I have been looking forward to seeing General Growth Properties (GGP) spin off Rouse Properties (RSE). You may recall General Growth Properties, a real estate investment trust (REIT) that owns and operates shopping malls around the United States, famously went bankrupt in 2009 at the height of the credit crisis. At the time, the bankruptcy was the largest real estate bankruptcy since 1980. However, GGP has since re-emerged, first spinning off its real estate development projects into Howard Hughes (HHC) and now Rouse Properties.

Rouse Properties is a collection of 30 low-quality (Class B and C) malls across 19 states totaling about 21 million square feet of retail space. The firm is not yet a REIT, but plans to convert shortly. Unsurprisingly, many of the malls are located in out of the way locations such as Rock Springs, Wyo., and Logan, Utah. The malls are anchored by tenants across the retail landscape, including Macy’s, JC Penney, and smaller names such as Forever 21 and Chipotle. The firm is about the eighth-largest publicly traded owner of mall real estate in the U.S.

So, what could possibly prompt our interest in this collection of second-tier assets? The spin-off dynamics are quite compelling. First, the spin-off ratio was 26 to 1, and Rouse has a market cap today of around $490 million versus the $14 billion market cap of GGP. Second, despite its size, GGP is not particularly well covered by Wall Street with only three analysts on it, which means Rouse is unlikely to attract much attention at all. Third, Rouse was spun off on Dec. 28 when practically no one on Wall Street was paying attention. Fourth, hedge fund maven Bill Ackman and skilled real estate investor Brookfield Asset Management (BAM) are large holders of the stock, and Brookfield has offered to backstop a $200 million rights offering at $15 per share, which is well above the $11 per share where Rouse currently trades. Finally, unlike most spin-offs, the Rouse deal is taxable, which means most investors may actually choose to sell the stock rather than come up with the cash needed to pay the required taxes. Therefore, Rouse strikes us as a particularly compelling investment worth of further study.

Does Investing in Class B Malls Make for an A+ Investment?
Rouse's properties are decidedly toward the lower end of the scale. Tenant sales are $281 per square foot. For reference, $250 per square foot for a property is considered a "failure" by real estate standards, and peer Taubman (TCO) generates $615 in tenant sales per square foot. Occupancy levels are about 88%, down from 93% in 2006. But, there's cause for optimism. Rouse's properties were decidedly noncore for GGP, and probably weren't emphasized by a mall operator that was skewed toward the premium end of the scale. In addition, about 60% of Rouse's property portfolio is made up of malls that are located in one-mall markets with no competition, where they have a loyal consumer following and serve as social hot spots. One example is the Sikes Senter Mall in Wichita Falls, Texas. It is the only mall in a 100-mile radius with an Air Force base and a decent-sized university in the area. On the flip side, Rouse has a number of dogs that will require re-tenanting and a change in the merchandise mix to attract new mall shoppers. An example of this is the Bayshore in Eureka, Calif., which is the only mall in the area but contains too many shops and not enough big-box retailers. As a result, Rouse plans to redevelop the site to increase its tenants' sales and thus its own rents.

One of the challenges for REITs is access to low-cost capital, and lots of it. Rouse is somewhat unusual in that it should receive about $200 million from a rights offering shortly, which is being backstopped by Brookfield Asset Management at $15 per share. Brookfield is an important partner to have, as it is one of the world's largest property managers with about $150 billion in assets, which include power, infrastructure, and private equity. Brookfield already owns 37% of Rouse, as a result of its successful restructuring of GGP, and by backstopping the offering, it is essentially indicating its willingness to increase ownership of Rouse to 54% at $15 per share. As a result of Brookfield's involvement in GGP, it is probably better positioned than most to value mall-related assets. Thus, it's interesting that we're been given an opportunity to purchase shares at $11 each, a substantial discount to what Brookfield feels they are worth.

