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February 9, 2018 Dear
Investori:
Our portfolio rose 3.51% in Q4 versus the S&P 500‘s rise of 6.64%, bringing our full year (unaudited) gross return to 23.66%. This compares to the S&P 500‘s total return of 21.83%. The charts below show our performance figures year-to-date and since inception:
2017 Year Since Inception (60 Months) CAGR
Incandescent 23.66% 122.01% 17.28%
S&P 500 21.83% 108.13% 15.78%
Difference 1.83% 13.88% 1.50%
Returns Since Inception Incandescent
S&P 500 Total Return
140.00% 120.00% 100.00% 80.00% 60.00%
40.00% 20.00% 0.00%
Last 12 Monthly Returns Incandescent
S&P 500 Total Return
15.00%
10.00% 5.00% 0.00%
(5.00%) (10.00%) J
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222 Broadway, 19th Floor • New York, NY 10038 • 646-912-8886 • www.incandescentcapital.com
Page |2 Although Incandescent Capital was officially founded in 2013, I have personally managed money for friends and family since 2009. Gross returns (unaudited) from my personal reference account (where I keep 95% of my net worth) since then are thusly:
2009 2010 2011 2012 2013 2014 2015 2016 2017 CAGR
Incandescent 50.75% 18.78% 2.28% 16.38% 60.68% 5.31% 3.69% 2.52% 23.66% 18.88%
S&P 26.46% 15.06% 2.05% 16.00% 32.31% 13.69% 1.38% 11.98% 21.83% 15.24%
Difference 24.29% 3.72% 0.23% 0.38% 28.37% (8.38%) 2.31% (9.46%) 1.83% 3.64%
HFRX1 13.40% 5.19% (8.88%) 3.51% 6.72% (0.58%) (3.64%) 2.50% 5.99% 2.51%
Difference 37.35% 13.59% 11.16% 12.87% 53.96% 5.89% 7.33% 0.02% 17.67% 16.37%
And here is how $100,000 would have compounded versus those two benchmarks if it was invested at the end of 2008: $474,078
$500,000 $450,000 $400,000
$358,353
$350,000 $300,000 $250,000 $200,000 $124,965
$150,000 $100,000 2008
2009
2010
2011
Incandescent
2012
2013 S&P
2014
2015
2016
2017
HFRX
All figures above are gross of fees (that is, before any fees are deducted). Since each investor in Incandescent Capital has the option to negotiate different fee arrangements, net returns will vary. For 2017, if you elected our standard 20% performance fee (no hurdle, no management fee) arrangement, your net return would be around 18.9% compared to your gross return of ~23%.
1
This is the HFRX Global Hedge Fund Index, a widely used index to praise or pan hedge funds in the press.
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Page |3 Customary Preamble For the benefit of new investors receiving this letter, allow me to repeat what I‘ve written in previous memos: short-term performance numbers as precise as the ones given above should be taken with a grain of salt. Industry standards compel me to report the numbers, but philosophically, I think of our investments like a business owner, and business owners are typically not in the habit of running out and getting valuation opinions on their enterprises on a monthly basis. Indeed, the only times that price should matter is 1.) when a business is being bought, and 2.) when a business is being sold. I generally save discussions of specific securities for my annual letter (although this is not an iron clad commandment as I will occasionally bring up names as examples for a discussion topic I am musing on). The reason behind the ―secrecy‖ is multi-fold. 1. We often traffic in illiquid securities whose price can easily be manipulated with a few hundred shares, 2. This letter goes out to people who are not currently invested with us and I do not want to promote to them a long/short recommendation that I would not be accountable to if/when the facts change, and 3. It helps me avoid the psychological bias of wanting to defend a position just because I made it public, even if circumstances change and I ought to reverse course. Item number three is probably the most important. Value investing is a constant battle against emotions and irrationality, and erecting psychological defenses against innate human biases is critical2. It naturally becomes more difficult to admit mistakes if ego gets involved, and believe me, mistakes will be made. So it‘s far better if I simply not go there at all. Final housekeeping item to note: Your results may differ slightly from the main reference account reported above depending on the timing of your various capital contributions. It takes a bit of time to sync each account to the same exposure as I buy/sell according to the ebb and flow of the market. Your patience is asked for as I tune your individual portfolios, but rest assured: what you own, I own. I am committed to eating my own cooking3. ***
2
Charlie Munger has called understanding the psychology of human misjudgment a “superpower”.
3
The main reference account Interactive Brokers statement is available upon request from any investor.
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Portfolio Review Here are our positions sizes by percentage and their geographic split as of the end of the quarter:
Position Size by %
Geographic Split
8.0% 20.5%
21.4%
10.3%
6.7%
92.0%
5.5% Cash
Canada
USA
And here are our positions broken down by investment ―type‖ and by sector:
Investment "Type" Special Situations 8.8% Mispriced 26.3%
Compounder 64.9%
Consumer Cyclicals 12.7%
Sectors
Tech 30.5%
Energy 13.1% Other 14.2%
Financials 29.5%
As a reminder: ―Compounders‖ are businesses I believe have long, predictable runways for growth that we‘ve invested in at fair, if not arguably bargain prices. ―Mispriced‖ are businesses undergoing transformation or have fallen out of favor with the market and are thus in my opinion widely misunderstood and misvalued. ―Special Situations‖ are businesses with hidden assets and/or have potential catalysts that will unlock value in the near future, e.g. spin-offs, buyouts, arbitrage, and the sort. The ―Other‖ sectors we have investments in include (one of each): conglomerate, telecom, industrial, and basic materials.
