Fund Positioning and Q3 2015 Review

For a number of reasons, the Fund has been positioned bearishly since February, 2014. I recently described in “An Accident Waiting to Happen” why I believe cyclical pressures are increasing, but this position bears further discussion.

Secular, Or Long Cycle, Reasons

Back in the 1930s through the 1970s, capital markets participants regularly analyzed inventory cycle dynamics to inform their macro and market outlooks. From the 1980s forward, the US economy transformed fairly rapidly and more fully to a postindustrial one. Supply chain innovations like ERP software, third party logistics companies, just-in-time inventory management, electronic data interchange, the internet, increased cargo containerization, corporate restructuring and consolidation, and offshoring (among other things) all combined to reduce inventory volatility and dampen macro cycles. These technologies will help corporations manage the heavy accumulation of inventories currently underway, but the magic of supply chain management tools won’t ever trump the greed-fear cycle that exists in markets, among management teams, and Boards.

Because much of Wall Street today has lived in an environment of steadily declining marginal inventory volatility, I believe Street awareness of inventory cycles and their investment ramifications is far from common. This awareness was much more common for 19th century through later-20th century investors.

The second point is perhaps emblematic of a larger lack of societal awareness of just how incredibly special the 20th century was in the United States. Having been the premier emerging market of the 18th and 19th centuries, the US emerged from World War I the greatest creditor nation in the world. That progressed forward to World War II, from which the US emerged a Western military and global financial hegemon. The US was preeminent in the 1950s and 1960s because all its industrialized rivals had been decimated. The US provided credit to those nations to acquire our output, which ballooned US corporate profits and real personal incomes in the US.

Many parts of the political establishment point to that long period of economic tranquility as something to which we can return, implying it’s normal. Many decry the stagnation of real incomes over the last 40 years and the loss of labor’s bargaining power as the results of one element of society taking more than its fair share. It’s quite debatable and I won’t defend some of the terrible incentive biases that drive Boards and management teams to engage in actions that sow the seeds of long-value destruction.

But the bottom line is the competition is better and more global. Where did the 0.400 hitters go in baseball? Pitchers got better thanks to the extraordinary incentives attaching to being a great pitcher. Heck, a sports agent imported pitchers from India in search of an edge. The 0.400 hitters in the postwar era were both corporations and labor. Corporations churn all the time: they go bankrupt and the weak get broken up or

absorbed by the strong and almost no one but their immediate constituencies shed a tear for them.i Unfortunately for labor, it works differently. How do you restructure a steelworker or a UAW assembler? They can take up programming. Programming is now global, however, and employers are using the H-1B visa program to arbitrage employment regulations. For a number of reasons, the American worker hasn’t seen an increase in real incomes in decades and I believe that will continue to be a headwind for the foreseeable future.ii

Furthermore, the 20th century and certainly much of the postwar era, were punctuated by a secular rise in leverage across the system. That takes the burrs off the key in attenuating cycles and promoting growth in investment and consumption, but has an ultimate limit past which the potential for a blowup increases, as does the magnitude of such a blowup. I don’t know where the end of that cycle lies iii, but we can say with near-certainty we’re much closer to the end of that cycle than we are the beginning.

Exhibit 1: Federal Reserve Flow of Funds, All Sectors; Total Liabilities / Nominal GDPiv

Source: Federal Reserve Board of Governors, Charlotte Lane Capital (CLC)

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So, it’s best to be conversant in end-of-cycle dynamics and prepare your investment tactics before those need to come into play. Anyone trying to figure that out in the midst of a crisis when the bullets are flying is probably going to be in trouble.

I will add here I’m not a Fed hater. I believe easy money and its risks are far more preferable than a deflationary depression and a 19th century-type capital destruction cycle. The most positive spin I can put on Fed action is it’s a temporizing move. There are incredible secular innovations happening in the US economy. These include

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advances in materials sciencesv; additive manufacturingvi; green technologyvii; biotechnology therapies that could cure diseases and reduce the deadweight costs imposed upon society by the healthcare system; dronesviii; autonomous vehiclesix; and quantum physics breakthroughs in semiconductors, to list a few. On the latter item, our computing tools continue to improve and really big discontinuous innovations often flow from improvements in enabling technologies.

