Its been a great year for some of the smaller value oriented hedge funds ie Denali Investors, Maglan Capital, among others. Our friends at Arquitos Capital are also having a fantastic year with a return of 22% YTD due in part to ALJJ – see the full letter below.

Also make sure to read Arquitos detailed bullish case for the stock – ALJ Regional Holdings: Cheap Plus Valuable NOLs

Arquitos Capital Partners second quarter 2014 letter to investors.

Dear Partner:

Arquitos Capital Partners returned 13.5% net of fees and expenses in the second quarter of 2014, bringing the year to date return to 21.8%. The fund has cumulatively returned 91.4% since inception on April 10, 2012 through the end of Q2 2014.

Arquitos Capital’s largest holding ALJ Regional

As I mentioned at our investor dinner last week, our largest holding, ALJ Regional Holdings, Inc. (OTCMKTS:ALJJ) has continued to perform well. It is up more than 60% on the year, after being up by more than 120% last year. EBITDA, cash flow, and earnings are continuing to grow. The future is very bright, yet even today the company only trades at six times earnings and five times EBITDA.

ALJJ’s most recent financial results do not include a new acquisition. In April the company purchased 82.63% (fully diluted) of Carpets N’ More for $5.5 million. This is a company that was previously sold for $46.5 million back in 2008. It’s clearly a different environment now, but I’m sure Carpets N’ More CEO Steve Chesin feels liberated from the previous owners. He should now be able to make decisions focused on the long-term.

Many thanks are deserved for ALJJ CEO Jess Ravich and CFO Rob Christ, as well as the managers of their two subsidiaries. This company exemplifies the importance of proper incentives, from the value of the Net Operating Losses (NOLs), which encouraged cash-flow positive acquisitions, to the employment contracts designed for the subsidiary managers. Combining operational incentives with effective capital allocation can lead to special investments.

Corporate reorganizations have been an area of the market that has been very interesting to me over the past few years. If a prospective investment includes a re-organization, NOLs, management or shareholders who understand capital allocation and the value of these tax benefits, and a reasonable valuation, then the chances of success are high.

It’s surprising to me how companies with these characteristics can sometimes trade below their net asset value. At one point last year, ALJJ traded for 25% less than its net cash and investments, with no cash burn. We have two other companies in the portfolio that have similar characteristics and trade for less than their liquid net assets, and two additional companies in the portfolio who recently were in that situation.

Arquitos Capital’s buys Special Diversified Opportunities

Special Diversified Opportunities Inc (OTCMKTS:SDOI) is a company that we first started purchasing in February 2014. The company sold off their operations last year at the behest of an activist investor who has since acquired 34% of the company. They currently do not have any operations and are hunting for an acquisition, according to their new CEO. There are also some NOLs present.

Two things stand out about SDOI: The activist investors know what they are doing, and the stock trades for less than its net cash and investments.

Becker Drapkin Management, a $300 million hedge fund, is the activist investor involved. One of its general partners, Steven Becker, is the chairman of SDOI. Becker Drapkin has been one of the most successful activist funds around, while also flying under the radar. Barron’s recently noted (after we had bought the stock) that Becker Drapkin has put a representative on the board of companies 11 times. In those instances, the stock of those companies has advanced 109% on average, compared to 27.8% for the S&P 500.

See full Arquitos Capital Partners – Q2 2014 Investor Letter? in PDF Format here.