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Page |5 *** The S&P 500 has had only one down quarter out of the past five years. One! (Q3 of 2015.) In 2017, it booked 12 out of 12 positive months, a ―perfect‖ year. That‘s a record. It has compounded at 15.78% per annum since 2013. At that rate, capital doubles approximately every five years. We‘ve managed to stay a nose ahead thus far, but should the S&P match or exceed its rate of return over the next five years with the same, non-existent volatility of a death march, it‘s probably only even odds we will be able to keep up. As a value investor, I commit capital only to assets that I understand to be undervalued. A market that does not sell-off or even mildly correct itself is a market that offers slim pickin‘s of discounted securities. Ergo, as valuations inflate ever higher, not only will our cash balance increase as I trim our dear holdings, said cash will have trouble finding new prospects to invest in. To wit, we begin 2018 with a cash balance of ~20%. That‘s historically higher than our average of between 10-15%. Also notice: Compounders now consist of almost 65% of our invested capital, compared to just 37% in Q3. This is not because I made any dramatic buy/sell decisions in the fourth quarter – it‘s because our largest position, BlackBerry, once a mispriced, misunderstood security, has turned the corner and been re-rated by Mr. Market. Accordingly, it is no longer ―mispriced‖, but has instead been re-categorized as a promising compounder given its pivot towards a long runway of re-investment opportunities in a large and growing market. A ballooning cash pile and a growing preponderance of Compounders vs. Mispriced or Special Situation securities is the organic evolution of our portfolio‘s composition in response to the market‘s inexorable climb. This will inevitably dampen investment returns. But to try to fight this would be to betray our value-oriented strategy. Numerous erstwhile value investors in recent years have, in valiant attempts to keep pace with the locomotive S&P, drifted, either by lowering their valuation standards, or adopting shorter-term momentum strategies, or, most dangerous of all, increased their usage of leverage. For some it has worked, and for some it has not. But as the inimitable Charlie Munger puts it, sometimes the worst thing that can happen is to succeed… because it only encourages you to do it again. Few investors have the balletic ability to pirouette between strategies with oracular timing consistently. I certainly do not. And thus I am compelled to actively lower your expectations of our future returns should the current market environment persist indefinitely. In contrast to this dour admission is the relative unlikelihood of another five years of doubledigit S&P gains sans turbulence 4 . Indeed, even in the preceding five year period of unprecedented tranquility, there were enough squalls to be opportunistic, e.g. partners who heeded my calls for capital between Q3 of 2015 to Q1 of 2016 have since enjoyed a boost to their bottom lines (excavate my letters during those periods for evidence). Most importantly, individual securities themselves are wont to offer periodic entry points to enterprising investors. So anyway, enough of this highfalutin preaching. Let‘s get down to business and talk stocks.
4
N.B. that as of this writing in early February 2018, the general market has finally experienced a mild correction exceeding 5%, the first time in 24 months. Ignore the hysteria on business news. This does not count – not yet.
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Table of Contents Portfolio Review .............................................................................................................................. 4 BlackBerry........................................................................................................................................7 General Motors .............................................................................................................................. 11 Banking & Insurance ..................................................................................................................... 13 Atlas Financial ............................................................................................................................ 13 Heritage Insurance Holdings ..................................................................................................... 14 Customers Bancorp .................................................................................................................... 15 CIT Group................................................................................................................................... 16 Takeouts ......................................................................................................................................... 17 Whole Foods ............................................................................................................................... 17 Calpine........................................................................................................................................18 Dynegy ........................................................................................................................................18 A Quick Tour Of A Few Others ...................................................................................................... 19 ―Billy‖ ...................................................................................................................................... 19 Dish Network ......................................................................................................................... 19 ―Ricardo‖................................................................................................................................ 20 ―Daphne‖ ............................................................................................................................... 20 Dillards ................................................................................................................................. 20 Mistakes ......................................................................................................................................... 21 CBL & Associates Properties ...................................................................................................... 21 A Look Back and A Look Ahead .................................................................................................... 22
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BlackBerry For the past three and a half years, BlackBerry (BB) 5 has been our largest position. In 2017, it was also our biggest winner, rising 62.1% and contributing ~12% to our overall gains. Given the importance of this investment on our overall portfolio, it‘s appropriate to spend some time to rehash the history and thesis for your analysis and judgment. The rise and fall of BlackBerry, née Research In Motion, from 1984 to 2013 is well-chronicled: Canadian engineering wunderkinds invent two-way pager capable of pushing e-mail over-theair, thus birthing the era of mobility. Wealth and fame follows, as does hubris, when they fail to take seriously the dual threat of iPhones and Androids. Responses to threat are too late and are botched (BlackBerry Storm, anyone?), market share declines rapidly, last ditch efforts to regain glory ends in smoldering rubble, and billions of dollars of shareholder value are vanquished. Canadian insurance conglomerate Fairfax Financial enters the scene in late 2013, puts together a consortium swapping a $1.25 billion life raft in exchange for convertible debt, and revamps the directors and officers of the company. The keys to the kingdom were handed to then-58 year old John Chen, who in his career has already turned around two publicly traded tech companies, the most recent of which, Sybase, in the course of a dozen years, U-turned from a $400 million market cap also-ran to a $5.6 billion SAP buyout. Despite the fact that BB did not quantitatively fit the traditional ―value‖ model, I initiated our investment on several key insights, originally outlined in last year‘s annual letter and reproduced here for convenience: 1. The unheralded money maker in most tech enterprises is their high margin software services business – software is akin to the razorblade versus the hardware‘s razor. Despite the company‘s claim to fame being the BlackBerry smartphone, it was actually the monthly service access fees (SAF) filling their coffers with profit. So even as their fate in hardware was doomed, the residual SAF continued to flow in, providing them a cushion for a softlanding. More importantly, the technologies behind the SAF was software. Software that could efficiently compress and encrypt network packets, software that provided cybersecurity and controls to IT departments that manage thousand-strong fleets of devices, software backed by significant Intellectual Property, software that could be repurposed to support not just BlackBerries but also iPhones and Androids. The sexy success of BlackBerry smartphones had diverted prior management‘s attention away from the meat & potatoes of the business, but John Chen has since refocused the company upon its true DNA: software. 2. Good software alone is not sufficient for success, especially in the enterprise space. A platform from which to market, distribute, sell, and support is arguably more important. It‘s one thing for a whiz-hacker in a basement to write an app that goes viral; it‘s a whole different ballgame when software is powering mission critical functions. A not-insignificant 5
The ticker changed from BBRY to BB in October 2017 when they moved from the Nasdaq to the NYSE stock exchange. This was, by my estimation, largely a marketing/branding move, done to buff a “prestige” of being on The Big Board. There will be no discernable difference to passive shareholders like ourselves.