Do we want a deflationary depression with all the misery and bad feedback loops that go with it? Or do we want to take a chance with monetary policy and temporize? To me, the risk/reward is fairly simple from the Fed’s viewpoint. Along the way, however, society will fight the pulsing forces of disinflation to outright deflation and a capital formation rate running in excess of nominal growth. This is further deflationary because more capital has to fight over a sales and profit pool that will not grow as quickly as retained earnings.

Charlotte Lane Explicit Position. We are net bearish for a number of the foregoing reasons and have been since our February, 2014 inception:

Exhibit 1: Net Exposure, February 2014 – October 21, 2015Source: CLC

(50%)

(40%)

(30%)

(20%)

(10%)

0%

10%

20%

30% Net L/S

We have consistently maintained a high gross exposure, which last stood at 73% long by 98% short, for 171 points of gross. As of October 21, 2015, industry exposures were as follow:

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Exhibit 2: Exposures by IndustrySource: CLC

As of9/30/15

Long Short Net GrossConsumer Staples 24.2% (4.3%) 19.9% 28.5% 9.5% 10.4%Consumer Discretionary 19.7% (30.5%) (10.8%) 50.2% 13.1% (23.9%)Energy 6.4% (5.7%) 0.7% 12.1% 7.2% (6.6%)Financials 5.0% (23.6%) (18.6%) 28.7% 16.5% (35.1%)Health Care 7.2% 0.0% 7.2% 7.2% 14.5% (7.3%)Industrials 4.5% (31.9%) (27.4%) 36.4% 10.2% (37.6%)Materials 0.0% 0.0% 0.0% 0.0% 2.9% (2.9%)Information Technology 5.3% (6.2%) (0.9%) 11.5% 21.0% (22.0%)Utilities 0.0% 0.0% 0.0% 0.0% 2.8% (2.8%)Telecommunication Services 0.0% 0.0% 0.0% 0.0% 2.3% (2.3%)Total 72.3% (102.2%) (29.9%) 174.5% (29.9%)

SPX Net VariancePortfolio

We have structured our exposures according to our greatest experience levels and breadth and depth of knowledge. These include consumer names, industrials, and financials with lesser positions in energy, information technology, and healthcare.

If I were outright bearish, the Fund would be much shorter, but I believe the world can muddle along. Civilization isn’t going to implode tomorrow, but I maintain markets are susceptible to shocks and the Fund is therefore short companies and securities most susceptible to them, whether through poor capital structures or exposure to volatile revenue streams and competitive conditions that threaten their positions.

We also seek out cyclically-exposed companies, especially “new era of consolidation” stories such as airlines or DRAM producers. To some extent, our cruise line short combines all of these factors – supply is coming on across the industry, margins are extended, and substitute services are getting cheaper with lower airfares. For our cruise line short, the market embeds strong pricing we see as inconsistent with both announced capacity growth and a historical lack of pricing integrity in the industry. In addition, embedded expectations reflect an expansion in margins and a very long duration of increasing returns on capital with a lengthy competitive advantage period (CAP). CAP is the period during which a company can invest in new projects producing returns on capital in excess of its cost of capital. Our cruise line short has failed to meet its cost of capital in nine of the last ten years while growing its capital base at a 6% compounded rate.

On a longer-cycle basis, we believe the end of the commodity supercycle has not been fully discounted across an array of names. This includes our 8% short in a class I railroad and a 5% short in a large Australian bank. This residential real estate market is one of the most extended such bubbles in the last 20 years (with loan-to-values twice as high as the peak in the US) and this particular bank has thin capital, a high dividend

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payout ratio, and is running loan loss provisions at only 16 bps of loans, setting up sizable operating deleverage potential. We have long maintained a short position in CAT (we originally shorted in another fund in Q1 2011 when the company forecast a 2015E EPS range of $15-20 vs. our $5-6 estimate) and maintain a short position in equipment rental.

One of the behavioral pitfalls that is a recurring source of inefficiency in capital markets is the length of commodity cycles. These cycles can last from 10 to 30 years from trough to trough and peak to peak, so a half cycle can seem entirely secular to someone that has been in the business for 5, 10, or even 20 years. People become impatient and are reinforced by trends. Sitting out energy from 2001 forward was entirely painful for many firms and damaging to careers.

