Greenhaven Road Capital letter to investors for the second quarter ended June 30, 2015.

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Dear Limited Partners,

We were fortunate to have another strong quarter of performance on both a relative and absolute basis. The fund is up 13.7% YTD vs. overall markets that have effectively languished year to date. As always, please view these results through the lens that short-term outperformance and underperformance is effectively random. If I told you we outperformed on any given day, you would shrug and say “so what?” That should be the reaction to any given quarter and even year. There is no attempt being made to beat a specific index or eliminate volatility. I am just trying to find the best investments I can and hold on as long as possible. My goal is to outperform your non Greenhaven Road investment alternatives such as cash and ETFs – not every single day, week, month, quarter, or year – but over a multiyear time period. As the investor John Paulson once said, “Our goal is not to outperform all of the time – that is not possible –we want to outperform over time.” For the investing legends who have actually accomplished this feat, the path was rarely smooth. For example, Charlie Munger underperformed the market by 37% between 1972 and 1974. If one were to view his performance only through that two-year period, you would question his competence and decision to leave his law practice. However, the same partnership that underperformed the market from 1972-1974 outperformed the market by almost 18% a year over the full 14 years of the partnership, an astounding accomplishment.

I continue to believe that our small size, long-term orientation, and stable capital provide advantages that will play out over time. In fact, when you compare the cumulative results of Greenhaven Road to the S&P 500 over the four-and-a-half-years of the fund, the results are quite favorable. After all fees and expenses, Greenhaven Road has compounded capital at just under 19% per year vs. just over 14% for the S&P 500, and just over 4% for the Barclays Hedge Fund Index. This is meaningful because of the power of compounding. The small differences year after year add up. The exact magnitude of 5%, 10%, or 15% of outperformance per year depends on the number that is being outperformed, but a reasonable rule of thumb is that an incremental 5% a year over a 30-year period will lead to four times as much money. Simply put, instead of having say $5M at the end of 30 years, if you got an extra 5% per year, you would end with $20M. In the event of 10% outperformance, the results are even more stark, leading to in excess of 15 times as much money at the end of 30 years. That base case $5M would be $75M in a scenario of 10% outperformance.

One of the drivers of outperformance in the quarter was Rally Software, which I profiled in some detail in the second quarter 2014 letter. The initial investment effectively doubled over the course of a year. A phenomenal investment. However, to me, the performance is less interesting than the reception the investment thesis received. As an opportunistic investor, I look high and low for ideas to invest in. One of the places that has been a fruitful source of leads over the years has been online investment forums such as Value Investors Club and Sum Zero. These are curated communities of “professional” investors where fellow members are allowed to ask questions and rate each other’s ideas. To have access to the flow of ideas, members must contribute ideas annually. Since Rally Software had not appeared in any value forum that I was aware of, I wrote up the investment thesis for the Sum Zero community to maintain my access. Let’s just say the Sum Zero community was not overwhelmed by the brilliance of my Rally Software analysis. In fact, my write up was ranked in the bottom 20% for expected performance among all ideas submitted. To be fair, my write-up was shorter than many because I am trying to find great investments, not write the longest and most detailed write-ups. However the community is also not limited to Warren Buffett, Charlie Munger, Bruce Berkowitz, and Monish Pabrai: a community where I would clearly be in the bottom 20%. The low rating serves as a reminder that my investing style is often not well received by the larger investment community. I am not going to win a lot of beauty or popularity contests. In a world filled with social media, blogs, and talking heads, there is a short term tyranny of the articulate. Those who can speak the most clearly and string together the most advanced arguments in the simplest terms are deemed the “winners.” The articulate get the most “likes,” “re-tweets,” “favorites,” and are voted the highest expected returns. Is there a connection between short-term popularity and long-term performance? I am skeptical. The data suggests that I am clearly going to lose the short-term battle of the articulate, but if investment performance holds up, the long-term war for performance appears winnable, and that is all I really care about.

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Greenhaven Road Capital - Let Them Use Index Funds - The Case For Selective Management

Can we continue to outperform? Can we continue to beat index funds? I keep coming back to this issue, so clearly it haunts me on some level. Have we just been lucky? We will certainly have our down periods (quarters and years) at some point. The conventional wisdom is that index funds and ETFs are unbeatable. Active management is dead. The low fee structure of an index fund is insurmountable. But what is an index? Murray Stahl continues to put out really interesting research addressing these questions and others that I wrestle with, but with far more depth. This month, Murray delved into the existential question of what is in an index fund? (http://www.horizonkinetics.com/docs/InternationalDiversification_June2015.pdf) He points out that financial planners who want their clients to diversify in a low-cost way will often recommend that their clients own primarily U.S. domestic equities through something like the S&P 500 with a sprinkling of international through MSCI EAFE Index. This seems like a reasonable and prudent plan. It can even sound scientific if you recommend a portfolio with precise allocations such as 70% equities - with 73% domestic equities (S&P 500) and 27% international (MSCI EAFE). It can be back tested and can lead to fancy charts and a sense of certainty for the investor/client. Unfortunately, businesses and groupings are not as clear as they may appear. When you dig into the S&P500 as Murray has done, of the top 50 companies in the S&P 500, a full 44% of revenue is in fact from overseas and not from the US. When you dig into the “International” companies in the MSCI EAFE index, it turns out that 30% of their revenue is from the U.S. In addition to the buckets not being as neat as one would hope for, it turns out it is really hard to know what you own or why you own it when you own 500 of anything.

