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Alluvial Up 12.1% In Q1 On Small Cap Picks

Alluvial

Dear Alluvial Clients,

I am pleased to report strong results for Alluvial’s strategies this quarter. Alluvial has now completed three full years of formal operations, a milestone I was not sure would be reached when I began in 2014! Since its March 31, 2014 date of inception, Alluvial’s flagship Global Focused Value strategy has produced annualized returns, net of fees, of 17.6%. This compares quite favorably with the Russell 2000 Index at 7.1% and the Russell Microcap Index at 4.9%. I have been consistent in requesting clients assess Alluvial’s performance over time periods of multiple years. The small and often neglected or illiquid securities that are Alluvial’s focus often move (or don’t move) for no fundamental reason, and patience is required to see this investment approach to its fruition. In my view, a track record of minimum sufficient length to be meaningful has now been achieved, and I hope clients find Alluvial’s results acceptable. In general, I am satisfied with Alluvial’s investment decision-making processes and the results of those processes these three years. That does not mean I have not made errors. I certainly have and I have made efforts to discuss them candidly. But, I can say with confidence that I am better investor than I was three years ago. This is the result of constant effort to accumulate knowledge and understanding. An investor must never cease learning, because there is always more to know! More knowledge creates clearer sight, which allows better decisions and eventually, better results. I do not know if market conditions will be conducive to continued out-performance over the next few quarters or even years. I am exceptionally confident that Alluvial’s approach will continue to bear fruit over any reasonable timeframe.

Alluvial is growing, and with growth always comes change. Alluvial Fund, LP commenced operations on January 1 and has already welcomed several limited partners. With the launch of the partnership, Alluvial’s separately managed accounts are now closed to new clients. I believe the new partnership offers several advantages over the separately managed accounts. If you are an accredited investor and are invested in becoming a partner, please let me know.

Since Alluvial Fund, LP is now Alluvial’s only open investment vehicle, I will no longer be reporting performance for Alluvial’s legacy accounts. Doing so would only invite confusion and distract from efforts to attract new partners for Alluvial Fund. Because of rules surrounding general solicitation I am limited in my ability to provide information and commentary on Alluvial Fund’s holdings and results to non-accredited investors. Writing two different quarterly letters, one for separately managed account clients and one for limited partners in Alluvial Fund is untenable, so I am currently assessing strategies for continued communication with separately managed account clients. Future quarterly letters to nonaccredited clients may be summary in nature. Regardless, Alluvial will continue to provide its services to both its separately managed accounts clients and to Alluvial Fund limited partners for the foreseeable future.

But that’s the future, and this is now. Let’s discuss a few of Alluvial’s holdings and their pertinent developments.

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Stanphyl April 2017 Letter

April  letter from Stanphyl Capital. The hedge fund was profiled in our second edition and returned 31% in 2016. Check out the post and especially the end of the PDF for more on their small cap stocks.

