Home Top Stories Arlington Value Capital December 2014 Presentation – Avoid The Deadly Sins

Arlington Value Capital December 2014 Presentation – Avoid The Deadly Sins

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Arlington Value Capital presentation on “Avoid The Deadly Sins” from December 2014.

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Also see

Arlington Value Capital 2015 Annual Letter


Allan Mecham's Arlington Value 2014 Annual Letter

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Allan Mecham On His Investment Style; Favorite Books

Investment Philosophy

  • We view stock as ownership in a business.
  • We let volatility work to our advantage.
  • Arlington Value Capital strives to be conservative, and invest with a margin of safety.
  • We exercise patience and discipline to only invest in exceptional opportunities.

Above all, we think vigilance towards risk is central to solid investment returns.

We view stock as ownership in a business:

  • The over-arching principle of our investment discipline is to approach buying stock as though we were buying the whole business outright and retaining management.
  • Employing an owner’s mentality helps us tune out distracting noise, allowing us to focus on the long-term fundamentals of the business as opposed to the daily gyrations of the share price.

We let volatility work to our advantage:

  • On average, individual stock prices fluctuate more than 75% in a 52-week period.
  • We don’t believe volatility equates to risk.
  • We welcome volatility as volatile markets occasionally offer extraordinary opportunities.

Arlington strives to be conservative and invest with a margin of safety:

  • When analyzing a business, we strive to be conservative and realistic in our assumptions.
  • We are disciplined investors, and purchase stocks only when favorably priced.

We exercise patience and discipline to only invest in exceptional opportunities:

  • Fiercely competitive markets combined with a limited mental aptitude makes it difficult to find attractive investments - where the risk/reward equation is extremely favorable.
  • Because exceptional opportunities are rare, we want to make meaningful investments when such opportunities are identified.
[Speaking about Berkshire Hathaway growing from 10 million to 120 billion over 40 years] “Success wasn’t based on hyperkinetic activity. It was achieved through nondiversification, a hell of a lot of patience, and intensely opportunistic behavior on a few occasions… If you took the top 15 decisions out, you would have a pretty modest record.” - Charlie Munger / Vice Chairman, Berkshire Hathaway

Investment Criteria And Process

Our success depends on exercising patience and discipline to only invest in situations that meet our criteria:

Strictly adhering to our criteria often results in a concentrated portfolio.


Arlington Value Capital

In July 2008, Arlington Value Capital launched AVM Ranger Fund, LP. AVM Ranger Fund, LP is our primary fund has generated a 37.9% annualized return (before fees) and has outperformed the S&P 500 by approximately 28% per annum since inception.

Arlington Value Capital

Prior to AVM Ranger LP, Arlington Value Management LLC (AVM) was our primary fund. From mid 2008 through mid 2011, AVM and AVM Ranger were managed side by side. After Q2 2011, AVM LLC was merged into AVM Ranger LP. The above chart shows the combined returns since inception.

Arlington Value Capital

The two tables above demonstrate how Arlington has stacked up against the S&P 500 and the top 10 performing funds of the approximately 5,000 and 3,000 US equity funds tracked by Morningstar over the approximately 6.5 years since AVM Ranger Fund’s inception and the 11.5 year lifespan of Arlington Value Management LLC respectively. The average return for all funds is likely below the returns for the index as it is widely noted that most funds underperform the index over time. Performance for all funds is gross of management fees.

Arlington Value Management LLC was merged into AVM Ranger LP in Q3 2011. The 11.5-year data represents Arlington Value Management LLC’s return from its inception in December of 1999 through June 2011.

Batting Average:

“I was a good investor myself, but I couldn’t do what Warren and Charlie do so well – virtually never have any losers.” – Otis Booth, major Berkshire Hathaway shareholder

Arlington Value Capital

  • A stubborn adherence to our investment principles results in a high batting average.
  • A high batting average is the key driver of strong long-term performance.

The above graph displays the 3-year performance of each stock in which Arlington committed more than 3% of its capital relative to the 3-year performance of the S&P 500 over the first eight years of the fund. For perspective, the accompanying graph displays the 3-year performance of each company in the S&P 500 compared to the 3-year performance of the index average. Arlington may have held the investment for less or more than three years, but we feel a 3-year period accurately demonstrates the success of the initial investment decision.

Vigilance Towards Risk

Above all, we think vigilance towards risk is central to solid investment returns.

“It is very easy to generate performance by taking on more risk. And so what you need to do is compensate for risk-adjusted performance... and that is where all the bodies are buried.” – Ragharum G. Rajan, IMF Chief Economist (2003 - 2007)

A Consistent Vigilance Toward Risk:

From Arlington Value Capital's 2001 Annual Letter:

“. . . a big portion of our assets are invested in companies that should thrive in a period of declining equity markets and tight capital markets in general.”

From Arlington Value Capital's 2003 Annual Letter:

“Junk bond spreads over treasuries have narrowed sharply. It seems as though institutional investors are focusing solely on returns and forgetting about risk. . . our top three holdings are defensively positioned.”