The energy cycle is instructive here:

Exhibit 3: Energy Exploration & Production ROIC vs. Spot Crude (YoY)Source: Bloomberg, CLC

(80.0%)

(60.0%)

(40.0%)

(20.0%)

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60.0%

80.0%

100.0%

120.0%

140.0%

(15%)

(10%)

(5%)

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5%

10%

15%

20%ROIC

Oil (RHS)

Returns on capital had been subpar for 15 years or more, with some fits and starts, as had returns on incremental capital. Starting in 1999, oil moved up sharply as marginal non-OECD demand began to claim the majority or all of marginal global demand for crude, particularly with Chinese central government policies geared toward growth. This kicked off an eight year cycle during which average ROIC for the E&P industry surpassed its cost of capital. Stock prices responded, which was fantastic for those who were in or jumped on the escalator and painful for those who weren’t and doubted the move. I define the up-cycle as the portion of the full cycle in which returns on

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incremental invested capital surpass the sector’s cost of capital and vice-versa. It’s critical to look at the marginal return, given the biggest piece of ROIC is price received for output and given the capital base reflects the price for land acquisitions and oil services costs that prevailed many years in the past.

Simply tracking ROIC won’t tell you what you need to know. ExxonMobil’s 5- and 10-year average ROICs were 15% and 18.5% with 2014 at 11%. Over those time periods, the stock badly lagged the S&P 500 in the former case and outperformed by a bit in the latter case. Looking at the 5- and 10-year trailing periods from the point at which return on incremental capital peaked, the stock had outperformed by 15.3 percentage points and 8.3 percentage points annually.

Energy is a special cyclical situation, however. As far as iron ore mines and earth moving equipment are concerned, China won’t be building out ghost cities at the pace they have, or at all, so those industries will drift and the fund remains short such sectors because they are not cheap yet on mid-cycle or trough earnings. For crude oil, however, about 92 million barrels per day are still consumed. This is a recurring demand model that will remain hampered for some time by developed supply that was brought about by massive investment over the last 10+ years. Further complicating the picture, half the exploration & production industry globally are national oil companies (NOCs). When I look at the price of crude necessary to deliver incremental ROIC at least equal to WACC, that’s in the neighborhood of $80 or more.

NOCs define “return” differently. Many such entities engage in exploration, development, and production decisions on the basis of promoting growth of their economies, encouraging societal harmony or reducing discord, or to achieve regional / global political ends. The return portion of ROIC is delivered in some other way. Furthermore, how do they define their cost of capital? China’s 10-year notes yield 3.2% today; if that country can clear this hurdle on E&P investment, then that will drag down the market-clearing hurdle rate for the industry globally.

Thus Charlotte Lane is net neutral energy, which consists of two longs in EOG (EOG) and Cloud Peak (CLD), a US coal producer. EOG has extremely low finding & development costs (which improves ROIC as it lowers invested capital per barrel in reserves and delivers more barrels per dollar of earnings reinvested in exploration and development) while Cloud Peak is the best in the bunch of US coal companies. I say that somewhat tongue-in-cheek, as its leverage is 5x now, but that’s the cream of the crop in US coal. It is nearly exclusively a Powder River Basin producer, which should be the more preferred coal source for US utilities due to its lower cost and lower sulfur and nitrogen content vs. Appalachian coal.

With a number of Appalachian and diversified coal producers in the US having declared bankruptcy in the last 12-18 months, we are well down the path of supply being shut down. Stockpiles remain high and natural gas remains low, so the immediate picture in coal is very dim. However, coal prices are less volatile than natural gas and coal remains a strategically secure source of energy for the US. I like to say, “Coal:

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America’s baseload utility fuel of yesterday, today, and tomorrow” because just under half the US utility industry is fueled by coal. I realize it’s dirty and regulations are evolving, but voters tend to take a more flexible view of this fuel source when natural gas prices are high. It’s no accident Google has data centers in places like Council Bluffs, Iowa and Lenoir, North Carolina. Utilities in these states are largely fueled, or majority fueled, by coal. Coal might be gone in 30+ years, but I believe it will be a long and steady slope down and low sulfur / low ash coal has an advantage over bituminous coal.

