April 2013 – Volume 3, Issue 2
The
Essence
The Aussie Shepherd
T
he Coliban Park Sheep Farm was purchased by his great-grandfather nearly 100
years ago. It was valuable land, even at the time, due to its rolling hills, partially
wooded areas and fertile acreage. It is located about 90 miles north of Melbourne
(pronounced “Mel-bun” by those down under), in the southern part of Australia, the
nearest town being the small village of Kyneton.
“Dignity does not consist
in possessing honors, but in
deserving them.”
~ Aristotle ~
In this issue...
P.2 The Value Chain
P.3 Equities Strategy
P.4 Investment Activity
P.5 Fixed Income Strategy
P.5 Conclusion
“This is the best road in Kyneton,” said Duncan Barber as he guided us toward his farm.
“Why is that? It looks fairly nondescript to us.”
“It’s because it leads you out of the town! ”
Yes, this part of the country is not for those who prefer big city living. The island/
country/continent of Australia is one of the least densely populated in the world. But
that is one of the features that keeps Mr. Barber, his wife Jess and their three children at
Coliban. “It’s a lifestyle like no other,” says Jess, “and Duncan and I love it! ”
Duncan and Jess Barber open their home – a 6,600-acre farm with 14,000 head of sheep
(plus a few cattle) – to visitors once or twice a month. They charge for these tours as a
way to supplement their income, but also to show off their land with great pride. They
are the epitome of modesty and hospitality. After a long drive from Melbourne, upon
entering their home set in the middle of the farm, one of our Portfolio Managers – who
was on the tour as part of a trip to the region – was offered the use of the “facilities.”
There were several people charging the bathroom at once, so Duncan guided some to
another room that had an en suite – it was the master bedroom of the house.
After the group freshened up, Jess led them to the parlor where some drinks were
served. Jess and Duncan recounted the history of the farm and discussed the origins of
the country. Aboriginal Australians are believed to have first arrived on the Australian
mainland by boat from the Malay Archipelago between 40,000 and 60,000 years ago.
A fleet of British ships arrived at Botany Bay in January 1788 to establish a penal
colony. Since then, the aborigines have declined in number, Europeans (and most
recently Asians) have increased, and along the way the country gained independence
from Great Britain.
Coliban Park is a genuine operating sheep property that has been in the Barber family
since 1917. Duncan represents the fourth generation to own and manage the property.
Australia and New Zealand are known for their sheep, both for eating and for the wool
they produce. The group partook in both that day, but not from the same animal. They
saw how Duncan, aboard his four-wheel ATV, shouted commands to his sheep dogs,
who herded the animals and guided them through a small opening in a vast fence that
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bordered part of the property. The dogs were amazing; just
two of them were able to corral a hundred sheep, not letting
even one get away.
All the noise scared up some wild kangaroos that also call
Coliban Park home. They are protected by law and so must
be allowed to run wild (some with little babies in the females’
pouches). They also must be allowed to eat the grass on
the farm, sometimes competing with the sheep for the best
morsels. But both are peaceful species that have co-existed
on the land since the first Merino sheep were brought there
from Spain circa 1796.
Next it was time for the sheep-shearing demonstration. The
group was led to a barn where several sheep were in a pen
waiting for their annual shearing. The group then learned,
to their amazement, that the sheep shearing is the only task
on the 6,600-acre property that is not performed personally
by Duncan or Jess. All the shepherding, feeding, watering
and caring for the sheep is done by the couple, aided only by
the dogs. Not to mention the mending of fences, measuring
the protein content of the grass, watching that every one
of the flock eats and drinks appropriately (lest the wool not
grow out with the quality desired). Added to all these chores
is the task of raising their own three children who, while
cute as could be, were not as easily corralled as the sheep!
The entire country plays host to migrant workers who
specialize in the shearing of sheep. They are paid $6 per
skin and the more experienced tradesmen could do up to 80
per 10-hour day. But it had rained the night before and the
sheep in the pen were not yet dry enough for shearing. So
the workers were not present, but Duncan did one anyway
as a demonstration. While it takes a good tradesman only
7½ minutes to properly shear a sheep, it took Duncan twice
that long. Unfortunately, he nicked the sheep twice, making
the onlookers cringe.