From Arlington Value Capital’' 2004 Annual Letter:

“Going into 2005 we continue to have the portfolio positioned defensively. . . Given the high prices and significant risks in the market, we believe our positioning is prudent for the long term.”

From Arlington Value Capital's 2005 Annual Letter:

“The current market environment reminds me of the crocodile pond my brother described to me after returning home from Australia: What looks calm and inviting to jump into is fraught with potential danger just below the surface. I think it’s a mistake to equate the low volatility in the market to a low risk environment in which to invest.”

From Arlington Value Capital’' 2006 Annual Letter:

“Wall Street tends to overweight, and extrapolate the most recent past performance - which has been favorable and without any serious gyrations or shocks. As a result, financial markets are pricing in tranquility as far as the eye can see.

. . . Many take comfort in the derivatives market to hedge risk. The number and amount of derivative products have proliferated at an incredible rate over the past few years. In normal times these innovations help to spread out risk. However, it’s times of unusual shocks and distress when one needs these products the most. Unfortunately, this is likely to be the time when these products add to the instability as large-scale liquidations take place between a small number of counterparties. I can’t pretend to know how derivatives will play out in the next shock to the system. My worry is that it exacerbates the problem instead of dampening it - which is why the products were created in the first place.

. . . The most dangerous environment is oftentimes at the cusp of euphoria; combining maximum leverage with rosy outlooks, on the heels of record profit growth and low interest rates, is a recipe for disaster in my opinion. . . The common theme for managers investing for others is a seemingly blissful willingness to ignore risks and lever up in order to achieve their desired returns. This is manifested in the narrow credit spreads across virtually all types of securities, which in my opinion have gone to crazy levels.”

From Arlington Value Capital’' 2007 Annual letter:

“The common theme running through the veins of Wall Street, and what is largely responsible for much of the anxiety, is leverage. The insane amount of leverage being employed is all the more perilous when considering the interconnected nature of the financial system. Having dry powder and financial flexibility in this environment, as we do, and FFH does, is a very favorable position to occupy in a market of forced asset sales and massive de-leveraging.

. . . I must sound like a broken record, as my overall tone of caution hasn’t changed much over the years. . . Our portfolio continues to be positioned somewhat defensively.”

Protecting Capital during Down Markets:

Arlington Value Capital

Arlington Value Capital's keen focus on risk has protected capital during the two worst peak-to-trough periods for the S&P 500 over the last 15 years.

Investment History

Three Periods of Arlington Value Capital:

  • Period 1: (5 Years: Dec 1999 - Dec 2004): Arlington Value Capital's primary founding partner was responsible for all investment activity.
  • Period 2: (1.5 Years: Jan 2005 - June 2006): In January 2005, Arlington took on two new active partners which resulted in material changes to Arlington’s investment process. The altered investment process resulted in significant internal conflicts. The fund’s performance during this period was extremely poor.
  • Period 3: (8 Years: July 2006 - Current): In July 2006, Arlington Value Capital went back to its original investment process and structure.

Arlington Value Capital

Arlington Value Capital - Avoid The Deadly Sins

We strive to avoid the deadly sins of portfolio management:

  • Accepting Unsuitable Capital
  • Groupthink – Lack of Independent Thinking
  • Overconfidence – Self-Deception
  • Overactivity – Insufficient Patience and Discipline

“All I want to know is where I’m going to die, so I’ll never go there” – unknown

Accepting Unsuitable Capital:

  • Unsuitable capital misaligns interests and expectations, interfering with one’s ability to execute the strategy.
  • Incompatible investors distort one’s investment mentality and can cause one to focus on short-term fluctuations rather than long-term values.

“The single greatest edge an investor can have is a long-term orientation. In a world where performance comparisons are made not only annually and quarterly but even monthly and daily, it is more crucial than ever to take the long view. In order to avoid a mismatch between the time horizon of the investments and that of the investors, one's clients must share this orientation. Ours do." – Seth Klarman

Groupthink – Lack of Independent Thinking:

  • Relying on others’ analysis results in paralysis or panic under volatile conditions.
  • Groups have a tendency to reinforce preconceptions and suppress critical thinking.
  • Seeking consensus results in making decisions with the heart rather than the brain.

“Madness is rare in individuals – but in groups, parties, peoples and ages it is the rule.” – Gustave Le Bon

Overconfidence – Self-Deception:

  • Inability to say ‘I don’t know.’
  • Investors own too many stocks, ignoring the boundaries of their mental capacity, resulting in excessive mistakes and harmful frictional costs.
  • Average holding period on NYSE: 6-months!

“The awareness of ignorance is the dawning of wisdom.” – Socrates

“Never fool yourself, and remember you are the easiest person to fool.” – Richard Feyman

Overactivity – Insufficient Patience and Discipline:

  • Unable to sit still without tiring of sitting still.
  • Act too often, think too little.
  • Relaxing investment standards after a drought of ideas.
  • Average holding period on NYSE: 6-months!

“The enemy of investment success is activity.” – Warren Buffett

“The big money is not in the buying and selling, but in the waiting.” – Jesse Livermore


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