Allan Mecham’s annual letter to Arlington Value Capital partners for the year ended December 31, 2015. According to a letter obtained by ValueWalk. See the full letter below.

 

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Dear Partners,

2015 was a difficult year. I’m disappointed to report that AVM Ranger registered its first loss in 7+ years (Arlington Value Capital's first loss in over a decade). We finished the year down 6.7% vs. a gain of 1.4% for the S&P 500. This brings our 7.5-year annualized return to 30.9% vs. 8.7% for the S&P 500. (All figures are gross of fees as we have two different fee structures.)

(For long-term Arlington LPs, our 16-year annualized return is 20.1% vs. 4.1% for the S&P 500.)

Being down in any given 12-month period doesn’t necessarily demand disappointment, as price and value often diverge. More than sixty-five years ago, Ben Graham introduced his “Mr. Market” concept: a bipolar business partner who each day offers to buy your interests or sell you his—occasionally at irrational prices. This apt parable has passed the test of time, as history is littered with silly investment behavior. Ben Graham’s other adage has also retained merit: “In the short-run the market is a voting machine, in the long-run it’s a weighing machine.”

Unfortunately, part of our poor performance in 2015 can’t be attributed to a manic “Mr. Market” as it reflects mistakes I made. The poor results do not stem from a bevy of blunders; rather, my discipline slipped and execution suffered.

Though I’m disappointed with our results, bouts of volatility and underperformance at Arlington Value Capital  are not without precedent. A look back over Arlington Value Capital's 16-year history reveals multiple periods of volatility and lagging performance. The table below provides historical context:

Arlington Value Capital

Twelve years ago I penned my annual letter and referenced a study that highlighted 5 funds with 15-year records that handily beat the S&P 500 yet underperformed 30% of the time. Back then I speculated that if we were to continue to outperform we would need to accept periods of underperformance as well.

After 16+ years my opinion hasn’t changed. In fact, I think a dispassionate attitude toward potential quotational loss is a prerequisite to achieving solid long-term results. Our preferred antidote is to don a business owner’s hat (who buys for keeps), instead of a fund manager’s hat who’s unduly concerned with short-term measures. This common-sense attitude helps calibrate our analysis to think about long-term earnings power and intrinsic value; although, it doesn’t guarantee mistake-free investing.

Arlington Value Capital - Portfolio Overview

2015 was a tale of two halves: the first half was marked by muted action (minor selling) and a cash position, while the second half saw excessive activity and poor returns. Unlike the Vegas slot-player however, the stock market’s instant-feedback system doesn't always accurately reflect success or failure. In investing, mistakes occur when decisions are made yet sometimes don’t vest until much later. I’m a big believer in learning from mistakes (unfortunately, I keep furthering my education); however, I think it’s dangerous to let short-term wiggles drive frenetic postmortems. Conversely, I try to be alert to hairline cracks in my analysis, irrespective of stock price action.

Arlington Value Capital - Outerwall Inc. (OUTR)

The major black eye impacting 2015 (though the decision was made in late 2014) was our investment in OUTR. This was a mistake I should have avoided. My assumptions appear faulty, and I clearly underestimated the effects of substitutes on consumer behavior.

Further, I should have insisted upon first-class stewardship before considering an investment given the challenges at Redbox. With scarce reinvestment options and a declining business, capital allocation (important in any business) takes on critical importance. The conditions prevailing at OUTR demand thoughtful capital allocation, not a blind devotion to venture-like investments in kiosk businesses and systematic share buybacks without reference to value or opportunity costs.

In hindsight, I should have recognized the folly of investing alongside executives with poor incentives (no skin in the game), and a destructive record of capital allocation. I naively thought our overtures would nudge management and the board in the right direction and produce smart results … Lesson learned.

The critical variables at OUTR rest upon Redbox’s future decline rate (and associated level of cash flows) and the efficacy of future capital allocation. Given the many variables at play, it’s hard to know if Redbox’s recently reported decline rate will continue apace, accelerate, or perhaps snap back slightly (given better content buying and a stronger release slate) and moderate in the years ahead. Equally important is our unease with the current management and board of directors.

As of this writing there’s hopeful news: Glenn Welling at Engaged Capital (an “activist” hedge fund) has taken a large stake and is advocating urgent change. Engaged Capital’s top priorities are to redirect capital allocation and sell the company. In the near term we plan on working with interested parties to support rational behavior and value creation. Unfortunately, even under new leadership OUTR will likely remain a candidate for my “wall of shame,” serving as a reminder to avoid similar mistakes in the future. If we were to sell out of our remaining position today–around $34 per share–OUTR would end up costing us roughly 4.5% of capital, one of the worst losses in our 16-year history.

Arlington Value Capital - NOW Inc (DNOW) & MSC Direct (MSM)

Beyond OUTR, we had a few new positions suffer declines in 2015, though I don’t believe they’re mistakes. Midway through the year, feeling happy with a 10% gain andidle cash, I was attracted to two companies, DNOW & MSM, that harbored key elements I look for in businesses: staying power and unique competitive positions within their respective industries. Both companies are distributors with business models that generate cash in downturns and require minimal capital expenditures. Further, both DNOW and MSM enjoy scale advantages, strong balance sheets, and seasoned management teams with strong track records.

In both cases, what appeared moderately cheap (perhaps I could have exercised better price discipline) became cheaper as industry headwinds intensified. I was somewhat ambivalent to the declines (which reflected industry challenges), as part of the investment appeal rested upon my view that growing stress would benefit both companies at the expense of competitors.

MSC CEO Erik Gerstner explains in the most recent Q:

Economic slowdowns are the times when MSC makes its greatest strides. These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately. History tells us what will happen to local distributors if this downturn prolongs. Reducing their inventory leaves customer service vulnerable. Clamping down on receivables disrupts long-standing customer relationships. Laying off people creates hiring opportunities to acquire industry talent not typically available. We are just starting to

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