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Page |8 investment must be made to build B2B awareness, a sales force, relationships with thousands of channel partners, and a 24x7 support platform, a platform that has almost nothing to do with technology itself but rather old fashioned human resources and all its foibles. BlackBerry, with its globally recognized brand, a reputation for security, and its toehold in enterprises, had about half of that crucial platform already in place. Mr. Chen spent $800 million throughout 2014 and 2015 on acquisitions to fill out a complementary portfolio of offerings and hired Carl Wiese and Richard McLeod from Cisco to build out a world-class sales force and channel partners ecosystem. Overall software revenues will likely exceed $700 million for fiscal 2018, having grown from a mere $250 million in 2015, an accomplishment that is backfilling the old vanishing SAF stream and buttressing the company as it invests in growth for the future. 3. A mature, humming enterprise software company with a global sales and distribution reach is extremely valuable. Software has no tangible cost, so every incremental subscription sold is pure gross margin. Operating leverage is also significant, with industry operating margins reaching the 30-40% range. There are also other favorable economics, such as getting to bank annual subscription revenues upfront while recognizing them quarterly, reducing taxable income while enjoying a deferred revenue ―float‖ with which to reinvest. Furthermore, reinvestments in R&D and marketing are typically above-the-line expenses, recognized immediately, further reducing taxable income to the benefit of higher future revenues. In other words, true free cash flow is masked. As such, you will often see a sea of red ink on the income statements of these companies despite ever-growing revenues; but understand that they give a distorted view of the underlying economics which are actually very advantageous. This is due to the conservative nature of GAAP (Generally Accepted Accounting Principles) which has trouble interpreting the value of businesses whose bedrocks are intangible assets. I am, of course, hardly the first person to have these insights, which is why scaled up enterprise software businesses are generally so expensive, sometimes trading at double-digit multiples of revenues. It is very rare to buy into them at a decent valuation. BlackBerry‘s turnaround was an opportunity to get in at the ground floor, at a sensible price, of a proven leadership team‘s ability to build such a wonderful business. BB common stock finally got their due in 2017, appreciating from $6.89 to $11.17 per share, helped along by an unexpected $940 million (~$1.75 per share) refund from Qualcomm due to royalty overpayment in the past. As such, much of the easy money has been made, and it should no longer be considered a mispriced security. It is also my guess that we will not enjoy such a dramatic rise this year. Mr. Market has already re-rated the stock, giving it credit for its transformation from a low-margin hardware shop to a high-margin software shop. Furthermore, growth will likely flatline for the foreseeable future as the enterprise mobility management market is down to single digit growth rates. In the past, this would have been enough impetus for me to sell our stake. However, as mentioned earlier, it is exceedingly rare to invest in this type of business at a decent valuation. We now have in our possession pieces of a valuable asset at a low cost basis which is currently trading for a fair (or perhaps a wee bit expensive) price. Further appreciation, although maybe
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Page |9 not as dramatic and maybe another several years out, is highly likely over the long run. Given the dearth of reinvestment opportunities out there, swapping our stake in BB for mere cash is unattractive, especially as we are now sitting on a cost basis in the mid-$7‘s. This is not to say I have not or would not trim off profits, but I am dis-inclined to trigger large tax payments despite already achieving long-term status. Thus, the analysis at this juncture must focus on future value, of which there are two key components: 1.) What are the prospects of BlackBerry‘s existing growth efforts, and 2.) What are their prospects for continued intelligent reinvestments further into the future? *** Within the next three to five years, the best hope for growth comes from QNX, a real-time operating system designed to run on a very small footprint in very important, ultra-high availability projects (think nuclear reactors and such). QNX was acquired by BlackBerry in 2010 with which they built their excellent-but-too-late BB10 mobile OS on6. Prior, it was owned by Harman International, a company that specialized in automotive audio and visual products, i.e. the infotainment dash in your car. Under Harman‘s ownership, QNX quietly went into the backbone of nearly all the automaker OEMs‘ cars and today is in 60 million automobiles, a market share north of 50%. An operating system is heinously complex and is easily the most important piece of software in any PC, mobile, desktop, server, ―thing‖, or otherwise. It acts as the frame, plumbing, and electrical infrastructure of a computer. A good OS provides safety and stability to everything built on top, and does so efficiently. As such, OS‘s are not trivial apps that are easily competed away. Once they are established and accepted, they are very difficult to dislodge, and network effects apply – the more widespread an OS, the more apps are written for it, which begets further adoption. It‘s no wonder in the history of computing, there have been only a handful of major OS‘s such as Unix, Linux, and Windows7. QNX itself is a derivative of Unix and has been around since the ‗80s. BlackBerry is leveraging its reputation for safety and reliability as well as its established footprint in the automotive supply chain to push QNX into the new frontier: advanced auto technologies, the most highprofile of which is of course self-driving technology. The car of tomorrow will have, if not full level 5 autonomous capabilities, advanced driver assist, over-the-air updating, dynamic software 6
Today, despite its app-starved condition, BB10 devices remain the single most unflappable, reliable smartphones I have ever owned. They never crash and have Methuselah-ian battery lives. If 90+% of what you do with your phone is e-mail and texting and web browsing, I recommend you try a BB10 device (available on Amazon), either the BlackBerry Classic or the BlackBerry Passport. They can be had for < $200.
7
You may have heard of more, e.g. Solaris, BSD, Red Hat, etc., but they are all derivatives of either Unix or Linux. Even Android is a derivative of Linux, while iOS and macOS are derivatives of BSD which itself is a flavor of Unix. OS’s are so valuable and complex that it’s often smarter to buy one than to develop one from scratch. Android was purchased by Google for $50 million, and the core of iOS and macOS stemmed from NeXT (which was where Steve Jobs was exiled) which was purchased by Apple after they failed for years to develop their own.
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P a g e | 10 powered instrumentation, communication with both ―smart‖ infrastructure and other active vehicles, and many more innovations that will revolutionize the driving experience. All of this will be powered by software and will be connected over 5G wireless. Cars will be more computer than engine + wheels, and the hope is QNX will underpin much more than just your radio station tuner. To date, partnerships have been struck with a variety of Tier-1 suppliers such as Bosch, Aptiv (f.k.a. Delphi), Denso, and Magna, as well as with technologists like Qualcomm, NVIDIA, and Baidu. All of these relationships represent potential, but it will take time to convert these design wins into recurring sales. It is not currently possible to quantify how long nor how much, but there is significant momentum and I am confident this is no longer science fiction. The R&D and political will behind this revolution has eclipsed a tipping point – industry-wide, too many billions have been poured into this effort with untold billions more to come. BlackBerry stands a good chance to grab a slice of this gigantic pie, of which even the thinnest could multiply their current annual revenues8. Automotives are but just one industry in which QNX holds potential. Adjacent is the trucking and shipping industry, where BlackBerry has launched Radar, a lightweight scanner about the size of a gold bar that, when affixed onto a container door, transmits real-time info into the cloud regarding cargo location, temperature, pressure, humidity, etc. The core of Radar‘s technology is QNX and all the IP that served the company‘s smartphone producing days. In my opinion, its true importance lies not in its potential sales, but as a proof-of-concept for what QNX can do to accelerate innovation in ―smart‖ devices in any industry. *** Tackling the second question of longer term growth requires scrutinizing management‘s reinvestment capabilities. As mentioned above, subscription enterprise software businesses have a number of attractive economics such as no tangible costs, deferred revenue ―float‖, and abovethe-line ―capex‖ in the form of R&D which reduce taxable income. As such, the capital allocation abilities of management is critical over the long haul. It is otherwise too easy to vaporize the prodigious cash flows of such businesses with ill-advised investment programs. BlackBerry only needs to look to its own history for painful lessons. With John Chen as Chairman and CEO and Fairfax‘s Prem Watsa as the company‘s largest shareholder, there is a multi-decade track record of intelligent investment conduct. BlackBerry‘s acquisitions since present management took over have been measured and successful. Their largest, Good Technology for $425 million, was a classic distressed asset scoop for less than 50 cents on the dollar9. If anything, more criticism has been probably applied re: the opposite –
8
The excitement for QNX’s potential within the company was greatly heightened (“sent shockwaves through the building”) upon the news of the return of Gordon Bell, co-founder of QNX, who, last year, at the ripe old age of 62, is “having the time of my life. I see a company that’s turned around.” (http://ottawacitizen.com/news/localnews/after-13-year-hiatus-qnx-cofounder-returns-to-company-to-spur-expansion)
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Fun (for us, but not for ex-Good shareholders) quote: “Around 9 a.m., hundreds of employees filed into a conference room or started up videoconference software to watch Good’s chief executive, Christy Wyatt, discuss
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P a g e | 11 that they have not been aggressive enough in acquiring more revenues, for despite spending $800 million from 2014-2015, they are still sitting on $2.5 billion in the bank. But to me, discipline in not over-paying, especially in a red hot tech sector that is routinely overvaluing businesses barely out of the garage, is far more important. It jives with mine own value-oriented sensibilities, to keep our heads whilst everyone around us are losing theirs. As long as the Chen/Watsa duo is at the helm of this ship, we should sleep pretty well knowing our equity is in responsible yet opportunistic hands. A further comment on management: Our initial investment thesis hinged on John Chen‘s continued involvement with BlackBerry. I do not believe the turnaround would have succeeded without him, as he actively recruited a small army of his former mates from Sybase and SAP to fill out the senior management ranks and leveraged connections from his time with private equity giant Silver Lake and the boards of Wells Fargo and Disney to bolster BlackBerry‘s credibility at a time when it was exceedingly shaky. As such, from 2014 to 2017, had Mr. Chen left the company for any reason, our thesis would have been busted. Happily, we were spared that conundrum. Going forward, I believe the criticality of his presence for BlackBerry‘s continued success is somewhat diminished with the company stabilized and its strategy well defined. Should he elect to retire once his 13 million restricted stock units fully vest in 2018, we may very well remain shareholders depending on who the reins are handed off to.
