12/21/2011 $26.98 $ % $37.04 MT Arcelor-Mittal Buy 9/21/2012 $16.06 $ % $16.76 Consumer EXPE Expedia Buy 10/31/2013 $58.97 $ % $64.85 PG Procter & Gamble Buy 12/21/2011 $65.84 $ % $72.95 Energy BP BP Hold 12/21/2011 $41.33 $ % $50.00 Financial Services BK BNY Mellon Buy 12/21/2011 $19.43 $ % $33.04 C Citigroup Hold 12/21/2011 $25.74 $ % $55.92 JPM JP Morgan Buy 12/21/2011 $32.12 $ % $60.03 Pharmaceuticals PFE Pfizer Buy 01/21/2012 $21.90 $ % $33.27 Tech, Media, Telecom ADP ADP Buy 12/21/2011 $53.21 $ % $72.84 AAPL Apple Buy 2/21/2013 $ $ % $604 EBAY ebay Hold 12/21/2011 $30.18 $ % $54.32 PAYX Paychex Buy 12/21/2011 $29.14 $ % $35.22 Industrials & Transportation CSX CSX Buy 12/21/2011 $20.80 $ % $24.57 UPS UPS Hold 12/21/2011 $72.40 $ % $108 UTX UTX Buy 04/21/2012 $80.40 $ % $116 Total 65.7% Total return is calculated since inception date of 12/21/2011 and includes reinvested dividends. When a stock is bought in the portfolio, it is added on an equal cash-weighted basis at the time of purchase.

10 Disclaimer The Berman Value Folio (TBVF) is published monthly and provides information and investment ideas on stocks. All material in TBVF is Copyright by Trefis and JBGlobal.com LLC and may not be reproduced in whole or in part in any form without written consent. TBVF is written by James Berman with assistance from Trefis staff. TBVF is distributed by both Trefis and Forbes. Forbes acts only as distributor and is not responsible for, nor does it endorse, any TBVF content or investment ideas. All stock buys and sells are the sole decision of James Berman. TBVF is intended for experienced investors, who understand the risks, costs, mechanics and consequences of investing. None of the content in this newsletter is intended to be, nor should be interpreted as, a solicitation to buy or sell securities. The selection of portfolio stocks is based on fundamental analysis. There is, however, no assurance that these securities will produce profits. They may instead produce serious losses. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of any prior securities mentioned in the TBVF. All investing involves risk of serious loss. No graph, chart, formula or other device offered or portrayed in TBVF can in and of itself be used to make trading or investment decisions. Any graph, chart, formula or other device is inherently unreliable in making a trading or investment decision due to the intrinsically misleading nature of such items. Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. TBVF results may not reflect the impact that material economic and market factors might have had on the adviser's decision-making if the adviser were actually managing clients' money in this portfolio. TBVF contains stocks that are managed with a view towards capital appreciation. James Berman and JBGlobal.com may manage other portfolios with different strategies and returns that may materially differ from TBVF results with substantially higher or lower performance. TBVF model results do not reflect the deduction of any management fees, advisory fees, brokerage or other commissions, bid-ask spreads, tax consequences, and any other expenses that a client would have to actually pay or would have actually paid in a real portfolio. All return figures assume the reinvestment of all dividends. When a stock is bought in the portfolio, it is added on an equal cash-weighted basis at the time of purchase. Past performance does not guarantee future results. Any forward-looking statement is inherently uncertain and cannot be relied upon as a statement of actual performance. If you would like a spreadsheet furnishing a list of all recommendations made by TBVF since inception on 12/21/2011, please send an request to: info@jbglobal.com. Although all content is derived from data believed to be reliable, accuracy cannot be guaranteed. James Berman, JBGlobal.com LLC, Insight Guru Inc., Trefis, TBVF s publisher and distributor(s) and their employees assume no liability whatsoever for any investment losses as a result of securities purchased on TBVF recommendations. TBVF is not intended to provide personalized investment advice. Readers and subscribers should consult their financial adviser before investment. James Berman is an investor in Insight Guru Inc., the parent company of Trefis, both personally and through the venture fund he subadvises. James Berman, therefore, has a financial interest in Trefis aside from his interest in TBVF. James Berman, JBGlobal.com LLC and employees of TBVF, Insight Guru Inc., JBGlobal.com L.L.C. and Trefis may hold positions in some or all of the stocks mentioned here, both personally and in the accounts and funds they manage for others. No compensation for recommending particular securities, services, or financial advisors is solicited or accepted. If you are unwilling or unable to abide by any conditions of this disclaimer, then you may obtain a refund for the unused portion of your subscription at any time. The Berman Value Folio info@jbglobal.com