Via Steven L. Kiel’s Arquitos Capital Partners (a value hedge fund) 2013 letter to investors
January 10, 2014
He who lives by the crystal ball soon learns to eat ground glass.
Edgar R. Fiedler
Arquitos Capital Partners returned 46.6% net of fees and expenses in 2013. This compares to 32.4% for the S&P 500 (INDEXSP:.INX) for the year. Our compound annual growth rate since inception on April 10, 2012 is 29.46%. This means if a limited partner put in $100,000 at inception, their investment is now worth $157,120.
2013 was a good year all around. But we made our returns a bit differently than others and, I believe, in a way that is more likely to be replicable in different market environments. The largest contributor to this year’s gains was ALJ Regional Holdings, Inc. (OTCMKTS:ALJJ). I first started purchasing ALJ in late 2012 with the idea that this company would effectively utilize its cash and tax benefits. Our downside was protected because shares traded for less than the company’s net cash and there were no operations, de minimis expenses, and a dynamic chairman. This thesis was realized during the 4th quarter of 2013 when ALJ purchased another, larger company. Shares appreciated nearly 90%. This was our largest position. Shares still trade below what I believe to be the company’s true value, so we’re continuing to hold them.
InfuSystem Holdings Inc (NYSEMKT:INFU) was another big gainer in the 4th quarter. Shares appreciated more than 67%, significantly contributing to our overall gains. You may recall that we originally held Infusystem both because it was cheap and because I expected it to be bought out by the company’s executive chairman. The buyout fell through in the 3rd quarter, temporarily depressing the stock price. Two positive things happened in the 4th quarter: The company received certainty on its Medicare and Medicaid billing rates in several regions where it does business; and another operator in the space was bought out for a much higher multiple than where Infusystem traded. Multiples reset across industries after buyouts much like how the value of your house gets reset when another house in the neighborhood sells. The metric for your house may be something like the Price per Square Foot. In Infusystem’s case, its metrics are Price to EBITDA and Enterprise Value to EBITDA. These ratios increased in the quarter to begin to reflect the actual value of the company, thereby increasing the price of the stock. Like ALJ Regional Holdings, Inc. (OTCMKTS:ALJJ), Infusystem still has some room to run, though I have trimmed our position somewhat.
There is a spirited debate going on among investors on whether the markets are fairly or overvalued. I don’t have a strong opinion either way, though it has become harder to find obvious values among larger companies. One concern about the market’s gains in 2013 is that the highest returners were companies like Tesla Motors Inc (NASDAQ:TSLA) and Netflix, Inc. (NASDAQ:NFLX). They may be interesting companies, but won’t be mistaken for safe investments. In the case of a highly priced stock such as Tesla, analysts attempt to justify today’s valuations by looking far into the future. This is where Fiedler’s crystal ball quote comes in particularly handy. If you have to figure out cash flow of a company in 2020 to justify its stock price in 2013, it should be a good indication to simply move on to a different potential investment.
This will be the last time I pick on Tesla Motors Inc (NASDAQ:TSLA). I sincerely hope they succeed as a company and am personally fascinated by Elon Musk. His vision and creativity contributes to society greatly, and I wish him all the best. But these types of investments are simply dangerous, especially at current valuations. You can admire a company without owning it. If investors kept that in mind, they’d be more likely to stay out of trouble.
Crystal balls are alluring. To remain skeptical of forecasts and predictions I do a few tricks. Every few months I take a Wall Street Journal or a Forbes, and I throw it aside for safe keeping. At the same time, I grab one that I had previously set aside from a year, two years, or three years ago, and I re-read it cover to cover. The especially entertaining articles are the ones predicting how a particular stock will perform. It’s a good way to stay skeptical of short term predictions and financial reporting. Go back and read the articles about Bank of America in the fall of 2011 (up nearly 200% since then and still undervalued) or, on the other hand, J.C. Penney Company, Inc. (NYSE:JCP) and the promise of Ron Johnson (down 75% since the fall of 2011).
Unfortunately, in J.C. Penney’s case, I’m embarrassed to read my own past comments and angry that I lost you money owning the stock in the fund. Some lessons are expensive, I suppose, but I did certainly learn a lesson and I think you’ll benefit from it in some way in the future.
At the beginning of each year I also like to look back at what the market predictions were from the year earlier. This can be insightful and, sometimes, disturbing. As an extreme example, in December 2007 a group of very talented and intelligent analysts from several very large financial institutions predicted that the S&P 500 would end 2008 between 1520 and 1700. It ended the year at 903 and with a few of those institutions no longer existing.
Here were the predictions from December 2012 for where the S&P 500 would end in 2013:
UBS AG (NYSE:UBS): 1,425
Morgan Stanley (NYSE:MS): 1,434
Deutsche Bank AG (NYSE:DB) (ETR:DBK): 1,500
Barclays PLC (NYSE:BCS) (LON:BARC): 1,525
HSBC Holdings plc (NYSE:HSBC): 1,560
Goldman Sachs Group Inc (NYSE:GS): 1,575
Oppenheimer Holdings Inc. (NYSE:OPY): 1,585
Wells Fargo & Co (NYSE:WFC): 1,390
Bank of America Corp (NYSE:BAC): 1,600
Citigroup Inc (NYSE:C): 1,615
The S&P 500 ended the year at 1,848.
Goldman Sachs Group Inc (NYSE:GS) followed the old adage that if you have to forecast, forecast often. You’re bound to be right at some point. They adjusted their 2013 and 12 month forecast several times throughout the year.
In December 2012 they predicted 1,575. By March 2013 they raised it to 1,625. A few months later in May, the same forecaster upped his prediction to 1,750. In November he moved ahead to predict that the S&P 500 would go to 1,900 by the end of 2014, 2,100 in 2015 and 2,200 in 2016. This ridiculousness calls for an ESPN Monday Night Countdown, c’mon man!
Most of these forecasts are the result of the analyst adding up their estimated earnings per share of all S&P 500 companies, and then assigning a Price to Earnings multiple. Forget the fact that a company’s earnings, an often easily manipulated figure, is not necessarily representative of a company’s health. But then the analyst has to put a multiple on that potentially meaningless earnings number. That multiple represents sentiment. How is it possible to predict that nearly a year in advance?
These are smart people doing dumb things and deluding themselves and their clients. If something is unknowable, you certainly don’t want to convince yourself or others that it is knowable.
I’ve spent too much time here chiding these (in many cases) good people. I certainly don’t care about offering them advice they wouldn’t take anyway. However, I think it’s a valuable practice to mock the forecasters each year in order to remind myself of the risks associated with predictions.
I certainly don’t know how 2014 will go, but we do continue to own some cheap stocks. I will continue to try to find stocks that trade at meaningful discounts to their company’s underlying value. We’ll do well over the long term as long as I follow the process of sticking to my circle of competence, buying with a margin of safety and, for companies that we want to own as compounders, identifying whether they have sustainable competitive advantages. Couple this approach with the risk controls that I find most meaningful, such as clarity of thought, objectivity, and intellectual honesty, and we’ll be fine. It also doesn’t hurt to stay away from buying on margin.
Thank you again for following along. We are actively seeking limited partners. For those with retirement accounts, we can accept investments through your IRA. If you’d like to learn more about the fund or are interested in investing, please let me know. I can be reached at (571) 766-8089 or [email protected]. I look forward to hearing from you.
Steven L. Kiel
Arquitos Capital Management