Rouse plans to reinvest the capital raised from the rights offerings in its malls over the next four years to improve occupancy levels, tenant sales per square foot, rent levels, and ultimately financial results. The $50 million in annual reinvestment is far above 2008 and 2009 investment levels of $20 million and $8 million, respectively, which argues that the malls were ignored by GGP and neglected in its bankruptcy. However, given the somewhat dire state of Rouse's properties, it's not surprising that a massive capital investment is needed to remake the portfolio.

The investment case for Rouse hinges on whether it is successful in allocating its capital. In that regard, we have a fairly experienced management team at Rouse. CEO Andrew Silberfein was previously the executive vice president of Forest City's retail portfolio for 16 years, and has 22 years of experience in the retail real estate industry. He will receive a one-time award of $1.9 million worth of restricted shares that vest over three years, plus another award of $10 million in options that vest over five years. The board is made up of several experienced GGP and Brookfield executives, as well as other real estate investors. Top executives also include CFO Rael Diamond, who previously worked for Brookfield's real estate arm, and two executive vice presidents who have lengthy histories with GGP. Thus, we believe there's a reasonable case to be made that some neglected assets will be polished into better shape in the next few years, with the prospects of meaningful returns if the malls can be successfully repositioned more favorably.

Risks
Real estate investments can be difficult. In Rouse's case, the malls are exposed to the continued deleveraging of the U.S. consumer as well as any increase in interest rates, which could boost Rouse's financing costs. That said, I think there are two big trends that will provide some headwinds for Rouse during the next few years.

The first is the rise of the Internet, which is disrupting many brick-and-mortar based businesses by making the retail mall store less important as a customer destination. The list of companies damaged or nearly destroyed by Amazon (AMZN) is growing longer on a regular basis: Borders, Best Buy, Barnes & Noble, Circuit City, Linens & Things, and Wal-Mart. There's even a growing trend called "showrooming," where customers visit retailers to look at the products and then go home to order it more cheaply on Amazon. It also means that retailers and popular restaurants are going to be less likely to want to locate new stores in decidedly substandard Class B malls. New store locations are more likely, in our view, to be in high-profile top-quality malls, where they can grab consumer attention and traffic. In order words, there should be a growing divergence in performance and financial numbers between top-end malls and low-end malls over time. In fact, the U.S. is frequently described as over-retailed, where too many retail stores compete for the  consumer, which ultimately means store closures and difficulty raising rents over time. Thus, marginal owners of real estate such as Class B mall operators face long-term headwinds.

The second major trend, admittedly less destructive than the Internet, is the rise of outlet malls. In a weak economic environment, consumers are flocking to value-focused outlet malls and retailers want to take advantage of the increased traffic. Industry insiders have noted that the outlet space is perhaps one of the only places in the U.S. that is actually under-retailed, and they are structurally attractive because people want value in good times and bad. Outlet malls are generally located far away from traditional malls and designed to cover a wide geographic area. Both factors mean that outlet malls are potentially a serious threat to Rouse's large base of isolated, regional, one-mall markets.

Valuation
The basic investment thesis for Rouse is that experienced managers can fix its merchandising and tenant issues while operating in an environment with several structural headwinds. The investment definitely leans toward the cigar butt end of the spectrum, and Rouse’s management team has quite a job ahead of it.

Rouse's financials are quite a mess. Core net operating income (NOI) probably will be around $150 million in 2011, versus more than $200 million in 2008. We value higher quality mall peers such as Simon Property Group (SPG), Taubman Centers (TCO), and Tanger Factory Outlets (SKT) at around a 5.7% to 7% capitalization rate on their 2011 NOI. Given Rouse's position at the low end of the market, it likely deserves a higher capitalization rate in the 8% to 10% range, which implies a $7 to $15 fair value estimate. Book value for the firm is around $435 million versus its $490 million market cap, which also suggests that the firm is reasonable valued. We note that Rouse is highly leveraged, with debt/EBITDA around 10 times and debt/gross property value of around 80%. EBITDA in 2011 should cover interest expense by about 2 times, but its major debt maturities are pushed off until 2013 and 2014, which gives the firm time to make progress on its turnaround.