Mr. and Mrs. Barber are very proud of their extremely
high-quality Merino sheep. The resultant sheared wool was
bright white, strong and contained extra-long fibers. This
type of wool is highly sought after by the finest European
suit makers and the Barbers were proud to call Ermenegildo
Zegna their biggest client.
“What do you charge Zegna for the wool? ” our Portfolio Manager
asked.
“Sixty dollars [today the Aussie dollar is about one-for-one
with the U.S. dollar] buys a skin, enough for about three Zegna
suits,” answered Duncan.
That was the genesis for this quarter’s report. Duncan pays
his laborers $6 to shear a sheep. That sheepskin wool is then
sold to Zegna (and others) for $60. The wool is then used
to create three suits that, at retail, sell for between $800 and
$3,000 each, or $2,400 to $9,000 in total. This, and the steps
in between, are what we call the “value chain.”
The Value Chain
In analyzing a company, we at Aristotle Capital try to
understand the entirety of its business model. Using cash
flows as one element of understanding, we learn the capital
cost to get into business. That is, what is the value of all
the buildings, machinery (if any), equipment, patents, legal
and professional fees, etc.? What does it cost before one
even turns on the lights on Day 1? Next, what are the input
costs (materials and labor) for the product or service being
offered? What are the distribution and sales costs? Finally,
are there indirect or overhead expenses associated with the
business at hand?
We then take this analysis one step further and ask the same
series of questions for the entirety of an industry, from the
raw material suppliers through to the end-use customers.
We refer to this as the “value chain.” To illustrate the
process, let’s use the Coliban Park Sheep Farm as our
business and textiles as our industry (from the sheep right
through to and including retail). As we described earlier,
we begin with a farm (the issue around whether to use the
1917 purchase price or today’s “value” is a topic we will
leave for future discussions). The farm has sheep and we
assume that “God” provides most of the water and grass.
These are the material inputs. Add labor to this – in this
case only the hired wool shearers plus the dogs (another
future topic will be whether to impute labor costs to the
owners of the farm).
It became clear to us that, at $60 per skin, the value derived
from all the Aussie Shepherd’s work is but a small part of
the entirety of the value chain of textiles. What about
the remaining thousands of dollars until the Zegna suit is
purchased off the rack? In addition to the wool, Zegna
has capital, labor and material costs. It then sells its suits
wholesale (to either a distributor or a final retail outlet like
Bloomingdale’s or even its own Zegna boutiques). The
thousands of dollars for three suits is clearly a larger share
of the value chain than that earned by the Aussie Shepherd.
Next, we look to uncover if value is accruing more to the
suit designer, manufacturer, distributor or retailer. In this
example, we have a good estimate that Zegna as a designer/
manufacturer earns in excess of 15% operating margins in
its business while the typical retailer earns margins of ~10%.
This brief illustration shows that within textiles, designers
have the potential to earn the greatest portion of the value
chain, retailers next and our poor Aussie Shepherd a distant
third. While we often find opportunities to invest in all
parts of the value chains of industries, we have found that
investments in the “richest” portions thereof could yield
higher business returns. Here are a few other examples:
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Within commercial aerospace, how much of the average
$400 airline ticket is accorded to the many participants in
this value chain? Little value accrues to the ticket distributor
(travel agents, Priceline.com, etc.), negative value has
historically accrued to the airline industry as a whole, about
a third of the value accrues to the airplane manufacturers
(Boeing and Airbus) and most of the value accrues to parts
and component suppliers (GE, Honeywell, Michelin Tyres,
etc.). Within components we have found that servicing
aircraft, including replacement parts, garners the highest
share of the value chain overall.

Within wireless telecommunications, how is the $56
monthly fee received by the Verizons and T-Mobiles of
the world apportioned? Here we find a good example of
how the value chain has changed over time. In the early
days of cell phones, most of the value chain accrued to the
service providers themselves. Then Nokia, Motorola and
others began to chip away at that pie. Then along came
Apple that, with its highly differentiated phones, grabbed
an ever-larger share. If the average cell phone bill is $56
per month, Apple charges close to $600 for an (unlocked)
phone, the average phone plan has a two-year duration, and
the operating margins of the service providers are near 50%,
we find that nearly all of the value chain of iPhones accrues
to Apple itself. One big question we are currently studying
is how this may change in the coming years.