For April 2017 the fund was down approximately 4.4% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 1.0% while the Russell 2000 was up approximately 1.1%. Year to date the fund is down approximately 9.3% net while the S&P 500 is up approximately 7.2% and the Russell 2000 is up approximately 3.6%. Since inception on June 1, 2011 the fund is up approximately 109.7% net while the S&P 500 is up approximately 101.1% and the Russell 2000 is up approximately 79.4%. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two.
As in March, our shorts killed us this month while our longs (collectively) had little impact. I thought April’s €20 billion ECB taper would be enough on the margin to start deflating a worldwide asset bubble that—by many metrics– was topped only in 1929 and 1999-2000; I was wrong. Despite ridiculous equity valuations and signs of a U.S. economic slowdown via increasing defaults in auto loans & credit cards and an awful Q1 GDP number, worldwide central bank balance sheet expansion may still be too massive to fight in significant size on the short side. Although the S&P 500’s current Shiller PE is an absurdly high 29, one must acknowledge that it hit almost 33 just before the 1929 crash and 44 just before the 2000 crash, and in neither of those instances were central banks printing over $100 billion a month (in 2017 dollars) as they are now, nor were major worldwide real interest rates almost universally negative. Belatedly acknowledging the possibility that this market may grow from the third-biggest bubble in history (as measured by Shiller) to the “first biggest,” in April I covered our Russell 2000 short position (fortunately, mostly before the French election) while maintaining our shorts in non-US sovereign debt (“the bubble that enables the other bubbles,” via our BNDX short), and—in reduced size– in Tesla (the market’s biggest single-stock bubble, with so many red flags that it could—and should– collapse regardless of what the broad market does). Once significantly more ECB tapering is at hand I may again put on a broad-market short position; alternatively, if we get a major sell-off prior to that we’ll have plenty of liquidity to buy when others are glued to their “sell” buttons.
Meanwhile, beginning this month (April) I’m waiving the fund’s 0.5%/year management fee until we’re back above our high-water mark. (We’re currently approximately 9.3% below it.) I didn’t do this when we drew down 17% between 2014 & 2015 because we had lots of deep value longs then that I felt would take off and make us a lot of money (and they did in 2016, when we were up over 30%). But on an “absolute value” basis (I don’t play the game of “relative value”) I’ve yet to find any cheap new long positions to add this year (which tells me how overvalued this market is), and don’t want to charge a management fee in a down year while positioned defensively. Here then are the fund’s positions…
As noted above, we continue to hold a short position in the Vanguard Total International Bond ETF (ticker: BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 0.74% at an average effective maturity of 9.2 years. As I’ve written since putting on this position in July 2016, I believe this ETF is a great way to short what may be the biggest

asset bubble in history, considering that Europe and Japan (which comprise most of its holdings) are printing approximately $115 billion a month (¥6.7 trillion + €60 billion, yet are long-term insolvent due to their massive liabilities. When will the bond buying end? For Europe I suspect it will be when the current ECB commitment expires at the end of 2017 and isn’t renewed, thanks to German pressure due to U.S. tariff threats, struggling savers & insurance companies and “enough” inflation. In fact, Eurozone inflation is now surging. Japan I think can never stop printing (its ratio of debt to GDP is too high) but will eventually crash the yen into oblivion (we’ve been short yen since late 2012) and with that its bonds will crash too. (I discuss Japan more extensively in the last paragraph of this letter.) The borrow cost for BNDX is just 1.6% a year (plus the yield) and as I see around 5% potential downside to this position (vs. our basis, plus the cost of carry) vs. at least 30% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement.

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Ticker and other info removed for non subs or one stock – this stock and 3 more small cap tickers below for subscribers

We continue to own XXXXXXXXXXX maker XXXXXXXXXXXXXXXXXXXXXX which in March reported a somewhat disappointing FY 2017 Q1 (its seasonally weakest quarter) with revenue down 6% year over year and a small operating loss ($6X,000) vs. $23X,000 in operating income a year ago. However, the company did generate almost $5XX,000 in free cash flow and seems to have turned its international division around nicely, with solid growth from its XXXXX  acquisition. More importantly, XXXXX has hired an investment bank to “explore strategic alternatives”—in other words it has put itself up for sale (and also paid out a .70/share special dividend in February). Thanks to its 53% gross margin and potential for large SG&A eliminations if it weren’t an independent public company, I think XXXXX should be sell-able to a strategic buyer at a significant premium to the current price; for example, an enterprise value of 1.25x 2016 revenue would be roughly $12.65/share (net of the cash paid in the February special dividend), while a “worst case” scenario of 1x revenue would still be around $10/share.

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Bluetower Q1 Letter

Blue Tower Asset Management  is off to a slower start in 2017 but had a monster 2016 with an impressive 35% return. Check out our exclusive interview with the PM on some of the hedge fund’s favorite small caps.

Also see Livermore Partners up 85% in 2016 (also profiled here)

The Global Value strategy returned -2.90% gross (-3.14% net) for Q1 2017. Our performance this quarter was somewhat weak primarily due to three factors: 1) relative weakness in US small-cap equities, 2) a sentiment-driven sell off in EZCORP’s stock, 3) a general meltdown in the subprime auto lending sector. In this letter, I will give updates on EZCORP’s business and our investments in auto lending.