I cannot run a four-minute mile (or a five-minute mile), I am terrible at the piano, and all indications are that I would be terrible at organic chemistry. However, finding 15 companies that can outperform a blob that comprises an index fund? I have hope. Particularly when the index is constructed in a very crude manner that ignores even the most basic indicators of quality.

The S&P and Russell are both “float weighted” which, I would argue is a very poor selection criteria for finding the best investments. I understand why they do it, but “float weighted” means 2 things, both of which are clear negatives for investors. First, float is not based on the total amount of shares in a company, but rather the amount of shares that are available for public trading. Essentially if a large portion of a company is tightly controlled by the founder or management team, that company will be a smaller part of the index. Second, all things equal, if a company is more expensive, it will be a larger part of the index because float is the number of shares available for trading multiplied by their price. Other indices are capitalization weighted, where bigger is better which has its own short comings. Fortunately, in the Greenhaven Road partnership, we are not constrained by size and we can choose to only invest in higher quality companies with a set of particular attributes. We can be “active managers” and seek out the very companies that the indexes deliberately exclude: those with strongly incentivized management teams trading at cheap prices. However, I think the term “active managers” inaccurately describes our aspirations. We want to be low turnover, holding for years, or essentially inactive once we have identified securities that maximize our chances of success. What we really want to be is selective. Not a term thrown around often – but selective management is our aspiration. We want to know what we own and why we own it. We want to select companies for specific attributes that are most likely to lead to value creation and share price appreciation. While few companies will have all of the following attributes, I believe over time companies with a combination of the following attributes will outperform the average company and index.

Insider Ownership: Why is insider ownership at the top of the list? Because insider ownership can bring along so many potential benefits. At a minimum there is typically an alignment of incentives. The same way I expect you to sleep better knowing that I have essentially all of my investable resources invested in Greenhaven Road, I sleep better knowing there is high insider ownership in many of the companies that we own. High insider ownership also often comes with excellent capital allocation skills – the insiders have managed to build a valuable company without giving away the equity. Think about the incentives if you own $200M in stock and are the CEO. Are you focusing on your performance bonus that can be gamed quarter to quarter? Or are you focusing on growing the business in the right way for long-term value? I would argue the latter. High insider ownership aligns with our long investing time horizon.

Reasonable Valuation/Asymmetric Risk Reward: While not religious about what constitutes value (ie. a low P/E, a high free cash flow yield, a discount to book value etc.), like the US Supreme Court’s definition of pornography, I would like to think I know it when I see it. In terms of asymmetric risk/reward, we are looking for situations with downside protection (lose a little) and substantial upside (double our money in a couple of years).

Variant Perception: Many of the most rewarding investments emerge from situations where most market participants are focused on “noise” that is not really critical to the business. This can manifest itself in several ways, such as growth investors panicking when revenue slows while they fail to appreciate underlying cash flows. It can also happen when complicated GAAP accounting obfuscates the true health of a business. A variant perception can take many forms, but is very hard to form for an individual company, and I would argue virtually impossible to form for an index.

Scalable Business Model: Companies such as asset managers and software firms can generally add customers with very low incremental costs. When coupled with large un-penetrated markets and strong growth prospects, this can create a very attractive investment with asymmetric economics. The potential to scale is more important than having achieved scale, which is what size weighted indexes are capturing.

Growing Market: An expanding marketplace can compensate for management and product weakness.

Recurring Revenue: A long tail business where existing customers provide a steady source of future revenue is just an easier business to manage and grow. These businesses are more forgiving as the existing base is a source of stability and predictable revenue that can fund future growth.

Customer Value Proposition: There are a lot of ways to make money in the short term that are at the expense of the customer. A simple example would be websites that are built to monetize traffic when a real website name is misspelled. There are businesses such as casinos where there can be a debate about the value proposition to their customers – but they are certainly not no-brainers. A strong value proposition for customers tends to lead to recurring revenue and many ancillary benefits that compound over time. Product matters.

None of these attributes listed above determine if a stock is in the typical index which are myopically focused on float, size and/or industry. This lack of selectivity by the indexes just has to create opportunities. Fortunately to date the variance has been so large that for Greenhaven Road, “selective management” has significantly overcome a non-trivial incentive fee. For your friends, you may want to clue them into the opportunities afforded by selective management using intelligent criteria. For your acquaintances and enemies, let them keep buying the market blindly as it will only create opportunities for us.