Within housing, heretofore much of the value chain has
accrued to mortgage originators and servicers (typically
banks such as J.P. Morgan, Bank of America and others).
Historically, land developers earned big profits in some years,
but realized large write-downs in others. Homebuilders,
operating within a very fragmented industry, by our measure
reap only about 10% of the housing value chain. Home
improvement stores, however, such as Home
Depot and Lowe’s, can earn consistently high
profits with relatively little capital required
(inventory turns are rapid in this business). But
Mn
the dollar profits of even the hardware stores
40
cannot compare, over time, with banking profits
20
on home loans. A $250,000 loan, originated with
10
a 3% spread between the rate the borrower pays
and that which the bank pays interest, earns the
5
bank $7,500 per year. The average loan remains
2.5
outstanding for 10 years, yielding $75,000 in
profits, by our estimate the largest piece of the
600
value chain.
capture the largest part of the chain. We will evaluate how
each portion of the value chain has fared historically (and
why) and, perhaps most importantly, how may the partition
of value along the chain change within our three- to five-year
investment time horizon. This is one of the methods we
employ in our attempt to uncover hidden values.
EQUITIES STRATEGY
The visit with the Aussie Shepherd also got our Portfolio
Manager thinking about labor and productivity. The
Shepherd’s great-grandfather employed more than 20
people on the same 6,600 acres to care for the same number
of sheep. Today, other than the laborers who shear the
sheep, the Shepherd and his wife are the sole caretakers of
the ranch. The couple has three children, but none of them
wants anything to do with being a shepherd.
It is often very difficult to pull away from the day-to-day
“noise” of the global markets. But distance ourselves we
must. So we’d like to present one of the reasons why we
have remained optimistic for the long-term outlook for
the global economy and equity markets. As evidenced by
Coliban Park, long-term productivity growth remains solid.
In time, productivity improvements may lead to higher
living standards. This transfer can occur through corporate
profits, real employee wages or even wealth transfers by
government (not always the most efficient of the three).

We can perform a similar analysis for each
industry. As always, however, we will not invest
in any company based solely upon any one factor,
including the analyses given above. Instead, as a
part of our process, we will consider where within
the value chain individual companies participate.
We favor those businesses that may sustainably
500
The Bank Credit Analyst devoted a recent issue to long-term
improvements in productivity, income, living standards
and even human intelligence. It pointed out that “for over
50,000 years, humans lived on the edge of subsistence. Then, within
the course of a few hundred years, living standards skyrocketed.”
“Why? ” they asked.
Escape from the Malthusian Trap
Mn
40
ENGLAND: POPULATION
20
Up 300%
10
5
2.5
600
REAL DAY WAGES OF BUILDING WORKERS
(Indexed to 1860 = 100)
500
400
400
300
300
200
200
No change
100
100
1300
1400
1500
1600
1700
1800
1900
2000
Source: BCA Research based upon data from various sources
Page 3
The Malthusian Trap, named after political economist
Thomas Robert Malthus (1766-1834), suggests that for
most of human history, per capita income was largely
stagnant because technological advances and discoveries
only resulted in more people, rather than in more output per
person. As evidenced by the chart on the previous page, it
is only with the onset of the Industrial Revolution circa 1800
that the income per person dramatically increased in some
countries, breaking out of the Trap.
levels of education and skill to be truly productive in the
labor force may also be in play. Stronger competition from
overseas workers, from a lower base, may also be a factor.
The transition from a product-based economy to a servicesbased economy may have relegated our younger workers to
hamburger flipping, as opposed to the higher value-added
factory work of yesteryear. Demographic factors, including
the aging of the labor force, may also have aided this trend.
It is possible that even 30 years is too short a period over
which to measure. When asked why his great-grandfather
needed 20 people to do the job of he and Jess, Duncan
Barber’s answer was “Why not? Labor was plentiful and very
cheap back then. There were additional sheep herders, more men to do
things like fetch water, people needed to make the trips into town to buy
fresh food . . . and he even had a Boot Boy! ”
“What’s a ‘Boot Boy? ’” our PM asked.
“Well, it’s the boy you keep around who shines your boots, of course! ”
It seems that at one time labor was so available, it was
sometimes wasted.