Overall, we view Rouse as a highly speculative investment, as it is a heavily leveraged turnaround in progress facing both short-term and long-term headwinds. The poor quality of its mall portfolio and the absence of structural tailwinds mean that we are largely dependent on absolutely outstanding management to see significant value creation. As such, we'd be reluctant to make Rouse anything larger than a very small and short-term speculation on its very unusual spin-off dynamics, which may lead to a short-term pop in the share price once the initial selling pressure subsides.

Our investment in Advanced Micro Devices AMD has not been without its challenges, and to date, it has been a disappointing pick for us. However, AMD's recent quarter was actually not bad for a change. The financial results were respectable: fourth-quarter revenue was flat sequentially at $1.69 billion, while gross margin improved a point to 46% in the same time frame. Given the disruptive effect of the Thailand flooding on the HDD supply chain, our expectations were pretty low, and AMD managed to exceed our low bar.

We think there was a number of positive items from AMD's latest quarter. First, the manufacturing problems at GlobalFoundries seem to be subsiding. Availability of AMD's Llano chips jumped substantially quarter over quarter as 32-nanometer yield and performance improved, which led to an 80%-plus increase in 32-nanometer chip shipments sequentially. Fusion chips now account for 100% of all mobile shipments and the firm continued to gain share in the notebook market. There were still some supply issues on the desktop side, but they should be resolved by the end of the first quarter. Thus, AMD's recent practice of cannibalizing more profitable desktop share for notebook share should be at an end. Given the seasonal drop-off in demand for chips next quarter, AMD shouldn't have any chip supply issues.

The other bit of positive news, especially given the disappointing Bulldozer benchmarks, is that AMD gained server share for the second straight quarter. Bulldozer shipments accounted for more than a third of AMD's total server shipments for the quarter, and the server rollout is still in the early stages. Hewlett-Packard (HP) and Dell (DELL) have launched attractive Bulldozer-based server products, and AMD remains optimistic that its server efforts will continue to see growth in the data centers and high-performance computing space. Our assumptions for share gains in the server space are decidedly low, so we consider any upside here as gravy for our investment thesis at this stage.

We indicated in our last note on AMD that its path to value creation hinged on GlobalFoundries fixing its production issues and the firm continuing to take share in the notebook market. Fortunately, AMD has made solid strides this quarter in achieving both goals. If AMD can continue to take share in the server market, we still may be pleasantly surprised with our investment. In addition, AMD has plans this year to launch its latest generation of Fusion chips (named Trinity), which offer improved performance and lower power requirements over the current generation of chips, and the new chips appear to be a compelling solution for ultrathin notebooks. Overall, we have no desire to add to our AMD stake with the stock trading close to $7 per share, but we remain optimistic that we'll eventually see a nice profit from our AMD holdings.

--Stephen

When we wrote our December wrap-up last week, we mentioned that we would be working on a more detailed article going over the events of 2011. All told, it was a rough year. We had several large losses, both realized and unrealized, that really weighed down returns. On the bright side, two of our companies were acquired at significant premiums, and we took timely gains on several more names. Still, on  balance, it was a rather lackluster year and we dearly hope to improve in 2012.

Score Card
Last year, we created a "score card" to compare all the transactions we did this year against the market. We did this because at the time we had a very large cash drag that made it difficult to see our true performance. Also, it allowed us to see exactly what we did right and wrong. We've replicated that exercise this year.

The system is pretty simple. First, we looked at the 21 buy transactions we made over the year. We compared the total return of each purchase to the S&P 500 through either when we sold the stock or the end of the year if we continued to hold.