General Motors Our second largest position, General Motors (GM), was also initiated in 2014 shortly after their ignition-switch scandal broke. At the time, it was feared GM would not only have to pay billions in fines and lawsuits, they would, worst of all, suffer a permanent tarnishing of their brand. However, CEO Mary Barra expertly guided the company through this tough stretch, setting up a settlement fund headed by independent administrator / disaster compensation czar Kenneth Feinberg10 which paid out almost $600 million in reparation. More impressively, she owned up to the mistakes made, testifying as such in front of Congress and took the political beating on the chin. Contrary to the ―moving on‖ rhetoric most people take when confronted with scandal, she exhorted the company to ―never forget‖ instead. I believe there is a genuine cultural transformation going on at GM that, in parallel with their post-2009 bankruptcy financial transformation, is creating a corporation that is differentiated from both their complacent past as well as their Detroit peers. As mentioned in last year‘s annual letter, our position in GM is expressed via its ―B‖ warrants, which you‘ll see on your statement as ―GM WS B‖. The warrants are freely traded on the New
the sale. Ms. Wyatt introduced BlackBerry’s chief, John S. Chen, who winkingly apologized for how his deal makers had driven Good’s final sale price down to $425 million, less than half of the company’s $1.1 billion private valuation.” (https://www.nytimes.com/2015/12/27/technology/when-a-unicorn-start-up-stumbles-itsemployees-get-hurt.html) 10
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Who also headed the Sept. 11 Victim Compensation Fund and the BP Deepwater Horizon Disaster Fund.
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P a g e | 12 York Stock Exchange with a strike to purchase GM common for $18.33 per share expiring on July 201911. In 2016 I began swapping GM common for GM warrants, which, given that shares are trading significantly above the strike, act as de facto leverage12, allowing us to increase our exposure without spending more cash13. Our 6-7% position roughly represents a synthetic 13% position in the common, which is why I coin it our second largest position despite it not appearing so on our statement – a little mental reminder that I am applying leverage here. GM WS B rose from $17.16 to $23.40 in 2017, a 36.4% gain. The company‘s fundamentals remained steady in a U.S. market that is, while plateauing after a seven year expansion, experiencing a secular shift towards trucks, SUVs, and cross-overs, the bread and butter of GM. The stock made most of its up-move from September 2017 onwards, when excitement surrounding its autonomous driving efforts, now believed by industry experts to be at least on par with Tesla and Uber and Waymo, jump-started its shares, altering investor perception that the driver-less future is not the apocalypse for an old line auto OEM. What further separates GM from its Silicon Valley competitors is something perhaps just as oldfashioned: profits. Per-share profits for FY 2017 will likely show a slight bump from the year before period, somewhere on the high end between $6.00 and $6.50 per share, which does not sound terrifically impressive at first glance, especially when compared to the torrid growth of the tech darlings, but when gauged against its $40.99/share stock price at year-end, becomes an immensely attractive < 7x P/E ratio. Why GM‘s shares continue to trade at such a depressed valuation will make for an interesting case study in the future. Bear arguments vary, but most of them rely on a view firmly rooted in past. Detroit‘s auto giants have traditionally experienced extreme boom-bust cycles. During good times, they crank and crank and, due to the lag time of manufacturing complex machinery and an inflexible union workforce, inevitably overshoot demand, which lead to bad times of new cars sitting unsold on lots and used cars coming off leases, a terrible glut that requires deep discounts to clear which compresses margins down to zero or worse. The classic theory is that, as such, they deserve low P/Es during the peak and high P/Es during the trough. So prevalent is this bear case that it is brought up nearly every quarter during their conference calls. And despite management‘s repeated reassurance that, yes, they are well aware of this phenomenon and they are taking steps such as tightening up supply chain inefficiencies and drastically cutting back on low-margin sales to rental car companies and furloughing part-time workers and idling plants that make slow-selling sedans and putting policies in place to not extend irresponsible financing just to make their monthly sales numbers but to focus instead on building brand loyalty, there appears to be just no assuaging the bears. 11
The warrant was issued as part of their restructuring in 2009.
12
In derivative parlance, its Delta is very nearly 1.0, i.e. for every $1 that the common moves (up or down), the warrant moves $1 x 1.0 = $1. Meaning if GM common goes from, say, $40 to $41, the warrant’s intrinsic value goes from $21.67 to $22.67. We are exposed to the equivalent $1 move but we only need to spend $21.67 per share rather than $40 per share.
13
The flip-side is that the warrants do not pay cash dividends. It is my judgment that the liquidity we gain to buffer us in the event of further shocks against the cost of missing some quarterly dividends is worth the trade-off.