Mechanization and advances in technology allowed for many
of the industrial world’s people to move off farms (where
they previously had to live to grow their own food) and into
cities and towns. There, people began to specialize their
labor. Not all persons are best suited to live as agrarians.
As individuals were able to choose their occupations, they
naturally gravitated towards what they liked best and/or
where they were most productive.
Fast forward to today and we believe we continue to
witness the same forces as has civilization since 1800. The
following chart shows, as the solid line, real output per hour
from 1947 to today. Note the almost continual increase.
The step up in the rate of growth in the late 1990s was
likely due to significant advances in communications and
computerization. Even during the recent “great recession,”
productivity continued its advance. We see no signs of a
meaningful slowdown.
The Value Chain of Labor
450
Ultimately, we are not yet sure of the long-term ramifications
of the divergence of the two lines in the chart. But as long
as productivity growth remains strong, we remain confident
of our sanguine views of business, the economy and the
global financial markets.
450
400
400
350
350
300
300
250
250
200
200
150
150
100
100
50
0
Real output per hour
Real compensation per hour
Index base 1947 Q1 = 100
47
52
57
62
67
72
77
82
87
92
97
02
07
50
12
Sources: Bureau of Labor Statistics; Deutsche Bank
The dashed line in the above chart represents real
compensation per hour – akin to the “day wages of building
workers” shown in the prior chart. While also ascending,
compensation has, for the past 30 years, risen at a slower
rate than output per hour. Referring back to the Aussie
Shepherd, we would say that labor’s share of the U.S.
economic value chain has declined. Many factors could be
at work here. The decline in the peak power of labor unions
could be a factor. The requirement of higher and higher
0
NOTE: We have not independently verified The Bank Credit
Analyst’s “Human Intelligence” special report from which
most of the discussion regarding productivity was taken. We
present the topic this quarter as it is of interest to us and to
make several investment points. The topics are worthy of
additional study, and we will not invest based solely on these
findings.
INVESTMENT ACTIVITY
This quarter, we’d like to highlight a recent addition to
any or all of Aristotle Capital’s investment strategies:
•Walgreen (WAG) is the largest and most
profitable drugstore chain in the United States.
From its position of strength, the company has
enacted several recent measures that we believe
set it on a path of continued prosperity within
a consolidating industry. The company took a
calculated risk with one of its largest customers,
pharmacy benefits manager Express Scripts, by
insisting on maintaining pricing for its services in
dispensing drugs. Express Scripts balked and they
ceased doing business, resulting in a loss of market
share for Walgreen. Recently, the two settled on
terms we believe are favorable to WAG. Next it
entered into a tiered agreement to acquire U.K.based Alliance Boots, the largest and most profitable
retail and wholesale drugstore business in Europe.
The synergies between the two could be exceptional.
Page 4
Finally, and most recently, WAG entered into an
exclusive agreement with AmerisourceBergen
Corp. (ABC) whereby Walgreen pharmacies will
use ABC as its exclusive distributor of branded,
generic and specialty drugs within the U.S. These
and other strategic moves make Walgreen, in our
view, an exceptionally compelling business and
long-term investment.
FIXED INCOME STRATEGY
We are sometimes asked why economic growth has been so
anemic, even with all the Fed’s easing tactics. We have also
been asked if rising inflation is inevitable. The answer is not
known for certain, but we believe that perhaps the premise
of the query may be false or misplaced. These (and related)
questions presuppose that central banks have complete
control over the economies of their countries. While we
think the Fed may directionally influence the economy, it
does not have the power to control it. The following chart
exemplifies one reason why.
Velocity of Money
[GDP/M2]
(last obs. Q4 2012)
2.2
2.1
2.0
to 2.1. There were times when U.S. monetary policy was
considered “tight,” such as the mid- to late-90s, yet the
economy expanded quickly. Note the upwardly sloping line
during that time period. More recently, monetary policy has
been extraordinarily accommodative, yet GDP growth has
been modest. Hence we are at a point today whereby even
record growth in the money supply has resulted in anemic
economic growth. Most of the world’s major countries are
experiencing a similar phenomenon.