We also looked at the performance of the portfolio we held on Dec. 31, 2010, dividing the list between companies we held onto and companies we trimmed or sold during the year. For the companies we sold or trimmed, we compared the total returns of our stocks with the S&P 500 over our holding period.

Lastly, in order to get a complete picture of the year, we also looked at the stocks we sold. In this case, we looked at their performance from our sale date to the end of the year and compared that with the S&P 500 over the relevant period.

Stock Holdings and Buys

Looking at this, the reason for our performance becomes patently obvious. Simply put, we did not make good buy recommendations this year. Our biggest loser is probably AMD (AMD), which we bought on three separate occasions in modest quantities. Unfortunately, the thesis has gone rather badly astray, and we are sitting on significant losses, both in absolute terms and in relation to the benchmark. The upside we were hoping to achieve (double our investment) is at this point pretty much a pipe dream. Today we are merely trying to salvage our initial investment--perhaps slightly more if we are very lucky. In either case, I do not anticipate owning this stock past 2012. If things don't turn around by then, they never will. AMD is not a typical stock we would invest in. We failed because we did not get a good enough read on its technology--something that in hindsight perhaps we were not well equipped to do.

Our second biggest loser is Sprint (S). We sold our position earlier this year for a significant loss. As we've admitted already in earlier articles, I think we failed here because Sprint was just too complicated. The company had a lot of debt and was juggling too many balls, leaving too little room for error. As it turns out, the company did drop a few balls and then promptly shot itself in the foot by entering into a $20 billion contract with Apple.

The third biggest loser is Baker Hughes (BHI), which we bought on two occasions, both of which are well under water. On the first occasion we bought Baker, I actually mentioned that I was leery of the stock because of its high economic sensitivity. As a result, we never took a full position, even after averaging down on it once. Obviously, the macroeconomic picture went dark and the stock took a clobbering, but I think the future remains to be written. In fact, I'm quite optimistic about Baker Hughes as a long-term value creator. That said, I wish I'd taken my own advice when buying this stock and patiently waited until we had a better valuation.

Icon Plc (ICLR) is a similar situation. We bought Icon twice during the year, both times resulting in a modest loss. We are not quite as bad off here (down 18% as of this writing, as opposed to 26% for Baker Hughes). The stock has a fairly large European exposure, and has drifted down in large part due to all the region's well-known troubles. I've long said that Icon is one of my favorites in the portfolio, and I'm sticking by that assessment.

A rare bright spot this year was Renaissance Learning (RLRN), which was acquired just weeks after our purchase. This was one of our highest conviction purchases of this year, and I wish I had put more capital to work (though we did make it a full-sized position). At the time, the stock had run up quite a bit, and I was hoping to acquire even more on weakness. As it turns out, we never got that chance.

Pre-2011 Holdings

The portfolio that we carried into 2011 from 2010 did not perform well, but it was not a huge drag on performance. Most of our troubles this year can be traced to the purchases we made in the first half. Still, not everything was hunky-dory on this front either.

The biggest problem we had was AMN Healthcare (AHS), which after a very weak 2010 declined another 28% in 2011. An ill-advised merger in 2010 left shareholders diluted and the company heavily indebted. We couldn't have anticipated the merger, but we certainly could have managed our investment better in the aftermath. At one point this year, AMN was actually up over 40%, before declining in the back half of the year on economic weakness. In hindsight, one of my biggest mistakes this year was not trimming the stock at over $9 per share, as it was not far from my opinion of its intrinsic worth in the low teens. Today, with the stock barely scratching $4, I'm not inclined to sell out. Assuming health-care spending doesn't crater because of government budget cuts, and the economy does okay, AMN should survive its huge debt load and I believe we will salvage this investment. I remain very worried about this position, but for a high risk-very high reward bet, I'm not giving up on AMN. Bad news aside, I did learn a valuable investment lesson here: immediately run away from "bet the company" deals.