Charlotte Lane has a small position in Cloud Peak and I would next look to add to, or swap into, the company’s 6 3/8% of 2024 credit. This is trading at a yield-to-worst (YTW) of 19.5% more than eight years out. Meanwhile, this is senior unsecured and pari passu with the other debenture outstanding. That credit trades at 62 while the 2024 paper trades at 47. I believe this gives us protection should Cloud Peak file. Should they elect to so, we are creating the company at less than three times EBITDA (offsetting mine retirement liabilities with cash on hand). I could run into a Court that has a dimmer view of the value of Cloud Peak, but this is a very low valuation, especially considering capex for a long-lived asset such as this can remain well below DD&A for a number of years (addressing safety capex and whatever is most vital and ignoring growth capex while the downturn grinds on).

The fund is short energy in an amount equal to its longs. I have no desire to have directional exposure to hydrocarbon prices at this time, as the down-cycle has more to it. We have been short a US natural gas liquefaction company for a number of quarters due to my view of the poor economics of LNG liquefaction. An activist long has said the company’s take-or-pay contracts are money-good. I disagree – contracts are made to be broken in the energy industry, input vs. sale price differentials could collapse the value of those contracts, and in a “pay” election by the customer, return on capital won’t be very attractive. A commodity company with huge growth aspirations suddenly showing low returns usually gets shut out of the capital markets. I believe these growth aspirations will dissolve.

We are also short a US refiner, which has been a tremendously attractive sector for the last 5-10 years. This industry has been helped by a weak dollar and restrained capacity elections within the industry. A stronger dollar will invite in refined product from abroad, however, while a partial or wholesale lifting of the US’s crude export ban will hurt the local economics of this industry. I believe the downtrend in US crack spreads will continue, having peaked in 2012, driving down returns and leaving these companies overvalued.

In the near-term, the fund is agnostic on energy prices. I am trying to extract alpha within the sector without making a directional bet on hydrocarbon prices. My base case holds that energy prices will drift from here given supply / demand dynamics:

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Exhibit 4: Global Crude, Liquid Fuels Production Less ConsumptionMillion Barrels per Day

Source: Bloomberg, US DOE, CLC

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(1.5)

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0.5

1.0

1.5

2.0

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Exhibit 5: Excess Crude Supply as Percentage of Demand vs. Brent SpotSource: Bloomberg, US DOE, CLC

(2.0%)

(1.5%)

(1.0%)

(0.5%)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0% $45.00

$55.00

$65.00

$75.00

$85.00

$95.00

$105.00

$115.00

$125.00

$135.00 Brent

Supply - Demand / Demand (RHS, Inverted)

The nightmare scenario for energy shorts, and another reason the fund has no directional exposure, would be Islamic State entering Saudi Arabia or Kuwait and taking out vital infrastructure or perhaps sinking a ship in the Straits of Hormuz. Energy prices would respond quickly with a geopolitical risk premium.

Finally, I will note I believe Fed policy creates a state of overvaluation in commodity-oriented equities. Many of these equities price in the hope for a rebound in commodity prices. Caterpillar at 16x mid-cycle earnings and maybe 70x or “N/M” trough earnings embeds hope because negative real rates make it easy to carry this option. As an illustration, here’s a chart I can plot for a number of sectors, but while we’re on energy, we’ll look at this one:

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Exhibit 6: Brent Spot vs. S&P 500 Energy SectorSource: Bloomberg, CLC

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co1 s5enrs

The correlation between these two series is 93% and in the last 3+ years, that has pulled apart. As with many such relationships I can see, I will absolutely volunteer that it may resolve through the commodity price recoupling with equities prices. For now, the collapse in the relationship is curious. We’ll seek to arbitrage this in other sectors, however.

Other short positions are idiosyncratic in nature. For instance, we have an 8% short positon in a third party logistics company (3PL) that had once dominated its space. It has been a truly incredible company and was one of the growth monsters of the past 20 years. However, an aggressive company entered its space de novo about seven years ago and is targeting an EBIT margin of 15% to maybe 20% vs. this company’s core margin of 45%. The CEO of the aggressor was part of the management team that sold in 1999 its company to the firm we’re short. This executive stayed on for a while and then went out and did his own thing. Between 2007 and 2014, the aggressor grew from no revenue to $2B, which helped slow the growth of our target.