The situation today is sometimes referred to as “pushing on
a string.” That is, the Fed can try to “grease” the economy,
but traction cannot be attained. Why this is happening is
beyond the scope of The Essence this quarter. It may even
be beyond what the Fed knows or is capable of doing. For
these and other reasons, we are wary that the Fed can do
any more to help U.S. economic growth, but we will remain
vigilant and watch for signs of improving velocity.
The characters described and stories told herein are
often, but not always, based on true incidents. Poetic
license is taken to dramatize a point about an investment
topic. Not all securities mentioned herein are necessarily
owned in all Aristotle portfolios. Differences due to
restrictions, tax considerations, cash flows and other
factors may have impacted the decisions to buy and/or
sell certain securities at specific times. Inclusion does
not imply that investments in these securities have been
profitable. A list of at least five contributors to and five
detractors from performance is available upon request.
GDP/M2
1.9
CONCLUSION
1.8
1.7
1.6
1.5
1.4
Mar-70
Mar-75
Mar-80
Mar-85
Mar-90
Mar-95
Mar-00
Mar-05
Mar-10
Sources: Federal Reserve; Bureau of Economic Analysis; Encima Global
This chart, dating from 1970 through the fourth quarter of
2012, depicts the Velocity of Money. Velocity is the ratio
of U.S. Gross Domestic Product (GDP) to the M2 money
supply. M2 includes most currency in circulation, banking
deposits, checking accounts and their equivalents. It is often
used as an inflation gauge, the thinking being that too much
money chasing too few goods may result in higher inflation.
The Fed can largely control the money supply through its
open market operations and other monetary actions.
Note that the line in the chart is highly variable. It is referred
to as the “velocity” of money as it is a measure of how
many dollars of money supply are required for a dollar of
GDP. Note the 40-year average of 1.8, but a range of 1.5
As we have discussed foreign lands and long-term trends,
we could not complete The Essence this quarter without
the mention of an act so rare that it has not occurred
in almost 600 years. Pope Benedict XVI, saying he “no
longer has the strength to lead the world’s 1.2 billion Catholics,”
resigned from the papacy. His successor, the 266th leader
of the church, was selected on March 13th, the first full
day of the cardinals’ conclave in the Sistine Chapel at
the Vatican. The new Pope, 76-year-old Cardinal Jorge
Mario Bergoglio, the former archbishop of Buenos Aires,
Argentina, took the name Pope Francis.
The new Pope is described, at his roots, as a humble man.
While not in a religious sense, we found similarities between
him and our Aussie Shepherd, Duncan Barber. Both work
extremely hard and take their businesses seriously. Both
have a keen sense of history. Both men have “flocks” to
look after (sorry, but we could not resist including this pun).
Most telling, both are content to take for themselves only a
small share of the “value chain” of a material life. We are
humbled by both of these men and hope to use this sense
of humility to better understand not only the value chain of
businesses, but of life itself.
Page 5
We are thrilled to announce additions to our Investment Team
this past quarter. Jay Cunningham, CFA (re)joins us to help analyze
great businesses within the value chain of Financial Services.
We also welcome former colleague Sandy Incontro, CFA,
who will specialize in building and maintaining client relationships
to enhance the Investment Team’s efficiency.
20 Pacifica, Suite 1050
Irvine, CA 92618
(949) 681-2100
www.AristotleCap.com
11100 Santa Monica Blvd., Suite 1700
Los Angeles, CA 90025
(310) 478-4005
[email protected]
The Essence is published by the investment management team at Aristotle Capital Management, LLC. This report is published solely for information purposes and is not to be
construed as the solicitation of an offer to sell or an offer to buy any security. The report is based on data obtained from sources believed to be reliable but is not guaranteed as
being accurate and does not purport to be a complete summary of the available data. Officers and employees of Aristotle Capital Management, LLC, its affiliates or members of
their families may have a position in securities mentioned herein. Past performance is not indicative of future results.
This material is not financial advice or an offer to sell any product. Not every client’s account will have these exact market exigencies at the time of investment. Aristotle Capital
Management, LLC reserves the right to modify its current investment strategies’ characteristics. The information provided in this report should not be considered a recommendation
to purchase or sell any particular security. Recommendations for the past twelve months are available upon request.
Aristotle Capital Management, LLC is a registered investment advisor. More information about the advisor, including its investment strategies and objectives, can be found in its
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