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P a g e | 13 In the end, this boils down to a simple thought experiment: do you believe the structural cyclicality of this industry is a permanent, unavoidable phenomenon, or do you believe there are discrete steps that can be taken to lessen, if not eliminate, the pain of the cycle? And if yes to the latter, is this management team capable of executing? By the virtue of our long position it is clear what my beliefs are. The cyclical pressures of selling cars is indeed strong, but not unmanageable and proof exists in the form of Toyota Motors, the best-in-class operator which has experienced a consistency in sales and profits extending through multiple cycles. GM is not Toyota, not by a long shot—not yet—but I believe they have the right financial structure in place with the right management team espousing the right ideas that is right-sizing the culture. A steady EPS combined with stock buybacks at a sub-10x P/E valuation with the potential of an expanding multiple as they slowly march towards Toyota-esque efficiency should continue to provide us a highly satisfactory result over time.
Banking & Insurance Our insurance holdings provided perhaps the most ―excitement‖ I‘ve experienced this year. In my Q1 letter, I mentioned that a couple of them sold off, both to degrees that overshot any fundamental reasoning, and, both of which I subsequently invested more into. The first was Atlas Financial (AFH), a top three position of ours which specializes in the niche corner of taxi, limo, and paratransit commercial auto insurance. Atlas reported a significant ―reserve strengthening‖ in late February last year, which is insurance lingo for bigger-than-expected losses. Economic net impact amounted to $17 million, but its stock shed about $40 million in market cap in the aftermath. At the time, I wrote that it implies a permutation of several possibilities: 1.) Much more losses will come to light (i.e. the cockroach theory), and/or 2.) Future profitability will be significantly impacted, and/or 3.) Mr. Market over-reacted. After much thought, I judged #3 to be most likely and upped our stake by 25%. With small cap insurance companies though, you can never entirely rule out #1 and #2, but having followed this company for four years and watched CEO Scott Wollney meticulously grow premiums from $20 million to over $200 million, my inclination was to believe him when he asserted that this reserve strengthening was an isolated event related to specific laws and circumstances in Michigan that allowed lawyers to pursue large personal injury claims. Mr. Wollney promised the state would be < 1% of Atlas‘s overall book of business by year-end — better to exit a wretched place than try in vain to write profitable insurance there. AFH started 2017 at $18.05 but crumpled to $13 following the news, which is the price where I added shares. Subsequent quarters revealed no further damage from Michigan (or any other states) nor discernable impairment in earnings power or growth trajectory, which helped AFH to rally methodically for the rest of the year. The stock ended 2017 at $20.55, a 13.9% gain, but our opportunistic trading boosted our IRR to 21%, which actually ended up being the second
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P a g e | 14 largest dollar amount contributor to our overall bottom line. AFH is now, by my estimation, fairly valued, so I have sold those booster shares. Atlas remains a large position for us because of its compounding capabilities. It is in a niche business with a wide moat – insuring hired car service is not nearly as straightforward as it may seem, because it requires a large cache of proprietary data around accident rates and severities not easily reproducible. As such, it is capable of sustaining an enviable combined ratio between 80-90%14. In the past, large generalist insurers have attempted to splash into the space without the specific skills in underwriting such a risk, and they have ended up nursing large losses over time and been forced to abandon this line. Furthermore, with the growing popularity of Uber and Lyft, the market is expanding and legislation is catching up. Many states now require drivers to hold commercial-level insurance, which plays into Atlas‘s strengths nicely. The thesis also rests on the belief that Scott Wollney is a rational insurance executive who understands his circle of competence and operates with a long-term owner‘s mentality. This means a focus on underwriting results and not on chasing premium dollars of lesser quality. 2017‘s fiasco in Michigan notwithstanding, this focus has generally held up. *** The other insurer was Heritage Insurance Holdings (HRTG), a property catastrophe insurer based in Florida. Heritage suffered a general malaise for much of 2017, with shares, which started at $15.67, drifting down to $12 and below with no apparent catalyst. This is not uncommon, by the way, especially with small cap stocks which are easily moved by a mediumsized fund in excitement (or despair). In August, they announced a large acquisition of a private insurer in the New England, NBIC, which, perhaps since it required jamming a $125 million issue of convertible debt into the market, drove shares further down into the $11 range. And so, throughout the course of the year, I bought scoops of it here and there as it flip-flopped around, building it up to an 8-9% position by September. Then the excitement really started. 2017 was an abnormally active hurricane season, setting a record for activity in the Atlantic Ocean with Hurricanes Harvey, Irma, Jose, and Maria all making landfall as category 4 or 5 behemoths. Irma, in particular, was of interest to me because as it strengthened, it made a beeline towards Florida, and in particular, Miami, ground zero for the most expensively insured properties in the entire state. Heritage and its peers suffered indiscriminate sell offs as Mr. Market entered into one of his patented depressive moods. HRTG went from $11 to $9, sinking 30% below book value, a draconian haircut that assumes Irma will probably be the single most destructive hurricane in Florida history, inflicting inflation-adjusted damages more than twice that of the previous record-holder Hurricane Andrew. The sell-off was egged on by hysteria in the media, several doing what were essentially hit pieces on Florida-based regional insurers, giving the impression that they were all thinly capitalized and thus had questionable wherewithal to withstand a major hurricane when in fact,
14
The simplest way to understand Combined Ratio is the percentage of total expenses (loss + SG&A) to premiums earned. Thus, an 80-90% combined ratio = a 10-20% profit margin.