We believe the market has misidentified the addressable market open to our target. We have heard our target’s core market as being $300B to $350B in size vs. our target’s $8B core gross revenue number. Seems lush, right? Tiny market share, huge returns on capital. What’s not to like? The issue we see is the addressable market is a 10% subset of the larger market. These companies sell space in the vehicles of asset operators

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those companies cannot fill, but no one starts a trucking company to hand off all its sales to these companies. To expect the entire addressable market to be open to capture by these companies would be like expecting scalpers to sell every NFL ticket or priceline to sell every last hotel room night in its markets.

I believe the addressable market is 80-90% smaller than many believe, which means this company has already captured a good portion of its addressable market. We can see that its lack of growth whereas the aggressor has compounded revenue at a 50% organic rate over the last five years. Meanwhile, the aggressor was going to come public but was acquired by UPS, a company with all the resources in the world to grow the aggressor. UPS also brings global freight flows to that acquisition as well as less-than-truckload (LTL) traffic from its internally owned large-scale LTL, which has been a growth area for our target.

Finally, 3PL companies are often network effects businesses. This is a weaker-form radial network vs. a combinatorial network, but both networks grow in value an incremental user is added to the network. Each is an increasing returns type of business in its early stages and each model at scale produces high returns on capital. When a network effects business starts to lose elements, however, the decline in value can be staggering as deleveraging kicks in past a certain point.

I believe these elements taken together at 20x 2015E EPS with modest financial leverage produce an attractive short with 30% downside potential to our assessed value.

Boston Beer and Why We Own It. On the long side, I hardly see a 10% position in Boston Beer (SAM) as a defensive holding and the fund is not just hiding out in tired staples names like P&G. SAM has a multiple on it and I’m well aware of the potential for a drawdown on multiple compression in a bad market. However, I believe this is an emerging franchise with incredibly capable management, who own over 30% of the company.

This is a company I believe can generate 21% EPS growth over the next few years with return on incremental capital in the 30% to 100% range driving ROIC from 23% last year to 45% over a five year horizon.

I get pushback on this based on the number of craft breweries growing across the United States. If you go into a supermarket with a vast beer selection, it’s often difficult to find Sam Adams, the company’s flagship brand. I have found nothing different in the Heartland supermarkets where I shop. Sam Adams is often wedged between two lovely craft brews that are truly artisanal and scrumptious.

The difference between Sam Adams and locals microbrewers, however, is more stark than the difference between Coke and Pepsi. Coca-Cola and PepsiCo’s carbonated soft drink brands have nearly identical share in take-home retail channels, so why is Coca-Cola so much more profitable? Its success is due to its overwhelming availability in cold

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serve / immediate consumption venues. Coca-Cola is nearly ubiquitous in such settings (the 1970s Saturday Night Live sketch, “No Coke! Pepsi!” still rings true), which gives the company huge share in the highest-value distribution channels, where the unit price point is 2-5 times higher than take home channels.x

Similarly, Sam Adams is the go-to craft beer for bars and restaurants across the US. If you walk into a restaurant in an unfamiliar city and you don’t feel like squinting at the menu board and working your way through 100 choices, you know the restaurant is likely to carry Sam Adams and you know what you’re getting. The paradox of choice works well in packaged foods and beverages and almost nowhere is there such an abundance of choices in beverage as in craft beer.

Humans need shortcuts, or heuristics, to get through the day, which is a well-documented phenomenon.xi Boston Beer has for decades focused on putting a great distribution force in the field, focusing on immediate consumption channels. It is truly national brand, which matters in terms of marketing reach, absorption of variable costs, and in physical distribution. Beer is heavy and distribution radius matters on the gross margin line. There are thousands of craft brewers that have zip code-level scale or even metro-level scale, but very few that have national scale. I don’t dismiss outright these small competitors, but Boston Beer is playing a different, national scale game vs. these companies.

Despite being a well-known brand, I believe Boston Beer is still under-earning, based on correlations between market share, price point, and unit throughput vs. gross margin observed elsewhere in the beer industry. 15 years ago, Boston Beer was largely an outsourced producer of beer that would contract with breweries such as FX Matt. That worked for the contract brewers, which want to raise their capacity utilization, as well as Boston Beer, which didn’t want to raise capital just to sink in the ground.

Between 1999 and 2014, the company’s unit sales increased by 3.5-fold while net PP&E grew by a factor of 14.5. As we see below, growth imposes costs associated with increased complexity and stair steps in capacity utilization.

