Editor’s note: Arquitos Capital Partners – This is a pretty impressive performance and note how Steve is cautioning investors not to expect this to continue indefinitely – very humble and smart!

January 15, 2015

I saw the angel in the marble and carved until I set him free.

Michelangelo

Dear Partner:

Arquitos Capital Partners returned 57.8% net of fees and expenses in 2014 compared to 13.7% for the S&P 500. Our annualized performance since inception on April 10, 2012 is 39.1%. See additional performance details in the chart below:

Arquitos Capital

Clearly 2014 was a very strong year for the partnership both in absolute terms and when compared to the overall markets. These results are even more striking considering that the portfolio does not utilize margin debt. We’ll occasionally own some warrants or options, but the vast majority of the holdings are plain vanilla equities.

I am certainly confident that we’ll continue to do well over time, but I caution you not to expect another year like 2014. My focus is on minimizing long term loss of capital. I’ll happily trade the opportunity for gains in order to prevent potential losses. This approach has led to high returns since the launch of the partnership, but these returns are totally dependent on my ability to find significantcompany-specific mispricings. Future returns will likely have little correlation to the overall markets. I can’t predict what I’ll be able to find. I can only promise that I’ll continue to comb through a lot of haystacks in the hopes of finding a golden needle.

It can be helpful to turn the perspective around in order to better understand this approach. I remember an interview that involved a prominent venture capitalist. He said that he had always had an appetite for risk. He described himself as a gambler who needs the adrenaline rush. He’ll bet money on coin flips.

“You’ve got to take on risk to get a reward,” he said, and all that kind of stuff.

I saw a real world example of this in the hedge fund world in an article I read a few days ago. The portfolio manager explained why he was buying into a company that is experiencing major structural

problems. He said that he thought the stock could double. What he didn’t say (or perhaps what he doesn’t want to acknowledge) is that if his thesis is wrong, there is a very high chance the stock is worthless. He’s essentially flipping a coin.

Frankly, those two examples are a horrifying way to invest. Putting it all on red or black works out slightly less than 50% of the time after transactional costs, but even if you’re successful that’s a pretty hollow way to make money. When we make money in the partnership, it won’t be because we got lucky. We’ll have earned it, and you won’t have to worry about losing it on the next roll of the dice.

Unlike the two investors above, I have no appetite for risk. My goal is to find anomalies in the market where little risk exists. We’re playing a completely different game than those two “investors.”

Focusing on the downside doesn’t mean we won’t have hiccups in the short term. There is no way to completely prevent that. This is natural if you believe that volatility by itself isn’t risk. My advice is to ignore the results over the past month, quarter, and year. Judge the performance over 3-5 years. Set your expectations appropriate to that time horizon and forget about the next quarter.

I’ve talked before about arbitraging the intrinsic value of a company with the current trading price of its stock. We must have an advantage or there’s no point in getting involved. Often, our biggest advantage is our time horizon. I am willing to deal with short term volatility, which we can’t control, in order to capture long term gains. We want to tap into the power of compounding. As an investor, that requires a multi-year perspective. I’ll do the hard work. All I ask is that you trust in the process.

Let’s look at the portfolio over the past year. Our largest positions will typically be the biggest drivers for performance. This was very much true over the past year. The partnership’s three largest holdings on January 1, 2014 returned 180%, 6%, and 47% respectively over the course of the year. We continue to own the two largest positions. We completely sold out of the third position in early June when I felt that the stock had reached full value. That stock currently trades at a price similar to where we had sold it.

SWK Holdings (SWKH), which I discussed in our 3rd quarter letter, has taken over as our third largest holding. On the negative side, the stock is down about 6% from the time I wrote the 3rd quarter letter. On the positive side, we own quite a bit more shares because the company did a rights offering which allowed us to buy a significant number of shares at a 40% discount to its stock price at the time.Net-net, we’re way ahead.

Rights offerings can be a great way to join excellent capital allocators at a discount. You have to be a current shareholder in order to participate, but you often have time to buy into a company after they announce their intentions. For example, SWKH first submitted a preliminary registration statement detailing a rights offering in February 2014, several months before we first bought the stock. For a number of reasons they didn’t consummate the offering until the end of November.

SWKH’s rights offering was unique because of the history of the company, its Net Operating Losses, and the dynamic between the directors, management, and its largest shareholder. Companies who do rights offerings usually have unique circumstances, though. That’s why they’re a great place to look for potential investments. In fact, I’d say that if you see a company announcing a rights offering, the presumption should be that it’s interesting enough to look at as a prospective investor.

The reason why something like a rights offering should be interesting to investors is because investing is more art than science. Do we know why a company like SWKH wanted to raise money? Based on the numbers alone, not exactly. But we can make several educated guesses. You have to have some imagination here. Why are the operators of the company and its major investor doing all they can to put more of their own money into a company that they know better than anyone else? They clearly have better visibility into the company’s prospects than outside investors do. This is a major form of signaling that good things are likely to be ahead. As a bonus, because of the rights offering, we are then able to pick up additional shares at a discount to the stock price at that time.

This is where the Michelangelo quote applies to investing. If you look close enough, anyone can see what a company is now. How do you see, now, what it will be in the future? Examining decisions made by a company’s owners and operators, or finding other interesting characteristics that provide a signal that things at the company are going well, can be very useful.

It’s important to remember, though, that above all, the price of the stock is what matters. If a company is performing well, but its stock price reflects that strong performance, then it is not an investable opportunity. We’re looking for significant anomalies between the stock price and the value of the company.

A few administrative matters: My wife and I recently moved to the San Diego area. The firm will be moving into a new office in February. I’ll forward contact details as they become available, though the phone number will remain the same. You may be receiving documents from our auditor soon requesting verification of your investment or other information. Your timely reply will help to expedite the year-end audit and the generation of your K-1 tax statements.

Please don’t hesitate to contact me if you have any questions. I can be reached at (571) 766-8089or [email protected]. Thank you again for being an investor in the partnership. I look forward to compounding funds on your behalf far into the future.

Best regards,

Steven L. Kiel

Arquitos Capital Management

This letter is for informational purposes only and does not reflect all of the positions bought, sold, or held by Arquitos Capital Partners. Any performance data is historical in nature and is not an indication of future results. All investments involve risk, including the loss of principal. Arquitos Capital Partners disclaims any duty to provide updates or changes to the information contained in this letter.

Performance returns for Arquitos Capital Partners reflect the fund’s total return, net of fees and expenses. They are net of the high water mark and the 20% performance fee, applied after a 4% hurdle, as detailed in the confidential private offering memorandum.

Performance returns for 2014 are estimated by our third party administrator, pending theyear-end audit. Actual returns may differ from the returns presented. Positions reflected in this letter do not represent all the positions held, purchased or sold.

This letter in no way constitutes an offer or solicitation to buy an interest in Arquitos Capital Partners or any of Arquitos Capital Management’s other funds or affiliates. Such an offer may only be made pursuant to the delivery of an approved confidential private offering memorandum to an investor from Arquitos Capital Partners.