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P a g e | 15 almost all of them have significant reinsurance capable of surviving Andrew-level losses easily. You may recall I wrote about this in my Q3 letter, which you can refer back to for a more detailed blow-by-blow and footnotes. Long story short, Irma veered slightly west, sparing Miami the worst, but still dealing extensive damage due to her colossal wind field which basically covered the entire state longitudinally. Heritage sustained gross losses of approximately $400 million, but net of reinsurance, losses were capped at a $20 million retention. For perspective, they could have suffered four Irmas and still not exhaust their total $1.75 billion reinsurance tower. HRTG shares rebounded immediately after the hurricane passed and did not look back, closing the year at $18.02 per share, a 15% gain year over year. But our opportunistic buying, as it did with AFH, beefed up our IRR to 24%. We continue to own Heritage and I consider it still to be attractively priced. Moreover, I consider this space to be more inefficient, more prone to market hysteria, and therefore I have a discernable edge developed over following this industry for years. However, Heritage does not enjoy as wide a moat as Atlas does with regards to underwriting and thus it does not deserve as big a position in our portfolio. Catastrophe insurance is a well-trodden line of business with competitors who all use the same handful of vendors that model natural disasters and the same array of reinsurers backing them up. Nevertheless, their NBIC acquisition will be an interesting development to follow, as it immediately pushes their written premiums past $900 million but more importantly diversifies them out of Florida significantly. Together they will represent a ―super regional‖ insurer with more scale to throw around. *** On the banking side, our big winner in 2015 and 2016, Customers Bancorp (CUBI), had a miserable 2017, declining -27.4% from $35.82 to $25.99. This was not, to me, a great surprise. I wrote in last year‘s letter that repeating their outstanding performance would be unlikely due to the P/B multiple expansion that has already valued them in-line with their peers. Subsequently, I sold about half of our stake in Q1 for $33.89 per share. Customers is a regional business bank serving the New York/New England area that eschews brick-and-mortar branches and instead recruits banking teams who travel to client sites to conduct business and have deep roots within each local community. The benefits of this ―concierge‖ model are multiple. CUBI has much lower fixed costs and much higher productivity per employee than the typical bank. Lower fixed costs give them the leeway to generate good ROEs (10-12%) without reaching for higher-yielding risky loans (non-performing loans were a miniscule 0.30% of assets compared to peer/industry averages of around 1%). CEO Jay Sidhu founded Customers during the Great Recession a few years after he was pushed out of Sovereign Bancorp, an institution he grew from a tiny thrift into a $89 billion asset powerhouse. His ignominious exit came at the hands of a disgruntled activist in 2006, and since then he‘s had a proverbial ―chip on the shoulder‖, incentivized to reclaim a legacy as a successful banking executive. He set up shop in the same city where he built his previous empire and rallied his old Sovereign management team back together. By 2017, eight years after taking
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P a g e | 16 control of the erstwhile New Century Bank and rechristening it Customers Bancorp, they had grown assets from $350 million to just shy of $10 billion. What derailed 2017 was their BankMobile subsidiary, a digital bank venture targeting young millennials started in 2015 by Mr. Sidhu‘s daughter, Luvleen. For most of the year Customers was trying to sell it for at least $100 million. In March, they announced Flagship Community Bank agreed to pay $175 million in cash for BankMobile, a strange deal considering Flagship is a podunk two-branch bank in Florida with an equity book value of just $13.2 million. Not surprisingly, Flagship was unable to come up with the financing necessary to close, and instead, by year end, Customers agreed to do a spin-off of BankMobile followed immediately by a shareswap merger with Flagship with the resultant entity retaining the BankMobile name. The dramatically increased complexity of this deal, now slated to close in mid-2018, drained time, expenses, and management attention away from the core Customers Bank business, and muddied the quarterly results. Furthermore, they had to cap total assets to less than $10 billion due to a regulation that would have restricted the bank from charging debit card fees, the main impetuses to sell BankMobile in the first place. Net income per share, which had been growing 15-20% like clockwork for the past three years, fell -15% in 2017. While it‘s unfortunate that these events dragged down their overall results, the core economics and low-cost advantages of the business remain intact. We remain shareholders, living with the understanding that Jay Sidhu, while a talented and accomplished banker, has a tendency to take the occasional oddball risk now and then. The BankMobile saga should come to a merciful end this year, and the bank itself should once again return to 15-20% EPS growth, with $2.75 to $3.00 per share within reach, a completely acceptable ~10x P/E valuation at today‘s prices. *** On a happier note, our other bank holding company, CIT Group (CIT), advanced drama free in 2017 from $42.68 to $49.23 for a 15.3% gain. CIT is a middle-market bank that has, over the past several years, transformed from a hodge-podge collection of global lending businesses overly reliant on high-cost capital markets for funding into a legitimate mid-sized commercial bank focused on serving the United States with a growing low-cost deposit base. Its transformation has been a multi-year affair, after emerging from bankruptcy in 2009 and led by ex-Merrill Lynch CEO John Thain who, as his final stroke, acquired OneWest bank in 2014 and promptly retired, handing the reins to current CEO Ellen Alemany. The OneWest acquisition has been, with hindsight, a good one, because it vastly expanded CIT‘s deposit base, but it came with a host of headaches. OneWest was itself a turnaround project built from the pieces of infamous subprime mortgage lender IndyMac. CIT took hundreds of millions of charge-offs related to soured loans, specifically in the reverse mortgage business. In 2017, it was finally sold. Also sold were their commercial aircraft leasing business as well as their European railcar leasing business. The end result is a much slimmer company more focused on their historic niche in the middle-market with a dramatically improved funding structure. Ellen Alemany has been CEO now for two years and she and her management team have proven to be impressive operators, methodically chopping off extraneous pieces of the business, selling
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P a g e | 17 them for good prices, excising the damage from the OneWest acquisition, getting back on the bank regulators‘ good side, using the proceeds to buy back $2.75 billion in common stock, and studiously marching CIT back towards a 10+% ROE earnings power. Here is a fun slide showcasing just how much muck Ms. Alemany‘s team had to hack through to reach a semblance of normality over the past two years:
Figure 1: Noteworthy items impacting earnings (use a magnifying glass)
This year we should see CIT hit that 10% ROE mark, with the distinct possibility of reaching 1112%. With shares still trading right around tangible book value, we stand a good chance of enjoying further double-digit gains over the next year or two.
Takeouts I have often written about one of the beauties of value investing is that if you‘re directionally correct with your analysis and valuation, even if Mr. Market eternally disrespects your stock, eventually someone will come along and scoop up the entire enterprise. This came true several times in 2017 for us, contributing about 2.75% in gains to our total capital. The first was Whole Foods (WFM), a name I highlighted in my Q2 letter‘s Case Study. WFM was acquired by Amazon for $42 per share, netting us an approximately 40% gain over 1.5 years. Prior to 2015, I would never have thought of being able to buy WFM at an un-obscene valuation. But thanks to a series of operational miss-steps that led to several sloppy quarters, the market offered us WFM for 13 times cash flows ex-store expansion costs in late 2015. 13x may be a bit more than I usually pay for a stock, but perhaps I‘ve listened to Warren Buffett lecturing about See‘s Candy one too many times and have internalized the qualitative value of a platinum brand with a history of success and plenty of expansionary runway left.
