Arquitos Capital Management letter to partners for the first quarter ended March 31, 2015.
What we learn from experience depends on the kind of philosophy we bring to experience. – C.S. Lewis
Arquitos Capital Partners returned -5.1% net of fees and expenses in the first quarter of 2015. Our annualized return since the April 10, 2012 launch through the end of the first quarter is 33.0%. Please see page four for more detailed performance information.
Arquitos Capital Management: SWK Holdings
Despite poor performance results for the quarter, several underlying investments had positive operational developments not yet reflected in their stock price. I’ve written about SWK Holdings (SWKH) previously. The company has a large amount of Net Operating Losses (NOLs) that will shield future income from taxation for some time to come. Its largest investor, Carlson Capital, provided a substantial amount of new capital to the company. In conjunction with that capital raise, we participated in a rights offering (including an oversubscription allocation) to acquire additional shares at discounted prices.
Since that capital raise in in November, the company has been aggressively putting this new money to work. SWKH provides funding to health care-related companies in a variety of ways including royalty streams, debt financings, and customized offerings. They earn very attractive returns, often coupled with a grant of warrants, which give SWKH the right to purchase shares of recipient company stock at predetermined prices. An example of a recent deal involved Hooper Holmes (HH). HH made an acquisition and needed funding in order in order to complete the transaction. SWKH provided a $5 million loan at an annual interest rate of Libor (with a 1% floor) plus 14%, currently 15%. SWKH also received warrants to purchase up to $3.75 million of HH shares at a strike price similar to where HH’s stock traded at the time of the acquisition. Over time, those warrants are likely to become valuable. Of course, the 15% interest rate is nothing to scoff at either.
SWKH’s stock price does not come close to reflecting the value of the company. The company is consistently getting rates of return on their invested capital in the mid-teens. Because they are currently putting this new capital to work, the overall results do not reflect where they will be in the next six to 12 months. They trade for slightly more than book value today. Given the company’s earnings potential as they put the new capital to work, along with the prospect of safely leveraging up their balance sheet, the stock should trade at a level significantly higher than where it is at now. An added bonus is that the company has announced plans to pursue a reverse stock split in order to cut costs and allow them to uplist to a national exchange. This will give the company more exposure, which will help close the gap between the stock price and the value of the company.
Arquitos Capital Management: Signature Group Holdings
Another holding that had significant operational advancements during the quarter is Signature Group Holdings, soon to be renamed Real Industry (RELY). This is another NOL shell that recently made a significant acquisition. The transaction closed in the first quarter and the parent company uplisted to the NASDAQ. The management team has a great track record of impressive operational performance. I have no doubt they will run a lean operation and squeeze out every dollar they can from the business.
As the company incorporates the new subsidiary it will take some time to determine its normalized earnings power. However, if we look to the financial results of the acquired company from the past few years, it’s fair to say that applying a reasonable and appropriate multiple should yield an outsized return for RELY over time. Like SWKH, we’ll have more visibility over the next six to 12 months. In the meantime, we are being handsomely compensated for the perceived uncertainty.
A common theme of these investments, as well as other holdings in our portfolio, is that they rely on company-specific results. The goal is to dramatically reduce exposure to market risk, and instead take on company risk. This rewards us for finding companies that are significantly mispriced and, to a degree, insulates us from the general ups and downs of the overall markets. The success or failure of the portfolio will depend on my stock picking abilities, not on the general markets.
At this point in the market cycle I’m most interested in companies going through unique situations where potential downside is limited. We’ve recently participated in rights offerings, invested in companies going through corporate reorganizations and liquidations, and acquired positions in several companies with significant NOLs but limited operations. In all of these circumstances our exposure to market risk is low.
Arquitos Capital Management: The magic of compounding
At the launch of the fund I wrote about the magic of compounding. By taking a long-term approach, an investor receives exponential benefits. There is no better example of this than Berkshire Hathaway. Berkshire’s annual meeting is this upcoming weekend, and it will be a special one. Warren Buffett took over Berkshire 50 years ago this year. During that time period, the compound annual growth rate for the company has been 21.6%. This is a truly, truly extraordinary result. To put this into perspective, a $1,000 investment in Berkshire in 1965 would be worth more than $18 million today.
Berkshire has done more than just produce exponential gains. Buffett and Charlie Munger have also revolutionized the concept of a holding company. They harnessed the advantages of permanent capital by pursuing opportunities to invest in both private and public companies, they’ve utilized float in an extraordinary way (This is now dominated by the use of insurance float, but in the early days they recognized its value via their ownership of Blue Chip Stamps), and they set up a decentralized structure for the company that helps to mitigate risks common with conglomerates.
Of course Buffett has inspired an entire generation of investors, myself included. Without Buffett I would have never discovered or appreciated Ben Graham, Seth Klarman, Joel Greenblatt or the other investors that form the foundation of my investing style and approach.
Buffett and Munger taught me the importance of the psychological side of investing. They taught me that investing is much more art than science. For me, it involves creativity and curiosity. It requires mental discipline. Investing has taught me the importance of intellectual honesty. It has shown me the value in avoiding envy, which reduces the chances of emotional decision making. It has demonstrated the power of incentives. Recognizing and respecting these things are generally useful in life, but they are absolutely essential for long term investing success.
Arquitos Capital Management: Investing approach
My investing approach is based on the style Buffett employed when he ran his hedge fund prior to Berkshire. In fact, the Arquitos Partner’s mission statement is directly lifted from the Buffett Partnerships: To compound funds at a better than average rate with less exposure to long term loss of capital. In the first three years of the fund, we’ve accomplished that goal. The fund has beaten the markets each year, sometimes by a considerable amount like in 2014, sometimes more narrowly like in 2012. After all fees and expenses, we’ve beaten the S&P 500 by more than 16% per year.
I’m convinced that this success could not be possible without having the proper investor base. Your long-term focus is a significant advantage to the fund. It allows me to take advantage of the emotional short-term decisions made by most stock market participants. Those emotional decisions are how the markets get mispricings, and mispricings are where we make our money. Your trust allows me to stay analytical and disciplined. Thank you for treating your investment in the fund the way that you have, and please continue to stay focused on long-term compounding.
As I mentioned in the last letter, I moved into a new office during the quarter. Our new address is 928 Fort Stockton Drive, Suite 207, San Diego, CA 92103. If you’re going to be in the area, please let me know. I’d love to have you stop by. I’m always happy to answer any questions and can be reached at (571) 766-8089 or firstname.lastname@example.org. Thank you again for being an investor in the partnership. I look forward to continuing to compound funds on your behalf.
Steven L. Kiel
Arquitos Capital Management