When the horrible acquisition of MedFinders was announced way back in mid-2010, we should have immediately sold the stock. As soon as the deal happened, our investment thesis changed irrevocably. All sorts of new risks, such as hugely increased financial leverage, entered the picture. We actually applied this lesson to beneficial effect this year. Almost as soon as Sprint announced its ruinous tie-up with Apple, we sold the stock and saved ourselves quite a bit of money.

Charles River (CRL) was another source of pain in 2011. Despite having some unique and valuable assets, such as a world-class research animals business, Charles River has the most inept management team in the entire contract research organization industry. We sold most of our holdings midway through the year to buy Icon Plc, which worked only slightly better financially. In hindsight I wish I had sold the entire position and firmly staked our ground on what I consider to be a vastly better run enterprise. In fact, I would strongly consider doing this even now, even though we've already built up a heavy position in Icon.

Thankfully, the portfolio we carried over from 2010 had a few bright spots. The biggest of these was the purchase of Tradestation (TRAD) by a Japanese company for a healthy premium. Another stock that performed very well was baby clothing retailer Carters (CRI), which gained over 35% in 2011. Carters was an amazingly simple investment thesis. It has a straightforward business model, and the company has executed its plan consistently for nearly two decades. Unlike many of our other holdings, we didn't lose any sleep worrying about the business or management, which is a welcome change. We saw a similar situation at Core-Mark (CORE), which scored a strong 13% gain last year. Core-Mark is a boring company, delivering merchandise to convenience stores day after day. But by consistently executing on its plan, the stock outperformed by quite a bit without costing investors any pulled hairs. More and more, I think we'd be better served for buying more of these businesses. In the investment world, effort does not necessarily correlate with returns.

Stock Sales

One positive this past year was our sell discipline. In fact, we've consistently done a good job with this in the past two years. As you can see, the companies we sold underperformed the S&P by over 13% to the end of the year. Ordinarily, this would have been a source of excess returns for the portfolio, but since we had bought poorly performing stocks with the proceeds from selling other poorly performing stocks, the effect essentially washed itself out.

Possibly the best sale we've ever made was Transocean (RIG), which we exited in late February for about $82. We bought Transocean after the Macondo oil spill, which had caused the stock price to fall by half. I knew at the time Transocean's long-term future was highly uncertain, with the massive oil boom in Brazil rapidly changing the structure of the drilling industry. In other words, we could not count on Transocean generating value for shareholders in the long run. In this light, almost as soon as the legal issues with the oil spill abated and the stock rallied, we stuck to our original plan and cashed out. This turned out to be the correct decision. Economic weakness, combined with operational problems, hit Transocean hard; the stock has fallen over 50% since.

For the last two years, we've generally done a good job of avoiding the dreaded "thesis drift." When an investment thesis is played out or starts to morph into something else, it's often a very good time to sell, or else it's easy to get stuck with poorly performing, structurally weak companies that always appear "cheap." In a related vein, if we find out something important that disproves our previous understanding of the company (usually for the worse), it's almost always best to immediately sell. This is not easy to do, because most people--including us--do not like to admit that we made a mistake.

We have generally kept true to these principles, and mostly, our decisions have been correct. Moreover, in the instances where we failed to keep true to these principles, we have usually lived to regret it. AMN Healthcare and AMD are the two portfolio holdings that have suffered the most thesis drift. Not coincidentally, they are two of our least successful investments as well. In both cases, admitting our mistake early on and selling out would have saved us quite a bit of headache and money. Another stock potentially on the verge of the same fate is Aeropostale (ARO), which I am very seriously thinking of disposing soon.