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P a g e | 18 Shares were relatively range-bound for over a year, but things started heating up in Q2 after Jana Partners, an activist hedge fund, took a big stake and pressed aggressively for changes, threatening to overhaul the board if their demands were not met. On June 16th, Amazon announced their bid, effectively a white knight coming to Founder/CEO John Mackey‘s rescue. And while there was no way I could have guessed Amazon would be how we monetized our stake, I didn‘t have to. Good things happen when you look for situations where there are multiple ways to win, often coming completely out of left field, and very few ways to lose. The other takeouts were two companies in the Independent Power Producer (IPP) space. The first was Calpine (CPN), a name we‘ve also owned since 2015, attracted by its fleet of best-inclass natural gas power plants as well as their geothermal assets that are increasingly valuable in a world moving inexorably away from dirty coal and towards more efficient and renewable energy sources. It turned out I was a too early, as our CPN position, established at $16 per share, ratcheted down to $10 in Q2 last year. The company suffered mightily from persistently low electricity prices and competition from a glut of newly built plants. I managed to lower our cost basis to $13, but the complexity of the U.S. power market with all its different regulatory zones and political incentives and fluctuating commodity prices kept me from averaging down our position too aggressively – I am aware I don‘t have much of an edge here except patience. Fortuitously, in late summer, Calpine agreed to be bought out by private equity group Energy Capital Partners for $15.25 per share. This was an admittedly difficult investment where the outcome brought me as much relief as joy. Dynegy (DYN) was the other, an investment I alluded to having initiated in my Q1 letter. Spring of 2017 was really the nadir of the IPP space, about as hated as I‘ve ever seen a sector in my entire career. Dynegy was at ground zero of the pain, a name saddled with debt, too many coal plants, and grappling with a $3.3 billion acquisition of even more power plants at a time when investors preferred slimming down as opposed to bulking up. Yet, as Howard Marks oft states, there is no good/bad investment, only a good/bad price, and DYN holders, in the midst of this agony, were willing to part with their stock for a mere 3x free cash flows (FCF). Despite all the hair and complexity, it was irresistible, so I legged into it at a cost basis of $7.86/share. An equity valuation at 3x FCF is often a harbinger of doom, a sign that investors have almost no confidence in the company ever achieving any profitability for common shareholders. Generally, unsecured bonds of such abandoned equities would also carry a large haircut of, say, 70 cents on the dollar or less. Oddly, though, Dynegy‘s 7-year bonds were trading above 90 cents on the dollar, implying there were no real worries from that investor base. When there are conflicting signals between the stock market vs. the bond market, more often than not it‘s the bond market you should listen to15. Sentiment shifted after the Calpine acquisition. It signaled that companies are in play, and there are deep-pocketed hunters looking to capitalize on the stubbornly depressed valuations. In October, Vistra Energy announced they will merge with Dynegy in an all stock deal, sending 15
The bond market is often called the “smart money” market for the reason that most of its inhabitants are professionals who invest with the priority of not losing money, while the equity markets are played by many, many laymen whose goal is primarily speculation.
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P a g e | 19 DYN shares above $11. The combined company will retain the Vistra name and gain geographic diversification, operating efficiencies, and economy of scale benefits. Importantly, Vistra, itself a restructured entity that went bust during the financial crisis, has the balance sheet to support Dynegy‘s existing debt levels. I believe this deal is a good one for all shareholders and thus I plan to exchange our DYN shares for shares in the new Vistra.
A Quick Tour Of A Few Others
“Billy”, the Canadian alternative energy power producer I first talked about in my 2014 investor letter16, remains a staple in our fund as it has been since our inception. Nothing has changed with the core thesis. Wind keeps blowing and water keeps running and their cash keeps flowing, driving their stock up another 22.7% in 2017, an ideal compounder and Exhibit A as to why compounding works:
Figure 2: A five year chart of "Billy", a boring but steady compounding machine
16
Dish Network (DISH) declined -17.6% in 2017 as the great M&A Dance of Telecoms never came to fruition. As the world hurtles towards a 5G wireless future, Dish is well positioned to compete with its large swath of virgin spectrum, meticulously accumulated over the past decade by boss Charlie Ergen and now substantial enough to create a stand-alone nationwide network. Prior to last year, most analysts speculated that Mr. Ergen‘s purpose in hoarding this cache is to flip it to AT&T or Verizon for a profit, but it‘s becoming apparent that short of a Godfather offer, his intent is to build a real business around it. Buyers of the stock hoping for a quick payday have since sold their shares in disappointment. We, on the contrary, have been in it since day one because I want us to partner with Mr. Ergen who, as the company‘s founder and majority shareholder, plays a
Which I will continue to demure from revealing for now due to… political reasons. Call me if you want to know.
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P a g e | 20 long game17. Indeed, with much of the speculative froth blown off, DISH has become increasingly attractive. At its current price, you are paying ~10x free cash flows for its pay-TV business with everything else thrown in for free.
17
“Ricardo”, a pinksheet microcap who shall remain unnamed for the duration of our holding due to its small and illiquid float, is a value-added reseller (VAR) of a Fortune 500 software company – i.e. they are a wholesaler of their products. Companies like ―Ricardo‖ play an integral part in distributing and supporting enterprise software, enabling their vendors to reach niche customers, be it geographic or industry-specific, they otherwise wouldn‘t be able to. ―Ricardo‖ recapitalized in 2014, with majority control being taken by a private equity fund with permanent capital, essentially the vehicle of a wealthy activist with a long and sterling track record of value creation. The company has since simplified their business and redirected most of its excess cash flows to debt reduction, even electing to delist from an expensive stock exchange. ―Ricardo‖ began as a Special Situations investment as I had anticipated another recapitalization once its debt was sufficiently reduced to completely buy out minority shareholders such as ourselves. However, in 2017, they began acquiring other VARs instead, a roll-up strategy that will require operational discipline to be value accretive. Early indications are promising, but more time is needed to see if they can successfully transition into a Compounder.
“Daphne” is a Canadian microcap, also too small and illiquid to be revealed throughout the extent of our involvement. They are a B2B provider offering Canadian businesses document and marketing print services. This is not a growth business, frankly, but there is ample precedence of producing solid shareholder returns in a no-growth arena, especially when our purchase price was 4x free cash flow. Still, this is without question the highest risk investment in our portfolio, an extremely distressed situation where management is racing to consolidate warehouses while buying up niche companies with sustainable business models to replace their own. Thus far, a little over a year into our initial investment, it has lost -60% of its value as they heap on debt and issue ever more shares of stock with their acquisition binge. Chances are not insignificant it could be worthless and I will be writing about it in the Mistakes section of a future letter. And yet, there are enough flickering signs of hope that I am not ready to give up just yet, especially since it is our smallest position so even a total loss wouldn‘t really move our needle. Should ―Daphne‖ pull through though, it could reward us with a needle moving 3-4x return.
Dillards (DDS) is an American department store company I previously invested in in 2014 when we briefly rode its shares from ~$90 to ~$110. Since then, Amazon has laid waste to brick-&-mortar retailers all over, and Dillards was no exception. DDS, after
As a fun aside, Charlie Ergen’s neighbor in Denver, Dr. John Malone, famous for being one of the founding fathers of cable and current chairman of the spaghetti of Liberty holding companies that control Charter Communications, is widely worshipped by the investorati for his brilliance and vision and wealth creation. Few realize that Mr. Ergen, as his peer in the telecom space who essentially bootstrapped his satellite TV business and who garners much less attention, is actually far wealthier.
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P a g e | 21 reaching $140 in early 2015, crumbled below $50 in May 2017, where I decided 4x free cash flows is cheap enough for another go ‗round. In contrast to its department store brethren, e.g. JCP, M, JWN, etc., its main attractions are: 1.) relatively low levels of debt, 2.) relatively high ownership of its underlying real estate, 3.) owner-operated and controlled by the Dillards family who, together with its employees‘ 401(k) plan, own almost 50% of all shares outstanding, and 4.) voracious buyers of their own stock, having repurchased almost 40% of shares outstanding over the past five years, entirely funded by free cash flows. With DDS trading at 4x FCF, simply buying back shares achieves an ROIC of 25%. The bet here is on management rationally allocating capital by pruning underperforming stores and continuing their relentless repurchase of shares.