Blue Tower Asset Management

Blue Tower Asset Management – Relative Weakness in small-caps

Smaller companies had a rougher start to the year than the overall market. The Russell 2000, an index of smaller companies that (as of the most recent reconstitution) have market capitalizations between $3.9 billion and $133 million, had a return of 2.47% in Q1 relative to 6.07% for the S&P 500. If I were to speculate on the origin of the relative weakness of small cap stocks, I believe it is the result of the tremendous post-election rally that small cap stocks had after the election. This post-election bump in small caps was largely due to the belief that US corporate tax reform would be forthcoming (Trump campaigned on lowering the corporate tax rate to 15%). Small companies in the US pay a higher effective tax rate than large caps stocks, with the average for the Russell 2000 and the S&P500 being 30.6% and 25.8% respectively1. As hopes for a rapid tax reform process dim, Russell 2000 stocks have pulled back. Due to the Blue Tower Global Value strategy historically being invested mostly in US small cap stocks, the Russell 2000 has been the most correlated of the major indices to the strategy.

EZCORP

EZCORP (EZPW) was the largest detractor to our performance in Q1 2017 with a performance impact of -4.5%. EZCORP has gone through significant changes since we first invested. Late last year, they sold Grupo Finmart, their Mexican government employee payday lending service. The company recently had their annual shareholder meeting in Austin, TX where the company’s leadership discussed the growth in pawn loans outstanding and other aspects of the business. Over the past year, the company has grown loans in the US faster than either of their two major competitors. They are also undergoing a major hiring push and switching their workforce towards being fulltime only and phasing out many part time roles. They explained that they believe that fulltime employees will give the company less turnover which will allow them to gain more experience and create a better customer experience.

The creation of a new point of sale system for EZPW is a major initiative for the company. EZPW is developing the new system in-house with a software development team in Austin and has already invested $3 million into the project. This system will use the individual history of each borrower to determine the relative likelihood that the borrower will repay their pawn loan. For individuals who are more likely to pay back the loan, EZPW can give a larger loan and therefore boost the balance upon which they are collecting interest. For those who are less likely to pay back their loans, EZPW can give a smaller loan and thereby lower the cost of their merchandise and boost their gross margin. The point of sale software will provide store staff with a minimum and maximum loan amount for each item used as collateral allowing them to still make adjustments based on their judgement. If well implemented, such a system could give it a significant advantage over other pawn chains.

The company is also doing a major refurbishment of their stores due to significant deferred maintenance. For example, the company mentioned during the annual meeting that one store had pot holes in its parking lot. This reinvestment should improve the experience for customers and borrowers as well as increase the morale of employees.

Blue Tower Asset Management

Charlie Munger once said in response to a question about the power of incentives: ‘I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.’ The incentive structure of any company’s management is important towards understanding their behavior, and this is certainly true for EZCORP.

It’s important to note that several of the senior executives at the company left far larger corporations to work at EZCORP. For example, Stuart Grimshaw, the Executive Chairman, was previously the CEO of the Bank of Queensland, an Australian bank with a market capitalization of $3.5 Billion US Dollars. For them to leave larger companies, they must have seen an opportunity to make more money off of their EZPW equity.
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Arquitos Capital Up 30% CAGR On 5 Year Fund Anniversary

We profiled Steve Kiel in our latest edition and he is killing it yet again. See his Q1 letter below and find the full issue here.

Also see

Arquitos Capital Up 55% In 2016 (28% CAGR) Amid Big

Hedge Fund Interview: Steven Kiel: Arquitos Capital … –


Arquitos Capital Partners returned 17.6% net of fees in the first quarter of 2017. Please see page four for more detailed performance information.

We celebrated the fund’s five year anniversary on April 10. During that time period, we returned 30.9% annually net of fees, beating the S&P 500 by 17.2% per year and the HFRI Index, an index that broadly measures the performance of all hedge funds, by 26.9% per year. Before fees, the fund returned 38.8% annually.

