Successful investing is about having people agree with you… later.

Jim Grant

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Dear Partner:

Arquitos Capital Partners returned 8.0% net of fees and expenses in the second quarter of 2015, bringing the year to date return to 2.5%. Our annualized return since the April 10, 2012 launch is 33.2%. Please see page four for more detailed performance information.

Arquitos Capital Partners - Biggest performance contributor: Real Industry

Our biggest winner during the quarter was Real Industry (RELY). The price of its shares advanced from $6.14 to $11.35 during that time period. I briefly mentioned it in last quarter’s letter, saying that I was happy with their operational advancement. At the time the stock price simply was not representative of the company’s value. It still isn’t. I only wish I would have made it a larger piece of the portfolio. Even at today’s price, fair value is twice its current share price. I apologize in advance to those looking for quick gains, but we’ll probably have to be more patient than one quarter for shares to double again.

We recently spoke with Craig Bouchard, RELY’s CEO. He comes across as promotional. That originally gave me pause, and was why I didn’t allocate a larger piece of the portfolio to the company. Sometimes it’s worth it to talk to management. Other times it can skew the way you think. Senior executives typically are talented marketers. That’s good, but I always need to guard against my objectivity being compromised. It pays to be skeptical.
In this case, I outsourced the Bouchard interview to Rodney Lake from The Benval Group. Rodney has been doing some work for the fund over the past few months and has been very helpful. Reading Rodney’s notes about Bouchard and the company, as opposed to me speaking with Bouchard directly, helped keep a bit of distance between my thoughts on the company and Bouchard’s optimism.

Ironically, the interview made me realize I was overcautious with the company. Bouchard’s track record at his previous company, Esmark, which he ran with his brother James, was remarkable. It wasn’t just the exponential increase in shareholder value for Esmark owners (shares advanced from 25 cents/sh to $19.25/sh during their tenure), it was also the operational expertise and the adept timing when selling the company to Severstal in 2008. Bouchard is high energy and has shown he can put together a strong team. He’s done it again with RELY.

Another key part of the story is the involvement of famed investor Sam Zell. Zell originally controlled the company when it was no more than a shell with no operations. After Bouchard got involved in 2013, he received Zell’s blessing to pursue the subsequent strategy. Zell has been a master for more than 30 years at monetizing companies that have substantial Net Operating Losses (NOLs). RELY fell into this category.

On the operational side, RELY is benefiting from both cyclical and structural changes. I’ve shied away from commodity-related business in the past because of the high number of variables involved. Here, aluminum demand is clearly on the upswing because of increased economic activity. On the structural side, the company will continue to benefit from the move to use lighter materials in the auto and other industries.

At a stock price of less than 4x EBITDA, shares are still absurdly cheap, especially considering that EBITDA will likely grow considerably over the next few years. RELY will not have to pay federal income taxes for far into the future. Bouchard is also actively looking to make additional acquisitions. This is a company we want to own for quite some time.

Arquitos Capital Partners - Performance detractor - Gyrodyne

One of our other holdings did not work out as planned during the quarter. Our investment in Gyrodyne (GYRO) is a good example that we don’t make more money just because a transaction is complex. I entered the company for a specific purpose related to its planned liquidation. We participated in a rights offering at a price far below the liquidation value of the company after taking the dilution into account. Our upside appeared to be about 20% over a limited duration. The chance for a loss appeared to be low. Unfortunately the liquidation value attributable to shareholders is now far lower than the original estimate by the company, eliminating our potential gain.

I’ll spare you the specific details here as the reasons for our loss were a bit complicated, but contact me if you’d like the full story. We’ve nearly exited the position and are looking at about an 8% loss. It was a disappointing result.

Arquitos Capital Partners - Investments in small community banks

An area I’ve started to get involved in are small community banks. Some of these have converted from mutual savings banks to stock companies, others are simply very cheap and overlooked by other investors. The ones we own or are looking at are small, so I’ve decided to purchase a basket of them. This makes them easier to acquire as a whole, and I’ll treat them as a group going forward.

The common theme for the banks I’m interested in is that they are highly overcapitalized. Essentially, if they were able to liquidate, investors would collect substantially more than where the bank stocks currently trade. Of course these banks won’t liquidate, but they are likely to get bought out by larger banks, and that is where the value is. I’m focused on banks trading below .7 times tangible book that have solid loan books and are near break-even on the income statement side.

Dodd-Frank and other new regulations make it very difficult for very small banks to compete. These banks also cannot commit funds to things like mobile banking and other modern conveniences for deposit holders. It’s inevitable that many of them will be bought out by larger banks in order to get access to the deposit base and the cash on the balance sheets of the smaller banks. The current buyout multiple for these types of situations is around 1.2 times tangible book. If we can buy into the bank at .6 times tangible book, which we’ve done in several cases, then a buyout offer would give us a double in the stock.

The small banks that I’ve been particularly interested in are currently attractive buyout candidates. An activist may already be involved either as an investor or board member. For the mutual conversions we simply need to have patience until the waiting period for increased ownership ends. For these and other bank holdings we can collect a dividend and participate in book value growth due to stock buybacks. I’m not overly concerned about trading liquidity for these banks stocks. The lack of liquidity keeps larger investors away and allows us to buy into some of these banks at an even bigger discount than would seem possible. It just takes some time to build out our position. For banks that are profitable with solid loan books, it doesn’t get much cheaper than the prices we’re paying.

We held our annual investor dinner in Washington, DC earlier this month. If you would like a copy of the slides or if you would like to discuss the presentation, please let me know. I can be reached at (571) 766-8089 or [email protected] Thank you again for being an investor in the partnership. I look forward to continuing to compound funds on your behalf.

Best regards,

Steven L. Kiel

Arquitos Capital Management

Arquitos Capital Management NOLs