Mistakes Dillards was not the only adventure I attempted in retail land last year. CBL & Associates Properties (CBL), a mall REIT18, found its way into our portfolio at the same time. I have a high level of conviction that the brick-&-mortar retail complex as a whole is mispriced; the difficulty lies in determining which ones will survive, which ones will thrive, and which ones will die. Of the three, the thrivers will produce the most immense returns for those that are brave (or lucky) enough to invest today. I believe Dillards is a survivor, but CBL, on the other hand, has a chance to be a thriver. As a mall REIT, they are essentially landlords, and yes, malls are in trouble, but the beauty about being a landlord is you can make wholesale changes. Out are the enclosed spaces, in are the open-air ―town centers‖ anchored by movie theaters and fitness centers and restaurants. This model works. Amazon may be eating the world, but people will always want to go out and mingle and gossip. The ultimate fate of CBL is still to be determined, but by December, I sold out for $5.90 per share on a cost basis of $7.84, a -25% loss. Fortunately, it occupied just 1% of our portfolio. My mistake here was not that my analysis was wrong – it‘s that I didn‘t do enough analysis in the first place before entering into this position. I caught wind of this idea from some outside sources whom I respect and quickly jumped in after only superficial due diligence of my own, rationalizing that I am piggybacking on hours and hours of existing research from people I know who do good work. This is not an indictment on their diligence (which I still consider to be excellent), but rather, on my process, which when I ―outsource‖ research in this manner, do not afford me a level of conviction that girds me to hold through volatility, especially in as precarious a space as retail in this current environment. Watching CBL drop from $8 to $5.50 in a week was paralyzing. If I had done the work, perhaps I would have the conviction, even enthusiasm, to buy more, but alas, the dominant voice in my head was doubt. I sold in the name of generating some tax losses and vowed that this time, I will do the work. which continues to be in progress.
18
REIT = Real Estate Investment Trust, a legal structure that requires passing through 90% of profits as dividends.
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P a g e | 22
A Look Back and A Look Ahead Incandescent Capital has now capped off five years in existence. Our ~23% gross return in 2017 and ~17% annualized since inception is a decent but dampened achievement in light of the S&P 500‘s comparable rise. More notable is that we were able to achieve our gains idiosyncratically, generally focusing ~50% of our investments in just a half-dozen securities, none of which in the past couple of years belonged to the top 25 performers of the index nor the FAANG19 gang. An element of my value to you is thus exposure to the contrarian and/or obscure – your wealth is diversified away from not just the general market but also popular stocks that you can easily buy should you be inclined to play the market yourself. Sentiment around many high-flying stocks like the FAANGs and their ilk is that they are so dominant in their respective industries, so large, and suck up so much top talent that at whatever valuation they are bid up to, they‘re worth it because they will inexorably grow into it over time. These economic arguments are not irrational, and with their double digit growth rates in an era of low interest rates, there is even a mathematical argument to be made that they are literally invaluable20. A note of prudence, however: history has seen such a phenomenon before, and I am not talking about the housing crisis nor even the dot com bubble. In the ‗60s, the U.S. economy entered into a period of growth and optimism fueled by the country‘s emergence as a world superpower. The corporate titans of the time like McDonald‘s, IBM, Avon, Polaroid, Xerox, etc. were coined the Nifty Fifty and were considered no-brainer blue chips that deserved unlimited premium. Such a sentiment lasted for years, with each passing annum of ever increasing stock prices serving as evidence of some newfound physical law of the universe: ―Just buy IBM. It will never go down.‖ Stocks, of course, always go back down at some point. The law of gravity trumps all. The world is chaotic, unpredictable, messy, greedy, vicious. In 1973, the Dow peaked at 1,052 and that peak was not to be seen again until… 1982. Almost every Nifty Fifty stock declined 50+% from peak to trough as America succumbed to recession, war, an impeached president, inflation, and an energy crises. The earlier euphoria gave way to one of the worst bear markets in history: an utterly lost decade. Our collection of businesses, on the other hand, is a motley crew of obscure, unloved, and/or misunderstood underdogs who are making money for us while others get the glory. Our management teams are comparatively old fashioned. Their uniform is business-casual, not hoodies; dress shoes, not Allbirds21. They tend to prioritize profits and cash flows and underpromise but over-deliver. These are people we want to be in the trenches with day in and day out.
19
Facebook, Amazon, Apple, Netflix, Google F.A.A.N.G.
20
One method calculating the terminal value of a Discount Cash Flow model is the perpetuity growth methodology, where if the growth rate is greater than the cost of capital, it results in a terminal value that is effectively infinity.
21
“To Fit Into Silicon Valley, Wear These Wool Shoes”: https://www.nytimes.com/2017/08/11/technology/allbirdshoes-silicon-valley.html
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P a g e | 23 *** Looking forward on a macro level, the crystal ball remains as murky as always. The S&P 500 has been a most difficult opponent for active managers over the past eight years, and there are now a whole class of millennial financiers who have never experienced a meaningful drawdown, much less a bear market. An unscientific survey of a few peers as well as anecdotes gathered from general news clippings suggest even the most hardy bears have scaled the wall of worry and now harbor great expectations for 2018 and beyond driven by tax cut euphoria and deregulation. Color me cautious. I am prepared to suffer some cash drag and moderately underperform a roaring market as to be willing and able to strike when called for. As Warren Buffett wrote in Berkshire‘s 2016 annual letter, ―Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it‘s imperative that we rush outdoors carrying washtubs, not teaspoons.‖ As the Omahaian Oracle commands, so your humble investment manager will build washtubs and await the deluge. Thank you as always for your patience and partnership. Please feel free to reach out anytime. May you and yours experience a joyous and fulfilling 2018.
Sincerely,
Eric Wu
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The information set forth herein is being furnished on a confidential basis to the recipient and does not constitute an offer, solicitation or recommendation to sell or an offer to buy any securities, investment products or investment advisory services. Such an offer may only be made to eligible investors by means of delivery of a confidential private placement memorandum or other similar materials that contain a description of material terms relating to such investment. All performance figures and results are gross of fees, unaudited, and taken from a designated reference separately managed account (sometimes referred to as: the “Fund”). The information and opinions expressed herein are provided for informational purposes only. An investment in the Fund is speculative due to a variety of risks and considerations as detailed in the confidential private placement memorandum of the particular fund and this summary is qualified in its entirety by the more complete information contained therein and in the related subscription materials. This may not be reproduced, distributed or used for any other purpose. Reproduction and distribution of this summary may constitute a violation of federal or state securities laws.
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