What We Could Improve and Plans for Next Year
There is no question we should have done better in 2011. Our biggest losses this year were (in no particular order) Sprint, AMD, AMN Healthcare, and Baker Hughes. On the surface, each of these situations was quite different. For example, they involved completely different business models in completely different industries. That said, in at least two of these cases (AMD and Sprint), and possibly AMN Healthcare as well, we were sucked into very complex situations largely outside of our control. AMD and Sprint in particular involved a veritable tangle of technological and strategic issues that were difficult to sort out and understand. I think we suffered some bad luck on both names, but we probably bit off more than we could chew as well. With AMN, the company's operations were easy enough to understand, but the macroeconomic exposure combined with the financial leverage left very little room for error. This made holding the stock exceedingly nerve-wracking, and worst of all, we didn't even make money for our troubles.

Over the last few years, I've found that our best returns usually came from simple stories. I've highlighted Carters and Core-Mark above, but even something as hairy as Transocean can be distilled down to only one big question: will the company be crippled by Macondo-related liabilities? We answered this question correctly and made a very good return. Many of our other significant winners, such as Tradestation (super low valuation combined with a call option on higher interest rates), were very straightforward as well. I'm not saying that you can't make money in complicated situations, but you have to be exceedingly careful where you step, and a wrong step could have dire consequences. Oftentimes, trying harder doesn't lead to more success.

Many of our more recent recommendations, such as Autoliv (ALV) and Anixter (AXE), hew to the pattern of simplicity. These companies are well established, have simple business models, are well managed, and have the potential to consistently generate shareholder value for long periods of time. Even our newest purchase, TripAdvisor (TRIP), falls roughly in this mold. On the surface, there are a lot of things going on with TripAdvisor, but at the valuation we purchased the stock, we only have to answer one question correctly: will Google eventually kill this company? If not, then we almost certainly have a winner.

We have already been gradually tilting the portfolio toward simpler, better run companies that are likely to steadily create shareholder value. In many of these cases, the companies not only have economic moats, but are actively strengthening them. We won't always shy away from complexity, of course (Life Technologies (LIFE) is a recent purchase and quite complicated), but we are going to be more careful about what we bite off going forward. Hopefully, 2012 will bring more to celebrate.

--Mike

Last week, we wrote a pair of articles highlighting the spin-off of TripAdvisor (TRIP) from Expedia (EXPE). The company is very fast-growing and is benefiting from several very large trends that are buoying all manner of Web-related enterprises. Still, at today's price, we are buying a company that is set to grow 30% in 2011 for something like 18 times forward earnings. Although there is some long-run strategic uncertainty, we took the plunge today and bought a position for the Opportunistic Investor. Here are the details:

Bought 135 shares of TRIP at $25.49 each for total net outlays of $3,451.00

At this point, TRIP is about 3% of our portfolio. We continue to have plenty of cash on hand--about $12,800 or 11% of our portfolio.

Although TripAdvisor has shown impressive and steady growth over the last five years, the cone of possibility here in the next five years is extremely wide. If the company can peacefully coexist with Google and the other Web heavyweights, I believe we will make an impressive return, perhaps a multibagger. However, if other sites were to start stealing users from TripAdvisor, the game would be up. Historically, it's been extremely difficult for Web companies to reverse a decline in users. In fact, I can't think of a single good counterexample. Most companies in this situation seem to be caught in a doom spiral--see AOL's current predicament. If we ever saw signs of this--falling Web traffic and user engagement--we would probably sell immediately rather than wait to be flushed down the drain in a few years' time.

Another interesting thing is that the spin-off may eventually set TripAdvisor up to be acquired by another Web or media heavy hitter. Barry Diller is nearly 70 years old, and it wouldn't surprise me if he were looking for an exit strategy. Google is obviously in the running here, but I wouldn't be surprised if a media conglomerate like News Corp took a swing as well. If this were to happen, we would probably make out very well.

All in all, I'm actually quite excited about owning TripAdvisor. It will be one of the fastest-growing companies in our portfolio, and I feel that we are buying in with a very reasonable valuation. Moreover, it has the potential to become a dominant force in the emerging vacation home rental industry. Down the road, who knows what that might lead to? I have a feeling we are going to see some very interesting things in the next few years from this company.

--Mike