Arquitos provided positive returns in four out of five years and beat the market four out of five years. $100,000 invested at the outset is now worth $384,750. At that pace, your money has doubled every two years and seven months.

Do not expect these astronomical gains to continue. We had a variety of things working in our favor. First, the market was up each year during this time period. The S&P 500 itself performed very well, netting 13.7% per year with dividends reinvested. While I have tried to invest in companies outside of the mainstream, we have still ridden a strong wave.

Second, we are small. Assets under management today are $11 million. They were far smaller when we started and along the way. In the investment world, we are a speck. A brightly burning one, for sure, but still not much more than a piece of dust. Right now and since the launch of the fund, we have had the ability to make an investment in nearly any public company no matter the size. As assets grow, some of those companies will be too small for us to make a meaningful investment. My philosophy and approach will stay the same, but at some point the universe of opportunities will begin to shrink. We are not yet to that point, and may not get there for some time, but it will happen and it will have an effect on returns.

In my first letter to you in 2012 I wrote about the partnership that Warren Buffett ran from 1957 to 1968. He beat the markets by about 16% per year and returned 25.3% per year to investors, with no down years, I might add. We simply will not beat that performance over the lifetime of our fund.

The great thing is that because of the power of compound interest, we only have to do a fraction of our past performance in order to do well in the future. Compounding at 10% per year makes an initial $100,000 investment worth about $673,000 in 20 years and $1.75 million in 30 years. That is a tremendous gain. The keys for compounding are getting started and patience.

When I started the fund I knew we would do well. A fundamental value strategy focused on long term results promised that. It turns out that trying to not lose money gives you a big advantage over the competition. I did not strive for this performance by taking risks. It came from investing in companies that I understood, companies that generally had strong balance sheets and low risk of permanent capital loss, and situations where the markets did not fully recognize attractive aspects of the business. We will continue to do well by taking this approach.

Arquitos Capital Partners 3Q16 Investor Letter; Up 14.6 ..

While I write these letters and provide performance returns each quarter, and you get investor statements monthly, this is far too short of a time period to make any determination of investment skill. Investors get excited or depressed about specific companies at various times. The emotional state of the market is not a reflection of the actual value of a company. That actual value will generally be reflected over time periods much longer than a month, a quarter, or a year. Ignore short term performance and focus on longer time periods. A three to five year time period is a better gauge. A track record over several market cycles is best.
What has led to our success over the first five years?
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Stanphyl Capital March Letter To Investors

February letter from Stanphyl Capital. The hedge fund was profiled in our second edition and returned 31% in 2016. Check out the post and especially the end of the PDF for more on their small cap stocks.

For March 2017 the fund was down approximately 4.9% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 0.1% and the Russell 2000 was also up approximately 0.1%. Year to date the fund is down approximately 5.1% net while the S&P 500 is up approximately 6.1% and the Russell 2000 is up approximately 2.5%. Since inception on June 1, 2011 the fund is up approximately 116.5% net while the S&P 500 is up approximately 99.0% and the Russell 2000 is up approximately 77.4%. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two.

Our shorts really hurt us this month while our longs (collectively) had little impact. Despite this month’s awful performance, for the reasons outlined below I think there’s now much more money to be made on the short side of these markets than on the long side, and thus we remain net short. Here are the specifics…

In March I added substantially to our short position in the Vanguard Total International Bond ETF (ticker: BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 0.78% at an average duration of 7.7 years. As I’ve written since putting on this position in July 2016, I believe this ETF is a great way to short what may be the biggest asset bubble in history, considering that Europe and Japan (which comprise most of its holdings) are printing approximately $124 billion a month (¥6.7 trillion + €60 billion [tapered beginning in April from €80 billion]), yet are long-term insolvent due to their massive liabilities. What will force the bond buying to stop (beyond the April taper)? For Europe I suspect it will be intense pressure from Germany in the face of U.S. tariff threats due to the weak euro or perhaps pressure from German savers, or it could simply be inflation. And when European printing stops (or even tapers), I think asset prices of all types worldwide (including, or perhaps especially, stocks) will correct heavily. (See our Russell 2000 short, below.)

