Value Investing

Arquitos Capital Management 4Q15 Letter: Microcap Value Stocks

Steve Kiel’s Arquitos Capital Management letter for the fourth quarter ended December 31, 2015.

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In the short run, the market is a voting machine, but in the long run it is a weighing machine. - Benjamin Graham

Dear Partner:

Arquitos Capital Partners returned -14.8% net of fees in 2015 compared to 1.4% for the S&P 500. Our annualized return since the April 10, 2012 launch is 22.6%. Please see page five for more detailed performance information.

I have previously stressed that our overall results are contingent on the individual performance of the companies we own. In 2013 and 2014 our gains were dramatic. That positive performance occurred because our largest holdings performed well operationally, and that operational performance was rewarded by investors.

In 2015 our companies have generally continued to improve their operational performance.

Unfortunately this operational success was not recognized by investors during the year. The good news is that our holdings, which were cheap in 2015, are even cheaper today. This has given me an opportunity to refocus the portfolio on the companies that have the greatest disparity between their market price and their actual value.

Last year’s results were disappointing, but I am as optimistic as I have ever been about the future of the companies in our portfolio.

In the beginning of each year, Barron’s holds a roundtable discussion with leading investors and strategists. The comments from that discussion, published this past weekend, were particularly interesting. Value investing was out of fashion last year, and those who focus on fundamentals were punished. Oscar Shafer made the following point about 2015:

“We had a stealth bear market last year. Despite the fact that the averages didn’t do much, 70% of stocks in the Russell 2000 [an index measuring small companies] are down more than 20% from their 52-week highs. That is also true of 49% of the S&P 500, and 68% of the Nasdaq Composite. It really will be a stockpicker’s market, because a lot of stocks that are down 30% or 40% are buys now.”

I don’t typically comment on market conditions, but it is useful to reflect on the point that Shafer is making. He is referring to the market’s breadth. The overall markets were relatively flat last year, but that occurred because of positive market performance by a small number of companies. If you remove the performance of those companies, the market’s results, like ours, were miserable.

The financial press has been trumpeting a new acronym to explain this: FANG stocks. They are referring to Facebook, Amazon, Netflix, and Google. The average return of these four companies in 2015  was 84%. These stocks carried most of the other companies in their respective indices.

Arquitos Capital Management Portfolio Updates

The point is that even though the overall markets have performed extremely well from 2009 through the end of last year, there are opportunities in some specific companies. I feel strongly that this is the case in the companies that we own. I am not bullish on the S&P 500.I am bullish on our portfolio. Our results in the next year will be dependent on seven companies, our core holdings. These seven companies currently make up approximately 75% of our portfolio. We will rise or fall on their results. Below is an update on each:

ALJ Regional Holdings (ALJJ): ALJ closed on an acquisition in August 2015 that practically doubles the net income per share of the company. Inexplicitly, market participants have given no credit to the value of the acquisition. That will change in the future for two reasons: One, the effects of their most recent acquisition will become clear once future earnings results are released. Two, the company has announced that it is in the process of applying to uplist to a major exchange. While ALJ is well known in the underground value investing community in which I reside, the average investor has never heard of the company and does not know its compelling story. This uplisting will make the company’s shares available to a much wider audience.

Bank of America (BAC): I have owned Bank of America’s TARP warrants since the partnership’s inception. They are priced as attractively now as they have ever been since we bought them. The value of the warrants is linked to the price of Bank of America’s stock. The stock is now trading below the company’s tangible book value. Tangible book is essentially the equivalent of the liquidation value of the company. Despite all of the pressures that are on big banks, this valuation is absolutely insane. Bank of America is a profitable company with all major legal and regulatory expenses behind it. New loans made since the crisis are the safest loans ever recorded. Bank of America and the other major banks certainly do not deserve the high multiples they had before the crisis, but for investors to now treat Bank of America as if it is distressed is not appropriate. When these warrants expire three years from now, investors will be kicking themselves for not taking advantage of the obvious bargain that currently exists.

Berkshire Hathaway (BRK.B): Berkshire’s massive size coupled with its tremendous record means that its future performance will certainly not be as impressive as its past. Even so, there is obvious value at its current trading price of about 1.25 times its book value. Warren Buffett has stated that the company will buy back shares at 1.2 times its book value. While we can’t unconditionally rely on that statement, it does tell us the price at which the greatest investor ever thinks his company is a bargain. We have a few different ways to take advantage of Berkshire’s current price. I believe the best risk/reward is to own long-dated options with strike prices that are in the money. This is the primary way we currently own the company.

MMA Capital (MMAC): The performance of MMA Capital’s shares was one of the few bright spots in 2015. We saw a gain of approximately 15% from when we bought shares until the end of the year. MMA has a complicated story. A simple way to look at it is that the company’s reported Net Asset Value (NAV) is $15.55. The NAV is the level where the company previously has been willing to buy back a large number of shares. Shares currently trade for $14.21. However, the company’s actual NAV is above $21, not $15.55. GAAP accounting rules skew reporting with MMA’s specific characteristics. MMA also has several development opportunities on land that it owns and for tax assets that it controls. They are actively working to monetize their assets, which will help make the value of the company more clear to investors.

Real Industry (RELY): Real Industry shares have been crushed over the past six months as the price of aluminum has plummeted due to the drop in Chinese demand. The drop in the company’s share price has happened because investors have misunderstood the effect of the aluminum price drop. Real Industry sent a press release out last week announcing the date of their next quarterly call. In that release, after praising employees for recording “one of the finest performances in the history of the company,” CEO Craig Bouchard made the following comment:

“The world is a tough place right now for some of our less fortunate competitors and customers. In our conference call we will address the global macro-economic outlook, the importance, or lack thereof of China, the credit markets, and update our plans to grow Real Industry. 2016 will one day be remembered as a time of outsized opportunity. Well-managed companies prosper in such times.”

Bouchard has proven himself as a masterful operator. He would not have been allowed by company lawyers to make those comments unless financial results were strong. The company was cheap six months ago at $12. It may be the biggest bargain in the markets today at $5.84.

Sitestar (SYTE): Much has happened at this tiny company over the past six weeks. After a dispute with the CEO, the board of directors appointed me as the interim CEO on December 14. I spent the holidays at the company’s headquarters in Lynchburg, Virginia. While I can’t go into details beyond what the company has publicly released, I have attached a letter to Sitestar shareholders from December 29 that provides more background.

WMI Holdings (WMIH): I have written about WMI Holdings several times in the past year, so I won’t belabor the point. WMI is essentially a shell company controlled by the private equity firm, KKR. The company has very large tax assets that KKR is working to monetize by pursuing an acquisition. KKR has their best and brightest working on the company, and I am confident we will get a positive result.

After a year like 2015 it was important to review all of our holdings in detail and to objectively determine if I am continuing to adhere to the fundamental philosophy that has made the partnership a success. I feel strongly about the value in our portfolio. In order to take advantage of the specific opportunities highlighted here, I have refocused the portfolio to focus on these seven companies.

I recognize that some investors joined the partnership over this past year and did not participate in the gains from prior years. When I explained that your partnership was to be a long-term endeavor, I did not anticipate that you would be immediately challenged by our poor performance. I appreciate your longterm commitment and am certain that my investment approach will yield attractive gains over time.

Thank you again for being an investor in the partnership. Please don’t hesitate to contact me if you have any questions. I look forward to continuing to compound funds on your behalf.

Best regards,

Steven L. Kiel

Arquitos Capital Management

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