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Exhibit 7: Boston Beer PP&E vs. Unit COGS / bbl, YoYSource: Company filings, CLC

(4.0%)

(2.0%)

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2.0%

4.0%

6.0%

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10.0%

12.0%

14.0%

(50.0%)

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100.0%

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PP&E, YoY

COGS per bbl, YoY

Gross margin in 2014 was 800 bps below its 2004 peak, due I believe to the company’s production operating below capacity. That’s not a knock any more than saying a puppy’s paws are too big for it. It will grow into this capacity over time. At the same time, the company has expanded its product line and its Angry Orchard brand became in a scant few years the #1 hard cider offering in the US. Here again, its on-premise distribution was instrumental achieving this position. Tastes are made in restaurants and bars and Boston Beer was there with the right product and the right sales team.

Cider contributed to a massive expansion in sales from 2012 through 2014, as the topline grew 54%. That came with a cost, though, as gross margin fell from 54.3% in 2012 to 51.5% in 2014, which created some skepticism among investors as sales cooled over the last four quarters. Slower sales with lower gross margins: there’s a scary combo for growth investors. To continue the canine analogy, the rate of growth of the puppy slows at some point unless they are T-Rex size retrievers roaming the jungles of Borneo.

In the case of SAM, this slowing has allowed the company to catch its breath and start to optimize its production process on the larger PP&E base. Let’s look at how this rolled through the P&L and how the contribution flowed through the opex lines:

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Exhibit 7: Boston Beer P&L DevelopmentSource: Company filings, CLC

Almost every incremental indicator has accelerated over the last year as sales growth has slowed. With the two-year “stacked” growth rates close to 30-40% over the last three quarters, it’s amazing the company is not letting up on advertising & marketing spend. Under the leadership of Kim Koch, Boston Beer has been an innovator since the early 1980s and I don’t see that letting up.

I believe the company can continue to grow the topline at a high single digit / low double digit rate over a 10-year and longer time horizon. Boston Beer has an approximate craft beer / malted beverage share of 8% and craft beer / malted beverage has a 12% share of the larger US market. Some view going into cider or hard iced teas as somehow “cheating.” If that’s the case, then Coca-Cola somehow cheated in introducing Diet Coke and Coke Zero and Monster Energy “cheated” went it brought out flavors.

Boston Beer is a good example of the type of company I look forward. Insiders have a large stake consisting of “hard” capital – it’s not just a package of options a rubber-

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Q1A Q2A Q3A Q4A Q1A Q2A Q3A2014 2015

Sales, YoY 35.2% 27.7% 24.6% 6.1% 8.5% 8.9% 8.7% 23.4% 8.7% Units, YoY 31.8% 25.2% 23.5% 4.2% 6.1% 6.7% 4.5% 21.2% 5.8% Price / mix 2.6% 2.0% 0.9% 1.7% 2.3% 2.0% 4.0% 1.8% 2.8%

COGS / bbl, YoY 3.9% 3.0% 1.6% 4.2% 0.9% 0.1% 2.8% 3.2% 1.3%

Gross profit, YoY 33.5% 26.7% 23.9% 3.6% 10.0% 10.7% 9.8% 22.0% 10.2%Gross margin 49.2% 53.1% 53.0% 49.8% 49.9% 54.0% 53.6% 51.3% 52.5% Delta, YoY (bps) (63) (42) (30) (118) 69 87 56 (63) 71 Incremental margin 47.5% 51.6% 51.8% 30.3% 58.1% 63.8% 60.0% 45.3% 60.6%

Opex, YoY 32.8% 26.9% 12.4% 1.2% 0.5% 8.2% 18.7% 18.3% 9.1%Opex / bbl, YoY 0.8% 1.4% (9.0%) (2.9%) (5.3%) 1.4% 13.7% (2.4%) 3.3%

Note: Advertising, marketing, YoY 41.0% 31.4% 15.9% 0.5% (1.6%) 8.3% 20.3% 22.2% 9.0%Advertising, marketing / bbl, YoY 7.0% 5.0% (6.2%) (3.6%) (7.3%) 1.4% 15.1% 0.6% 3.1%

EBIT, YoY 38.3% 26.4% 43.6% 10.0% 65.3% 15.6% 0.4% 29.5% 27.1%EBIT margin 7.3% 17.5% 22.5% 14.7% 11.1% 18.6% 20.8% 15.5% 16.8% Delta, YoY (bps) 16 (19) 297 53 381 108 (171) 87 106 Incremental margin 7.7% 16.8% 34.5% 23.4% 55.9% 30.7% 1.0% 20.6% 29.2%