Japan I think can never stop printing (its ratio of debt to GDP is too huge and growing too quickly) but will eventually crash the yen into oblivion (we’ve been short yen since 2012) and with that its bonds will crash too. (I discuss Japan more extensively in the last paragraph of this letter.) The borrow cost for BNDX is less than 2% a year (plus the yield) and as I see around 5% potential downside to this position (vs. our basis,n plus the cost of carry) vs. at least 30% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement.

In March I also added substantially to our short position in the Russell 2000 (via the IWM ETF). I think this is a good hedge for our microcap long positions as well as an outright bet against what I perceive to be a dangerously expensive market, especially in the face of soaring auto loan defaults and a plunge in used vehicle prices that may be both a warning and a cause of a recession. Meanwhile, valuation is far above historical norms, measured by both a current PE of 138 and an EV-to-EBITDA ratio near 18x:

Stanphyl Capital
Stanphyl Capital

Again, I strongly believe that as Europe tapers its printing the liquidity that’s been keeping the equity bubble inflated will dry up and the bubble will burst. I can think of few better ways to profit from that than to be short this obscenely overpriced index.

Stanphyl Capital Letter continues below – skip to end to see small cap discussion

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Stanphyl Capital March Letter To Investors

February letter from Stanphyl Capital. The hedge fund was profiled in our second edition and returned 31% in 2016. Check out the post and especially the end of the PDF for more on their small cap stocks.

For March 2017 the fund was down approximately 4.9% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 0.1% and the Russell 2000 was also up approximately 0.1%. Year to date the fund is down approximately 5.1% net while the S&P 500 is up approximately 6.1% and the Russell 2000 is up approximately 2.5%. Since inception on June 1, 2011 the fund is up approximately 116.5% net while the S&P 500 is up approximately 99.0% and the Russell 2000 is up approximately 77.4%. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two.

Our shorts really hurt us this month while our longs (collectively) had little impact. Despite this month’s awful performance, for the reasons outlined below I think there’s now much more money to be made on the short side of these markets than on the long side, and thus we remain net short. Here are the specifics…

In March I added substantially to our short position in the Vanguard Total International Bond ETF (ticker: BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 0.78% at an average duration of 7.7 years. As I’ve written since putting on this position in July 2016, I believe this ETF is a great way to short what may be the biggest asset bubble in history, considering that Europe and Japan (which comprise most of its holdings) are printing approximately $124 billion a month (¥6.7 trillion + €60 billion [tapered beginning in April from €80 billion]), yet are long-term insolvent due to their massive liabilities. What will force the bond buying to stop (beyond the April taper)? For Europe I suspect it will be intense pressure from Germany in the face of U.S. tariff threats due to the weak euro or perhaps pressure from German savers, or it could simply be inflation. And when European printing stops (or even tapers), I think asset prices of all types worldwide (including, or perhaps especially, stocks) will correct heavily. (See our Russell 2000 short, below.)

Japan I think can never stop printing (its ratio of debt to GDP is too huge and growing too quickly) but will eventually crash the yen into oblivion (we’ve been short yen since 2012) and with that its bonds will crash too. (I discuss Japan more extensively in the last paragraph of this letter.) The borrow cost for BNDX is less than 2% a year (plus the yield) and as I see around 5% potential downside to this position (vs. our basis,n plus the cost of carry) vs. at least 30% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement.

In March I also added substantially to our short position in the Russell 2000 (via the IWM ETF). I think this is a good hedge for our microcap long positions as well as an outright bet against what I perceive to be a dangerously expensive market, especially in the face of soaring auto loan defaults and a plunge in used vehicle prices that may be both a warning and a cause of a recession. Meanwhile, valuation is far above historical norms, measured by both a current PE of 138 and an EV-to-EBITDA ratio near 18x:

Stanphyl Capital
Stanphyl Capital

Again, I strongly believe that as Europe tapers its printing the liquidity that’s been keeping the equity bubble inflated will dry up and the bubble will burst. I can think of few better ways to profit from that than to be short this obscenely overpriced index.

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