Greenhaven Road Capital - Top 5 Holdings

One theme that has driven several investments over the last couple of years is Software is Eating the World. In the technology investing world, this idea was popularized by Marc Andreessen, the founder of Netscape and the venture capital firm Andreessen Horowitz. The core of the Software is Eating the World thesis is that software is permeating our world and creating opportunities for the disruptors. A very obvious example would be of stock trading, where 40 years ago a transaction that took several people passing orders to the floor of an exchange can now be handled from beginning to end through software. Software is throughout the automobile – used not only extensively in the design and testing, but also in the mechanics of the automobile down to anti-lock brakes. Software is Eating the world was one of the factors in both of our investments this past quarter (Interactive Brokers and Halogen Software, discussed later in detail), as well as Rally Software, which is software for creating software (software squared) and Radisys, which is part of software replacing hardware in the telecom ecosystem. I mention this concept as I find it a helpful lens to view the world and investment opportunities through. We are not becoming a software fund, there will still be opportunities in real estate like Howard Hughes, and spinoffs, and mispriced high quality companies. Quite frankly, given the age and orientation of most of our limited partners, I suspect this is a theme many of you have not thought about, and I wanted to just highlight it briefly.

Careful readers will notice that ChipMos holdings is not in the top five holdings at the end of the quarter. The fund currently still owns ChipMos and has not made any additions or subtractions to the position; it found itself out of the top five as a function of poor relative performance with the chip complex selling off and a relatively weak short term revenue outlook. The company is selling at a roughly 25% discount to its cash and Taiwan 8150 holdings, with a newly announced buyback and pursuit of a long-term corporate structure simplification (buyout of our shares by Taiwan 8150 holders) underway. Furthermore, there are modest tailwinds for the company with increased component usage in TVs and smartphones. We will continue to hold our position at least for the intermediate term.

Greenhaven Road Capital

We did exit a position in the quarter: Vectrus. This was a defense contractor spinoff. The core reason we bought the stock was a variant perception around management incentives. During the spinoff process, management’s stock options had not been priced. There was thus an incentive to downplay the revenue pipeline and keep the stock price low until the options were priced. This played out, and with their options priced nice and low management ceased talking down their own pipeline and the stock rallied. We earned a nice return in a short period of time, however, we were then stuck with an ok business in an ok industry with ok management. While I hate paying short-term capital gains taxes, our thesis had largely played out, and any “edge” that we had was long gone.

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Greenhaven Road Capital - The Short Side

The short side remained an area with limited activity focused primarily on indices. We closed a small short position in a consumer packaged goods company with a small profit. We also closed a small position in an “organic” super market chain for a small profit. We initiated a small short position in an oil and gas “fracker” that has proven modestly profitable to date. We also initiated a short position in a telecom services company that I first looked at shorting in 2008. The company recently lost a contract representing the majority of revenue, and the risk reward finally became attractive enough. The individual company short positions remain very small, with no single short position being larger than 2% of the overall portfolio.

Greenhaven Road Capital - August 1st Subscriptions Closed - September 1st Open

Fortunately Greenhaven Road’s investment approach, process, and results have continued to attract new investors to the partnership this year from as far away as South Africa and Uruguay to as close as Scarsdale, NY (five miles from my house). Given the fee structure where I assume operating expenses, the only way I make any money is when your returns are greater than 6% a year there are no benefits to stockpiling cash. As I indicated in the last letter, I want to limit new subscriptions in the fund to 10% or less in any given month unless there is a major dislocation in the capital markets. Given the commitments to date for August 1st and our current cash levels, the next available opening for capital will be for September 1st. Please let me know if you have a desire to add any funds to the partnership.

Greenhaven Road Capital - Investing Through Fidelity

Several LPs have come through Interactive Brokers and Millennium Trust for retirement accounts, these are niche platforms. While not finalized, it looks like investments of IRA funds and possibly taxable accounts will be available through Fidelity in the near future. If this is of interest to you, please reach out directly.

Outlook

As I write this letter, the news cycle is filled with Greece and the country’s future within the Euro. When attention on Greece dies down, the talking heads focus on a Chinese market that has largely retraced its hyperbolic year to date appreciation and label it a “crash.” With my long bias I would love for the markets I invest in to “crash” and still be up 90% in the past 12 months, like the China market commentators are worrying about. I understand that newspapers have to be filled with content because blank pages don’t sell papers or ads, and TV anchors have to talk about something, but I struggle to see the connection between Greece and China and the fundamentals of the 15 companies that we own. The angst in the world creates volatility, multiple compression, and buying opportunities for investors that are focused on companies that are not impacted in any direct way by the crisis of the month. I remain optimistic. The fund remains by far my largest personal holding, so I am eating my own cooking every single day. Thank you for the opportunity to manage your assets alongside mine and my family’s.

Sincerely,

Scott Miller

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