Gross prof it "beta" to sales 0.95 0.96 0.97 0.60 1.18 1.20 1.13 0.87 1.17EBIT "beta" to gross prof it 1.14 0.99 1.82 2.78 6.50 1.46 0.04 1.68 2.67EBIT "beta" to sales 1.09 0.95 1.77 1.65 7.67 1.76 0.04 1.36 3.16

2014 2015Average

stamp Board just handed out to the company’s leadership. It’s an innovator in its field, it’s well respected, it continues to defy expectations, it reinvests, and the margin expansion and sales growth I believe are achievable (and supportable) are not embedded in the current valuation.

This is also a rare asset. So is something like Brown-Forman, but that’s trading 3-5 turns more expensive on my estimates and Boston Beer is growing much faster from an under-optimized base. That’s another wonderful family business as well, but I believe it is full while Boston Beer embeds a four-year competitive advantage period whereas many staples companies embed 10-15 years of value-creative growth.

Finally, trophy beverage companies have been bought at 20-25x EBIT over the years, a good portion of G&A can be collapsed within a larger host organization. Those multiples would price Boston Beer at $265-$330 on consensus estimates for 2016 and $330-$415 on my estimates. My $320 central valuation implies upside of 53%, for a 3-5 year IRR of 18% to 25%.

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i “Larry the Liquidator,” the Danny DeVito character in the 1991 film Other People’s Money, delivers the best film soliloquy on the 1980s in “A prayer for the dead.” This is, in my opinion, a far more realistic and insightful soliloquy than the better-known Gordon Gekko address to the Teldar board in Wall Street. https://www.youtube.com/watch?v=62kxPyNZF3Q

ii Purchasing power parity calculations reflect the different levels of “value add” in each dollar of final GDP. The US has more layers of value-add from which costs can be extracted. Over time, unless the terms of global trade change or unless needle-moving secular change kicks in, the layers of value-add in US GDP will remain under assault from overseas labor, offshore tax havens, and domiciles that have more casual regulatory regimes.

iii Reinhart and Rogoff are specific in This Time is Different, though their data are controversial. Their narrative is compelling, in my opinion.

iv At the same time, financial assets were rising and some might look at the net worth of all sectors vs. GDP, but as we have seen over many cycles, asset values are highly variable while liabilities are highly fixed. Settling liabilities at the bottom of a capital markets cycle is no fun. In addition, “value at risk,” or “VAR,” assumes all counterparty transactions settle synchronously. This is not, in my experience, the way the world works.v

We like Hexcel (HXL) in part because we think they occupy a position from which they could become a prime supplier of auto body materials and structural elements to auto OEMs. If you take 500 – 1,000 pounds of steel out of a car’s weight, the energy usage of that car declines, it doesn’t corrode in the same way, its safety characteristics are improved, and the environmental volatility of the manufacturing process is reduced vs. steelmaking processes.

Nanotechnology is spreading across these industries as well.

vi Or 3-D printing. This can change the nature of intellectual property monetization, reduce logistics costs, depress the importance of national labor cost differentials, slash waste, cut down fixed cost cyclicality, improve time-to-market, and on and on. I’m fascinated and watch this closely.

vii I am all for anything that reduces the economics of scarcity. Vaclav Smil’s books on energy are the definitive reference items on the applicability of energy across the global economy and across history.

viii Good for instant delivery of life saving healthcare, not just a pint of ice cream at 2:00 a.m. All sorts of logistics inefficiencies go out the window with these.

ix Well-documented game changer. It will happen soon enough and I say bring it on. We’ll volunteer to be beta testers.

x Boston’s Beer’s price mix, at $184 net revenue per hectoliter, is far richer than Budweiser’s (North America, $131 / hl) due to the same effect. Sure, Boston Beer has higher-quality ingredients, but at a mix of 300 grams of hops to a hectoliter, Boston Beer’s cost per hl would be about $10 more than a watered down brew if it paid twice for hops what its competitor pays. That $53 revenue / hl advantage pays for a lot of quality and still provides good contribution profits to reinforce and grow the brand.

xi The Paradox of Choice: Why More Is Less, Barry Schwartz